114 T.C. No. 27
UNITED STATES TAX COURT
AMERICAN STORES COMPANY AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13142-97. Filed May 26, 2000.
P purchased the stock of LS. Prior to purchasing LS, P had negotiated with the Federal Trade Commission to satisfy the antitrust concerns about the purchase. Shortly after P’s purchase of LS, and 1 day after the FTC entered its final consent order, the State of California filed an antitrust suit in Federal District Court objecting to P’s purchase of LS. The State asked for various remedies including divestiture. The District Court issued a temporary injunction prohibiting P from integrating the business operations of LS and P. The District Court’s opinion was the subject of an appeal and was ultimately resolved by the Supreme Court. Thereafter, P and the State settled the antitrust suit. P incurred substantial legal fees in defending against the State’s antitrust suit. Those legal fees were deducted as ordinary and necessary business expenses. R disallowed those deductions based on R’s determination that the legal fees should be capitalized. - 2 -
Held: P’s legal fees incurred in defending against the State’s antitrust suit arose out of, and were incurred in connection with, P’s acquisition of LS. The origin of the State’s antitrust claim was P’s acquisition of LS. P’s legal fees must be capitalized.
Fredrick J. Gerhart, Kevin M. Johnson, and Thomas Edward
Doran, for petitioner.
Mark H. Howard, for respondent.
OPINION
RUWE, Judge: Respondent determined deficiencies of
$7,963,850 and $1,773,964 in petitioner’s Federal income tax for
its taxable years ending January 28, 1989, and February 3, 1990,
respectively (hereinafter referred to as the 1989 and 1990 tax
years). After concessions, the only issue for decision is
whether petitioner may deduct or must capitalize legal fees and
costs (legal fees) incurred in defending an antitrust suit
brought by the State of California subsequent to petitioner’s
acquisition of Lucky Stores, Inc. This case is before the Court
fully stipulated. See Rule 122. The stipulation of facts and
the attached exhibits are incorporated herein by this reference.
Background
Petitioner is an affiliated group of corporations which
annually files a consolidated Federal income tax return.
American Stores Company (American Stores) is the common parent of - 3 -
the affiliated group, and it filed the petition on behalf of all
eligible members of the group pursuant to section 1.1502-77,
Income Tax Regs. At the time the petition was filed, American
Stores, a Delaware corporation, maintained its mailing address
and principal office at 709 East South Temple, Salt Lake City,
Utah. Petitioner files its income tax returns on the basis of a
52-53-week fiscal year ending on the Saturday nearest to each
January 31. Petitioner prepared and filed the consolidated
income tax returns for its 1989 and 1990 tax years using the
accrual method of accounting.
By January 28, 1989, American Stores and its subsidiaries
operated approximately 1,917 retail units in 39 States. During
the 1989 and 1990 tax years, petitioner principally engaged in
the retail sale of food and drug merchandise. Petitioner is one
of the nation’s leading retailers, operating combination
drug/food stores, super drug centers, drug stores, and food
stores. Petitioner sells both food and nonfood merchandise such
as prescription drugs, tobacco products, housewares, health and
beauty aids, and sundry merchandise for home and family use.
Petitioner maintains a substantial inventory for its various
retail grocery and drug stores throughout the nation.
Prior to its acquisition of Lucky Stores, Inc. (Lucky
Stores), petitioner conducted its activities through American
Stores’ wholly owned subsidiaries: American Super Stores, Inc., - 4 -
comprised of Acme Markets, Inc., Jewel Food Stores, Star Market
and Jewel OSCO; American Food and Drug, Inc., comprised of Skaggs
Alpha Beta and Buttrey Food-Drug; American Drug Stores, Inc., a
nationwide drug chain; and Alpha Beta Company (Alpha Beta).
During the 1989 tax year, American Stores also acquired and
commenced operations through Lucky Stores. Lucky Stores operated
food stores in California, Arizona, Nevada, and Florida.
Acquisition of Lucky Stores
In December 1987, the second and third largest grocery store
chains in the State of California, Vons and Safeway, merged.
