Opinion
Docket No. 7216-83.
1985-10-24
RONALD COLEMAN AND NANCY COLEMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
MATTHEW H. ROSS and LEON C. BAKER, for the petitioners. SUSAN G. LEWIS and PATRICIA H. DELZOTTI, for the respondent.
Petitioners purchased an interest in certain computer equipment from C, which had purchased such interest from E, which had purchased an interest in the equipment from A. Petitioners then leased their interest back to C. HELD, petitioners did not own a depreciable present interest in the equipment in the years in issue. HELD FURTHER, petitioners, acquisition constitutes an activity not engaged in for profit, within the meaning of sec. 183, I.R.C. 1954. HELD FURTHER, interest payments on petitioners' nonrecourse note, which does not constitute genuine indebtedness, are not deductible. HELD FURTHER, interest payments on a recourse note are deductible. MATTHEW H. ROSS and LEON C. BAKER, for the petitioners. SUSAN G. LEWIS and PATRICIA H. DELZOTTI, for the respondent.
TANNENWALD, JUDGE:
Respondent determined deficiencies in petitioners' Federal income taxes for taxable years 1979 and 1980 of $2,189 and $2,442, respectively, relating to petitioner Nancy Coleman's 1 percent interest in a computer leasing transaction. In his amended answer, respondent alleged additional deficiencies for taxable years 1979 and 1980 of $31,840 and $64,700, respectively, relating to petitioner Ronald Coleman's interest in the same transaction. The issues for decision are whether petitioners' deductions for depreciation and interest expenses were properly disallowed.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. This reference incorporates the stipulations of facts and attached exhibits. At the time they filed their petition in this case, petitioners resided in Oradell, New Jersey. Petitioners timely filed joint Federal income tax returns for 1979 and 1980.
During the years 1979 and 1980, petitioner Ronald Coleman was a one-third partner in Majestic Construction Co. (‘Majestic‘), a New Jersey general partnership. The other partners were Ronald Coleman's brothers, Harvey and William Coleman. Majestic's business was constructing rental income properties for its own account. During 1979 William Coleman and Leon C. Baker, a first cousin of the Colemans' and an attorney who had been involved with equipment leasing since 1972, discussed Majestic's need for a tax shelter and the economic and tax aspects of computer leasing. Baker approached Nigel Leopard, a representative of Carena (Computers) B.V. (‘Carena‘), a Netherlands corporation, to develop a deal for the Colemans. Baker had dealt with Leopard for about seven years, the latter generally acting as an intermediary between European leasing companies and American brokers who, in turn, sought investors for equipment leasing transactions. Baker sought from Leopard an equipment transaction that gave the Colemans an ‘inside price,‘ i.e., a higher percentage of leverage than that featured in typical equipment deals.
Leopard contacted Vernon Davies, co-founder and, at that time, president of Atlantic Computer Leasing p.1.c. (‘Atlantic‘). Atlantic, a United Kingdom (U.K.) corporation, was a large, reputable supplier of configured computer systems consisting of IBM central processors, IBM operating systems, and IBM and IBM-compatible peripherals. Atlantic supplied such equipment mainly through ‘arranged leases,‘ i.e., transactions in which Atlantic arranged financing for its customers by transferring title to the equipment to financial institutions or corporate leasing subsidiaries and arranging leases between these parties as lessors and the customer-users as lessees. To a lesser extent, Atlantic utilized direct leases and outright sales to its customers. Leopard had known Davies for approximately 2 years, and had done several deals with him, by the time of their meeting regarding the Colemans' transaction. Their negotiations centered on certain computer equipment (the ‘Equipment ‘) financed through leases ‘arranged‘ between seven lessors (the ‘Lenders‘) and six end users and having the following terms:
For the notes to the following table, see notes 2-4.
In each of these ‘arranged-lease‘ transactions, Atlantic had purchased the Equipment, transferred title thereto to the Lender, and arranged the initial lease between the Lender and the user-lessee. Atlantic generally transfers title to lenders in order to get lower financing rates from them, and thus to be competitive in the user market; because U.K. tax law provides for first-year expensing of equipment costs by the title holder,
and lenders offer better rates in exchange for title to the equipment. In each case, the Lender provided Atlantic with an amount based upon the discounted value of the stream of rents receivable under the leases being arranged. Such amount included the value-added tax (VAT) imposed by the United Kingdom on consumption.
Respondent contends that petitioners have not adequately proven that U.K. tax law contains such a provision. However, Rule 146, Tax Court Rules of Practice and Procedure, requires only notice that an issue of foreign law will be raised. In any event, this issue has no bearing on our decision herein.
In each lease agreement, the Lender covenants to the user-lessee that it is ‘the lawful owner of the Machines leased hereunder.‘ Additionally, each of the leases contains an automatic renewal provision that is to take effect if the lessee does not terminate its lease in writing within three months after completion of the initial term. Atlantic bears no recourse credit risk with respect to the arranged leases; upon default by a lessee, the Lender, as lessor, is entitled under its lease agreement to take immediate possession of the subject equipment, and would look to Atlantic for help in arranging a new lease in order to recoup its losses. Atlantic has no legal obligation to provide such help.
Apparently, the Lenders paid Atlantic the discounted value of the rental stream including VAT because they received a VAT credit from the U.K. tax authority for VAT amounts remitted to Atlantic. VAT amounts received by the Lenders with the lessees' rental payments were apparently turned over to the U.K.
Concurrently, Atlantic and the Lenders entered into residual agreements whereby Atlantic retained or still retains options to repurchase the Equipment for nominal consideration upon completion of the leases' initial terms, ‘subject to the receipt of all monies due thereunder or the receipt of an agreed early termination settlement.‘
Atlantic generally looks to the residual value of equipment to make a profit on its ‘arranged-lease‘ transactions. This is so because the combination of intense competition in the user market, forcing low rentals and thus lower payments from lenders, the necessity of giving the lenders title to the equipment during the initial lease terms, and the costs associated with arranging the lease transactions and purchasing the equipment frequently drains the initial leases of any profit potential for Atlantic. Atlantic carried its residual interests in the Equipment on its balance sheet at a discount from the IBM list price in effect at the time of valuation, less the cost of repurchase under the residual agreements and estimated remarketing costs. A valuation committee meets regularly to calculate the appropriate discount factors for the various equipment in which Atlantic has residual interests, and takes into account factors such as the equipment type, the initial lease terms, money market rates, and IBM product announcements; with regard to the last factor, the committee, based on past experience with the accuracy of such announcements, exercises a degree of skepticism, and does not accept such announcements at face value. Remarketing costs include the expenses necessary to refurbish the equipment to the engineering and cosmetic specifications of the new user-lessees after the completion of the initial leases. These expenses total up to 15 percent of the cost of the equipment being refurbished. Maintenance and repair expenses necessary to bring the equipment as configured to peak performance are not included in the remarketing costs, as user- lessees are required to arrange with IBM for such maintenance. The user-lessees are also required to carry insurance on the Equipment. The financial information with respect to the Equipment is as follows:
Atlantic retained a 90-day option to repurchase with respect to the leases numbered 4 and 5, see supra p. 5; with respect to the other leases, Atlantic retained a right to repurchase not specifically limited in time. The repurchase price under the residual agreements is One Pound for leases 3 and 8, 1/2 percent of the Lender-lessor's original ‘cost‘ (i.e., amount of funds provided) for lease 5, 1 percent of such cost for leases 2 and 4, and 2 percent of such cost for leases 1, 6, and 7. Atlantic's total repurchase price, assuming repurchase at the end of each of the initial lease terms, may be computed as follows:
See infra p. 12. For the 3 Cheshire leases, for which the record contains one aggregate ‘financing obtained‘ figure, we computed the repurchase prices by allocating the total financing obtained from the lenders on such leases to the individual Cheshire leases pro rata by the rentals stated on the leases.
