Taiyo Hawaii Company, Ltd. v. Commissioner , 108 T.C. 590 ( 1997 )

108 T.C. No. 27UNITED STATES TAX COURT
TAIYO HAWAII COMPANY, LTD., Petitioner v. COMMISSIONER
OF INTERNAL REVENUE, Respondent
Docket No. 10159-95. Filed June 25, 1997.
P, a foreign corporation wholly owned by a foreign
conglomerate, was engaged in real estate activity in
Hawaii. P borrowed funds from foreign banks and also
received advances from its parent and a related foreign
corporation. Interest on bank borrowing was paid, and
interest on advances from related corporations was
accrued and not paid. P reported the interest as
deductible. After an audit examination, respondent
determined that the accrued but unpaid interest was
subject to the excess interest tax provided for in sec.
884, I.R.C. P, although reporting the advances from
related corporations as debt, now claims that they
were, in substance, equity. P also contends that the
accrued and unpaid interest is not deductible due to
sec. 267, I.R.C., and therefore sec. 884 should not
apply. Finally, if it is concluded that sec. 884
applies, P argues that certain of its property did not
qualify as part of the base for computing the excess
interest tax.
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Held: The advances were debt, and P is subject to
the sec. 884 excess interest tax provisions. Held,
further, sec. 884 and regulations interpreted--excess
interest tax provisions apply. Held, further, the
questioned assets are includable in the excess interest
tax computation.
Michael Rosenthal and Thomas E. Busch, for petitioner.
Jonathan J. Ono, for respondent.
GERBER, Judge: For the taxable years ended September 30,
1989, 1990, and 1991,1 respondent determined deficiencies in
petitioner's Federal income taxes in the amounts of $35,529,
$71,692, and $84,331, respectively. Respondent also determined
an $8,433 addition to tax under section 6651(a)(1)2 for 1991.
The issues for our consideration are: (1) Whether
petitioner is liable for excess interest tax under section
884(f)(1)(B) for 1989, 1990, and 1991; (2) if petitioner is
liable for the excess interest tax, whether certain assets should
be included in the taxable base; and (3) whether petitioner is
liable under section 6651(a)(1) for failure to timely file a
return for 1991.
1
All taxable years shown in this opinion, although
expressed simply as years, refer to taxable years ended Sept. 30
of the referenced year.
2
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the period under
consideration. Rule references are to this Court's Rules of
Practice and Procedure.
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FINDINGS OF FACT3
At the time its petition was filed, petitioner, Taiyo Hawaii
Co., Ltd. (Taiyo Hawaii), had its principal place of business in
Honolulu, Hawaii. Petitioner was a Japanese corporation engaged
in real estate activity in Hawaii. Petitioner was incorporated
on October 30, 1985, with its outstanding capital stock held by
Taiyo Fudosan Kogyo Co. (Fudosan), a Japanese corporation.
Pursuant to an October 31, 1985, merger agreement, Fudosan
transferred its Hawaiian assets to petitioner and its Japanese
assets to another related company.
Fudosan and another Japanese corporation were merged into
the Seiyo Corp. (Seiyo), a Japanese corporation, as of January 1,
1986. As part of the merger, Seiyo acquired (and retained
throughout the years in issue) petitioner's issued and
outstanding capital stock. Seiyo was part of the real estate and
tourism group of a Japanese conglomerate, Seibu Saison Group.
On October 1, 1988, petitioner's assets included: Cash;
certain receivables; a condominium in Waikiki, Hawaii; a 50-
percent interest in a Hawaiian partnership, T-3 Wailea Joint
Venture; and certain unimproved real property on the island of
Hawaii. The Hawaiian realty had been held by petitioner since
1986, having been acquired by Fudosan between 1973 and 1980. One
3
The parties’ stipulation of facts and the attached
exhibits are incorporated by this reference.
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portion of the realty was known as the "Ginter Property" and the
other as the "Gomes Property".
Petitioner initially continued Fudosan's lead and sought to
develop the realty. An architect was retained to prepare
development plans that were submitted to the local county
planning commission responsible for land development. Petitioner
proposed that the Ginter property, which was zoned for single-
family residences, be subdivided into 7,500- and 15,000-square-
foot residential lots with houses. Subsequently, petitioner
commissioned a feasibility study concerning development of a 9-
or 18-hole golf course in proximity with the Ginter subdivision.
Petitioner sought to develop the Gomes property into
approximately 300 subdivided residential units and a botanical
garden.
Prior to the taxable years before the Court, petitioner
encountered significant impediments that ultimately proved fatal
to its development plans. On several occasions, the County of
Hawaii proposed the construction of a major highway through the
Ginter property, which would have provided the necessary access
for development. The proposed highway was never constructed.
Also, the Gomes property was located in a flood plain, and
substantial drainage work would have been required prior to
further development. Petitioner determined that the cost
(several millions of dollars) to improve the Ginter and Gomes
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properties was too large to warrant development. Petitioner did
not receive any revenue from either the Gomes or Ginter
properties during the years at issue. Petitioner did not
advertise the properties for sale, and no bona fide purchase
offers were received until 1995.
On May 2, 1995, an unrelated company, Towne Development of
Hawaii, Inc., made an offer to purchase and did eventually
purchase the Ginter and Gomes properties. The purchase price was
to be approximately $3 million. A possible cloud on the title,
however, caused the price to be reduced to $2.4 million.
With respect to the joint venture, T-3 Wailea partnership,
petitioner owned a 50-percent interest and was also the managing
partner. The joint venture owned approximately 600 acres of land
immediately above Wailea, Hawaii. In 1990, petitioner liquidated
its interest in the T-3 Wailea partnership in exchange for a
$5,963,431 distribution, resulting in a $2,450,722 profit.
Sometime in 1990, petitioner acquired a 50-percent interest
in Pines Plaza Associates, a Hawaiian general partnership engaged
in real property construction. Petitioner utilized certain
portions of advances from Seiyo and Taiyo Development Co. (Taiyo
Development) to develop the Pines Plaza project.
Petitioner obtained financing from unrelated financial
institutions including Mitsubishi Trust & Banking (Mitsubishi
Trust), Bank of Tokyo, and Dai-Ichi Bank in order to conduct its
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real property business activity in Hawaii. Petitioner also
received advances from its parent corporation, Seiyo, as well as
another related company, Taiyo Development, a Japanese
corporation. The advances received from Seiyo and Taiyo
Development were reflected on petitioner's books, records, and
tax returns as payables to affiliates. These advances were
utilized for working capital to develop projects, to pay
outstanding debts owed to financial institutions, and to exploit,
maintain, and hold the Ginter and Gomes properties.
