Upham v. C.I.R.
| Decision Date | 24 January 1991 |
| Docket Number | No. 90-1172,90-1172 |
| Parties | -481, 91-1 USTC P 50,050 John D. UPHAM, and Estate of Marion B. Upham, Deceased, John D. Upham, Personal Representative, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. |
| Court | U.S. Court of Appeals — Eighth Circuit |
Richard E. Timbie, Washington, D.C., for appellants.
Nancy Morgan, Washington, D.C. for appellee.
Before LAY, Chief Judge, and BRIGHT and TIMBERS, * Senior Circuit Judges.
John D. Upham and the Estate of Marion B. Upham appeal the decision of the United States Tax Court 1 in favor of the Commissioner of the Internal Revenue Service (Commissioner). The appeal relates to certain disallowed deductions and an investment tax credit flowing from John D. Upham's share as a limited partner in an investment partnership which purchased rights in a motion picture. Taxpayer 2 primarily contends that the tax court erred in finding that the partnership had not acquired any substantial ownership of the film, but only a contract right to participate in the exploitation proceeds, with the resulting adverse tax consequences. For the reasons stated below, we affirm.
Taxpayer purchased a one-third interest in one unit of a limited partnership, Prince Associates (partnership). 3 The partnership was organized and promoted by Daniel Glass, a New York attorney who promotes movie tax shelters, 4 to purchase and exploit the feature-length film, "Prince of the City." The tax deficiency assessed by the Commissioner and upheld by the tax court arose from the disallowance of deductions and an investment tax credit claimed by the taxpayer relating to the film. 5
LAH Film Corporation produced the film for Orion Pictures Company (Orion) in 1980. Glass negotiated with Orion for the purchase of the film by the partnership. The package negotiated between Orion and Glass involved the simultaneous execution of two agreements, a purchase agreement and a distribution agreement.
Under the purchase agreement, the partnership paid Orion $11,875,000, the purported production cost of the film, to purchase the negative and copyright of the film, payable as follows: $100,000 cash at closing; $1,400,000 cash on February 1, 1982; delivery of a promissory note in the amount of $6,025,000, with interest at nine percent per annum, due January 10, 1990, purportedly recourse as to repayment of principal and non-recourse as to repayment of interest (recourse note); and delivery of a non-recourse promissory note in the amount of $4,350,000 with interest at nine percent per annum, due January 10, 1990 (non-recourse note). No payment of either principal or interest was due on either note until January 10, 1990. The agreement entitled the partnership to claim an investment tax credit with respect to $7,525,000 of the production costs of the movie. Orion retained the right to claim the investment credit with respect to the balance of the production costs.
Although Orion purported to transfer all its "right, title, interest, ownership and claims of any kind" in the movie and copyright to the partnership, the purchase agreement also included a rather extensive laundry list of rights retained by Orion. 6 Essentially, Orion reserved for itself all rights in the film and copyright except those needed to allow the partnership to distribute the film. Furthermore, Orion lacked the right, at the time of contracting, to sell the distribution rights because it had already committed them to Warner Bros. Inc. (Warner) under an earlier separate agreement between Orion and Warner. In the end, Warner handled the actual distribution of the film.
Additionally, the partnership agreed to provide Orion with $4 million for advertising expenses. In return, Orion agreed to spend an additional $7,875,000 to advertise the film, for a total advertising budget of $11,875,000. In the event Orion failed to spend that amount by December 31, 1982, Orion would become obligated to pay the partnership on January 10, 1990, as an additional license fee, a sum equal to the difference between $7,875,000 and the amount it actually expended on advertising above the partnership's $4 million contribution (additional license fee).
The partnership funded the advertising advance by giving Orion $1,650,000 in cash and borrowing $2,350,000 on a non-recourse note from Chemical Bank (marketing loan). Pursuant to an Assignment Agreement dated July 31, 1981, the partnership assigned its right to the first $2,350,000 of gross receipts as security for the marketing loan. Under that agreement, Orion agreed to pay the foregoing amount, to the extent then earned, directly to Chemical Bank on January 10, 1984. Orion further agreed to make the interest payments on the marketing loan. By letter dated July 31, 1981, Warner guaranteed the foregoing obligations of Orion.
