Mapco Inc. v. United
States (1977)
MAPCO INC. v. THE UNITED STATES
No. 287-74
UNITED STATES COURT OF CLAIMS
214 Ct. Cl. 389; 556 F.2d 1107;
77-2 U.S. Tax Cas. (CCH) P9476; 40 A.F.T.R.2d (RIA) 5144
June 15, 1977, Decided
CORE TERMS: pipeline, easement, right-of-way, income
tax, landowner,
certificates of deposit, offset, repayment, tenant,
future income,
certificate, lump-sum, purported, seller, net
operating loss carryover, obligated, borrowed, investment credit,
constructing, anticipated, conveyance, expire, entitled to recover, bona
fide sale, lump sum, carryover, assigned, acquire, earned, crops
SYLLABUS:
ON THE PROOFS
Taxes; income tax; tax period; net operating loss
carryover; assignment of income in exchange for lump-sum payment; credits
against tax; investment credit; pipeline construction costs v. easement
costs. -- Plaintiff, an accrual basis taxpayer, is a common carrier of
petroleum products through an interstate pipeline system. In order to
construct and lay pipelines across certain privately owned lands,
plaintiff purchased 50-foot right-of-way easements from the owners, and
also agreed to pay to the owners (and tenants) damages to crops, timber or
improvements on the lands arising from exercise of the rights granted.
Plaintiff had a net operating loss carryover expiring in 1966 if not
offset by reportable income in that year. In December 1966 plaintiff,
Chemical Bank New York Trust Company, and Rock Creek entered into a
transaction whereby plaintiff in return for $ 4 million in cash assigned
to Rock Creek a 75% interest in its future, unearned pipeline revenues
until the sum was paid off with interest. Rock Creek borrowed the money
from Chemical Bank and as security assigned to the bank its interest in
said future revenues. Contemporaneously plaintiff used the money to
purchase certificates of deposit issued by the bank, the maturity dates
coinciding with the anticipated dates for Rock Creek's repayments to the
bank. In 1967 the bank deposited proceeds from the matured certificates to
plaintiff's account and then transferred enough therefrom to pay Rock
Creek its profit margin and credited the remainder against the bank's loan
to Rock Creek plus appropriate interest. Plaintiff reported the $ 4
million as 1966 income for tax purposes only; plaintiff did not report as
income that portion of its revenues paid to Rock Creek. The IRS held that
all pipeline revenues earned by plaintiff in 1967 were taxable in that
year. Also on its 1967 and 1968 income tax returns, plaintiff claimed
investment credits on the basis of damage payments which it made pursuant
to said agreement, taking the position that the damage payments
constituted part of the cost of constructing the pipeline. The IRS
disallowed the credit, holding the damage payments were part of the cost
of obtaining the easements, i.e. intangible assets. It is held that the
assignment by Mapco to Rock Creek lacked commercial substance to be a bona
fide sale, and was ineffective to produce income as of the time of
assignment to offset the net operating loss carryover; the petition is
dismissed as to this claim. It is also held that the damage payments made
by plaintiff constituted pipeline construction costs; plaintiff is
entitled to recover on this claim. The amount of recovery will be
determined pursuant to Rule 131(c).
Taxes; income tax; form v. substance.
In resolving whether a bona fide sale has occurred for
income tax purposes, the court can consider motive, intent and conduct in
addition to what appears in written instruments made by the parties to
control rights among themselves. However, a transaction will not be
disregarded merely because it was entered into for tax-saving motives if
it otherwise has real substance.
Taxes; income tax; taxability of income; tax period;
sale v. loan-type investment.
Under the circumstances of the instant transaction,
whereby Rock Creek (RC) in exchange for a lump-sum payment, which it
borrowed from bank (C), received an assignment of future pipeline revenues
from plaintiff (M), and where M used the money to purchase certificates of
deposit issued by C which matured coincidently with RC's repayments to C
via transfers from M's account to RC's account, where RC was only to
receive a sum certain at an interest rate approximating the standard
prevailing rate, RC had no risk of eventual nonpayment, RC had none of the
usual risks or benefits associated with ownership of property, RC had no
dominion or control over the revenue payments, and M was not free to do as
it wished with the proceeds of the transaction, the transaction was not a
sale but was a loan-type investment, and was ineffective to produce income
as of 1966 to offset an expiring net operating loss carryover.
Taxes; income tax; credits against tax; investment
credit; damage payments; easement costs v. construction costs.