During the taxable year 1988, Taiyo Development made
advances to petitioner which were not evidenced by promissory
notes or other written instruments. Although the records in
which the 1988 advances were shown did not expressly reflect a
stated rate of interest, Seiyo had instructed petitioner to
accrue interest at a certain rate on its books.
At the end of the 1988, 1989, 1990, and 1991 fiscal years,
petitioner had outstanding bank loans with third-party banks, in
the aggregate amounts of $12,722,465, $15,440,132, $13,479,595,
and $5,548,809, respectively. During the period under
consideration, petitioner paid down several of the loans due to
third-party banks. The loans were evidenced by promissory notes
executed by petitioner.
During the taxable years 1989, 1990, and 1991, Seiyo and
Taiyo Development advanced the following amounts to petitioner:
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Year Seiyo Taiyo Development
1989 $5,000,000 $3,604,746
1990 191,755 ---
1991 2,194,378 ---
The advances were not evidenced by promissory notes, had no fixed
maturity date, and were unsecured. The advances were not repaid
during the years in issue. During the years 1993 and 1994,
petitioner repaid approximately $5 million and $400,000 of the
related party debt, respectively. There was no stated rate of
interest, and no interest was paid by petitioner on the advances.
Seiyo and Taiyo Development did not demand payment or take legal
action against petitioner regarding the advances.
At the end of the 1990 and 1991 fiscal years, petitioner's
outstanding liabilities (including advances from Seiyo and Taiyo
Development, bank indebtedness, and miscellaneous liabilities)
and the tax basis of its assets were as follows:
Fiscal
Year Ended Outstanding Total Tax Basis
Sept. 30 Liabilities of Assets
1990 $27,680,245 $20,858,967
1991 21,955,602 16,907,976
As of September 30, 1995, the outstanding advances (including
principal and accrued interest) totaled $23,875,036.82.
On its Federal income tax returns, petitioner generally
reported that it was engaged in real estate development and
property investment and real estate investment and development.
On its 1989, 1990, and 1991 tax returns, petitioner reported
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"Land Development Costs" of $13,800,857, $13,830,400, and
$11,481,780, respectively.
Petitioner, on originally filed returns, claimed the
following amounts of interest as deductions related to its
effectively connected income (ECI) from the conduct of a trade or
business in the United States:
Fiscal Year
Ended Interest Deducted
9/30/89 $887,324
9/30/90 1,837,751
9/30/91 1,346,795
On its original income tax returns for the taxable years
1989 through 1991, petitioner reported that it had no excess
interest tax liability by means of the following reported
information:
Fiscal Year
Ended Excess Interest Computed
9/30/89 Designated as N/A
9/30/90 $1,837,751 - $1,837,751 = None
9/30/91 $1,346,795 - $1,346,795 = None
Petitioner, for the years 1989 through 1991, withheld and
paid tax to respondent in an amount equivalent to 10 percent of
the interest paid to third-party foreign banks (Mitsubishi Trust
and Bank of Tokyo), in accordance with the applicable 10-percent
withholding rate under the United States-Japan Income Tax Treaty
(the treaty) as follows:
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Fiscal Year
Ended
Sept. 30 Interest Paid Tax Withheld
1989 $838,037.66 $83,803.77
1990 1,451,660.54 145,166.06
1991 941,821.13 94,182.11
On or about June 14, 1995, petitioner filed amended 1989,
1990, and 1991 Federal income tax returns. On the amended
returns, petitioner claimed deductions for interest expense
related to its ECI from the conduct of a trade or business in the
United States, as follows:
Fiscal Year
Ended
Sept. 30 Interest Deducted
1989 $834,750
1990 1,307,734
1991 1,348,414
On amended returns, petitioner reported the sum of its
assets and liabilities, as follows:
Fiscal Year
Ended Net Liabilities
Sept. 30 Over Assets1
1989 ($8,211,833)
1990 (8,917,909)
1991 (7,143,782)
1
These amounts were derived from Schedule L of petitioner's
amended Federal income tax returns.
Petitioner's amended returns for 1989, 1990, and 1991, reflected
its net income or loss (prior to the deduction for interest
expense) and gain or loss on its ECI, without considering net
operating loss deductions, as follows:
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Fiscal Net Income or
Year Ended (Loss) Prior to Gain or (Loss)
Sept. 30 Interest Deduction1 on ECI
1989 ($5,088,223) ($5,922,973)
1990 1,201,048 (106,686)
1991 4,025,081 2,676,667
1
Petitioner, on its first and second amended 1989 returns,
reported the same net loss, prior to the deduction for interest
expense, as had been reported on its original 1989 return.
In connection with the amended returns, petitioner filed a
statement entitled "Elections under Treasury Regulation Section
1.884-1(i) and 1.884-4(e)" seeking to reduce its liabilities and
interest expenses, as follows:
Fiscal Year Interest
Ended Liability Reduction Expense Reduction
9/30/89 $8,585,294 $355,292
9/30/90 10,669,677 716,924
9/30/91 8,447,873 843,312
Precipitated by respondent's audit examination, petitioner's
accountant, Kent K. Tsukamoto (Tsukamoto), a certified public
accountant, requested that the Seiyo office in Japan provide
copies of promissory notes for the 1988 through 1991 advances.
The employees of Seiyo initially did not understand why Tsukamoto
requested copies of promissory notes evidencing the advances as
loans. Ultimately, Tsukamoto received a Japanese language
document from Seiyo along with an English translation, entitled
"Confirmation/Acknowledgment". The document was dated June 2,
1993, and signed by the presidents of Seiyo and petitioner. It
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reflects petitioner as the borrower and Seiyo as the lender, as
follows:
Loan Loan Amount Interest
Date (Yen) Rate Conditions
7/31/86 50,000,000 Short-term prime Payment of principal is
rate of payment the priority
8/30/86 52,000,000 Short-term prime Payment of principal is
rate of payment the priority
11/29/86 20,000,000 Short-term prime Payment of principal is
rate of payment the priority
12/31/86 13,000,000 Short-term prime Payment of principal is
rate of payment the priority
3/31/87 32,000,000 Short-term prime Payment of principal is
rate of payment the priority
6/30/87 30,000,000 Short-term prime Payment of principal is
rate of payment the priority
9/30/87 29,000,000 Short-term prime Payment of principal is
rate of payment the priority
12/31/87 27,000,000 Short-term prime Payment of principal is
rate of payment the priority
3/31/88 158,000,000 Short-term prime Payment of principal is
rate of payment the priority
6/30/88 28,000,000 Short-term prime Payment of principal is
rate of payment the priority
9/30/88 27,000,000 Short-term prime Payment of principal is
rate of payment the priority
12/31/88 27,000,000 Short-term prime Payment of principal is
rate of payment the priority
3/31/89 28,000,000 Short-term prime Payment of principal is
rate of payment the priority
5/31/89 400,000,000 Short-term prime Payment of principal is
rate of payment the priority
6/30/89 31,000,000 Short-term prime Payment of principal is
rate of payment the priority
9/29/89 21,000,000 Short-term prime Payment of principal is
rate of payment the priority
Tsukamoto was not aware of some of the advances listed in the
aforementioned document. No copies of individual promissory
notes evidencing the advances were received.
