t c no united_states tax_court ronald c bachner petitioner v commissioner of internal revenue respondent docket no filed date p's employer withheld tax from his wages for p filed a timely return reporting no tax_liability and claiming a refund for the withheld tax no tax has ever been assessed or refunded for r issued a notice_of_deficiency after the expiration of the period of limitations assessment of any_tax against p for is now barred p claims that the entire amount of withheld tax is an overpayment within the meaning of sec_6512 i r c r maintains that any overpayment is limited to the amount by which the withheld tax exceeds the amount of tax which might have been properly assessed but for the statute_of_limitations held pursuant to 284_us_281 the amount of an overpayment for a taxable_year is limited to the excess of the tax paid over the amount which might have been properly assessed and demanded even though assessment is now barred by the statute_of_limitations dennis p craig for petitioner edward j laubach jr for respondent opinion ruwe judge this case is before the court on remand from the u s court_of_appeals for the third circuit for further consideration consistent with its opinion in 81_f3d_1274 3d cir affirming our decision regarding petitioner's tax_year and remanding with respect to petitioner's taxable_year subsequent to the remand of this case the parties filed a supplemental stipulation of facts and briefs relating to the issue on remand the issue for decision on remand is whether there is an overpayment of petitioner's income_tax for the taxable_year and if so the amount background in and petitioner was employed as a laboratory technician by the westinghouse electric corp in date petitioner sent the first of three letters to the internal_revenue_service all requesting assurance that his filing of a tax_return would not cause him to be treated as having relinquished any of his constitutional rights the district_director responded with letters emphasizing that the internal_revenue_code mandated the filing of returns describing the penalties otherwise applicable and urging petitioner to submit the required information and pay the required amount on or about date petitioner filed a form_1040 for the tax_year in addition to providing his name social_security_number and other identification information petitioner reported dollar_figure on line captioned wages salaries tips etc and attached the form_w-2 from his employer stating the same amount of compensation petitioner typed xxxxxx over the caption designated moving expense on line and typed the amount dollar_figure in the space provided he added in the margin the notation no income or taxable compensation see attached letter and eisner v macomber u sec_189 in a letter attached to the form_1040 petitioner claimed a refund of erroneously withheld federal income taxes cited court decisions and the internal_revenue_code for support and stated that his submission did not constitute a waiver of any rights petitioner subtracted the claimed deduction on line from his stated income and reported zero taxable_income he further claimed a refund of dollar_figure the total amount withheld as taxes from his year's salary the withheld taxes were not refunded in date petitioner was indicted on one count of tax_evasion for the tax_year in violation of sec_7201 and four counts of filing false fictitious or fraudulent claims for the years through in violation of u s c sec after a jury trial in the u s district_court western district of pennsylvania petitioner was acquitted of all charges on date respondent issued a notice_of_deficiency to petitioner for the year in which respondent determined a deficiency in the amount of dollar_figure and an addition_to_tax pursuant to sec_6653 of dollar_figure respondent filed an answer asserting in the alternative that petitioner is liable for additions to tax pursuant to sec_6651 and sec_6653 and in our original bench opinion we upheld respondent's deficiency determination and respondent's alternative position regarding the additions to tax under sec_6651 and sec_6653 we held that the altered form_1040 that petitioner filed for did not qualify as a return that would commence the running of 1unless otherwise indicated all section references are to the internal_revenue_code in effect for the taxable years in issue and all rule references are to the tax_court rules_of_practice and procedure 2we did not uphold respondent's determination of fraud citing 676_f2d_980 3d cir revg tcmemo_1980_571 wherein the court_of_appeals for the third circuit reversed a finding of fraud in a case involving similar facts respondent did not appeal our holding on this point the period of limitations under sec_6501 in doing so we relied on 82_tc_766 affd 793_f2d_139 6th cir and its rationale that tampered forms which are a conspicuous protest against the payment of tax and are intended to deceive respondent's return processing personnel into refunding the withheld taxes do not meet the requirement that there be an honest and reasonable attempt to satisfy the requirements of the federal_income_tax law petitioner appealed our decision on appeal respondent reversed his position at trial and conceded that petitioner's altered form_1040 was a valid_return and that the 3-year period of limitations for assessment of petitioner's tax had expired as a result the statute_of_limitations bars the assessment of the deficiency and additions to tax for the court_of_appeals declined to decide whether petitioner was due a refund of the dollar_figure that had been withheld from his wages stating that questions as to the existence and amount of any overpayment are appropriately under the jurisdiction of this court in the first instance see sec_6512 bachner v commissioner supra pincite discussion the issue before us is whether there is an overpayment of petitioner's income_tax and if so the amount petitioner claims that the dollar_figure that was withheld from his wages as tax should be refunded or credited to him with interest generally under sec_6402 if a taxpayer has made an overpayment the secretary must refund the overpayment including interest in cases where this court has jurisdiction to redetermine a deficiency sec_6512 gives us jurisdiction to determine the amount of any overpayment which is to be credited or refunded sec_6512 does not define the term overpayment petitioner directs us to sec_6401 for the definition of overpayment sec_6401 provides that the term 'overpayment' includes that part of the amount of the payment of any internal revenue tax which is assessed or collected after the expiration of the period of limitation properly applicable thereto emphasis added in 85_tc_445 we stated that sec_6401 contains a description of certain specific items that are statutorily treated as overpayments but that there is no specific statutory definition of the term overpayment within the code therefore we decline to accept any argument that the term overpayment is specifically and narrowly defined by sec_6401 in any event the facts of this case do not come within 3the overpayment may first be applied against any of petitioner's outstanding tax_liabilities the literal terms of sec_6401 here as explained infra the withheld tax was deemed paid on date well within the period of limitations and respondent is no longer seeking to make any assessments or collections the term overpayment has been interpreted to mean any payment in excess of that which is properly due 332_us_524 in 494_us_596 n the supreme court again addressed the meaning of the term overpayment stating the commonsense interpretation is that a tax is overpaid when a taxpayer pays more than is owed for whatever reason or no reason at all in estate of baumgardner v commissioner supra pincite we stated the liberty glass co generic definition of 'overpayment' is in reference to section of the internal_revenue_code_of_1939 section d of the internal_revenue_code_of_1939 in pertinent part included the following language which is substantially_similar to its successor sec_6512 'if the tax_court finds that there is no deficiency and further finds that the taxpayer has made an overpayment_of_tax the tax_court shall have jurisdiction to determine the amount of such overpayment ' the liberty glass co definition applies in our determination of an overpayment as provided by sec_6512 it follows that in order to have an overpayment petitioner must have made a payment of tax for in excess of the amount which is properly due petitioner argues that his withheld taxes are fully recoverable with interest because they are deposits rather than payments petitioner relies on 995_f2d_205 fed cir wherein the court stated if the remittance was a deposit a payment did not occur until the formal assessments petitioner argues that since the period of limitations for assessment has expired the deposit should be treated as an overpayment which should be refunded we disagree the taxes withheld from petitioner's wages were not deposits sec_6513 provides that for purposes of sec_6511 or any_tax actually deducted and withheld at the source during any calendar_year under chapter shall in respect of the recipient of the income be deemed to have been paid_by him on the 15th day of the fourth month following the close of his taxable_year during westinghouse electric corp withheld tax from petitioner's wages in the amount of dollar_figure pursuant to sec_6513 the taxes withheld from petitioner's wages are deemed to have been paid_by 4in 995_f2d_205 fed cir the taxpayer made a deposit that was followed by untimely assessments in the instant case there has been no untimely assessment sec_3402 requires that every employer making payment of wages shall deduct and withhold upon such wages a tax further sec_3401 provides the term 'wages' means all remuneration for services performed by an employee for his employer petitioner on date as the court_of_appeals for the third circuit in the instant case noted there is ample basis to find unpersuasive bachner's view of wage withholdings as 'deposits ' refundable merely upon late assessment bachner v commissioner f 3d pincite9 citing 720_f2d_1096 9th cir see 590_f2d_68 3d cir petitioner argues that he is entitled to a refund of all his withholding credits for his tax_year because respondent failed to properly assess the tax within the statutory period of limitations provided by sec_6501 however whether or not there has been a timely assessment with respect to a specific year does not alone determine whether there has been an overpayment which would entitle a taxpayer to a refund as the court_of_appeals for the third circuit stated the language in sec_6501 refers only to 'limitations on assessment and collection ' and the operative clause of sec_6501 directs only that taxes 'be assessed within years after the return was filed ' a deficiency determination by which the irs seeks to establish the taxpayer's additional tax_liability is patently different from a refund determination by which the taxpayer seeks repayment or credit from the irs bachner v commissioner supra pincite under the principles established by the supreme court in 284_us_281 a taxpayer's claim_for_refund must be reduced by the amount of the correct_tax liability for the taxable_year regardless of the fact that the commissioner can no longer assess any deficiency for the taxable_year in lewis v reynolds supra the taxpayer filed a claim_for_refund alleging that certain deductions had been improperly disallowed by the commissioner after the period of limitations on additional_assessment had expired the commissioner agreed with the taxpayer that the period of limitations had expired but denied a refund on the basis that the correct computation of tax resulted in additional tax the taxpayer argued that the commissioner lacked the authority to redetermine the tax after the period of limitations