American Stores determined that acquiring Lucky Stores would
complement Alpha Beta’s operations in California. On March 21,
1988, American Stores initiated a hostile takeover bid or tender
offer for all the outstanding shares of Lucky Stores for $45 per
share (tender offer). At the time of the tender offer, Alpha
Beta stores constituted California's fourth largest retail
grocery chain. Alpha Beta operated 252 supermarkets in
California, 54 in northern California, and 198 in southern
California. Lucky Stores operated 340 stores located throughout
California, and it was the largest grocery store chain in the
State of California.
On May 23, 1988, American Stores amended its tender offer
increasing the offer to $65 for each Lucky Stores share. This
increase in price was attributable, in part, to competing bids by - 5 -
other companies interested in acquiring Lucky Stores. On May 23,
1988, the board of directors for Lucky Stores approved the
amended tender offer and a merger proposal with American Stores.
FTC’S Actions
On March 21, 1988, American Stores gave notice of its
intention to purchase all the stock of Lucky Stores to the
Federal Trade Commission (FTC), pursuant to the Hart-Scott-Rodino
Antitrust Improvements Act of 1976, Pub. L. 94-435, sec. 201, 90
Stat. 1390, codified at 15 U.S.C. sec. 18a (1997). In response
to American Stores’ Hart-Scott-Rodino filing, the FTC conducted
an investigation of the proposed merger and worked to negotiate a
settlement with American Stores.
The FTC and American Stores negotiated a preliminary
settlement of the FTC's concerns about the tender offer. This
preliminary settlement was reflected in two simultaneous actions
taken by the FTC on May 31, 1988. First, the FTC filed an
administrative complaint charging that American Stores’
acquisition of Lucky Stores violated section 7 of the Clayton
Act, ch. 323, 38 Stat. 731 (1914), as amended and codified at 15
U.S.C. sec. 18 and section 5 of the Federal Trade Commission Act,
ch. 311, 38 Stat. 719 (1914), as amended and codified at 15
U.S.C. sec. 45. Second, the FTC filed a proposed consent order
(proposed consent order). As part of the proposed consent order,
the tender offer was permitted to proceed subject to certain - 6 -
conditions. The conditions were contained in an agreement titled
“Hold Separate Agreement” (hold separate agreement). That
agreement required American Stores to:
a. refrain from integrating the assets of American Stores and Lucky Stores until American Stores had divested itself of 24 of its 54 Alpha Beta supermarkets in Northern California; b. maintain separate books and records for the acquisition; c. prevent any waste or deterioration of Lucky Stores’ California operations; d. refrain from replacing the executives of Lucky Stores; e. maintain Lucky Stores as a viable competitor in California; f. refrain from selling or otherwise disposing of Lucky Stores’ California warehouses, distribution or manufacturing facilities, and retail grocery stores; g. preserve separate purchasing for Lucky Stores’ retail grocery sales.
Relying on the FTC’s proposed consent order of May 31, 1988,
American Stores proceeded with its tender offer to purchase 100
percent of Lucky Stores stock. American Stores’ tender offer for
Lucky Stores stock was carried out by a wholly owned subsidiary
of Alpha Beta, Alpha Beta Acquisition Corp. (ABAC). ABAC had
been formed solely for the purpose of acquiring the stock of
Lucky Stores. On June 2, 1988, ABAC acquired more than 80
percent of the Lucky Stores common stock at $65 per share. As
between ABAC and the former Lucky Stores shareholders, ABAC’s
acceptance and purchase of stock was final and irrevocable.
Petitioner’s objective in acquiring Lucky Stores was to
achieve future long-term benefits from the merger of the Alpha - 7 -
Beta chain of stores and Lucky Stores. The long-term benefits
being sought were a greater market share in the California
grocery market, greater operating efficiencies in the combined
operations of the two chains, and the adoption of some of the
management/operating policies of Lucky Stores such as Lucky
Stores’ “everyday low pricing” policy.
