Honeywell Inc. v. Comm'r of Internal Revenue
| Decision Date | 22 September 1986 |
| Docket Number | Docket No. 15807-83. |
| Citation | 87 T.C. 624,87 T.C. No. 37 |
| Parties | HONEYWELL INC. AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
P manufactured, leased, and sold computers and reported depreciation under the Class Life Asset Depreciation Range system described in section 1.167(a)-11(d)(3), Income Tax Regs. Literally applying the regulations, P reported sales of leased computers as credits to its depreciation reserve until the appropriate vintage account balance was exceeded, thereby delaying realization of income from sales. R determined that computers held for sale and/or lease were ‘dual purpose property‘ not covered by his regulations. Held: P correctly reported income from sales of computers.
P's subsidiary issued debentures convertible into stock of P. Held: (1) P cannot amortize as original issue discount a portion of the issue price attributable to the conversion privilege. (2) P cannot amortize as bond premium the difference between the fair market value of the stock issued on conversion and the face value of the debentures. National Can Corp. v. United States, 687 F.2d 1107 (7th Cir. 1982), followed. Clinton A. Schroeder, David C. Bahls, and Myron L. Frans for the petitioner.
James F. Kidd, for the respondent.
Respondent determined deficiencies of $1,592,852 and $9,542,483 in petitioner's Federal income taxes for 1976 and 1977, respectively. Certain of the adjustments in the statutory notice of deficiency have been resolved by agreement, and all of the facts have been stipulated. Three issues remain to be resolved on cross motions for partial summary judgment. They are:
(1) Whether sales of leased equipment depreciated under the Class Life Asset Depreciation Range (CLADR) system constitute ordinary retirements under section 1.167(a)-11(d)(3), Income Tax Regs.;
(2) whether amortizable original issue discount arises on the issuance of debentures by a subsidiary, convertible into stock of its parent, to the extent that the issue price is attributable to the conversion privilege; and
(3) whether amortizable bond premium arises upon conversion of debentures, equal to the difference between the fair market value of stock distributed in exchange for the debentures and the face value of the debentures.
Honeywell Inc. (petitioner) is a Delaware corporation with its corporate headquarters in Minneapolis, Minnesota. Petitioner and its numerous domestic and foreign subsidiaries engage on a worldwide basis in the design, manufacture, sale and service of automation equipment and systems, including automation systems and controls for homes and buildings, industrial controls and control systems, aerospace and defense systems, and computer and communication products.
Petitioner and its domestic subsidiaries file consolidated Federal income tax returns using the accrual method of accounting with the calendar year as the taxable year. Petitioner timely filed its Federal income tax returns for 1976 and 1977 with the Internal Revenue Service Center at Ogden, Utah. In addition to disputing the amounts determined by respondent in the statutory notice, petitioner contends that it overpaid its Federal income taxes by $415,509 and $361,591 for 1976 and 1977, respectively.
Since 1957 petitioner has developed and manufactured electronic data processing (EDP) systems. An EDP system, often termed and hereinafter referred to as a computer, is a complex series of equipment consisting of a central processor, input devices, and output devices. Input devices are mechanisms for reading data off punched cards, magnetic tape, and other similar input media and translating it into a form usable by a central processor. Output devices are mechanisms such as printers and magnetic tape units which transcribe data from the central processor into a form that can be used or stored outside the central processor.
Since 1970, petitioner's computer business has been conducted principally by its subsidiary, Honeywell Information Systems Inc. (HIS). For purposes of this action there is no need to differentiate between petitioner and HIS, so reference generally will be made simply to petitioner with the understanding that the activities described are in most instances carried on by HIS.
As petitioner's computer business evolved, it came to include both outright sales of new computers to customers, leases of computers to lessees and sales of leased computers to lessees. Petitioner now manufactures, sells, and leases computers.