On September 30, 1995, petitioner's balance sheet reflected
an outstanding loan of $18,018,708.85, as well as accrued
interest of $5,856,327.97, shown as payable to Seiyo. Patrick
Kubota (Kubota), petitioner's treasurer and project manager from
1986 through 1994, was responsible for petitioner's accounting
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and financial records. Kubota was one of four individuals who
operated and managed petitioner. He worked with Michio Ito, a
representative of Seiyo who supervised petitioner's Hawaiian
operation. Seiyo, through Ito, instructed Kubota with regard to
the advances, to accrue certain interest amounts on petitioner's
books and records.
Kubota had difficulty differentiating petitioner's real
estate development from its real estate investment activity.
Overall, Kubota believed that petitioner would not have had
sufficient funds to pay its bank debt and develop its properties,
as well as maintain and hold the Ginter and Gomes properties, if
it had not obtained the advances from Seiyo. Kubota also
believed that petitioner was willing, at any point, to sell the
Ginter and Gomes properties provided that a bona fide offer was
received. Kubota thought that the advances from Seiyo and Taiyo
Development to petitioner were not considered a priority item for
repayment.
Petitioner's accountant, Tsukamoto, included the advances
from Seiyo and Taiyo Development as liabilities on Schedule L of
petitioner's Federal income tax returns. In Tsukamoto's
professional judgment petitioner did not have the financial
ability to pay interest and amortize principal on the advances.
The advances to petitioner from Seiyo and Taiyo Development
enabled it to make payments on principal and interest to third-
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party banks. Without the advances, petitioner would not have
been able to conduct its real estate development activities as
well as maintaining and holding the Ginter and Gomes properties
from 1988 through 1991.
Petitioner did not elect under section 882(d) to treat any
of its income from real estate activity as effectively connected
with a U.S. trade or business.
OPINION
The primary controversy concerns whether petitioner is
liable for the excess interest tax pursuant to section
884(f)(1)(B).4 Section 884, here considered by this Court for
the first time, was enacted to create parity between foreign
corporations that choose to operate in branch form and those that
choose to operate through a domestic subsidiary in the United
States.5 See H. Conf. Rept. 99-841 (Vol. II), at II-646 to II-
647 (1986), 1986-3 C.B. (Vol. 4) 1, 647-648; Staff of Joint Comm.
4
This subsection is part of the statutory provisions
referred to as the branch tax regime.
5
Although included in subsec. (f) of sec. 884, the branch
tax regime is a self-contained group of provisions intended to
achieve parity between branch operations and domestic
subsidiaries of foreign corporations. The application of these
provisions is complicated due to their complexity, lack of
specific definitions, and reliance on Internal Revenue Code
concepts that do not necessarily comport with the sec. 884
structure. Artificial bases are used to reach parity, and
certain distinctions made in other portions of income taxation
are ignored for purposes of the branch tax laws. These
attributes have made our analysis more difficult.
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on Taxation, General Explanation of the Tax Reform Act of 1986,
at 1037 (J. Comm. Print 1987). To achieve that result, three
distinct taxes may be imposed.6 Section 884(a) imposes a tax on
earnings of a U.S. trade or business deemed to be repatriated by
a foreign corporation. Section 884(f)(1)(A) treats certain
interest paid by the U.S. trade or business of a foreign
corporation (referred to as branch interest) as if it were paid
by a domestic corporation. This is accomplished by subjecting
the interest to withholding under sections 881(a) and 1442, as if
it were U.S.-source income paid to a foreign person or entity.
Finally, section 884(f)(1)(B) imposes a tax on excess interest to
the extent the interest deduction allocable to the U.S. trade or
business in computing its taxable ECI (as provided for in section
1.882-5, Income Tax Regs.) exceeds the branch interest of section
884(f)(1)(A). The excess interest is treated as if it were paid
to the foreign corporation by a wholly owned domestic corporation
6
The three taxes to achieve parity are in addition to any
tax under sec. 882(a) on income of a foreign corporation engaged
in a trade or business within the United States that is
effectively connected with the conduct of the trade or business
in the United States.
"Effectively connected income" (ECI) is a term of art
defined in sec. 864(c). ECI includes certain types of foreign
source income earned by a foreign corporation. Sec. 882 allows
certain deductions and credits for ECI, and the net income is
subject to tax.
Conversely, income that is not effectively connected with
the conduct of a trade or business in the United States is
subject to U.S. taxation at a flat rate of 30 percent unless a
different amount is provided for in an income tax treaty. Sec.
881.
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on the last day of the foreign corporation's taxable year and
subject to tax under section 881(a) (the excess interest tax).
The controversy here concerns the excess interest provisions.
The excess interest tax ties in with the withholding
provisions of section 884(f)(1)(A). The withholding on interest
paid to foreign persons or entities is a means of collecting tax
on the interest recipient, whereas the excess interest tax of
section 884(f)(1)(B) is imposed on the foreign branch payor. The
interest deduction allocable to the branch is determined by a
formula provided in section 1.882-5, Income Tax Regs., and is an
apportionable amount of ECI, which is used as the base. The
amount of interest deductible for purposes of the branch tax law
is therefore derived in a theoretical fashion7 to complete the
statutory configuration designed to achieve parity between a
foreign branch and a domestic subsidiary of a foreign parent.
Here, petitioner, a Japanese corporation wholly owned by
another Japanese corporation, obtained funding from unrelated
banks and also from related corporations (its parent and another
related corporation). Petitioner paid interest on the loans from
unrelated banks. Also, petitioner accrued interest without
making any payments on the funds obtained from the affiliated
7
The amount derived is not necessarily equivalent to the
amount of interest actually paid or accrued. Instead, the
deductible amount of interest pursuant to sec. 1.882-5, Income
Tax Regs., is an amount prescribed to achieve parity.
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companies. On its Forms 1120F, U.S. Income Tax Return of a
Foreign Corporation, petitioner reported interest paid by a U.S.
trade or business (branch interest) under section 884(f)(1)(A) to
include the accrued amounts in connection with the funding from
related foreign sources. Petitioner did not withhold any amount
under sections 884(f)(1)(A) and 1442 with respect to the accrued
interest but did withhold with respect to the interest paid to
the unrelated banks. Respondent, following the audit examination
of petitioner, determined that the accrued interest to related
entities did not qualify as branch interest and, instead,
constituted excess interest within the meaning of section
884(f)(1)(B).
