Opinion
Docket Nos. 468-69, 469-69.
Filed May 4, 1970.
In 1958, petitioners organized Midtown Holdings Corp. for the purpose of constructing and operating an enclosed mall shopping center adjacent to their department stores. They had equal ownership and control of Midtown. The shopping center opened for business in 1962. During the years in issue, Midtown paid no interest on certain loans made to it by petitioners. In addition, petitioners made certain equal payments to Midtown ostensibly to prevent the erection of kiosks in the part of the mall adjacent to their stores. Held, that respondent may not utilize sec. 482, I.R.C. 1954, to impute interest income to petitioners on said loans, since Midtown and petitioners were not controlled, directly or indirectly, by the same interests. Held, further, that, at least by 1962, Midtown had decided in its own interest not to erect kiosks, with the result that purported kiosk-prevention payments constituted disguised capital contributions to Midtown, and not ordinary and necessary business expenses within the meaning of sec. 162, I.R.C. 1954.
Ellsworth A. Van Graafeiland, Peter L. Faber, and William M. Colby, for the petitioners.
Marvin E. Hagen and Stephen M. Miller, for the respondent.
Respondent has determined deficiencies in petitioners' Federal income taxes as follows: Petitioner TYE — Deficiency
Jan. 30, 1965 $66,025.55 B. Forman Co., Inc. ................ Jan. 29, 1966 58,775.14 Jan. 28, 1967 59,692.00 Jan. 30, 1965 59,181.99 McCurdy Co., Inc. ................ Jan. 29, 1966 61,323.29 Jan. 28, 1967 62,343.56 Only two issues were raised in the petitions:(1) Whether respondent properly imputed to petitioners interest income on certain loans made by petitioners to a corporation, pursuant to section 482; and
All references, unless otherwise noted, are to the Internal Revenue Code of 1954.
(2) Whether certain payments petitioners made to a corporation in which they were sole and equal shareholders are ordinary and necessary business expenses, deductible under section 162.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Both petitioners are corporations organized under the laws of New York. Each had its principal place of business at Rochester, N.Y., at the time of filing its petition herein. Each petitioner filed its corporate income tax returns for the taxable years herein in issue with the district director of internal revenue, Buffalo, N Y
McCurdy Co., Inc. (hereinafter McCurdy's), operates a general department store located on Main Street East in Rochester. B. Forman Co., Inc. (hereinafter Forman's), operates a department store specializing in men's and women's apparel located on Clinton Avenue South in Rochester. The two stores are located on adjacent sides of the same block and are competitors.
During all times herein relevant, the stock of McCurdy's was owned primarily by or for members of the McCurdy family. The stock of Forman's was owned by Maurice R. Forman and by Fred S. Forman or his estate. McCurdy's and Forman's had no shareholders, directors, or officers in common.
During the 1950's, the gross sales of Forman's declined rapidly. McCurdy's experience at its downtown store was similar. These difficulties reflected a general decline in the downtown area of Rochester. Since both petitioners owned the land upon which their stores stood, this decline concerned them not only in connection with the prosperity of their businesses, but also in connection with the value of their real estate investment.
McCurdy's appears to have had suburban branch stores, not material herein.
In 1958, petitioners organized Midtown Holdings Corp. (hereinafter Midtown) for the purpose of constructing and operating an enclosed-mall shopping center adjoining the two stores. This project was intended to revitalize petitioners' business and protect and enhance their real estate investment.
On March 23, 1959, petitioners entered into an agreement pertaining to their investment in Midtown. The agreement provided that McCurdy's and Forman's should each have equal representation on the board of directors of Midtown. Provision was made for the designation of an additional odd-numbered director, if either party so requested. Such additional director was to be selected by mutual consent or, if such consent was not forthcoming, by an independent third party.