On June 9, 1988, ABAC was merged with and into Lucky Stores,
pursuant to short-form merger provisions of the Delaware General
Corporation Law. As a result of the short-form merger, ABAC
disappeared and Lucky Stores became a wholly owned subsidiary of
Alpha Beta. The total consideration paid by American Stores in
the tender offer and merger exceeded $2.5 billion. For purposes
of State law, the merger was final and irrevocable. After its
acquisition of Lucky Stores, American Stores complied with the
requirements of the hold separate agreement and did not integrate
the operations of Lucky Stores with the operations of Alpha Beta.
State of California’s Actions
In April 1988, American Stores provided the State of
California with the filings it had made with the FTC pursuant to
section 7 of the Clayton Act. Through that filing, American
Stores gave formal notice to the State of California of its
intentions to acquire all of the Lucky Stores stock and to merge
ABAC into Lucky Stores. - 8 -
The FTC allowed, in accordance with its regulations, a
comment period during which the public was invited to submit
comments on the proposed consent order. The attorney general of
California submitted comments expressing concern that American
Stores’ acquisition of Lucky Stores would reduce competition in
the retail supermarket industry in California.
The FTC entered a final consent order on August 31, 1988.
On September 1, 1988, the State of California filed suit against
American Stores, ABAC, and Lucky Stores in the United States
District Court for the Central District of California (District
Court). The State of California claimed that the merger violated
Federal and State antitrust laws by decreasing competition in the
supermarket industry in California. The State of California
requested various forms of relief, including rescinding the
merger transaction, a divestiture of Lucky Stores or,
alternatively, a permanent “hold separate agreement” like the one
that American Stores had entered into with the FTC.
The District Court issued a temporary restraining order
against American Stores and Lucky Stores on September 29, 1988.
The order required the continuation of the hold separate
agreement and the maintenance of the status quo at American
Stores and its subsidiaries and Lucky Stores and its subsidiaries
until a hearing on the preliminary injunction could be held. The
opinion of the District Court in this matter was published as - 9 -
State of Cal. v. American Stores Co., 697 F. Supp. 1125 (C.D.
Cal. 1988). American Stores appealed the decision of the
District Court. The Court of Appeals for the Ninth Circuit
published its opinion in that appeal as State of Cal. v. American
Stores Co., 872 F.2d 837 (9th Cir. 1989). The Court of Appeals
affirmed the District Court's finding that California had shown a
likelihood of success on the merits of the case and possible
irreparable harm. The Court of Appeals, however, found that the
preliminary injunction ordered by the District Court was
tantamount to an indirect divestiture which was not a remedy
available to private plaintiffs under section 16 of the Clayton
Act. The United States Supreme Court granted certiorari to the
State of California. See California v. American Stores Co., 493
U.S. 916 (1989). Prior to granting certiorari, Justice O’Connor
entered a stay continuing the District Court’s injunction pending
further review by the Supreme Court. See California v. American
Stores Co., 495 U.S. 271, 278 (1990).
The Supreme Court reversed the judgment of the Court of
Appeals for the Ninth Circuit and remanded the case for further
proceedings. The Supreme Court held that divestiture is a form
of injunctive relief within the meaning of section 16 of the
Clayton Act and that the District Court had the authority to
divest the acquirer of any part of the acquirer’s ownership
interest in the acquired company. See id. The Supreme Court - 10 -
answered the specific question before it stating:
We are merely confronted with the naked question whether the District Court had the power to divest American of any part of its ownership interest in the acquired Lucky Stores, either by forbidding the exercise of the owner's normal right to integrate the operations of the two previously separate companies, or by requiring it to sell certain assets located in California. We hold that such a remedy is a form of “injunctive relief” within the meaning of section 16 of the Clayton Act. * * * [Id. at 296.]
The Supreme Court remanded the matter for further proceedings.
The Court of Appeals for the Ninth Circuit vacated part of its
earlier opinion and remanded the case to the District Court.