The computer business is capital intensive, requires vast expenditures for research and development, and changes rapidly, with equipment quickly becoming technologically obsolete. This means, on the one hand, that manufacturers are particularly concerned with maximizing the number of units delivered to customers and, on the other hand, that customers are frequently reluctant to purchase computers outright. Leasing is a way to accommodate both sets of concerns and, consequently, the leasing of computers has become a significant economic activity.
A willingness to lease computers is a vital part of the business of computer manufacturers such as petitioner. Many potential customers either cannot afford to purchase the equipment or prefer to lease the equipment for financial, tax, or accounting reasons. From the manufacturer's point of view, the ability to lease computers enables it to reach more customers, which permits the generation of additional revenue to offset the massive overhead involved in the development and manufacture of computers. In the computer industry, leasing is so important that a failure to offer leasing as an option would seriously circumscribe a manufacturer's business by substantially reducing the volume of computers that it could ship to customers, thereby reducing its potential revenue and making it more difficult to operate profitably.
The computer business is a significant part of petitioner's business. Petitioner's revenue from its computer business in 1976 and 1977 was approximately 36 percent of its total revenues. More than 30 percent of total inventories as of December 31, 1977, related to its computer business. As of December 31, 1977, more than 70 percent of petitioner's investment in tangible property (land, buildings and improvements, machinery and equipment, and construction in progress), net of accumulated depreciation, was invested in property used in its computer business. During the years in issue, petitioner's investment in equipment leased by it to third parties was in excess of 60 percent of its total investment in tangible property, whether measured by cost or net book value.
Petitioner's revenues from computer rental and service were as follows in 1976 and 1977, which were typical of other years:
+-----------------------------------------------------------------------------+
¦ ¦1976 ¦1977 ¦
+---------------------------------------------------+------------+------------¦
¦Computer rental revenue ¦$304,000,000¦$323,000,000¦
+---------------------------------------------------+------------+------------¦
¦Computer service revenue ¦218,000,000 ¦275,000,000 ¦
+---------------------------------------------------+------------+------------¦
¦Total ¦522,000,000 ¦598,000,000 ¦
+---------------------------------------------------+------------+------------¦
¦Percentage of information systems (computer ¦57.1% ¦57.7% ¦
¦business) revenue ¦ ¦ ¦
+---------------------------------------------------+------------+------------¦
¦Percentage of total revenue ¦20.9 ¦20.5 ¦
+-----------------------------------------------------------------------------+
The computer service category includes maintenance service income on computers that have been leased as well as sold.
Petitioner must supply the capital to finance its costs of owning leased computers either through retention of earnings, issuance of stock or borrowing. Petitioner borrows substantial amounts of capital in order to finance its computer business in general and its ownership of leased computers in particular.
All leases of computers by petitioner were subject to written lease contracts. Various forms of contract were used from time to time, depending upon the length of the lease and other factors, and the forms in use were changed from time to time. Such contracts generally granted the lessee an option to purchase the leased equipment and provided that a portion of the rentals paid would be credited against the sale price upon the exercise of the option.
Some of the computers initially leased to customers in 1976 ultimately were sold in 1976. The total sales proceeds from the sale of such computers were $4,978,492. Some of the computers initially leased to customers in either 1976 or 1977 ultimately were sold in 1977. The total sales proceeds from the sales of such computers were $26,002,110.
Petitioner's cost of new computers originally placed in service by lease in each of the years 1976 through 1980, and the percentage, by cost, of those leased computers which were sold in each of the years 1976 through 1983 are as follows:
+-----------------------------------------------------------------------------+
¦Year placed ¦1976 ¦1977 ¦1978 ¦1979 ¦1980 ¦
¦in service ¦ ¦ ¦ ¦ ¦ ¦
+------------+------------+------------+------------+------------+------------¦
¦Cost of ¦ ¦ ¦ ¦ ¦ ¦
¦computers ¦ ¦ ¦ ¦ ¦ ¦
¦placed on...To continue reading
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