Fed. Home Loan Mortg. Corp. v. Comm'r
Opinion
*155 At the close of business on Dec. 31, 1984, P had 30 debt
instruments outstanding on which it paid effective contract
interest rates that were below current interest rates that P
would have incurred had it issued comparable debt instruments.
P's right to use the proceeds of these financing arrangements
with below-market interest rates constitutes an economic
benefit generally referred to as "favorable financing". In a
prior Opinion, we held that special legislative provisions
entitled P to use the fair market values of its intangible
assets on Jan. 1, 1985, as its bases for purposes of
amortization. Fed. Home Loan Mortgage Corp. v.
Commissioner,
we held that the benefit of below-market financing can, as a
matter of law, constitute an intangible asset which P may
amortize if it establishes a fair market value and a limited
useful life.
Comm'r, 121 T.C. 254 (2003).
P calculated the fair market value of its favorable financing
intangible assets to be $ 428,391,551*156 using the market approach;
the market approach compared the adjusted issue prices of P's
debt instruments to their market prices on Jan. 1, 1985. P
calculated the limited useful lives of its 30 debt instruments
to be their average weighted lives. R argues that P's favorable
financing had no value and was not an asset. R also argues that
P did not properly adjust for the volatility of the market in
determining the useful lives.
Held: P may amortize its favorable financing intangible
assets because it reasonably estimated the fair market value of
its favorable financing to be $ 428,391,551 and reasonably
estimated the remaining limited useful lives.
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*155 At the close of business on Dec. 31, 1984, P had 30 debt
instruments outstanding on which it paid effective contract
interest rates that were below current interest rates that P
would have incurred had it issued comparable debt instruments.
P's right to use the proceeds of these financing arrangements
with below-market interest rates constitutes an economic
benefit generally referred to as "favorable financing". In a
prior Opinion, we held that special legislative provisions
entitled P to use the fair market values of its intangible
assets on Jan. 1, 1985, as its bases for purposes of
amortization. Fed. Home Loan Mortgage Corp. v.
Commissioner,
we held that the benefit of below-market financing can, as a
matter of law, constitute an intangible asset which P may
amortize if it establishes a fair market value and a limited
useful life.
Comm'r, 121 T.C. 254 (2003).
P calculated the fair market value of its favorable financing
intangible assets to be $ 428,391,551*156 using the market approach;
the market approach compared the adjusted issue prices of P's
debt instruments to their market prices on Jan. 1, 1985. P
calculated the limited useful lives of its 30 debt instruments
to be their average weighted lives. R argues that P's favorable
financing had no value and was not an asset. R also argues that
P did not properly adjust for the volatility of the market in
determining the useful lives.
Held: P may amortize its favorable financing intangible
assets because it reasonably estimated the fair market value of
its favorable financing to be $ 428,391,551 and reasonably
estimated the remaining limited useful lives.
CONTENTS
MEMORANDUM FINDINGS OF FACT AND OPINION
FINDINGS OF FACT
I. Favorable Financing Intangible Assets
A. Ginnie Mae Bonds
B. Notes Issued to*157Federal Home Loan Banks
C. Debenture
D. Note Payable to North Dakota Bank
E. Capital Debentures
F. Zero Coupon Bonds
G. Collateralized Mortgage Obligations (CMOs)
H. Guaranteed Mortgage Certificates (GMCs)
II. Average Weighted Lives of the Debt Instruments
III. Tax Returns
OPINION
I. The Values of Petitioner's Favorable Financing Intangible Assets
A. Petitioner's Valuation of Its Favorable Financing Intangible
Assets as of January 1, 1985
B. Respondent's Position That Favorable Financing Has No Value
1. Expectation of Income
2. Realization of Value
3. Contra-Liability Theory
a. Favorable Financing Is an Asset
b. Favorable Financing Can Be Assigned a Separate
Value
c. Double Counting the Value
4. Petitioner's Purchase of Its Debt Obligations Would
Result in Discharge of Indebtedness Income
C. Respondent's Argument That the Value of Petitioner's
Favorable Financing Is Limited*158 to the Value of Petitioner's
Income Spread
D. Respondent's Argument That Taxes Reduce the Value of
Favorable Financing
II. Favorable Financing Intangible Assets Have a Reasonably Estimable
Useful Life As of January 1, 1985
III. Conclusion
APPENDIX: Investment Bank Bid Prices
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge: In docket No. 3941-99, respondent determined deficiencies in petitioner's Federal income tax of $ 36,623,695 for 1985 and $ 40,111,127 for 1986. Petitioner claims overpayments of $ 9,604,085 for 1985 and $ 12,418,469 for 1986.
In docket No. 15626-99, respondent determined deficiencies in petitioner's Federal income tax of $ 26,200,358 for 1987, $ 13,827,654 for 1988, $ 6,225,404 for 1989, and $ 23,466,338 for 1990. Petitioner claims overpayments of $ 57,775,538 for 1987, $ 28,434,990 for 1988, $ 32,577,346 for 1989, and $ 19,504,333 for 1990.
When petitioner was chartered, it was exempt from Federal, State, and local taxation, except for real estate tax imposed by any State or local taxing authority. Pursuant to the Deficit Reduction Act of 1984 (DEFRA),
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts and the attached exhibits are incorporated herein by this reference. At the time the petitions were filed, petitioner's principal office was in McLean, Virginia.
Congress created petitioner in 1970 to promote access to mortgage credit throughout the United States by increasing the liquidity of mortgage investments and improving the distribution of investment capital for mortgage financing. Since its incorporation, petitioner has facilitated investment by the capital markets in single-family and multifamily residential mortgages in two ways. First, petitioner has acquired mortgages from originators and resold them in securitization transactions, principally by pooling the mortgages and issuing participation certificates*161 (PCs). Second, petitioner bought mortgages from originators and held them until maturity in its retained mortgage portfolio, generally financing this activity by issuing various debt instruments. Petitioner financed approximately 10 percent of its mortgage purchases through the issuance of long-term debt. 3
At the close of business on December 31, 1984, petitioner had outstanding long-term indebtedness on a number of debt instruments. The effective contract interest rates 4 on some of these outstanding long-term debt obligations were below the interest rates that petitioner would have incurred on January 1, 1985, had it issued comparable debt instruments in the market for the remaining term of the particular debt instrument. Petitioner's favorable financing intangible assets consisted of the benefits it derived from financing arrangements that required*162 it to pay interest at rates below those prevailing in the financial markets as of January 1, 1985.
As of January 1, 1985, petitioner had the following 30 outstanding long-term debt instruments, which had below-market interest rates and market prices that were lower than the adjusted issue prices.
Ginnie Mae Bonds G-15, G-16, and G-17 were mortgage-backed bonds, which consisted of promissory notes secured by mortgage loans owned by petitioner. The underlying mortgages were held in trust by petitioner as trustee as security for payment of the bonds. These mortgage-backed bonds were guaranteed as to principal and interest by the Government National Mortgage Association, *163 a wholly owned corporation within the Department of Housing and Urban Development.
Notes F-8, F-12, F-15, F-18, F-11, and F-13 were promissory notes payable to Federal Home Loan Banks (FHLB). These notes were passthroughs of the FHLBs' own obligations. Under the Federal Home Loan Mortgage Corporation Act,
Debenture D-2 was issued under
The note bearing code ND was a fixed-rate loan that petitioner issued in a private transaction to the Bank of North Dakota.
