department of the treasury internal_revenue_service washington d c number release date cc intl uilc internal_revenue_service national_office field_service_advice dated date memorandum for from steven a musher chief cc intl subject this field_service_advice responds to your memorandum dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be used or cited as precedent legend a b c d e f g h i j k l m n o p q r s t u v w x y z action citation a citation b citation c citation d citation e date a date b date c date d date e date f date g tl-n-3001-98 date h date i merchandise parent period period period period period petitioner product a product b rate a rate b rate c rate d ussub year year year year year issues whether application of the comparable_profits_method cpm under sec_482 requires adjustments based on the potential for imposition of antidumping duties on u s imports of tangible merchandise and the obligation to post cash deposits for the estimated amount of such duties whether the taxpayer must ignore antidumping duty deposits as extraordinary or consistently treat them both for purposes of determining taxable_income and evaluating arm’s length results for purposes of sec_482 assuming that the taxpayer’s basic position with respect to antidumping duties and deposits were correct whether it correctly calculated the adjustment to income pursuant to sec_1_482-1 and sec_1_482-1 conclusions tl-n-3001-98 yes to the extent exposure to the risk of antidumping duties the requirement to post cash deposits and other associated economic conditions and circumstances constitute material differences between the controlled and uncontrolled transactions adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results sec_1_482-5 sec_1 d no the potential for antidumping duties cannot simply be ignored since it represents a material difference in risks economic conditions or other circumstances between the taxpayer and the comparables eventual refunds or imposition of duties in excess of deposits may however constitute extraordinary items for purposes of the analysis provided appropriate adjustments are made to ensure that comparisons are valid in the transfer_pricing analysis the starting points for the determination of taxable_income and the evaluation of arm’s length results need not be identical no assuming the taxpayer’s position were correct it should have adjusted its operating_profit for the year in question to the median of the comparables for that year rather than make a single-year adjustment that brought taxpayer’s three-year average operating_profit within the range of the three-year averages for the comparables sec_1 f iii d e example sec_2 and facts ussub is a domestic_corporation and a wholly-owned subsidiary of parent ussub distributes and manufactures merchandise in the united_states introduction statutory scheme for imposition of antidumping duties because this case involves antidumping duties we briefly review the statutory and regulatory framework for imposition of such duties before turning to the specific facts of this case the antidumping duty law in general the antidumping law seeks to reduce harm to a domestic industry caused by u s sales of imported merchandise at less than fair value 311_fsupp_340 cust ct aff’d 457_f2d_991 c c p a merchandise is said to be dumped if its u s price is less than its foreign market_value generally foreign market_value consists of the f o b factory price at which such or similar merchandise is sold in the home market in cases involving related parties u s price consists of the arm’s length resale price in the united_states adjusted to approximate the hypothetical amount received by the foreign manufacturer tl-n-3001-98 ie the net amount returned to the foreign exporter see 540_fsupp_1341 ct int’l trade aff’d sub nom 713_f2d_1568 fed cir if u s price is determined to be lower than foreign market_value the u s department of commerce commerce orders the u s customs service customs to collect on all imports of subject merchandise an antidumping duty equal to the differential or dumping margin initial investigation and suspension of liquidation in general an antidumping investigation is begun in response to a petition filed on behalf of a domestic industry an antidumping duty petition alleges imports of merchandise at less than fair value and that the imports have caused or threaten to cause material injury to the domestic industry producing a like product see u s c and following if the petition meets the requirements commerce and the u s international trade commission itc initiate investigations regarding respectively sales at less than fair value and material injury to the domestic industry if commerce and the itc issue affirmative final determinations commerce publishes an antidumping duty order upon publication of the order commerce instructs customs to suspend liquidation assessment of customs duties and charges with respect to the subject imports commerce also requires identified importers to post at the time of entry of merchandise for consumption or withdrawal from warehouse cash deposits of estimated antidumping duties these deposits calculated based on the customs_value of the merchandise approximate the margin below fair value at which the merchandise was sold in the united_states during the initial commerce investigation administrative review and imposition of antidumping duties during the anniversary month of publication of the antidumping duty order an importer of subject merchandise or a domestic interested_party may request commerce to conduct an administrative review which will determine the final dumping margin for entries in the preceding annual period deposits of estimated antidumping duties on entries during that period are taken into account in one of two ways if the first sale of dumped merchandise is to a unrelated entity in the united_states the u s price of the merchandise for antidumping purposes is generally determined by reference to the price to the unrelated entity rather than the price to the resale customer see 652_fsupp_724 ct int’l trade u s c 1677a b in such cases u s price is also subject_to different and fewer adjustments than if a related_entity resold the merchandise in the united_states tl-n-3001-98 no administrative review requested commerce instructs customs to liquidate entries with antidumping duties equivalent to the deposit amount no refund or additional duty administrative review conducted commerce determines dumping margins for all transactions in the review period and issues instructions to customs for collection of the appropriate duty a b if the dumping margin is more than the deposit amount customs collects the additional duty if the dumping margin is less than the deposit amount customs refunds the difference to the importer together with interest calculated from the date of entry to the date of liquidation see u s c modification of cash-deposit and duty rates the importer-specific dumping margin contained in the final results of an administrative review provides the basis for liquidation instructions to customs for individual importers’ entries in the annual period as well as the estimated duty-deposit rate for entries after the date of the determination ie until the deposit rate is superseded by a subsequent administrative review significant time may elapse between commerce’s administrative-review determination and actual collection of antidumping duties commerce is authorized to issue liquidation instructions to customs when the administrative review is completed yet importers and domestic interested parties may seek judicial review of the administrative review results because liquidation of the underlying entries could moot judicial review the u s court of international trade cit customarily enters a preliminarily injunction restraining liquidation given that such injunctions generally remain in effect for the duration of the cit action and during remands or appeals therefrom several years may elapse between the date of an entry subject_to antidumping scrutiny and customs’ final liquidation of that entry antidumping proceedings involving taxpayer in date a petitioner a u s producer of product a filed an antidumping petition alleging that ussub and parent among others engaged in sales of product b at less than fair value ltfv and that those sales caused or threatened to cause material injury to the domestic industry producing a like product tl-n-3001-98 in date b after affirmative determinations by both agencies commerce issued an antidumping duty order with respect to product b for entries on or after date c ussub was required to post cash deposits with customs equal to rate a of the entered customs_value of the merchandise ussub ’s cash-deposit rate stated as a percentage of entered customs_value approximated the ltfv margin determined for ussub sales during the period of investigation commerce issued the following final determinations with respect to product b imported by ussub entry dates proceeding fair value invest period first review period second review period third review period fourth review period margin commerce determination_date rate a rate b rate c rate c rate d citation a citation b citation c citation d citation e ussub entries of product b from date c to date d were subject_to a cash-deposit requirement equal to rate a commerce’s determination on date d that ussub imports in the first review period were not dumped entitled ussub to refunds of cash deposits for that period with interest although refunds might be delayed pending the outcome of judicial review moreover for entries after that date ussub was not required to post cash deposits unless and until commerce determined dumping margins that were more than de_minimis ie more than in a subsequent administrative review as of the date of this memorandum it appears that only ussub entries in the third administrative review period have been subject_to liquidation for the first and second administrative reviews the domestic interested_party initiated judicial review and likely obtained preliminary injunctions restraining liquidation of the underlying entries however for the third administrative review it does not appear that an injunction was obtained with respect to ussub ’s entries although this point should be verified by the field therefore as of date e entries between the date of commerce’s preliminary determination and the publication of the order were subject_to bonding_requirements and might ultimately be subject_to antidumping duties however the cash-deposit requirement per se generally does not apply to entries made prior to the effective date of the antidumping duty order see u s c 1673b d see action in date f tl-n-3001-98 