After respondent determined that there was an excess
interest tax liability, petitioner attempted to fashion a
solution for relief that would also avoid any additional tax to
petitioner or its parent. The branch tax law contains various
provisions designed to permit alternatives to the tax under
section 884 and to enable a taxpayer to choose which provision of
that section applies. The "relief" provisions include elections
that, for example, would permit shifting the tax burden from
section 884 to section 882(e) as ECI or from excess interest tax
to branch interest withholding (section 884(f)(1)(B) to (A)).
None of the approaches provide the tax relief that petitioner
seeks. Petitioner has also proposed several alternative
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approaches under which it is seeking both to avoid the excess
interest tax under section 884(f)(1)(B) and, in the process, to
avoid bearing the tax burden of another provision of the branch
profit tax regime.
In that connection, petitioner did not make an election
under section 1.884-4T(b)(7), Temporary Income Tax Regs.
(finalized in 1992 as sec. 1.884-4(c)(1), Income Tax Regs.), 53
Fed. Reg. 34054 (Sept. 2, 1988), to treat the accrued interest as
paid in the year of accrual, thereby relieving itself of the
potential for excess interest tax liability.8 The election by a
foreign corporation must be made with its income tax return, its
amended income tax return, or a separate written notice to the
Commissioner of Internal Revenue, none of which was done in this
case. See sec. 1.884-4T(b)(7)(iii), Temporary Income Tax Regs.,
supra (finalized as sec. 1.884-4(c)(1)(iii), Income Tax Regs.).
After respondent's audit began, petitioner filed amended
Forms 1120F for the years under consideration seeking to
eliminate any excess interest by attempting an election to reduce
the affected liabilities under section 1.884-1(e)(3), Income Tax
Regs. Finally, after filing the petition in this case,
8
If petitioner had made that election, it would have been
binding for all years, and petitioner would then have been
subject to a 10-percent withholding obligation under art. 13 of
the U.S.-Japan Income Tax Treaty (the treaty). Convention for
the Avoidance of Double Taxation, Mar. 8, 1971, U.S.-Japan, art.
13, 23 U.S.T. (Part I) 967, 990. Under the treaty, the
withholding under sec. 1442 is reduced from 30 to 10 percent.
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petitioner posed two additional alternative arguments in support
of its allegation that respondent's excess interest tax
determination is in error. Petitioner contends that the advances
from related entities were equity rather than debt and, as a
second alternative, that section 267(a)(3) prevents the
application of the excess interest tax because the deduction for
its interest obligations to the related entities is prohibited.
If we do not accept petitioner's primary arguments, petitioner
also argues that: (1) Generally, the excess interest tax
violates the nondiscrimination clause of the treaty, and/or (2)
certain properties held by petitioner were not U.S. trade or
business assets for purposes of calculating the excess interest
tax.
Debt vs. Equity--We first address petitioner's contention
that the advances in question were equity rather than debt.
Petitioner, taking the position ordinarily advanced by
respondent, argues that there is no deductible interest based on
statutory (section 385) and case law concerning the debt versus
equity issue. If the advances are not debt for Federal income
tax purposes, as petitioner contends, there could be no
deductible interest expense on the advances and no liability for
the excess interest tax imposed by section 884(f)(1)(B).
Conversely, respondent argues that the debt versus equity issue
should be decided in favor of debt, rather than equity.
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Respondent, however, raises the threshold question of whether
petitioner should be allowed to disavow the form of the
transaction, which was cast as debt. In this regard, respondent
agrees that if we find the advances were equity (and not debt),
the matter would be resolved in petitioner's favor. Petitioner
bears the burden of proof. Rule 142(a); Welch v. Helvering, 290
U.S. 111 (1933). If we find that the transaction was cast as
debt, then it would be more difficult for petitioner to disavow
the form and successfully show that the advances were equity in
substance.
Respondent contends that, prior to the audit, petitioner
treated the advances for financial purposes and tax reporting as
loans or debt. Petitioner counters that, irrespective of the
labels originally attached to the advances, they were, in
substance, capital contributions. Petitioner argues that it is
entitled to disavow the form of its transaction.9
Taxpayers are free to structure their transactions in a
manner that will result in their owing the least amount of tax
possible. However, the Supreme Court observed in Commissioner v.
9
In support of its argument, petitioner, cites J.A. Tobin
Constr. Co. v. Commissioner, 85 T.C. 1005 (1985); Georgia-Pac.
Corp. v. Commissioner, 63 T.C. 790 (1975); J.A. Maurer, Inc. v.
Commissioner, 30 T.C. 1273 (1958); LDS, Inc. v. Commissioner,
T.C. Memo. 1986-293; Inductotherm Indus., Inc. v. Commissioner,
T.C. Memo. 1984-281, affd. without published opinion 770 F.2d
1071 (3d Cir. 1985).
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National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149
(1974):
that, while a taxpayer is free to organize his affairs
as he chooses, nevertheless, once having done so he
must accept the tax consequences of his choice, whether
contemplated or not, * * * and may not enjoy the
benefit of some other route he might have chosen to
follow but did not. [Citations omitted.]
See also Television Indus., Inc. v. Commissioner, 284 F.2d 322,
325 (2d Cir. 1960), affg. 32 T.C. 1297 (1959).
Taxpayers have, however, been permitted to assert substance
over form in situations where their “tax reporting and other
actions have shown an honest and consistent respect for * * * the
substance of * * * [a transaction]". FNMA v. Commissioner, 90
T.C. 405, 426 (1988) (citing Illinois Power Co. v. Commissioner,
87 T.C. 1417, 1430 (1986)), affd. 896 F.2d 580 (D.C. Cir. 1990).
Petitioner has, for all purposes, treated the advances as
loans and was instructed by its parent corporation to accrue
interest. Under those circumstances, we reject petitioner's
approach of testing its own choice of form with traditional debt
versus equity considerations, such as the absence of a fixed
payment schedule, maturity dates, enforcement, or formal debt
instruments.10 We are likewise unpersuaded by petitioner's
10
Petitioner, for example, relies on the following line of
cases. Hardman v. United States, 827 F.2d 1409 (9th Cir. 1987);
Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968);
Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980); Nestle
Holdings, Inc. v. Commissioner, T.C. Memo. 1995-441; Green Leaf
(continued...)
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accountant's (Tsukamoto's) after-the-fact testimony that, in
retrospect, he should have considered the advances as equity and
reported them as such on petitioner's tax returns.
