115 T.C. No. 32
UNITED STATES TAX COURT
UNION CARBIDE FOREIGN SALES CORPORATION, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 14641-97, 14642-97, Filed November 8, 2000. 14643-97, 11119-99.
P leased an asset, and the terms of the lease became onerous or burdensome. Under lease agreements, P was entitled to either terminate the lease or purchase the leased asset by the payment of a certain sum. P chose to acquire the leased asset and, relying on Cleveland Allerton Hotel, Inc. v. Commissioner, 166 F.2d 805 (6th Cir. 1948), revg. a Memorandum Opinion of this Court dated May 7, 1947, seeks to bifurcate and allocate the asset acquisition cost into two portions. P asserts one portion should represent the value of the leased asset without considering the value of the existing lease. P further asserts that the remaining portion should be allowed as a business deduction for
1 Cases of the following petitioners are consolidated herewith: UOP, Catalysts, Adsorbents and Process Systems, Inc., Tax Matters Partner, docket No. 14642-97; Union Carbide Corporation and Subsidiaries, docket No. 14643-97; and Union Carbide Corporation and Subsidiaries, docket No. 11119-99. - 2 -
terminating a burdensome lease. R contends that sec. 167(c)(2), I.R.C., enacted in 1993, requires that the acquisition cost must be allocated solely to the acquired tangible capital asset. P contends that the holding of Cleveland Allerton Hotel, Inc. permits the allocation. Held: Sec. 167(c)(2), I.R.C., interpreted to prohibit allocation of any portion of the asset acquisition cost to a deduction for P’s termination of a burdensome lease.
Harold J Heltzer, Philip F. McGovern, Jerry L. Robinson, and
Howard Mark Weinman, for petitioners.
Steven R. Winningham, Joseph F. Long, Carmino J.
Santaniello, S. Katy Lin, and Robin L. Peacock, for respondent.
OPINION
GERBER, Judge: Respondent moved for partial summary
judgment on the legal question of whether section 167(c)(2)2
applies to petitioner’s3 acquisition of ownership of a previously
leased oceangoing vessel. Respondent contends that section
167(c)(2) would require petitioner to allocate to the depreciable
asset all of its cost and, further, that petitioner was not
entitled to allocate a portion of the cost to a deduction for
2 Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the periods under consideration, and Rule references are to the Tax Court Rules of Practice and Procedure. 3 References to “petitioner” in this group of related and consolidated cases refers to Union Carbide Corp., petitioner in docket Nos. 14643-97 and 11119-99. - 3 -
relief from the terms of a burdensome lease. Petitioner argues
that section 162 is applicable to the portion of the cost that it
contends was attributable to buying its way out of an onerous or
burdensome lease. Our consideration of whether section 167(c)(2)
applies in these circumstances is a question of first impression.
Background
For purposes of this motion for partial summary judgment,4
the parties agree about the underlying facts and that this matter
is ripe for consideration of the legal question. Although
respondent generally questions the substance of this transaction,
for purposes of the legal question presented in his motion,
respondent accepts the form of and/or petitioner’s explanation
for the subject transaction. If respondent is unsuccessful in
his motion, a trial will be necessary to address respondent’s
position regarding the substance of the transaction(s) and
related issues including the basis of the vessel in question.5
The asset under consideration, the Chemical Pioneer is a
seagoing vessel that was manufactured to petitioner’s
specifications for the transport of liquid chemicals. When the
4 With the exception of what appears to be a computational issue, all other issues in these consolidated cases have been resolved by agreement of the parties. 5 In addition, there are several procedural motions outstanding that we will need to address if the motion for partial summary judgment is not dispositive of the substantive issue. - 4 -
vessel was completed during 1983, petitioner did not wish to show
it as an asset on its balance sheet, so petitioner arranged a
series of transactions that permitted it to lease rather than own
the vessel. For purposes of the legal question we consider, it
is only necessary to understand that petitioner leased the vessel
and then, several years later, wanted to be relieved from the
burdensome terms of the lease. Under the agreements, petitioner
had the choice of paying either to terminate the lease or to
acquire the vessel. Petitioner chose to acquire the vessel under
the terms of the agreements. By acquiring the vessel, however,
petitioner effectively terminated the burdensome lease.