The preliminary injunction obtained by the State of
California was modified on at least four occasions. A
modification filed with the District Court on November 7, 1989,
permitted American Stores to integrate specified northern
California operations of Alpha Beta with specified northern
California operations of Lucky Stores following a stipulated
divestiture of specified Alpha Beta assets. American Stores
ultimately settled the dispute with the attorney general of
California by entering into a stipulation for entry of consent
decree on May 16, 1990 (the California consent decree). The
California consent decree did not require American Stores to
divest any of its Lucky Stores stock, and Lucky Stores remains a
wholly owned subsidiary of American Stores. Instead, the
California consent decree required American Stores to dispose of
approximately 152 of its 175 southern California Alpha Beta - 11 -
Stores and 9 of its newly acquired southern California Lucky
Stores, together with most of the related Alpha Beta support
facilities. The California consent decree did not require
petitioner to divest any supermarkets in northern California or
Nevada beyond those specified in the November 7, 1989,
modification.
On June 17, 1991, pursuant to the California consent decree,
American Stores sold its stock in Alpha Beta Company for
approximately $251 million to Food-4-Less Supermarkets, Inc. At
the time of the sale, the assets of Alpha Beta included 145
stores located in southern California. The attorney general of
California and the District Court approved this transaction as
fulfilling the requirements of the settlement agreement and the
California consent decree.
From June 2, 1988, and continuing throughout the course of
antitrust litigation with California, Lucky Stores was a member
of American Stores’ consolidated group. As such, American Stores
included Lucky Stores in its consolidated financial statements
and consolidated Federal income tax returns. Lucky Stores
accounted for $3,697,086,836 of the total American Stores’
affiliated group gross revenue of $19,096,763,598 for the 1989
tax year (Lucky Stores was only a member of American Stores’
consolidated group during the 1989 tax year for the period from
June 2, 1988 to January 28, 1989) and $6,281,249,713 of the total - 12 -
American Stores’ affiliated group gross revenue of
$22,450,415,818 for the 1990 tax year.
In the 1989 tax year return, petitioner did not claim an
ordinary and necessary business expense deduction for the legal
fees attributable to the FTC proceeding involving the acquisition
of Lucky Stores. Petitioner incurred approximately $2.6 million
in such legal fees in the 1989 tax year. Petitioner also did not
deduct investment banking fees incurred in the acquisition of
Lucky Stores stock. Instead, petitioner capitalized all of these
expenditures as costs incurred in the process of acquiring Lucky
Stores.
From June of 1988 until the end of the 1989 tax year,
American Stores’ subsidiary, Lucky Stores, paid $1,074,867 in
legal fees to defend against the claims of the attorney general
of California for violations of Federal and State antitrust laws
arising from the acquisition of Lucky Stores. American Stores
charged these legal fees to account No. 650800/7025, Lucky
Acquisition, and moved these expenses to American Food and Drug,
Inc. In the financial books and records of American Food and
Drug, Inc., for the 1989 tax year, American Stores capitalized
the $1,074,867 for legal fees associated with the antitrust
litigation with the attorney general of California. Petitioner’s
accountants prepared a journal entry for these legal fees. - 13 -
On its consolidated corporation income tax return for the
1989 tax year, petitioner reported on Schedule M-1 a deduction
for “LEGAL AND RELATED EXPENSES IN CONNECTION WITH: CA ATTORNEY
GENERAL LITIGATION” in the amount of $1,074,867. This deduction
is found on the tax return Schedules M-1 and M-2 at the second
page of Statement 429 of the 1989 return. The 1989 tax return
includes this amount as a Form-1120, U.S. Corporation Income Tax
Return, line-26 deduction as detailed on Statement 82 of the
return.
During the 1990 tax year, American Stores’ subsidiary, Lucky
Stores, paid $2,666,045 for legal fees associated with the
antitrust litigation with the attorney general of California.
American Stores charged these legal fees to account No.
650800/7025, Lucky Acquisition, and moved these expenses to Alpha
Beta. American Stores capitalized the $2,666,045 for legal fees
on the financial books and records of Alpha Beta for the 1990 tax
year. Petitioner’s accountants prepared documentation for these
legal fees.