commerce was authorized to issue and likely did issue liquidation instructions with respect to ussub entries in the third review period because commerce found de_minimis dumping margins for ussub in that period commerce would have ordered refunds to ussub of all antidumping duty deposits for entries in period taxpayer’s tax treatment of antidumping duty deposits in computing taxable_income ussub included cash deposits of antidumping duties in cost_of_goods_sold and deducted such deposits as it consumed inventory thus although liability for antidumping duties was contingent and although cash deposits might be refunded with interest ussub deducted the deposits from income in year sec_1 and total deposits were approximately dollar_figurea in year dollar_figureb in year and dollar_figurec year cumulative deposits as of the end of year were approximately dollar_figuree on date g ussub filed form_3115 application_for change in accounting_method for year ussub requested permission to change from deducting antidumping duty cash deposits as a component of cost_of_goods_sold as it had done since cash deposits were first required in year to deducting them only when and if antidumping duty liability was finally imposed upon liquidation on date h the national_office granted ussub ’s request and required that it recognize income of dollar_figuree in each of five consecutive years beginning in year pursuant to sec_481 the cumulative adjustment of dollar_figuref is the difference between costs under the taxpayer’s old and new methods_of_accounting the adjustment prevents double-deduction of deposits ie initially when inventory was consumed and again when duties were assessed in a subsequent tax_year under ussub ’s new method_of_accounting which became effective in year cash deposits and refunds of such deposits have no effect on taxable_income taxpayer-initiated adjustment pursuant to sec_482 on a timely-filed tax_return for year ussub made an adjustment pursuant to sec_1_482-1 and the comparable_profits_method cpm of sec_1_482-5 which reduced its income as the tested_party by dollar_figureg a large portion of this adjustment was attributed to cumulative antidumping duty deposits of dollar_figured made in years ussub argued that these deposits were properly eliminated from operating_profit as extraordinary items pursuant to sec_1_482-5 and ussub reduced its income for year by an additional dollar_figureh in order to place ussub ’s three-year average operating_profit -- stated on a basis that excluded the effect of antidumping duty deposits -- within the interquartile range of operating profits of the comparables tl-n-3001-98 in calculating the self-adjustment to year pursuant to sec_1_482-1 ussub did not deduct antidumping duty deposits for purposes of calculating operating_profit ussub ’s year operating_profit data with antidumping duties excluded from cost_of_goods_sold yields the following ratios of operating_profit to sales op s year year i j year wt avg k l in contrast ussub ’s operating_profit data calculated with antidumping duties included as components of cost_of_goods_sold yield the following op s ratios year year m n year wt avg o p the corresponding op s ratios for the non-controlled comparables were as follows third interquartile median first interquartile year q s u avg yrs r t v it is assumed solely for purposes of this advice that the cpm constitutes the best_method in this case and that op s constitutes the appropriate profit_level_indicator pli law and analysis issue adjustment under cpm to reflect potential imposition of antidumping duties the cpm compares the profitability of the tested party’s relevant business activity that incorporates the controlled transactions measured by a pli often based on operating_profit to the profitability of the similar_business activities including the corresponding uncontrolled transactions of uncontrolled taxpayers the comparables in similar circumstances sec_1_482-5 i the pli should be derived from a sufficient number of years of data to reasonably measure returns that accrue to the comparables sec_1_482-5 generally such a period should encompass at least the taxable_year under review and the preceding two taxable years ie years in this case id as with all methods that rely on external market benchmarks the greater the degree of comparability between the test party’s and in this context the exclusion of antidumping duty deposits an expense item from cost of goods increases apparent gross operating_profit tl-n-3001-98 the comparables’ transactions the more reliable will be the results derived from the application of the method and the degree of comparability depends upon all the relevant facts and circumstances id the degree of comparability is determined by applying the provisions of sec_1_482-1 id comparability does not require identity between the controlled and uncontrolled transactions but those transactions must be sufficiently similar so that the uncontrolled_transaction provides a reliable measure of an arm’s length result sec_1_482-1 if there are differences between the tested party’s relevant business activity including the controlled transactions and the comparables’ business activities including the uncontrolled transactions that would materially affect the profits determined under the relevant pli adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results sec_1_482-5 sec_1_482-1 generally such adjustments must be made to the results of the uncontrolled comparables and must be based on commercial practices economic principles or statistical analyses sec_1 d if adjustments for material differences cannot be made the uncontrolled transactions may be used as a measure of an arm’s length result but the reliability of the analysis will be reduced id although all of the factors described in sec_1_482-1 must be considered comparability under the cpm is particularly dependent on resources employed and risks assumed sec_1_482-5 other factors listed in sec_1_482-1 also may be particularly relevant under the cpm one such factor is a comparison of the significant economic conditions that could affect the prices that would be charged or paid or the profit that would be earned in the controlled and uncontrolled transactions sec_1_482-1 the degree of comparability between the controlled and uncontrolled transactions requires a comparison of the significant risks that could affect the prices that would be charged or paid or the profit that would be earned in the two transactions sec_1 d iii a such a comparison necessitates an analysis of the circumstances of the controlled and uncontrolled transactions regarding a controlled_transaction if the contractual arrangement specifically provides for an allocation of a particular risk the allocation of risks so specified or implied by the taxpayer’s contractual terms will generally be respected if it is consistent with the economic_substance of the transaction sec_1_482-1 sec_1_482-1 in the absence of a written_agreement the contractual arrangement regarding the controlled_transaction may be imputed consistent with the substance of the transaction sec_1_482-1 in determining the economic_substance of the transaction greatest weight will be given to the actual conduct of the parties and their respective legal rights id an allocation of risk after the outcome of such risk is known or reasonably knowable lacks economic_substance sec_1_482-1 in our view the potential for antidumping duties and the associated obligation to post tl-n-3001-98 deposits likely constitute significant risks economic conditions or other circumstances that would materially affect the prices that would be charged or paid or the profit that would be earned in connection with the importation of the affected merchandise and would likely have been taken into account by parties at arm’s length this risk condition or circumstance existed with respect to the taxpayer’s relevant business activity including the controlled transactions but not with respect to the comparables’ business activities including the uncontrolled transactions accordingly adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results in accordance with the above-cited regulatory provisions the incidence of the antidumping associated risks must be determined as of the time the controlled transactions were entered into not after-the-fact once the outcome of such risk is known or reasonably knowable thus taxpayer cannot argue that ussub did not bear any risk different than the comparables just because taxpayer already knew or could reasonably know at the time it filed its return for year that in fact no duties could be imposed on the year entries and that the corresponding deposits would be refunded rather it was incumbent upon the taxpayer at the time it filed its year return to report its operating income in light of the risks economic conditions and other circumstances existing at the time of the transactions examination needs to develop the facts surrounding the controlled transactions to ascertain the relevant allocation of risks the economic conditions and the other circumstances attendant to the potential for antidumping duties and the requirement to make deposits any contractual agreements expressly or impliedly addressing the risk allocation should be examined in the absence of such expressly applicable agreements examination may impute an arrangement allocating the risk consistent with the economic_substance of the controlled transactions giving greatest weight to the actual conduct of the parties and their legal rights in this case important legal rights of the parties are defined under the antidumping laws including implementing regulations prior to importers subject_to antidumping duty orders were generally permitted to post bonds as security for antidumping duties that were ultimately determined to be due a new cash-deposit requirement was implemented by title i of the trade agreements act of which repealed the antidumping act of and enacted in its place title vii of the tariff act of as amended the legislative_history of the trade agreements act of indicates that congress intended the cash-deposit requirement to provide the domestic industry prompt relief from dumping and to act as a strong incentive for affected importers to submit the information necessary for determination of final antidumping duties see as of date g commerce had issued a final_determination of no dumping by ussub for the first administrative review and a similar preliminary determination for the second review the last ussub entries in the third administrative review entered u s commerce on date i thus before it filed its return for year ussub could analyze all of its entries in year and could