In accordance with the agreement and at the times relevant herein, Midtown had four directors: Gilbert J. C. McCurdy, Gordon W. McCurdy, Maurice R. Forman, and Fred Forman until his death in 1963, when he was replaced by Robert Aex. During the same period, the officers of Midtown were:
President ............. Gilbert J. C. McCurdy Vice president ........ Maurice R. Forman Secretary ............. Gordon W. McCurdy Treasurer ............. Fred Forman (until his death in September 1963). Robert Aex (replaced Fred Forman in November 1963). Vice president and general manager ..... Lynn Johnston (to Apr. 1, 1963). Angelo Chiarella (from May 27, 1963).
The 1959 agreement also provided that stock purchases from Midtown should be made equally by each petitioner and, in accordance with this provision, each petitioner in due course acquired for value an equal number of shares of common stock of Midtown. The agreement further provided, in part, that:
VII. The parties hereto agree to loan to Midtown additional amounts so that their aggregate loans to Midtown shall be One Million Dollars ($1,000,000) each, at any time and from time to time, if, prior to January 1, 1965, the Board of Directors of Midtown, by resolution, shall determine that such additional funds in the form of borrowing are necessary or advisable. Loans shall be made equally by the parties.
Such loans shall be represented by notes, or other evidence of indebtedness, of Midtown, the essential features of which shall be as follows:
(A) The notes shall pay interest at the rate of five (5) percent per annum payable semi-annual on the first days of January and July in each year.
(B) The notes shall be due and payable thirty (30) years after issuance.
(C) Midtown shall have the right to prepay the notes in whole or in part on any interest paying date prior to maturity upon the payment of the principal amount thereof and accrued interest.
(D) The notes may be unsecured but shall not be subordinated to the claims of any other unsecured creditor of Midtown.
(E) The notes shall be part of a series, and there shall be no preference between the parties hereto as to payment of the notes of a series.
Midtown began construction of the shopping center in 1959. The costs of construction had initially been estimated at $8 million; they turned out to be far higher, eventually amounting to about $18 million.
During 1958 and the first 4 months of 1959, each petitioner made a number of loans to Midtown. On May 1, 1959, these loans were consolidated into single obligations totaling $662,500 to each petitioner in the form of 30-year notes bearing interest at 5 percent. In July 1959, Midtown satisfied these notes, without payment of interest, from the proceeds of a $2,700,000 line of credit established by Midtown with the Lincoln Rochester Trust Co.
On September 9, 1960, each petitioner loaned to Midtown $1 million, receiving in return a 3-year note bearing interest at 3 1/2 percent. In April 1961, these notes were canceled without payment of principal or interest and replaced by 3-year notes in the same principal amount, bearing no interest and dated back to September 9, 1960. When the notes fell due, on September 9, 1963, they were replaced by new 3-year notes. These notes were in turn replaced by new 3-year notes on September 9, 1966. None of these notes bore interest and no payments have ever been made on any of them. The loans evidenced by these 1963 and 1966 notes are the subject matter of the interest issue involved in this case.
During 1961 through 1963, Forman's loaned an additional $1,445,000 to Midtown, which was fully repaid in December 1964 from the proceeds of loans which Midtown secured from the Lincoln Rochester Trust Co. Also during 1961 through 1963, Gilbert J. C. McCurdy, Virginia G. McCurdy, and Maurice Forman made various loans totaling $1,895,000 to Midtown. These loans also were paid off in December 1964 with the proceeds of a Lincoln Rochester Trust Co. loan.
The enclosed-mall shopping center was named Midtown Plaza Shopping Center and is hereinafter referred to as Midtown Plaza. Midtown Plaza is constructed around a mall which measures 300 feet north and south and is hereinafter referred to as the mall. Over most of its length, the mall is 110 feet wide, but in the northernmost 90 feet or so there is an alcove opening out to the east which makes the mall close to 200 feet wide. The entire northern border of the mall is taken up by McCurdy's, except for an arcade going through to Euclid Street. Forman's borders the mall on the west, taking up approximately the northern half of the western border. The remaining borders of the mall are occupied by a miscellany of different stores.
