I am looking
at a District Court case worth discussing, if only for the refresher on how to
select a court of venue. Let’s set it up.
ABC Beverage
Corporation (ABC) makes and distributes soft drinks and non-alcoholic beverages
for the Dr Pepper Snapple Group Inc. Through a subsidiary it acquired a company
in Missouri. Shortly afterwards it determined that the lease it acquired was
noneconomic. An appraisal determined that the fair market rent for the facility
was approximately $356,000 per year, but the lease required annual rent of $1.1
million. The lease had an unexpired term of 40 years, so the total dollars
under discussion were considerable.
The first
thing you may wonder is why the lease could be so disadvantageous. There are
any number of reasons. If one is distributing a high-weight low-value product
(such as soft drinks), proximity to customers could be paramount. If one owns a
franchise territory, one may be willing to pay a premium for the right road
access. Perhaps one’s needs are so specific that the decision process compares
the lease cost to the replacement cost of building a facility, which in turn
may be even more expensive. There are multiple ways to get into this situation.
ABC obtained
three appraisals, each of which valued the property without the lease at $2.75
million. With the lease the property was worth considerably more.
NOTE: Worth more to the landlord, of course.
ABC
approached the landlord and offered to buy the facility for $9 million. The
landlord wanted $14.8 million. Eventually they agreed on $11 million. ABC
capitalized the property at $2.75 million and deducted the $6.25 million
difference.
How? ABC was
looking at the Cleveland Allerton Hotel decision, a Sixth Circuit
decision from 1948. In that case, a hotel operator had a disastrous lease,
which it bought out. The IRS argued that that the entire buyout price should be
capitalized and depreciated. The Circuit Court decided that only the fair
market value of the property could be capitalized, and the rest could be
deducted immediately. Since 1948, other courts have decided differently, including
the Tax Court. One of the advantages of taking a case to Tax Court is that one
does not have to pay the tax and then sue for refund. A Tax Court filing
suspends the IRS’ ability to collect. The Tax Court is therefore the preferred
venue for many if not most tax cases.
However and
unfortunately for ABC, the Tax Court had decided opposite of Cleveland
Allerton (CA), so there was virtually no point in taking the case there.
ABC was in Michigan, which is in the Sixth Circuit. CA had been decided in the
Sixth Circuit. To get the case into the District Court (and thus the Circuit),
ABC would have to pay the tax and sue for refund. It did so.
The IRS came out with guns blazing.
It pointed to Code Section 167(c)(2), which reads:
(2) Special rule for property
subject to lease
If any property is acquired subject
to a lease—
(B) the entire adjusted basis shall be taken into account in
determining the depreciation deduction (if any) with respect to the property
subject to the lease.
The IRS argued that the Section meant
what it said, and that ABC had to capitalize the entire buyout, not just the
fair market value. It trotted out
several cases, including Millinery Center and Woodward v Commissioner.
It argued that the CA decision had been modified – to the point of reversal –
over time. CA was no longer good precedent.
The IRS had
a second argument: Section 167(c)(2) entered the tax Code after CA, with the presumption
that it was addressing – and overturning – the CA decision.
The Circuit Court
took a look at the cases. In Millinery Center, the Second Circuit
refused to allow a deduction for the excess over fair market value. The Sixth
Circuit pointed out that the Second Circuit had decided that way because the
taxpayer had failed its responsibility of proving that the lease was
burdensome. In other words, the taxpayer had not gotten to the evidentiary point
where ABC was.
In Woodward
the IRS argued that professional fees pursuant to a stockholder buyout had to
be capitalized, as the underlying transaction was capital in nature. Any
ancillary costs to the transaction (such as attorneys and accountants) likewise
had to be capitalized. The Sixth Circuit pointed out the obvious: ABC was not
deducting ancillary costs. ABC was deducting the transaction itself, so Woodward
did not come into play.
The Court then
looked at Section 167(c)(2) – “if property is acquired subject to a lease.”
That wording is key, and the question is: when do you look at the property? If
the Court looked before ABC bought out the lease, then the property was subject
to a lease. If it looked after, then the property was not. The IRS of course
argued that the correct time to look was before. The Court agreed that the wording
was ambiguous.
The Court reasoned
that a third party purchaser looking to acquire a building with an extant lease
is different from a lessee purchaser. The third party acquires a building with
an income stream – two distinct assets - whereas the lessee purchaser is paying
to eliminate a liability – the lease. Had the lessee left the property and
bought-out the lease, the buy-out would be deductible.
The Court
decided that the time to look was after. There was no lease, as ABC at that
point had unified its fee simple interest. Section 167(c)(2) did not apply, and
ABC could deduct the $6.25 million. The Court decided that its CA decision from
1948 was still precedent, at least in the Sixth Circuit.
ABC won the
case, and kudos to its attorneys. Their decision to take the case to District Court
rather than Tax Court made the case appealable to the Sixth Circuit, which
venue made all the difference.