On petitioner’s corporation income tax return for the 1990
tax year, petitioners claimed a deduction for “LEGAL FEES - CA
ATTORNEY GENERAL LITIGATION” in the amount of $2,666,045. The
1990 return includes this amount as a Form-1120, line-26
deduction. - 14 -
Stores, paid $175,630 for legal fees associated with the
antitrust litigation with the attorney general of California. Of
the $175,630, Lucky Stores paid $95,355 to the law firm of
Sonnenschein, Carlin, Nath for legal work on the antitrust case
and paid $80,275 for other expenses related to the antitrust
case.
tax year, petitioner claimed a deduction on Form 1120, line 26
for various items including “Litigation Expenses” of $10,706,713.
American Stores included the $175,630 for legal fees and costs
identified above in the “Litigation Expenses”.
For financial reporting purposes, American Stores was
required to account for its acquisition of Lucky Stores using the
“purchase accounting” method pursuant to Accounting Practices
Board Opinion No. 16 (“APB 16"). Under this method, American
Stores’ acquisition was treated as an acquisition of Lucky
Stores’ assets. Lucky Stores’ liabilities were treated as if
they were assumed by American Stores in this hypothetical asset
acquisition.1 Under the purchase accounting method, petitioner
was required to identify and quantify all of Lucky Stores’
1 On Mar. 13, 1989, American Stores filed a Form 8023, Corporate Qualified Stock Purchase Elections, related to the acquisition by American Stores of Lucky Stores and related entities in the Lucky Stores affiliated group. - 15 -
liabilities, including liabilities for current and pending
litigation. The legal fees associated with Lucky Stores’ current
and pending litigation were required to be capitalized under the
purchase accounting method because they were considered
liabilities that American Stores assumed in the hypothetical
asset purchase, and as such, the legal fees and other liabilities
were treated as additional consideration that American Stores
paid for Lucky Stores’ assets. In addition to the legal fees
related to the State of California’s antitrust suit, petitioner
also capitalized under the purchase accounting method more than
$1 million of Lucky Stores’ legal fees incurred in connection
with employment discrimination suits, torts, and other
litigation. Although petitioner capitalized these legal expenses
for financial accounting purposes under the purchase accounting
method, petitioner claimed them as ordinary and necessary
business expenses on its consolidated Federal income tax returns
for the 1989 and 1990 tax years. With the exception of the legal
fees incurred in connection with the State of California's
antitrust suit, respondent allowed petitioner to deduct for
Federal income tax purposes the legal fees related to Lucky
Stores that petitioner had capitalized under the purchase
accounting method for financial reporting purposes.
In the notice of deficiency, respondent disallowed legal
fees incurred by petitioner in defending against the State of - 16 -
California’s antitrust suit. Respondent disallowed $1,074,867 of
deductions for legal fees claimed for the 1989 tax year and
disallowed separate deductions of $2,666,045 and $175,630 for
legal fees claimed for the 1990 tax year.
Discussion
The issue for decision is whether legal fees incurred in
connection with the State of California’s antitrust litigation
are deductible as ordinary and necessary business expenses under
section 162.2 Respondent determined that the legal fees must be
capitalized pursuant to section 263(a). Petitioner argues that
the legal fees were postacquisition expenditures incurred in
defending its business operations.
Income tax deductions are a matter of legislative grace, and
the burden of clearly showing the right to the claimed deduction
is on the taxpayer. See Rule 142(a); INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992). Moreover, deductions are
strictly construed and allowed only “as there is clear provision
therefor.” INDOPCO, Inc. v. Commissioner, supra at 84 (quoting
New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)).
The principal difference between a deduction and an item
that must be capitalized and amortized is the timing of the
recovery of the expenditure. The Supreme Court in INDOPCO, Inc.