evaluate the likelihood that commerce would impose antidumping duties tl-n-3001-98 sen_rep no 96th cong 1st sess reprinted in u s c c a n see also h_r rep no 96th cong 1st sess congress recently indicated that the incidence of antidumping duties should be on u s importers in the uruguay round agreements act of congress specified that duty- reimbursement should be considered as a negative factor in proceedings involving revocation of existing antidumping duty orders see u s c a see also sen_rep no 103d cong 2d sess commerce regulations specifically prohibit reimbursement of antidumping duties to the importer ussub in this case c f_r b see also c f_r sec_351 f an importer subject_to an antidumping duty order must certify prior to importation that it has no agreement or understanding for the payment or for the refunding to it by the manufacturer producer seller or exporter of all or any part of the antidumping duties assessed upon imports of the merchandise c f_r b if the importer fails to provide the necessary certification commerce may deduct from u s price any amounts deemed to be reimbursed potentially doubling the amount of antidumping duty payable because cash deposits are credited against the amount of final duties assessed the underlying obligations for deposits and duties are closely linked the party who posts the cash deposit in any given case is in effect the same party who assumes liability for final antidumping duties as assessed commerce has stated that the remedial effect of the antidumping law is defeated where exporters themselves pay antidumping duties or reimburse importers for such duties color television receivers from the republic of korea fed reg dept comm moreover commerce may determine that reimbursement has occurred if evidence demonstrates that the exporter directly pays antidumping duties for the related importer or reimburses the importer for such duties color television receivers from the republic of korea fed reg pincite applying this standard commerce has on several occasions found prohibited reimbursement see 4_fsupp2d_1213 ct int’l trade listing determinations finding reimbursement however interpretation of the regulation in this manner is relatively recent see hoogovens f_supp 2d pincite noting change in practice in several earlier cases commerce refused to investigate reimbursement absent written evidence in the administrative record that the practice occurred see the 127_f3d_1077 fed cir the antecedent of the current reimbursement regulation was issued by what was then the bureau of customs pursuant to the antidumping act of see t d treas dec see also c f_r f the reimbursement regulation with changes in wording and numbering has been in force from to the present tl-n-3001-98 the legal rights of the controlled parties thus support the view that at the time of importation ussub bore the risk that antidumping duties would ultimately be assessed on the imported merchandise that is the antidumping statute and regulations apparently place the burden of antidumping duties on the u s importer and may impose negative consequences if duties are reimbursed by another party as noted adjustments must be made to account for the potential imposition of antidumping duties to the extent this represents a significant risk economic condition or other circumstance that would materially affect the prices that would be charged or paid or the profit that would be earned in connection with the importation of the affected merchandise provided the effect of such risk economic condition or circumstance on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results such adjustments must generally be made to the results of the uncontrolled comparables and must be based on commercial practices economic principles or statistical analyses sec_1_482-1 in this case the adjustment may be thought of as corresponding to the premium an uncontrolled taxpayer would have demanded under circumstances comparable to those faced by ussub in our view the service may consider the cash deposit rate as in effect from time to time as evidence relevant to what that premium might be the cpm analysis for year spans the three-year period years again in accordance with the above-cited regulatory provisions the incidence of the antidumping associated risks must be determined as of the time the controlled transactions were entered into not after-the-fact once the outcome of such risk is known or reasonably knowable thus in our view the service may consider rate a in determining the premium an uncontrolled taxpayer might demand with regard to imports of affected merchandise during years of course this evidence must be evaluated in light of the transfer_pricing regulations and any other relevant evidence further adjustments may be warranted in light of that evaluation consequently additional factual and economic analysis may be necessary to determine the appropriate adjustment in this case within year in date b commerce ordered cash deposits on entries of product b beginning with date c in year at rate a rate a remained in effect until date d in year when commerce issued its determination that ussub ’s imports in the first review period were not dumped and so entitled ussub to refund of cash deposits for period including year and part of year as of date g in year commerce had issued a final_determination of no dumping by ussub for the first administrative review and a similar preliminary determination for the second review period ie period including the balance of year and part of year the last ussub entries in the third administrative review period ie period including the balance of year and part of year entered u s commerce on date i in year commerce’s actions in year and other year data however are not relevant assuming they could not reasonably be anticipated in years tl-n-3001-98 issue extraordinary or consistent treatment of antidumping duty deposits taxpayer’s argument that the cash deposits were properly eliminated from operating_profit as extraordinary items pursuant to sec_1_482-5 and as well as the argument that deduction of such deposits similarly were eliminated under the change_of method_of_accounting granted by the service must be considered in the context of the above discussion as discussed in our view the potential imposition of antidumping duties is likely a material difference in risks economic conditions or other circumstances between the taxpayer and the comparables that requires adjustment under the regulations from this perspective this potential is not extraordinary and requires some consideration in the analysis on the other hand that consideration does not necessarily involve deducting the amounts of the cash deposits in determining ussub ’s operating_profit for purposes of the cpm in line with the foregoing discussion the adjustment for the antidumping duty potential may be to reflect a premium over and above the normal returns of the comparables the cash deposit rate as in effect from time to time is evidence relevant to what that premium might be although it may not be identical with the premium that the service ultimately determines to be appropriate thus one possible approach would be to back out the cash deposit amounts from ussub ’s cost_of_goods_sold but then add in the appropriate premiums into the returns of the comparables for purposes of the comparison under the cpm alternatively premium amounts might indeed be deducted in computing ussub ’s operating profits no adjustment would then be made to the returns of the comparables for purposes of the comparison under the cpm under either the approach taken in this or the preceding paragraph the eventual refund of cash deposits or the imposition of duties in excess of prior deposits would represent extraordinary gains or losses that should be excluded from the computation of the operating_profit of ussub or the comparables sec_1 d and provided appropriate adjustments are made to ensure that comparisons are valid in the transfer_pricing analysis the starting points for the determination of taxable_income and the evaluation of arm’s length results need not be identical see sec_1_482-5 if the comparable operating_profit of the tested_party is determined from profit level indicators derived from financial statements or other accounting_records and reports of comparable parties adjustments may be made to the reported operating_profit of the tested_party in order to account for material differences between the tested party’s operating_profit reported for u s income_tax purposes and the tested party’s operating_profit for financial statement purposes in any event the approach adopted by the taxpayer is inappropriate ie both to back out the cash deposit amounts from ussub ’s cost_of_goods_sold and then to leave the returns of the comparables unadjusted the problem with that approach is its failure to make any adjustment tl-n-3001-98 regarding ussub ’s antidumping duty exposure we note that under the position herein arm’s length pricing and antidumping policies are mutually reinforcing by adjusting the application of the cpm to reflect the differences between ussub and the comparables with reference to the potential for antidumping duties ussub is in effect required to report the same operating_profit whether or not dumping occurs in other words this position avoids creating a tax advantage to dumping conversely to assume that ussub ’s results as measured with reference to the comparables should be unaffected by potential dumping would imply an arrangement in which the financing of deposits the benefit of any refunds and the burden of any final duties in excess of deposits are at the risk of parent such an arrangement would contravene the commerce regulations which dictate that such risk rests with ussub issue evaluation of taxpayer-initiated adjustment performed by ussub the foregoing sections set forth substantive shortcomings in the taxpayer’s cpm analysis even assuming that the taxpayer’s basic position with respect to antidumping duties and deposits were correct however it incorrectly calculated the adjustment to year income pursuant to sec_1_482-1 and sec_1_482-1 the taxpayer made its year adjustment pursuant to sec_1_482-1 which permits a controlled_taxpayer if necessary to reflect an arm’s length result to report a decrease in taxable_income from its controlled transactions based on prices different than those actually charged but only on a timely filed u s income_tax return including extensions in our view a taxpayer-initiated adjustment must comply with the same rules as apply for service-initiated adjustments in making its year adjustment under the cpm the taxpayer compared ussub ’s average operating_profit to the interquartile range of