CD-1, CD-2, and CD-3 were capital debentures. These capital debentures were subordinated and junior in right of payment to all obligations and liabilities of petitioner.
Petitioner issued zero coupon bonds Z-2 and Z-3, which were subordinated capital debentures junior*164 in right of payment to all senior obligations of petitioner. Zero coupon bonds have no stated interest rate but are issued at a substantial discount to face value. At maturity, the holder is entitled to receive the face of amount of the bond.
CMO A-2, CMO A-3, and CMO C-4 were debt instruments secured by mortgages which were outstanding on December 31, 1984. These CMOs were subject to put and call options; the call dates, put dates, and final maturity dates were as follows:
Debt Call Put Final
Instrument Date n.1 Date n.2 Maturity Date
__________ ____ ____ _____________
CMO A-2 N/A N/A 12/15/95
CMO A-3 6/15/03 6/15/08 6/15/13
CMO C-4 1/31/04 1/31/04 1/31/09
n.1 The call date is the earliest date on which petitioner, if it so chose, could repay the debt in full.
n.2 The put date is the earliest date on which the holder had the right to require*165 petitioner to pay any remaining unpaid principal balance plus accrued interest.
Each series of CMOs was collateralized by pools of mortgages owned by petitioner and held by it as trustee. 5 Petitioner made principal payments to holders in the greater amount of (1) the minimum scheduled payments, or (2) monthly and other payments of principal petitioner received on the mortgages serving as collateral. Petitioner structured the CMOs to permit holders of certain classes to receive payment in full before other classes.
The terms of each CMO required petitioner to apply all payments of principal and interest on the subject mortgages into a sinking fund for the benefit of the holders. Petitioner was required to make payments to the sinking fund semiannually. The balance of the sinking fund was then used to make semiannual principal payments on*166 the senior class of bonds until they were fully retired. Thereafter, additional amounts of principal were paid semiannually to the holders of the class of bonds next in seniority until those bonds were fully paid, and then on the same basis to holders of the most junior classes. The holders received semiannual interest payments at the stated rate. 6 The holders of CMOs received payments of principal at a rate at least corresponding to the schedule of minimum payments set forth in the offering circular or prospectus. The holders received payments at a faster rate if the principal amount of the mortgages that served as collateral paid down faster than implied by the schedule of minimum payments. Petitioner never had to satisfy any minimum sinking fund obligation (i.e., cover a deficit between funds received from mortgages and minimum payments of principal to CMO holders).
GMC A 1975, GMC B 1975, GMC A 1976, GMC B 1976, GMC A 1977, GMC B 1977, GMC C 1977, GMC A 1978, GMC B 1978, GMC C 1978, GMC A 1979, GMC B 1979, and GMC C 1979 were certificates guaranteed by petitioner and denominated as representing an interest in a pool of single- family mortgages held by petitioner as trustee. 7
*168 The terms of each GMC series obligated petitioner to pay interest at a rate stated on the face of its prospectus and to repay the face amount of the certificate to the holder. Principal payments were made annually. GMC holders received principal repayments in amounts equal to the greater of (1) minimum scheduled payments, or (2) monthly and other payments of principal petitioner received on the mortgages serving as collateral. Petitioner was unconditionally required to make annual principal payments to the GMC holders in an amount at least equal to the minimum levels specified, regardless of the amounts of principal received from the underlying mortgages. If mortgages that served as collateral paid down the principal amount faster than implied by the schedules of minimum payments, GMC holders received payments of principal at a faster rate than required by the schedule of minimum payments. GMCs holders had the option to require petitioner to purchase their certificates at the then-unpaid principal balance plus accrued interest at a future date specified by the prospectus.
With respect to the 13 GMCs in issue, the put dates and the final maturity dates were as follows:
*169 Debt Put ? Final
Instrument Date Maturity Date
__________ ____ _____________
GMC A 1975 3/15/90 3/15/05
GMC B 1975 9/15/90 9/15/05
GMC A 1976 3/15/91 3/15/06
GMC B 1976 3/15/96 9/15/06
GMC A 1977 3/15/97 3/15/07
GMC B 1977 3/15/02 3/15/07
GMC C 1977 9/15/02 9/15/07
GMC A 1978 3/15/03 3/15/08
GMC B 1978 9/15/03 9/15/08
GMC C 1978 9/15/03 9/15/08
GMC A 1979 3/15/04 3/15/09
GMC B 1979 3/15/04 *170 3/15/09
GMC C 1979 9/15/04 3/15/09
With the possible exception of GMC B 1975, petitioner made minimum payments pursuant to the schedule for all GMCs on all payment dates after March 1980 through September 1993. 8 For GMC B 1975, petitioner made minimum payments on all payment dates after December 31, 1984.
Petitioner initially funded the acquisition of the mortgages held as collateral for each of the CMOs and GMCs at issue by means other than the issuance of those particular CMOs and GMCs. When issuing its GMCs, petitioner disclosed that the proceeds would provide funds for petitioner to engage in additional activities consistent with its statutory purposes, including the purchase of additional mortgages and interests in mortgages and*171 that some portion of the proceeds could be used to repay part of petitioner's borrowings. When issuing its CMOs, petitioner disclosed that the proceeds would be used to provide funds for the corporation to finance its purchase of the mortgages securing the CMOs.
With respect to the CMOs and GMCs, petitioner received monthly payments of interest and principal on the mortgages that served as collateral. Petitioner made semiannual or annual payments of principal and interest to the CMO and GMC holders. Petitioner paid interest through the date of payment to the holders on the outstanding principal balance of the CMOs or GMCs, notwithstanding any receipt of principal amounts on the mortgages serving as collateral since the previous date of payment.
Petitioner received spread and float income with respect to the CMOs and GMCs. Spread income is the amount by which the effective interest income rate on the mortgages serving as collateral exceeds the interest payments to the holders of the CMOs and GMCs. The float income is the interest on the monthly principal and interest payments that could be earned between receipt of the payments by petitioner and remittance to the CMO and GMC holders.
