Custom Chrome v. Comm'r on Internal Revenue

• Decision Date: 14 April 2000
• Docket Number: No. 98-71378,98-71378
• Citation: 217 F.3d 1117
• Parties: (9th Cir. 2000) CUSTOM CHROME, INC., and Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1117

217 F.3d 1117 (9th Cir. 2000)

CUSTOM CHROME, INC., and Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 98-71378

U.S. Court of Appeals for the Ninth Circuit

Argued and Submitted April 14, 2000--San Francisco, California

Filed July 10, 2000

[Copyrighted Material Omitted] Harry J. Kaplan, San Jose, California, for the petitioner-appellant.

Richard Farber, Tax Division, U.S. Department of Justice, Washington, DC, for the respondent-appellee.

Appeal from a Decision of the United States; Tax Court Tax Ct. No. 5530-96

Before: A. Wallace Tashima and Susan P. Graber, Circuit Judges, and Alicemarie H. Stotler, District Judge*.

TASHIMA, Circuit Judge:

Custom Chrome, Inc., an independent supplier of Harley-Davidson motorcycle parts and accessories, and its subsidiaries, appeal from the decision of the Tax Court determining deficiencies in Custom Chrome's income taxes for the tax years 1992-1994. Specifically, Custom Chrome appeals the Tax Court's determination that warrants issued by Custom Chrome to its lender in connection with a loan transaction were valueless, so that Custom Chrome was not entitled to any deductions relating to the warrants. Custom Chrome also appeals the Tax Court's holding that it was not entitled to deduct fees relating to the acquisition of its sole shareholder's stock. The Tax Court had jurisdiction pursuant to 26 U.S.C. SS 6213 and 7442. We have jurisdiction pursuant to 26 U.S.C. S 7482, and we affirm in part, reverse in part, and remand for further proceedings.

I. Factual and Procedural Background¹

In the late 1980s, the Jordan Company ("Jordan") entered into an agreement with Tyrone Cruze ("Cruze"), the sole shareholder of Custom Chrome,² to purchase all of Cruze's stock for $16.75 million, along with an extra $5 million for a covenant not to compete and an additional $2.6 million to enable him to pay federal taxes for prior years. Jordan's purchase of stock was structured as a leveraged buyout whereby a holding company and an acquisition company were utilized to purchase Cruze's shares. Subsequent to the purchase, the acquisition company was merged into Custom Chrome, which became a wholly-owned subsidiary of the holding company.

Three groups funded the buyout. The acquisition company borrowed $26 million from the First National Bank of Boston ("FNBB"). The holding company borrowed $7 million from Mezzanine Capital and Income Trust ("Mezzanine"). Finally, the holding company raised $500,000 through the sale of its stock to insiders at $500 per share.

In connection with its $26 million loan, FNBB received warrants (in essence, options) to purchase effectively up to 12.5 percent of the stock of Custom Chrome at $500 per share the same price paid by the insiders. The warrants also contained a put option that allowed FNBB to sell a portion of the warrants back to Custom Chrome at specified times according to a formula price. According to FNBB's officers, the warrants were intended to compensate FNBB for the high risk associated with providing the loan. FNBB loan officers thought that the warrants might be worth as much as $5 million in five years, and the terms of the warrants were hotly negotiated among the interested parties.

FNBB listed on its books, however, that the warrants were purchased in their entirety for $1,000. Shortly after acquiring the warrants, FNBB assigned them to Bank of Boston Capital ("BancBoston") [FNBB and BancBoston are collectively referred to as the "Bank"], which also listed on its books the value of the warrants as $1,000. BancBoston subsequently assigned a portion of the warrants to Security Pacific National Bank ("Security Pacific") for an unspecified amount.

In connection with the buyout of Cruze, the acquisition company incurred expenses of $1,342,347. Of that amount, $692,347 represented finance charges for the loan provided by FNBB and Mezzanine, and the remaining $650,000 was for legal and professional fees relating to the acquisition of Cruze's stock.

In late 1991, Custom Chrome's stock was offered to the public in an initial public offering ("IPO") at $10 per share. At that time, BancBoston and Security Pacific exercised their warrants, receiving a total of 313,125 shares of stock with a combined value (net of the exercise price) of $3.07 million. In July 1993, Jordan sold off all its stock in Custom Chrome in a secondary public offering.

On its federal income tax returns, Custom Chrome did not take any deductions relating to the issuance of the warrants. FNBB reported the warrants on its books with a value of $1,000, but it did not report any income relating to the issuance of the warrants.

