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.
Leopard contacted Vernon Davies, cofounder and, at that time, president of Atlantic Computer Leasing p.l.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 terms set forth in the chart on pages 180-181.
Monthly rental User-lessee Lender-lessor Quantity Equipment Initial lease term 1(exclusive of VAT) 2(1) Reuters, Ltd. Mansfield Hosery 1 3138-J Processor Dec. 28, 1979- £5,298 Mills, Ltd. 1 3046-l Power unit June 28, 1982 (2) Northumberland Beaverline Leasing, Ltd. 1 3138-J Processor Nov. 5, 1979- £5,550 for first County Council 1 3046-l Power unit Nov. 5, 1982 2 years, £4,000 thereafter (3) Thomson Travel, Ltd. Thompson, Lloyd & 1 3330-1 Disk storage Feb. 27, 1978 £587 Ewart, Ltd. Feb. 27, 1982 (4) Torrington Co., Ltd. Anochrome, Ltd. 1 3135-I Processor Mar. 1, 1979- £2,500 1 3046-1 Power unit Mar. 1, 1984 31 3215-1 Console printer 1403-N1 Printer 1 (5) Chesire County A. Beckman, Ltd. 2 3350-B2 Direct June 29, 1979- £1,490 Council access storage Dec. 29, 1985 1 3350-C2 Direct access storage 1 3350-C2 Direct access storage (6) Cheshire County Noble Grossart, Ltd. 1 333-11 Disk storage July 13, 1979- £860 Council and control Jan. 13, 1986 1 3330-11 Disk storage
(7) Cheshire County Noble Grossart, Ltd. 2 3830-2 Storage control Sept. 28, 1979- £3,200 Council 3350-A2 Direct Mar. 28, 1986 1 access storage 3350-B2 Direct 1 access storage (8) C & J Clark, Ltd. S. Mason Leasing, Ltd. 1 1403-N1 Printer Mar. 30, 1979 £895 1 2821-2 Control unit Mar. 30, 1981 1We 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. 2VAT is the U.K. value-added tax, imposed on consumption at every level. Atlantic's leases provided for a monthly or quarterly rental "Plus V.A.T." 3The 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.
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
The financial information with respect to the equipment is as shown in the chart on pages 186-187.
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.
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 7½% of cost without minimum cash flow and approximately 8.55% of cost with minimum cash flow. The investment can be
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.
The schedules referred to in Baker's letter read, in relevant part, as shown on pages 188-189.
The table on page 190 represents the comparable calculations, under the "contingent flow assumption," on an
IBM (UK) list price Date of Cost to Atlantic (including VAT) Amount obtained Lease Atlantic's purchase (including VAT) late 1979 1from lenders (1) Reuters July 27, 1977 2£308,103.48 £267,547.50 £160,903 (2) Northumberland Nov. 5, 1979 3£136,016.25 £229,897.65 £189,379 (3) Thomson Travel Jan. 10, 1979 4£18,079.21 £27,694.30 £29,489 (4) Torrington Jan. 30, and 5£220,018.00 £475,459.45 £143,851 Feb. 15, 1978 (5-7) Cheshire June 29, July 12, 6£238,545.98 £351,466.45 £374,695 and Sept. 28, 1979 (8) C & J Clark Nov. 6, 1978 £29,700.00 £54,605.45 £23,461 _________ _____________ _________ Totals £950,462.92 £1,406,670.70 £921,778 =========== ============= ========== Conversion to dollars 7$1,831,500.72 $2,710,593.47 $1,776,226.13 ============= ============= ============= 1We calculated the figures in this column by pricing the equipment appearing on the invoices using the 1979 IBM (U.K.) 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. 2This 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 (U.K.) list price based on the actual equipment leased. 3As noted, note 1 supra, 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. 4Atlantic 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 FF/£. 5For 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. 6We note that two of the three invoices relating to the Cheshire leases are 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) different 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 note 2 supra. 7For 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 Dec. 26, 1979, $2.216/£, and the 15-percent VAT rate.