We describe the following transactional steps employed for
purposes of completeness: (1) The vessel was transferred to a
trust created by Merrill Lynch Leasing, Inc. (Merrill Lynch), and
of which Bankers Trust Co. (Bankers) was trustee; (2) Bankers, as
trustee, entered into a Bareboat Charter6 through January 3,
2004, (20 years) with a partnership named Union Marine Transport
Co. (UMTC), which consisted of two equal partners--petitioner’s
subsidiary, Chemical Marine Fleet, Inc., and a subsidiary of
Marine Transport Lines, Inc. (MTL), an unrelated entity that
petitioner had previously utilized for operation and management
of its oceangoing transport of chemicals; (3) UMTC concurrently
6 This was described by the parties as a long-term lease of a ship. - 5 -
entered into a contract (sublease) with petitioner, under which
petitioner reserved 75 percent of the vessel’s capacity and was
responsible for 100 percent of the payments due under the
Bareboat Charter; (4) UMTC also entered into an operating
agreement with Marine Transport Management, Inc. (a subsidiary of
MTL), to manage and operate the vessel; and, (5) UMTC entered
into a marketing agreement with another MTL subsidiary to market
the portion of the vessel not used by petitioner, including the
25 percent not reserved by petitioner.
The terms of the Bareboat Charter permitted petitioner to
terminate the lease and walk away from the arrangement by the
payment of a scheduled amount. Petitioner, however, chose to
acquire the vessel. On December 29, 1993, petitioner purchased,
for $107,748,925, Merrill Lynch’s interest in the grantor trust
that held the vessel, including the title to the vessel and
rights to its use. The $107,748,925 payment was about 20 percent
less than the amount that petitioner would have had to pay to
terminate the lease without acquiring ownership of the vessel.7
On June 30, 1994, the Bareboat Charter and related contracts were
canceled, the UMTC partnership was dissolved, and petitioner
acquired title to the vessel from the trust. After December
1993, petitioner did not make any (lease) payments under the
7 For purposes of deciding the issue in this summary judgment motion, it should not matter whether it was more or less costly to acquire the vessel or to simply terminate the lease. - 6 -
Bareboat Charter. Any payment made by petitioner would have
resulted in a wash under the various agreements. The UMTC
partnership and the sublease arrangements remained in effect, and
the marketing and third-party leases continued to operate
normally under the agreement until sometime in 1994.
Solely for purposes of his motion, respondent also accepts
the fact that the lease was burdensome and that, at the time
petitioner acquired it, the value of the vessel was $13,865,000,
without considering the value of the lease8. Under this
scenario, petitioner is seeking to allocate $93,883,295, or 87
percent, of the $107,748,295 purchase price to the termination of
the burdensome lease, leaving $13,865,000 attributable to its
basis in the vessel.
Petitioner questions respondent’s assumption in his motion
that the lease remained in existence and was not terminated until
June 30, 1994. Petitioner argues that the lease was effectively
terminated in December 1993 after the vessel was purchased, and
the June 30, 1994, termination was merely a formality.
Petitioner contends, however, that respondent’s position that
section 167(c)(2) applies would fail under either scenario.
8 Respondent’s concessions cause sec. 167(c)(2) to be the focal point of this opinion and our consideration. - 7 -
Discussion
A. Summary Judgment. Summary judgment may be granted if
it is demonstrated that no genuine issue exists as to any
material fact and that a decision may be entered as a matter of
law. See Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C.
518, 520 (1992), affd. 17 F.3d 965 (7th Cir. 1994). The moving
party bears the burden of proving that there is no genuine issue
of material fact, and factual inferences will be read in a manner
most favorable to the party opposing summary judgment. In that
regard and solely for purposes of deciding the issue here, we
accept petitioner’s interpretation that the lease terminated upon
acquisition of the vessel. The parties’ contentions with respect
to section 167(c)(2) are delineated in a way that would obviate
the need to decide whether any of the leases continued to exist
after the acquisition of the vessel. That is so because
petitioner contends that the statute applies to property only if
acquired subject to a lease that continues in the future, and
respondent contends that the statute would apply here because the
property acquired was subject to a lease when acquired.
Construing the transactional facts here most favorably to the
defending party, we are to decide whether a lessee of an asset
who purchases that asset for the purpose of terminating the lease
is subject to section 167(c)(2). Accordingly, we may render
judgment on the issue as a matter of law. See Rule 121(b). The - 8 -
pleadings, exhibits, transcript of argument, and affidavits
contain the facts and information used for the purpose of ruling
on the motion herein.