2 Unless otherwise indicated, section references are to the Internal Revenue Code applicable to the subject years, and Rule references are to the Tax Court Rules of Practice and Procedure. - 17 -
v. Commissioner, supra at 83-84, explained:
The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. * * * Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. * * *
To qualify as an allowable deduction under section 162(a),
an item must (1) be paid or incurred during the taxable year, (2)
be for carrying on any trade or business, (3) be an expense, (4)
be a necessary expense, and (5) be an ordinary expense.
Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345,
352 (1971). Respondent argues that the legal fees were neither
“ordinary” nor “for carrying on any trade or business” but were
expenditures associated with the acquisition of a capital asset.
In one sense, the term “ordinary” in section 162 prevents
the deduction of expenses that are not normally incurred in the
type of business in which the taxpayer is engaged (“ordinary” in
the sense of “normal, usual, or customary” in a taxpayer’s trade
or business). Deputy v. Du Pont, 308 U.S. 488, 495 (1940). More
importantly, the term “ordinary” serves as a means to “clarify
the distinction, often difficult, between those expenses that are
currently deductible and those that are in the nature of capital - 18 -
expenditures, which, if deductible at all, must be amortized over
the useful life of the asset.” Commissioner v. Tellier, 383 U.S.
687, 689-690 (1966).
Expenses incurred in defending a business and its policies
from attack are generally ordinary and necessary--and deductible-
-business expenses. See, e.g., Commissioner v. Heininger, 320
U.S. 467 (1943) (a dentist's mail order business faced ruin when
the Postmaster General deprived him of access to the mails; the
Supreme Court held that his legal fees, incurred in litigating
the propriety of the Postmaster General’s order, were properly
deductible as ordinary and necessary business expenses);
Commissioner v. Tellier, supra (holding that the taxpayer’s legal
costs “incurred in his defense against charges of past criminal
conduct” arising out of his business activities were deductible
under section 162). On the other hand, no current deduction is
allowed for a capital expenditure. See sec. 263(a); INDOPCO,
Inc. v. Commissioner, supra at 83.
A particular cost, no matter what its type, may be
deductible in one context but may be required to be capitalized
in another context. Simply because other cases have allowed a
current deduction for similar expenses in different contexts does
not require the same result here. For example, in Commissioner
v. Idaho Power Co., 418 U.S. 1, 13 (1974), the Supreme Court made
the following observation about wages paid by a taxpayer in its - 19 -
trade or business:
Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. * * * But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be amortized over the life of the capital asset so acquired. * * *
Petitioner’s reliance on El Paso Co. v. United States, 694 F.2d
703 (Fed. Cir. 1982), and E.I. du Pont de Nemours & Co. v. United
States, 432 F.2d 1052 (3d Cir. 1970), to support the proposition
that expenses incurred in an antitrust defense are always
deductible is misplaced. As previously indicated, expenditures
which otherwise might qualify as currently deductible, must be
capitalized if they are incurred “in connection with” the
acquisition of a capital asset. Commissioner v. Idaho Power Co.,
supra at 13. As stated in Ellis Banking Corp. v. Commissioner,
688 F.2d 1376, 1379 (11th Cir. 1982):
The requirement that costs be capitalized extends beyond the price payable to the seller to include any costs incurred by the buyer in connection with the purchase, such as appraisals of the property or the costs of meeting any conditions of the sale. See, e.g., Woodward v. Commissioner, 1970, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577; United States v. Hilton Hotels Corp., 1970, 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585. Further, the Code provides that the requirement of capitalization takes precedence over the allowance of deductions. §§ 161, 261; see generally Commissioner v. Idaha Power Co., 1974, 418 U.S. 1, 94 S.Ct. 2757, 41 L.Ed.2d 535. Thus an expenditure that would ordinarily be a deductible expense must nonetheless be capitalized if it is incurred in connection with the acquisition of a capital asset.6 The function of these rules is to achieve an accurate measure of net income for the year by matching outlays - 20 -
with the revenues attributable to them and recognizing both during the same taxable year. When an outlay is connected to the acquisition of an asset with an extended life, it would understate current net income to deduct the outlay immediately. * * * 6 We do not use the term “capital asset” in the restricted sense of section 1221. Instead, we use the term in the accounting sense, to refer to any asset with a useful life extending beyond one year.