Petitioner's approach does not show that the substance of
the advances was not loans. It merely illustrates that the
parties to the transactions did not follow all of the formalities
that might be considered probative that the advances were debt
rather than equity. In that regard, petitioner has not shown
that the form of the transaction did not comport with its
substance. We must take into consideration here the fact that
both petitioner and its parent were corporations formed under the
laws of Japan and that they are foreign entities conducting
business in the United States. Additionally, when the "home
office" (foreign parent corporation's office) was asked for
evidence of the indebtedness, it provided a foreign language
document, which was translated to reflect the title
"Confirmation/Acknowledgment" and contained a list of advances
and dates made. With respect to each advance, the document
indicates that "Payment of principal is the priority" and that
the rate of payment is "Short-term prime". These descriptive
terms are indicative of debt and interest rather than equity or
capital.
10
(...continued)
Ventures, Inc. v. Commissioner, T.C. Memo. 1995-155.
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Accordingly, we hold that petitioner has not carried its
burden of showing that the substance of the transaction was
different from its form. Elrod v. Commissioner, 87 T.C. 1046,
1066 (1986); Pritchett v. Commissioner, 63 T.C. 149, 171 (1974)
(citing Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959),
affg. 29 T.C. 129 (1957)); Estate of Durkin v. Commissioner, T.C.
Memo. 1992-325, supplemented by 99 T.C. 561, 572 (1992); see also
Estate of Corbett v. Commissioner, T.C. Memo. 1996-255.
Consistent with our holding, the Court of Appeals for the
Ninth Circuit (the circuit in which this case would be
appealable) has held, in certain instances, that taxpayers may
not cast a transaction in one form, file returns consistent with
that form, and then argue for an alternative tax treatment after
their returns are audited. See Investors Ins. Agency, Inc. v.
Commissioner, 677 F.2d 1328, 1330 (9th Cir. 1982), affg. 72 T.C.
1027 (1979); McManus v. Commissioner, 583 F.2d 443, 447 (9th Cir.
1978) ("A taxpayer is estopped from later denying the status he
claimed on his tax returns."), affg. 65 T.C. 197 (1975);
Parkside, Inc. v. Commissioner, 571 F.2d 1092 (9th Cir. 1977),
revg. T.C. Memo. 1975-14; In re Steen, 509 F.2d 1398, 1402-1403
n.4 (9th Cir. 1975); Demirjian v. Commissioner, 457 F.2d 1, 5
n.19 (3d Cir. 1972), affg. 54 T.C. 1691 (1970).
In its tax and financial reporting and other actions,
petitioner has not demonstrated an honest and consistent respect
- 23 -
for what it now contends was the substance of the transaction.
Comdisco, Inc. v. United States, 756 F.2d 569, 578 (7th Cir.
1985); Estate of Weinert v. Commissioner, 294 F.2d 750, 755 (5th
Cir. 1961), revg. and remanding 31 T.C. 918 (1959); FNMA v.
Commissioner, supra at 426.
Having decided that petitioner is bound by the form of the
transaction and that, for purposes of section 884, the advances
in issue were debt as opposed to equity, we now consider
petitioner's alternate arguments. Because the accrued interest
has not been paid to the related party, petitioner contends that
section 267 prevents its deduction. Petitioner argues that
interest must be deductible for the excess interest tax to apply.
Petitioner's Proposed Deductibility Requirement--Section
267(a)(2) generally limits the deductibility of interest by the
payor until it is included in the related payee's gross income.
Section 267(a)(3) empowers the Secretary to promulgate
regulations to apply the matching provisions of section 267(a)(2)
to include instances where the payee is a foreign person
(entity). In particular, petitioner relies on section 1.267(a)-
3(b)(1), Income Tax Regs.11 Petitioner argues that section
11
Petitioner acknowledges and we note that the regulation
relied upon was published Dec. 31, 1992, in T.D. 8465, 1993-1
C.B. 28, a date subsequent to the years under consideration.
Petitioner, however, points out that the Commissioner had
published the essence of that interpretation in Notice 89-84,
1989-2 C.B. 402, for taxable years beginning after Dec. 31, 1983.
- 24 -
884(f)(1)(B) does not authorize the deduction of interest; it
merely provides the extent to which interest is allowable as a
deduction in the section 882 computation of ECI. Petitioner
theorizes that we must look to section 163 for the deduction, and
in turn, the section 267 limitations would then apply.
Respondent does not comment about or analyze whether
petitioner's section 267 argument is correct.12 Instead,
respondent argues that petitioner's proposed deductibility
requirement is irrelevant because section 884 applies even if the
interest is not deductible.
The excess interest tax statutory language, in its present
form, does not support petitioner's position that deductibility
of interest on debt to related creditors is a prerequisite to the
application of the excess interest tax. Section 884(f)(1), as
enacted in the Tax Reform Act of 1986, Pub. L. 99-514, sec. 1241,
100 Stat. 2085, 2579, and amended by the Small Business Job
Protection Act of 1996 (1996 Act), Pub. L. 104-188, sec.
1704(f)(3), 110 Stat. 1755, 1879, provides:
SEC. 884(f). Treatment of Interest Allocable to
Effectively Connected Income.--
(1) In general.--In the case of a foreign corporation
engaged in a trade or business in the United States (or
12
We do not decide here whether sec. 267 is applicable
under the circumstances found in this case. Due to our ultimate
conclusion, it is unnecessary to decide which, if any, limitation
may have existed with regard to the deductibility of the interest
in question.
- 25 -
having gross income treated as effectively connected
with the conduct of a trade or business in the United
States), for purposes of this subtitle--
(A) any interest paid by such trade or business in
the United States shall be treated as if it were
paid by a domestic corporation, and
(B) to the extent the amount of interest allowable
as a deduction under section 882 in computing the
effectively connected taxable income of such
foreign corporation exceeds the interest described
in subparagraph (A)to the extent that the
allocable interest exceeds the interest described
in subparagraph (A), such foreign corporation
shall be liable for tax under section 881(a) in
the same manner as if such excess were interest
paid to such foreign corporation by a wholly owned
domestic corporation on the last day of such
foreign corporation's taxable year.
To the extent provided by regulations, subparagraph (A)
shall not apply to interest in excess of the amounts
reasonably expected to be allocable interest.
reasonably expected to be deductible under section 882
in computing the effectively connected taxable income
of such foreign corporation. [Emphasized language added
and stricken language removed by the 1996 Act,
effective retroactively to all tax years beginning
after Dec. 31, 1986.]
On the basis of the stricken portions of the above-quoted
statutory language, petitioner argues that the interest had to be
deductible before the excess interest tax could apply.13 The
above-emphasized retroactive amendments effective for the taxable
years in controversy, however, obviate any ambiguity that may
have existed in the language that has been retroactively stricken
13
Most unfortuitously for petitioner, the statute in
question was retroactively amended subsequent to the trial of
this matter and during the briefing pattern of the parties.
- 26 -
from the 1986 statutory version. See 1996 Act sec.
1704(f)(3)(A)(iii), 110 Stat. 1879, amending section 884(f)
retroactively for tax year beginning after December 31, 1986.