The mall is entirely roofed over; the decorated ceiling is 45 feet above the main level. There is a terrace level of stores which front on a broad balcony 16 feet above the main level.
Forman's has 145 feet of frontage, three entrances, and seven display windows on the main level. On the terrace level, Forman's has 145 feet of frontage, two entrances (one blocked off), and eight display windows. McCurdy's has 214 feet of frontage (including frontage on the corridor leading off to the northeastern arcade), two entrances, and six display windows on the main level and 76 feet of frontage and two display windows on the terrace level. Pillars approximately 18 inches square support the balcony's inside edge.
One means of access to the terrace level is a pair of escalators athwart the open part of the mall; at this point the mall is bridged over by a causeway connecting the balconies on either side of the mall. The escalators debouch onto this causeway. The escalators and causeway effectively divide the mall into two unequal parts. The southern part is approximately 90 by 110 feet and is referred to as the "South Mall"; the northern part is approximately 180 by 110 feet (not including the alcove at the northeast corner) and is referred to as the "North Mall." The North Mall thus has roughly twice the area of the South Mall.
In addition to the mall itself, Midtown constructed and owns an 18-story building abutting the southern end of the mall; one of the floors opens out onto the main level of the mall. Midtown also constructed and owns a 4-story building which abuts onto the alcove at the northeast corner of the mall. An arcade goes through this building to Euclid Street, thus providing access to Midtown Plaza from the northeast. Below the southern end of Midtown Plaza is a three-level underground parking garage with a capacity of 1,700 automobiles. An escalator from the garage opens directly onto the South Mall. A bus terminal is located outside the southeastern corner of Midtown Plaza and there are pedestrian passageways leading directly into the South Mall. Buses using the terminal run frequently throughout the day and service many suburban areas near Rochester.
Midtown has constructed and rented four different kiosks in the South Mall; at any one time, however, there have been no more than three kiosks there. American Airlines rented a kiosk of 125 square feet at a rental of $26.10 per square foot during each of the years herein in issue. John T. Nothnagle, Inc., a real estate concern, rented a 60-foot kiosk at $40.35 per square foot during 1964 through 1966. The National Key Co. rented a kiosk of 64 square feet during 1964-67. The base rental in each year was $23.48 per square foot. The total rental in each year was $67.16 per square foot in 1964, $58.13 in 1965, $69.37 in 1966, and $72.27 in 1967. In 1967, the Allstate Insurance Co. rented 100 square feet of floor space at $54 per square foot.
The North Mall contains a pool with a fountain, a large pit filled with earth and planted with indoor plants, and a permanent exhibit known as the Clock of Nations. This clock is 25 feet high. Around its base are a series of cylinders containing animated dolls; these dolls are dressed in costumes characteristic of various foreign countries. At appropriate times, each cylinder is lit up, the dolls within move, and music characteristic of the particular country is played automatically. The Clock of Nations is considered a focus of interest at Midtown Plaza and a significant attraction to tourists and shoppers. To be fully effective, it was necessary that the clock be visible from as large a part of the North Mall as possible. The North Mall also contains a small structure which acts as a bulletin board for advertisements and announcements of community events.
The architect who designed Midtown Plaza initially contemplated that both parts of the Mall would have kiosks. At a late stage in the construction, it was decided to save money by cutting out unnecessary costs. The possibility of making no provision at all for kiosks was explored. But construction was so far advanced that very little, if any, money would have been saved by eliminating the utility pits for the kiosks. However, certain planned plumbing and lighting facilities for kiosks were omitted. The installation and placement of utility pits did not commit Midtown to any particular number of placements of kiosks; several kiosks could be serviced from one utility pit.
The design of a kiosk varies widely with the type of tenant for which it is intended, so widely that there is no point in building the kiosk until the nature of the tenant is known.