Where plaintiff, pursuant to conveyance of
right-of-way easements for purpose of constructing and laying
petroleum-carrying pipelines, made payments to private landowners and
tenants for damages to crops, etc. on lands along said easements, such
payments were an integral part of the cost of constructing the pipelines
(tangible property) rather than the cost involved in acquiring the
easements (intangible property), entitling plaintiff to investment tax
credit.
COUNSEL: J. W. Bullion, attorney of record, for
plaintiff. Buford P. Berry and Thompson, Knight, Simmons & Bullion, of
counsel.
Patricia B. Tucker, with whom was Acting Assistant
Attorney General Myron C. Baum, for defendant. Theodore D. Peyser, of
counsel.
JUDGES:
Davis, Judge, Skelton, Senior Judge, and Kashiwa,
Judge. White, Senior Trial Judge.
OPINIONBY: PER CURIAM; WHITE
OPINION: This tax refund action comes before the court
on plaintiff's and defendant's exceptions and briefs to the recommended
decision of Senior Trial Judge Mastin G. White, which he has submitted in
accordance with Rule 134(h) on August 25, 1976. Neither party has taken
exception to any of the trial judge's proposed findings of fact; however,
both parties have taken exception to the trial judge's recommended
conclusion of law. Upon consideration of the parties' briefs and after
having heard oral argument, the court agrees with the trial judge's
opinion and findings and adopts the same, with the following
modifications, as the basis for its judgment in this case. n1
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n1 The trial judge's findings of fact, copies of which
have been distributed to the parties, are not printed because those
essential to the decision appear in the opinion which follows.
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Pipeline Revenues
To reach his recommended conclusion of law that the
transaction in issue did not correspond with the concept of a sale, the
trial judge focused upon two ultimate facts: that the plaintiff obligated
itself to produce future pipeline revenues (T.J. op. 405) and that the
transaction was contrived solely for income tax purposes (T.J. op. 406).
However, we believe that more important than these facts are the facts
that Rock Creek was only to receive a sum certain at an interest rate
which approximated the standard prevailing rate; that Rock Creek had no
risk of eventual nonpayment; that Rock Creek had none of the usual risks
or benefits associated with ownership of property; that Rock Creek had no
dominion or control over the revenue payments; that Mapco was not free to
do as it wished with the proceeds of the transaction; and that Mapco
indirectly secured the repayment of Rock Creek's loan to Chemical Bank.
The three participants in the instant transaction are:
Mapco, the plaintiff-taxpayer; Chemical Bank; and Rock Creek. On December
22, 1966, the participants executed the documents necessary to effectuate
the transaction. Plaintiff, in return for $ 4 million in cash, assigned to
Rock Creek a 75 percent interest in its future, unearned revenues until
such time as Rock Creek had received $ 4 million plus interest on the
outstanding balance. The $ 4 million which Rock Creek paid to the
plaintiff was borrowed by Rock Creek from Chemical Bank; as security for
the loan from Chemical Bank, Rock Creek assigned only its interest in
plaintiff's future revenues to the bank. Contemporaneously with the above
transaction, plaintiff used the $ 4 million received to purchase
certificates of deposit issued by Chemical Bank. The maturity dates of the
certificates of deposit were selected to coincide with the anticipated
dates for the repayment to Chemical Bank of the $ 4 million borrowed from
that bank by Rock Creek. Chemical Bank held plaintiff's certificates of
deposit. After receiving notification from plaintiff about every two
weeks, the bank would deposit the proceeds from the matured certificates
into plaintiff's account and then transfer enough from that account to pay
Rock Creek its profit margin and to credit the remainder against the
outstanding balance of the bank's loan to Rock Creek and the interest due
on such loan.
Rock Creek did not report the pipeline revenues as
income when earned by Mapco, but only treated the interest differential,
viz., three-eighths of 1 percent, as income. Also, Rock Creek never
notified the customers of Mapco that the pipeline revenues had been
assigned. In 1966 plaintiff reported the $ 4 million as income for tax
purposes only; on its financial statements, plaintiff included the
relevant pipeline revenues as income in 1967. Although plaintiff admits
that it did not need or use the $ 4 million for any business purpose,
except to create in 1966 taxable income to offset a net operating loss
carryover which otherwise was scheduled to expire, defendant does not
claim that the transaction was devoid of legal effect or that the
consideration received was inadequate.