DATA PROCESSING EQUIPMENT LEASE MINIMUM CASH-FLOW Legal expense and interest Mortgage Tax savings Rental Depreciation on deferred ---------------------- Cash- Tax loss Tax savings plus Sinking fund Year income S.L. 6 years investment Amortization Interest flow (income) (tax) 70% cash-flow Investment Accumulation (7% after tax) 1979 0 $85,875 $5,000 0 0 0 $90,875 $63,613 $63,613 $33,000 $30,613 $30,613 1980 $83,575 171,750 3,150 $25,825 $57,000 $750 148,325 103,828 104,578 38,650 65,928 98,684 1981 167,150 171,750 2,040 56,392 109,258 1,500 115,898 81,129 82,629 19,040 63,589 169,190 1982 167,150 171,750 63,362 102,288 1,500 106,888 74,822 76,322 76,322 257,355 1983 167,150 171,750 71,194 94,457 1,500 99,056 69,339 70,839 70,839 346,209 1984 167,150 171,750 79,993 85,657 1,500 90,257 63,180 64,679 64,679 435,123 1985 167,150 85,875 89,881 75,770 1,500 (5,505) (3,854) (2,354) (2,354) 463,227 1986 167,150 100,990 64,661 1,500 (102,490) (71,743) (70,243) (70,243) 425,410 1987 167,150 113,472 52,179 1,500 (114,972) (80,480) (78,980) (78,980) 376,209 1988 167,150 127,497 38,153 1,500 (128,997) (90,298) (88,798) (88,798) 313,746 1989 167,150 143,256 22,395 1,500 (144,756) (101,329) (99,829) (99,829) 235,879 1990 83,575 78,137 4,688 750 (78,887) (55,221) (54,471) (54,471) 197,919
DATA PROCESSING EQUIPMENT LEASE CONTINGENT CASH-FLOW ONLY Legal expense and interest Mortgage Tax savings Rental Depreciation on deferred ---------------------- Cash- Tax loss Tax savings plus Sinking fund Year income S.L. 6 years investment Amortization Interest flow (income) (tax) 70% cash-flow Investment Accumulation (7% after tax) 1979 0 $85,000 $5,000 0 0 0 $90,000 $63,000 $63,000 $33,000 $30,000 $30,000 1980 $82,825 170,000 2,520 $25,825 $57,000 0 146,695 102,687 102,687 32,520 70,167 102,267 1981 165,650 170,000 1,440 56,392 109,258 0 115,048 80,534 80,534 13,440 67,094 176,520 1982 165,650 170,000 63,362 102,288 0 106,638 74,647 74,647 74,647 263,523 1983 165,650 170,000 71,194 94,457 0 98,806 69,164 69,164 69,164 351,134 1984 165,650 170,000 79,993 85,657 0 90,007 63,005 63,005 63,005 438,718 1985 165,650 85,000 89,881 75,770 0 (4,881) (3,417) (3,417) (3,417) 466,011 1986 165,650 100,990 64,661 0 (100,990) (70,693) (70,693) (70,693) 427,939 1987 165,650 113,472 52,179 0 (113,472) (79,430) (79,430) (79,430) 378,465 1988 165,650 127,497 38,153 0 (127,497) (89,248) (89,248) (89,248) 315,709 1989 165,650 143,256 22,395 0 (143,256) (100,279) (100,279) (100,279) 237,530 1990 82,825 78,137 4,688 0 (78,137) (54,696) (54,696) (54,696) 199,461
Legal expense and interest Mortgage Tax savings Rental Depreciation on deferred ---------------------- Cash- Tax loss Tax savings plus Sinking fund Year income S.L. 6 years investment Amortization Interest flow (income) (tax) 70% cash-flow Investment Accumulation (7% after tax) 1979 0 $171,296 $5,000 0 0 0 $176,296 $123,407 $123,407 $66,176 $57,231 $57,231 1980 $158,206 342,592 5,053 $43,903 $114,303 0 303,742 212,619 212,619 65,213 147,406 208,643 1981 316,412 342,592 1,444 95,866 220,546 0 248,170 173,719 173,719 25,508 148,211 371,459 1982 316,412 342,592 107,715 208,697 0 234,877 164,414 164,414 0 164,414 561,875 1983 316,412 342,592 121,029 195,383 0 221,563 155,094 155,094 0 155,094 756,301 1984 316,412 342,592 135,988 180,424 0 206,604 144,623 144,623 0 144,623 953,865 1985 316,412 171,296 152,796 163,616 0 18,500 12,950 12,950 0 12,950 1,033,585 1986 316,412 171,682 144,730 0 (171,682) (120,177) (120,177) 0 (120,177) 985,759 1987 316,412 192,902 123,510 0 (192,902) (135,031) (135,031) 0 (135,031) 919,731 1988 316,412 216,745 99,667 0 (216,745) (151,721) (151,721) 0 (151,721) 832,391 1989 316,412 243,534 72,878 0 (243,534) (170,474) (170,474) 0 (170,474) 720,185 1990 316,412 273,634 42,778 0 (273,634) (191,544) (191,544) 100 (191,644) 578,954 1991 158,206 149,250 8,956 0 (149,250) (104,475) (104,475) 0 (104,475) 515,006 _________ _________ ______ __________ _________ __ _________ _________ ________ _______ __________ ________ Total 3,480,532 2,055,552 11,497 11,905,044 1,575,488 0 162,005 113,404 113,404 156,997 (43,593) 515,006 1The difference between this amount and the $1,905,053 face value of the nonrecourse note is due to rounding off.