the comparables for the three-year period year sec_1_482-5 provides in pertinent part the profit level indicators should be derived from a sufficient number of years of data to reasonably measure returns that accrue to uncontrolled comparables generally such a period should encompass at least the taxable_year under review and the preceding two taxable years this analysis must be applied in accordance with sec_1_482-1 accord sec_1_482-1 regarding adjustment if taxpayer’s results are outside arm’s length range see sec_1_482-1 for determination of an adjustment when a controlled taxpayer’s result for a multiple year period falls outside an arm’s length range consisting of the average results of uncontrolled comparables over the same period tl-n-3001-98 sec_1_482-1 provides applications of methods using multiple year averages if a comparison of a controlled taxpayer’s average result over a multiple year period with the average results of uncontrolled comparables over the same period would reduce the effect of short-term variations that may be unrelated to transfer_pricing it may be appropriate to establish a range derived from the average results of uncontrolled comparables over a multiple year period to determine if an adjustment should be made in such a case the district_director may make an adjustment if the controlled taxpayer’s average result for the multiple year period is not within such range such a range must be determined in accordance with sec_1 e arm’s length range an adjustment in such a case ordinarily will be equal to the difference if any between the controlled taxpayer’s result for the taxable_year and the midpoint of the uncontrolled comparables’ result for that year if the interquartile range is used to determine the range of average results for the multiple year period such adjustment will ordinarily be made to the median of all the results of the uncontrolled comparables for the taxable_year see example of sec_1_482-5 in other cases the adjustment normally will be made to the arithmetic mean of all the results of the uncontrolled comparables for the taxable_year however an adjustment will be made only to the extent that it would move the controlled taxpayer’s multiple year average closer to the arm’s length range for the multiple year period or to any point with in such range in determining a controlled taxpayer’s average result for a multiple year period adjustments made under this section for prior years will be taken into account only if such adjustments have been finally determined as described in sec_1_482-1 see example of sec_1_482-5 emphasis added see also sec_1_482-5 example iii to determine the amount if any of the allocation the district_director compares ussub’s reported operating_profit for to comparable operating profits derived from the uncontrolled distributors’ results for sec_1_482-5 example iii in this case the foregoing rules require that if ussub ’s year average operating_profit is outside the interquartile range of the comparables’ year average operating profits then the adjustment will ordinarily be made to the median of all the results of the uncontrolled comparables for the taxable_year ie year note the stated condition would be met since a downward adjustment of ussub ’s operating_profit for year from k to s the median of the comparables’ year results would move ussub ’s year average l before adjustment w after adjustment closer to the limit of the interquartile range of the comparables for the three-year period r the taxpayer however performed a far larger one-year adjustment sufficient in itself to move ussub ’s year average within the year comparable range tl-n-3001-98 reducing ussub ’s operating_profit from dollar_figurex to dollar_figurey would result in an op s ratio of s for year ie the median of the results of the comparables for that year thus even assuming that ussub ’s legal analysis is valid the maximum permissible adjustment under sec_1_482-1 for year is only dollar_figurez rather than the dollar_figureg calculated by ussub case development hazards and other considerations tl-n-3001-98 tl-n-3001-98 tl-n-3001-98 if you have any questions regarding this matter please call branch at __________________________________ steven a musher chief branch office of the associate chief_counsel international


t c memo united_states tax_court sooren hovhannissian and estate of mary hovhannissian deceased sooren hovhannissian executor petitioners v commissioner of internal revenue respondent docket no filed date stephen g utz and ann mcclure for petitioners elise f alair and bradford a johnson for respondent memorandum findings_of_fact and opinion beghe judge respondent determined the following deficiencies addition_to_tax and penalties year petitioner s deficiency addition_to_tax sec_6651 penalty sec_6662 sh mh sh mh dollar_figure big_number big_number dollar_figure --- --- dollar_figure big_number big_number petitioners are sh--sooren hovhannissian mh-- estate of mary hovhannissian deceased sooren hovhannissian executor and sh mh--sooren hovhannissian and estate of mary hovhannissian deceased sooren hovhannissian executor after concessions by both parties we first address whether petitioner sooren hovhannissian petitioner is required to include in his gross_income as gain under sec_1038 dollar_figure the portion of the cash he received on an installment_sale of real_property in that he had not previously reported as gain we hold that sec_1038 governs petitioner’s reacquisition in of the property upon the buyer’s default on the installment note secured_by the property petitioner must include dollar_figure as gain in his gross_income we also hold that petitioner is not entitled to claim a sec_165 loss in on his reacquisition of the property as a result petitioner conceded the addition_to_tax and respondent conceded the penalties petitioners argued on brief that they have conceded only dollar_figure of their claim for car and truck expenses for taxable_year however the parties’ stipulation clearly states that petitioners conceded dollar_figure of those claimed deductions all section references are to the internal_revenue_code in effect for the years in issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated petitioners are not entitled to any loss_carrybacks from to findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts and the attached exhibits are incorporated herein by reference petitioners resided in trumbull connecticut when they filed their petition mrs hovhannissian thereafter died and her estate was substituted as a party to this proceeding beginning in petitioner acquired several contiguous parcels of land in bridgeport connecticut hereinafter boston avenue property and boston avenue property upon which he built several structures petitioner operated a retail carpet and furniture business on the premises from the time of their construction until he sold the boston avenue property in petitioner continued to operate a carpet business at the boston avenue property through at least in petitioner began to build a combination parking garage and warehouse on the rear portion of the boston avenue property petitioner encountered various difficulties in building this structure which was never completed or put into service petitioner estimated that he spent dollar_figure in constructing this structure but lost his records of the construction costs petitioner submitted an expert report that estimated the likely construction costs of the structure at dollar_figure at the time of construction in the early 1970's thereafter petitioner let the structure stand idle and unfinished fenced off to prevent vandalism one of the walls of the structure collapsed prior to the sale and was never repaired on date petitioner sold the boston avenue property which then consisted of the furniture store building the front property and the unfinished garage warehouse structure the rear property to the bridgeport mini limited_partnership the partnership for the stated consideration of dollar_figure petitioner received dollar_figure in cash and a nonrecourse purchase_money_mortgage note in the face_amount of dollar_figure under the terms of the note petitioner was to receive quarterly payments of interest for years at which time the principal_amount of dollar_figure and all accrued or unpaid interest would become due as part of the sale petitioner obtained an engineering report showing that the garage structure was suitable for conversion into a self-storage facility he also obtained the permits necessary for conversion of both the front and rear properties into self-storage facilities as part of the dollar_figure petitioner received from the partnership approximately dollar_figure above and beyond the sale price which was properly reported by petitioner as part of the payments from the sale that were received during for taxable_year petitioner and mrs hovhannissian filed a joint income_tax return of the dollar_figure in cash received upon the sale of the boston avenue property petitioners reported dollar_figure as gain and dollar_figure as a recovery_of basis from an installment_sale petitioners also received and reported dollar_figure in interest payments from the partnership petitioner and mrs hovhannissian filed separate returns for taxable_year they each reported dollar_figure of the dollar_figure of interest payments received from the partnership during that year in petitioner and mrs hovhannissian received no interest payments from the partnership following the sale in the partnership began converting the boston avenue property into a self-storage rental facility in the partnership filed for bankruptcy leaving the conversion incomplete and defaulting on its obligations to pay interest and principal on the mortgage note the main building on the front property which had formerly served as petitioner’s furniture store had been stripped to a bare shell to house the self-storage facility the main building contained mini storage bins installed on all three floors the doors from all of the bins were missing the partnership had also removed the roof of the unfinished garage structure and several important structural members on or about date the federal bankruptcy court supervising the partnership bankruptcy permitted petitioner to reacquire the boston avenue property the parties have stipulated that the fair_market_value of the boston avenue property on the reacquisition date was dollar_figure pursuant to a claim petitioner made in date he received an insurance recovery_of dollar_figure in a later year for damage resulting from alterations made to the boston avenue property by the partnership petitioner also filed suit against the attorney who represented him on the sale