Rice's Toyota World, Inc. v. C.I.R.

• Decision Date: 07 January 1985
• Docket Number: No. 84-1246,84-1246
• Citation: 752 F.2d 89
• Parties: -580, 85-1 USTC P 9123 RICE'S TOYOTA WORLD, INC. (Formerly Rice Auto Sales, Inc.), Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 89

752 F.2d 89

55 A.F.T.R.2d 85-580, 85-1 USTC P 9123

RICE'S TOYOTA WORLD, INC. (Formerly Rice Auto Sales, Inc.), Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 84-1246.

United States Court of Appeals, Fourth Circuit.

Argued Nov. 1, 1984.

Decided Jan. 7, 1985.

William L. Tankersley, III, Greensboro, N.C. (J. Reed Johnston, Jr., Tuggle, Duggins, Meschan & Elrod, P.A., Greensboro, N.C., on brief) for appellant.

Bruce R. Ellisen, Tax Div., Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Tax Div., Dept. of Justice, Washington, D.C., on brief) for appellee.

Before HALL, PHILLIPS, and SPROUSE, Circuit Judges.

JAMES DICKSON PHILLIPS, Circuit Judge:

Rice's Toyota World (Rice) appeals the Tax Court's decision upholding the Commissioner's disallowance of interest and depreciation deductions that Rice took on income tax returns filed for 1976, 1977 and 1978 on the basis that underlying sale and leaseback transactions were, for tax purposes, a sham. We affirm disallowance of the depreciation deductions and a portion of the interest deductions; but we reverse disallowance of a portion of the interest deductions.

I

In form the transactions in issue involved the sale and leaseback of a used computer and financing of the purchase by secured recourse and nonrecourse notes payable to the seller. The principal officer of Rice, a company primarily engaged in the sale of automobiles, learned about computer purchase-and-leaseback transactions through a friend who had already entered into a similar transaction through Finalco, a corporation primarily engaged in leasing capital equipment. Rice's accountant contacted Finalco to request information, and Finalco mailed Rice literature describing potential transactions. Finalco's literature noted that the transactions generate large tax losses in early years because the purchaser could claim depreciation deductions calculated under accelerated depreciation provisions as well as interest expense deductions. The transactions produce income in later years as depreciation deductions decrease.

After meeting with a Finalco representative, Rice purchased a used computer from Finalco in 1976 for a total purchase price of $1,455,227, giving Finalco a recourse note in the amount of $250,000 payable over three years, ¹ and two nonrecourse notes in the amount of $1,205,227 payable over eight years. Finalco had recently purchased the used computer for $1,297,643.

Rice leased the computer back to Finalco for a period of eight years, beginning in 1976. Under the lease, rental payments exceeded Rice's obligations on the nonrecourse debt by $10,000 annually. Finalco's obligations to pay rent were made contingent on its receiving adequate revenues in subleasing the computer. At the time of Rice's purchase and leaseback of the computer, Finalco had arranged a five year sublease of the computer. Finalco was entitled to 30 percent of proceeds generated if it arranged re-lease or sale of the computer after expiration of the five year sublease.

Rice paid off the $250,000 recourse note in three years along with $30,000 in interest on the deferred installments. On its income tax returns for 1976, 1977, and 1978, it claimed accelerated depreciation deductions based upon its ownership of the computer, and interest deductions for its payments on the notes.

The tax court upheld the Commissioner's disallowance of all the depreciation deductions and the interest expense deductions based on both the recourse and nonrecourse notes because the court found that the sale and leaseback was a sham transaction that the Commissioner is entitled to ignore for tax purposes. Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184 (1983). The tax court found as fact that Rice was not motivated by any business purpose other than achieving tax benefits in entering this transaction, and that the transaction had no economic substance because no reasonable possibility of profit existed. Id. at 200-10. The court accordingly held as a matter of law that the transaction should be treated for tax purposes as if Rice paid Finalco a fee, in the form of the cash payment of $62,500 made on the recourse note in the year of purchase, ² in exchange for tax benefits. Id. at 207 and 210.

This appeal followed.

