FRANK LYON CO. v. UNITED STATES
Legal provision: Internal Revenue Code
Argument of Erwin N. Griswold
Chief Justice Warren E. Burger: We will hear arguments next in Frank Lyon Co. v. United States.
Mr. Griswold you may proceed whenever you are ready.
Mr. Erwin N. Griswold: Mr. Chief Justice and may it please the Court.
This is a federal income tax case.
It comes here on a writ of certiorari to review a decision of the Eighth Circuit Court of Appeals which reversed a judgment for the taxpayer in the United States District Court for Arkansas.
The question involved is the effect of a sale lease-back transaction, involving a bank building between the petitioner Frank Lyon Co. as leaser and the Worthen Bank & Trust Company as lessee.
Before stating the facts, I would like to place them in context by briefly indicating the basic approach which we take in this case.
In planning a substantial business venture of the sort involved here, taxpayers should be able to predict the tax consequences with some degree of certainty.
To this end the tax collectors should avoid applying the tax laws to frustrate bona fide bargains unless he can point to some reason for doing so which is pragmatically based in tax policy.
This does not mean that taxpayers should be allowed to manipulate tax consequences with arbitrary labels or with maneuvers which have no economic substance, but neither should the tax lawyers be a joker in the deck for a business planning.
In a situation where ownership is inevitably divided and that is true of most business property.
No transaction can be safely planed if its tax consequences are made to depend on an abstract comparison of the ownership of bundles of sticks which various parties carry.
The policy for which we argue is in effect that there should be a presumption in favor of taxing bona fide business transactions as they were bargained, structured and understood by the parties, particularly whereas here there is no realistic tax policy reason for scrambling the bargain which was made between Frank Lyon Co. and the Worthen Bank.
Unknown Speaker: Mr. Griswold I take it no one -- you tell me does any one question that these were independent companies and not the bargains rentals --?
Mr. Erwin N. Griswold: No, Your Honor that is not question they were independent.
There is one -- the President of Frank Lyon Co. is a director of Worthen Bank but the Court found that they were independent and that is not now contested.
Worthen Bank in Little Rock for many years in 1967 add a capital of $4 million.
It decided to build a new building and it was able to obtain a desirable site.
It retained an architect and build a public parking garage on an adjoining track.
The total project would cost about $12 million of which about $1,500,000 was the cost of the land and $7,500,000 was the cost of the bank building on this particular piece of land.
The bank sought approval for the financing of the building from the State Banking Commission of Arkansas and the Federal Reserve Bank of St. Louis.
Unknown Speaker: Mr. Griswold could I interrupt for just a second what if the other $3 million represent and was it part of that --?
Mr. Erwin N. Griswold: They have represented an adjoining track which included a parking garage, several stories high which was integrated in the ultimate project, but was not a part of the leases involved here.
Unknown Speaker: So that $3 million really is not part of the packet sold to Lyon?
Mr. Erwin N. Griswold: That $3 million is not the part of this case except that it consumed most of the $4 million which was the maximum that Worthen Bank could invest in bank premises.
Unknown Speaker: Is it correct that the cost to Worthen of the facilities that were sold to Lyon was about $7,500,000?
Mr. Erwin N. Griswold: Yes.
Unknown Speaker: I See okay.
Mr. Erwin N. Griswold: The Lyon paid essentially the cost.
There was a contract by which Lyon agreed to pay not in excess of $7,640,000 and that is the exact amount which they paid.
They were advised by the banking authorities that Worthen could not legally own the building either directly or through a wholly owned subsidiary at a cost in excess of the amount of its capital stock which was then $4 million and that is Section 25 (a) of the Federal Reserve Act.
In addition to this legal obstacle there was also a practical barrier, Worthen Bank had planned to have a $5 million conventional mortgage and to issue $4 million in debentures, but Arkansas law forbade Worthen from paying more than 6% on debentures and the bond simply were not marketable at that rate.
In this situation, Worthen sought both legal and financial advice.
It consulted a number of potential investors and lenders including Goldman Sachs & Company and Eastman Dillon, Union Securities Company of New York.
It also made preliminary contact with the First National City Bank of New York for interim financing and with New York Life Insurance Company for a long term loan on the completed building.