Distinguishing between expenses that can be deducted under
section 162 and those that must be capitalized under section 263
is not always an easy task. As the Supreme Court has noted, “the
cases sometimes appear difficult to harmonize,” and “each case
‘turns on its special facts.’” INDOPCO, Inc. v. Commissioner,
supra at 86 (quoting Deputy v. Du Pont, supra at 496). After
considering all the facts and circumstances, we must determine
whether the costs incurred in defending the State of California’s
antitrust litigation are better viewed as costs associated with
defending a business or as costs associated with facilitating a
capital transaction. See Woodward v. Commissioner, 397 U.S. 572
(1970).
In Woodward, the Supreme Court rejected a subjective
“primary purpose” test in favor of the objective “origin of the
claim” test used in United States v. Gilmore, 372 U.S. 39 (1963).
Under the origin of the claim test, the nature of the transaction
out of which the expenditure in controversy arose governs whether
the item is a deductible expense or a capital expenditure,
regardless of the motives of the payor making the payment. See - 21 -
Woodward v. Commissioner, supra at 578. In determining whether
legal fees paid for business advice and counsel are capital, we
look to the nature of the services performed by the adviser
rather than the designation or treatment by the taxpayer. See
Honodel v. Commissioner, 76 T.C. 351, 365 (1981), affd. 722 F.2d
1462 (9th Cir. 1984); Cagle v. Commissioner, 63 T.C. 86, 96
(1974), affd. 539 F.2d 409 (5th Cir. 1976). Our inquiry focuses
on whether the services were performed in the process of
defending the business or whether the services were performed in
the process of effecting a change in corporate structure for the
benefit of future operations. See INDOPCO, Inc. v. Commissioner,
503 U.S. at 89.
In United States v. Hilton Hotels Corp., 397 U.S. 580
(1970), the Supreme Court held that litigation expenses incurred
to determine the price of stock, whose title had already passed
to the acquiring corporation under State law, were costs that
arose out of the acquisition process itself and therefore capital
and nondeductible. In Norwest Corp. & Subs. v. Commissioner, 112
T.C. 89 (1999), this Court analyzed a similar question by asking
whether the expenses were sufficiently related to the acquisition
process and essential to the achievement of the long-term
benefits of the acquisition. See id. at 102. In applying the
origin of the claim test, courts look beyond the formal
characterization of the claim. See Clark Oil & Refining Corp. v. - 22 -
United States, 473 F.2d 1217 (7th Cir. 1973). All the
circumstances surrounding the claim must be considered. See id.
at 1220.3
The District Court described the State of California’s
antitrust complaint in the following terms:
The State requests a preliminary injunction “preventing and restraining [Alpha Beta and Lucky], and all persons acting on their behalf, from taking any action, either directly or indirectly, in furtherance of the proposed acquisition of Lucky, and requiring Alpha Beta to hold and operate separately all of Lucky’s California assets and businesses pending final adjudication of the merits of this action; and ... such injunctive relief, including recission ... as is necessary and appropriate to prevent the effect of the unlawful activities alleged.” Complaint at 14. Furthermore, the State seeks to “permanently enjoin [Alpha Beta and Lucky] from carrying out any agreement, understanding, or plan, the effect of which would be to combine the supermarket business of [Alpha Beta] and Lucky.” * * * [State of Cal. v. American Stores Co., 697 F. Supp. 1125, 1133 (C.D. Cal. 1988).]
The Supreme Court described the complaint in the following terms:
The State sued, claiming that the merger violates the federal antitrust laws and will harm consumers in 62 California cities. The complaint prayed for a preliminary injunction requiring American to operate the acquired stores separately until the case is decided, and then to divest itself of all of the acquired assets located in California. * * * [California v. American Stores Co., 495 U.S. 271, 274 (1990).]