*172 The debt instruments in issue had issue dates, maturity dates, outstanding principal on December 31, 1984, effective contract rates, and market prices per $ 100 on January 1, 1985, as follows:
Effective
Principal Contract Market Price
Debt Maturity Outstanding Interest Per $ 100 on
Instrument Issue Date Date On 12/31/1984 Rate n.1 1/1/1985n.2
__________ __________ ________ ____________ _________ ____________
G-15 11/19/1970 11/27/1995 $ 70,000,000 8.681 87.335069
G-16 8/2/1971 8/26/1996 82,500,000 7.813 81.835069
G-17 5/25/1972 5/26/1997 150,000,000 7.250 70.381944
F-12 2/25/1977 2/25/1985 200,000,000 7.407 99.906250
F-15 2/27/1978 5/28/1985 200,000,000 8.158 99.890625
F-8 11/25/1976 11/25/1985 40,000,000 *173 8.442 99.187500
F-18 5/25/1979 2/25/1986 200,000,000 9.581 99.937500
F-11 10/25/1973 11/26/1993 400,000,000 7.412 77.000000
F-13 2/25/1977 2/25/1997 300,000,000 7.910 75.687500
D-2 3/30/1983 3/30/1990 300,000,000 10.937 98.062500
ND 7/1/1975 11/1/1986 11,363,000 7.750 95.968750
CMO-A2 6/15/1983 12/15/1995 350,000,000 11.162 97.664063
CMO-A3 6/15/1983 6/15/2013 435,000,000 11.803 96.390625
CMO-C4 1/31/1984 1/31/2009 85,052,100 12.403 94.890625
Z-2 11/29/1984 11/29/2019 n.3/212,584,000 10.252 2.703125
Z-3 11/30/1984 11/30/1994 n.4/79,678,000 11.820 31.458333
CD-1 12/26/1978 12/27/1988 150,000,000 9.412 94.671875
GMC A-75 2/25/1975 3/15/2005 98,100,000 8.200 92.437500
GMC B-75 2/25/1975 9/15/2005 63,400,000 8.750 93.125000
GMC*174 A-76 2/25/1976 3/15/2006 70,600,000 8.550 92.593750
GMC B-76 8/25/1976 9/15/2006 75,600,000 8.375 88.000000
GMC A-77 1/25/1977 3/15/2007 77,600,000 8.050 88.937500
GMC B-77 5/25/1977 3/15/2007 94,000,000 8.125 85.875000
GMC C-77 11/25/1977 9/15/2007 108,200,000 8.200 83.468750
GMC A-78 6/1/1978 3/15/2008 186,000,000 8.850 86.250000
GMC B-78 9/1/1978 9/15/2008 98,800,000 9.000 87.218000
GMC C-78 12/4/1978 9/15/2008 98,800,000 9.400 89.656250
GMC A-79 2/1/1979 3/15/2009 114,000,000 9.875 92.125000
GMC B-79 6/4/1979 3/15/2009 114,000,000 10.250 93.875000
GMC C-79 8/2/1979 9/15/2009 114,000,000 10.000 91.937500
n.1 See supra note 4.
n.2 The market prices per $ 100 on Jan. 1, 1985, are based upon petitioner's calculations. Respondent's calculations of the market price per $ 100 on Jan. 1,1985, are slightly different. Respondent*175 agrees that this difference is not significant.
n.3 This figure represents the outstanding principal on Dec. 31, 1984. Because Z-2 did not pay interest periodically, the principal amount at maturity will equal $ 7 billion.
n.4 This figure represents the outstanding principal on Dec. 31, 1984. Because Z-3 did not pay interest periodically, the principal amount at maturity will equal $ 250 million.
The average weighted life represents the time it takes for the average dollar of principal borrowed to be repaid to the lender. When principal repayment can vary, or when there is a chance an option will be exercised to retire the security early, the average weighted life is calculated using certain assumptions regarding principal payment rate and exercise timing. The expected remaining average weighted life of each debt instrument as of January 1, 1985, depends on: (1) The remaining term to maturity; (2) whether the debt was subject to any call or put options; and (3) whether any principal repayments would be made pursuant to either a mandatory schedule or terms that provided for repayment of principal on the debt based on the*176 rate of principal repayments received on the mortgages serving as collateral. On January 1, 1985, the average weighted lives of petitioner's 30 debt instruments in issue were as follows:
Debt Average weighted life
_____ _____________________
G-15 5 years, 5 months
G-16 6 years, 8 months
G-17 12 years, 5 months
F-8 11 months
F-11 8 years, 11 months
F-12 2 months
F-13 12 years, 2 months
F-15 5 months
F-18 1 year, 2 months
D-2 5 years, 3 months
Z-2 34 years, 11 months
*177 Z-3 9 years, 11 months
ND 1 year, 8 months
CD-1 4 years, 0 months
GMC A 1975 3 years, 4 months
GMC B 1975 3 years, 9 months
GMC A 1976 3 years, 10 months
GMC B 1976 5 years, 6 months
GMC A 1977 4 years, 9 months
GMC B 1977 6 years, 3 months
GMC C 1977 8 years, 2 months
GMC A 1978 8 years, 5 months
GMC B 1978 7 years, 4 months
GMC C 1978 7 years, 4 months
GMC A 1979 6 years, 10 months
GMC B 1979 6 years, 10 months
GMC C 1979 7 years, 4 months
*178 CMO A-2 5 years, 11 months
CMO A-3 17 years, 7 months
CMO C-4 14 years, 6 months
Petitioner claimed a tax basis for its favorable financing equal to its claimed fair market value at close of business on December 31, 1984. On its 1985 Federal income tax return, petitioner claimed that as of December 31, 1984, its favorable financing intangible assets had an aggregate amortizable value of $ 456,021,853. 9*179 Petitioner now claims that its favorable financing intangible assets had an aggregate amortizable value of $ 428,391,551 on January 1, 1985. 10
OPINION
As part of the legislation that subjected petitioner to Federal income taxation, Congress enacted a dual-basis rule for petitioner. DEFRA
(2) Adjusted basis of assets. --
(A) In general. -- Except as otherwise provided in
subparagraph (B), the adjusted basis of any asset of the
Federal Home Loan Mortgage Corporation held on January 1,
1985, shall --
(i) for purposes of determining any loss, be equal to the
lesser of the adjusted basis of such asset or the fair
market value of such asset as of such date, and
(ii) for purposes of determining any gain, be equal to the
higher of the adjusted basis of such asset or the fair
market value of such asset as of such date.
The "special basis rules [were] *180 designed to ensure that, to the extent possible, pre-1985 appreciation or decline in the value of * * * [petitioner's] assets will not be taken into account for tax purposes." H. Conf. Rept. 98-861, at 1038 (1984),
If an intangible asset is known from experience or other factors
to be of use in the business or in the production of income for
only a limited period, the length of which can be estimated with
reasonable accuracy, such an intangible asset may be the subject
of a depreciation allowance. * * *181 * An intangible asset, the
useful life of which is not limited, is not subject to the
allowance for depreciation. No allowance will be permitted
merely because, in the unsupported opinion of the taxpayer, the
intangible asset has a limited useful life. No deduction for
depreciation is allowable with respect to good will. * * *
Petitioner's favorable financing intangible assets arise from debt obligations in existence on January 1, 1985, that required petitioner to pay interest to the holders at rates below-market rates on that date. In
Both parties rely heavily on expert opinions and testimony to support their respective positions concerning the values and useful lives of the favorable financing intangible assets. "[W]e * * * consider expert opinion testimony to the extent that it assists us in resolving the issues presented".
A. Petitioner's Valuation of Its Favorable Financing Intangible Assets as of January 1, 1985
The fair market value of property is a question of fact.
Petitioner argues that the benefit of below-market interest should be measured by the present values of the difference between the contract interest rates on its debt instruments and market interest rates over*185 the terms of the loans. Petitioner calculated that the January 1, 1985, fair market value of each favorable financing intangible asset was as follows:
Debt Fair Market Value
____ _________________
G-15 $ 8,865,451
G-16 14,986,068
G-17 44,427,083
F-8 325,000
F-11 92,000,000
F-12 187,500
F-13 72,937,500
F-15 218,750
F-18 125,000
D-2 5,812,500
Z-2 24,389,887
Z-3 1,448,674
ND *186 458,071
CD-1 7,992,188
GMC A 1975 7,418,813
GMC B 1975 4,358,750
GMC A 1976 5,228,813
GMC B 1976 8,342,336
GMC A 1977 8,146,021
GMC B 1977 12,825,330
GMC C 1977 17,407,946
GMC A 1978 24,814,023
GMC B 1978 12,413,781
GMC C 1978 9,776,662
GMC A 1979 8,521,734
GMC B 1979 6,626,888
GMC C 1979 8,946,893
CMO A-2 6,254,753
? CMO A-3 12,511,453
CMO C-4 623,683
*187 ____________
Total 428,391,551
Petitioner relies on the expert opinion and testimony of Dr. Stephen M. Schaefer to determine the value of its favorable financing. Professor Schaefer received his doctor of philosophy at the University of London, Faculty of Economics. He currently serves as a professor of finance at London Business School and has been a visiting professor at seven universities around the world. Professor Schaefer has also served on the editorial boards of numerous publications, published two books, and published over 30 articles and notes relating to finance and economics.