Midtown Plaza opened for business on April 10, 1962. At that time, there were no kiosks in the North Mall and none were contemplated. Midtown had decided to keep the North Mall available for noncommercial events and exhibits — civic, cultural, educational, social, etc. The presence of kiosks would have made the North Mall physically less useful for such activities, some of which would require a large open space. In addition, the presence of kiosks with mercantile tenants would have given the North Mall an excessively commercial aura, incompatible with many noncommercial activities.
The North Mall has in fact been extensively used for noncommercial activities, including a National Aeronautics and Space Administration exhibit, a high school dance, and a nondenominational Easter sunrise religious service. These events and exhibits have attracted considerable pedestrian traffic to Midtown Plaza. Even more importantly, they have occasioned considerable publicity, which, in turn, has made Midtown Plaza better known, kept Midtown Plaza in the minds of the residents of the Rochester area, and generated goodwill. In effect, making the North Mall available for noncommercial purposes has served as a very effective form of institutional advertising for Midtown Plaza as a whole. Space on the North Mall is normally made available for use free of charge, but Midtown has occasionally charged and received a fee for its use.
The advertising, with the generalized goodwill it built up, made Midtown Plaza a more attractive business location for merchants; the advertising thus had long-run benefits to Midtown, since it placed Midtown in a better position to charge higher rents in later years. Petitioners' businesses also benefited from this advertising, since their stores were identified with Midtown Plaza in the public mind. The businesses of the other mercantile tenants of Midtown Plaza benefited from this advertising. Since most such tenants were on percentage leases, Midtown would in all probability immediately share in these benefits through increased rental receipts.
From the point of view of Midtown's independent economic interest, the use of the North Mall as it was in fact used, for noncommercial activities, was preferable to using it for commercial kiosks, even without payments by petitioners in lieu of kiosk rentals. The immediate and long-term benefits to Midtown from the advertising effect outweighed the loss of potential kiosk rental payments.
From the point of view of the owner of an enclosed mall shopping center, kiosks are desirable, other things being equal, since they generally increase the total rental to be expected from the entire project. But from the point of view of a store tenant, they are undesirable in that they obstruct the free flow of pedestrian traffic and, under some circumstances, may block the vision of potential customers. Insofar as petitioners were concerned, the presence of kiosks would not have materially interfered with the vision of potential customers.
In May 1963, Angelo Chiarella (hereinafter Chiarella), who had worked for the architect who designed Midtown Plaza, became vice president and general manager of Midtown under an oral agreement as to his duties and compensation. A written employment contract was executed in August 1964 and was subsequently modified in 1966. Chiarella was entitled, in addition to a base salary, to bonuses based on Midtown's "operating income." In general, Midtown's then current income had to increase substantially before Chiarella would get any bonus at all. Such an increase in Midtown's operating income would increase Chiarella's bonus. Chiarella has, in fact, received bonuses under this formula (as modified in 1966).
Since the completion of construction, Midtown's income has come largely from rental of space in Midtown Plaza. The owners of all stores adjoining the mall, including petitioners, made payments during the years in question to Midtown to cover the cost of operating and maintaining the common mall area upon which their stores fronted. Midtown's profit and loss statements are prepared on the basis of a fiscal year ending July 31. The profit and loss statement for each of the years herein relevant shows a net loss, except for the year ending July 31, 1967, as to which the statement shows a small profit. At least during 1964 and 1965, Midtown was in need of working capital. Midtown had no taxable income subject to Federal tax during the years herein in issue.