had expired the supreme court disagreed while no new assessment can be made after the bar of the statute has fallen the taxpayer nevertheless is not entitled to a refund unless he has overpaid his tax an overpayment must appear before refund is authorized although the statute_of_limitations may have barred the assessment and collection of any additional sum it does not obliterate the right of the united_states to retain payments already received when they do not exceed the amount which might have been properly assessed and demanded lewis v reynolds supra pincite the doctrine established in lewis v reynolds supra has been applied by this court in the determination of an overpayment see 40_tc_597 vacated and remanded pursuant to stipulation 2d cir holding that the decision in lewis v reynolds supra was controlling and allowing a reduction in an overpayment claimed by the taxpayer 28_tc_871 applying the doctrine_of lewis v reynolds supra to this case we find that even though assessment and collection of petitioner's tax_liability is now barred by the statute_of_limitations respondent has the right to retain prior timely payments to the extent they do not exceed the amount of petitioner's actual tax_liability 6our holding in morris v commissioner tcmemo_1966_245 is distinguishable in morris the taxpayer received and cashed a refund check of dollar_figure from the commissioner relating to her tax_year later in after the period of limitations for assessment had expired the commissioner assessed dollar_figure representing the erroneous refund of dollar_figure plus interest in the commissioner collected by way of a levy on funds the taxpayer had on deposit at a savings bank we held that the rationale underlying lewis v reynolds is not properly applicable where as here the assessment and collection by the commissioner was illegal here respondent has neither assessed nor collected the funds illegally 7the statutes authorizing tax refunds and suits for their recovery are predicated upon equitable principles 301_us_532 in a tax_court proceeding either party is free to raise equity-based defenses to the assertions of the other party and the court insofar as it has jurisdiction over the main claim is free to entertain those defenses 101_tc_551 here we have jurisdiction to determine the overpayment under sec_6512 and therefore respondent is free to raise the defense provided in 284_us_281 see estate of mueller v commissioner supra 92_tc_776 we previously determined that petitioner's correct_tax liability for the taxable_year is dollar_figure petitioner's withholding payments totaled dollar_figure petitioner made no other_payments therefore any overpayment due to petitioner cannot be greater than the amount by which petitioner's tax_payments exceed his proper tax_liability for respondent also contends that the doctrine_of lewis v reynolds supra applies to the addition_to_tax under sec_6653 in the amount of dollar_figure and that any overpayment due petitioner should be reduced by this amount we agree additions to tax pursuant to sec_6653 are assessed collected and paid in the same manner as taxes sec_6662 while no addition_to_tax can be assessed for the doctrine_of lewis v reynolds supra permits the retention of any_tax payment which might have been properly assessed and demanded lewis v reynolds u s pincite 51_f3d_1012 11th cir see also 80_f3d_1576 fed cir holding interest barred from assessment by expiration of the statutory period of limitations may be offset against overpayment 577_f2d_1206 5th cir 8by conceding that the altered form_1040 is a valid_return respondent necessarily concedes that petitioner cannot be liable for the sec_6651 addition_to_tax for failure_to_file sec_6653 provides that if any part of any underpayment as defined in subsection c is due to negligence or intentional disregard of rules or regulations there shall be added to the tax an amount equal to percent of the underpayment in determining the existence of an underpayment no credit is given for tax withheld and paid over by the taxpayer's employer sec_6211 314_f2d_478 3d cir affg in part and revg in part tcmemo_1961_192 102_tc_596 myers v commissioner tcmemo_1988_160 mighell v commissioner tcmemo_1985_135 we previously held that petitioner was liable for the addition_to_tax under sec_6653 nothing in the record as supplemented gives us reason to change our prior holding while respondent now concedes that petitioner's form_1040 for is a return the position taken on this return is one frequently characterized as a frivolous time-worn tax protesting device the addition_to_tax under sec_6653 in the amount of dollar_figure percent of dollar_figure is part of petitioner's total tax_liability which might have been properly assessed and demanded lewis v reynolds supra pincite the difference between petitioner's total tax_liability of dollar_figure and his payments of dollar_figure is dollar_figure we hold that there is an overpayment with respect to petitioner's tax_year in this amount plus interest decision will be entered under rule


t c memo united_states tax_court na general_partnership subsidiaries iberdrola renewables holdings inc subsidiaries successor_in_interest to na general_partnership subsidiaries petitioner v commissioner of internal revenue respondent docket no filed date miriam louise fisher brian c mcmanus gary b wilcox and steven p johnson for petitioner mary e wynne james p thurston scott w mentink and shirley d chin for respondent memorandum findings_of_fact and opinion kroupa judge respondent determined deficiencies exceeding dollar_figure million in petitioner’s federal_income_tax for taxable years ended date tax_year date tax_year and date tax_year collectively years at issue the deficiencies concern dollar_figure million of payments made on loan notes that na general_partnership subsidiaries nagp issued to its parent scottishpower plc scottishpower the sole question2 is whether an advance made by scottishpower to nagp in connection with nagp’s acquisition of pacificorp subsidiaries pacificorp was a loan or a capital_contribution for federal tax purposes and thus whether petitioner is entitled to interest_expense deductions under sec_162 a and we hold the advance was a loan and the payments on the loan notes are deductible as interest findings_of_fact some of the facts have been stipulated and are so found we incorporate the stipulation of facts the supplemental stipulation of facts and the accompanying exhibits by this reference 1all monetary amounts are rounded to the nearest million 2all other issues either have been conceded or will follow from resolving the interest_deduction issue 3all section references are to the internal_revenue_code code for the years at issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated i introduction to the parties nagp was a nevada general_partnership and elected to be treated as a corporation for federal tax purposes see sec_301_7701-3 proced admin regs nagp maintained its principal_place_of_business in portland oregon at the time it filed the petition and filed consolidated federal tax returns on the accrual basis for the years at issue scottishpower indirectly owned nagp at all material times scottishpower was a publicly held multi-utility business in the u k with its principal office in glasgow scotland scottishpower provided customers in scotland england and wales with electric gas telecommunications and water services scottishpower organized nagp as a special-purpose entity to acquire pacificorp pacificorp was a publicly held u s utility company and the common parent of a u s consolidated federal_income_tax group that owned various regulated and nonregulated subsidiaries pacificorp provided electricity and energy-related services to retail customers in several states including oregon utah washington idaho wyoming and california pacificorp also indirectly owned interests in australian companies pacificorp owned of powercor australia ltd 4iberdrola renewables holdings inc subsidiaries a delaware corporation became the successor_in_interest to nagp in date australia powercor an electric distribution company in victoria australia and of the hazelwood power station hazelwood an adjacent brown coal mine in victoria australia ii scottishpower’s acquisition of pacificorp a scottishpower targets pacificorp scottishpower began exploring international acquisitions in the mid-1990s scottishpower’s strategy group studied the u s utility industry and obtained advice from various advisers including investment bankers and u s regulatory experts pacificorp’s stock in late was trading at approximately dollar_figure per share down sharply from over dollar_figure per share a year earlier pacificorp’s stock had declined in part due to a failed acquisition attempt of its own and management turnover there also was a general perception in the financial community that pacificorp had taken its eye off the ball of its core businesses in pursuing international expansion activities scottishpower believed that pacificorp had not paid sufficient attention to controlling its costs pacificorp was otherwise a highly valuable and respected company with an a debt rating a good asset base with solid growth and demand for electricity a consistent dividend-paying record and a strong presence in the western united_states in sum scottishpower viewed pacificorp as a sound company and ultimately an ideal acquisition target b acquisition preliminaries in early date scottishpower contacted pacificorp to discuss possibly strategically combining the parties discussed potential combination scenarios over the summer and early fall and eventually entered into a confidentiality and standstill agreement in date both companies commenced detailed due diligence and engaged numerous advisers to provide advice on financial regulatory tax and legal matters scottishpower organized nagp to serve as the acquirer of pacificorp anticipating the proposed merger scottishpower’s management presented to its board_of directors the results of their financial analysis cost-savings projections and due diligence reviews of pacificorp scottishpower’s management ultimately advised its board that the merger would create significant value for scottishpower’s shareholders and recommended that scottishpower proceed scottishpower’s board unanimously authorized the merger with pacificorp in date likewise the pacificorp board_of directors unanimously approved the proposed merger after pacificorp management and advisers made presentations scottishpower pacificorp and nagp entered into a plan and agreement of merger in date which was later amended in date merger agreement scottishpower would indirectly acquire of pacificorp issued and outstanding common_stock under the merger agreement pacificorp common_stock shareholders would receive scottishpower american depository shares ads alternatively pacificorp’s common_stock shareholders could elect to receive common shares of scottishpower the merger agreement further provided that nagp would own pacificorp’s shares and would issue loan notes to scottishpower in consideration for the shares c acquisition transaction on date scottishpower and pacificorp completed their proposed merger under which pacificorp became a direct subsidiary of nagp and an indirect subsidiary of scottishpower acquisition to effect the acquisition scottishpower organized two wholly owned u k subsidiaries with an aggregate capital_contribution of big_number na1 limited na1 and na2 limited na2 both na1 and na2 were treated as disregarded entities for u s federal_income_tax purposes na1 and na2 contributed the big_number to nagp in exchange for and of the interests in nagp respectively nagp formed a subsidiary_corporation scottishpower acquisition co solely for the purpose of effecting the acquisition scottishpower acquisition co was merged with and into pacificorp under oregon corporate law at