We have considered carefully all the evidence in this
case. Although the various transactions were constructed with an obviously
meticulous attention to detail, we agree with the trial judge that the
assignment by Mapco to Rock Creek of its future revenues, in substance,
was not a bona fide sale. Whether a bona fide sale has occurred depends
not upon the form of the transaction but upon its substance. n2 In other
words, we are merely employing the established principle that in resolving
such questions as whether there was a sale, the court can consider motive,
intent and conduct in addition to what appears in written instruments used
by the parties to control rights among themselves. n3 After examining the
extrinsic evidence behind the assignment of revenues in this case, we
believe that the transaction merely produced a loan-type investment
secured by the right to future revenue. This is not to say that the
assignment was invalid between the parties or that it was devoid of legal
effect. We merely are saying that the transaction was not an economically
real sale and, therefore, cannot be recognized as a sale for tax purposes.
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n2 Higgins v. Smith, 308 U.S. 473, 477-78 (1940).
n3 United States v. Cumberland Pub. Serv. Co., 338
U.S. 451, 454 note 3 (1950); Commissioner v. Tower, 327 U.S. 280, 289-91
(1946); Helvering v. Clifford, 309 U.S. 331, 335-37 (1940); Helvering v.
F. & R. Lazarus & Co., 308 U.S. 252, 255 (1939).
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We recognize that a transaction will not be
disregarded merely because it was entered into for tax-saving motives if
it otherwise has real substance. n4 Since a taxpayer is free to use all
lawful means to decrease taxes that he would otherwise be required to pay,
the mere fact that an otherwise bona fide transaction was entered into to
save taxes does not affect its validity for tax purposes. We also
recognize that a taxpayer may sell a property right to future income. If
the bona fide sale occurs at arm's length for adequate consideration, the
seller is taxed in the year of sale on the amount of consideration he
actually receives and the buyer is taxed on any excess of income received
over his purchase price. n5 However, if the purported sale of future
income is not bona fide, the "seller" cannot include in current
income the amount he was paid for "selling" his future income.
Instead, he is taxed on that income in the later year when it is collected
and paid to the "buyer."
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n4 Gregory v. Helvering, 293 U.S. 465 (1935).
n5 Wilkinson v. United States, 157 Ct. Cl. 847,
855-56, 304 F.2d 469, 472-73 (1962); Cotlow v. Commissioner, 228 F. 2d 186
(2d Cir. 1955).
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In determining whether the instant transaction was a
bona fide sale, we have concentrated on the economic substance of the
transaction rather than the mere form in which it was cast. To us, the
facts that valuable consideration was present and that the assignment had
legal effect between the parties are insufficient to show that a
substantive sale occurred. We readily admit that the distinction is narrow
between selling a property right to future income and assigning
anticipated income as collateral to secure financing. Nevertheless, we
feel that the distinction seems logically and practically to turn upon an
out-and-out economically realistic transfer of a substantial property
interest. Where the line of demarcation should finally be placed we need
not try to anticipate here. n6 But we are certain that distinctions
attempted on the basis of the various legal names given a transaction,
rather than on its actual results between the parties, do not afford a
sound basis for delimitation.
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n6 As stated by Mr. Justice Stone in Harrison v.
Schaffner, 312 U.S. 579, 583 (1941):
"* * * 'Drawing the line' is a recurrent
difficulty in those fields of the law where differences in degree produce
ultimate differences in kind." * * *
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As we interpret the facts of this case, the assignment
was actually in the nature of a nonrecourse secured loan. Because Rock
Creek was to receive 75 percent of Mapco's pipeline revenues until it
received $ 4 million, the transaction appears to be a loan for that
amount. Further, although Rock Creek had no rights against Mapco, Mapco
had a consistent record of earning pipeline revenues, of which Rock Creek
and Chemical Bank were aware. Since Rock Creek had the right to receive
payments until it was repaid, even if Mapco's revenues declined, Rock
Creek was certain to be repaid eventually. This certainty of repayment is
more characteristic of a loan than a sale. n7 Further evidence that the
risks were at most minimal is the fact that the interest rate calculated
on the basis of the period of repayment was the then standard prevailing
interest rate. Had the transfer involved risks of ownership, one would
expect a higher interest factor. Cumulatively, these factors lead us to
the inescapable conclusion that there is no difference between the
transaction in question and a nonrecourse secured loan at prevailing
interest rates. In other words, the consideration was not consideration
for a sale but principal loaned to a debtor.
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n7 The validity of a sale of income is enhanced where
the claim is contingent, doubtful and uncertain. Jones v. Commissioner,
306 F. 2d 292 (5th Cir. 1962) Although Rock Creek's claim against Mapco
was not contingent, we view this fact as merely an additional argument
against the commercial substance of the transaction to be a sale of
income.