B. Analysis of Section 167(c)(2). Section 167(c)(2) was
enacted as section 13261(b)(2) of the Omnibus Budget
Reconciliation Act of 1993, Pub. L. 103-66, 107 Stat. 532. It
was part of a larger package of provisions aimed at the treatment
of intangibles that was enacted in section 197.9 Under the
regimen of section 197, various intangibles are identified,
categorized, and subjected to uniform tax treatment. As part of
this larger package of rules, section 167(c)(2) was enacted to
specifically exclude leasehold interests, including subleases,
from the effect of section 197. Even though leases were removed
from the effect of section 197, by enacting section 167(c)(2)
Congress intended uniform treatment for all situations where a
tangible asset was “acquired subject to a lease”. In that
regard, section 167(c)(2) is designed to prevent taxpayers from
allocating any of the cost of acquiring tangible property to
9 Prior to the enactment of sec. 197, depreciation or amortization of intangibles was governed by sec. 1.167(a)–(3), Income Tax Regs., and was a source of considerable controversy between taxpayers and the Internal Revenue Service. See Staff of Joint Comm. on Taxation, Technical Explanation of the Tax Simplification Act of 1993 (J. Comm. Print 1993), Title V, Treatment of Intangibles, Amortization of goodwill and certain other intangibles (sec. 501 of the bill and new sec. 197 of the Code), at 147. - 9 -
leases or subleases to which the property is subject. See H.
Rept. 103-111, at 769 & n.139 (1993), 1993-3 C.B. at 345.
The statute is concise, to the point, and expressed as
follows:
SEC. 167(c). Basis for Depreciation.-- (1) In general.--The basis on which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the adjusted basis provided in section 1011, for the purpose of determining the gain on the sale or other disposition of such property. (2) special rule for property subject to lease.-- If any property is acquired subject to a lease-- (A) no portion of the adjusted basis shall be allocated to the leasehold interest, and (B) the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease. [Sec. 167(c)(1) and (2).]
The parties do not dispute that if we decide that the vessel
acquired by petitioner is “property subject to a lease,” as
referenced in the statute, then no portion of the acquisition
cost can be attributed to any lease in question. Where the
parties part company is in their interpretation of the phrase “If
any property is acquired subject to a lease”. Respondent argues
that petitioner acquired the vessel subject to the lease to the
UMTC partnership; i.e., the lease under which petitioner was
entitled to use the vessel. Petitioner, on the other hand,
argues that the statute only applies to property that is subject
to a lease when acquired and will continue to be subject to the
same lease afterwards. Petitioner argues that its purpose in - 10 -
acquiring the vessel was to terminate the lease, and therefore,
it did not acquire property subject to a lease. We must decide
which party’s interpretation (or possibly whether both
interpretations) was intended. Under respondent’s position,
petitioner would be entitled to depreciate the acquisition cost
(approximately $108 million) over the remaining life of the
vessel. Petitioner, however, seeks to deduct 87 percent of the
acquisition cost (approximately $94 million) in the year of
acquisition of the vessel as the cost of terminating a burdensome
lease. The remaining amount (approximately $14 million) was to
be attributable to the depreciable basis of the vessel.
Ultimately, this controversy concerns the timing of deductions in
connection with petitioner’s acquisition of the vessel and its
attempt to terminate the lease.
There is no question about whether the vessel was subject to
a lease at the time it was acquired by petitioner. Petitioner
argues, however, that as a matter of proper grammatical syntax
the statutory language has been phrased to require that acquired
property must remain subject to a lease to come within the
allocation requirements of section 167(c)(2). Petitioner
suggests that Congress would have used the phrase “If any
property subject to a lease is acquired” to achieve the outcome
advanced by respondent. Petitioner contends that respondent
appears to treat the phrase “subject to a lease” as if it - 11 -
modified the word “property”. Petitioner contends that the
placement of the phrase “subject to a lease” shows that it
modifies the word “acquired” which, grammatically, should mean
that the property remains subject to a lease in the hands of the
acquiring party.
Respondent agrees that the phrase “subject to a lease”
modifies the term “acquired”, but contends that “It does so * * *
as part of the past participial phrase ‘acquired subject to a
lease’, which, used in conjunction with the verb ‘is’, modifies
and governs ‘property’”. Respondent contends that such usage
constitutes a past participial phrase and that “acquired subject
to a lease” merely denotes the gaining of possession. Respondent
also points out that the phrase has been placed in the past tense
by the use of the word “acquired” and is without continuing or
future tense. Finally, respondent references 1 U.S.C. sec. 1
(1994), which provides that “words used in the present tense
include the future as well as the present”. From this statement,
respondent reasons that, conversely, words stated in the past
tense (such as “acquired”) do not include the future. Thus,
respondent concludes that Congress intended to limit the subject
phrase to the point of the acquisition of the asset.
Although we appreciate the parties’ arguments concerning
grammar, Congress’ intent should not be decided solely by
reference to finite nuances to be found in the rules of grammar. - 12 -
That is especially so here, where neither party’s grammar
argument is obviously more correct than the other’s. We do not
focus solely on such distinctions to decide the intent of
Congress in this case.