In the course of these discussions, the suggestion was made that the practical and legal problems could be solved by a sale and leaseback with an independent buyer and leaser.
After these discussions were well underway, Frank Lyon Co. decided to enter the competition.
Lyon as, I have said is an independent company, thought its Chairman, Frank Lyon is a director of Worthen Bank.
Unknown Speaker: And what is its principal business Mr. Griswold?
Mr. Erwin N. Griswold: What?
Unknown Speaker: What is its principal business, the Lyon your client --?
Mr. Erwin N. Griswold: Their principal business was the Central Midwest distributorship for Whirlpool and Zenith, but they had by this time also begun to branch out and do other thing and among other things at about this time, they bought the controlling interest in another bank in Little Rock and they were engaging in other business activities but their basic business was the distributorship for Zenith and Whirlpool.
Unknown Speaker: Mr. Griswold was Lyon a corporation?
Mr. Erwin N. Griswold: Frank Lyon Co. is an incorporation yes.
Unknown Speaker: I see.
Mr. Erwin N. Griswold: Frank Lyon Co. underbid the other potential buyers by reducing the rent payable by Worthen for the building by $21,000 a year for each of the first five years and on this basis Frank Lyon Co. was accepted by Worthen as the investor owner and Lyon was approved by the financing agencies.
After extensive further negotiations, Lyon entered into a number of agreements both with Worthen and the financial institutions and there was first a ground lease by which Worthen leased the land to Lyon for a term of 76 years and 7 months.
That was actually a year and seven months for a construction and 75 years after the end of this.
The idea for leasing the ground had been suggested by some of the New York financiers as a way of simplifying the ultimate transaction.
There was secondary sales agreement by which Worthen sold the building to Lyon and this is interesting but I do not think readily significant.
Bit by bit as it was built for a price not exceeding $7,640,000 as each piece of material was incorporated in the building, it was sold to Lyon.
Now, this was adopted because Worthen Bank could not own banking premises in excess of its capital and if it built the whole building and then sold it they would have violated the law and also because Worthen Bank was not subject to the Arkansas sales tax on the materials which would have amounted to something like $125,000.
Finally, there was a building lease by which Lyon leased the building to Worthen for a term of 25 years subject to two sets of options.
There were first four options to purchase the building at stated figures, at the end of the 11th , 15th , 20th and 25th years of the lease and the basic term of the lease, the original term of the lease was 25 years and then there were eight options to renew the lease, beginning with the 25th year for consecutive five year periods.
If all the options to renew or exercise, Worthen Bank would occupy the premises for a total of 65 years, but that still after a term of ten years at the end,where Lyon’s ground lease would continue and it would have full entitlement to the building no matter of what.
The transactions became effective on May 1st 1968. During the construction period, Frank Lyon Co. borrowed the money to finance the cost from First National City Bank of New York in the amount of $7 million.
It did this on its own note on which it alone was liable, when the building was completed Frank Lyon Co. discharged this obligation to First National City Bank and to Worthen by putting in $500,000 of its own money and by borrowing $7,140,000 from New York Life Insurance Company.
Again, Frank Lyon Co. alone signed this note.
Worthen was not a party to it although Worthen did join in providing additional security for the note by mortgaging the parking garage and the land to which it still owned the fee and also consenting to an assignment of the lease to New York Life.
After Lyon had borrowed the $7,140,000 from New York Life, it paid off its debt to First National City Bank and had $500,000 of its own invested in the project.
The Government has made much of the fact that the rent for the first 25 years under the ground lease was fixed to $50.
There was some confusion in the record about this.
The lease itself says $50 for the term at one place in the finding that says $50 per year.
I think $50 for the whole term is correct I do not think it is of any importance.
However the amount of this rent is entirely irrelevant, whatever rent was fixed for the land during the initial 25 year period would inevitably be taken into account in determining the rent for the building during this period.
If the rent to the land had been fixed at $100,000 a year, then for simple economic reasons the rent for building would have been increased by $100,000 a year.
It was a large transaction.
Unknown Speaker: Mr. Griswold you mean decreased, don't you.
If you increase the ground rent, you decreased the building rent?
Mr. Erwin N. Griswold: No, you would have to increase that.