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In addition to the fact that the transaction bore a
negligible risk factor, which evinces that it lacked commercial substance
as a sale, the fact that Mapco deposited the $ 4 million proceeds in
Chemical Bank certificates of deposit implies that Mapco indirectly
guaranteed repayment. Although we understand the assignment contract
specified that Mapco was not personally liable to Chemical Bank for Rock
Creek's loan and that Rock Creek and Chemical Bank -- as assignee of Rock
Creek's rights under the Mapco-Rock Creek assignment -- would look to the
transferred future pipeline revenue for their return, we do not feel that
the certificates of deposit were merely a handsel to Chemical Bank from
Mapco. Quite the contrary, by depositing in Chemical Bank the proceeds of
the Mapco-Rock Creek transaction, Mapco indirectly assured Chemical Bank
that it would comply with the assignment of revenue agreement. Moreover,
rather than directly underwrite the Chemical Bank-Rock Creek loan, Mapco
indirectly ensured or sponsored that loan by converting its proceeds into
those certificates. The maturity dates of the certificates of deposit were
specifically selected to coincide with the anticipated dates for the
repayment to Chemical Bank of the $ 4 million borrowed from that bank by
Rock Creek. Nevertheless, plaintiff points to its other creditors and
suggests that they, not Chemical Bank, required the proceeds of the
transaction to be deposited into a form so that Mapco could not spend the
proceeds prematurely to their detriment. We recognize that those creditors
played an important role for Mapco to acquire certificates of deposit;
however, those creditors did not mandate that Mapco acquire Chemical Bank
certificates. And, we do not subscribe to plaintiff's theory that it
acquired Chemical Bank certificates on its own volition. The exhibits to
the record evidence an understanding between Mapco and Chemical Bank that
Mapco would acquire that bank's certificates. We believe that this
understanding was vital to the whole transaction. While holding the
proceeds of the transaction, Chemical Bank, as assignee of Rock Creek's
rights, would be in a much better legal position to redress its rights
against Mapco, should Mapco default in its obligation to Rock Creek, than
if an independent third party held the proceeds of the Mapco-Rock Creek
transaction. The hypothecation of the $ 4 million was, in our opinion, an
integral part of the whole transaction, which precluded Mapco from doing
with the proceeds as it wished.
Lastly, we point to those facts which demonstrate to
us that Rock Creek had no dominion or control over the revenue payments
and had none of the usual risks or benefits associated with ownership of
property. It should first be noted that the pipeline revenues were never
paid to Rock Creek. Instead, the bank, upon notification by plaintiff,
would transfer an amount from plaintiff's regular account to credit Rock
Creek with its profit margin and to credit the outstanding balance of and
interest due on the bank's loan to Rock Creek. In light of the other facts
of this case, we think that this transfer arrangement has more
significance than mere convenience for the parties. We think it adds to
the evidence on record which demonstrates that Rock Creek did not consider
itself owning a property interest. When Rock Creek negotiated this
transaction, it was interested in only its fee, the three-eighths of 1
percent interest differential. Since it viewed no risk on repayment, Rock
Creek considered its profit margin to be determined by how long Mapco took
to pay off the $ 4 million. Rock Creek did not consider itself having
purchased an economic property interest in future revenues since it
neither notified Mapco's customers of the assignment nor reported the
pipeline revenues as income when earned by Mapco. As a result, on its
federal income tax returns Rock Creek treated only this interest
differential as income. n8
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n8 Bookkeeping entries and income tax returns,
although evidence of the facts which they purport to record, are not
conclusive. Helvering v. Midland Mut. Life Ins. Co., 300 U.S. 216, 223
(1937); Doyle v. Mitchell Bros. Co., 247 U.S. 179, 187 (1918).
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Based on all the facts of this case, which we have
examined cumulatively, having focused on no one fact, we agree with the
trial judge that the assignment by Mapco to Rock Creek of its future
revenues lacked commercial substance to be a bona fide sale. Accordingly,
the plaintiff's exceptions with relation to this issue are overruled and
the petition is dismissed as to such claim.
With relation to the issue concerning damage payments,
since the court agrees with the trial judge's recommended decision,
without modification, defendant's exceptions are overruled. It is
therefore concluded that plaintiff is entitled to recover on its claim
relating to damage payments, and judgment is entered for plaintiff with
the amount of recovery to be determined pursuant to Rule 131(c).