Normally, we begin our inquiry by looking to the plain
language of the statute to interpret its meaning. See Consumer
Prod. Safety Commn. v. GTE Sylvania, Inc., 447 U.S. 102, 108
(1980). When interpreting the words used in a statute, we give
them their ordinary meaning. See Jones v. Liberty Glass Co., 332
U.S. 524, 531 (1947). Considering the phrase “If any property
subject to a lease is acquired” we reach the conclusion that
either party’s interpretation is possible, depending on the
intent of Congress. The question we must answer is whether the
legislation was directed only to situations where a lease is to
continue beyond the time of acquisition of the property subject
to that lease or whether it applies to an acquisition of property
by a lessee where the lease merges into the lessee’s new
property ownership interest.
The legislative history provides no direct assistance or
decisive indicator to answer our particular inquiry. The
conference report contains the following general statement:
Interests under leases of tangible property.--The term “section 197 intangible” does not include any interest as a lessor or lessee under an existing lease of tangible property (whether real or personal). The cost of acquiring an interest as a lessor under a lease of tangible property where the interest as lessor is - 13 -
acquired in connection with the acquisition of the tangible property is to be taken into account as part of the cost of the tangible property. For example, if a taxpayer acquires a shopping center that is leased to tenants operating retail stores, the portion (if any) of the purchase price of the shopping center that is attributable to the favorable attributes of the leases is to be taken into account as a part of the basis of the shopping center and is to be taken into account in determining the depreciation deduction allowed with respect to the shopping center. The cost of acquiring an interest as a lessee under an existing lease of tangible property is to be taken into account under present law (see section 178 of the Code and Treas. Reg. sec. 1.162-11(a)) rather than under the provisions of the bill. * * * [Fn. refs. omitted.10]
H. Conf. Rept. 103-213, at 681-682 (1993), 1993-3 C.B. 393, 559-
560.
Petitioner focuses on the use of the phrase “under an
existing lease” in the first paragraph of the above-quoted
commentary. The use of that terminology could refer either to a
lease in existence at the time of the acquisition or to a lease
that continues in existence. Petitioner links the use of that
phrase to the legislative commentary and the single example that
addresses circumstances where the lease would continue beyond the
acquisition date. Petitioner would have us accept that this
10 Sec. 1.162-11(a), Income Tax Regs., similar to sec. 167(c)(2), requires the purchaser of a leasehold interest to amortize an annual aliquot part of the cost over the remaining term of the lease. As pertinent to this discussion, sec. 178 addresses lease renewal options as affecting the remaining term of a lease. - 14 -
factor shows that section 167(c)(2) applies only where the lease
is to continue.
Respondent correctly points out that the example and
discussion of continuing leases does not “expressly condition the
application of section 167(c)(2) on the acquisition of a
continuing ‘interest of a lessor under a lease of tangible
property.’” In the context of the commentary and the example, we
agree with respondent that it was not intended to limit the
application to a particular type of transaction set forth in the
example. Although the example discusses a lease that continues
beyond the time of acquisition, it is clear that the example is
not intended to be all-inclusive. More particularly, the
statutory language could easily apply to leases that terminate
upon or immediately after acquisition and/or leases that continue
beyond acquisition of the leased asset. Accordingly, the
legislative history does not provide definitive guidance or a
direct answer to our inquiry of whether section 167(c)(2) applies
only to a situation where a lease is to continue in futuro. The
commentary and the example do make it absolutely clear, however,
that all costs were intended to be allocated to the depreciable
tangible property.
Petitioner also points out that one of the purposes for
enacting section 167(c)(2) was to deal with a specific
controversy between lessor/taxpayers and the Internal Revenue - 15 -
Service. Those situations involved the amortization of the
premium value of an acquired lease on facts similar to the
example in the legislative history, supra. We agree with
petitioner that one of the motivating factors for enacting
section 167(c)(2) was to deal with that problem. The statutory
language, however, would ostensibly apply to anyone acquiring
property and is not in any manner limited to acquisitions for a
premium and/or by a purchaser of an asset subject to a lease that
is to continue into the future.
The parties have gone to great lengths to reword and/or
hypothesize the meaning of statutory phrase in controversy. The
phrase we consider, however, is quite succinct--“If any property
is acquired subject to a lease”. The threshold for application
of section 167(c)(2) applies to “any property” that “is acquired”
when it is “subject to a lease”. If property was not subject to
a lease when it was acquired, section 167(c)(2) would not apply.
So we must decide whether the property here was subject to a
lease when it was acquired. The plain language of the statute is
not limited in its application to acquisitions by lessors. Nor
does it delineate a requirement that the lease must continue
after the acquisition, only that the property be acquired subject
to a lease.