All of the agreements give Atlantic, on repurchase, the benefit of any lease not terminated at the end of its initial term. Early termination (e.g., due to default by a lessee) has the following consequence: for leases 3-8, Atlantic has the same repurchase rights as in the case of no early termination; for leases 1 and 2, Atlantic has a right to repurchase the Equipment for a price equal to the discounted value of the Equipment, less any termination charge received by the Lender-lessor, plus the repurchase price that would apply without early termination. For leases 1, 2, 6, and 7, in the event the Lender-lessor accepts a follow-on lease with the same lessee within 6 months after the end of the initial lease term, the Lender-lessor is required to refund to Atlantic 50 percent of Atlantic's repurchase price, i.e., the One Pound 1/2 percent, 1 percent, or 2 percent.
For the notes to the following table, see footnotes 9-15.
Leopard negotiated with Davies a deal known to Atlantic as a ‘forward sale,‘ whereby Atlantic sells to an investor its residual interest in leased equipment.
Their intense negotiations centered on the amount of cash that would flow from the Colemans to Atlantic, and the degree to which the Colemans would share in the residual value of the Equipment. Upon the conclusion of these negotiations, Baker, apparently after ironing out the details with Leopard, wrote the following letter, dated October 16, 1979, to William Coleman proposing the equipment leasing deal:
A 1983 prospectus offering shares of Atlantic refers to the forward sales as follows:
Such sales, which relate to equipment at present on lease, involve the receipt by Atlantic of almost all of the sales price within eighteen months of the sale although delivery will take place some 7 to 11 years in the future. * * * These transactions depend for their economic viability from the purchaser's point of view, upon the provisions of the tax legislation of the United States of America. Accordingly any change in the relevant tax legislation or administrative practice on the part of the United States Internal Revenue Service could reduce sales of the kind hitherto made by Atlantic, or possibly cause them to cease.
Dear Bill:
Enclosed are two schedules on an equipment leasing deal which I believe would be suitable for your purposes. The first schedule provides for no minimum net cash flow and the second provides for a small minimum. Naturally, the cash investment is higher in the second case. In either case, there would be contingent rent payable commencing in the fifth year.
The equipment would be data processing or other office equipment with a six year depreciation life for tax purposes. The cash investment would be approximately 7-1/2% of cost without minimum cash flow and approximately 8.55% of cost with minimum cash flow. The investment can be paid in three installments over a period spaced over three fiscal years, with interest on the unpaid portion of the investment of 12% per annum.
As in all tax shelters, the key is leverage. You invest 7.5 or 8.55 cents and you depreciate $1.00.
The good news is that you could generate tax losses, per $1,000,000 of equipment, of $90,000 in 1979 and $146,695 in 1980, which could be carried back to 1979. Actually, since there are four of you, you could get $16,000 of first year depreciation in 1979, if you have not taken this amount on other property, and $40,000 of accelerated depreciation in each year without paying minimum tax. This would bring the total for the two years to over $400,000 so you could solve your entire 1979 problem with two $1,020.000 (sic) units.
By 1981 your new project should be generating substantial ordinary income so you could use the additional deductions generated in 1981 through 1984.
The bad news, of course, is that in 1985 the deal turns around and you would start generating taxable income without cash flow. There are ways to avoid this, but the conservative assumption to make is that you will be obligated to pay the taxes projected in the years 1985 through 1990.
How do you make out overall? The last column entitled ‘Sinking Fund Analysis at 7% A.T.‘ assumes that net tax savings are invested to earn 7% after taxes and that the accumulation is used to pay the taxes when they become due. (Actually, of course, no one does this. It is only a method of financial analysis.) You will note that the accumulation as a $1,020,000 ‘module‘ grows to a maximum of $466,011 and then declines to $199,461. At no time do you have any net investment in the deal and you wind up with $199,461 even after paying taxes. You would be paying the taxes, of course, in dollars which are likely to be worth much less than the tax dollars you would be saving currently.
As I indicated earlier, there are three favorable possibilities which are not reflected in the tables: 1) you may be able to avoid the tax on the turnaround if there is no change in law before 1985; 2) you may receive contingent rental; and 3) the equipment may have residual value in 1990. There are pluses but the deal should be evaluated on the basis that none will eventuate.
If you are interested, I will have to contact the owners of the equipment to make sure that there is $2,000,000 available (or whatever amount you are interested in). I am leaving for China on October 26, so, if you want to proceed you should let me know before then, even though the closing need not take place until later.
Sincerely yours, Leon C. Baker
The schedules referred to in Baker's letter read, in relevant part, as follows:
Baker, based upon his admittedly second-hand experience with computer leasing, believed that the residual value of the Equipment might be 10 to 20 percent of original value at the end of the eleventh year after the beginnings of the lease terms. This estimate seemed conservative to Baker, even recognizing that technologically new IBM equipment would drive the value of old equipment down. In discussions with the Colemans, Baker outlined the possible residual values of the Equipment, but felt unqualified actually to predict the residual values, and thus did not do so. William Coleman, who had responsibility within Majestic to evaluate investments, analyzed the proposed transaction, relying solely on Baker's opinion and Majestic's experience with construction deals and used equipment, discussed the deal with his brothers, and entered into the transaction.
On December 19, 1979, Atlantic, ‘for and in consideration of One Pound (L1) and other good and valuable consideration received,‘ assigned ‘all of Atlantic's right, title and interest in and to the residual agreements annexed hereto, including all of Atlantic's rights in and to the agreement(s) of lease described therein and the equipment covered thereby,‘ to European Leasing, Ltd. (‘European‘) a Liberian corporation. It is unclear from the record how much ‘other good and valuable consideration‘ actually passed to Atlantic, and Baker did not in December 1979 know the actual price of this assignment to European.
On December 26, 1979, several documents pertaining to the instant transaction were executed. Atlantic, European, Carena, and Majestic entered into a Sale and Purchase Agreement whereby,
SUBJECT as hereinafter mentioned and in consideration of the payment herein provided, European hereby sells, transfers, and assigns to Carena all of Atlantic's Interest in the Equipment. A copy of the Lease(s), as amended is attached hereto together with a copy of the residual agreement(s) (the ‘Residual Agreement(s)‘), made between Atlantic and the lessor(s) (the ‘Lessor(s)‘) under the Lease(s),
Exhibit A to the Sale and Purchase Agreement contains copies of the leases and residual agreements, and some of the invoices, with respect to the Equipment.
until the Final Date * * *, Carena will not concern itself with the leasing or additional leasing of the Equipment and all liability therefor and all benefit therefrom will be for European's account except that, commencing January 1, 1987 and continuing until and including December 31, 1990 (the ‘Final Date‘), European shall pay, or procure the payment to Carena within a reasonable time after the same has been collected, of the following percentages of the net proceeds (as hereafter defined) from leasing of the Equipment:
In each case ‘net proceeds‘ means gross proceeds actually derived less the reasonable and necessary expenses of remarketing. The agreement states the purchase price as $95,353, all but $100 of which was payable contemporaneously with the execution of the agreement, and $100 of which is payable on December 31, 1990. Under the agreement, Atlantic and European warrant to Carena and Majestic, inter alia, that (1) the Lenders own the Equipment ‘free and clear of any claims, liens, charges or encumbrances except for the Lease(s)‘; (2) ‘upon payment of the repurchase price specified in the Residual Agreement(s), Atlantic (acting as trustee and agent for European) will acquire title to the Equipment free and clear of any and all claims, liens, charges or encumbrances except for the Lease(s)‘; and (3) the agreement ‘is effective to transfer to Carena Atlantic's interest in the Equipment, subject only to the payments (of $95,353), free and clear of all claims, liens, charges or encumbrances.‘ Atlantic agrees to exercise its repurchase rights under the residual agreements, and Atlantic and European agree to ‘pay or cause to be paid, when due, all debts, liabilities, or obligations secured by liens, claims, charges or encumbrances on the Equipment * * * including, without limitation, all amounts due and payable by the lessee(s) under the Lease(s) and by Atlantic under the Residual Agreement(s). ‘ Additionally, the agreement gives European and Atlantic
the right to lease the Equipment to others within the United Kingdom until (December 31, 1990); provided, however, that neither Atlantic nor European will agree to, or cause or permit, any lease, agreement, amendment, extension or other modification of any nature which would affect the Residual Agreement or Atlantic's Interest in the Equipment or which would create any right, title or interest of any other party in the Equipment or any lease thereof after (December 31, 1990), without the prior written consent (which consent shall not be unreasonably withheld or delayed) of (Majestic). Under the agreement, the risk of loss and damage, and the duty to insure, rest with Atlantic and European.