The trial judge's opinion, hereinabove modified by the
court, follows:
OPINION OF TRIAL JUDGE
White, Senior Trial Judge: The plaintiff, a common
carrier of petroleum products through an interstate pipeline system, sues
for the recovery of income taxes and interest which the plaintiff paid to
the Internal Revenue Service on or about September 6, 1972, in accordance
with deficiency assessments made by the IRS against the plaintiff for the
years 1967 and 1968.
For the years involved in the present litigation, the
plaintiff's books of account were maintained, and its tax returns were
filed, on the accrual basis and on the basis of a year that ended on
December 31.
The case presents two legal questions for
determination by the court:
(1) The first question is whether, for income tax
purposes, the plaintiff is entitled to investment credit under 26 U.S.C.
@@ 38 and 46-49 with respect to payments made by the plaintiff to
landowners and tenants as compensation [8] for damage done to crops, etc.,
in the course of constructing pipelines across lands owned or leased by
the payees.
(2) The second question is whether a lump sum which
the plaintiff received in exchange for an assignment of future pipeline
revenues constituted, for tax purposes, income to the plaintiff as of the
time when the lump sum was received.
Damage Payments
During the years involved in these proceedings, the
plaintiff constructed various pipelines across lands which were owned in
fee by other persons and which, in some instances, were occupied by
tenants. The pipelines were constructed on 50-foot right-of-way easements
previously acquired by the plaintiff from the owners of the particular
lands.
The normal sequence of events whereby the plaintiff
acquired a right-of-way easement across a particular parcel of land and
constructed a pipeline thereon was as follows: first, the plaintiff
purchased the easement and obtained a conveyance of it from the landowner;
and then, at a later time, the plaintiff cleared and graded the surface of
the land within the boundaries of the right-of-way, dug a ditch for the
pipeline, and laid the pipeline.
A right-of-way easement was customarily purchased for
a consideration that included a nominal lump sum (e.g., $ 5.00) plus a sum
calculated on the basis of an agreed amount per rod for the linear length
of the right-of-way. Upon paying the agreed lump sum and "roddage"
to the landowner, the plaintiff received from the landowner, through a
formal document of conveyance, a perpetual easement "to construct,
maintain, inspect, operate, protect, repair, replace, change the size of,
or remove a pipeline or pipelines, * * * within the confines of a right of
way 50 feet in width, * * * for the transportation of natural gas, oil,
petroleum products or any other liquids, gases or substances which can be
transported through a pipeline, * * * over, under, through and
across" certain land described in the document of conveyance.
The document conveying a right-of-way easement to the
plaintiff customarily contained the following provision that has special
significance in the present case:
Grantee [plaintiff] agrees to pay to the then owners
and to any tenant, as their interests may be, any and all damages to
crops, timber, fences, drain tile, or other improvements on said premises
that may arise from the exercise of the rights herein granted. * * *
When the time came for the plaintiff to utilize an
easement by clearing and grading the surface of the land within the
boundaries of the particular right-of-way, by digging a ditch for the
pipeline, and by laying the pipeline, such activities on the part of the
plaintiff generally caused damage to crops, timber, fences, drain tile, or
other improvements on the parcel of land where the work was performed. By
virtue of the provision in the document of conveyance that is quoted in
the immediately preceding paragraph of this opinion, the plaintiff was
obligated to pay, and did pay, the landowner (and the tenant, if any) for
all such damages. For example, the damage payments totaled $ 27,600 in
1967 and $ 425,484 in 1968.
In its income tax returns, the plaintiff claimed
investment credits in the amounts of $ 1,932 for 1967 and $ 29,783.88 for
1968 on the basis of the damage payments previously mentioned. These
amounts were disallowed by the Internal Revenue Service, and the propriety
of the administrative action is questioned by the plaintiff in the present
litigation.
The parties are in agreement that the question of
whether the plaintiff is entitled to investment credits on the basis of
the damage payments that are involved in the present litigation depends,
in turn, upon: (1) whether the damage payments should be regarded as part
of the cost of obtaining the right-of-way easements, which are intangible
assets (Panhandle Eastern Pipe Line Co. v. United States, 187 Ct. Cl. 129,
139-40, 408 F.2d 690, 697-98 (1969)) and are therefore outside the scope
of the provisions of the Internal Revenue Code authorizing investment
credit in certain situations (see 26 U.S.C. @ 48(a)(1)); or (2) whether
such payments should be regarded as part of the cost of constructing the
pipelines, which are tangible assets and provide a proper basis for
investment credit.