In order to interpret the phrase “subject to a lease” solely
as a continuing requirement as suggested by petitioner, we would - 16 -
have to look outside the statutory language. It appears that
section 167(c)(2) would be triggered irrespective of whether the
lease had a remaining term of 1 day or 10 years. With that
premise, it is difficult to accept petitioner’s argument that its
own circumstances should be exempted from the statutory
requirements. If we accept petitioner’s interpretation that the
lease must continue, a taxpayer would be able to avoid the
intended effect of section 167(c)(2) merely by a simultaneous
acquisition of tangible property, cancellation of the “existing
lease”, and the renegotiation of a new lease. Under petitioner’s
interpretation, section 167(c)(2) would be rendered impotent and
meaningless. Whether we accept the fact that petitioner’s lease
terminated upon, 6 months after, or sometime more distant from
the acquisition of the vessel, the lease did not terminate until
petitioner acquired the vessel. Accordingly, petitioner acquired
the vessel at a time when it was subject to the lease.11
11 Respondent points out that in Kloppenberg & Co. v. Commissioner, T.C. Memo. 1986-325, where the taxpayer was similarly attempting to value a capital asset without considering the value of the lease, this Court used the phrase “subject to [a] lease” in the same manner in which respondent advocates that it be used here. In disagreeing with the taxpayer’s approach in Kloppenberg, we stated: No one disputes that after May 3, 1978, * * * [the taxpayer] owned the * * * property in fee simple. However, * * * [the taxpayer’s] argument that the lease should therefore be disregarded ignores the fact that * * * [the taxpayer] owned a significant interest in the * * * property prior to the challenged transaction. It is not the value of the combined interest which (continued...) - 17 -
C. Petitioner’s Alternative Position. Although we have
decided that petitioner’s acquisition of the vessel is governed
by section 167(c)(2), the same result would have been reached
even if section 167(c)(2) had not been enacted. Petitioner
argues that we should treat the acquisition as though it were two
separate payments or portions. Petitioner contends that one
portion would be attributable to the acquisition of a vessel
worth substantially less than the $108 million total payment and
the other should be attributable to the cancellation of a
burdensome lease. Respondent points out that petitioner chose
the approach to acquire the vessel instead of making the payment
to terminate the burdensome lease. We note that petitioner’s
cost to acquire the vessel was approximately 20 percent less than
the cost of the option permitting termination of the lease.
Petitioner, therefore, wishes us to treat the acquisition of the
vessel as though it had, in effect, exercised both choices--
petitioner wishes “to have its cake and eat it too!”12
11 (...continued) * * * [the taxpayer] owned after May 3, 1978, which is in issue. Rather, it is the interest which * * * [the taxpayer] purchased from * * * [the owner/lessor] on that date, i.e., a fee simple interest subject to the outstanding lease. * * * [Id.; with emphasis as suggested by respondent.] 12 Petitioner obviously followed the less costly approach from a financial perspective, but not necessarily from a tax perspective. Petitioner has provided no explanation for the 20 percent larger cost to terminate the lease than to acquire the (continued...) - 18 -
The main thrust of petitioner’s argument is that it was
effectively doing two different things, even though it had solely
exercised the option of acquiring the vessel for the contract
price. On brief, petitioner went to great lengths to convince us
that section 167 deals solely with depreciation or amortization
and that section 162 (concerning ordinary and necessary business
deductions) governs the portion of its transaction that effected
the termination of the lease. Respondent does not question
petitioner’s premise that section 162 deals with the pure
situation where there is an expenditure to cancel or terminate a
burdensome contract or lease. The approach that petitioner uses
to make its point is to argue that the value of the vessel
without considering the lease is $14 million, and so the
remaining $94 million of the $108 million acquisition price was
paid to cancel a lease13. Petitioner’s approach has met with
12 (...continued) vessel. The difference was built into the contract terms so that it was not due to some change in conditions, such as extraordinary wear of the vessel (leased asset). 13 We note that the parties, for purposes of this summary judgment motion, agree that the vessel’s value, without considering the value of the subject lease, was $14 million. Petitioner would attribute the difference between the $108 million acquisition cost and the $14 million to cancellation of the lease. Respondent, on the other hand would attribute the difference to value of the use of the acquired vessel for the remainder of its useful life. Respondent’s approach is in line with the approach, if not the intent, of sec. 167(c)(2) and existing case law. As discussed infra, the fair market value of the vessel when petitioner acquired it was more than $14 million (continued...) - 19 -
success in only one circuit and has not met with success in this
Court, the Court of Appeals for the Second Circuit, and the
Supreme Court.14
Petitioner attempts to bolster its argument by referencing
several cases where transactions were split or bifurcated to
permit differing results with respect to each portion of the
transaction. With one exception,15 the courts have not permitted
a current deduction to terminate a burdensome lease where the