On the same day, i.e., December 26, 1979, Carena and Majestic executed a Purchase Agreement whereby
Majestic hereby purchases from Carena, and Carena hereby sells, transfers and assigns to Majestic, all of the IBM computers and peripheral equipment (collectively, the ‘Equipment‘) described in the lease agreements attached as part of Exhibit A hereto (the ‘User Leases‘), subject and subordinate only to the * * * rights and interests under (a) the User Leases, of the parties thereto, and (b) the Residual Agreement(s), of the Lessor(s) under the User Leases * * * together with all of Carena's right, title and interest in and to the (Sale and Purchase Agreement). The stated purchase price is $2,055,553, payable as follows: $66,176 by check payable to Leon C. Baker, as attorney; a recourse note for $60,160 (plus $5,053 interest) payable on July l, 1980; a recourse note for $24,064 (plus $1,444 interest) payable on January 3, 1981; $100 on December 31, 1990; and a nonrecourse note for $1,905,053, secured under a security agreement. The purchase price was based solely on Leopard's representation to Baker of the value of the Equipment, which representation Baker had no means of investigating but had reason, based on experience with Mr. Leopard, to find reliable.
Under the Purchase Agreement, Carena warrants to Majestic that (I) ‘Carena owns Atlantic's Interest free and clear of all liens, charges, claims and encumbrances whatsoever‘; (2) ‘upon the execution and delivery of this Agreement, Majestic will acquire good and marketable title in and to Atlantic's Interest, free and clear of any and all leases, liens, claims and encumbrances of any kind or nature whatsoever‘; (3) ‘except for the User Leases, the Residual Agreements and (the documents executed pursuant to the instant transaction) there are no agreements of any kind, written or oral which affect in any respect the Equipment‘; and (4) ‘upon the exercise of the repurchase option provided for in each Residual Agreement, Majestic, its successors or assigns, will be the owner of the Equipment, free and clear of any lien or encumbrance except the User Lease, if then in effect, and, if then in effect, the interest of lessor under the User Lease.‘ Carena covenants with Majestic to ‘exercise or cause the exercise of the repurchase option under the Residual Agreements and to pay or cause the payment otherwise than by Majestic of the repurchase price thereunder, promptly upon the expiration of the initial term of the User Leases;‘ to pay all taxes (other than Majestic's income tax) pursuant to the transaction; and to ‘pay or cause to be paid, when due, all debts, liabilities, or obligations (collectively ‘Debts‘), secured by liens, claims or encumbrances on the Equipment, including without limitation, the Encumbrances.‘
The fact that the price stated in the Purchase Agreement, $2,055,553, is approximately equal to the total cost to Atlantic (less VAT) of the Equipment, $1,831,500.72, see supra p. 12, is, according to Baker, a coincidence. We note that it is indeed an ODD coincidence that the alleged price of Majestic's interest in the Equipment exceeds the original cost to Atlantic thereof. See infra pp. 35-42.
Under the heading ‘Limited Assumptions,‘ the following appears in the Purchase Agreement:
The Purchase Agreement defines the ‘Encumbrances‘ as ‘the rights and interests under (a) the User Leases, of the parties thereto, and (b) the Residual Agreement(s), of the lessor(s) under the User Leases. ‘ The ‘Debts‘ are defined to include ‘all sums payable by lessees under the User Lease(s) or subsequent leases covering the Equipment, with respect to which a residual agreement has been entered into, and all sums payable pursuant to such residual agreement, whether or not such sums are payable solely upon the exercise of any purchase or other option thereunder.‘
Majestic acknowledges that Carena has informed Majestic that the principal financing for purchase of the Equipment from IBM has been provided by the lessors under the User Leases, that the indebtedness to the lessors is secured by legal title to the Equipment and by a right to receive rentals due from users of the Equipment and that Majestic is acquiring the Equipment subject to the title of the lessors and to the right of lessors to receive rentals under User Leases. On or before each December 31 through 1984 Majestic will deliver to Atlantic an assumption agreement in favor of lessors in the form attached as Exhibit B of the following amounts payable to lessors in the subsequent year with respect to Equipment purchased hereunder:
The provision for Majestic's assumption was included in the Purchase Agreement for purposes of complying with the at-risk requirements in the Internal Revenue Code of 1954, as amended.
A later document, purporting to be the first annual assumption, makes it clear that the ‘amounts payable to lessors‘ referred to above are the lessees‘ obligations under the user leases. See infra p. 29.
The nonrecourse note in the amount of $1,905,053,
referred to in the Purchase Agreement and executed by Majestic on December 26, 1979, provides for interest of 12 percent annually and equal semi-annual payments of interest and principal of $158,206 through January l, 1991. The note may be prepaid in whole or in part, without penalty, at any time. Carena ‘agrees to look solely and only to the Equipment and the rights and interests transferred by (Carena) to (Majestic) pursuant to the Purchase Agreement for the payment, performance and observance of all of the obligations of (Majestic), hereunder and (Carena), for itself and its successors and assigns, hereby expressly waives any rights to enforce payment or performance by (Majestic) * * * or its * * * partners. ‘ The Security Agreement referred to in the Purchase Agreement and in the nonrecourse note, and executed by Carena and Majestic on December 26, 1979, grants to Carena a security interest, subject to the ‘Encumbrances,‘ see supra note 19, in:
The note appearing in the record herein is in the amount of $1,905,054, the $1 difference being neither explained nor material.
(a) the interest of (Majestic) in the Equipment and all additions, attachments, accessions and replacements thereto, wherever located and whenever owned or acquired, and all proceeds therefrom, (b) all rentals or other monies payable to (Majestic) under the lease (with Carena) or in connection therewith and (c) all other agreements providing for the sale, lease (including, without limitation, (Majestic's) interest in the User Leases(s) and Residual Agreement(s) referred to in the Purchase Agreement) or other disposition of the Equipment, or its use, and all proceeds and products therefrom (collectively, the ‘Collateral‘). Carena agrees to ‘look solely and only to the Collateral for the payment and performance‘ of Majestic's obligations under the note and agreements.
Also on December 26, 1979, Majestic and Carena executed an Agreement of Lease, whereby Majestic leased its interest in the Equipment back to Carena through December 31, 1990. The agreement fixes rental payments at $158,206 semi-annually, the last payment being due on January 1, 1991. In addition, beginning January 1, 1987, Carena is to pay Majestic ‘Contingent Rent‘ in the amount of the following percentages of rentals received by Carena under subleases of the Equipment, less any remarketing expenses: Under the agreement, Carena bears the risk of loss of the Equipment, must maintain and insure the Equipment, and must protect and defend Majestic's ‘title‘ and interest in the Equipment ‘from and against any and all claims, liens, charges, encumberances and legal processes of (Carena's) creditors or other persons having claims against (Carena) or the Equipment.‘ Additionally, Carena is given the right to sublease the Equipment during the term of the Agreement of Lease to the lessees under the user leases and, after the completions of the initial lease terms, to any party within the United Kingdom. With the prior written consent of Majestic, which consent is not to be unreasonably withheld or delayed, Carena may agree to modifications and extensions of the user leases and may enter subleases for the Equipment having terms extending beyond December 31, 1990.
On December 26, 1979, Majestic executed (1) a Nominee Agreement whereby it ‘acknowledges that it holds all rights to the equipment and the lessor's interest in the lease 97 percent for Majestic's account and 1 percent for the account of each of Arlette Coleman, Carol Coleman and Nancy Coleman,‘ the wives of the Coleman brothers, and (2) a letter to Atlantic, European, and Carena in which Majestic acknowledges, inter alia, that none of the three companies had made any representation concerning its ability to sublease the Equipment, the possible rentals receivable after the completion of the initial terms of the leases, or the value, if any, that the Equipment will have after December 31, 1990.
