878 F.2d 306 (9th Cir. 1989), 87-7447, Cheng v. C.I.R.

Docket Nº:87-7447.
Citation:878 F.2d 306
Party Name:William P. CHENG, Petitioner-Appellant, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellee.
Case Date:June 27, 1989
Court:United States Courts of Appeals, Court of Appeals for the Ninth Circuit

Page 306

878 F.2d 306 (9th Cir. 1989)

William P. CHENG, Petitioner-Appellant,



No. 87-7447.

United States Court of Appeals, Ninth Circuit

June 27, 1989

Argued and Submitted Oct. 31, 1988.

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.


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

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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...

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