lessee purchased the leased asset. There are cases permitting a
current deduction for the cost of terminating a burdensome lease
or contract obligation, but those cases do not involve the
13 (...continued) because of the value of the stream of income attributable to the lease. In the factual setting of this case, the fair market value of the vessel (as opposed to the value without considering the existing lease) included the stream of rental income. Accordingly a willing seller would not have ignored the value attributable to the use of the vessel, especially where the lessee was obligated to pay for that use, irrespective of whether the lessee used the vessel. When petitioner acquired the vessel, it acquired the physical asset and the right to its use. Petitioner in attempting to attribute the majority of the acquisition cost to an expense for canceling the lease, ignores its ability to use or lease the vessel. Accordingly, it is difficult to reconcile petitioner’s approach to value. 14 To some extent the case law that predated the enactment of sec. 167(c)(2) is instructive in interpreting the statute. The very approach suggested by petitioner has been thoroughly considered by this and other courts. 15 The exception is to be found in Cleveland Allerton Hotel, Inc. v. Commissioner, 166 F.2d 805 (6th Cir. 1948), revg. a Memorandum Opinion of this Court dated May 7, 1947, which is discussed in detail later in this opinion. - 20 -
acquisition of a capital asset. When section 167(c)(2) was
enacted, with the exception of some precedent in the Sixth
Circuit, the courts did not permit the approach sought by
petitioner here--allocating part of the cost of acquiring a
leased asset to a deductible expense (attributable to the
termination of a burdensome lease).
Generally, the courts have held16 that in the acquisition of
a leased asset, the portion of the cost attributable to an
existing lease is to be associated with or attributable to the
value of the asset. The value of the asset without considering
the lease has not been considered the true measure of the asset’s
value. To value the asset without considering the lease would be
to ignore a stream of income (rent) to which the owner of the
asset is entitled. A seller of an asset would not separate the
lease from the leased asset and ignore what may be the asset’s
principal source of value. At some point in the life of a leased
asset, the income (rent) to be derived may exceed the residual
value of the asset. That is why the vessel here (about halfway
through the term of a 20-year lease) may have a value (without
considering the lease) of about $14 million, whereas the income
16 The opinions in which this question was considered date back more than 40 years and preceded the enactment of sec. 167(c)(2) by more than 30 years. - 21 -
stream from the remaining life of the lease may have been valued
at about $94 million.17
Respondent contends that case precedent in existence prior
to the enactment of section 167(c)(2) is consistent with the
restriction contained in section 167(c)(2); i.e., that the buyer
may not allocate to the lease any portion of the acquisition cost
of the leased property. As explained above, petitioner contends
that its transaction is a two-part transaction and should be
bifurcated into the cost of acquiring a capital asset and the
cost of canceling or terminating a burdensome lease. Although
the acquisition of the vessel may have effectively terminated the
lease, the transaction which caused the lease termination was
capital in nature. Accordingly, a significant prerequisite to
petitioner’s success is its ability to bifurcate the cost
expended to acquire the capital asset and allocate the cost into
two portions--one attributable to the capital asset and the other
to the cost of terminating the burdensome lease.
Petitioner argues that the value of the vessel at the time
of the acquisition was substantially less than it was required to
17 The acquisition of a leased asset by the lessee is somewhat unique when compared to the acquisition of the asset by a third party. That is so because at the time of acquisition of a leased asset by the lessee, the leasehold interest merges into the fee ownership whereas a third-party purchaser of a leased asset does not experience a merger of interests. Petitioner’s approach would result in highly beneficial treatment to lessees that would not otherwise be available under sec. 167(c)(2) to lessors and others who might acquire leased assets. - 22 -
pay and the difference is attributable to the lease cancellation.
Petitioner’s characterization is no different from the arguments
that have been made in several cases considered by this and other
courts prior to the enactment of section 167(c)(2). Except for
the holding in one circuit, courts have not permitted a lessee’s
allocation of a portion of the acquisition cost of a leased
capital asset to the cancellation of a burdensome lease in order
to permit a business deduction under section 162. The Supreme
Court, the Court of Appeals for the Second Circuit, and this
Court have all reasoned that the value attributable to the
lease’s income stream represents value that a third-party buyer
would be required to pay the seller for the leased asset. As
pointed out above, no seller would part with a leased asset
without receiving value for the income attributable to the lease.
Using that rationale, the Supreme Court approved the Court of
Appeals for the Second Circuit’s approach of allowing the
acquisition cost (including the portion attributable to the value
of the lease) to be made part of the acquired asset’s depreciable
basis.
Petitioner’s argument was addressed about 40 years ago in
two seminal cases: Cleveland Allerton Hotel, Inc. v.