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 the original value at the end of the 11th year after the beginning 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 (£1) 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
* * * * * * *
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:
1987 ..................... 30% 1988 ..................... 40% 1989-90 .................. 50%
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
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 1, 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 (1) "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,
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:[
Dec. 31, 1979 ................... $60,000 Dec. 31, 1980 ................... 300,000 Dec. 31, 1981 ................... 232,000
Dec. 31, 1982 .................. $212,000 Dec. 31, 1983 .................. 200,000
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.
The nonrecourse note in the amount of $1,905,053,
(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 Lease[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.
1987 ................... 30 percent 1988 ................... 40 percent 1989 ................... 50 percent 1990 ................... 50 percent
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, encumbrances 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
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 1 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
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 2-year lease plan.
The peripheral market was less volatile. The 1403-Nl 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
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 United Kingdom is manufactured for 50-cycle current, while U.K. 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 United States and the United Kingdom. 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.
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. To put the matter in a different frame, our holding herein is that, based upon the entire record,
As we see it, the threshold question is whether petitioners had, during 1979 and 1980, a depreciable interest in the equipment. 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 transfer to them via European and Carena.
A significant element in determining ownership is the location of title to the property. It cannot be gainsaid that the documentation herein shows that title to the equipment was unconditionally vested in the lenders. Indeed, that result was intended by the parties, i.e., Atlantic and the lenders, not only in form but also in substance in order to achieve the unquestioned objective of providing the lenders with a first year tax deduction of the cost of the equipment under U.K. law. Thus, under U.K. tax law, Atlantic did not have ownership of the equipment. Such being the case, the question arises as to the extent to which petitioners herein can disavow the form of the transaction between Atlantic and the lenders in order to sustain their right to depreciation under U.S. tax law, since it seems clear to us that the sine qua non of petitioners' depreciable interest in the taxable years before us is the existence of a depreciable interest in Atlantic.
We think it important to note that, in the instant case, it is the taxpayer and not the Government which seeks to disavow the form of the transaction. As we observed in
The bulk of the cases relied upon by petitioners herein involved situations in which the Government was attacking the form of the transaction and the taxpayer was seeking to persuade the Court that the substance and form of the transaction coincided. Certainly this was the posture in Frank Lyon Co. v. United States, supra, and Estate of Thomas v. Commissioner, supra, and consequently, taking into account other factors to which we will subsequently advert, those cases are readily distinguishable from the situation in the instant case. See Bradley v. United States, supra at 720. Moreover, there is nothing in either Frank Lyon or Thomas which compels us to ignore the form of a transaction structured to obtain tax benefits in one jurisdiction and to restructure the transaction, at the insistence of the taxpayer, in order to confer tax benefits in another jurisdiction — in short, to enable the taxpayer to play both ends against the middle. Although Helvering v. F. & R. Lazarus & Co., supra, ostensibly stands for the proposition that a taxpayer can attack the form of a transaction which encompasses the passage of title, there were various other factors present in that case which the Supreme Court considered significant in reaching its conclusion and on which we will subsequently comment. Moreover, we think it important that, in permitting the taxpayer to attack the form of the transaction, the Supreme Court in Lazarus did not hold that the location of title was irrelevant. Bowen v. Commissioner, 12 T.C. 446 (1949), and Oesterreich v. Commissioner, 226 F.2d 798 (9th Cir. 1955), revg. a
In light of the foregoing analysis, we conclude that the proper posture of this case is that the unconditional and consistently confirmed vesting of title in the lenders for a bona fide purpose creates a situation in which respondent has made a prima facie case that Atlantic was not the owner of the equipment for purposes of depreciation, and in which petitioners, claiming through Atlantic, should not be in a better position since, under the various agreements, Majestic simply acquired Atlantic's interest in the equipment. In so concluding, we emphasize that we are not holding that Atlantic was not the owner of the equipment, but only that petitioners have the burden of producing, at a minimum, "strong proof" that the other elements of the burdens and benefits of ownership were such that Atlantic should be considered the owner and, additionally, that Majestic assumed such burdens and was entitled to such benefits of ownership with the result that it (and therefore petitioners) should be entitled to depreciate its (and their) investment
We recognize that, according to the tabulation on page 186, Atlantic obtained some $55,000 less than the original cost of the equipment from the lenders and that this
The terms of all the initial leases extended beyond the taxable years involved herein and the leases 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, 84 T.C. 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 depreciable 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.
Atlantic had assigned the rents under the leases to the lenders without recourse. Thus, 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 payment by the lessees of all amounts due under such leases, Atlantic had no liability to the lenders for the payment of such amounts prior to undertakings resulting from the transactions involved herein. The first
Nor do we view the leaseback from Majestic to Carena as indicating that Majestic either held a depreciable interest in the equipment in 1979 and 1980 or made any investment in the equipment beyond the $150,500 it paid in cash and recourse notes for an interest in the residuals at a future date. 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, 84 T.C. at 436), we think it appropriate, in the context of determining whether petitioners acquired an interest in the equipment depreciable in 1979 and 1980, to view those
As far as the $150,500 is concerned, this too did not, in our opinion, create an interest depreciable by Majestic during the taxable years at issue. It was clearly paid for the right to participate in the contingent benefits hopefully to be derived from the future use of the equipment at a point of time when that use was at best speculative in view of the maximum residual value of the equipment.