Professor Schaefer explained that the benefit of favorable financing is based on the difference between the interest payments on an existing debt obligation and the interest payments made at the prevailing market rate. The value of the favorable financing benefit equals the present value of this difference. When debt obligations are exchanged in a free market, the price paid for the debt instruments equals the fair market value of the future cashflows. The market price reflects uncertainties; for*188 example, when a bond is prepayable, the market price incorporates the likelihood that the bond will be prepaid. A comparison of the adjusted issue prices of petitioner's debt instruments and the market prices indicates that petitioner's instruments were traded at a discount as of January 1, 1985. The difference between the adjusted issue price and the market price is the market discount. The discount reflects the present value difference between petitioner's contractual interest rate for each debt instrument and the market rate for comparable debt on January 1, 1985. From petitioner's perspective, the amount of the discount is the present value of the additional interest cost that the debtor would have to incur to borrow the amount of the existing debt at market rates.
Professor Schaefer calculated the fair market value of the favorable financing inherent in each of the 30 debt instruments as of January 1, 1985, as the difference between the adjusted issue price per $ 100 of principal and the January 1, 1985, market price per $ 100 of principal, multiplied by the unpaid principal balance divided by $ 100. 11 Professor Schaefer's report provided the January 1, 1985, market price,*189 adjusted issue price, and unpaid principal balance for the 30 debt instruments as follows:
Debt Adjusted Jan. 1, 1985 Unpaid
instrument issue price n.1 market price n.2 principal balance
__________ ___________ ____________ _________________
G-15 100.0000 87.335069 70,000,000
G-16 100.0000 81.835069 82,500,000
G-17 100.0000 70.381944 150,000,000
F-8 100.0000 99.187500 40,000,000
F-11 100.0000 77.000000 400,000,000
F-12 100.0000 99.906250 200,000,000
F-13 100.0000 75.687500 300,000,000
F-15 100.0000 99.890625 200,000,000
F-18 100.0000 99.937500 200,000,000
D-2 100.0000 98.062500 300,000,000
Z-2 3.0516 2.703125*190 7,000,000,000
Z-3 32.0378 31.458333 250,000,000
ND 100.0000 95.968750 11,363,000
CD-1 100.0000 94.671875 150,000,000
GMC A 1975 100.0000 92.437500 98,100,000
GMC B 1975 100.0000 93.125000 63,400,000
GMC A 1976 100.0000 92.593750 70,600,000
GMC B 1976 99.0348 88.000000 75,600,000
GMC A 1977 99.4349 88.937500 77,600,000
GMC B 1977 99.5190 85.875000 94,000,000
GMC C 1977 99.5574 83.468750 108,200,000
GMC A 1978 99.5909 86.250000 186,000,000
GMC B 1978 99.7826 87.218000 98,800,000
GMC C 1978 99.5517 89.656250 98,800,000
GMC A 1979 99.6002 92.125000 114,000,000
GMC B 1979 99.6881 93.875000 114,000,000
*191 GMC C 1979 99.7857 91.937500 114,000,000
CMO A-2 99.4511 97.664063 350,000,000
CMO A-3 99.2668 96.390625 435,000,000
CMO C-4 95.6239 94.890625 85,052,100
n.1 The adjusted issue price is the unpaid principal balance minus the fraction of any unamortized original issue discount remaining as of the valuation date. For a debt instrument issued at a price that equaled its face value and for which there had been no redemption before Dec. 31, 1984, the adjusted issue price equals the initial face amount. The adjusted issue price listed above is the adjusted issue price per $ 100 of unpaid principal balance.
n.2 The Jan. 1, 1985, market price equals the middle price -- this is the average of the bid and asked prices. With the exception of G-15 and G-16, Professor Schaefer used the average of the bid prices obtained by Arthur Andersen and petitioner from the Salomon Brothers, First Boston, Merrill Lynch, and Shearson Lehman investment banks as the bid price. See appendix. The bid prices for G-15 and G-16 equaled the average*192 of the available prices.
We find that petitioner's method of valuing its favorable financing intangible assets provides a reasonable estimate of fair market value.
Respondent primarily argues that petitioner failed to show that the favorable financing intangibles had any value because: (1) Petitioner did not show it expected to receive a stream of income from the favorable financing intangible assets; (2) petitioner did not prove that it could realize the value of the favorable financing; (3) the favorable financing is a contra-liability, not an asset; and (4) petitioner could realize the value*194 of favorable financing only by buying back its debt instruments in the market, which would be impractical because it would have to pay tax on the discharge of indebtedness.
The main thrust of respondent's arguments is that petitioner's favorable financing is not an asset. We addressed this contention in
1. Expectation of*195 Income
Respondent argues that the favorable financing intangible assets do not have any value because petitioner did not receive any additional income or earnings from these assets. Respondent relies on the expert opinion and testimony of Dr. Scott D. Hakala. 12 Dr. Hakala explained that "Intangible assets are defined as all elements of a business enterprise that exist in addition to monetary and tangible assets. Their existence is dependent on the presence, or expectation of earnings." (Fn. ref. omitted.)
*196 First, it seems clear that petitioner's favorable financing had a positive effect on its net income. To the extent that petitioner's financing costs were lower than they would have been had petitioner financed its operations with the market rates prevailing on January 1, 1985, its net income was enhanced. Second, respondent does not support with legal authority his contention that the value of the favorable financing intangible must be based on income. Indeed, courts have determined the value of similar intangible assets using cost savings methods.
We have already held that petitioner's favorable financing constituted an economic benefit that can be an amortizable intangible asset if petitioner establishes a fair market value and limited useful life as of January 1, 1985.
2. Realization of Value
Respondent argues that the favorable financing intangible assets do not have a fair market value and that any value is hypothetical because petitioner could not transfer favorable financing to a willing buyer. We might agree that petitioner's favorable financing could not be transferred by itself. However, we have previously rejected respondent's argument that favorable financing could not be valued because it could not be transferred except as part of a larger acquisition. Obviously, intangibles such as core deposits or deposit base 13 might have economic significance only in a larger context, but that does not prevent giving them a separate value. See
We also cannot distinguish the cases involving deposit base for
the reason that those cases involved an acquisition of deposit
base in conjunction with a larger acquisition of assets of a
company. We might agree that, as a practical matter, a debtor's
*198 position with respect to its favorable financing would not be
transferred, except as a part of a larger acquisition of a
company or property. However, this is not, in our view,
determinative of the question of whether there exists an
amortizable asset of value. * * *
*199 3. Contra-Liability Theory
Respondent argues that petitioner's favorable financing is a contra-liability, not an asset. Respondent's expert Dr. Hakala explained that a contra-liability is a liability on the balance sheet that is misstated in some economic sense because the liability is worth less than face value and the liability has been marked to market. Dr. Hakala further explained that transferring the liability to the asset side of the balance sheet creates an unrealizable asset. As a result, respondent argues that the favorable financing intangible assets cannot be valued separately, without looking at the value of the underlying mortgages. According to respondent, petitioner's valuation method results in overvaluation, double counting of assets, and accounting irregularities because petitioner marks its liabilities to market without making the corresponding downward adjustment to its assets.