closing each outstanding share of pacificorp’s common_stock was cancelled and converted into the right to receive either scottishpower ads or scottishpower shares pacificorp issued new shares of common_stock to nagp nagp issued loan notes to scottishpower equal to of the scottishpower adss and scottishpower common shares provided to pacificorp’s shareholders nagp also pledged its pacificorp shares as security for repayment and na1 and na2 issued shares to scottishpower representing of the value of the scottishpower adss and scottishpower common shares provided to pacificorp’s shareholders at the closing a new holding_company for the combined_group new scottishpower plc was incorporated under the laws of scotland in date also in connection with the acquisition under an arrangement scottishpower became a subsidiary of new scottishpower plc new scottishpower plc was renamed scottishpower plc and scottishpower was renamed scottishpower u k plc d events after the acquisition insertion of phi scottishpower and nagp contemplated separating pacificorp’s nonregulated subsidiaries from its regulated subsidiaries and placing them under a newly formed holding_company before and after the acquisition to that end scottishpower decided to insert pacificorp holdings inc phi as a holding_company for pacificorp pacificorp group holdings company pghc and pacificorp power marketing ppm a little over a year after the acquisition phi restructuring phi was formed and scottishpower and pacificorp sought consent from the u k treasury and u s state regulators to insert phi and separate the regulated businesses from the nonregulated businesses nagp transferred its pacificorp stock to phi at the end of approximately a year after seeking regulatory approval pacificorp thereafter distributed pghc to phi making pghc and pacificorp brother-sister subsidiaries of phi sale of pacificorp’s australian operations scottishpower’s management anticipated selling pacificorp’s australian operations australia powercor and hazelwood before the acquisition australia powercor was eventually sold in date and pacificorp’s subsidiary pghc received net cash proceeds from the sale of australia powercor of approximately dollar_figure million pghc distributed dollar_figure million of those proceeds as a dividend to australia powercor in date hazelwood was sold in date for approximately dollar_figure million iii related-party financing at issue a loan notes as previously mentioned nagp issued loan notes to scottishpower in consideration for scottishpower transferring on behalf of nagp its ads shares and common shares to pacificorp shareholders in connection with the acquisition advance the loan notes consisted of dollar_figure billion of fixed-rate loan notes fixed-rate notes and dollar_figure million of floating-rate notes floating-rate notes to scottishpower collectively loan notes or intercompany debt each loan note was evidenced by a certificate issued to scottishpower the fixed-rate notes had an interest rate of and matured in date the floating-rate notes had an interest rate equal to libor5 plu sec_55 basis points and matured in date the fixed- rate notes and the floating-rate notes were each issued under separate loan libor is an acronym for london interbank offering rate see generally 120_tc_174 aff’d in part vacated in part and remanded sub nom j p morgan chase co v commissioner 458_f3d_564 7th cir instruments and subject_to separate conditions the loan notes however were identical in all material respects except for the maturities interest rates and principal values the loan notes shared many key terms first interest was payable quarterly in arrears second the loan notes were unsecured and ranked equally and ratably with other debt obligations of nagp third scottishpower as the noteholder could require nagp to repay all or a portion of the loan notes at any time with proper notice fourth nagp had the right to redeem the loan notes without penalty at an agreed market rate fifth scottishpower could require repayment of all the loan notes at market rate if any principal or interest was not paid within days of the due_date finally the loan notes were transferable scottishpower and nagp both reflected the loan notes as debt on their books_and_records and tracked accruals and payments of interest on their books as well additionally correspondence between the parties consistently recognized the loan notes as debt finally the parties represented to the u s securities_and_exchange_commission that the loan notes were debt b interest repayment and tax years nagp failed to make the first and only interest payment due in the tax_year ended date tax_year similarly nagp failed to make the first interest payment due in the tax_year nagp ultimately paid dollar_figure million of the dollar_figure million interest it accrued on the loan notes for the tax_year pacificorp dividends were used to pay the interest tax_year scottishpower suspended dividend payments from pacificorp during the tax_year while regulatory approval was pending for inserting phi as a holding_company for pacificorp nagp borrowed dollar_figure million short-term intercompany loan from scottishpower to fund the first two interest payments for the tax_year nagp paid the first interest payment of dollar_figure million from funds that scottishpower actually transferred to it under the short-term intercompany loan the second interest payment of dollar_figure million however was 6scottishpower was concerned with the u k and potential u s tax consequences from dividends to nagp and consequently wanted nagp to receive payments by way of a return_of_capital and not a dividend made through journal entries on the parties’ books_and_records no funds were actually transferred in addition nagp entered into a dollar_figure million credit facility rbs credit facility with royal bank of scotland rbs in late the rbs credit facility matured in date and subordinated scottishpower’s right to repayment of the loan notes to rbs nagp borrowed dollar_figure million under the rbs credit facility in date and dollar_figure million in date nagp used the loan proceeds to repay the short-term intercompany loan and to fund additional interest payments on the loan notes while pacificorp’s dividends remained suspended nagp fully repaid the advances against the rbs credit facility in the tax_year after phi distributed pacificorp dividends and proceeds from the sale of australia powercor in total nagp made interest payments to scottishpower totaling dollar_figure million for the tax_year with payments exceeding accrued interest for the tax_year nagp was in arrears of approximately dollar_figure million at the end of the tax_year 7nagp reversed dollar_figure of the accrued interest on the floating-rate notes in connection with its decision to capitalize them discussed more fully below tax_year finally nagp paid dollar_figure million of interest on the fixed-rate notes for the tax_year nagp’s interest obligations with respect to the loan notes were current at the end of the tax_year neither nagp’s nor scottishpower’s books_and_records allocated the amounts paid between the interest accrued on the fixed-rate notes and the floating- rate notes for either the tax_year or the tax_year c capitalization of the floating-rate notes nagp and scottishpower decided in date to capitalize the floating- rate notes into equity after pricewaterhousecoopers llp pwc advised the parties that at best nagp would be able to support the characterization of the dollar_figure billion of fixed-rate notes as debt to that end scottishpower made contributions to na1 and na2 in turn na1 and na2 made contributions to nagp nagp used the contributions to fully retire the dollar_figure million principal balance outstanding on the floating-rate notes nagp recorded the elimination of the floating-rate notes on its books as additional paid-in capital of na1 and na2 d partial capitalization and repayment of the fixed-rate notes in date the parties decided to partially capitalize and repay the fixed-rate notes as part of a restructuring of the nagp consolidated_group u s restructuring the u s restructuring was in response to a proposed regulation under sec_894 that would characterize interest payments nagp made to scottishpower under the existing structure as nondeductible dividends and subject them to a withholding_tax additionally the existing structure was also becoming less efficient because scottishpower had mostly exhausted its foreign tax_credits creating potentially increased u k tax obligations on dividend payments from the u s scottishpower arranged for a daylight borrowing facility of dollar_figure6 billion with rbs in early date to effect the u s restructuring nagp received dollar_figure5 billion from phi as payment for certain phi shares the same day and after the daylight borrowing facility funds moved through a series of transactions connected with the u s restructuring nagp then paid dollar_figure5 billion to scottishpower to partially repay the fixed-rate notes at the end of the day scottishpower repaid the daylight borrowing facility from rbs using the dollar_figure5 billion received as partial repayment of the dollar_figure billion fixed-rate notes also that same day nagp capitalized into equity the remaining portion of the fixed-rate notes iv tax returns nagp timely filed consolidated federal_income_tax returns for the years at issue claiming interest_expense deductions with respect to the loan notes totaling dollar_figure million respondent disallowed the interest_expense deductions claiming the advance should be characterized as a capital_contribution not a loan for federal tax purposes petitioner timely filed the petition opinion i introduction we must decide whether nagp is entitled to deduct as interest under sec_162 and sec_163 payments made to its parent scottishpower totaling dollar_figure million resolving this question turns on whether the advance by scottishpower of its stock to nagp in connection with the acquisition of pacificorp is properly characterized as a loan or a capital_contribution respondent argues the advance was a capital_contribution ie equity and the payments therefore constitute dividends or returns of capital petitioner argues the advance was a loan ie debt 8the taxpayer generally bears the burden of proving the commissioner’s determinations are erroneous rule a the burden_of_proof may shift to the commissioner if the taxpayer satisfies certain conditions sec_7491 we resolve the issues here on a preponderance_of_the_evidence not on an allocation of the burden_of_proof therefore we need not consider whether sec_7491 would apply see 133_tc_340 and the payments therefore are deductible as interest we now turn to whether the advance was debt or equity ii debt versus equity a transaction’s substance not its form controls its effect for tax purposes see 827_f2d_1409 9th cir nevertheless tax consequences are a significant consideration in many commercial transactions and planning a legitimate transaction to take advantage of tax benefits does not invalidate the transaction id an appeal in this case lies unless otherwise stipulated to the united_states court_of_appeals for the ninth circuit we shall therefore follow the approach taken in the ninth circuit the court_of_appeals for the ninth circuit considers eleven factors to determine whether an advance is debt or equity these factors include the name given to the documents evidencing the indebtedness the presence of a fixed maturity_date the source of the payments the right to enforce payments of principal and interest participation in management a status equal to or inferior to that of regular corporate creditors the intent of the parties thin or adequate capitalization identity of interest between creditor and stockholder payment of interest only out of dividend money and the corporation’s ability to obtain loans from outside