By letter to Atlantic dated December 31, 1979, Majestic stated: ‘Pursuant to our agreement with Carena, we hereby assume payment of lessees' obligations to lessors to you relating to Equipment we have purchased falling due during January 1, 1980 through December 31, 1980 to the extent of $60,000.00. * * * We shall not be required to make any payment hereunder until lessors have exhausted all their remedies against lessees and the Equipment (including sale). We will pay such amount as we are liable to pay lessors hereunder in ten equal installments without interest on each January 1 following determination of the amount of our liability.‘
The $66,176 portion of the $2,055,553 purchase price stated in the Purchase Agreement was paid 97 percent by Majestic's check, dated December 26, 1979, for $64,190.72, and I percent by petitioner Nancy Coleman's check, also dated December 26, 1979, for $661.76. The two recourse notes, required by the Purchase Agreement to be delivered to Carena, were, by agreement of December 26, 1979, sold by Carena to the Coleman Capital Corporation Employees Profit Sharing Trust for their discounted value of $44,117. Baker was both a trustee and a beneficiary of such trust. Leopard requested the discounting because of his concern about Majestic's credit. The note having a due date of July 1, 1980 and a face amount of $60,160 plus interest of $5,053 was paid 97 percent by Majestic's check, drawn to Baker's order and dated July 1, 1980, for $63,256.61, and 1 percent by petitioner Nancy Coleman's check, drawn to Baker's order and dated June 30, 1980, for $652.13. The note having a due date of January 3, 1981 and a face amount of $24,064 plus interest of $1,444 was paid 97 percent by Majestic's check, drawn to Baker's order and dated January 2, 1981, for $24,742.76, and 1 percent by petitioner Nancy Coleman's check, drawn to Baker's order and dated December 30, 1980, for $255.08.
Presumably, the remaining 2 percent of the obligations was paid by the wives of William and Harvey Coleman, each of whom had a 1-percent interest in the transaction.
During the years in issue, the used computer market was volatile. IBM was the dominant supplier of computer equipment to the leasing companies, and its product announcements and introductions had a major impact on used computer values. IBM introduced the first models of the System 370, the series to which the processors involved in the instant transaction belong, in 1971. The System 370 was a half-generation step up from the System 360, which, first installed in 1965, was the first integrated family of computer models, allowing upgrades without major reinvestments in peripherals and software. The 370/135 (or 3135) model was introduced in 1971, as initial deliveries of the System 370 were taking place. The 370/138 (or 3138) processor, introduced in 1976, offered a 29- to 36-percent increase in performance, and a 42-percent price cut, over the 3135, and thus effectively replaced the 3135 model on the market. In April 1977, the 303X series of processors was introduced as an interim upgrade in the System 370 series. However, the most profound effect on the market came in January 1979, when IBM announced the 4300 series in the United States and United Kingdom. The 4300 was roughly comparable to the 3135 processor in power, but its announced purchase price was 25 percent of that of the 3135, and maintenance and power costs were expected to be significantly less. Additionally, IBM drastically reduced the price of memory on the 4300 series, and offered an attractive two-year lease plan.
The peripheral market was less volatile. The 1403-N1 printer was introduced to the market in 1965, and has become a most popular, durable item for IBM. The 3330-1 disk drives were first installed in 1971, and the 3350 direct access storage devices were first delivered in 1976.
Residual values of computer equipment depend on the age and type of the equipment being evaluated. Because the physical qualities of a particular computer remain new due to the replacement of modular units under a maintenance contract, the technological age of the equipment is more important than its physical age; computer obsolescence is less a matter of physical depreciation than of technological innovation. Thus, valuation is based on the announcement and installation dates of the model, rather than the manufacture date of the actual machine in question. Moreover, because peripherals are generally more mechanical than they are electronic, technological obsolescence is less rapid for peripherals than for processors. Generally speaking, then, technological innovations decrease peripheral values less than they do processor values.
The markets for used computers in the United States and the United Kingdom involve the same IBM models, but are somewhat different. Computer equipment for the U.K. is manufactured for 50-cycle current, while U.S. equipment is manufactured for 60-cycle current. Prices are different in the two countries due to exchange-rate fluctuations and decisions by IBM to cut prices in one country and not the other. Moreover, tax considerations and availability of capital make the leasing business in the two countries somewhat different. However, the markets have recently tended to behave in a more similar manner than in the 1960's and early 1970's. For example, recent product announcements have been simultaneous in the two countries, and dealers have been shipping equipment across the Atlantic Ocean to take advantage of price disparities between the U.S. and the U.K. It is now possible economically to adapt 50-cycle machinery to 60-cycle current, and vice versa. While shipping, packing, insurance, and the electricity adaptation have a cost, the overseas shipment potential operates to keep IBM from setting widely disparate prices (as a ratio to list price) in the two countries. Generally speaking, residual values in the United Kingdom, as a percentage of list price, track those in the United States.
There is evidence of some market for used computer equipment in Western Europe and the so-called southern-tier countries in Europe; however, on the record herein, that market cannot be quantified even in macro terms. Moreover, the record herein is unclear as to whether the re-leasing of the Equipment outside the U.K. was authorized under the various agreements. see supra pp. 22-23, 28.
OPINION
Respondent has mounted a broad attack on petitioners' depreciation and interest deductions relating to certain computer leasing arrangements. Because we are satisfied that the issue of the deductibility of these two items can be resolved within a relatively narrow framework, we see no point in articulating each of the grounds of respondent's attack. We also observe that we have reached our conclusions herein irrespective of the location of the burden of proof, which is upon petitioners with respect to the original deficiencies and upon respondent with respect to the increased deficiencies set forth in his amended answer.
As we see it, the threshold question is whether petitioners had, during 1979 and 1980, a depreciable interest in the Equipment. In arguing this question, both parties have expended considerable effort in analyzing the arrangements between Atlantic and the Lenders. Respondent, taking the leasing arrangements at face value, contends that the Lenders, rather than Atlantic, were the owners of the Equipment, and concludes that since Atlantic would thus not be considered as having a depreciable interest, it follows that petitioners, whose interest is derived from that of Atlantic, are not entitled to deductions for depreciation. Petitioners counter with the assertion that the leasing arrangements were nothing more than financing arrangements, with the result that Atlantic was, in substance, the owner of the Equipment and thus of a depreciable interest therein, which petitioners in turn acquired by virtue of the transfers to them via European and Carena. We find it unnecessary for purposes of this case definitively to resolve the question of the nature of the relationship between Atlantic and the Lenders. We will assume for purposes of decision herein that the leasing arrangements were simply financing arrangements as petitioners contend. However, it does not necessarily follow that petitioners acquired an interest in the Equipment that was depreciable by them in 1979 and 1980. Indeed, for the reasons hereinafter set forth, we conclude that what petitioners acquired by virtue of the December 1979 agreements amounted to no more than a future interest in respect of the Equipment, which conceivably might ripen into a depreciable interest in taxable years subsequent to the taxable years involved herein. Given that the issue herein is thus at best the depreciability of a future interest in depreciable property, cases such as Frank Lyon Co. v. United States, 435 U.S. 561 (1978), Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985), affg. on the depreciation issue 81 T.C. 184 (1983), Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976), affg. 64 T.C. 752 (1975), and Estate of Thomas v. Commissioner, 84 T.C. 412 (1985), which both parties herein have subjected to detailed analysis, are largely irrelevant; those cases involved situations in which the taxpayers were the original purchasers of the property involved, and in which it could not be gainsaid that whatever interest they had included a present, as opposed to a future, interest.
A careful analysis of the documentation and factual situation herein reveals the following:
(1) While it appears that Atlantic sold its entire interest in the Equipment to European, the same cannot be said of European's sale to Carena, and that from Carena to Majestic, because the documentation for those transactions makes clear that ‘until (December 31, 1990) * * *, Carena will not concern itself with the leasing or additional leasing of the Equipment and all liability therefor and all benefit therefrom will be for European's account.‘ To be sure, Carena, and through it Majestic, received a right to participate in the rental income from the Equipment,
but such right was subject to European's right to (a) all the rentals after the completions of the terms of the initial leases through 1986, (b) 70 percent of the rentals in 1987, (c) 60 percent of the rentals in 1988, and (d) 50 percent of the rentals in 1989 and 1990; thus, Carena's, and, as a consequence, Majestic's, right to participate was not to commence until 1987, and did not extend to the rents under the initial leases, which had been discounted by Atlantic and, under our assumption, were securing the Lenders' loans to Atlantic. Moreover, Atlantic's and European's retention of the right, conditional upon Majestic's consent, which consent was not unreasonably to be withheld or delayed, to enter into agreements affecting Carena's interest and to create rights in other parties in the Equipment extending beyond 1990, is further evidence that Carena and Majestic had no present interest in the Equipment in 1979 and 1980.