of the property alleging that the partnership’s purchase_money_mortgage note should have been recourse and not nonrecourse petitioner recovered no damages for taxable_year petitioner and mrs hovhannissian filed a joint income_tax return reporting a loss of dollar_figure upon the advice of their then income_tax_return_preparer they did not report any gain_or_loss on the reacquisition petitioner and mrs hovhannissian filed separate form sec_1045 application_for tentative refund claiming net_operating_loss carrybacks of dollar_figure and dollar_figure respectively from to taxable_year in january to date respondent issued separate notices of deficiency to petitioner and mrs hovhannissian for taxable_year and a joint notice_of_deficiency for taxable_year petitioners filed a timely petition with this court opinion application of sec_1038 the primary issue for decision is whether sec_1038 governs petitioner’s reacquisition of the boston avenue property requiring petitioners to report dollar_figure as hitherto unrecognized_gain in taxable_year under sec_1038 congress added sec_1038 to the code to ensure that certain reacquisitions of real_property sold in installment_sales would not be treated as taxable exchanges by simple reference to the fair_market_value of the reacquired_property act of date publaw_88_570 78_stat_854 sec_1038 provides that a reacquisition of real_property governed by sec_1038 is one in which a sale of real_property gave rise to indebtedness in favor of the seller the indebtedness was secured_by the real_property sold and the seller reacquired the real_property in full or partial satisfaction of the indebtedness except as provided in sec_1038 no gain_or_loss results from the reacquisition and no debt can be treated as having become worthless or partially worthless for any such reacquisition sec_1038 provides if-- a sale of real_property gives rise to indebtedness to the seller which is secured_by the real_property sold and continued for reacquisitions governed by sec_1038 sec_1038 requires the seller to recognize gain to the extent that money and the fair_market_value of other_property received from the sale prior to reacquisition exceed the amount of gain recognized in previous periods sec_1038 limits the amount of gain to be recognized to the amount by which the original sale price exceeded the sum of the adjusted_basis of the property gain previously recognized on the sale and continued the seller of such property reacquires such property in partial or full satisfaction of such indebtedness then except as provided in subsections b and d no gain_or_loss shall result to the seller from such reacquisition and no debt shall become worthless or partially worthless as a result of such reacquisition sec_1038 provides in the case of a reacquisition of real_property to which subsection a applies gain shall result from such reacquisition to the extent that-- a the amount of money and the fair_market_value of other_property other than obligations of the purchaser received prior to such reacquisition with respect to the sale of such property exceeds b the amount of the gain on the sale of such property returned as income for periods prior to such reacquisition any money paid or other_property measured by its fair_market_value transferred in connection with the reacquisition sec_1038 governs the federal_income_tax treatment of all reacquisitions described therein even where the mandatory language of sec_1038 works a hardship on a taxpayer 76_tc_1018 relief available to such taxpayers through increases to basis under sec_1038 that offset gain reported upon reacquisition sec_1_1038-1 income_tax regs sec_1038 applies to such reacquisitions even when substantial improvements have been made sec_1038 provides limitation --the amount of gain determined under paragraph resulting from a reacquisition during any taxable_year beginning after the date of the enactment of this section shall not exceed the amount by which the price at which the real_property was sold exceeded its adjusted_basis reduced by the sum of-- a the amount of the gain on the sale of such property returned as income for periods prior to the reacquisition of such property and b the amount of money and the fair_market_value of other_property other than obligations of the purchaser received with respect to the sale of such property paid or transferred by the seller in connection with the reacquisition of such property for purposes of this paragraph the price at which real_property is sold is the gross_sales price reduced by the selling commissions legal fees and other expenses incident to the sale of such property which are properly taken into account in determining gain_or_loss on such sale that substantially change the property 88_tc_541 in conners v commissioner supra we held that sec_1038 does not require a taxpayer who reacquires land improved by the buyer to recognize gain on the reacquisition with respect to the improvements in conners the taxpayers sold land for dollar_figure cash and a dollar_figure promissory note to a developer who constructed a 48-unit town house project the developer buyer defaulted on his note to the taxpayers when he could not sell all the units the taxpayers ultimately agreed to take title to six units the land underlying those units and six forty-eighths of the common land in lieu of exercising their right to foreclose the taxpayers did not report any gain upon the reacquisition id pincite in conners the commissioner argued that the taxpayers were required to recognize gain from the improvements because the property was substantially different from that which they sold id pincite contending that sec_1038 did not apply because contrary to congressional intent the taxpayers were in a better position following the reacquisition id pincite however we found that the taxpayers were not in a better position and that to tax them on the improvements at that point would be to require the recognition of gain not yet realized out of funds not yet received id we held that repossession of improved property in satisfaction of an obligation resulting from the sale of the same property prior to improvements is entitled to nonrecognition treatment under sec_1038 id pincite to aid in determining the applicability of sec_1038 to the facts in conners we used four factors enumerated in the legislative_history indicating that congress felt it was inappropriate to measure gain upon repossession of the property by reference to the fair_market_value at the time of the repossession because the taxpayer was actually in no better position than he was before he made the sale valuation at the time of repossession was difficult to tax the initial seller on gain at the time of repossession was to tax him on gain not yet realized and because the taxpayer had not received a monetary return with respect to the property funds to pay the taxes may be unavailable id pincite citing s rept 88th cong 2d sess 1964_2_cb_828 petitioners argue that the boston avenue property was so changed by reason of the partnership’s failure to complete the conversion to the self-storage facility that sec_1038 should not apply to the entire property but only to the front property the former furniture store and the land on which it stands petitioners argue that sec_1038 should not apply to the rear property because the buyer so irreparably damaged the parking structure that petitioners cannot be taxed as though the building still existed and could therefore be said to have been recovered as well petitioners argue alternatively that even if sec_1038 does apply to the entire property petitioner is entitled to a sec_165 loss upon the reacquisition of the rear property in its damaged condition respondent citing conners v commissioner supra argues that sec_1038 applies to real_property that has been reacquired even if it has been substantially changed before considering the four factors described in the legislative_history and quoted in conners v commissioner supra pincite we address petitioner’s argument that the property should be bifurcated so as to apply sec_1038 only to the front property petitioner sold the boston avenue property as a single piece of property and reacquired it as a single piece of property the warranty deed by which petitioner conveyed the property to the partnership in also identifies the property as a single parcel cf goudas v commissioner tcmemo_1996_ there is nothing in the facts of this case to support a finding that the boston avenue property is divisible in any meaningful way that would be supported by language of the statute the regulations or the legislative_history on this ground alone we could hold that sec_1038 applies to the reacquisition of the entire boston avenue property because petitioners have conceded the applicability of sec_1038 to the front property however we go on to consider the four factors referred to in the legislative_history we cannot determine from the record whether petitioner was in a better or worse position at the time of reacquisition than he was at the time of the original sale upon the reacquisition petitioner had the property plus dollar_figure in cash he had received at the time of sale and dollar_figure in interest payments the parties have stipulated that the fair_market_value of the boston avenue property was dollar_figure at the time of reacquisition under the terms of the mortgage note petitioner had no further recourse against the partnership or its general partners upon reacquisition of the property despite his subsequent expressions of discontent with the terms of the transaction petitioner willingly sold the property on those terms in and received dollar_figure at the closing and interest payments pursuant to the mortgage note in and only when petitioner resells the property will he be able to ascertain whether the changes by the partnership and the then-current market conditions will result in a loss congress enacted sec_1038 to provide mandatory uniform income_tax treatment in precisely this kind of case deferring recognition of either gain_or_loss until the seller once again sells the reacquired_property and the amount of the gain_or_loss can be objectively measured s rept supra c b pincite see also greene v commissioner t c pincite6 the difficulty in determining a fair_market_value by which to ascertain an amount_realized in the absence of a realization event was another major reason why congress enacted sec_1038 s rept supra c b pincite that valuation difficulty is present in this case although the parties have stipulated based on petitioner’s expert’s opinion a fair_market_value of dollar_figure at reacquisition the record also contains a appraisal of the same property in the same