During the years in issue, McCurdy's reported gross sales and taxable income as follows: Year ending — Gross sales Taxable income
Jan. 30, 1965 ..................... $22,536,052.21 $780,137.30 Jan. 29, 1966 ..................... 24,116,410.91 1,155,580.84 Jan. 28, 1967 ..................... 25,184,893.61 1,216,421.17 During the years in issue, Forman's reported gross sales and taxable income as follows: Taxable Year ending — Gross sales income Jan. 30, 1965 ............................. $10,077,631 $286,420 Jan. 29, 1966 ............................. 10,807,663 420,264 Jan. 28, 1967 ............................. 11,041,748 425,144On May 7, 1964, Chiarella wrote a letter to each petitioner, proposing that each petitioner pay Midtown $75,000 per year not to rent out kiosks on the North Mall. The letter pointed out that petitioners benefited from the noncommercial events held in the North Mall. To justify the amount requested, the letter argued that 10 kiosks could be put into the North Mall and that $150,000 per year could be obtained in rentals from 10 kiosks in that location. On November 6, 1964, petitioners and Midtown executed a written contract embodying this proposal. Under the contract, Midtown was to "retain complete control, direction and management" of the North Mall. Each petitioner agreed to pay Midtown $75,000 per year, starting with the year beginning February 1, 1964. Each petitioner paid Midtown $75,000 during each of the taxable years involved herein. The sums were included in Midtown's "operating income" for the purpose of computing Chiarella's bonus. None of Midtown's tenants has ever been approached by Midtown to make payments for the purpose of preventing the establishment of kiosks in the shopping mall, and no such payments have ever been made. None of the leases prohibits the erection of kiosks and only one lease restricts the placement of kiosks.
Advertising expenses are usually about 5 percent of the gross sales of department stores. During the years in issue, McCurdy's advertising and publicity expenditures, counting the $75,000 payments to Midtown as advertising, ranged from 3.7 percent to 4.1 percent of gross sales. During the years in issue, Forman's advertising and publicity expenditures, counting the $75,000 payments to Midtown as advertising, ranged from 3.7 percent to 3.9 percent of gross sales.
ULTIMATE FINDINGS OF FACT
1. Neither petitioner was directly or indirectly controlled by the same interests, nor was Midtown and either of the petitioners so owned or controlled.
2. Had Midtown decided to construct and rent kiosks on the North Mall, it could have realized at least $150,000 annually during the periods relevant herein in rents from such kiosks.
3. At least by April 10, 1962, when Midtown Plaza opened for business, Midtown had made a firm decision not to construct and rent kiosks on the North Mall and such decision continued in full force and effect during all periods relevant herein.
4. The $75,000 paid to Midtown by each petitioner in each of the taxable years herein in issue did not constitute an ordinary and necessary business expense.
OPINION Imputation of Interest Income Under Section 482
Each petitioner owns and operates a department store in downtown Rochester, N.Y. In 1958, petitioners organized Midtown Holdings Corp. as a vehicle for constructing and operating an enclosed-mall shopping center abutting upon their department stores. It was hoped that the shopping center would not only revitalize their business, but also enhance the value of their real estate investment.
The project (known as Midtown Plaza) turned out to be far more expensive than expected. In consequence, petitioners from time to time made various loans to Midtown. As our findings of fact show, no interest was paid on these loans. With respect to $1 million of such loans, originally made in equal amounts in September 1960 and renewed in September 1963 and again in September 1966, respondent has imputed interest income at 5 percent per annum to each petitioner. In so doing, respondent has relied on section 482 and the regulations issued thereunder. See sec. 1.482-2(a), Income Tax Regs.
SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.
At all relevant times Forman's and McCurdy's were the sole shareholders of Midtown, each owning 50 percent of its issued and outstanding stock. Members of the Forman family controlled Forman's and members of the McCurdy family controlled McCurdy's. There is not the slightest suggestion in the record that any members of the McCurdy family and the Forman family were in any way related and respondent has made no contention in this respect.