Under the Agreement of Lease between Carena and Majestic, i.e., the leaseback, Carena is obligated to pay Majestic ‘contingent rent‘ payments amounting to the 1987-1990 percentages of rentals to which Carena is entitled from European. In this connection, we note that while the Purchase Agreement between Carena and Majestic refers at one point to a sale of ‘all of the IBM computers and peripheral equipment,‘ other provisions of the Purchase Agreement clearly indicate that what was sold was Carena's interest in the residual agreements, an interest limited to a percentage of rentals, if any, in 1987-1990, and the ownership of the Equipment thereafter.
(2) We are satisfied that neither Majestic nor petitioners reported any rental income from the initial leases,
although the usual treatment by an owner of property who acquires ownership therein subject to outstanding leases and who claims depreciation thereon is to report rent payments by the lessees as income. See Belz Investment Co. v. Commissioner, 72 T.C. 1209, 1232 (1979), affd. 661 F.2d 76 (6th Cir. 1981); Bolger v. Commissioner, 59 T.C. 760, 768 (1973); Amey v. Commissioner, 22 T.C. 756 (1954). This failure to recognize that the rents due under the initial leases belonged to them is further evidence that petitioners and Majestic did not acquire any interest in the Equipment that was depreciable by them in the years in issue.
Majestic's Federal income tax returns for 1979 and 1980 each in lude entries on Schedule H (‘Income from Rents‘), but these entries refer specifically to ‘garden apts‘ and a ‘frame house,‘ making no mention of equipment leases. Petitioners' joint returns for the same years reflect only Ronald Coleman's interest in Majestic; there are no entries on the Schedules E, Part II (‘Rent and Royalty Income or Loss‘) to reflect Nancy Coleman's 1-percent interest in the transaction. We note, however, that she did deduct depreciation in 1979 and 1980 and interest paid on the 1980 recourse note in 1980.
(3) We do not view the leaseback from Majestic to Carena as indicating that Majestic either held any present interest in the Equipment in 1979 and 1980 or made any investment in the Equipment beyond the $150,500 it paid, i.e., in cash and recourse notes, for a future interest therein. While we are cognizant that the identity between the amounts of the lease payments by Carena to Majestic and the nonrecourse debt payments by Majestic to Carena does not preclude separate recognition of the lease and the indebtedness, see, e.g., Estate of Thomas v. Commissioner, supra at 436, we think it appropriate, in the context of determining whether petitioners acquired a present (i.e., in 1979 and 1980) interest in the Equipment, or a future residual interest in respect of the Equipment, to view those offsetting payments as cancelling each other and therefore properly to be ignored in determining the nature of the acquired interests. In this connection, we note that the instant case differs significantly from cases such as Frank Lyon and Estate of Thomas in that the leaseback portion of this transaction is separate from the initial purchase of the Equipment and the indebtedness created therefor; petitioners' debt payments do not amortize such indebtedness, but rather reduce an indebtedness created between petitioners and a seller remote as to the original financing transaction after the actual purchase of the Equipment.
(4) Aside from the fact that Atlantic's right to reacquire title to the Equipment from the Lenders upon the completion of the initial lease terms was conditional on the lessees' payments of all amounts due under such leases, Atlantic had no liability to the Lenders for the payment of such amounts prior to the transactions involved herein. In other words, Atlantic's obligation to the Lenders was nonrecourse, secured only by its reversionary, i.e., residual, rights in the Equipment. The first time a recourse liability to the Lenders on the part of Atlantic, and also European, could possibly be said to exist would be upon the execution of the Purchase and Sale Agreement, by way of considering the Lenders as third-party beneficiaries of Atlantic's and European's obligations thereunder to Carena to pay or cause to be paid the debts encumbering the Equipment. At the same time, such liability was the subject of a coextensive undertaking by Carena to Majestic in the Purchase Agreement, which undertaking was partially offset by Majestic's ‘assumption‘ agreement with Carena. These undertakings, in our opinion, represent neither any present investment in the Equipment by any of the parties to the agreements nor any evidence of any present interest of petitioners therein, irrespective of any third-party beneficiary rights that may thereby have been created in the Lenders. In fact, the offsetting undertakings by and in favor of Carena lend support to our view that Carena purchased a future residual interest in respect of the Equipment for $95,353 and in turn sold such interest to Majestic for $150,500.
As far as Majestic's ‘assumption‘ is concerned, we view it as a mere sharing in the newly created undertaking with respect to the rents; at best, the ‘assumption‘ was Majestic's guaranty to make good any default by a lessee under the initial leases.
We note that the record herein is devoid of any explanation of the difference between Carena's purchase price of $95,353 and Majestic's of $150,500; however, such difference has no bearing on the issue of whether Majestic acquired a present interest in the Equipment. See supra note 25. Indeed, petitioners, rather than arguing that Majestic acquired something more than did Carena, contend that the two purchase prices are equivalent when viewed in the context of the Lenders' encumbrance on the Equipment, a contention we also reject in light of the chain of undertakings by the parties.
Cf. Brand v. Commissioner, 81 T.C. 821 (1983). Indeed, Baker's testimony at trial clearly indicates that the ‘assumption‘ agreement served no purpose other than as a device designed to enable the transaction to meet the ‘at risk‘ requirements under section 465.
It is clear to us that the Lenders viewed the lessees as financially responsible entities and the Equipment as sufficient security that those responsibilities would be duly discharged. We are satisfied that neither Atlantic, European, Carena, nor Majestic had any reason to believe otherwise, and that Carena simply viewed Majestic's assumption as security for its effective second-mortgagee position behind the Lenders in the unlikely event that the lessees were to default under their leases. Indeed, Majestic's ‘assumption‘ became operative only after all remedies against the lessees and the Equipment had been exhausted by the Lenders. Moreover, the ‘assumptions‘ were to be given in separate amounts year by year, and it appears that the amounts covered by the ‘assumptions‘ were to be paid, if at all, over a ten-year period without interest. Clearly, a promise to pay in future installments a liability of another that becomes immediately due and payable can hardly be characterized as anything more than a guaranty.
All statutory references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue, and all Rule references are to the Rules of Practice and Procedure of this Court.
At the trial of the instant case, Baker testified as follows:
In order to comply with the at-risk requirements, which were introduced about that time, the documents provided—I'm going to say this was done with the at-risk requirements in mind. They could not, in compliance with the statute, assume—assumption of personal liability on the nonrecourse mortgage wouldn't have availed any because the nonrecourse mortgage was held by (Carena). So, therefore, assumption of liability on that nonrecourse mortgage would not have satisfied the requirements of the statute. Therefore, they undertook to assume a portion of the underlying liability. * * * And they assumed sufficient amounts of that liability to comply with the at-risk requirements.
(5) The terms of all the initial leases extended beyond the taxable years involved herein and were net leases, which placed the full responsibility for the Equipment and its maintenance, except for wear and tear, upon the lessees. Thus, neither Atlantic nor any entity deriving its interest from Atlantic bore most of the normal burdens of ownership. While we recognize that net leases of the type involved herein are common in the business world and, in and of themselves, do not control the question of who is entitled to depreciation (see Estate of Thomas v. Commissioner, supra at 433; Northwest Acceptance Corp. v. Commissioner, 58 T.C. 836 (1972), affd. per curiam 500 F.2d 1222 (9th Cir. 1974)), we think that, in the context of this case, it is an element that may properly be taken into account in determining whether petitioners had a present interest in the Equipment during the years in issue. Moreover, we note that the Purchase and Sale Agreement among Atlantic, European, Carena, and Majestic made clear that Majestic had no responsibility for maintaining or replacing the Equipment.
On the basis of all of the above, and of the entire record herein, we find that Majestic, and thus petitioners, did not own a present interest in the Equipment in 1979 and 1980, but instead contracted for a future interest in the Equipment which, at best, will not ripen into present ownership until 1987.