Concurrently with the execution of the purchase agreement, Orion and the partnership entered into a distribution agreement pursuant to which Orion received back the exclusive and irrevocable right to distribute and exploit the film throughout the world in all media, "including, without limitation, all present and future theatrical, nontheatrical and television rights, merchandising, commercial tie-in, sound track album and music publishing rights." Orion acquired the distribution rights for an initial period of twelve years with renewal options for an additional twelve years and thereafter in perpetuity.
The agreement prohibited the partnership from making any changes to the film before delivering it back to Orion. On the other hand, the agreement granted Orion the right to edit the movie, change the movie titles, make foreign language versions of the movie, exhibit the movie at film festivals, and display its logo in the film credits and in connection with advertising the movie. Although the agreement required Orion to consult with the partnership with respect to advertising and promoting the movie and its release pattern, it expressly stated that Orion possessed final and binding decision-making authority.
The distribution agreement further provided for an allocation of gross receipts between Orion and the partnership based upon a series of complex computations. Cutting through the complexities, the agreement entitled the partnership to receive: (a) 3.5% of the first $15 million in gross receipts, plus (b) 7.5% of gross receipts in excess of $15 million until breakeven is reached, 7 plus (c) 8.2% of gross receipts in excess of breakeven. Orion received the remainder.
The distribution agreement further entitled the partnership to receive from Orion, by January 10, 1990, to the extent of and to be applied against the balances due on the recourse and non-recourse notes, an amount equal to 100% of the film's gross receipts derived prior to December 31, 1982, plus reduced multiples (ranging from 5.5 to .7) of gross receipts derived between 1982 and 1989 (multiplier clause). As a result of this provision, the gross receipts of the film would satisfy the partnership's obligation to Orion under the recourse note if the proceeds, generated over an eight-year period, totalled approximately $1,500,000. Prior to making the investment, Glass's expert estimated that the film would gross $39.5 million.
In 1981, the taxpayer claimed his pro rata share of a depreciation deduction for the recovery of the purchase price of the film, a business expense deduction for the $4 million advertising expense, and a tentative investment tax credit. 8 The IRS disallowed these items, asserting that the partnership did not acquire an ownership interest in the film and taxpayer sought review of the Commissioner's actions in the tax court.
The tax court 9 made the following rulings in favor of the Commissioner which are challenged on appeal:
First, the tax court determined that the partnership purchased only a contractual right to share in the profits of the film, not the film itself. Accordingly, the tax court characterized the partnership's interest in the film as an intangible property right and therefore not subject to the accelerated cost recovery system. Recognizing that the partnership could depreciate the contract right under the straight-line method, the tax court assessed eight years as the useful life of the contract right for depreciation purposes.
Second, the tax court limited the partnership's depreciable basis in the contract right to the cash portion of the purchase price. It excluded both the non-recourse and recourse notes from the basis on the grounds that the notes did not represent bona fide debt.
Third, the tax court disallowed the claimed deduction for the advertising fund as an ordinary and necessary business expense because Orion controlled and directed the expenditure of those funds rather than the partnership. The court characterized the payment as an attempt to turn a capital contribution into a currently deductible expense. In light of this characterization, the tax court deemed the cash portion of the partnership's advertising fund to be part of the contract purchase price, and allowed the partnership to treat this cash amount as part of the basis for depreciation purposes. It excluded the marketing loan from basis on the ground that the partnership's liability was effectively guaranteed by Orion.
Fourth, the tax court denied the partnership's entitlement to claim an investment tax credit. The court characterized the partnership's relationship to the film as that of a lender or guarantor. Under applicable regulations, a lender who can look solely to the proceeds of the film for payment of the loan qualifies for an investment tax credit. Treas. Reg. Sec. 1.48-8(a)(4)(iii). Here, the tax court concluded that the partnership could look to the additional license fee for repayment and thus did not qualify for an investment tax credit.
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