condition for dollar_figure we discuss the third and fourth factors in light of petitioner’s further argument that applying sec_1038 to this case would be unconstitutional because petitioner did not realize any gain in connection with the sale and subsequent reacquisition of the boston avenue property and should therefore not be taxed on any gain nor denied a claim for a loss at the time of reacquisition to support his argument petitioner also claims that the fair_market_value of the property at the time of reacquisition governs whether any gain was realized on the transactions at issue petitioner argues that he should not be taxed if the value of the property he received back and the amount of cash and other_property he received in connection with the initial sale are less than his presale basis in the property the amount that petitioner received dollar_figure plus the fair_market_value of the property at acquisition dollar_figure is slightly less dollar_figure than the adjusted presale basis in the property dollar_figure claimed on his income_tax return for the year of the sale continued petitioner’s arguments misconstrue both the intent and operation of sec_1038 as discussed supra congress enacted sec_1038 to obviate the difficulties in the absence of an identifiable sale or other exchange at the time of reacquisition of ascertaining the fair_market_value of the property and objectively determining whether gain_or_loss was actually realized see s rept supra c b pincite to that end sec_1038 expressly disallows any recognition of gain_or_loss in connection with the reacquisition itself sec_1038 requires only that the seller recognize and report as gain that amount of any cash or other_property that was received by the seller on the original sale and whose recognition was deferred under sec_453 such recognition rectifies the imbalance created by the sec_453 deferral which congress allowed in order to sidestep the seemingly elementary issue of when the ‘amount realized’ by the seller includes the value of the buyer’s obligations to make the future payments bittker mcmahon federal income_taxation of continued for at least two reasons this argument cannot prevail first the relevant realization event for measuring gain is the initial sale not the subsequent reacquisition second both the legislative_history and the regulations specifically state that the fair_market_value of the property at the time of reacquisition is immaterial see s rept 88th cong 2d sess 1964_2_cb_828 sec_1_1038-1 income_tax regs moreover we are not satisfied that petitioner has proved the presale basis claimed on the return individuals sec_29 pincite 2d ed supp as sec_1_1038-1 income_tax regs explains it is immaterial for purposes of applying sec_1038 whether the seller realized a gain or sustained a loss on the sale of the real_property or whether it can be ascertained at the time of the sale whether gain_or_loss occurs as a result of the sale it is also immaterial what method_of_accounting the seller used in reporting gain_or_loss from the sale of the real_property or whether at the time of reacquisition such property has depreciated or appreciated in value since the time of the original sale petitioner also argues that the dollar_figure he received in connection with the original sale was not income but only a receipt we may dismiss this argument by noting that it has been long settled that all amounts received in connection with a realization event which in this case was the original sale must be included in income under sec_1001 and sec_61 348_us_426 petitioner had complete dominion over the cash in that he had no expectation that he would ever have to return it to the buyer 493_us_203 106_tc_392 we note in passing that we could alternatively view the sale not as a sale of the property as such but as the sale to the partnership for dollar_figure of an option to purchase the property for the face_amount of the note dollar_figure especially if the nonrecourse note were seen as invalid under the analysis in 64_tc_752 affd on other grounds 544_f2d_1045 9th cir because the face_amount of the note so greatly exceeded the fair continued the operation of sec_1038 and c illustrates why it is appropriate that petitioner should be liable for income_tax on hitherto untaxed amounts received prior to the reacquisition in petitioner recognized dollar_figure of the dollar_figure received as part of the consideration for the sale of the boston avenue property and deferred the balance under sec_453 sec_1038 requires the recognition of that balance dollar_figure up to the limit imposed by sec_1038 of the original sale price less petitioner’s claimed presale basis or dollar_figure sec_1038 ensures that all receipts of cash and other_property by the seller prior to reacquisition are taxed as income to return the seller to as close to status quo ante continued market_value of the property if the sale were analyzed as the sale of an option to buy the boston avenue property the overall federal tax consequences would be similar to the operation of sec_1038 although the timing of recognition and adjustment to basis would differ only when an option lapses does the grantor of an option include in gross_income the amount received for the option id pincite 67_tc_71 see also revrul_78_182 1978_1_cb_265 revrul_58_234 1958_1_cb_279 as short-term_capital_gain sec_1234 the option grantor retains his property with its basis unchanged the more favorable treatment of a seller who reacquires real_property under sec_1038 in terms of allowed adjustments to basis belies petitioner’s argument that sec_1038 is unconstitutional in its application to the facts of his case see also 76_tc_1018 sec_1038 limits the amount required to be recognized under sec_1038 to the amount by which the sale price exceeds the sum of presale basis amounts previously recognized and amounts paid in connection with the reacquisition in this case nothing dollar_figure - big_number big_number big_number with respect to the reacquired_property as circumstances will permit sec_1038 c recalculates petitioner’s basis in the reacquired_property to account for the original presale basis that the seller had in the property plus other adjustments such as sales costs as reflected in the seller’s basis in the debt_instrument under sec_453 see sec_1_453-9 income_tax regs plus the gain reported under sec_1038 sec_1038 gain reported in prior taxable years sec_1038 and any amounts paid in connection with the reacquisition sec_1_1038-1 income_tax regs the operation of these two subsections leaves the seller having paid all federal taxes due on cash and other_property received prior to reacquisition and in possession of his original property with an increased basis in light of the foregoing we hold that sec_1038 governs petitioner’s reacquisition of the real_property pincite boston avenue in satisfaction of the indebtedness arising from its sale sec_1_1038-1 income_tax regs sec_1038 governs the entire reacquisition even though the property has been substantially changed through incomplete modifications to both the erstwhile furniture store and the structure on the rear there is conflicting evidence in the record with respect to petitioner’s basis in the parking structure at the time of the sale which will have a direct bearing on the calculation of petitioner’s post-reacquisition basis in the property under sec_1038 property see conners v commissioner supra pincite reacquisition of real_property governed by sec_1038 even though substantial improvements made under sec_1038 petitioner must recognize and include in gross_income the previously excluded balance of the initial cash payment dollar_figure disallowance of loss related to reacquisition governed by sec_1038 petitioner argues in the alternative that as a matter of law he is entitled under sec_165 to claim a loss on the reacquisition sec_1038 forestalls a seller incident to a sec_1038 reacquisition of real_property from claiming a bad_debt deduction under sec_166 for the default in payment of the purchase_money_mortgage debt secured_by that property rose v commissioner tcmemo_1987_19 affd 855_f2d_65 2d cir the language of sec_1038 which states that no gain_or_loss shall result to the seller from such reacquisition see also sec_1_1038-1 income_tax regs also disallows other kinds of losses including those that might be claimed under sec_165 disallowing any loss claimed under sec_165 is consistent with the broader congressional intent in enacting sec_1038 your committee also believes that it is desirable to have a uniform rule applicable in case of repossession of real_property whether the initial sale was at a gain_or_loss it is desirable to have the same rule applicable whether the value of the property after the initial sale has gone up or down s rept supra c b pincite applying the plain meaning of the language of the statute 489_us_235 103_f3d_5 2d cir affg 103_tc_615 996_f2d_607 2d cir affg tcmemo_1991_350 the legislative_history see s rept supra c b pincite and the associated regulations see sec_1_1038-1 income_tax regs we hold that petitioner as a matter of law is not entitled to recognize any loss on the reacquisition of the boston avenue property even if sec_1038 did not forestall a claim to a concurrent loss under section 165--a claim we reject--petitioner has not shown that he has satisfied the conditions for allowance of a loss under section dollar_figure we cannot easily identify from the record what--if any--loss petitioner incurred as a result of the closed and completed transaction 92_tc_1249 affd 909_f2d_1146 8th cir attributable to the sale and reacquisition that resulted in petitioner’s receipt and retention of more than dollar_figure million in cash plus the reacquisition of his property we sec_165 which limits the types of losses that individuals may claim does not appear to forestall petitioner from claiming a loss because he is claiming it incident to a transaction entered into for profit sec_165 cannot identify the specific amount that petitioner spent in constructing the structure although petitioner claims dollar_figure the record including the report submitted by petitioner’s expert indicates that petitioner spent or should have spent no more than dollar_figure after having spent this money constructing the structure petitioner let the structure stand unused for nearly years doing nothing with it except closing it off to prevent vandalism petitioner then received dollar_figure in cash and substantial interest payments thereafter and a note for dollar_figure for the sale of the entire boston avenue property at a time when the record including petitioner’s own testimony that one of the walls collapsed prior to the sale strongly supports