lending institutions hardman f 2d pincite no one factor is decisive and the weight given to each factor depends on the facts and circumstances id our objective is not to count the factors but rather to evaluate them see laidlaw transp inc v commissioner tcmemo_1998_232 we now evaluate the eleven factors to determine the proper tax characterization of the advance document labels the first factor in a debt-equity analysis focuses on the type of certificate the parties use to evidence the advance hardman f 2d pincite the issuance of a debt_instrument such as a promissory note supports the characterization of an instrument as debt see 464_f2d_394 5th cir 93_tc_382 in contrast the issuance of an equity instrument such as a stock certificate supports an equity characterization id see also estate of mixon v united_states f 2d pincite anchor nat’l life ins co v commissioner t c pincite here nagp issued scottishpower certificates called fixed-rate loan notes and floating-rate loan notes the loan note designation implies the certificates were akin to debt moreover the loan notes contained terms and conditions typical of a promissory note this factor supports characterizing the advance as debt fixed maturity_date the second factor in the debt-equity analysis examines whether repayment of the advance was required by a fixed maturity_date hardman f 2d pincite the presence of a fixed maturity_date for repayment indicates a fixed obligation to repay and supports a debt characterization id estate of mixon f 2d pincite anchor nat’l life ins co v commissioner t c pincite the absence of the same however indicates that repayment of the advance depends on the success of the business and favors an equity finding hardman f 2d pincite estate of mixon f 2d pincite anchor nat’l life ins co v commissioner t c pincite here the loan notes had specified maturity dates accordingly scottishpower had an unconditional right to demand repayment of the intercompany debt this factor supports characterizing the advance as debt source of payments the third factor in the debt-equity analysis is the source of payments on the advance hardman f 2d pincite an equity_investment is indicated where repayment depends on earnings or is to come from a restricted source id estate of mixon f 2d pincite 95_tc_257 in such a case the purported lender acts ‘as a classic capital investor hoping to make a profit not as a creditor expecting to be repaid regardless of the company’s success or failure ’ calumet indus inc v commissioner t c pincite quoting 862_f2d_112 7th cir here nagp was contractually obligated to pay the full principal amounts of the loan notes at set maturity dates notwithstanding its earnings moreover petitioner’s expert israel shaked concluded that pacificorp had reasonably anticipated cashflows at the time of the acquisition to pay nagp a holding_company dividends sufficient for nagp to timely service and retire the intercompany debt as it became duedollar_figure mr shaked also concluded that nagp 9this factor is somewhat anomalous because bona_fide loans are often repaid out of corporate earnings see 464_f2d_394 n 5th cir 10scottishpower developed a valuation model ex 7-j that included a 10-year cashflow forecast for pacificorp in connection with their evaluation of pacificorp as an acquisition target scottishpower updated the valuation model shortly before the acquisition closed projections for review by scottishpower and pacificorp mr shaked relied principally on the projections in reaching his conclusion could have likely refinanced the intercompany debt if nagp had been unable to fully repay it when due we accept mr shaked’s conclusions respondent’s expert robert mudge also analyzed nagp’s ability to repay the intercompany debt he concluded that nagp would have had a substantial cash shortfall when the fixed-rate notes matured mr mudge’s repayment analysis excludes however substantial expected proceeds from the sale of pacificorp’s australian operations which mr mudge acknowledges the relevant parties contemplated at the time of the acquisition mr mudge assumes that nagp would have used the sale proceeds to issue scottishpower a dividend rather than repaying the intercompany debt this assumption however is not supported by the record we therefore place less weight on his conclusions respondent also contends regulatory restrictions limited the amount of dividends that pacificorp could pay to nagp respondent cites various regulations but only a restriction the public_utility commission of oregon opuc restriction imposed actually affected pacificorp’s ability to make distributions to nagp the opuc restriction prohibited pacificorp from making any distribution that would reduce pacificorp’s common equity ratio below certain annual thresholds ranging from to from to we note however that the opuc restriction applied only to pacificorp’s regulated operations in oregon this would not have prevented pacificorp from maintaining a lower common equity ratio with respect to operations in other states and countries more generally the record does not reflect that the opuc restriction or any other regulatory restriction was a serious impediment to pacificorp paying nagp dividends sufficient to timely service and retire the intercompany debt thus the record reflects that repayment was not contingent on earnings this factor supports characterizing the advance as debt right to enforce payment of principal and interest the fourth factor in a debt-equity analysis focuses on the right to enforce payment of principal and interest hardman f 2d pincite a definite obligation to repay is evidence of debt id a lack of security for repayment of purported debt generally supports an equity characterization see 61_tc_367 am underwriters inc v commissioner tcmemo_1996_548 security is less important however in the related-party context see 61_tc_367 am underwriters inc v commissioner tcmemo_1996_548 nagp was contractually obligated to pay interest and principal owing on the intercompany debt by specified dates if nagp failed to pay any interest or principal within days of its being due scottishpower could require repayment of the full amount of the intercompany debt moreover nagp pledged its pacificorp stock as security for the intercompany debtdollar_figure we find that scottishpower had an unconditional right to enforce payment of the intercompany debt this factor supports characterizing the advance as debt participation in management the fifth factor in a debt-equity analysis is whether the person making an advance increases his or her management rights hardman f 2d pincite an increased right to participate in management resulting from an advance contributes to an equity finding id scottishpower was effectively nagp’s sole owner when it advanced the pacificorp shares to nagp and thus did not increase nor could have increased its right to participate in management as a result of the advance this factor is neutral status equal to or inferior to that of regular corporate creditors the sixth factor applied in characterizing an advance as debt or equity considers whether the person making the advance has equal or inferior rights to those of a regular corporate creditor id subordinating a purported creditor’s right to 11we disagree with respondent that the pledge agreement was mere window dressing regardless the importance of the pledge agreement here is minimal as scottishpower effectively controlled the pacificorp shares that nagp held see supra p repayment to that of other creditors supports an equity characterization id nevertheless subordination does not necessarily indicate equity when an advance is given priority over the claims of shareholders am underwriters inc v commissioner tcmemo_1996_548 see also estate of mixon f 2d pincite the loan notes did not subordinate scottishpower’s right to repayment to that of other creditors respondent argues however that the advance resembles equity more than debt because the loan notes did not restrict nagp from taking on more senior debt and nagp did in fact subordinate scottishpower’s right to repayment when obtaining the rbs credit facility we are not persuaded by respondent’s argument we have recognized that certain creditor protections are not as important in the related-party context for example we have previously found that a parent’s ownership_interest in its subsidiary adequately substituted for a security_interest or at least minimized its importance litton bus sys inc v commissioner t c pincite similarly scottishpower as nagp’s sole shareholder had the power to prevent nagp from taking on any additional debt including senior debt further we find that subordination of scottish power’s right to repayment was not significant under the circumstances nagp obtained the rbs credit facility to pay interest to scottishpower on the loan notes while pacificorp delayed paying dividends in connection with the phi restructuring moreover nagp reasonably expected pacificorp to pay a dividend sufficient to repay the rbs credit facility on or before its maturity which was within the same tax_year that nagp entered into the rbs credit facility respondent also argues that scottishpower’s right to repayment was structurally subordinated to rights of pacificorp’s creditors and therefore inferior to that of a regular creditor we disagree courts have long recognized that certain types of subordination to other creditors are not so unusual as to cast doubt on the bona fides of the purported debt see eg 390_f2d_965 ct_cl 379_f2d_569 ct_cl 377_f2d_291 5th cir alstate-schuylkill co v commissioner tcmemo_1969_9 see also 398_f2d_694 3d cir van dusen j dissenting with holding_companies any debt issued is necessarily subordinated to the creditors of its operating company accordingly this type of subordination is to be expected and does not in and of itself cast doubt on the legitimacy of debt issued by a holding_company this factor supports characterizing the advance as debt parties’ intent the seventh factor is whether the parties intended the advance to be debt or equity hardman f 2d pincite here the record contains substantial objective evidence showing nagp and scottishpower intended to create a debtor-creditor relationship the loan notes were in the form of debt provided for interest payments had stated maturity dates and were not subordinated to general creditors nagp and scottishpower recorded the loan notes as debt on their books_and_records at all times relevant and correspondence between the parties consistently recognized the loan notes as debt finally the parties represented to the sec that the loan notes were debt we discredit respondent’s argument that scottishpower capitalized nagp with the intercompany debt primarily to obtain interest_expense deductions respondent posits that nagp had tax_avoidance motives indicating that the advance was really an equity_investment see eg 248_f2d_399 2d cir rev’g and remanding tcmemo_1956_137 nagp’s desire to minimize tax is not conclusive however of the characterization of the advance as debt or equity see 232_f2d_118 2d cir indeed tax considerations permeate the decision to capitalize a business_enterprise with debt or equity_interest paid on indebtedness is deductible while no deduction is allowed for dividends_paid moreover scottishpower’s desire to obtain interest_expense deductions in capitalizing nagp with debt does not show that the parties lacked the requisite intent to enter into a debtor-creditor relationship as respondent implies if anything it shows the opposite we also discredit respondent’s additional arguments that the parties’ post- acquisition conduct demonstrates they lacked the requisite intent to form a genuine debtor-creditor relationship first respondent argues that certain instances of nagp’s failing to timely pay interest and incurring arrears and scottishpower’s allowing of the same indicates a lack of intent between