Cheng v. C.I.R.

• Decision Date: 27 June 1989
• Docket Number: No. 87-7447,87-7447
• Parties: -5130, 89-2 USTC P 9414 William P. CHENG, Petitioner-Appellant, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 306

878 F.2d 306

64 A.F.T.R.2d 89-5130, 89-2 USTC P 9414

William P. CHENG, Petitioner-Appellant, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 87-7447.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Oct. 31, 1988.

Decided June 27, 1989.

Yaakov Vanek and Eugene D. Silverman, De Castro, West, Chodorow & Burns, Los Angeles, Cal., for petitioner-appellant.

David M. Moore, Attorney, Tax Div., Washington, D.C., for respondent-appellee.

Appeal from a Decision of the Tax Court of the United States.

Before WRIGHT, NORRIS and WIGGINS, Circuit Judges.

WIGGINS, Circuit Judge:

William P. Cheng appeals from the Tax Court's grant of partial summary judgment in favor of the Commissioner of the Internal Revenue Service (Commissioner) upholding the Commissioner's determination that Cheng's minimum royalty payments of $20,000 in 1977 and $60,000 in 1978 for unmined diamonds were not deductible under Treas.Reg. Sec. 1.612-3(b)(3) (as amended in 1977). We conclude that we lack jurisdiction for want of an appealable final order and dismiss the appeal.

I

In 1977, Cheng entered into a five-year mining sublease with Imperial Finance, N.V. (Imperial). Under the terms of the sublease, Imperial granted Cheng the right to mine and remove diamonds from a specified parcel of land in South Africa leased by Imperial in exchange for a "minimum annual royalty" of $30,000 ¹ per lease year. The minimum annual royalty was subject to recoupment at the rate of $125.00 per carat on the first 1,200 carats (minimum yearly carats) mined by or on behalf of Cheng in that year. In the event the number of carats mined in any lease year was less than the minimum yearly carats, the resulting deficiency (cumulative deficiency) could be carried forward to subsequent lease years. ²

Although the term of the sublease was five years, after the first year and for each succeeding year, Cheng could terminate his obligations under the sublease simply by providing timely notice of his intent not to pay the minimum annual royalty. If Cheng gave notice of his intent not to pay the minimum annual royalty, his liability for any future minimum annual royalties terminated and he had no further rights under the agreement except with respect to any existing cumulative deficiency. If Cheng failed to pay the minimum annual royalty without notifying Imperial, Cheng forfeited all rights under the sublease agreement, including the right to any cumulative deficiency.

In order to finance the minimum royalty payments, Cheng entered into an agreement with the Bank of Nova Scotia. The Bank of Nova Scotia agreed to loan Cheng 80% of the initial minimum annual royalty, and up to 80% of the minimum annual royalty in each subsequent year. Interest was to accrue at the rate of 10% per annum on the unpaid balance. The principal amount of the note and any interest due was payable out of Cheng's share of any proceeds from the sale of diamonds mined on his behalf. Any unpaid principal was due and payable fifteen years from the date of the note. As security for the note, Cheng assigned to the Bank of Nova Scotia all his rights to any diamonds mined or proceeds from their sale. The note otherwise provided the Bank of Nova Scotia with no recourse against Cheng. In accordance with the terms of the agreement, Cheng paid $6,000 of the minimum annual royalty in cash, and executed a promissory note to the Bank of Nova Scotia for the balance of $24,000.

Cheng did not elect to terminate his sublease at the end of the first year. Instead, Cheng entered into a second sublease agreement with Imperial identical to the 1977 sublease. For the 1978 lease year, Cheng paid $60,000 to Imperial. Twenty percent, or $48,000 of the amount paid to Imperial was provided by an independent financial institution. It is unclear from the record whether the lending institution was the Bank of Nova Scotia. Cheng apparently executed a separate promissory note that was subject to the same terms and conditions as the 1977 note. Cheng continued to pay the minimum annual royalties through 1980, when he terminated his interest under the sublease agreements. ³ No diamonds were mined or sold on behalf of Cheng in either 1977 or 1978.