Commissioner, 166 F.2d 805 (6th Cir. 1948), revg. a Memorandum
Opinion of this Court dated May 7, 1947, and Millinery Ctr. Bldg. - 23 -
Corp. v. Commissioner, 21 T.C. 817 (1954), affd. in part, revd.
in part 221 F.2d 322 (2d Cir. 1955), affd. 350 U.S. 456 (1956).
Cleveland Allerton Hotel, Inc. involved a hotel that was
built on land subject to a 100-year lease with a $25,000 annual
rental. About 20 years into the lease the hotel owner acquired
the underlying land for $441,250. At the time of the
acquisition, the unimproved and/or unencumbered value of the land
was $200,000, and the adjusted basis for the building was
$267,150. The taxpayer/building owner added to the adjusted
basis of the building, for depreciation purposes, the excess paid
over the $200,000 value of the land. The question considered by
this Court was whether respondent erred in disallowing
depreciation by the taxpayer in excess of the preacquisition
adjusted basis ($267,150).
This Court decided that the taxpayer’s purchase of the land
for $441,250 was the value any purchaser would have paid for land
that had the benefit of an income-producing lease. Accordingly,
it was concluded that the entire acquisition cost represented a
nondepreciable capital expenditure attributable to the cost of
the land. On appeal, the Court of Appeals for the Sixth Circuit
reversed, concluding that the taxpayer was entitled to currently
deduct, as a business expense, the excess of $441,250 over the
$200,000 value of the unencumbered land as a cost of
extinguishing the lease. - 24 -
In Millinery Ctr. Bldg. Corp. v. Commissioner, supra, the
facts were essentially the same as in Cleveland Allerton Hotel,
Inc. v. Commissioner, supra, and the taxpayer, relying on the
Court of Appeals’ holding in Cleveland Allerton Hotel, Inc.,
sought to deduct the excess of the acquisition cost of the
underlying leased land over the unimproved value of the land.
This Court, choosing not to follow the holding of the Court of
Appeals for the Sixth Circuit, held that the excess was not
currently deductible as an ordinary and necessary business
expense. In addition, this Court held that the taxpayer was not
entitled to add the excess of the amount paid over the unimproved
value of the land to the depreciable basis of the building.
On appeal, the Court of Appeals for the Second Circuit
affirmed this Court’s holding that the excess was not currently
deductible as a business expense. The Court of Appeals, however,
reversed our holding that the taxpayer was not entitled to
allocate a portion of the acquisition cost to the depreciable
basis of the building. Accordingly, the Court of Appeals agreed
with this Court and disagreed with the Court of Appeals for the
Sixth Circuit with respect to whether any portion of the cost
allocable to the lease was currently deductible. Because of this
conflict between the Courts of Appeals, the Supreme Court granted
the taxpayer’s certiorari petition. - 25 -
The Supreme Court affirmed the holding of the Court of
Appeals for the Second Circuit; i.e., that the taxpayer was
entitled to an allocation of the acquisition cost between the
building and land and entitled to depreciate the basis over the
remaining useful life of the building.18 The Supreme Court noted
that, as lessee of the land, the taxpayer’s “ownership” or use of
its building was subject to significant control by the lessor and
to conditions of the lease. For example, the taxpayer’s right to
use its building was burdened by the payment of rent and the
obligation to relinquish use of the building and/or to demolish
the building at the end of the lease term. This point suggests
that in purchasing the land, the taxpayer may, to some extent,
have been perfecting unfettered ownership in the building.