If Lyon had --
Unknown Speaker: In the effect --
Mr. Erwin N. Griswold: Paid more ground rent they would get more building rent out in order to come out.
Unknown Speaker: Well, but the effect of increasing the ground rent later was to decrease than that rent paid by the lessee?
Mr. Erwin N. Griswold: I am talking about the initial 25 year period --
Unknown Speaker: I see.
Mr. Erwin N. Griswold: And simply this apparently anomalous $50 rent for the term.
I suggest that that is irrelevant.
Unknown Speaker: Could you explain while you are on that point why it was that they made a substantial ground rent after the first 25 years, I think it was rather than simply reducing the rent on the building?
Mr. Erwin N. Griswold: Because they contemplated the very real risk that Worthen would not renew the lease.
That Lyon would be liable for the rent specified for the next 40 years at high rates, Worthen could walk away from it and could collect in a later period $250,000 a year rent for which Worthen was liable.
Unknown Speaker: Lyon was liable?
Mr. Erwin N. Griswold: At which Lyon was liable.
Yes of course Mr. Chief Justice.
After the first 25 years, as I have just said the ground lease provided for substantial and increasing rents payable by Lyon over the next 40 years aggregating $7,500,000 and for the final ten years of the lease, a reduced ground rent of $10,000 a year was provided.
The Government contends that it is inconceivable that Worthen would walk away from the building at the end of 25 years or at any subsequent time, but it is clear that these escalating ground rents were designed to deal with precisely this eventuality, if it were a foregone conclusion that Worthen would continue to rent the building throughout the entire 65 year term ground rentals of up to a quarter of a million dollars a year would not have been necessary just as in the first 25 years which were binding on the parties.
Lyon also had the absolute right to all the improvements made by Worthen to the building at any time the building lease terminates, Lyon comes into full possession of the building and all its pertinences.
And this shows a significant benefit of ownership for Lyon and operates as well to negate any inference that the parties never contemplated Worthen relinquishing control of the building.
Now, the ground lease must of course be considered together with the building lease.
The rent payable by the bank during the first 25 years of the building lease exactly put Lyon in funds to meet its liability to New York Life on a quarterly basis.
Thereafter as I have said, the bank had eight successive options to renew the lease for five year periods, and the rent for such periods is fixed at $300,000 per year and by that time Lyon has no longer any obligation to the financial institutions.
Under the building lease, Worthen Bank had four options to purchase the premises at the end of 11, 15 and 25 years, these options and the purchase price appeared at page 419 of the Appendix they are substantial amounts.
If Worthen exercised anyone of these options to purchase, both the building lease and the ground lease would terminate; however, if Worthen did not exercise the option to buy, the ground lease would continue in full force and Frank Lyon Co. would be liable for the aggregate of $7,600,000 of rent ado for the 50 years remaining under the ground lease.
In this respect the Government has significantly misstated the situation in a footnote on page 13 of its brief.
I am sure that this was unintentional, but it is significant.
The Government says there that and “the ground lease would terminate if Worthen did not renew the building lease” and as I have indicated this is not true, the Termination Clause is paragraph 9 on page 369 of the Appendix, under this the ground lease would terminate on the exercise of one of the options to buy under article 20 of the building lease, but there is no provision for termination of the ground lease on the failure to exercise one of the options to renew the building lease.
If the options to renew expire at anytime between the 25 and the 60 year of the lease, Frank Lyon remains liable for the rent stated on the ground lease including the rental stipulated for the final ten years of the lease and during all of this period or potentially 50 years, if an option to renew is not exercised Frank Lyon Co. is the unqualified owner of the building able to deal with it in anyway it thinks desirable, lease it to a new tenant, replace it, sell it or occupy it itself.
This is not a lease which provides for a bargain purchase.
The price is payable if Worthen exercises the options to buy are substantial.
The trial court has expressly found on evidence that “from page 304 of the Appendix, there has never been any understanding or agreement between Worthen and plaintiff that Worthen will ever exercise any of its options to purchase” and the trial court also found and this actually appears at three places in the findings but the quotation I gave is also on page 304, the Trial Court found that it is most unlikely and improbable that Worthen will exercise its options to purchase at the end of the first 11 years of the lease or at the end of any of the subsequent option periods.