The report of the House Ways and Means Committee
accompanying the 1996 Act makes it clear that the retroactive
amendments were intended to address an argument similar to that
made by petitioner in this case. In explaining the provision,
the report contains the statement that
The bill provides that the branch level interest
tax on interest not actually paid by the branch applies
to any interest which is allocable to income which is
effectively connected with the conduct of a trade or
business in the United States. * * * [H. Rept. 104-
586, at 174 (1996).14]
By way of comparison the House report also states, regarding the
withholding of tax from payments by a U.S. subsidiary to its
foreign parent, that
14
The Small Business Job Protection Act of 1996 (1996
Act), Pub. L. 104-188, 110 Stat. 1755, was intended to clarify
rather than change the branch profit tax provision. Even in the
context of sec. 884 as enacted by the Tax Reform Act of 1986 (TRA
'86), Pub. L. 99-514, 100 Stat. 2085, and prior to amendment by
the 1996 Act, we think that petitioner's argument would not be
persuasive. The House conference report in connection with the
TRA '86 clearly undermines petitioner's position by demarcating
between interest allocated to a foreign corporation's U.S. branch
under sec. 1.882-5, Income Tax Regs., and interest "actually
paid" by the branch. See H. Conf. Rept. 99-841 (Vol. II), at II-
646 (1986), 1986-3 C.B. (Vol. 4) 1, 646-649. In addition, the
General Explanation of TRA '86 appears to be consistent with
respondent's interpretation of the applicability of the excess
interest tax. See Staff of Joint Comm. on Taxation, General
Explanation of the Tax Reform Act of 1986, at 1037 (J. Comm.
Print 1987).
- 27 -
In the case of a U.S. subsidiary of a foreign parent
corporation, the withholding tax applies without regard
to whether the interest payment is currently deductible
by the U.S. subsidiary. For example, deductions for
interest may be delayed or denied under section 163,
263, 263A, 266, 267, or 469, but it is still subject
(or not subject) to withholding when paid without
regard to the operation of those provisions.
* * * * * * *
These provisions are effective as if they were
made by the Tax Reform Act of 1986. [Id. at 173-174.]
We are persuaded that in enacting and retroactively amending
section 884, Congress did not intend to allow the principles of
section 267 to preempt the parity between U.S. branches and
subsidiaries of foreign corporations that the excess interest tax
was designed and intended to accomplish.
Accordingly, we hold that interest expense allocable to the
ECI of a branch of a foreign corporation is taken into account
for purposes of section 884(f)(1)(B) even if the interest is
rendered nondeductible by section 267. We reject petitioner's
contention that the deductibility of the interest is a
prerequisite for inclusion in the calculation of a foreign
corporation's excess interest tax liability under section
884(f)(1)(B), and we find that petitioner is subject to the
excess interest tax provisions.15
15
Our conclusion is further reinforced by commentators
who, generally, have supported the proposition that the actual
deductibility is not a prerequisite for the application of the
excess interest tax. See Blessing & Markwardt, 909-2d Tax
(continued...)
- 28 -
Petitioner's Untimely Treaty Discrimination Argument--
Alternatively, if we find the excess interest provisions
applicable, then petitioner argues that section 884(f)(1)(B)
violates article VII (Nondiscrimination) of the treaty. The
antidiscrimination argument was raised for the first time in
petitioner's reply brief (the final brief in a seriatim briefing
pattern), following respondent's answering and petitioner's
opening briefs. Although petitioner fashions its argument as
though it were in response to respondent's arguments made on
brief, we find that this position or argument was, to the Court's
knowledge, not raised by petitioner prior to trial, and it was
not raised during trial or in petitioner's opening brief. Thus,
respondent was not afforded an opportunity to address
petitioner's position. Petitioner points out that the
Commissioner, in Notice 89-80, 1989-2 C.B. 394, articulated the
position that the excess interest tax provisions do not violate
nondiscrimination provisions of several income tax treaties,
including the one with Japan, to which the United States is a
party. We find petitioner's attempt to raise this argument to be
untimely.16
15
(...continued)
Management, Branch Profits Tax A-33 (1994).
16
Petitioner made the generalized argument that, as a
Japanese corporation, it would be treated "less favorably"
because it is "subject to more burdensome taxes" than a similarly
(continued...)
- 29 -
Are the Ginter and Gomes Properties To Be Included in the
Computation of the Excess Interest Tax?--Next, petitioner
contends that the related-party debt and resulting interest
connected with the Ginter and Gomes properties should not be
included in the base used to compute the excess interest tax.
Petitioner's argument concerns the computation of the excess
interest tax provided by section 884(f)(1)(B). Under those
provisions, excess interest is computed by subtracting interest
paid by the U.S. branch (branch interest) from the amount of
interest allocable to ECI under section 1.882-5, Income Tax Regs.
Section 1.882-5, Income Tax Regs., provides a three-step process
for determining the amount of interest allocable to ECI. The
first step determines which assets are U.S. connected by
ascertaining which assets generate ECI from the conduct of a
trade or business in the United States. Sec. 1.882-5(b)(1),
16
(...continued)
situated domestic corporation. In addition, petitioner contends
that sec. 1.884-1(e)(3), Income Tax Regs., violates the
nondiscrimination clause. Petitioner has not made any specific
arguments showing any particular discrimination. For example,
petitioner has not shown or argued that there was no income
against which "excess interest" could be applied or that the tax
on excess interest exceeds petitioner's potential tax benefit
from ECI. Petitioner, using the discrimination argument as a
stalking horse, contends that by providing a taxpayer with the
ability to reduce its U.S.-connected liabilities under sec.
1.884-1(e)(3), Income Tax Regs., without any limitation, there
would be no conflict with the nondiscrimination clause herein.
In general terms, petitioner's loosely formulated discrimination
argument is contrary to the purposes underlying sec. 884 and
without specificity or support.
- 30 -
Income Tax Regs. In the second step, the amount of U.S.-
connected liabilities is determined based on a "fixed" or
"actual" ratio. The latter is the ratio of the foreign
corporation's worldwide liabilities to its worldwide assets.
Sec. 1.882-5(b)(2), Income Tax Regs. In the third step, the
U.S.-connected liabilities are multiplied by an appropriate
interest rate to arrive at the interest expense allocable to
ECI.17 Sec. 1.882-5(b)(3), Income Tax Regs. The branch interest
is subtracted from the interest so allocable to ECI to determine
the excess interest. The parties disagree over the application
of the three-step process; in particular, whether the Ginter and
Gomes properties are step 1 assets (assets that produce income
effectively connected with the conduct of a U.S. trade or
business).
17
Sec. 1.882-5(b), Income Tax Regs., was amended for
taxable years beginning on or after June 6, 1996. Amended sec.