a. Favorable Financing Is an Asset
Respondent's contra-liability argument revisits the question of whether favorable financing can be an amortizable asset. We have already rejected respondent's argument that favorable financing is a liability. See
Respondent argues that petitioner's favorable financing
represents a "liability", not an "asset". Respondent claims that
petitioner is "attempting to adjust, for tax purposes, the asset
side of its balance sheet to account for an overstatement in
fair market value terms of its liabilities." We cannot agree
? with respondent's proposed characterization of petitioner's
favorable financing as a liability. Indeed, as petitioner points
out, there is a valuable economic benefit associated with the
below-market interest rates on its financing arrangements as of
January 1, 1985. It is this economic benefit which petitioner
claims as an intangible asset and upon which it bases its
claimed amortization deductions.
b. Favorable Financing Can Be Assigned a Separate Value
As previously indicated, the fact that favorable financing could not be transferred apart from a transfer of other assets and liabilities does not prevent assigning it a separate value. At trial, petitioner's counsel developed the following hypothetical situation while examining respondent's expert, Dr. Herbert*201 Kaufman: 14
Q: * * * The houses are both worth $ 300,000. They are identical.
They are next door to each other. They both have a "for sale"
sign in front of them. The first house just says, "For sale,
House, No Assumable Debt." The second house has "House for Sale
Plus 1 Percent Mortgage Assumable as Part of the Purchase."
* * * * * * *
Q: Do you believe the second seller is going to receive more
money at closing than the first seller?
A: Assuming that market interest rates are --
Q: They're five.
A: Sure.
Q: So the second seller would receive more money. Right?
A: I would think so.
Q: Why is that?
A: Because the assumable mortgage is in place.
Q: Does it have value?
A: The assumable mortgage?
Q: Yes.
A: Yeah. The value of the assumable mortgage with regard to the
house, which is the asset, --
* * * * * * *
A: -- has value.
Further, Dr. Kaufman was asked and*202 answered as follows:
Q: * * * Back to my other hypothetical about the two homes next
door to each other, let's assume you can't decide which house to
buy, the $ 300,000 one with no assumable mortgage or the $ 300,000
house with the 1 percent mortgage. Market rates are five.
* * * * * * *
Q: Do you think it's possible to calculate how much more you
would pay for that house with the assumable 1 percent mortgage?
Is that possible to do?
A: I think it's probably possible.
Q: But a buyer certainly would have the tools to determine how
much more to pay for the below-market financing. Is that right?
A: Not for the below-market financing; for the house with the
below-market.
* * * * * * *
A: Again, you keep wanting to separate. I can't separate that
because you're not going to buy a liability.
Q: Let's say the buyer hired an appraisal company and had in the
buyer's hand an appraisal saying the house is worth $ 300,000.
*203 Right? How would the buyer decide how much more to pay for the
house with the 1 percent mortgage? It would determine the value
of the below-market mortgage and add that to the price. Isn't
that fair?
A: That's true, yeah.
Like the purchaser and seller of the houses in the hypothetical situation, we think that petitioner can ascertain the value of the favorable financing. As we have mentioned, financial markets determined the current price of petitioner's debt obligations on the valuation date; a comparison of the contract price and the prevailing market price*204 provides a reasonable measure of the value of the favorable financing associated with the debt instrument. Therefore, we disagree with respondent that a separate value cannot be assigned to petitioner's favorable financing.
c. Double Counting the Value
Respondent also argues that petitioner's method of valuing its favorable financing overvalues and double counts petitioner's assets because petitioner's "real assets" -- the mortgages -- have lost value when compared to prevailing market rates.
We think that respondent's concerns of double counting are misguided. When petitioner was chartered, it was exempt from Federal, State, and local taxation, except for real estate tax imposed by any State or local taxing authority. Congress enacted special legislation that subjected petitioner to Federal income taxation. In that special legislation, Congress created a dual-basis rule for petitioner's assets "to ensure that, to the extent possible, pre-1985 appreciation or decline in value of * * * [petitioner's] assets will not be taken into account for tax purposes." H. Conf. Rept. 98-861, supra at 1038, 1984-3 C.B. (Vol. 2) at 292. Just as this legislation applies to petitioner's favorable*205 financing intangible assets,
4. Petitioner's Purchase of Its Debt Obligations Would Result in Discharge of Indebtedness Income
Respondent appears to argue that the only way petitioner could realize the value of favorable financing would be to buy back its debt instruments at their*206 discounted market prices. Respondent claims that this is impractical because petitioner would incur tax on the resulting discharge of indebtedness income.
When a taxpayer repays a debt at a discount, the taxpayer normally realizes income from the discharge of indebtedness. See
If petitioner entered*207 the market and purchased its debt obligations for less than the amount that it had borrowed, petitioner would normally realize income equal to the difference between the amount it borrowed and the amount it paid to purchase its debt instruments. We think that respondent's argument that petitioner could have received discharge of indebtedness income by repurchasing its debt at a discount supports our conclusion that petitioner's favorable financing had value.
Assuming, without conceding, that favorable financing is a valuable asset, respondent argues that the price an acquirer would pay to purchase petitioner's rights and obligations with respect to its CMOs or GMCs would not exceed the present value of petitioner's spread income associated with those instruments. As of January 1, 1985, respondent asserts that the present value of the spread related to petitioner's GMCs and CMOs equaled approximately $ 11.4 million and $ 7.2 million, respectively.
Dr. Hakala concluded that favorable financing is not an intangible asset; however, Dr. Hakala found that petitioner's*208 income spread has value because its assets and liabilities are closely matched. 15 According to Dr. Hakala, when previously issued debt is matched to income-earning assets, the issued debt does not have any intangible value by itself. In his report, Dr. Hakala explained that "what is of value to a potential buyer is the potential income stream between mortgages and obligations to holders of the securities."
To determine the value of the income spread from the GMCs, Dr. Hakala used the net management and guarantee income 16 petitioner reported for the 6 months that ended June 30, 1985, and compared that to the average principal balance outstanding over that same 6-month period. He concluded that the management and guarantee income totaled $ 3.5 million. Dr. Hakala assumed general and administrative costs of 9 basis points annually and reduced the total value to incorporate the effect of taxes; these adjustments reduced the net management and*209 guarantee income to $ 1.6 million. "Taking into account the actual runoff of each GMC and discounting to present value the future net spread income at the weighted average cost of capital results in a value of approximately $ 11.4 million for the spread associated with all of the GMCs." Dr. Hakala used the same analysis to find that the present value of the CMOs' future net spread income at the weighted average cost of capital equaled $ 7.2 million.