On the basis of all of the above, and of the entire record herein, we hold that Majestic, and thus petitioners, did not own an interest in the equipment depreciable in 1979 and 1980. It may well be that the interest will ripen into a depreciable interest, perhaps as early as 1987, but this is an issue which we need not and do not decide. See and compare Geneva Drive-In Theatre, Inc. v. Commissioner, 67 T.C. 764, 770-774 (1977), affd. per curiam 622 F.2d 995 (9th Cir. 1980); Davis v. Commissioner, 66 T.C. 260 (1976), affd. 585 F.2d 807 (6th Cir. 1978); Commissioner v. Moore, 207 F.2d 265, 268-269, 271-272 (9th Cir. 1953), revg. 15 T.C. 906 (1950); Fox River Paper Co. v. Commissioner, 28 B.T.A. 1184, 1203-1204 (1933); sec. 167(h); 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). But cf. Wagner v. Commissioner, 518 F.2d 655 (10th Cir. 1975), revg. and remanding a Memorandum Opinion of this Court. In view of this holding, we need not address the other major contentions of the parties relating to the existence of a profit motive under section 183 — an element which does not affect the issue of interest
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. du Pont, 308 U.S. 488, 497 (1940); Smith v. Commissioner, 84 T.C. 889, 897 (1985). It is also well settled that the "indebtedness" referred to in section 163(a) must be a genuine indebtedness. Knetsch v. United States, 364 U.S. 361 (1960); Elliott v. Commissioner, 84 T.C. 227, 244 (1985), affd. 782 F.2d 1027 (3d Cir. 1986). 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,
The starting point of our analysis is the residual value of the equipment, i.e., the value of the interest acquired. The parties' expert witnesses at trial varied widely in their estimates of 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 1987-91 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 1987-91, 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:
Lease 1987 1988 1989 1990 1991 (1) Reuters 10 0 0 0 0 (2) Northumberland 10 0 0 0 0 (3) Thomson Travel 0 0 0 0 0 (4) Torrington Processor 0 0 0 0 0 Printer 23 23 20 20 10 (5) Cheshire 35 35 25 25 15 (6) Cheshire 20 20 10 10 10 (7) Cheshire 40 40 30 30 20 (8) C & J Clark 25 25 20 20 10
By our calculation, given Majestic's contractual percentages of the 1987-90 rentals, McCormick's assertions as to 1979 IBM prices, and an exchange rate of $2.216/£,
1987 1988 1989 1990 1991 Total $44,732 $41,523 $37,083 $37,083 $115,443
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 substantially skewed upward. Mc Cormick 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 focused 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 a 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.
Thus we conclude that, in his calculations, McCormick erred by adding at least 40 percent to the proper 1979 estimate of the value of Majestic's interest in the equipment. Accordingly, we are left at the very most with the following cashflows and total residual value for Majestic:
1987 1988 1989 1990 1991 Total $31,951 $29,659 $26,488 $26,488 $82,459
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 Majestic's 1980 return includes its share of the interest on the recourse note. Additionally, although he appears to have disallowed deductions for such interest in the deficiency notice, respondent does not argue in this proceeding 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 order to account for the allowance of these deductions,
Decision will be entered under Rule 155.
"Equipment is purchased by Atlantic from suppliers and sold to third party lessors, usually banks or other financial institutions, with the benefit of a lease entered into by Atlantic's customer. The terms of the sale depend upon prevailing rates of interest and other factors, including the time of year at which a lease is entered into, levels of economic activity and relevant tax legislation. Atlantic does not bear the credit risk in respect of arranged leases.
"Atlantic retains a residual interest in the form of an option to acquire the equipment for an amount up to 2 percent of the original selling price at the expiry of the primary lease term or upon earlier termination of the lease. * * *"
Lease Repurchase price (1) Reuters ........................... £3,218 (.02 × £160,903) (2) Northumberland .................... 1,894 (.01 × £189,379) (3) Thomson travel .................... 1 (4) Torrington ........................ 1,439 (.01 × £143,851) (5) Cheshire .......................... 502 (.005 × £100,418) (6-7) Cheshire .......................... 5,486 (.02 × £274,277) (8) C & J Clark ....................... 1 _______ Total ........................... £12,541 =======
See p. 186 infra. 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 to 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 £1, 1/2 percent, 1 percent, or 2 percent.
"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."
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."
"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."