3 In Brown v. United States, 526 F.2d 135, 139 (6th Cir. 1975), legal expenses paid in settlement of a derivative action were held to be nondeductible capital expenditures. The court found that the origin of the derivative claim was the taxpayer’s efforts to acquire the shareholder’s stock. The court stated that although conserving the stock’s value was the immediate purpose of the derivative action, the test of deductibility relates to the origin rather than the purpose. - 23 -
The Supreme Court held: “the District Court had the power to
divest American of any part of its ownership interests in the
acquired Lucky Stores, either by forbidding the exercise of the
owner’s normal right to integrate the operations of the two
previously separate companies, or by requiring it to sell certain
assets located in California” under section 16 of the Clayton
Act. Id. at 296.
The claim of the State of California that gave rise to
petitioner’s legal fees was an alleged violation of section 7 of
the Clayton Act. That section prohibits the acquisition of stock
or assets in another company if “the effect of such acquisition
may be substantially to lessen competition, or tend to create a
monopoly.” 15 U.S.C. sec. 18. The antitrust claim in the
instant case involved American Stores’ right to acquire Lucky
Stores. The legal fees incurred in the antitrust action arose
out of, and were incurred in connection with, petitioner’s
acquisition of Lucky Stores.
Petitioner places great emphasis on the fact that legal
title to all the Lucky Stores shares had passed before the
antitrust litigation was commenced. In United States v. Hilton
Hotels Corp., supra at 584, the Supreme Court noted that the
prior passage of title in the underlying stock acquisition in
question was “a distinction without a difference” in deciding
whether costs of litigation arose out of the process of - 24 -
acquisition. This Court reached a similar result in Berry
Petroleum Co. & Subs. v. Commissioner, 104 T.C. 584, 622 (1995),
affd. without published opinion 142 F.3d 442 (9th Cir. 1998).
At the time the antitrust legal fees were being incurred,
the Supreme Court described the status of the “merger” involved
in this case in the following terms: “Thus, as a matter of legal
form American and Lucky were merged into a single corporate
entity on June 9, 1988, but as a matter of practical fact their
business operations have not yet been combined.” California v.
American Stores Co., 495 U.S. at 276. On this same point, the
District Court noted:
If the Hold Separate Agreement has meaning, this is not a completed merger. Alpha Beta and Lucky, pursuant to the Hold Separate Agreement, are performing numerous functions as separate entities. They retain their separate names and with them their respective corporate identities. While defendants maintain that it is “verbal calisthenics” to issue injunctive relief to stop a merger contending that such is tantamount to divestiture, they, nevertheless, ask the Court to perform a linguistic triathalon to understand how a Hold Separate Agreement is equivalent to a completed merger. The Court is unable to make such a leap in reasoning. [State of Cal. v. American Stores Co., 697 F. Supp. at 1134; fn. ref. omitted.]
When the legal fees were incurred, the substance of the
merger was not complete, despite the passage of title in the
Lucky Stores shares. The hold separate agreement and the
subsequent injunction issued by the District Court preserved the
status quo that existed prior to the Lucky Stores acquisition by
preventing the integration of the two supermarket chains in order - 25 -
to protect the California consumers from anticompetitive
behavior. Until the injunction was lifted, American Stores faced
the possibility of divestiture. Petitioner’s objective in
acquiring Lucky Stores was to achieve future long-term benefits
from the merger of the Alpha Beta chain of stores and Lucky
Stores. These benefits could not be realized if the State of
California’s antitrust suit was successful. Although petitioner
became the owner of Lucky Stores, it was unable to realize the
long-term benefits being sought until the antitrust suit was
resolved.
The origin of the State of California’s antitrust suit was
American Stores’ acquisition of Lucky Stores. The expenditure of
funds to defend against the antitrust litigation conferred long-
term benefits on American Stores. American Stores was not
defending an existing business structure from attack; rather it
was attempting to establish its right to create such a structure.
These benefits are comparable to the benefits that were required
to be capitalized in INDOPCO, Inc. v. Commissioner, 503 U.S. 79
(1992).
We hold that petitioner is not entitled to deduct the legal
fees it incurred in contesting the State of California’s
antitrust suit.
Decision will be
entered under Rule 155.