Interests that will not ripen into present ownership until some point after the year in question, i.e., future interests, generally are not currently depreciable. See Geneva Drive-In Theatre, Inc. v. Commissioner, 67 T.C. 764, 770-774 (1977), affd. per curiam 622 F.2d 995 (9th Cir. 1980); Commissioner v. Moore, 207 F.2d 265, 268-269, 271-272 (9th Cir. 1953), revg. 15 T.C. 906 (1950); sec. 167(h); Fox River Paper Co. v. Commissioner, 28 B.T.A. 1184, 1203-1204 (1933); see also Rev. Rul. 60-180, 1960-1 C.B. 114; Note, ‘Purchaser's Depreciation Rights in Property Subject to a Lease,‘ 82 Mich. L. Rev. 572, 582-588 (1983).
In Geneva Drive-In Theatre, Inc. v. Commissioner, supra, the taxpayer purchased property subject to a lease under which the lessee had constructed improvements on the property. The improvements had value beyond the lease term, and the taxpayer invested $200,000 in the property beyond the value of the raw land. Holding that the taxpayer was not entitled to depreciation until the date the lease terminated, this Court stated that prior thereto,
petitioners' interest in the improvements was not used by them in their business. The improvements could produce no income for petitioners until the lease terminated and their interest ripened into ownership of the improvements. Their interest in the improvements did not diminish in value as a result of the passage of time
The improvements may have deteriorated in value as they were used in (the lessee's) business between the date of petitioners' 1965 acquisition and the lease termination on March 2, 1970, but petitioners did not suffer any economic loss as a result of that deterioration. The purchase price petitioners paid (the lessor) no doubt took into account the facts that, under the lease, the theater improvements would not become petitioners' property until the lease terminated and that petitioners would receive them in their deteriorated condition as of the lease termination date. Petitioners paid nothing for any substantial immediate interest in the improvements and acquired none other than the reversionary interest.
We think it quite clear that petitioners' reversionary interest in the theater improvements was not a depreciable one. Upon the termination of the lease on March 2, 1970, when the theater improvements reverted to petitioners, their interest ripened into a depreciable one. 67 T.C. at 770-771 (citations and fn. refs. omitted). Cf. Davis v. Commissioner, 66 T.C. 260 (1976), affd. 585 F.2d 807 (6th Cir. 1978), in which the taxpayer's ‘ownership‘ was so circumscribed by restrictions in the documents comprising the transaction as to preclude a depreciation deduction.
We hold that the same analysis applies herein. At best, Majestic's interest in respect of the Equipment will not ripen into anything resembling present ownership until, at the earliest, 1987, when the rentals might first possibly accrue to Majestic. During 1979 and 1980, the Equipment was not, vis-a-vis Majestic, an asset that would depreciate in value or be held for the production of income—elements which are the touchstones for allowance of a depreciation deduction. Frank Lyon Co. v. United States, supra at 581; Commissioner v. Idaho Power Co., supra at 10; sec. 167(a). Compare also Fox River Paper Co. v. Commissioner, supra with Wagner v. Commissioner, 518 F.2d 655, 657-658 (10th Cir. 1975), revg. and remanding a Memorandum Opinion of this Court. Thus, we sustain respondent's determinations as to depreciation. Our conclusion as to the disallowance of petitioners' deductions for depreciation is reinforced by an examination of whether petitioners' participation in the instant transaction constitutes an ‘activity engaged in for profit,‘ within the meaning of section 183.
Section 183 allows deductions attributable to activities not engaged in for profit only to the extent the deductions are allowable irrespective of profit motive (e.g., interest) and to the extent that the gross income derived from the activity in the year in question exceeds the deductions allowable irrespective of profit motive. Sec. 183(a) and (b). Whether petitioners' activity is engaged in for profit depends upon whether Majestic
This question is relevant not only in connection with petitioners' depreciation deductions (see sec. 167(a)(1) and (2); Elliott v. Commissioner, 84 T.C. 227, 236 (1985)), but also with respect to other deductions taken and disallowed in connection with the instant transaction, such as the ‘legal expenses‘ mentioned in the tables attached to Baker's letter. See supra pp. 18-19.
had, at the time of its purchase of the interest in respect of the Equipment, a bona fide objective of making a profit. Estate of Baron v. Commissioner, 83 T.C. 542, 553 (1984). Such objective need not be reasonable, only honest, and the question of objective is to be determined from all the facts and circumstance. Sutton v. Commissioner, 84 T.C. 210, 221 (1985).
Cf. Brannen v. Commissioner, 722 F.2d 695, 703-704 (11th Cir. 1984), affg. 78 T.C. 471 (1982); Sutton v. Commissioner, 84 T.C. 210, 221 n.4 (1985); Fox v. Commissioner, 80 T.C. 972, 1007-1008 (1983), affd. without published opinion 742 F.2d 1441 (2d Cir. 1984), affd. sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984), affd. in unpublished orders sub nom. Hook v. Commissioner, Kratsa v. Commissioner, Leffel v. Commissioner, Zemel v. Commissioner, 734 F.2d 5-7, 9 (3d Cir. 1984). We note that the instant case, because Majestic is comprised entirely of the Coleman brothers and it has never been suggested that their objectives were not identical, analysis of profit objective at the partnership level is not different from such analysis at the partner level. Additionally, although the Coleman wives owned 3 percent of the transaction, there is no indication herein that the wives' objectives differed from those of their husbands.
While sec. 1.183-2(b), Income Tax Regs., lists nine factors normally to be taken into account in sec. 183 determinations, given the difficulty of fitting these factors to shelter activity such as petitioners', we will deal with the totality of the circumstances revealed by the record herein. See Estate of Baron v. Commissioner, 83 T.C. 542, 554 (1984); see also sec. 1.183-2(b), supra.
Petitioners argue that Majestic's objective was to profit from the residual value of the Equipment, and that, due to the high leverage, the high percentage of peripherals in the Equipment, Atlantic's ability to derive higher residual values than are generally obtainable on the market, and Baker's expertise in computer leasing deals, an honest belief that such profit was possible existed. Petitioners note that, even if the processors completely lose their value and the peripherals retain 20 percent of their value, the resulting 8 percent residual value overall (assuming 40 percent of the Equipment is peripherals) will leave petitioners, who paid less than 7.5 percent of the purchase price in cash, with a profit. For the reasons hereinafter stated, we disagree.
In the instant transaction, the critical point of inquiry with regard to profit objective is the residual value of the Equipment. See Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 92 (4th Cir. 1985), affg. on this issue 81 T.C. 184 (1983). This is especially true in the instant case, where Majestic, through its partners, invested $150,500 in cash in the deal and, due to the fact that the semi-annual rentals receivable from Carena exactly equal the semi-annual debt payments to Carena, had no possibility of receiving any positive cash flow until 1987 at the earliest. William Coleman, the representative of Majestic who spoke with Baker about the transaction, testified that he neither sought an independent appraisal of the Equipment nor checked with anyone but Baker about the residual value of the Equipment or the probability of being able to re-lease it. Instead, the Colemans relied solely on Baker's opinion and Majestic's experience with ‘supposedly obsolete‘ equipment
that was still usable. For his part, Baker, feeling unqualified to predict the residual value of the Equipment, told the Colemans only that a reasonably good possibility of a 10- to 20-percent residual value existed. Moreover, Majestic acknowledged in writing to Atlantic, Carena, and European that none of the companies made any representations as to its ability to re-lease the Equipment, possible rentals from such re-leasing, or the residual value of the Equipment. Added to this failure to seek contemporaneous opinions as to the economics of the deal are the facts that (1) William Coleman first approached Baker seeking ‘additional shelter‘ for Majestic's real estate income; (2) Baker's letter to the Colemans describing the deal spoke in terms of tax sheltering, the ‘good news‘ being generation of tax losses and the ‘bad news‘ being generation of taxable income without cash flow; and (3) the tables accompanying this letter reflected neither rental receipts in 1987-1990 nor residual value in 1991.
We note that Mr. Coleman's testimony does not indicate whether this equipment consisted of computers or some other type of equipment.