1.882-5(b)(1), Income Tax Regs., retains the three-step process
for allocation of interest expense to ECI but relies on sec.
1.884-1(d), Income Tax Regs., for the definition of a step 1
"U.S. asset". Sec. 1.884-1(d)(1), Income Tax Regs., provides
that an asset is a U.S. asset if "All income produced by the
asset on the determination date is ECI * * * and * * * All gain
from the disposition of the asset would be ECI if the asset were
disposed of on * * * [the determination date] and the disposition
produced gain." As an example of real property which is not
connected to a U.S. business, the regulation describes a U.S.
condominium apartment owned by the foreign corporation which
would not produce ECI if sold. See sec. 1.884-1(d)(2)(xi),
Example (3), Income Tax Regs.
- 31 -
In connection with the resolution of the "step 1
controversy", we also address the validity and effect of
petitioner's attempted retroactive liability election under
section 1.884-1(e)(3), Income Tax Regs. Section 1.884-1(e)(3),
Income Tax Regs., provides an election under which a foreign
corporation may reduce its U.S.-connected liabilities. The
effect of the election is to decrease the amount of interest
expense allocated to ECI and, consequently, decrease the amount
of excess interest.18
On its original returns, petitioner computed the interest
allocable to ECI based on all assets, including the Ginter and
Gomes properties, as "step 1 assets". In step 2, petitioner's
U.S.-connected liabilities were reported as equal to its
worldwide liabilities. Finally, in step 3, petitioner treated
all of its worldwide liabilities, including the advances from its
parent and another related corporation, as shown on the books of
its U.S. trade or business. On the original returns,
18
Sec. 1.884-1(e)(3), Income Tax Regs., containing the
election for reducing the amount of excess interest, was
promulgated in 1992, after the years in issue but before
petitioner filed amended returns for those years. The temporary
regulations under sec. 884 that existed during the years in issue
did not provide for a similar election. Respondent does not
argue that petitioner should not be permitted to retroactively
apply the regulatory election to the years in issue. Treating
this as a concession by respondent for purposes of this case, we
do not make any decision regarding the validity of retroactive
application of the sec. 1.884-4(e), Income Tax Regs., election to
years prior to the year in which the regulation was promulgated.
- 32 -
petitioner's interest expense allocable to ECI equaled all of its
interest, including the amounts paid to third-party banks and the
amounts accrued in connection with the advances from related
parties.
After respondent began the audit and raised the excess
interest tax issue, petitioner, in an attempt to eliminate any
excess interest tax liability, filed amended returns attempting
to elect to reduce its liabilities under section 1.884-1(e)(3),
Income Tax Regs. In this regard, respondent points out that a
foreign corporation may elect to reduce its U.S. liabilities by
an amount that does not exceed the excess of U.S.-connected
liabilities (determined under section 1.882-5, Income Tax Regs.)
over the liabilities "shown on the books of the U.S. trade or
business" (determined under either sec. 1.882-5(b)(3)(i) or
(ii)). Respondent concedes that prior to the 1996 amendment,
generally, section 1.882-5, Income Tax Regs., does not define
with particularity the meaning of U.S.-connected liabilities that
are "shown on the books".
With this background, respondent argues that petitioner's
attempted election has no effect because the liabilities shown on
the books of its U.S. trade or business equaled its U.S.-
connected liabilities. In other words, respondent contends that
petitioner must have some liabilities that were not shown on the
books of a U.S. trade or business in order to make the election,
- 33 -
citing section 1.884-1(e)(3)(ii), Income Tax Regs. We agree with
respondent that petitioner has not shown the requisite
circumstances for a liability reduction as required by section
1.884-1(e)(3)(ii), Income Tax Regs.
Now, we consider petitioner's argument that the Ginter and
Gomes properties should not be included in the step 1 asset
category. If petitioner is correct that the two properties do
not belong in the step 1 category, the amount of petitioner's
liabilities subjected to the excess interest provisions and the
amount of the excess interest tax would be reduced.
The question we must decide is whether unimproved real
property which is not currently being developed is a step 1
asset. To be included in "step 1", the asset must produce or be
able to produce ECI with the conduct of a U.S. trade or business.
Sec. 1.882-5(b)(1), Income Tax Regs. Section 864(c) governs the
determination of whether an asset generates ECI. If a foreign
corporation is engaged in a U.S. trade or business, income from
U.S. sources is generally placed into one or the other of two
categories pursuant to section 864(c)(2) and (3) to determine
whether the income is effectively connected with a U.S. trade or
business. Section 864(c)(2) applies to fixed or determinable
annual or periodic income and to gains from the sale of capital
assets. To determine whether such gain or income is ECI, section
864(c)(2) provides two tests: (1) Whether the income is derived
- 34 -
from assets used in or held for use in the conduct of the U.S.
trade or business (asset use test), and (2) whether the
activities of the trade or business were a material factor in the
realization of the income (business activities test). Sec.
864(c)(2)(A) and (B). All other U.S.-source income, besides
fixed or determinable annual or periodic income and capital
gains, is treated as effectively connected with the conduct of
the taxpayer's U.S. trade or business (regardless of whether an
actual connection exists). Sec. 864(c)(3).
Petitioner contends that the Ginter and Gomes properties are
capital assets that produce passive income rather than ECI from a
U.S. trade or business. Petitioner's argument assumes that the
sale of the Ginter and Gomes properties would not produce ECI
under either the asset use or business activities test of section
864(c)(2). Respondent contends that the Ginter and Gomes
properties are step 1 assets as petitioner had reported them on
its original Forms 1120F. Respondent maintains that the Ginter
and Gomes properties are ordinary income assets and would
nevertheless produce ECI under section 864(c)(3). Respondent
also contends that even if the Ginter and Gomes properties are
capital assets, their sale would produce ECI under section
864(c)(2). As discussed below, we find that the Ginter and Gomes
properties are ordinary income assets and produce ECI under
section 864(c)(3).
- 35 -
The branch tax law conceptually encompasses income which
could be characterized either as ordinary or capital in nature,
and both capital and ordinary assets may produce ECI. Thus, the
Ginter and Gomes properties, even if held as capital assets,
could generate ECI.
For the Ginter and Gomes properties to generate ECI under
section 864(c)(2) or (3), petitioner must be engaged in a trade
or business within the United States. Petitioner contends that
with respect to the Ginter and Gomes properties, it was not
engaged in a trade or business in the United States. Petitioner
relies on Neill v. Commissioner, 46 B.T.A. 197 (1942), where it
was held that, without more, the mere ownership of U.S. real
property, "quiescent" receipt of income therefrom, and customary
acts incidental to ownership is not the carrying on of a U.S.
trade or business. Conversely, where a taxpayer buys and sells
real property, collects rents, pays operating expenses, taxes,
and mortgage interest, makes alterations and repairs, employs
labor, purchases materials, and makes contracts over a period of
years, there is obvious evidence of a U.S. trade or business.