the two to create a debtor- creditor relationship while not exemplary this conduct falls short of establishing that the parties never intended to form a debtor-creditor relationship we are mindful that a true lender is concerned with interest and that failure to insist on payment of interest may indicate that a purported lender expects to be repaid out of earnings see cma consol inc v commissioner tcmemo_2005_16 we are also mindful however that strict insistence on payment when due is not expected and consistent with business realities in the related-party context see 175_f2d_718 9th cir stating no adverse inference should be drawn from a party’s failing to demand payment immediately when due from a related_party rev’g a memorandum opinion of this court the record reflects that nagp took seriously its obligation to pay interest nagp made regular payments by or near the interest payment dates with the exception of the first two interest payments being untimely additionally nagp paid all or substantially_all accrued interest for each tax_year that the loan notes were outstanding the only exception is the tax_year during which one interest payment was due which ended a little over a month later second respondent argues that scottishpower’s short-term intercompany loan of dollar_figure million to nagp to fund interest payments on the loan notes in the tax_year shows that the parties did not intend a debtor-creditor relationship we disagree we have previously held that an advance from a parent_corporation to its subsidiary may be characterized as debt even though the parent makes subsequent readvances to cover interest on the initial advance see litton bus sys inc v commissioner t c pincite nestle holdings inc v commissioner tcmemo_1995_441 vacated and remanded on another issue 152_f3d_83 2d cir salient to our findings in these cases was that each taxpayer reduced its overall related-party indebtedness despite the advance and continued paying interest id in contrast we have held that a parent’s funding of interest owed it on a purported related-party loan supports a finding of equity where substantially_all the interest payments were made through circular cashflows and did not change the parties’ financial positions see laidlaw transp inc v commissioner tcmemo_1998_ the facts here are more similar to those in litton bus sys and nestle holdings inc than those in laidlaw transp inc nagp paid the first two intercompany interest payments for the tax_year with the short-term intercompany loan because of a delay in dividend payments from pacificorp pending the phi restructuring the same tax_year nagp used funds it had borrowed under the rbs credit facility to repay the short-term intercompany loan as well as make additional interest payments the net result for the tax_year was payment of all accrued interest on the loan notes for the tax_year and no increase in nagp’s related-party indebtedness to scottishpower moreover nagp continued to make interest payments and eventually retired a substantial portion of the fixed rate notes pursuant to the u s restructuring we do not draw any adverse inference that nagp failed to reduce the principal_amount of the intercompany debt during the years at issue as no principal payments were due thus like the taxpayers in litton bus sys and nestle holdings inc nagp continued to pay interest and principal despite the readvance additionally unlike the payments in laidlaw transp inc payment of interest through the short-term intercompany loan did not result in circular cashflows and actually affected nagp’s financial position indeed nagp repaid the short-term intercompany loan with funds from the rbs credit facility which it fully repaid in date with funds it received from a pacificorp distribution third respondent argues that nagp’s capitalization of the floating-rate notes and its partial capitalization of dollar_figure5 billion of the fixed-rate notes demonstrate that nagp and scottishpower never intended a true debtor-creditor relationship again we are not persuaded we recognize that payment of principal is strong evidence that parties intended a debtor-creditor relationship see jack daniel distillery f 2d pincite capitalization of debt to equity however does not necessarily preclude a finding of debt see deseret news publ’g co v commissioner tcmemo_1975_156 for example we have held that capitalization of a portion of debt in response to a new business circumstance does not indicate the capitalized portion of debt or remaining debt was an equity_investment id the fundamental inquiry is whether the capitalization of the purported debt represents a change in the parties’ intentions or the mere recognition of a longstanding intent that the purported debt be an equity_investment id regarding the floating-rate notes the parties received advice from pwc during the tax_year that nagp could not likely support a debt characterization of more than dollar_figure billion of the intercompany debt the record reflects that based upon this advice nagp decided to capitalize the entire original principal balance of the floating-rate notes we are not convinced that the parties’ decision to capitalize the floating-rate notes in response to the pwc advice demonstrates that the parties always intended the floating-rate notes to be an equity_investment regarding the partial capitalization of the fixed-rate notes pwc also advised that scottishpower’s u s consolidated_group should be restructured pwc advised restructuring because proposed changes to u s tax regulations under sec_894 would significantly increase the tax cost of the existing structure in response to this advice the parties capitalized into equity dollar_figure5 billion of the fixed-rate notes in connection with the u s restructuring as with the floating-rate notes we are not convinced that the parties’ capitalizing a portion of the fixed-rate notes based on pwc’s advice demonstrates that the parties always intended for the floating-rate notes to be an equity_investment finally respondent argues that nagp’s repayment of the remaining dollar_figure5 billion was in substance a capitalization of that portion of the fixed-rate notes thus showing that the parties always intended for the fixed-rate notes to be equity here nagp repaid the remaining principal balance of the fixed-rate notes dollar_figure5 billion with funds that originated from scottishpower and that were transferred to nagp through a series of transactions done in connection with the u s restructuring while the funds originated with scottishpower they were actually transferred to nagp and respondent has not argued nor established that the u s restructuring or the different transactions through which the funds were transferred to nagp lacked economic_substance or should otherwise be recharacterized or disregarded accordingly we respect the form of the parties’ transactions we do not find that the manner in which nagp received the funds used to repay the dollar_figure5 billion of fixed-rate notes rendered such repayment meaningless in sum nagp’s post-acquisition conduct is not fatal to its otherwise established intent to form a true debtor-creditor relationship this factor supports characterizing the advance as debt inadequate capitalization the eighth factor in determining whether an advance is debt or equity concerns the sufficiency of the purported debtor’s capitalization hardman f 2d pincite inadequate capitalization indicates that an advance is equity id the purpose of this factor is to gauge the risk associated with repayment of the purported loan 748_f2d_1365 9th cir rev’g tcmemo_1983_120 capital adequacy however must not be viewed in a vacuum the debt to equity ratio that is adequate in one industry may be inadequate in another see eg scotland mills inc v commissioner tcmemo_1965_48 for example companies with high levels of business risk such as those in highly uncertain environments eg high-tech or in cyclical or volatile industries generally cannot bear the risk of significant leverage the opposite is true generally for companies with low business risk eg utilities the parties’ experts agree on how to evaluate the adequacy of nagp capital structure they say we should look at nagp and pacificorp on a consolidated basis we agree petitioner’s expert mr shaked calculated the debt to total capitalization ratio to evaluate nagp and pacificorp’s leverage on a consolidated basis he determined that the ratio would peak pincite immediately after the acquisition and then gradually decline as nagp paid down the intercompany debt mr shaked also compared the leverage ratio of nagp to the leverage ratios of similarly situated utilities that made large acquisitions near the time of the acquisition he concluded that large highly leveraged transactions similar to scottishpower’s acquisition of pacificorp occurred and were funded by third-party lenders mr shaked also analyzed nagp’s equity value ie the fair_market_value of its assets less the face value of its debts using a market-based approach and a discounted cashflow approach he concluded under both analyses that nagp had significant positive equity value at the time of the acquisition respondent argues relying on his expert mr mudge that nagp would have likely been rated below investment grade by an independent rating agency such as standard poor’s s p and that this establishes nagp was thinly capitalized we disagree both mr mudge and petitioner’s expert william chambers opined on the credit rating that likely would be assigned to nagp under the s p credit rating system at the time of the acquisition mr chambers determined that nagp would be assigned a rating of bb mr mudge determined that nagp would receive a lower credit rating of b we agree with mr chambers that mr mudge’s assigned rating is flawed because it fails to take into account nagp’s business riskdollar_figure nevertheless respondent’s argument still fails even assuming nagp would have actually been assigned a b credit rating a b rating does not indicate 12we more specifically agree with mr chambers that a company’s business risk is a fundamental component that must be examined in determining a credit rating for a company imminent distress or bankruptcy rather as acknowledged by mr mudge in his expert report a b rating under s p’s credit rating system indicates that a company has the current capacity to meet financial commitments with a certain amount of vulnerability to adverse business financial and economic conditions accordingly we do not find that a b rating establishes that nagp was so thinly capitalized that it would be unable to repay the intercompany debt this factor supports characterizing the advance as debt identity of interest between creditor and sole shareholder the ninth factor to analyze whether an advance is debt or equity looks at whether the advance was made by a sole shareholder hardman f 2d pincite a sole shareholder’s advance is more likely committed to the risk of the business than an advance from a creditor who is not a shareholder g -pac corp v commissioner 63_tc_790 see also cma consol inc v commissioner tcmemo_2005_16 scottishpower was nagp’s sole shareholder when it advanced the scottishpower shares to nagp this factor supports characterizing the advance as equity payment of interest only out of dividends the tenth factor in analyzing whether an advance is debt or equity involves the source of interest payments hardman f 2d pincite the presence of an obligation to pay interest and actual interest payments indicate an advance is debt in contrast a lack of interest payments indicates equity am offshore inc v commissioner 97_tc_579 am underwriters inc v commissioner tcmemo_1996_548 the fixed and floating-rate notes both required nagp to pay interest periodically moreover as previously mentioned nagp had sufficient anticipated cashflow to make the required interests payments and actually made