The problem of whether damage payments of the sort
involved here should be classified as easement costs or construction costs
was considered by another court in Tenneco, Inc. v. United States, 433
F.2d 1345 (5th Cir. 1970). In that case, the court reached the following
conclusion (at 1349):
We conclude that the damage amounts are properly
attributable to the cost of the easements. * * * We note that the
obligation to pay such amounts is incurred in the easement contract, even
though the actual payment is generally triggered by the construction * * *
of the pipeline. The construction of the pipeline and the damages incurred
result from utilization of the easement for which taxpayer contracted. We
think that the key lies in the fact that the damage amounts are paid to
the landowner for utilization of the contractual easement. They are
primarily easement costs, and only secondarily costs of the construction
of the pipeline. [Emphasis in original.]
The plaintiff in the present case contends (not
unexpectedly) that the court's conclusion in Tenneco was erroneous. With
all due respect to the other court, it is my opinion that the present
plaintiff has the better logic on its side in urging that damage payments
are an integral part of the cost of constructing a pipeline, rather than
part of the cost involved in acquiring right-of-way easements for the
pipeline.
In the usual situation, the purchase of a right-of-way
easement across a parcel of land is an entirely separate transaction --
and is chronologically removed -- from the making of a damage payment to
the landowner (or tenant). n1 Normally, the plaintiff first pays the
landowner the lump sum and the "roddage" that they have agreed
upon as the purchase price for the right-of-way easement, and the
landowner thereupon executes a formal document of conveyance granting a
perpetual right-of-way easement to the plaintiff. The easement vests in
the plaintiff at that time; and the vesting is not contingent in any way
upon the actual construction of a pipeline on the right-of-way at a later
time, resulting in an additional payment to the landowner (and tenant, if
any) for damages. It is only if -- and when -- the plaintiff subsequently
utilizes the easement, by clearing and grading the land within the
right-of-way, digging a ditch for the pipeline, and laying the pipeline,
that the plaintiff becomes obligated to pay the landowner (and tenant, if
any) for the damages occasioned by the plaintiff's construction
activities. Logically, it seems that such damage payments are as much a
part of the cost of constructing the pipeline as is the expense incurred
by the plaintiff in purchasing pipe for the pipeline.
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n1 In some instances, future damages are estimated and
paid for at the time when the easement is purchased.
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Accordingly, as the damage payments made by the
plaintiff constituted pipeline construction costs, the Internal Revenue
Service erred in denying the plaintiff investment credit with respect to
such payments; and the plaintiff is entitled to recover on this aspect of
its claim.
Pipeline Revenues
For the year 1966, the plaintiff had a net operating
loss carryover of approximately $ 4,700,000 that would expire at the end
of that year if not offset by income earned in 1966, and it also had a
carryover loss of approximately $ 548,034 that would expire at the end of
1967 if not offset by income earned in 1966 or 1967. It was anticipated by
the plaintiff that the taxable income from its operations in 1966 would
offset only about $ 1,600,000 of the carryover loss that would otherwise
expire at the end of 1966. Plaintiff's management was, quite naturally,
concerned over the possible expiration of the large loss carryovers, and
explored possible methods of realizing income to offset the losses.
After considering and rejecting various other
alternatives, the plaintiff's management began to investigate the
possibility of selling to someone the right to receive future pipeline
revenues in exchange for a lump-sum payment in 1966, which could be listed
as 1966 income for income tax purposes in order to offset the net
operating loss carryover that would otherwise expire at the end of 1966.
Such a possibility first occurred to Robert E. Thomas, chief executive
officer of the plaintiff. Mr. Thomas was familiar with the procedure
through which the plaintiff and other companies had previously acquired
interests in mineral properties in the form of carved-out production
payments.
In a carved-out production payment, the owner of
mineral-producing property sells to another person, for a stated price, an
interest in the minerals in place. Thereafter, as the minerals are
extracted, the purchaser of the mineral interest receives (in the typical
situation) a specified percentage of the production revenues until such
time as he shall have received a designated principal sum, plus an amount
equivalent to interest at a stated percentage.
The plaintiff's management ultimately decided that, as
a means of realizing income to offset the loss carryover for 1966, the
plaintiff would endeavor to make a sale of future pipeline revenues in
exchange for a lump-sum payment to be received in 1966. Mr. Thomas
thereupon approached William J. Sherry, president and principal
shareholder of Rock Creek Corporation ("Rock Creek"), and
inquired about the willingness of Mr. Sherry to act, through Rock Creek,
as the purchaser in such a transaction. Mr. Sherry, either personally or
through corporations which he controlled, had long been involved in the
acquisition of oil and gas production payments.