On the whole, Majestic's indifference to the profit derived from re-leasing or selling the Equipment in the future—the only hope, outside of tax benefits, of recouping the investment in the deal—coupled with petitioners' overriding interest in the tax benefits leads us to conclude that Majestic did not have a bona fide profit objective in entering into the transaction. See Sutton v. Commissioner, supra, at 224-225; Estate of Baron v. Commissioner, supra at 555-556; see also Elliott v. Commissioner, 84 T.C. 227, 237-241 (1985). We find the testimony of Baker and William Coleman regarding Majestic's lack of interest in investments not having economic benefits unconvincing; it is both uncorroborated by the evidence of the deal eventually entered into and tinged with Baker's obvious desire to set up a transaction that would give the appearance to a court of having economic substance.
See sec. 1.183-2(a), Income Tax Regs.
For example, when asked about his thoughts while setting up the transaction as to future litigation, Baker testified:
I, of course, was trying to structure the transaction in such a way that I felt confident that we would win. I was trying to build in the two features which I thought were essential to victory, namely that the price was not excessive, and there was a real possibility of economic profit. (Emphasis added.)
Moreover, an objective analysis of the actual value in December 1979 of the interest acquired by Majestic further supports our conclusion that Majestic did not have a profit objective. The parties' expert witnesses at trial varied widely in their estimates of this residual value. Each purporting to rely only on knowledge available in 1979, respondent's experts, Dee Morgan and S. Paul Blumenthal, predicted 1987 values of $13,000 and $37,500, respectively, whereas petitioners' experts, Davies and David McCormick, predicted 1987-1991 values of Majestic's interest in the Equipment totaling $393,023 and $337,941, respectively. Based upon the totality of the testimony and expert reports, we find that, of the parties' expert witnesses, McCormick was the most knowledgeable about the U.K. computer leasing market, prepared the clearest, most systematic analysis of the value of Majestic's interest in each of the years 1987-1991, and was generally the most convincing. Thus, we begin our analysis of the value of the interest purchased by Majestic with McCormick's figures.
McCormick, the president of ICA Europe, a computer leasing company that competes with Atlantic, estimated the Equipment's residual values, in terms of percentages of the 1979 IBM prices, as follows: By our calculation, given Majestic's contractual percentages of the 1987-1990 rentals, McCormick's assertions as to 1979 IBM prices, and an exchange rate of $2.216/Pound, /35/ McCormick's residual percentages result in cash flows to Majestic as follows:
An objective analysis of the totality of the record leads us to conclude that even this lower estimate of the value of Majestic's interest is skewed upward. McCormick testified that he based his estimates of residual value primarily on two factors: (1) the historical value of IBM equipment and (2) Atlantic's position in the U.K. leasing market. With regard to the first of these factors, we find that, while McCormick's testimony that the longevity of the earlier System 360 processors and 2311 disk drives made it reasonable in 1979 to predict that the processors would last 10 years and the peripherals 15 years was internally logical, McCormick failed sufficiently to take into account the 1978 announcement rumors and IBM price cuts as to disk drives and, more importantly, IBM's January 1979 announcement and late-1979 delivery of the 4300 series. To be sure, some skepticism as to the magnitude of the 4300's price-performance improvement over the System 370 models appears to have been warranted. But, given the experts' testimony and reports, we find that McCormick focussed excessively on the historical data and insufficiently on the objective indicia in 1979 of a severe flattening of the market for the processors and peripherals comprising the Equipment. We conclude that, at the minimum, McCormick's figures (as corrected) must be reduced by a factor of 20 percent on this ground.
With regard to the second factor—Atlantic's market position—we find we must again discount McCormick's figures. McCormick's testimony emphasized that Atlantic's unique position in the leasing market allows it to derive higher residuals than are generally obtainable from computer equipment.
The testimony of Davies and McCormick indicates that this advantage translates into residual values for Atlantic that are 20 percent higher, and equipment lives that are 25 percent longer, than the average in the brokers' market. However, while Atlantic may well have such advantage given its position in the British computer market, Atlantic has neither legal obligation nor economic incentive to use its ability in connection with the Equipment. Under our assumption (see supra p. 35), Atlantic secured its nonrecourse debt to the Lenders with the rents receivable and its residual interest in the Equipment. Atlantic, along with European, also undertook to pay the rents if necessary to clear Carena's rights in respect of the Equipment. However, once Atlantic sold its residual interest to European, Atlantic was economically out of the picture with respect to later rentals of the Equipment; upon the completion of the initial lease terms in the normal course (see supra note 28), Atlantic's debt to the Lenders and undertaking to Carena will be completely satisfied, and Atlantic will have no economic concern regarding the value of European's or Majestic's interest in the later rentals of the Equipment. Thus, European, an entity about which the record reveals nothing in connection with computer leasing experience, is on its own with respect to re-leasing the Equipment and extracting whatever profit potential remains therein through 1986, and Majestic, a company in the real estate business, is on its own thereafter. Consequently, to the extent that McCormick took Atlantic's remarketing ability into account in deriving his estimates, such estimates are too high; indeed, there is no evidence that Majestic and European have sufficient expertise to obtain even the brokers'-market level of residual value from the Equipment. We are satisfied, then, that a further reduction of McCormick's figures by a factor of at least 20 percent is appropriate.
For example, McCormick testified:
In 1979, whereas a normal company * * * would write a normal contract, say for 3 years or 4 years (or) 5 years (and) might expect to have a 37138 last 8 years from the date of first delivery, in Atlantic's case they well expected (them) to last 10 years because they had a customer base tied in, because they had an outstanding relationship with that customer base, and they had a very, very good reputation in the market.
Assuming, then, that McCormick erred by adding at least 40 percent to the proper 1979 estimate of the value of Majestic's interest in the Equipment, we are left at the very most with the following cash flows and total residual value for Majestic:
Petitioners' argument that their high leverage is indicative of a profit objective is also misguided. While a comparison of before- tax profits from a transaction with the initial cash outlay (here, $46,545 with $150,500, see infra note 39) may be relevant to the POSSIBILITY of economic profit, it is not determinative of the existence of a profit OBJECTIVE; otherwise, taxpayers entering into deals featuring 99-percent leveraging would almost certainly be found to have a profit objective irrespective of the actual economic return. Estate of Baron v. Commissioner, supra at 557-558. The better, more useful, comparison, namely between before-tax profit and the net tax benefit derived from the transaction, Estate of Baron v. Commissioner, supra at 558, indicates that petitioners did not have a profit motive for entering into the transaction. Using our calculation of $197,045 maximum residual values and assuming 50-percent tax brackets throughout, even if we were to ignore both the tremendous time-value in the deferral of tax resulting from the time span between petitioners' current depreciation deductions and distant taxable income and petitioners' tax benefits other than depreciation, we find that petitioners have built a 22.1-to-1 tax shelter.
Given the relevance (or, more accurately, the lack of relevance) of Atlantic's remarketing ability, petitioners' failure to investigate the value of the residual interest purchased by Majestic, the maximum value of such interest, and the comparison between Majestic's tax benefit and maximum before-tax profit, we conclude that Majestic's acquisition of an interest in respect of the Equipment constitutes an activity ‘not engaged in for profit‘ within the meaning of section 183.
The tax benefits to Majestic's partners and the Coleman wives from depreciation will total $1,027,776.50 ($2,055,553 x .50), while the before-tax profit will be, at most, $46,545 ($197,045 less cash investment of $150,500).
The next issue for decision is whether respondent properly disallowed petitioners' deduction of interest on the nonrecourse note. Section 163(a) provides for the deductibility of ‘all interest paid or accrued within the taxable year on indebtedness,‘ and it is well established that deductible interest is a payment for the use or forbearance of money. Deputy v. DuPont, 308 U.S. 488, 497 (1940); Smith v. Commissioner, 84 T.C. 889, 897 (1985). If is also well settled that the ‘indebtedness‘ referred to in section 163(a) must be GENUINE indebtedness. Knetsch v. United States, 364 U.S. 361, (1960); Elliott v. Commissioner, supra at 244. While transactions such as petitioners' generally receive scrutiny on this score due to the ‘obvious opportunities for trifling with reality,‘ Elliott v. Commissioner, supra at 244, neither the nonrecourse note nor the use of the sale-leaseback device in which rent payments are geared to interest and amortization on the note necessarily deprives the debt of its character as genuine indebtedness able to support an interest deduction. See Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976), affg. 64 T.C. 752 (1975); Hilton v. Commissioner, 74 T.C. 305, 348 (1980), affd. per curiam 671 F.2d 316 (9th Cir. 1982). However, where, in such situations, the purchase price and principal amount of the nonrecourse note unreasonably exceed the value of the property interest acquired,
it is settled that no genuine indebtedness exists. Estate of Franklin v. Commissioner, supra at 1049; Elliott v. Commissioner, supra at 245; Odend'hal v. Commissioner, 80 T.C. 588, 616 (1983), affd. on this issue 748 F.2d 908 (4th Cir. 1984). This is true because ‘the debt has economic significance only if the property substantially appreciates in value prior to the date at which a very large portion of the purchase price is to be discharged.‘ Estate of Franklin v. Commissioner, supra at 1049. The economics of such a transaction, then, are such that only a potential that a genuine indebtedness may arise exists, and thus that the purchaser has not secured the requisite ‘use or forbearance of money.‘ Estate of Franklin v. Commissioner, supra at 1049.