the inference that the garage structure was virtually worthless prior to the saledollar_figure these difficulties in identifying the amount and time of petitioner’s loss suffice to preclude petitioner’s claim of a casualty_loss under sec_165 and h there are other hurdles to allowance of a casualty_loss that petitioner has not surmounted a casualty even if petitioner were entitled to a casualty_loss he would be restricted to the lesser_of adjusted_basis or value prior to the casualty--the garage was not part of a trade_or_business because it had never been placed_in_service 305_us_468 sec_1_165-7 income_tax regs the evidence in the record that the garage structure was virtually worthless when the boston avenue property was sold which is even less than the dollar_figure cost of construction figure imputed by petitioner’s expert would leave petitioner short of his goal of proving entitlement to a casualty_loss loss must be sudden unexpected or unusual 680_f2d_91 11th cir affg 76_tc_593 54_f2d_537 2d cir affg 18_bta_674 as noted supra the garage was probably already worthless prior to the sale before the occurrence of any of the events that--petitioner claims-- destroyed the value of the garage the dismantling of the garage by the partnership was neither sudden nor unexpected both petitioner and the partnership contemplated that the partnership would convert the structure into a self-storage facility as evidenced by the permits and engineering reports that petitioner obtained prior to the closing of the sale finally we note that the circumstances in cases allowing casualty losses under sec_165 have been very different from the facts of this case this court and other courts have disallowed casualty losses where human hands intervene in circumstances not constituting fire storm shipwreck or theft sec_165 see eg maher v commissioner f 2d pincite citing numerous cases allowing and disallowing casualty losses 36_tc_1191 confiscation of automobile by officials in east germany acting under color of legal authority arbitrary and despotic as it may have been could not have been a ‘theft’ for tax deduction purposes dollar_figure neither sec_1038 nor sec_165 allows petitioners’ claim to a loss upon petitioner’s reacquisition of the boston avenue property in to reflect the foregoing and the parties’ concessions decision will be entered under rule sec_280b expressly restricts the deduction of losses resulting from demolition of buildings


department of the treasury int ernal revenue service washington d c o f f i c e o f c h i e f c o u n s e l april number release date postf-164802-01 cc psi b7 uilc internal_revenue_service national_office field_service_advice memorandum for associate area_counsel industry programs large and mid-size business cc lm nr dal attn todd a ludeke from associate chief_counsel passthroughs and special industries cc psi subject this chief_counsel_advice responds to your memorandum dated date in accordance with sec_6110 this chief_counsel_advice should not be cited as precedent legend taxpayer a date date date date date date issue ein whether taxpayer may value only the portion of a timber property affected by an ice storm for purposes of determining a casualty_loss under sec_165 whether taxpayer who harvested timber from a timber property that had been adversely affected by an ice storm may take into account the condition of the harvested timber as if it were harvested before the ice storm for purposes of sec_631 postf-164802-01 conclusion taxpayer may not value only the portion of a timber property affected by an ice storm for purposes of determining a casualty_loss under sec_165 taxpayer who harvested timber from a timber property that had been adversely affected by an ice storm may take into account the condition of the harvested timber as if it were harvested before the ice storm for purposes of sec_631 facts taxpayer is an integrated forest products company using a calendar_year for tax purposes taxpayer operates paper mills and lumber mills on date an ice storm completely destroyed or adversely affected the condition of several hundred acres of taxpayer’s timber taxpayer determined that the depletion block consisting of a acres of timber was its single identifiable property sip for purposes of determining any casualty_loss under sec_165 taxpayer determined the timber volume contained in the affected trees before the ice storm and the remaining timber volume contained in the affected trees after the ice storm then taxpayer calculated a loss for pine pulpwood pine sawtimber hardwood pulpwood and hardwood sawtimber by taking the difference between the fair_market_value for the volume of timber for each before the ice storm and the reduced fair_market_value reduced to reflect the impact of the ice storm on the quality of the affected trees for the remaining volume of timber for each after the ice storm for taxable years ending date date date and date taxpayer had a sec_631 election in effect taxpayer calculated its sec_631 gain by taking the difference between the fair_market_value for the remaining timber volume contained in the affected trees based on the condition the timber was in before the ice storm on date and the adjusted_basis taxpayer used the proceeds from the sec_631 hypothetical sale of timber to plant new plantations taxpayer deferred the sec_631 gain as an involuntary_conversion under sec_1033 taxpayer transferred the remaining timber to taxpayer’s mills law and analysis i sec_165 casualty losses sec_165 allows a deduction for any loss sustained during the taxable_year and not_compensated_for_by_insurance_or_otherwise sec_165 provides that postf-164802-01 the deduction shall be limited to inter alia casualty losses sec_165 defines casualty losses as losses arising from fire storm shipwreck or other_casualty sec_1_165-1 provides in part that to be allowable as a deduction under sec_165 a loss must be actually sustained during the taxable_year only a bona_fide loss is allowable substance and not mere form shall govern in determining a deductible loss sec_1_165-1 sec_1_165-1 provides that the amount of loss allowable as a deduction under sec_165 shall not exceed the amount prescribed by sec_1_1011-1 as the adjusted_basis for determining the loss from the sale_or_other_disposition of the property involved sec_1_165-7 provides that in the case of any casualty_loss whether or not incurred_in_a_trade_or_business or in any transaction entered into for profit the amount of the loss to be taken into account for purposes of sec_165 shall be the lesser_of either i the amount which is equal to the fair_market_value of the property immediately before the casualty reduced by the fair_market_value of the property immediately after the casualty or ii the amount of the adjusted_basis prescribed in sec_1_1011-1 for determining the loss from the sale_or_other_disposition of the property involved sec_1011 of the internal_revenue_code provides that the adjusted_basis of the property is generally the cost of such property under sec_1012 adjusted as provided in sec_1016 sec_1_165-7 provides that a loss incurred_in_a_trade_or_business or in any transaction entered into for profit shall be determined under sec_1 b by reference to the sip damaged or destroyed a taxpayer is not entitled to a casualty_loss deduction simply because some of its timber has been either completely destroyed or adversely affected by a casualty event to qualify for a casualty_loss deduction a taxpayer must demonstrate that it incurred an actual loss sec_1_165-1 under sec_1_165-7 a loss exists only if there has been a diminution in the fair_market_value of the sip 639_f2d_700 ct_cl finding that it is not enough for plaintiff to establish direct physical damage occurred to merchantable timber in order to satisfy the test for an allowable casualty_loss but plaintiff must also establish that there has been a reduction in the fair_market_value of the sip in cases involving timber the sip is as a matter of law the depletion block if the depletion block serves for commercial forest management and depletion purposes 92_f3d_1148 fed cir 39_fedclaims_478 639_f2d_700 ct_cl the depletion block is an area into which a taxpayer aggregates its timber for purposes of ensuring logical and reasonable timber valuation and tracking of the timber’s adjusted_basis see sec_1_611-3 sec_1_611-3 sets forth standards by which a taxpayer selects its postf-164802-01 depletion block for example a taxpayer may choose a depletion block based on manufacturing points geographical or political boundaries or management areas id taxpayer determined that a depletion block consisting of a acres was its sip accordingly taxpayer must determine whether there has been a diminution in value by taking the difference between the fair_market_value of the depletion block as a unitary property immediately before the ice storm and the depletion block as a unitary property immediately after the ice storm sec_1_165-7 and i see also 39_fedclaims_410 39_fedclaims_478 36_fedclaims_313 639_f2d_700 ct_cl ii sec_631 election to consider cutting of timber as sale_or_exchange sec_631 provides that if a taxpayer so elects on his return for a taxable_year the cutting of timber for sale or for use in the taxpayer’s trade_or_business during such year by the taxpayer who owns or has a contract right to cut such timber providing he has owned such timber or has held such contract right for a period of more than year shall be considered as a sale_or_exchange of such timber cut during such year if such election has been made gain_or_loss to the taxpayer shall be recognized in an amount equal to the difference between the fair_market_value of such timber and the adjusted_basis for depletion of such timber in the hands of the taxpayer such fair_market_value shall be the fair_market_value as of the first day of the taxable_year in which such timber is cut and shall thereafter be considered as the cost of such cut timber to the taxpayer for all purposes for which such cost is a necessary factor sec_1_631-1 provides that the fair_market_value of the timber as of the first day of the taxable_year in which such timber is cut shall be determined subject_to approval or revision by the district_director upon examination of the taxpayer’s return by the taxpayer in the light of the most reliable and accurate information available with reference to the condition of the property as it existed at that date regardless of all subsequent changes such as changes in surrounding circumstances methods of exploitation degree of utilization etc the value sought will be the selling_price assuming a transfer between a willing seller and a willing buyer as of that particular day due consideration will be given to factors and the principles involved in the determination of the fair_market_value of timber as described in the regulations under sec_611 sec_1_631-1 is an administrative provision intended to simplify and prevent multiplicity of valuations during the taxable_year see revenue revision of house hearings before the comm on ways and means 78th cong 1st sess and supplemental statement re timber tax reform submitted by the forest industries committee on timber taxation valuation and taxation taxpayer may take into account the condition of the harvested timber as if it were postf-164802-01 harvested before the ice storm for purposes of sec_631 because sec_1_631-1 requires taxpayer to determine the fair_market_value of the timber cut based on the condition of the property as it existed as of the first day of the taxable_year this office expresses or implies no opinion concerning taxpayer’s application of sec_1033 this writing may contain privileged information any unauthorized disclosure of this writing may have an adverse effect on privileges such as the attorney client privilege if disclosure becomes necessary please contact this office for our views please call if you have any further questions by paul kugler associate chief_counsel passthroughs and special industries brenda stewart assistant to the branch chief branch office of associate chief_counsel passthroughs special industries