From the outset, Mr. Sherry was interested in the
proposal that his corporation, Rock Creek, acquire a pipeline revenue
payment from the plaintiff. However, a substantial period of time was
required for the specific details of the transaction to be agreed upon by
the interested parties.
After being approached by Mr. Thomas concerning the
possible acquisition of a pipeline revenue payment from the plaintiff, Mr.
Sherry conferred on several occasions with officials of Chemical Bank New
York Trust Company ("Chemical Bank"), with which Mr. Sherry and
his corporations had done business through the years, regarding the
possibility of obtaining from that bank funds with which to finance the
acquisition of the proposed pipeline revenue payment.
By May of 1966, Mr. Thomas, the chief executive
officer of the plaintiff, had been brought into the negotiations with
Chemical Bank; by late November of 1966, the details of a transaction
involving the plaintiff, Rock Creek, and Chemical Bank had been agreed to;
and on December 22, 1966, the various formal steps to effectuate the
transaction were taken by the several parties, as outlined in the
succeeding numbered paragraphs of this opinion.
(1) On December 22, 1966, the plaintiff and Rock Creek
entered into a formal agreement that was evidenced by a document entitled
"Assignment of Pipeline Revenues." This document declared that
the plaintiff, in exchange for the sum of $ 4,000,000 paid by Rock Creek,
"hereby sells, transfers, assigns and sets over" to Rock Creek
75 percent of all pipeline revenues accruing to the plaintiff after 7 a.m.
on December 30, 1966, and continuing until such time as Rock Creek
received the principal sum of $ 4,000,000, plus an amount equal to
interest at the rate of 6 3/8 percent per annum on the unliquidated
balance of the principal sum, plus reimbursement for expenses incurred by
Rock Creek up to a maximum amount of $ 3,750. The document also declared
that "Buyer [Rock Creek] shall look solely to Assigned Pipeline
Revenues for liquidation and discharge of the Pipeline Revenue Payment and
Seller [plaintiff] shall not be personally liable for the payment thereof
* * *." However, the plaintiff obligated itself in the agreement to
continue to operate its pipeline system properly during the life of the
agreement, and to use its best efforts not only to maintain pipeline
revenues at the then-current level but to increase them if possible. (In
this connection, projections of the plaintiff's future monthly income had
been prepared in early December of 1966, and such projections indicated
that the transaction would be fully liquidated by July of 1967.)
(2) The $ 4,000,000 which Rock Creek paid to the
plaintiff was borrowed by Rock Creek from Chemical Bank. The borrowing was
evidenced by Rock Creek's promissory note of December 22, 1966, bearing
interest at the rate of 6 percent per annum and being secured by an
assignment of Rock Creek's right, title, and interest in the pipeline
revenue payment from the plaintiff.
(3) The $ 4,000,000 which the plaintiff received from
Rock Creek was used by the plaintiff contemporaneously to acquire
certificates of deposit from Chemical Bank. The certificates of deposit
ranged in amount from $ 125,000 to $ 312,500, they bore interest at the
rate of 5.1 percent per annum, and they were to mature at 2-week intervals
beginning February 16, 1967, and ending June 1, 1967. The maturity dates
of the certificates of deposit corresponded with the anticipated dates for
the repayment to Chemical Bank of the $ 4,000,000 which Rock Creek
borrowed from the bank.
Chemical Bank held the certificates of deposit, and
was directed by the plaintiff to deposit the proceeds to the plaintiff's
account as each certificate matured. Also, an arrangement was made whereby
Chemical Bank, upon being notified by the plaintiff every 2 weeks of the
amount of pipeline revenues earned during the preceding period, was
authorized to transfer 75 percent of such amount from the plaintiff's
account, to credit Rock Creek with its profit margin of 3/8ths of 1
percent, and to credit the remainder against the outstanding balance of
the bank's loan to Rock Creek and the interest due on such loan.