regular_interest payments paying substantially_all accrued interest during each year at issue this factor supports characterizing the advance as debt ability to obtain loans from outside lending institutions the eleventh factor evaluates whether the purported debtor could have obtained comparable financing hardman f 2d pincite this factor is relevant in measuring the economic reality of a transfer estate of mixon f 2d pincite evidence that the purported debtor could have obtained loans from outside sources points toward debt hardman f 2d pincite evidence that the taxpayer could not obtain loans from independent sources points toward equity id calumet indus inc v commissioner t c pincite we have recognized that the lender in the related-party context may understandably offer more flexible terms than could be obtained elsewhere see c m gooch lumber sales co v 49_tc_649 remanded on a different issue 406_f2d_290 6th cir we look to whether the terms of the purported debt were a patent distortion of what would normally have been available to the debtor in an arm’s-length transaction see litton bus sys inc v commissioner t c pincite nestle holdings inc v commissioner tcmemo_1995_441 cf 89_tc_816 stating that the touchstone of economic reality is whether an outside lender would have made the payments in the same form and on the same terms both respondent’s and petitioner’s experts analyzed whether nagp could have obtained comparable financing with respect to the advance respondent’s expert mr mudge concluded that nagp could not have obtained comparable financing the question he sought to answer however was whether nagp could have obtained financing from third-party creditors on the same terms and at the same price the requirement of precise matching misses the mark see litton bus sys inc v commissioner t c pincite declining to apply a mechanical test of absolute identity between the advance and what debt actually or hypothetically would have been available to the taxpayer cf segel v commissioner t c pincite we therefore give little weight to mr mudge’s conclusions petitioner’s expert charles chigas on the other hand concluded that fixed- rate notes would have been purchased by third-party fixed-income investors on substantially_similar terms as the dollar_figure billion fixed-rate notes he determined that the interest rate in the market would have been slightly higher but the transaction could have been sold in the debt capital markets to third-party investors mr chigas’ rationale relies on information including comparable debt issuances at the time and the stable credit profile of electric utilities issuers mr chigas considers a different method of lending and acknowledges that the debt capital markets would have required a slightly higher rate nevertheless we find that the terms of the fixed-rate notes were not a patent distortion of what nagp could have otherwise borrowed the record is void of any facts to persuade us that nagp could have obtained financing from an unrelated party comparable to the terms of the dollar_figure million in floating-rate notes mr chigas indicates that including the floating-rate notes would not change his conclusions regarding the fixed-rate notes he reaches this conclusion by noting that if including the floating-rate notes would have resulted in a rating downgrade for all of the loan notes such that they would be below investment grade then he would have recommended dividing the debt offering into senior and subordinate tranches accordingly we find that this factor favors characterizing the fixed-rate notes as debt and is neutral regarding the characterization of the floating- rate notes iii conclusion we recognize that there are features in this case pointing to both debt and equity nevertheless in view of the record as a whole we find that the advance was more akin to debt than equity we did not rely on any single overriding factor rather we find that the whole of this case is more reflective of the true relationship between the parties than the individual parts we therefore hold that the payments of interest made with the respect to the loan notes are deductible as interest for each year at issue we have considered all remaining arguments the parties made and to the extent not addressed we find them to be irrelevant moot or meritless to reflect the foregoing decision will be entered for petitioner


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 number release date cc pa apjp br3 tl-n-6681-98 uilc date internal_revenue_service national_office field_service_advice memorandum for district_counsel rocky mountain district cc wr rmd den from curtis g wilson assistant chief_counsel administrative provisions and judicial practice cc pa apjp subject partnership items in valuing partners’ partnership interests 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 disclosure statement field_service_advice is chief_counsel_advice and is open to public inspection pursuant to the provisions of sec_6110 the provisions of sec_6110 require the service to remove taxpayer identifying information and provide the taxpayer with notice of intention to disclose before it is made available for public inspection sec_6110 and i sec_6110 also authorizes the service to delete information from field_service_advice that is protected from disclosure under u s c sec_552 b and c before the document is provided to the taxpayer with notice of intention to disclose only the national_office function issuing the field_service_advice is authorized to make such deletions and to make the redacted document available for public inspection accordingly the examination appeals or counsel recipient of this document may not provide a copy of this unredacted document to the taxpayer or their representative the recipient of this document may share this unredacted document only with those persons whose official tax_administration duties with respect to the case and the issues discussed in the document require inspection or disclosure of the field_service_advice legend a p b group a the consolidated_group for which a filed income_tax returns a1 a2 group b the consolidated_group for which a filed income_tax returns b1 b2 c d e year date date date issue whether the valuation of a partners’ pro_rata share of partnership assets transferred pursuant to sec_367 requires a determination of partnership items in an administrative_proceeding under sec_6221 through conclusion we recommend that a partnership proceeding be instituted under sec_6223 for the purposes of determining that value of the partnership assets that are being used per elections under sec_1492 and sec_1_367_d_-1t to value the partnership interests that were transferred to entities outside the united_states facts p is a general_partnership formed by a1 a2 b1 and b2 on date a1 and a2 are corporations that file consolidated income_tax returns with the consolidated_group headed by a b1 and b2 are corporations that file consolidated income_tax returns which the consolidated_group headed by b combining the subsidiaries’ interests the two consolidated groups each held equal -- -- partnership interests in p in year on date a1 and a2 transferred their partnership_interest in p to c a foreign_partnership in exchange for a combined interest in c in a parallel transaction on the date b1 and b2 transferred their partnership_interest in p to d another foreign_partnership in exchange for a combined interest in d on date the next day c and d each transferred their assets including the newly acquired partnership interests in p to e a foreign_corporation in exchange for of the stock of e c and d each held of e’s stock a1 a2 b1 and b2 hereinafter collectively referred as the taxpayers each treated its transfer of its partnership_interest in p to the foreign entities c and d as not being subject_to excise_tax under former sec_1491 because they filed elections under sec_1492 each partner filed a form_926 return on a u s transfer of property to as foreign_corporation on which it made elections under sec_1492 and sec_1_367_d_-1t to apply the principles of sec_367 to the transfer of their partnership interests and to treat the outbound_transfer of operating_intangibles as a deemed sale thus under sec_367 each transfer of a partnership interests is treated as a transfer of each partner’s pro rate share of the assets of the partnership the gain on the sale is subject_to income_tax group a and group b each reported a gain from the transfers based upon a gross valuation of each partner’s pro_rata share of the assets of p less the adjusted_basis in those assets c and d similarly made deemed sales elections for treating their transfers of their interests in p to e on date p timely filed a form_1065 u s partnership return of income for year on which it reported in an attachment that the taxpayers had contributed their partnership_interest in p to c and d and that these contributions had caused a technical_termination of p on date p which was not required to report the sec_367 gain resulting from the partners’ transfer of partnership_interest in it did not otherwise report the transaction on its form_1065 the irs is auditing group a and group b for year in the course of those audits the irs has substantially completed its factual investigation of these transactions it has made a preliminary decision concerning that the fair_market_value of the assets of p in order to establish the value of the partnership interests transferred by the taxpayers before proposing adjustments to the consolidated income_tax liabilities of group a and group b based upon these transactions the service has asked whether an administrative review of p should first be completed under the tefra partnership audit provisions both group a and group b have agreed to extend the time to assess tax on form sec_872 law and analysis in congress enacted the tefra unified_audit and litigation procedures to substitute a simplified and streamlined entity-level partnership audit litigation and assessment process in lieu of instituting multiple separate proceedings with the partners tax equity and fiscal responsibility act of pub_l_no 96_stat_646 h_r rep no pincite 1982_2_cb_462 the tefra procedures provide rules for the examination of a partnership entity that parallel and supplement the existing rules and procedures in the code for the examination of a taxpayer’s return the tefra procedural rules at sec_6221 through supplement the general rules for making a tax_assessment against an individual taxpayer by inserting the audit of a tefra entity into the examination process before an assessment of taxes can be made against a partner based upon a partnership_item under tefra the tax treatment of any partnership_item can only be determined at the partnership level sec_6221 while nonpartnership_items can be determined in notice_of_deficiency issued to individual taxpayers sec_6225 prohibits the assessment of a deficiency attributable to a partnership_item before a notice of final administrative adjustment is mailed to the tax_matters_partner for the partnership see 87_tc_783 for a discussion of the dichotomy between the deficiency and partnership audit proceedings if a partnership_item is not raised in a partnership level proceeding the parties are precluded from raising the partnership issue in any subsequent proceeding 93_tc_730 the prohibition in sec_6225 is effective unless a partner waives any rights and any restrictions upon the service in a written_agreement under section thus if the determination of the tax effect of the taxpayers’ transfer of their partnership interests outside the untied states is attributable to a partnership_item it will be necessary to institute an administrative_proceeding under the tefra provisions before proposing adjustments to the income of the taxpayers from the transfers a partnership_item is defined in sec_6231 the term partnership_item means with respect