department of the treasury internal_revenue_service washington d c tax_exempt_and_government_entities_division nov uil no 408a legend taxpayer a custodian m amount a year year ira x ira y dear this is in response to your letter dated in which you request relief under sec_301_9100-3 of the procedure and administrative regulations the regulations such relief is requested regarding the recharacterization of an amount rolled over to a roth individual_retirement_arrangement ira for a taxable_year in which taxpayer a was ineligible to contribute to a roth_ira the following facts and representations have been submitted under penalty of perjury in support of the ruling requested taxpayer a owns ira x a simplified_employee_pension plan described in sec_408 of the internal_revenue_code the code and maintained by custodian m on december of year custodian m at taxpayer a’s request transferred amount a from ira x to ira y a roth_ira described in sec_408a of the code as a partial roth_ira_conversion taxpayer a represents that he consulted with his professional advisor about the partial conversion of amount a from ira x to ira y his professional advisor erroneously informed him that the modified_adjusted_gross_income magi limit for conversions did not include capital_gain income believing that his income was below such magi limit for conversions under sec_408a taxpayer a made the partial conversion from ira x to roth_ira y taxpayer a represents further that he intended to include amount ain income on his form_1040 u s individual_income_tax_return for tax_year and pay any applicable federal_income_tax taxpayer a timely filed form_4868 application_for automatic_extension of time to file u s individual tax_return for tax_year on october of tax_year while completing form_1040 for tax_year taxpayer a discovered that he was ineligible for the conversion because his magi exceeded dollar_figure in year on october of tax_year taxpayer a attempted to transfer the converted funds back into ira x custodian m aware of irs regulations refused to make the transfer taxpayer a was then informed by his professional advisor that he had until the end of calendar_year to recharacterize the conversion taxpayer a’s' request for relief under sec_301 of the regulations was filed shortly after discovering that they had missed the deadline to recharacterize roth_ira y back to ira x and prior to the internal_revenue_service the service discovering that taxpayer a had not timely elected to recharacterize roth_ira ytoa traditional_ira the statute_of_limitations on taxpayer a’s federal_income_tax return for year remains open based on the foregoing facts and representations you have requested a ruling pursuant to sec_301_9100-3 of the regulations that the service grant you an extension of time to make the election under sec_1_408a-5 of the income_tax regulations the i t regulations to recharacterize amount a to ira x as a contribution back with respect to your request for relief under sec_301_9100-3 of the regulations sec_408a of the code and sec_1_408a-5 of the t regulations provide that except as otherwise provided by the secretary a taxpayer may elect to recharacterize an ira contribution made to one type of ira as having been made to another type of ira by making a trustee-to-trustee transfer of the ira contribution plus earnings to the other type of ira in a recharacterization the ira contribution is treated as having been made to the transferee ira and not the transferor ira under sec_408a of the code and sec_1_408a-5 of the i t regulations this recharacterization election generally must occur on or before the date prescribed by law including extensions for filing the taxpayer's federal_income_tax return for the year of contribution sec_1_408a-5 q a-6 of the t regulations describes how a taxpayer makes the election to recharacterize the ira contribution to recharacterize an amount that has been converted from a traditional_ira to a roth_ira the taxpayer must notify the roth_ira trustee of the taxpayer's intent to recharacterize the amount the taxpayer must provide the trustee and the transferee trustee if different from the transferor trustee with specified information that is sufficient to effect the recharacterization and the trustee must make the transfer 2z2uusugu53 sec_408a of the code and sec_1_408a-4 q a-2 of the i t regulations provide in relevant part that an individual with adjusted_gross_income in excess of dollar_figure for a taxable_year is not permitted to make a qualified_rollover_contribution to a roth_ira from an individual_retirement_plan other than a roth_ira during that taxable_year sec_408a provides that a conversion of a traditional_ira to a roth_ira is treated as a rollover from the traditional_ira to the roth_ira sec_301_9100-1 sec_301_9100-2 and sec_301_9100-3 of the regulations in general provide guidance concerning requests for relief submitted to the service on or after date sec_301_9100-1 provides that the commissioner of internal revenue in his discretion may grant a reasonable extension of the time fixed by a regulation a revenue_ruling a revenue_procedure a notice or an announcement published in the internal_revenue_bulletin for the making of an election or application_for relief in respect of tax under among others subtitle a of the code sec_301_9100-2 of the regulations lists certain elections for which automatic extensions of time to file are granted sec_301_9100-3 generally provides guidance with respect to the granting of relief with respect to those elections not referenced in sec_301_9100-2 the relief requested in this case is not referenced in sec_301_9100-2 sec_301_9100-3 of the regulations provides that applications for relief that fall within sec_301_9100-3 will be granted when the taxpayer provides sufficient evidence including affidavits described in sec_301_9100-3 to establish that the taxpayer acted reasonably and in good_faith and granting relief would not prejudice the interests of the government sec_301_9100-3 of the regulations provides that a taxpayer will be deemed to have acted reasonably and in good_faith i if its request for sec_301_9100-1 relief is filed before the failure to make a timely election is discovered by the service ii if the taxpayer inadvertently failed to make the election because of intervening events beyond the taxpayer's control iii if the taxpayer failed to make the election because after exercising reasonable diligence the taxpayer was unaware of the necessity for the election iv the taxpayer reasonably relied upon the written advice of the service or v the taxpayer reasonably relied on a qualified_tax professional including a tax professional employed by the taxpayer and the tax professional failed to make or advise the taxpayer to make the election sec_301_9100-3 of the regulations provides that ordinarily the interests of the government will be treated as prejudiced and that ordinarily the service will not grant relief when tax years that would have been affected by the election had it been timely made are closed by the statute_of_limitations before the taxpayer's receipt of a ruling granting relief under this section the information presented and documentation submitted by taxpayer a is consistent with his assertion that his failure to elect to recharacterize the roth_ira on or before the date prescribed by law including extensions for filing his federal_income_tax return for the year of contribution was caused by his lack of awareness of his ineligibility to contribute amount a to roth_ira y and therefore the necessity of his making an election to recharacterize the contribution taxpayer a sec_301 relief shortly after discovering that he was ineligible to make the conversion and before the service discovered his failure to make a timely election to recharacterize the failed conversion filed this request for thus based on the information and the representations submitted by taxpayer a the requirements of sec_301_9100-1 and sec_301_9100-3 of the regulations have been met and taxpayer a acted reasonably and in good_faith with respect to requesting an extension of time to recharacterize amount a as a contribution to ira x specifically we conclude that taxpayer a has met the requirements of clauses i and iii of sec_301_9100-3 of the regulations additionally because the statute_of_limitations is still open under sec_301_9100-3 of the regulations granting relief will not prejudice the interests of the government accordingly taxpayer a is granted an extension of time not to exceed days as measured from the date of this letter_ruling to recharacterize amount a held in roth_ira y plus earnings attributable thereto as a contribution to a traditional_ira no opinion is expressed as to the tax treatment of the transaction described herein under the provisions of any other section of either the code or regulations which may be applicable thereto this ruling is directed only to the taxpayer who requested it sec_6110 of the code provides that it may not be used or cited by others as precedent if you wish to inquire about this ruling please contact d no at or _ fax please address all correspondence to se t ep ra t4 sincerely yours oth é tie tat _- oc donzell h littlejohn manager employee_plans technical group enclosures deleted copy of this letter notice of intention to disclose notice