After the Commissioner disallowed various claimed deductions (including those relating to the fees incurred in the purchase of Cruze's stock) for the tax years at issue and assessed penalties thereon, Custom Chrome petitioned the Tax Court for a redetermination of its income tax liabilities, claiming inter alia that the grant of the warrants entitled it to deductions of approximately $3.07 million.

The Tax Court found the warrants should be valued at the time of issuance. See Custom Chrome, Inc. v. Commissioner, 76 T.C.M. (CCH) 386, 393, 1998 WL 556319 (1998) ("Custom Chrome I"). Specifically, it held that, because the warrants were part of a loan package -as opposed to a trade discount or in exchange for services rendered -original issue discount rules, which mandated the time of valuation as of issuance, applied. See id. The Tax Court then found that the warrants had no value at the time of issuance because: (1) they were "at the money" (i.e., at the same price as the stock itself); (2) any future value was highly speculative; (3) FNBB had reported their value as $1,000; and (4) Custom Chrome failed to take any deductions with respect to the warrants on its original returns. See id. at 393-94. Furthermore, the Tax Court found no evidence to support the claim that the loan would have been offered only at a higher interest rate if the warrants had not been issued. See id. at 393.

The Tax Court also held that the $650,000 of expenses incurred in the purchase of Cruze's stock was barred by I.R.C. S 162(k) because, under the step transaction doctrine, the purchase was a redemption of stock by Custom Chrome. See id. at 392-93. Relatedly, the Tax Court determined that the accuracy-related penalty assessed by the Commissioner under I.R.C. S 6662(a) was warranted, because Custom Chrome had not shown any substantial authority supporting its deduction of the $650,000 in fees. See id. at 394. Custom Chrome timely appealed to this court.

II. Standards of Review

We review decisions of the Tax Court under the same standards as we review civil bench trials in the district court. See Estate of Rapp v. Commissioner, 140 F.3d 1211, 1214 (9th Cir. 1998). Although a presumption exists that the Tax Court correctly applied the law, no special deference is given to the Tax Court's decisions. See AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164 (9th Cir. 1992). Therefore, we review Tax Court conclusions of law de novo, see Harbor Bancorp & Subsidiaries v. Commissioner, 115 F.3d 722, 727 (9th Cir. 1997), and questions of fact for clear error, see Boyd Gaming Corp. v. Commissioner, 177 F.3d 1096, 1098 (9th Cir. 1999).

The Tax Court's choice of method under the applicable statutes and regulations to value the warrants is an issue of law subject to de novo review. See Monarch Cement Co. v. United States, 634 F.2d 484, 486 (10th Cir. 1980). Assuming that the Tax Court utilized the correct method to value the warrants, its determination of that value is a finding of fact subject to the clearly erroneous standard of review. See id. at 485. The Tax Court's determination that the several steps of a complex transaction are, under the step transaction doctrine, a single taxable transaction is a finding of fact subject to the clearly erroneous standard of review. See Robino, Inc. Pension Trust v. Commissioner, 894 F.2d 342, 344 (9th Cir. 1990). The Tax Court's factual findings regarding the penalty for substantial understatement of income tax are reviewed under the clearly erroneous standard of review. See Little v. Commissioner, 106 F.3d 1445, 1449 (9th Cir. 1997).

III. Discussion

A. The Appropriate Time for Valuing the Warrants

When a loan is provided at a face value higher than the amount actually loaned, the debtor is allowed to deduct the difference over the life of the loan as original issue discount ("OID"), while the creditor realizes the OID as ordinary income. See I.R.C. SS 163(e)(1) & 1272(a)(1).³ Under I.R.C. S 1273(c)(2), whenever "any debt instrument and an option . . . [are] issued together as an investment unit . . . the issue price for such unit shall be determined . . . as if it were a debt instrument."⁴ Under I.R.C.S 1273(b)(2), for non-publicly traded debt instruments, "the issue price of each such instrument is the price paid by the first buyer of such debt instrument."

Here, the warrants (effectively equivalent to options⁵) were granted at the same time the loan was provided to Custom Chrome. The most straightforward reading of S 1273 is that the value of the warrants should be considered as OID and should be valued at the time the warrants were granted. First, the warrants were clearly intended to compensate the Bank for its additional risk, thereby raising the effective interest rate of the loan and resulting in OID. Second, in order to deduct the OID ratably over the life of the loan, it is necessary to value the warrants at the time of grant. This is borne out by reading together SS 1273(b)(2) and (c)(2), which require that the warrants be valued as part of the "price paid by the first buyer of such debt instrument." I.R.C. S 1273(c)(2) (emphasis added). The most sensible approach is that the first buyer's price must be determined at the time of that buyer's purchase of the debt...