Cheng claimed a loss of $30,170.00 on his 1977 income tax return, and a loss of $60,340.00 on his 1978 income tax return. The additional claimed deductions of $170.00 in 1977, and $340.00 in 1978, apparently represented loan fees paid to the lending institution. The Commissioner disallowed Cheng's claimed deductions in their entirety on the ground that Cheng had not established that the losses were incurred in a trade or business. The Commissioner also disallowed Cheng's claimed deduction for his minimum annual royalty payments because they did not meet the requirements of Treas.Reg. Sec. 1.612-3(b)(3). Treas.Reg. Sec. 1.612-3(b)(3) permits the deduction of advanced royalties in "the year the mineral product, in respect of which the advanced royalties were paid or accrued, is sold." When, however, advance royalties are paid or accrued as a result of a "minimum royalty provision," the regulation provides that "the payor, at his option, may instead treat the advance royalties as deductions from gross income for the year in which the advanced royalties are paid or accrued," regardless of whether minerals are mined. Id. The regulation defines "a minimum royalty provision" as a provision that "requires that a substantially uniform amount of royalties be paid at least annually either over the life of the lease or for a period of at least 20 years...." Id.

Cheng petitioned the Tax Court for review of the Commissioner's determinations. In his petition, Cheng challenged the Commissioner's determination that the diamond mining venture was not a trade or business, and that the minimum annual royalty payments did not meet the requirements of Treasury Reg. Sec. 1.612-3(b)(3). He argued in the alternative that he should be permitted to deduct the total losses as a beneficiary of a trust established by Imperial or as a "theft and/or embezzlement loss."

The Commissioner moved for partial summary judgment on Cheng's claimed deductions for the minimum annual royalty payments under Section 1.612-3(b)(3). The Commissioner contended that Cheng's minimum annual royalty payments were not deductible because Cheng's obligation to make the annual payments was "illusory"; Cheng could avoid payment by providing timely notification of his intention not to pay. Alternatively, the Commissioner asserted that 80% of Cheng's claimed deductions should be disallowed because Cheng's nonrecourse notes were too contingent and speculative to be treated as bona fide indebtedness for tax purposes. Cheng opposed the Commissioner's motion and filed a cross-motion for partial summary judgment on the same issues.

The Tax Court denied Cheng's motion and granted the Commissioner's motion for partial summary judgment. The court held that the subleases did not satisfy the minimum annual royalty provision requirement under Treas.Reg. Sec. 1.612-3(b)(3), and that Cheng was therefore not entitled to deduct any portion of his minimum annual royalty payments. Relying on Wing v. Commissioner, 81 T.C. 17 (1983), the Tax Court concluded that the minimum annual royalty requirement under the subleases did not constitute a minimum royalty provision as defined in Treas.Reg. Sec. 1.612-3(b)(3) because there was no enforceable requirement that annual payments be made over the life of the lease. 51 T.C.M. (CCH) 861, 864 (1986). In the court's view, Cheng's "ability to withdraw from the lease at will 'belies any actual requirement to make annual royalty payments.' " Id. at 865. (quoting Capek v. Commissioner, 86 T.C. 14, 47 (1986)). Concluding that no payments were deductible under Treas.Reg. 1.612-3(b)(3), the court did not reach the question whether repayment of the nonrecourse notes was contingent on the success or failure of the mining venture and thus not deductible.

Following the entry of the Tax Court's order granting the Commissioner's motion for partial summary judgment, the parties entered into a stipulation and order to permit the entry of an appealable final order. The stipulation provides in relevant part:

Petitioner wishes to appeal the Court's order granting Respondent's motion for partial summary judgment. The parties recognize that in the event that the Court's motion for partial summary judgment is reversed on appeal and the case remanded to the Tax Court the remaining issues may have to be tried before the Court. However, in order to permit the entry of a final appealable decision at this time and without in any way impairing the parties ability to litigate the remaining issues, the parties hereby stipulate that:

[A final order] ... may be entered by the Court upon the stipulation that Petitioner is not conceding the remaining undecided issues and should a decision be entered in favor of Petitioner on appeal and the case remanded to the Court, Petitioner will, on remand, be permitted to present additional evidence and arguments in support of his entitlement to deduct the losses in issue, including those not addressed in the motion for partial summary judgment.

Under the terms of the stipulation Cheng agreed to permit the Tax Court to enter a decision in the full amount of the deficiencies asserted by the Commissioner, thereby waiving his claimed deductions for the loan fees as well as his other arguments in support of his entitlement to deduct his total losses for 1977 and 1978. In exchange, the Commissioner granted Cheng the right to resurrect the issues waived, including those not addressed in the motion for partial summary judgment, should the case be reversed by this court. Pursuant to the stipulation, the Tax Court entered a final order in the full amount of the deficiencies asserted by the Commissioner. Cheng appeals from the order entered by the Tax Court pursuant to the...