We disagree with respondent that the value of petitioner's favorable financing intangible assets is limited to the value of the income spread. Dr. Hakala's income spread analysis is premised on his conclusion that favorable financing cannot be an intangible asset. However, in
Professor Schaefer explained that the income spread is a measure of petitioner's equity value, and that equity is different from the value of petitioner's assets, including the favorable financing intangible assets. Equity is generally described as the excess of the value of assets (tangible and intangible) over liabilities. The value of petitioner's favorable financing assets is the present value of the cost savings between the effective contract interest rate on petitioner's debt obligations and the prevailing market interest rates on equivalent debt obligations at the valuation date. To illustrate the differences between the value of an intangible asset and equity value, Professor Schaefer gave the following examples:
To illustrate this further, suppose a company has a long lease
on office space at $ 5 per square foot when the market price for
similar space is, say, $ 70. It is clear that this lease is
valuable to the company; if it did not own the lease at $ 5 per
square*211 foot it would have to rent more expensive space and, as a
result, both the earnings and the value of the company would be
lower. Of course the price an acquirer would pay is the value of
the earnings stream from the whole company, i.e., its revenues
less its total costs, including the costs of space. However, it
is clear that paying $ 5 rather than $ 70 per square foot for
space increases the earnings of the company and therefore has
value to an acquirer.
Similarly, suppose two companies, A and B, have identical assets
and identical amounts of debt but pay different rates of
interest on their debt. Company A's liabilities pay the
Prevailing Market Interest Rate while company B's liabilities
pay a below-market interest rate. In this case, company B's
earnings will be higher than company A's and an acquirer would
clearly pay more for company B than for company A. The
difference in the earnings of the two companies is the
difference between interest payments at the Prevailing Market
Interest Rate (the rate on company A's liabilities) and the
*212 lower rate on company B's liabilities. Thus, the difference
between the earnings of the two companies is equal to company
B's Favourable Financing benefits and the higher amount that an
acquirer would pay for company B over company A is the value of
company B's Favourable Financing Assets.
To further rebut respondent's claim that favorable financing cannot exceed the value of equity, Professor Schaefer explained:
This claim is clearly flawed since all that is required for the
value of the Favourable Financing Assets to exceed the value of
equity is for the present value of the Asset Spread to
Market 17 to be negative. * * * the value of
Freddie Mac's equity is always equal to the present value
of its Asset Spread to Market plus the value of its Favourable
Financing Assets. Thus, if the present value of the Asset Spread
to Market is negative, the value of the Favourable
Financing Assets will exceed the value of equity. * * *
*213 In order to illustrate this point, Professor Schaefer used the following example:
A more concrete example is provided by the S&L crisis,which
featured negative Asset Spreads to Market, and therefore
Favourable Financing Assets with a higher value than equity. In
the early 1980s, when interest-rates rose sharply, the condition
of many S&Ls deteriorated as the value of their fixed-rate
mortgage assets fell. Suppose that, in September 1981
when mortgage rates were above 15%, an S&L held fixed-rate
mortgages paying a rate of 6% and therefore selling at around
40% of their face amount. Suppose further that this S&L was
fortunate in the sense that it was entirely financed with core
deposits * * * that paid 2%and therefore, despite earning 6% on
its assets when market rates were 15%, it nonetheless earned a
positive spread of 4% (equal to the rate on its assets of 6% less
2% paid on its liabilities).
To the extent that the core deposits remain in place,this S&L is
solvent. However, its positive net worth does not come from its
assets -- these have*214 fallen in value by 60% -- but from its
liabilities. The total spread of 4% is made up of a substantial
and negative Asset Spread to Market of -- 9% (a 6% asset return
less a 15% market rate) and a large and positive
Favourable Financing benefit of 13% (the 15% market rate less
the 2% paid on deposits). The value of the Favourable Financing
Assets for this S&L (the present value of the 13% spread) would
clearly exceed the value of it sequity (the present value of the
4% spread).
We must decide the value of petitioner's favorable financing intangible assets. Because income spread measures equity and not the value of individual assets, we find that the value of petitioner's favorable financing intangible assets is not limited to the income spread.
D. Respondent's Argument That Taxes Reduce the Value of Favorable Financing
Assuming that petitioner's favorable financing intangible assets do have value, respondent argues that petitioner's calculations over- valued these assets because its method failed to incorporate the effect of taxes. In his rebuttal report, Dr. Hakala explained that "the reduction in the value of the*215 liability would be partially offset by a deferred tax liability." Dr. Hakala calculated value by reducing the value of the intangible assets for income taxes and increasing the value by the tax shield. 18 After incorporating the tax effect, Dr. Hakala prepared a summary analysis of the favorable financing intangible assets using Professor Schaefer's market prices as follows:
Debt Corrected Value
____ _______________
G-15 $ 6,977,205
G-16 11,448,352
G-17 30,735,708
F-8 296,491
F-11 67,179,640
F-12 176,830
F-13 50,628,337
F-15 203,957
F-18 112,856
D-2 4,594,048
Z-2 14,598,063
Z-3 *216 1,039,813
ND 405,439
CD-1 6,538,498
GMC A 1975 6,194,495
GMC B 1975 3,592,694
GMC A 1976 4,299,020
GMC B 1976 6,551,705
GMC A 1977 6,524,267
GMC B 1977 9,891,261
GMC C 1977 12,890,475
GMC A 1978 18,287,188
GMC B 1978 9,347,594
GMC C 1978 7,361,840
GMC A 1979 6,486,039
GMC B 1979 5,043,839
GMC C 1979 6,737,022
CMO A-2 4,862,086
CMO A-3 8,187,424
CMO C-4 420,731
___________
Total 311,612,917
*217 Petitioner argues that its market-based valuation approach integrates the effect of taxes into the value of an asset. In other words, petitioner argues that the market prices of its debt instruments already reflect the tax considerations of buyers and sellers.
In his rebuttal report, Dr. Hakala quoted the following excerpt from "Assets Acquired in a Business Combination to be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries" (2001) by the AICPA's IPR&D Task Force: "The task force believes that the valuation of an intangible asset would include (a) the expected tax payments resulting from the cashflows attributable to the intangible asset and (b) the tax benefits resulting from the amortization of that intangible asset for income tax purposes." At trial, Dr. Hakala was asked to read the two sentences that immediately followed the sentence he quoted in his rebuttal report: "'Including the tax affects [sic] in the valuation is common in the income and cost approaches. It is not typical in the market approach because any tax benefits would already be factored into the quoted market price through the negotiation of market*218 participants during the bid and ask process.'"
Petitioner's expert, Mr. Howard A. Scribner, 19 testified that taxes can affect the value of intangible assets but that the market approach incorporates taxes into the valuation. Specifically, Mr. Scribner was asked and answered as follows:
Q: Are taxes relevant or irrelevant in a market-based valuation
of an intangible asset?
A: A market-based intangible asset reflects the interactions of
buyers and sellers. All factors, including taxes, are reflected
in those prices.
We agree with petitioner that the market approach of valuing an asset incorporates the effect of taxes. Respondent's expert relied on a source that states that the effect of taxes typically is not included in the market approach because the quoted market price already reflects taxes. Mr. Scribner confirmed that the market price incorporates the effect of taxes. We find that petitioner properly valued its favorable financing*219 intangible assets using the market- based method and that no further adjustment is necessary to account for the tax effect.