Compare Brannen v. Commissioner, 78 T.C. 471, 493 (1982), affd. 722 F.2d 695 (11th Cir. 1984) (purchase price) with Hager v. Commissioner, 76 T.C. 759, 774-775 (1981) (principal amount). See also Elliott v. Commissioner, 84 T.C. 227, 245 n.5 (1985).
In the instant case, Majestic purchased an interest in respect of the Equipment for a stated purchase price of $2,055,553 payable in part by execution of a $1,905,053 nonrecourse note. Without question, the maximum value of Majestic's interest of $197,045, computed above, when compared with either the $2,055,553 stated purchase price or the $1,905,053 nonrecourse note, establishes that the price and note unreasonably exceed the value of the interest acquired by Majestic. See, e.g., Elliott v. Commissioner, supra at 246 (maximum value of $7,800, note for $198,000, price of $235,000); Fuchs v. Commissioner, 83 T.C. 79, 102 (1984) (maximum value of $42,000, note for $687,500, price of $812,500); Dean v. Commissioner, 83 T.C. 56, 78 (1984) (maximum value of $58,500, note for $742,500, price of $877,500); Odend'hal v. Commissioner, supra at 617 (maximum value of $2 million, note for $3,920,000, price of $4 million). Thus, respondent correctly disallowed petitioners' deductions for interest on the nonrecourse note.
We note that this analysis also provides further support for our holding that the depreciation deductions herein were properly disallowed. See, e.g., Odend'hal v. Commissioner, 748 F.2d 908, 912 (4th Cir. 1984), affg. on this issue 80 T.C. 588 (1983); Brannen v. Commissioner, 722 F.2d 695, 701 (11th Cir. 1984), affg. 78 T.C. 471 (1982); Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-1049 (9th Cir. 1976), affg. 64 T.C. 752 (1975). In this connection, we further note that our decision in Estate of Thomas v. Commissioner, 84 T.C. 412 (1985), emphasized that it was stipulated and proved that the equipment had substantial value beyond the terms of the leases subject to which the taxpayer acquired such equipment.
Finally, we hold that the interest on the RECOURSE promissory note paid by Majestic and petitioner Nancy Coleman in 1980 is deductible under section 163(a). It is clear that petitioner Nancy Coleman deducted her share of such interest on her 1980 return, and we presume that the interest deducted on her 1980 return, and we presume that the interest deducted on Majestic's 1980 return includes its share of the interest on the recourse note. Additionally, respondent does not argue that such interest was not properly deducted. From all that appears in the record herein, the note was genuine, recourse indebtedness, and the interest paid thereon in 1980 is thus deductible.
In view of our disposition in respondent's favor of the items focussed on by the parties, i.e., depreciation and interest, and since respondent has stated on brief that such a disposition will avoid the necessity of a Rule 155 computation, a statement with which petitioners have voiced no disagreement,
Decision will be entered for respondent.
2 We note that the initial terms for leases 1 and 2 began after the negotiations between Leopard and Davies probably took place, and that the Reuters lease began after the execution of the agreements comprising the instant transaction. However, given no indication to the contrary, we will assume that the leases were all negotiated and ‘arranged‘ prior to the negotiations and agreements relating to the instant transaction.
3 VAT is the United Kingdom value-added tax, imposed on consumption at every level. Atlantic's leases provided for a monthly or quarterly rental ‘Plus V.A.T.‘
4 The Torrington lease provides for commencement of the 5-year term ‘On Acceptance.‘ The record, however, does not contain a copy of the acceptance note. Based upon the other leases and acceptances, and upon the February 23 execution of the Torrington lease, we estimated an early March commencement of the Torrington lease term. Such estimate, incorrect at most by a month, has no bearing on our decision herein.
9 We calculated the figures in this column by pricing the equipment appearing on the invoices using the 1979 IBM (UK) price list, all of which are part of the record herein. For the Northumberland lease (number 2), no invoice appears; thus, we used the equipment list appearing on the lease, as apparently petitioners' expert did in compiling his financial information. Our figures differ in some instances from those presented by petitioners' experts.
FN10 This figure inexplicably differs from petitioners' expert's figure. Our figure comes directly from the invoice purported by petitioners to relate to the equipment on the Reuters lease (number 1). We note that the purported invoice, however, lists equipment not identical to that listed on the Reuters lease—the invoice lists a 3138-I processor while the lease lists a more expensive 3138-J processor. We calculated the cost to Atlantic based on the invoice, as such is the only evidence thereof, and the IBM (UK) list price based on the actual equipment leased.
FN11 As noted supra note 9, no invoice for this equipment appears in the record herein. The only evidence of Atlantic's purchase is a copy of a ledger page containing this figure and date.
FN12 Atlantic acquired this equipment from a French company for 145,000 French francs, and apparently paid no VAT (known in France as TVA) thereon. For comparative purposes, we have added 15 percent to a figure in pounds appearing in handwriting on the invoice, used by petitioners' expert and nowhere objected to by respondent. We note that this would place the exchange rate at about 9.22 French Francs/Pound.
FN13 For this figure, we defer to petitioners' expert, as the invoices in the record herein refer to slightly different equipment from that covered by the Torrington lease.
FN14 We note that 2 of the 3 invoices relating to the Cheshire leases are inexplicably made out to Cheshire County Council, rather than Atlantic. Also, as with the Reuters equipment, one of the Cheshire leases lists equipment (model numbers 3330-11 and 3333-11) differ from that listed on the related invoice (Model numbers 3330-01 and 3333-01). We resolved this problem in the same manner as we did the Reuters problem. See supra note 10.
FN15 For purposes of comparison with the stated purchase prices in the later agreements, we converted the amounts in pounds sterling to dollars and subtracted out the VAT components, using the exchange rate asserted by petitioners and undisputed by respondent for December 26, 1979, $2.216/Pound, and the 15-percent VAT rate.
FN22 We note that the Agreement of Lease, apparently as a result of a typographical error, states that ‘lessor shall pay lessee‘ these percentages of rentals. Additionally, although the documents would seem literally to require European to allow Carena 30 percent of the 1987 subrental proceeds and Carena to pay Majestic 30 percent of the 30 percent it retained, the context indicates that Carena is to pay over to Majestic the full 30 percent allowed to Carena as between Carena and European. The same analysis applies to the 1988 through 1990 subrentals and the percentages applicable thereto.
FN35 As is obvious in 1985, when the exchange rate is approximately $1.40/L, this rate turns out to be totally unrealistic. In the absence of a more reasonable indication of the predicted future exchange rates that would have been used by an objective analyst in December 1979, however, we use $2.216/L in our calculation.
FN36 We note that respondent, correcting McCormick's mathematical errors, arrived at a total value of $274,682, and that our calculation further corrects the parties' errors.
FN38 We find further support for this valuation as an upper limit in the fact that Carena, presumably in an arms'-length transaction, paid $95,353 for the same interest it transferred to Majestic. Petitioners' argument that the difference in the prices to Carena and Majestic can be explained by the wraparound mortgage encumbering Carena's interest is belied by the fact that Atlantic and European agreed to pay the lessees' debts to the lessors in order to clear Carena's title; indeed, Majestic's interest is perhaps worth LESS than Carena's due to Majestic's ‘assumptions‘ of Atlantic's obligation.