The $ 4,000,000 payment which the plaintiff received
from Rock Creek on December 22, 1966, was reported by the plaintiff in its
income tax return for 1966 as income realized during that year, and it was
used as an offset against the net operating loss carryovers previously
mentioned. Subsequently, in 1967, as 75 percent of the plaintiff's
pipeline revenues were paid over to Rock Creek in accordance with the
assignment of December 22, 1966, the plaintiff did not report that portion
of its revenues as income for tax purposes. The plaintiff's income tax
return for 1967 showed that no tax was due. The Internal Revenue Service
took a different view of the matter, however, and held that all the
pipeline revenues earned by the plaintiff in 1967 were taxable in that
year. The IRS assessed against the plaintiff income tax in the amount of $
580,669.67, plus interest in the amount of $ 155,118.34, for the year
1967; and these amounts were duly paid by the plaintiff.
In two cases with facts similar in all substantial
respects to those of the present case, the Court of Appeals for the Fifth
Circuit affirmed, without discussion, decisions by the Tax Court to the
effect that attempted sales of future revenues for lump-sum payments were
ineffective to produce income for the purported sellers as of the times
when the lump-sum payments were received. One of the cases, Martin v.
Commissioner, 56 T.C. 1255 (1971), affirmed, 469 F. 2d 1406 (5th Cir.
1972), involved a purported sale of future rents by the owner of an
apartment building. The other case, Hydrometals, Inc. v. Commissioner, 31
TCM 1260 (1972), affirmed, 485 F. 2d 1236 (5th Cir. 1973), cert. denied,
416 U.S. 938 (1974), involved a purported sale of future manufacturing
revenues by a manufacturing company.
On the other hand, the Court of Appeals for the Sixth
Circuit has held that a sale of future dividends by an owner of corporate
stock for a lump-sum payment should be recognized for income tax purposes
as resulting in income to the seller when the lump-sum payment was
received. Estate of Stranahan v. Commissioner, 472 F. 2d 867 (6th Cir.
1973).
The principal difference between the Stranahan case,
on the one hand, and the Martin and Hydrometals cases, on the other hand,
is that in Stranahan the seller of the future income was not under any
obligation whatever to produce such income for the benefit of the
purchaser, who was compelled to look solely to a third person (the
corporation which issued the stock) for the future income that he had
purchased, whereas in the Martin and Hydrometals cases the purported
sellers of future income were themselves obligated to produce future
income for the benefit of the purported buyers. Thus, in substance, the
transactions in the Martin and Hydrometals cases were more like loans that
were to be repaid, with interest, by borrowers out of their own productive
efforts, than like true sales agreements.
As previously stated, the facts in the present case
are similar in all substantial respects to those of the Martin and
Hydrometals cases. Here, the plaintiff was obligated to produce the future
pipeline revenues that Rock Creek was to receive under the agreement of
December 22, 1966. Although the plaintiff did not, in terms, guarantee the
repayment of the $ 4,000,000 principal sum to Rock Creek, plus the
interest equivalent of 6 3/8 percent, plus reimbursement for Rock Creek's
expenses, the plaintiff, in substance, obligated itself to such a program.
The plaintiff specifically obligated itself to continue to operate the
pipeline system properly during the life of the agreement, and also
obligated itself to use its best efforts not only to maintain the pipeline
revenues at their then-current level (which would be sufficient to
liquidate the transaction by July 1967) but to increase such revenues, if
possible. Thus, when the agreement of December 22, 1966, was entered into,
it was certain, as a practical matter, that the plaintiff would itself
repay the $ 4,000,000 principal sum, plus the interest equivalent, plus
reimbursement for Rock Creek's expenses, within a matter of several
months. The agreement of December 22, 1966, therefore, was more in the
nature of a loan-and-repayment transaction than it resembled a
sale-and-purchase transaction.
Moreover, it is at least worthy of some consideration
that the transaction of December 22, 1966, was contrived solely for income
tax purposes. The plaintiff did not need or use the $ 4,000,000 which it
received from Rock Creek for any business purpose, except the attempt to
create in 1966 taxable income to offset the net operating loss carryover
which otherwise was scheduled to expire at the end of 1966.
It is my opinion that the Internal Revenue Service did
not err in refusing to recognize the December 22, 1966, transaction
between the plaintiff and Rock Creek as affecting the plaintiff's income
for tax purposes.
CONCLUSION OF LAW
Upon the trial judge's findings and opinion, which are
adopted by the court as modified, the court concludes as a matter of law
that the plaintiff is entitled to recover on its claim relating to damage
payments, together with interest as provided by law, and judgment is
entered to that effect. The amount of the recovery will be determined in
subsequent proceedings pursuant to Rule 131(c).
The court further concludes as a matter of law that
the plaintiff is not entitled to recover on its claim relating to the
purported sale in 1966 of future pipeline revenues, and the petition is
dismissed as to such claim.
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