II

The tax court read Frank Lyon Co. v. United States, 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978), to mandate a two-pronged inquiry to determine whether a transaction is, for tax purposes, a sham. To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists. Rice's Toyota, 81 T.C. at 209; see also Hilton v. Commissioner, 74 T.C. 305, 349-50 (1980), aff'd per curiam 671 F.2d 316 (9th Cir.1982). We agree that such a test properly gives effect to the mandate of the Court in Frank Lyon that a transaction cannot be treated as a sham unless the transaction is shaped solely by tax avoidance considerations. See 435 U.S. at 583-84, 98 S.Ct. at 1303-04.

Whether under this test a particular transaction is a sham is an issue of fact, and our review of the tax court's subsidiary and ultimate findings on this factual issue is therefore under the clearly erroneous standard. Boyter v. Commissioner, 668 F.2d 1382, 1388 (4th Cir.1981). Applying that standard, we affirm the tax court's findings on the sham issues.

A

The business purpose inquiry simply concerns the motives of the taxpayer in entering the transaction. The record in this case contains ample evidence to support the tax court's finding that Rice's sole motivation for purchasing and leasing back the computer under the financing arrangement used was to achieve the large tax deductions that the transaction provided in the early years of the lease. ³

First, the record supports the court's subsidiary finding that Rice did not seriously evaluate whether the computer would have sufficient residual value at the end of the eight year lease to Finalco to enable Rice to earn a profit on its purchase and seller-financed leaseback. Under the purchase and lease agreements with Finalco, Rice was obligated to pay (and did pay) $280,000 to Finalco in the form of principal and interest on the recourse note. Finalco's rental payments provided Rice with a return on the investment of $10,000 annually after payment of Rice's principal and interest obligations under the nonrecourse notes. At the time of the lease, Rice could therefore be certain of receiving a $50,000 return since Finalco had subleased the computer for five years, but Rice could recover the additional $230,000 of its investment only if it could re-lease the computer after five years or realize a substantial amount by its sale. Profit on the transaction therefore depended upon re-lease or sale because Finalco had no obligation to pay rent under its lease unless it received adequate revenues in subleasing the computer. Moreover, the sale and leaseback agreement gave Finalco a "marketing fee" of 30 percent of re-lease or sale proceeds if Finalco arranged the subsequent deal, thereby increasing further the amount Rice had to receive on re-leasing or selling the computer to earn a profit.

Residual value of the computer (either in selling or releasing) should therefore have been the crucial point of inquiry for a person with a business purpose of making a profit on this transaction. However, Rice's principal officer knew virtually nothing about computers, and relied almost exclusively on the representations of a Finalco salesperson regarding expected residual value. Despite the Finalco representative's frank concession that he was not an expert in predicting residual values, Rice did not pursue the representative's offer to provide an expert appraisal of likely residual value. Rice's accountant advised that the transaction appeared to be profitable, but the record does not reveal that the accountant's opinion reflects anything more than the fact that the transaction, if successful, would generate large tax deductions. Although Rice had in its possession a report containing a chart that showed a possibility that the computer would have sufficient residual value to earn Rice a profit, the report warned of great risk in predicting residual values, and also showed a large possibility of losses on the transaction. ⁴

The record contains additional support for drawing the ultimate inference that Rice was not motivated by potential profit. First off, Finalco's literature emphasized the large tax deductions the transaction would produce, not the potential for profit. To the contrary, the literature warned of great difficulty in predicting residual values.

More critical is the evidence that Rice paid an inflated purchase price for the computer: $1,455,227 for a used computer that Finalco had recently purchased, in an already declining market, for only $1,297,643. Considering that Finalco had a right to 30 percent of re-leasing or sale proceeds after five years, Rice can more accurately be said to have purchased for this amount only 70 percent of a computer, then worth less than $1,000,000. Because Rice paid so obviously inflated a purchase price for the computer and financed the purchase mainly with nonrecourse debt, it was properly inferable by the tax court that Rice intended to abandon the transaction down the road by walking away from the nonrecourse note balance before the transaction ran its stated course. See Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-49 (9th Cir.1976); Rice's Toyota, 81 T.C. at 209. The inference is amply supportable that this intended course of conduct explains Rice's apparent lack of concern with residual value or profitability of the transaction apart from tax benefits.

Rice points to several items of evidence...