Section 482 grants respondent authority to allocate income, deductions, credits, and allowances among two or more "organizations, trades or businesses * * * owned or controlled directly or indirectly by the same interests." This means actual, practical control rather than any particular percentage of stock ownership. South Texas Rice Warehouse Co. v. Commissioner, 366 F.2d 890, 894-896 (C.A. 5, 1966), affirming 43 T.C. 540, 561-562 (1965); Jesse E. Hall, Sr., 32 T.C. 390, 409-410 (1959), affd. 294 F.2d 82 (C.A. 5, 1961); sec. 1.482-1(a)(3), Income Tax Regs. Respondent contends, and petitioners deny, that the requisite control existed. We agree with petitioners.
Each petitioner had only a 50-percent interest in Midtown, but this, standing alone, would not enable it to dominate or manipulate Midtown. With the possible exception of forcing a dissolution (see N.Y. Bus. Corp. Law, sec. 1104 (McKinney 1963)), the best that either petitioner acting alone could achieve was a deadlock. There was no relationship between the shareholders of petitioners which could form the basis for finding that any group of shareholders could be said to have control of both Forman's and McCurdy's and, thus, control of Midtown as well. It was just such a relationship which supported a finding of control in Advance Machinery Exch. v. Commissioner, 196 F.2d 1006 (C.A. 2, 1952), affirming a Memorandum Opinion of this Court, Grenada Industries, Inc., 17 T.C. 231 (1951), affd. 202 F.2d 873 (C.A. 5, 1953), and Jesse E. Hall, Sr., supra, heavily relied upon by respondent. In Advance Machinery and Hall, the necessary relationship rested on family solidarity, and in Granada Industries, it stemmed from a proportional common ownership of the entities involved. These cases are consequently clearly distinguishable. In short, there was no ownership or control (in the usual sense of those terms) of " two or more organizations, trades or businesses." (Emphasis added.)
Respondent does not seriously contest this conclusion. Rather, he argues that the requirements of section 482 are met because Forman's and McCurdy's had a common interest as far as their department store businesses were concerned which dictated that they act in concert with respect to Midtown. In urging this expansive interpretation of section 482, respondent recognizes that our holding in Lake Erie Pittsburg Railway Co., 5 T.C. 558 (1945), is directly contrary to his position. He urges us to overrule our prior decisions and articulates on brief the analysis set forth in Rev. Rul. 65-142, 1965-1 C.B. 223. In essence, this analysis is premised on the assertion that, in organizing and operating Midtown, Forman's and McCurdy's should be considered as acting as a partnership and that there is, therefore, the requisite control of two entities, namely, the partnership and Midtown.
We have carefully reexamined our decision in Lake Erie Pittsburg Railway Co., supra, and have concluded that it should be reaffirmed. The clear language of section 482 requires that there be two business entities with respect to which direct or indirect control by the same interests can be found. If we look at Midtown and Forman's or Midtown and McCurdy's, no such control existed. To import a common objective test into section 482, and thereby create a theoretical partnership between Forman's and McCurdy's, would require an unwarranted elasticized reading of the statutory language. Perhaps the absence of an obligation to pay interest on the loans produced a distortion of income as between Midtown and petitioners, but we find nothing in the legislative history which would justify the interpretation of the phrase "same interests" urged by respondent. Congress clearly had in mind a finding of ownership or control of two or more businesses by the same interests. See H. Rept. No. 2, 70th Cong., 1st Sess., pp. 16-17 (1927). See also Fred J. Sperapani, 42 T.C. 308, 336 fn. 6.
In enacting the 1954 Code, Congress explicitly stated it was making no substantive changes in sec. 482. See H. Rept. No. 1337, 83d Cong., 2d Sess., p. A165 (1954); S. Rept. No. 1622, 83d Cong., 2d Sess., p. 310 (1954).