We agree that petitioner has proven that its favorable financing intangible assets have values that were reasonably estimated. We hold that the values of petitioner's favorable financing intangible assets are as follows:
Debt Fair market value
____ _________________
G-15 $ 8,865,451
G-16 14,986,068
G-17 44,427,083
F-8 325,000
F-11 92,000,000
F-12 187,500
F-13 72,937,500
F-15 218,750
F-18 125,000
D-2 5,812,500
Z-2 *220 24,389,887
Z-3 1,448,674
ND 458,071
CD-1 7,992,188
GMC A 1975 7,418,813
GMC B 1975 4,358,750
GMC A 1976 5,228,813
GMC B 1976 8,342,336
GMC A 1977 8,146,021
GMC B 1977 12,825,330
GMC C 1977 17,407,946
GMC A 1978 24,814,023
GMC B 1978 12,413,781
GMC C 1978 9,776,662
GMC A 1979 8,521,734
GMC B 1979 6,626,888
GMC C 1979 8,946,893
CMO A-2 6,254,753
CMO A-3 12,511,453
*221 CMO C-4 623,683
___________
Total 428,391,551
To amortize favorable financing, a taxpayer must show that the intangible assets have limited useful lives, the duration of which may be ascertained with reasonable accuracy.
If an intangible asset is known from experience or other factors
to be of use in the business or in the production of income for
only a limited period, the length of which can be estimated with
reasonable accuracy, such an intangible asset may be the subject
of depreciation allowance. Examples are patents and copyrights.
An intangible asset, the useful life of which is not limited is
not subject to the allowance for depreciation. * * *
"A taxpayer may establish the useful life of an asset for depreciation based upon his own experience with similar property, *222 or, if his own experience is inadequate, based upon the general experience in the industry."
Petitioner argues that on January 1, 1985, the reasonably estimated remaining useful lives of the 30 favorable financing intangible assets equaled the average weighted lives. Petitioner relies on the expert opinion and testimony of Mr. Howard A. Scribner. Mr. Scribner received a B.S.C. in accounting from Rider University and an M.B.A. in finance from Rutgers Graduate School of Management. He is also a licensed certified public accountant (C.P.A.) and an accredited business valuation specialist in the American Society of C.P.A.s. He is a partner in the Economic and Valuation Services practice of KPMG LLP. Mr. Scribner has more than 20 years of valuation experience involving intangible assets, debt, common and preferred stock, partnership interests, and stock options of privately and publicly held companies.
Mr. Scribner determined that the estimated useful lives of the favorable financing intangible assets equal the average weighted lives of the debt obligations that give rise to them. According to Mr. Scribner, the estimated*224 useful lives of the favorable financing intangible assets did not change on account of subsequent unforeseen events because
the interactions of market participants force the incorporation
of all known and expected information available at that date
into the existing prevailing market interest rate. Therefore,
the market consensus establishes the current market interest
rate to be the best estimate of the prevailing interest rate
over the life of the investment.
Mr. Scribner states that the average weighted life represents the time it takes for the average dollar of principal borrowed to be repaid to the lender. The average weighted life is calculated by: (1) Multiplying the principal payment by the number of years or pro rata portion of a year that the principal amount has been outstanding, (2) adding the results for all payment periods, and (3) dividing that sum by the total principal paid. 20 For debt obligations that do not repay any principal until maturity, the average weighted life is the time remaining to maturity.
*225 The following example illustrates how Mr. Scribner's calculated the average weighted life for ND:
Years Principal
Date Outstanding (A) Payment (B) (A*B)/11,363,000 n.1
____ _______________ ___________ _________________
1/1/1985 -- -- --
11/1/1985 0.8333 $ 1,407,703 0.10
11/1/1986 1.8333 9,954,795 1.61
____
Total average weighted life 1.71
n.1 This figure is the total principal outstanding on ND as of Dec. 31, 1984.
Mr. Scribner estimated that ND had an average weighted life of 1.71 years, or 1 year, 9 months.
When an issuer holds an option to repay debt, Mr. Scribner's report explains that the option may affect the average weighted life because the issuer may elect to redeem the instrument before maturity. Petitioner would elect to exercise an option to repay debt before maturity if it would save interest expense. *226 For example, petitioner would exercise the option to redeem the instrument before maturity when the interest rate of the instrument exceeded the market rate.
Similarly, if the holder of a debt has a put option, the holder will exercise the option when the debt obligation pays interest at a rate below the market rate of interest because the holder could reinvest at a higher rate. Favorable put options would shorten the estimated remaining useful life of favorable financing intangible assets.
Respondent argues that petitioner has not established a limited useful life for the favorable financing intangible assets because petitioner's calculations failed to consider the volatility of the markets, which may eliminate the benefit of these assets before the useful lives asserted by petitioner expire. Respondent's theory would seem to produce shorter useful lives for the favorable financing intangible assets, which would accelerate petitioner's depreciation allowance. 21 Instead, petitioner used a more conservative estimate of the useful life measured by the averaged weighted life.
*227 We disagree with respondent that petitioner failed to take market volatility into account when determining the useful lives of its assets. Mr. Scribner explained that the market incorporates all known information and expected information into establishing the prevailing market rates. Mr. Scribner concluded that "the market consensus establishes the current market interest rate to be the best estimate of the prevailing interest rate over the life of the investment."
Because respondent contends that there is no fair market value to support the existence of the favorable financing intangibles, respondent offered no view as to their useful lives. Although Dr. Hakala disagrees that the average weighted lives equal the remaining useful lives of the assets, Dr. Hakala substantially agreed with the average weighted life calculations performed by petitioner's experts. We find that petitioner has proven that its favorable financing intangible assets have reasonably estimable useful lives equal to the average weighted lives of the debt obligations from which these assets arose. We hold that petitioner's favorable financing intangible assets had useful lives as follows:
Debt*228 Average Weighted Life
____ _____________________
G-15 5 years, 5 months
G-16 6 years, 8 months
G-17 12 years, 5 months
F-8 11 months
F-11 8 years, 11 months
F-12 2 months
F-13 12 years, 2 months
F-15 5 months
F-18 1 year, 2 months
D-2 5 years, 3 months
Z-2 34 years, 11 months
Z-3 9 years, 11 months
ND 1 year, 8 months
CD-1 4 years, 0 months
GMC A 1975*229 3 years, 4 months
GMC B 1975 3 years, 9 months
GMC A 1976 3 years, 10 months
GMC B 1976 5 years, 6 months
GMC A 1977 4 years, 9 months
GMC B 1977 6 years, 3 months
GMC C 1977 8 years, 2 months
GMC A 1978 8 years, 5 months
GMC B 1978 7 years, 4 months
GMC C 1978 7 years, 4 months
GMC A 1979 6 years, 10 months
GMC B 1979 6 years, 10 months
GMC C 1979 7 years, 4 months
CMO A-2 5 years, 11 months
CMO A-3 17 years, 7 months
CMO C-4 14 years, 6 months
Petitioner has proven that the favorable financing intangible assets have*230 reasonably estimable values and ascertainable remaining useful lives in accordance with our findings. Since other issues in these cases remain unresolved, our conclusions, as stated herein, will be incorporated in a
APPENDIX: Investment Bank Bid Prices
The following table lists the investment bank bid prices obtained by petitioner and Arthur Andersen, which were used to value petitioner's favorable financing.