In addition, the Supreme Court pointed out that the
Millinery Ctr. Bldg. Corp. v. Commissioner, supra, taxpayer did
not prove that its rental payments were excessive for what it was
leasing, and, therefore, the Supreme Court left for another day
the question of the deductibility of payments for relief from the
terms of a lease. In deciding that the approach of the Court of
18 The allocation permitted was between a depreciable (building) and a nondepreciable (land) portion of the merged interest. The Government did not seek Supreme Court review of the depreciation allowance of that portion of the acquisition cost that exceeded the value of the building’s remaining economic life. No portion was permitted to be deducted as current business expense attributable to the effective cancellation of the land lease. - 26 -
Appeals for the Second Circuit was correct, however, it would
appear that the approach of the Court of Appeals for the Sixth
Circuit was rejected. Accordingly, the vitality of the holding
in Cleveland Allerton Hotel, Inc. v. Commissioner, supra, holding
is questionable.19 In spite of these circumstances, petitioner
strongly urges that it is entitled to rely on the Cleveland
Allerton Hotel, Inc. holding.20 Further complicating
petitioner’s situation, any appeal of our decision here would be
to the Court of Appeals for the Second Circuit--the “Millinery
Ctr. circuit”. That, of course, militates against petitioner’s
chances for success on appeal, because petitioner would have to
19 Petitioner has provided only one case with comparable facts and squarely on point that followed Cleveland Allerton Hotel, Inc. v. Commissioner, supra. See Troc, Inc. v. United States, 126 F. Supp. 786 (N.D. Ohio 1954). In that regard, we note that the Troc, Inc. case preceded the Supreme Court’s opinion in Millinery Ctr. Bldg. Corp. v. Commissioner, 350 U.S. 456 (1956) and that it was within the Sixth Circuit Court of Appeals’ venue. 20 Petitioner also relies on Priv. Ltr. Rul. 98-42-006 (June 22, 1998) and Field Service Advice 199918022 (May 7, 1999), both of which were issued subsequent to the transaction in question and, accordingly, could not have been relied upon. The administrative discussions give petitioner some solace in their discussions of Cleveland Allerton and the absence of any discussion of or reliance on sec. 167(c)(2). Irrespective of the positions or discussions contained in those administrative documents, they are statutorily of no precedential value. See sec. 6110(k)(3). Respondent argues that the cited ruling and advice are distinguishable. Accordingly, whether the discussion or positions in rulings or internal advice memoranda are favorable or unfavorable to taxpayers, in the present situation we give them no weight. - 27 -
sway the thinking of the appellate court that expressly disagreed
with the Cleveland Allerton Hotel, Inc. holding.21
Accordingly, at the time of the enactment of section
167(c)(2), the weight of case authority did not permit the relief
sought by petitioner. More significantly, in affirming the
Second Circuit Court of Appeals, the Supreme Court’s holding in
Millinery Ctr. Bldg. Corp. v. Commissioner, supra, resulted in
the same outcome as the one prescribed by section 167(c)(2);
i.e., no allocation of the acquisition cost to the lease was
permitted in circumstances where a leased asset is acquired.
Further, both the case precedent and the statute require that all
of the cost be allocated to the depreciable capital asset.22
21 Respondent attempts to resolve these entangled circumstances by reference to our holding in Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971). There we expressed the view that we would conform to the holding of a Federal Court of Appeals that is squarely on point, irrespective of whether we agree with that Court of Appeals’ holding. We have specifically disagreed with the holding of the Court of Appeals for the Sixth Circuit’s Cleveland Allerton holding. See Millinery Ctr. Bldg. Corp. v. Commissioner, 21 T.C. 817, 823-824 (1954), affd. in part, revd. in part 221 F.2d 322 (2d Cir. 1955), affd. 350 U.S. 456 (1956). The appeal of this case, as noted above, will be to the Court of Appeals for the Second Circuit, which agreed with our holding and disagreed with the Court of Appeals for the Sixth Circuit. See Millinery Ctr. Bldg. Corp. v. Commissioner, 221 F.2d at 323. 22 Where land with improvements was acquired, the courts have permitted the excess of the purchase price over the value of the land to be allocated to the building, a depreciable asset. In the present case, no such nondepreciable asset (such as land) is involved, and under sec. 167(c)(2) all of the acquisition cost is to be allocated to the acquired leased property. - 28 -
Therefore, the existing case law and statutory provision are
generally in harmony. It may also be fair to say that Congress
was aware of the Supreme Court’s holding in Millinery Ctr. Bldg.
Corp. v. Commissioner, supra, when it enacted section 167(c)(2)
for leases as part of a larger statutory package intended to
result in uniform treatment for intangibles.
We note that allocation of the acquisition cost of a leased
asset under section 167(c)(2) operates irrespective of whether it
would have been more or less beneficial to the taxpayer to
allocate otherwise. In petitioner’s situation, it obviously
would be more beneficial if 87 percent of the acquisition payment
for the vessel was currently deductible as a business expense
incurred to terminate a burdensome lease. We can think of no
reason why petitioner, as a lessee, should be treated any
differently from a nonlessee/taxpayer who acquires a leased
asset. In that regard, petitioner has not provided any
persuasive evidence showing that Congress intended to exclude the
acquisition of a leased capital asset by the lessee. Nor has it
shown that Congress intended that the lessees should be allowed
to allocate a portion of the acquisition cost of an asset to a
lease and that lessors should not be so entitled.
In summary, petitioner has not shown that there is any
reason to read section 167(c)(2) to exclude transactions where a
lessee purchases the leased asset or to read the statute as - 29 -
applicable only to existing leases that are to continue in
futuro. In addition, the existing case precedent is in harmony
with section 167(c)(2) by not permitting allocation of a portion
of the purchase price of a leased asset to the value or cost of
the lease.
Accordingly, we hold that section 167(c)(2) applies to
petitioner’s acquisition of the vessel, and respondent’s Motion
for Partial Summary Judgment will be granted.
An appropriate order will be
issued.