The hard fact is that Congress did not design section 482 to cover every potential distortion of income and deduction. To refer to McCurdy's shareholders and Forman's shareholders as "the same interests" would be a distortion, not of income, but of words. We are reinforced in our conclusion by the fact that respondent acquiesced in our decision in Lake Erie Pittsburg Railway Co., supra., for 20 years. See 1945 C.B. 5; acquiescence withdrawn 1965-1 C.B. 5; Rev. Rul. 65-142, supra. Such long-standing administrative interpretation of statutory language may properly be taken into account. See Hanover Bank v. Commissioner, 369 U.S. 672, 686 (1962).
In view of our conclusion that the requisite control under section 482 did not exist, we do not decide whether this case would fall within the ambit of those decisions dealing with the question of the extent to which that section authorizes the allocation of income where no income is realized. See, e.g., Smith-Bridgman Co., 16 T.C. 287, 293 (1951). Nor need we consider the impact on section 482 of the specific provisions of section 483 dealing with imputed interest in certain situations. Compare also J. Simpson Dean, 35 T.C. 1083, 1087-1090 (1961).
Deductibility of Kiosk Prevention Payments
During each of the years in question, each petitioner paid Midtown $75,000 to keep kiosks off the North Mall and deducted the payments as ordinary and necessary business expenses. Respondent has disallowed the deductions.
Whether or not a payment constitutes an ordinary and necessary business expense constitutes primarily a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). See Welch v. Helvering, 290 U.S. 111, 115 (1933). Clearly, there is no automatic barrier to resolving that question in favor of a taxpayer even though the payor and payee are in a corporation-shareholder relationship. Compare Ray's Clothes, Inc., 22 T.C. 1332 (1954). But where such a relationship exists, the payment should be subjected to close scrutiny to ensure that it is indeed what it purports to be. E.g., Darco Realty Corporation v. Commissioner, 301 F.2d 190 (C.A. 2, 1962).
A pair of escalators and a causeway divided the shopping mall of Midtown Plaza into two unequal parts. The South Mall, the smaller of the two, had kiosks in it, tenanted by various commercial enterprises. The North Mall, which had petitioners' department stores along two of its sides, was kept clear of kiosks so that it could be used for noncommercial events. In effect, the North Mall functioned as a sort of community center. The various events held there drew people to Midtown Plaza who would not otherwise come. This extra traffic was of value to Midtown, to petitioners' department stores, and to all the commercial tenants of Midtown Plaza. Even more important is the quite considerable publicity generated by these events; this publicity served as a very effective form of institutional advertising.
Petitioners posit their assertion of deductibility on the ground that the payments served an advertising function, since they made possible the use of the North Mall for promotional events from which they directly benefited. They further seek to support their claim by arguing that they, in effect, rented the North Mall from Midtown and that, since $150,000 constituted a reasonable rental, commensurate with what an independent lessee would pay, it follows that that amount was paid exclusively for the use of the Mall and is therefore deductible. Compare Polak's Frutal Works, Inc. v. United States, 176 F. Supp. 521 (S.D.N.Y. 1959), affd. 281 F.2d 261 (C.A. 2, 1960). We have no quarrel with petitioners' arguments as far as they go. The difficulty is that they are not determinative of the question before us.
Use of the North Mall as a sort of community center doubtless benefited the petitioners, but equally beyond doubt is the benefit to Midtown Plaza as a whole. Midtown stood to benefit immediately to the extent that it would share in the increased business through percentage leases. And beyond this immediate benefit, the attractiveness of Midtown Plaza to business tenants was increased, thereby enhancing the ability of Midtown to obtain higher rentals in the future. These factors made it in the interest of Midtown to keep the North Mall free of kiosks. Concededly, landlords of shopping centers may normally want to rent out kiosks in order to obtain additional rentals. But Midtown was not faced with a simple choice between kiosks and no kiosks; it had to choose between kiosks and an extremely effective form of institutional advertising. In short, Midtown was faced with a choice as to what was in its own best independent interests. In our opinion, as our findings of fact show, it made that choice no later than April 10, 1962, the date on which Midtown Plaza opened and long before the contractual obligation to pay the $150,000 was undertaken by petitioners.