to a partnership any item required to be taken into account for the partnership’s taxable_year under subtitle a income_tax provisions to the extent regulations prescribed by the secretary provide that for purposes of this subtitle such item is more appropriately determined at the partnership level than at the partner level sec_301 a - lists the items that are required to be taken into account for the taxable_year of a partnership and that the service considers to be more appropriately determined at the partnership level these items include the partnership aggregate and each partners’ share of i items of income gain loss deduction or credit of the partnership and iv other items determinable at the partnership level with respect to partnership assets investments transactions and operations necessary to enable the partnership to determine investment credits the recapture of investment credits amounts at risk depletion allowances and the application of sec_751 and b and optional adjustments to the basis of partnership property pursuant to an election under sec_754 including necessary preliminary determinations such as the determination of a transferee partner’s basis in a partnership_interest sec_751 provides that the amount received by a partner on the sale_or_exchange of a partnership_interest will include the amount received for unrealized_receivables and inventory as the amount_realized from the sale_or_exchange of property other than a capital_asset sec_301 b adds that the term ‘partnership item’ also includes the accounting practices and the legal and factual determinations the underlie the amount timing and characterization of items of income credit gain loss deduction etc the regulations do not specifically include the valuation of assets as a partnership_item in particular they do not address the valuation of assets for purposes of reporting the gain_or_loss resulting from the transfer of partnership_interest to a foreign_entity valuing partnership assets however falls within the regulation’s broad definition of partnership items the basis or value of partnership property is a partnership_item 87_tc_783 it is obviously necessary to value particular partnership assets to determine tax consequences such as the deductions allowable to a partnership for depreciation or the character and amounts of property distributed to a partner see regents park partners v commissioner tcmemo_1992_336 63_tcm_3131 tax_court valued real_estate acquired by the partnership in a tefra proceeding sec_301_6231_a_3_-1 likewise the assets may need to be valued to determine the proper amount of the income gain_or_loss from the partnership’s sale_or_exchange of such assets in any given partnership_tax_year because the taxpayers elected under sec_1492 and sec_1_367_d_-1t to apply the principles of sec_367 to the transfer of their partnership interests and to treat the outbound_transfer of operating_intangibles as a deemed sale the determination of their income_tax_liability on the transfer of their partnership interests is attributable to partnership items of their partnerships by virtue of the elections each partner’s transfer of a partnership_interest is treated under sec_367 as a transfer of the partner’s pro rate share of the assets of the partnership to determine the gain on the sale of the partnership’s assets the assets themselves must be valued we recognize that the gain on the sale of a partnership_interest or the character of such gain is not usually a partnership_item see regents park partners v commissioner tcmemo_1992_336 in regents park the service determined among other adjustments in a tefra partnership case that a partner must treat any gain from the sale of his partnership_interest that was attributable to exce sec_2 the gain on a sale_or_other_disposition of property is defined in sec_1001 as the amount_realized over the adjusted_basis while the amount by which the adjusted_basis exceeds the amount_realized is a loss sec_1001 provides that the amount_realized is the sum of money received plus the fair_market_value of the property received where as in this case the value of the assets being transferred between related parties is used to determine the value of the property being received in exchange it is necessary to determine the value of such assets themselves depreciation as ordinary_income the tax_court relying upon dicta in clovis i v commissioner t c determined that it did not have jurisdiction over that characterization of the partner’s income because the proposed_adjustment did not inter alia result in adjustments to the partnership income and return the critical question however is whether the items underlying the adjustment are items that a partnership is required to take into account on its books_and_records for the taxable_year see 95_tc_1 a shareholder’s basis is not a subchapter_s_item however to the extent that components of basis or amount_at_risk or other adjustments are more appropriately determined at the partnership level they should be raised in tefra partnership level proceedings see 97_tc_278 and gemini twin fund iii v commissioner tcmemo_1991_315 aff’d u s app lexis 9th cir if no partnership proceeding precedes a partner level proceeding the parties will be bound by the reporting of the partnership items on the partnership return and the treatment of these items on the partnership books_and_records doe v commissioner u s t c big_number a f t r 2d 10th cir 94_tc_853 to avoid being bound by p’s valuation of its assets in valuing the taxpayers’ partnership interests we recommend that you determine the value of the assets in a tefra_audit of p case development hazards and other considerations please call if you have any further questions


internal_revenue_service number release date index numbers ------------------------------------ ---------------------------------------------- ------------------------------ ------------------------------- - department of the treasury washington dc third party communication none date of communication not applicable_person to contact ---------------------- id no ------------- telephone number --------------------- refer reply to cc psi b03 plr-123814-06 date date ------------------- ------------------- ------------------------- --------------------------- ---------------------------------- legend x -------------------------------------------------- state date date a dear -------------- we received your letter dated date submitted on behalf of x requesting relief under sec_301_9100-1 through of the procedure and administration regulations for an extension of time in which to make an election under sec_754 of the internal_revenue_code this responds to your request laws of state on date on date a a member in x died x inadvertently failed to timely file the sec_754 election will not prejudice the interests of the government and that x is not using hindsight in requesting relief to make the election it is represented that x acted reasonably and in good_faith that granting the relief the information submitted states x is a limited_liability_company formed under the facts law and analysis sec_1_754-1 of the income_tax regulations provides that an election plr-123814-06 sec_754 provides that if a partnership files an election in accordance with the regulations prescribed by the secretary the basis of partnership property is adjusted in the case of a transfer of a partnership_interest in the manner provided in sec_743 such an election shall apply with respect to all distributions of property by the partnership and to all transfers of interests in the partnership during the taxable_year with respect to which the election was filed and all subsequent taxable years a transfer of an interest in a partnership on the death of a partner is eligible for the sec_754 election the value of the partnership_interest reported on the estate_tax_return including discounts is the value used to determine the basis of the partnership_interest and the adjustment to basis of partnership property under sec_743 and sec_754 see generally sec_1_1014-3 under sec_754 to adjust the basis of partnership property under sec_734 and sec_743 with respect to a distribution_of_property to a partner or a transfer of an interest in a partnership shall be made in a written_statement filed with the partnership return for the taxable_year during which the distribution or transfer occurs for the election to be valid the return must be filed not later than the time prescribed by sec_1 e including extensions thereof for filing the return for that taxable_year extension of time to make a regulatory election or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as an election whose due_date is prescribed by a regulation published in the federal_register or a revenue_ruling revenue_procedure notice or announcement published in the internal_revenue_bulletin determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 under sec_301_9100-3 a request for relief will be granted when the taxpayer provides evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and that granting relief will not prejudice the interests of the government conclude that the requirements of sec_301_9100-1 and sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days from the date of this letter to make an election under sec_754 effective date with the appropriate service_center a sec_301_9100-1 provides that the commissioner may grant a reasonable based solely on the information submitted and the representations made we sec_301_9100-3 provides the standards the commissioner will use to conclusion this ruling is directed only to the taxpayer requesting it sec_6110 pursuant to a power_of_attorney on file with this office a copy of this letter is plr-123814-06 copy of this letter should be attached to the sec_754 election a copy is enclosed for that purpose except as specifically set forth above no opinion is expressed concerning the federal tax consequences of the facts described above under any other provisions of the code provides that it may not be used or cited as precedent being send to x’s authorized representative enclosures heather c maloy associate chief_counsel passthroughs special industries sincerely s copy of this letter copy for purposes