Pinchot v. Commissioner, 113 F.2d 718 (2d Cir. 1940); see also De
Amodio v. Commissioner, 34 T.C. 894 (1960) (active management of
rental property on a "regular and continuous" basis is a U.S.
trade or business), affd. 229 F.2d 623 (3d Cir. 1962); Herbert v.
- 36 -
Commissioner, 30 T.C. 26 (1958); Lewenhaupt v. Commissioner, 20
T.C. 151 (1953), affd. 221 F.2d 227 (9th Cir. 1955).
In Neill v. Commissioner, supra, the taxpayer did not
participate in the management, operation, or maintenance of the
real property other than collecting the rents which her agent in
the United States sent her. We find petitioner's reliance on
Neill, as it relates to petitioner's business purpose and
generally to its business activity, to be inapposite. Petitioner
was engaged in the business of real property development and was
formed for the purpose of acquiring, managing, developing, and
selling real property in Hawaii.
Petitioner argues that a person engaged in the business of
real property development may also hold real property for passive
purposes. In that connection, petitioner contends that the
Ginter and Gomes properties were not used in a U.S. trade or
business and do not generate ECI. See sec. 1.882-5(b)(1), Income
Tax Regs. We disagree. Although there was no sale or
disposition of the properties during the years in issue,
petitioner's real estate activities were not those of a passive
investor.
A taxpayer may hold real property primarily for sale to
customers in the ordinary course of his trade or business and, at
the same time, hold other real property for investment purposes.
Maddux Constr. Co. v. Commissioner, 54 T.C. 1278, 1286 (1970);
- 37 -
Eline Realty Co. v. Commissioner, 35 T.C. 1, 5 (1960); Tollis v.
Commissioner, T.C. Memo. 1993-63, affd. without published opinion
46 F.3d 1132 (6th Cir. 1995); Planned Communities, Inc. v.
Commissioner, T.C. Memo. 1980-555. Additionally, a capital asset
may be used in a trade or business, but here petitioner argues
that the assets were held for passive investment purposes.
Although the primary purpose for which a taxpayer holds property
may change, it is the primary purpose for which the property is
held at the time of sale that usually determines its tax
treatment. Cottle v. Commissioner, 89 T.C. 467, 487 (1987);
Biedermann v. Commissioner, 68 T.C. 1, 11 (1977). However, we
may consider events over the course of the ownership to determine
the primary purpose for which the property is held at the time of
sale. Suburban Realty Co. v. United States, 615 F.2d 171, 183
(5th Cir. 1980). Whether property is held primarily for sale to
customers in the ordinary course of the taxpayer's trade or
business is a question of fact that is to be determined on a
case-by-case basis. Gartrell v. United States, 619 F.2d 1150,
1153 (6th Cir. 1980); Guardian Indus. Corp. v. Commissioner, 97
T.C. 308, 316 (1991).
Petitioner's predecessor, Fudosan, acquired the Ginter and
Gomes properties between 1973 and 1980 with the express intention
of developing and selling them as residential properties.
Fudosan obtained a change in the zoning classification from
- 38 -
agricultural or unplanned to single or multifamily residential.
Due to a series of mergers, in 1986, petitioner, as a successor
in interest, became the owner of the properties. Generally,
petitioner continued with the approach begun by Fudosan and
sought to develop the properties until it was subsequently
ascertained that development costs would be insuperable.
Petitioner maintained the zoning conditions and paid certain fees
with respect to the properties. Petitioner held these properties
as undeveloped land and derived no revenue from them during the
taxable years in issue.
On its Federal income tax returns, petitioner described its
activity as real estate development and property investment and
real estate investment and development. In its 1989, 1990, and
1991 returns, petitioner reported $13,800,857, $13,830,400, and
$11,481,780, respectively, in "Land Development Costs". The
significant real property items, other than the condominium in
Waikiki, were the Ginter and Gomes properties. Petitioner
consistently reported on its returns that the costs of carrying
the Ginter and Gomes properties were related to its business as a
developer of land.
There is no question that the Ginter and Gomes properties
were originally intended for development and that regular
business activity was pursued to that end. Development plans
were drafted and submitted to the planning commission in Hawaii.
- 39 -
An architect was retained to prepare plans for the proposed
subdivisions. The possibility of developing a golf course in
connection with the proposed Gomes subdivision was studied. At
some point, however, it appears that petitioner became aware that
it was not financially feasible to continue the development.
Although petitioner originally intended the Ginter and Gomes
properties to be developed, impediments to development such as
drainage, zoning, and lack of accessibility intermittently
stalled development plans. These factors impeded development
and, ultimately, made development a financial impossibility from
petitioner's point of view. No efforts were made to sell the
property during the years in issue. A bona fide offer and sale
occurred during 1995, 4 years after the last tax year under
consideration.
Generally, courts view frequent sales that generate
substantial income as tending to show that property was held for
sale rather than investment. Suburban Realty Co. v. United
States, supra at 181; Biedenharn Realty Co. v. United States, 526
F.2d 409 (5th Cir. 1976). On the other hand, less frequent sales
resulting in large profits tend to show that property was held
for investment. Bramblett v. Commissioner, 960 F.2d 526 (5th
Cir. 1992), revg. T.C. Memo. 1990-296.
We hold that the Ginter and Gomes properties are step 1
assets includable in the computation of the excess interest tax.
- 40 -
Petitioner's trade or business consisted of real estate activity
in Hawaii. It acquired, undertook to develop, and held
properties, including the Ginter and Gomes properties, for sale
to customers in the ordinary course of its real estate
development business. We cannot make the type of distinction
petitioner makes between the Ginter and Gomes properties and the
other properties held by petitioner. Petitioner's sales activity
was generally sporadic and occurred in large amounts (in the
millions of dollars). The sales occurring in the years under
consideration were no different from the Ginter and Gomes sale in
1995. Although petitioner decided that further development was
not warranted, the Ginter and Gomes properties were held for sale
and were sold to the first bona fide offeror.
Section 6651(a) Addition to Tax
Respondent also determined that petitioner is liable for an
addition to tax for 1991 under section 6651(a)(1) for its failure
to file a timely return. Section 6651(a)(1) imposes an addition
to tax of 5 percent of the tax due for each month a return is
delinquent, not to exceed 25 percent. The addition does not
apply if the failure to timely file is due to reasonable cause
and not due to willful neglect. Sec. 6651(a)(1). Petitioner
filed its 1991 return past its due date and has failed to show
that its failure to file a timely return was due to reasonable
- 41 -
cause and not due to willful neglect. We find that petitioner is
liable for the addition to tax under section 6651(a)(1) for 1991.
Decision will be entered
for respondent.