As we see it, the test is whether the arrangements calling for the payment of the $150,000 were in fact what they purported to be, namely, an annual expenditure for a current benefit to petitioners which Midtown had to be induced to confer. Clearly, the mere fact that petitioners were legally bound to make the payment is not determinative. See, e.g., Atlantic Monthly Co., 5 T.C. 1025, 1032 (1945). The question is: Should petitioners be allowed a deduction as an ordinary and necessary business expense for recurring payments for a promise by the payee not to undertake an activity which it had already decided not to undertake in its own independent interests? While we have found no decision which furnishes us with direct guidance, we conclude that the question should be answered in the negative. Cf. Swed Distributing Co. v. Commissioner, 323 F.2d 480 (C.A. 5, 1963), affirming a Memorandum Opinion of this Court, on remand from 272 F.2d 330 (C.A. 5, 1959), which, in turn, had reversed 31 T.C. 84 (1958); Ingle Coal Corporation v. Commissioner, 174 F.2d 569 (C.A. 7, 1949), affirming 10 T.C. 1199 (1948); Ray's Clothes, Inc., supra; Granberg Equipment, Inc., 11 T.C. 704 (1948).
Compare also Max J. Epstein, T.C. Memo, 1964-192.
Our conclusion that the arrangements were not what they purport to be is further reinforced by several additional elements present herein:
(1) The fact that petitioners' payments to Midtown were equal is highly suggestive. Petitioners' sales volumes and income differed markedly. The effect upon the revenue of their department stores of the North Mall activities would almost certainly be different. If the decision to keep kiosks off the North Mall had been made in connection with the department store businesses of petitioners, it would seem that the petitioner who could expect to reap a lesser benefit from the advertising would have demanded that payment be proportional to its expected benefit. Moreover, we note that none of Midtown's tenants were asked to make such payments, although they benefited from the promotional events. Finally, the original agreement between petitioners required that their investment be equal. Thus, the equality of payments suggests that they were intended as capital contributions.
(2) There were good reasons for artificially inflating Midtown's income at the expense of the department store businesses. Midtown needed cash; petitioners therefore had to make capital contributions or loans to Midtown. Petitioners had substantial taxable income against which deductions could be used, Midtown had substantial tax losses to soak up increases in income, and Chiarella's bonus would be increased by increased rental income. To the extent that a capital contribution could be disguised as income to Midtown and business expense to the petitioners, everybody benefited and no one was hurt significantly. While tax avoidance may be a permissible objective where the substance and form of the transaction coincide, the presence of a pattern of tax benefits certainly constitutes a yellow caution signal on our road to decision. Cf. George L. Schultz, 50 T.C. 688, 694 (1968), affirmed per curiam 420 F.2d 490 (C.A. 3, 1970).
We again emphasize that we are not dealing with a situation where the payment in question is for a benefit conferred which the payor was concerned it might lose through bona fide action by the payee. Under such circumstances, the measurement of the value of the payments against the benefit conferred in order to support the contention of a quasi rental, or the justification of the payments as an advertising expenditure, or the possibility of interference by the kiosks with the visibility of petitioners' store windows, or whether the petitioners were under obligation to Chiarella to maximize the income of Midtown in order to enhance his bonus would have been highly relevant. But in the posture of this particular case, those considerations are totally beside the point.
In this connection, we note that, under the agreement of Nov. 6, 1964, Midtown was to "retain complete control, direction and management" of the North Mall. And when charges were made for the use of North Mall space, Midtown, not petitioners, received the money.
We conclude that the payments of $75,000 by each of the petitioners to Midtown were disguised capital contributions and therefore not deductible expenses.
In order to reflect certain adjustments made in the notices of deficiency and not contested in the petitions, as well as our resolution of the first issue,
Decisions will be entered under Rule 50.
Reviewed by the Court.