internal_revenue_service number release date index number ----------------------------------------- ---------------------------------------------------------- -------------------- ----------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ----------------------- id no ------------------- --------------------------------------------------- telephone number ---------------------- refer reply to cc psi b03 plr-120038-13 date date legend x ------------------------------------------------------------ ------------------------------------------------- d1 ---------------------- dear ---- ------------ this letter responds to a letter dated date submitted on behalf of x requesting a ruling under sec_1362 of the internal_revenue_code code facts according to the information submitted x made an election to be a subchapter_s_corporation effective on d1 on d1 however an interest in x was owned by an ineligible shareholder steps were taken to transfer such interest in x to eligible shareholders x represents that its invalid s_corporation_election was inadvertent unintended and not the result of tax_avoidance or retroactive tax planning x further represents that at all relevant times x and its shareholders have treated x as an s_corporation x and its shareholders have agreed to make any adjustments required by the service consistent with the treatment of x as an s_corporation law and analysis plr-120038-13 sec_1361 provides that for purposes of title_26 the term s_corporation means with respect to any taxable_year a small_business_corporation for which an election under sec_1362 is in effect for such year sec_1361 provides that for purposes of subchapter_s the term small_business_corporation means a domestic_corporation which is not an ineligible_corporation and which does not-- a have more than shareholders b have as a shareholder a person other than an estate a_trust described in sec_1361 or an organization described in sec_1361 who is not an individual c have a nonresident_alien as a shareholder and d have more than class of stock sec_1362 provides that if an election under sec_1362 by any corporation a was not effective for the taxable_year for which made determined without regard to sec_1362 by reason of a failure to meet the requirements of sec_1361 or to obtain shareholder consents or b was terminated under sec_1362 or the secretary determines that the circumstances resulting in the ineffectiveness or termination were inadvertent no later than a reasonable period of time after discovery of the circumstances resulting in the ineffectiveness or termination steps were taken a so that the corporation is a small_business_corporation or b to acquire the shareholder consents and the corporation and each person who was a shareholder of the corporation at any time during the period specified pursuant to sec_1362 agrees to make such adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary with respect to such period then notwithstanding the circumstances resulting in the ineffectiveness or termination the corporation will be treated as an s_corporation during the period specified by the secretary conclusion based solely on the facts submitted and representations made we conclude that x’s election to be treated as an s_corporation as of d1 was invalid we also conclude that the invalid election constituted an inadvertent invalid election within the meaning of sec_1362 under the provisions of sec_1362 x will be treated as an s_corporation as of d1 and thereafter provided that x’s s_corporation_election was not otherwise terminated under sec_1362 except as expressly provided herein we express or imply no opinion concerning the federal tax consequences of any aspect of any transaction or item discussed or referenced in this letter specifically we express or imply no opinion regarding whether x is otherwise eligible to be treated as an s_corporation this ruling is directed only to the taxpayer that requested it sec_6110 provides that it may not be used or cited as precedent plr-120038-13 pursuant to a power_of_attorney on file we are sending copies of this letter to x’s authorized representatives sincerely s richard t probst senior technician reviewer branch office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes


internal_revenue_service number release date index number ------------------- ------------------------------------------ ----------------------------------------------- ----------------------------- in re ---------------------------------------- ----------------------------------------------- ---------------------------------- department of the treasury washington dc person to contact --------------------- id no ------------- telephone number --------------------- refer reply to cc tege et2 - plr-159272-03 date date legend state a ------------- act b -------------------------------------------------------------------------- department d ----------------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------------------- center x --------------------------------------------- year ------- dear ----------- this letter responds to your date private_letter_ruling request you have requested a ruling as to whether center x is an instrumentality of state a for the purposes of internal_revenue_code the code sec_3121 facts in year center x was incorporated under the general nonprofit law of state a subsequently the legislature of state a enacted act b center x amended its bylaws to implement all of the provisions of act b center x received a favorable determination_letter from the internal_revenue_service indicating that it is exempt from federal income taxes under code sec_501 as an organization described in code sec_501 under act b department d is required to contract with nonprofit_corporations such as center x to coordinate and deliver services to developmentally disabled people in a specific geographic area center x coordinates the provision of services in nine counties in state a currently in state a there are similar centers the centers center x coordinates community resources such as education recreation health and welfare further center x provides a wide array of services directly to the developmentally disabled within its region and funds health services that are not covered by other funding sources law code sec_3101 imposes a tax on employees for old age survivors and disability insurance ie the social_security_tax on the income of every individual received by such individual with respect to employment code sec_3111 imposes the social_security_tax on employers calculated as a percentage of wages with respect to employment subject_to certain exceptions not applicable in this case code sec_3121 provides that the definition of employment includes service in the employ of a state or any political_subdivision thereof or of any instrumentality of the foregoing by an individual who is not a member of a retirement_system of such state in revrul_57_128 1957_1_cb_311 the internal_revenue_service set forth the following six factors to take into consideration in determining whether an organization is an instrumentality of a state or political_subdivision for purposes of code sec_3121 whether it is used for a governmental purpose and performs a governmental function whether performance of its function is on behalf of one or more states or political subdivisions whether there are any private interests involved or whether the states or political subdivisions involved have the powers and interests of an owner whether control and supervision of the organization is vested in public authority or authorities whether express or implied statutory or other authority is necessary or exists for the creation and or use of the organization and the degree of financial autonomy and the source of its operating funds analysis governmental purpose and function pursuant to act b the centers were created in order for state a to carry out many of its responsibilities for providing services and support for the developmentally disabled under center x’s bylaws the express purpose of center x is to carry out the provisions of act b center x provides services such as recreation health rehabilitation welfare and education for individuals with developmental disabilities many of the duties that center x performs under a contract with department d are duties that department d or another state a agency would otherwise perform for example except for those judicially committed to a state hospital no developmentally disabled person is admitted to a state hospital without a referral from the appropriate center similarly upon discharge a developmentally disabled person is referred to the appropriate center accordingly we conclude that center x carries out a governmental purpose and performs a governmental function in the nine counties in which it operates function performed on behalf of state as noted above the centers are organized and operate under act b to provide social welfare services to developmentally disabled individuals on behalf of state a the centers were created to provide services that would otherwise be provided by department d under act b center x also has powers exercised concurrently with department d such as unannounced visits to service provider facilities additionally act b provides that under certain conditions and for a limited time department d can directly operate center x in order to avoid service disruption accordingly we conclude that center x performs its functions on behalf of department d private interest versus government ownership center x’s articles of incorporation provide that center x’s purpose is exclusively to promote social welfare less than one percent of center x’s operating budget comes from funds other than those provided by department d and state a under its contract with department d all the materials supplies and property furnished by state a or purchased with funds received under the contract are the property of state a unless a specific exception applies all unused contract funds revert back to department d at the end of each fiscal_year in addition all of center x’s bank accounts and investments are held jointly in the name of center x and state a accordingly we conclude that there are no private interests involved in center x and state a has the powers and interests of an owner public control and supervision a majority of of directors on center x’s board_of directors is chosen by designated county officials or in counties where these officials do not exist by the boards of supervisors in consultation with other local officials further act b requires center x to meet specific requirements in a wide range of areas such as qualification composition and term restrictions on the boards of directors staffing and performance requirements and budgeting accounting auditing and administrative practices similarly specific provisions of the contract between center x and department d place similar obligations and restrictions on center x accordingly we conclude that control and supervision of center x are vested in public authorities statutory authority the legislature of state a specifically provided in act b that the services provided by the centers are of such a special and unique nature that they cannot be satisfactorily provided by state agencies and therefore the centers would be operated by nonprofit_corporations organized and created to provide services to developmentally disabled individuals the state is required to provide services through the centers which are in turn subject_to specific requirements under act b accordingly we conclude that center x operates under the express authority of act b financial autonomy source of operating funds we previously noted that virtually the entire operating budget of center x comes from department d or state a the materials and property used by center x to fulfill its contractual obligations belong to state a and both center x’s bank accounts and investments are held jointly with state a act b provides that department d shall act as agent for the transmittal of funds for services through center x additionally department d is responsible for the processing audit and payment of funds made available to center x accordingly we conclude that center x has little or no financial autonomy and is dependent on state a and department d for its operating funds conclusion based on the above analysis we conclude that center x satisfies the criteria of revrul_57_128 and is an instrumentality of state a the services performed by center x’s employees who are qualified participants in a retirement_system within the meaning of code sec_3121 are excluded from employment for purposes of code sec_3101 and sec_3111 no opinion is expressed on whether the retirement_system of state a constitutes a retirement_system within the meaning of code sec_3121 the above analysis is based on the assumption that center x employees are not covered by a sec_218 agreement the ruling contained in this letter is based upon information and representations submitted by the taxpayer's representative and accompanied by a penalty of perjury statement executed by an appropriate party while this office has not verified any of the material submitted in support of the request for a ruling it is subject_to verification on examination this ruling is directed only to the taxpayer requesting it code sec_6110 provides that this ruling may not be used or cited as precedent sincerely lynne camillo chief employment_tax branch office of division counsel associate chief_counsel tax exempt government entities