___________________________________________________________________________
Bid Price
___________________________________________________________________________
Debt Salomon Merrill Shearson
Instrument First Boston Brothers Lynch Lehman
___________________________________________________________________________
G-15 -- -- -- 87.250000
G-16 -- -- -- 81.750000
G-17 70.343750*231 -- -- 70.250000
F-12 99.875000 99.812500 -- --
F-15 99.875000 99.812500 -- --
F-8 99.187500 99.093750 -- --
F-18 99.906250 99.812500 -- --
F-11 77.125000 76.625000 -- --
F-13 75.375000 75.750000 -- --
D-2 97.750000 -- -- 98.125000
CMO A-2 97.468750 96.875000 96.625000 97.687500
CMO A-3 96.406250 95.687500 96.250000 95.218750
CMO C-4 95.906250 93.343750 95.375000 92.937500
ND 95.562500 -- -- 95.625000
CD-1 94.718750 -- -- 94.500000
Z-2 *232 2.500000 -- -- 2.656250
Z-3 31.625000 31.000000 -- 31.375000
GMC A 1975 n.1/92.062500 -- -- --
GMC B 1975 n.1/92.750000 -- -- --
GMC A 1976 n.1/92.218750 -- -- --
GMC B 1976 n.1/87.625000 -- -- --
GMC A 1977 n.1/88.562500 -- -- --
GMC B 1977 n.1/85.500000 -- -- --
GMC C 1977 n.1/83.093750 -- -- --
GMC A 1978 n.1/85.875000 -- -- --
GMC B 1978 n.1/86.843000 -- -- --
GMC C 1978 n.1/89.281250 -- -- --
GMC A 1979 n.1/91.750000 -- *233 -- --
GMC B 1979 n.1/93.500000 -- ? -- --
GMC C 1979 n.1/91.562500 -- -- --
n.1 Mean of dealer bid prices obtained from First Boston and Salomon Bros.
Footnotes
1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. This issue is one of several involved in these cases. See
Fed. Home Loan Mortgage Corp. v. Commissioner, 125 T.C. 248 (2005) ;121 T.C. 129 (2003) ;121 T.C. 254 (2003) ;121 T.C. 279 (2003) ;T.C. Memo. 2003-298↩ .3. In this context, debt includes collateralized mortgage obligations (CMOs) and guaranteed mortgage certificates (GMCs).↩
4. The effective contract interest rate is the adjusted coupon interest rate (or for zero-coupon bonds, the adjusted effective interest rate). The adjusted coupon interest rate equals the sum of the coupon rate of interest, the hedging gain or loss percentage, and any discount from the face value when the debt obligation was issued.↩
5. The mortgages used as collateral for the outstanding CMOs as of Jan. 1, 1985, were entirely first lien, conventional residential mortgages having fixed rates of interest.↩
6. In some cases, interest on the most junior class of bonds was not paid currently but accrued until the senior classes had been paid in full.↩
7. Respondent issued to petitioner Priv. Ltr. Rul. 7607233060D (July 23, 1976), which states, in pertinent part:
Although the issuance of [Guaranteed Mortgage] Certificates
takes the form of a transfer to the Certificate holders by * * *
[petitioner] of undivided interests in the Mortgages, the terms
of the Certificates are such that for Federal income tax
purposes * * * [petitioner] will not be selling undivided
interests in the Mortgages but will be issuing debt obligations
for which the Mortgages held by the Trustee are security. * * *
On May 13, 1983, respondent revoked this private letter ruling and related rulings. See
Priv. Ltr. Rul. 8337016 (May 23, 1983) . Respondent does not presently regard GMCs as debt for tax purposes; however, under the provisions ofsec. 7805(b)↩ , respondent has permitted petitioner to treat its GMCs issued before May 23, 1983, including all of the GMCs at issue in this case, as debt for tax purposes.8. Petitioner made minimum payments pursuant to the respective schedule on GMC A 1978, GMC B 1978, GMC C 1978, GMC A 1979, GMC B 1979, and GMC C 1979 on all payment dates from the inception of the GMC through March 1980.↩
9. On its original Federal income tax returns for the years at issue, petitioner reported the aggregate adjusted bases of its favorable financing intangible assets as follows:
Aggregate adjusted
basis of favorable
Year financing intangible assets
____ ___________________________
1985 $ 456,021,853
1986 391,552,352
1987 337,931,651
1988 283,234,501
1989 237,398,945
1990 196,718,525
Petitioner adjusted the bases of the favorable financing intangible assets for tax benefits received and the lost bases on retirements.↩
10. Petitioner reduced the value of its favorable financing intangible assets using the valuation performed by Dr. Stephen M. Schaefer.↩
11. FMV = (adjusted issue price per $ 100 - market price per $ 100) x (unpaid principal balance / $ 100).↩
12. Dr. Scott D. Hakala received his doctor of philosophy, economics at the University of Minnesota. Dr. Hakala is currently a director and principal in CBIZ Valuation Group, LLC. His expertise includes: Corporate finance, restructuring and cost of capital; valuation of securities and business interests; valuation of intangible assets; analysis of publicly traded securities; economic loss analyses; wage and compensation determination; transfer pricing; and derivative securities. He has testified as an expert in over 60 cases in U.S. District Courts, this Court, and various State courts.↩
13. The term "deposit base" represents the present value of the future stream of income to be derived from employing the core deposits of a bank. See
Fed. Home Loan Mortgage Corp. v. Commissioner, 121 T.C. at 262 . "Core deposits are a relatively low-cost source of funds, reasonably stable over time, and relatively insensitive to interest rate changes."Citizens & S. Corp. & Subs. v. Commissioner, 91 T.C. 463, 465 (1988) . InFirst Chi. Corp. v. Commissioner, T.C. Memo. 1994-300 , we defined core deposits as follows:Core deposits can be an essential part of a commercial bank when
they represent a low cost and stable source of funds. Banks
typically invest the funds in loans or other income-producing
assets, and receive fees for services rendered to the
depositors. The excess of the income generated from the core
deposits over the associated expenses contributes to the
profitability of the bank. Core deposits are a separate and
distinct intangible asset with an inherent value because they
provide an inexpensive means to generate income. Therefore, when
one bank considers acquiring another bank, core deposits can
represent an attractive intangible asset and a reason for
acquiring a bank. [Fn. ref. omitted.]↩
14. Dr. Herbert M. Kaufman received his Ph.D. in economics from the Pennsylvania State University. He is a professor of finance at Arizona State University, W.P. Carey School of Business. Dr. Kaufman's fields of specialization are: Investments; financial markets and institutions; monetary economics; and applied econometrics. He provided a valuation analysis of petitioner's asserted favorable financing intangible assets.↩
15. Dr. Hakala indicates that the CMOs and GMCs are exactly matched.↩
16. Management and guarantee income is the excess income/expense during a month from each GMC trust, including the excess of the effective interest income on mortgages backing the GMCs over the amount payable to GMC investors and short-term investments.↩
17. Professor Schaefer describes Asset Spread to Market as follows:
the difference between the rate the firm actually earns
on its assets and the rate it would earn if it had to
invest in the market (at the Prevailing Market Interest Rate),
measures the benefit to the firm of the specific assets
it holds. I refer to this rate as the Asset Spread to Market. If
positive, this difference represents the "favourableness" of the
firm's assets, just as the difference between the market and
actual financing rates represents the "favourableness" of the
firm's liabilities. * * *↩
18. The reduction of value for income taxes reflects the present value of cashflows on an after-tax basis. The tax shield is the amortized tax benefit associated with creating an intangible asset.↩
19. See infra pp. 48-49.↩
20. The average weighted life formula is as follows:
AWL = [sum] PMT x n
_____________
P
PMT is the principal payment, n is the number of years that the principal amount has been outstanding, and P is the total principal paid.↩
21. Respondent did not offer alternative useful life calculations for petitioner's favorable financing intangible assets.↩
2006 T.C. Memo. 153 (Fed. Home Loan Mortg. Corp. v. Comm'r) — published by Counsel Stack Legal Research, free access to 12M+ legal documents.