Unknown Speaker: But did it give reasons for that conclusion?
Mr. Erwin N. Griswold: Yes, Mr. Justice one of them of course is the same capital buying that Worthen Bank is in.
Worthen Bank cannot exercise the option to purchase without becoming the owner of a bank building which in excess of its capital which violates the law.
Unknown Speaker: Any finding about the possibility of increasing its capital?
Mr. Erwin N. Griswold: No, there is no finding about that.
As I recall, of course, there is always the possibility but in these days of branch banking this applies to all banking premises and the need of a bank not to put its capital in the banking premises was certainly one of the factors which let the Court to come to that finding.
Unknown Speaker: Worthen is a very small bank with the capitalization of only $4 million?
Mr. Erwin N. Griswold: Its capital has increased since 1968.
I do not what it is, it has not increased to a Chase Manhattan Bank --
Unknown Speaker: And building, this $9 million building that was certainly more than just the offices of a small bank then?
Mr. Erwin N. Griswold: Its capital has always been small and the record is contained a number of references from the banking authorities saying Worthen Bank has a capital problem, it must increase its capital and they were aware of this and they were working at it.
Unknown Speaker: And what kind of building was this Mr. Griswold, was it more than just the offices of a small bank was it not, of a small bank that have -- was that an office building generally or --?
Mr. Erwin N. Griswold: Well, Worthen occupied a third of the building at the time it was completed and they leased it to other tenants, but they did incorporate end of the building and the adjoining premises quite a substantial amount of specialized bank equipments such as vaults and teller’s cages and things of that sort, but at the time they started, they occupied a third of the building.
Unknown Speaker: I share Mr. Justice Stewart's inquiry.
I have been under the impression that Worthen is one of the major banks in little Rock and this $4 million figure does seem to me to be almost under capitalization per se --
Mr. Erwin N. Griswold: I am not an authority on the banking facilities of Little Rock, my knowledge extends to the fact that in 1968 their capital was $4 million and that it has increased somewhat since that time.
Unknown Speaker: Mr. Griswold, may I return to the option -- the Trial Court found that there was little likelihood of an exercise of the option to purchase at the end of 25 years, price of $2 million, one I think it was, is not one reason why the bank was unlikely to exercise the option of purchase was that the present value of the extended lease term was a lesser value of something $8 million and therefore there would be no reason to take the purchase, they probably could have bargained for the purchase of the building for less than the $2 million one?
Mr. Erwin N. Griswold: Well, Mr. Justice that is the line which the Government is now pursuing after contesting the point vigorously below, the Government now seems to concede that it is unlikely that Worthen will exercise a purchase option, but the Government maintains that the reason Worthen will not buy the building is because of the rental options are so attracting which is essentially your point.
Unknown Speaker: Well, they are somewhat more favorable, there is difference between $2 million one and $1 million eight, as I read it -- do I correctly understand the basic economy that the value of, if they renewed on the lease basis rather than the purchase it would be like buying it for $8 million?
Mr. Erwin N. Griswold: This of course is a question of assuming up to 25 to 65 years in advance what interest rates will be involved, but I think the real difference is a flown away of reasoning that.
It is said that it will only cost Worthen Bank $50,000 to occupy this building in the later years because the rental is $300,000 in the later years but the ground rent is $250,000, but that ignores the fact that Worthen can walk away and still get the $250,000.
Frank Lyon is liable for the rent on the ground lease whether Worthen renews the lease at all or not, so the real question is whether it is advantageous for Worthen to occupy the premises and in contrast to moving away some place else, opening a new building and collecting $250,000 a year from Frank Lyon on the old one.
Unknown Speaker: I just want to be sure, I understand your side of the case on this Mr. Griswold.
Do you dispute the figure, I do not know that is a finding or just in the briefs that $8 million is a fair estimation of the value of the --?
Mr. Erwin N. Griswold: No, Mr. Justice, I do not that we dispute that.
We regard it as not necessarily controlling.
There are various reasons why Worthen might not wish to keep its bank there.
The banking community might move away to other parts of the city as it has in various places and this was suggested by the President of Worthen Bank in the evidence in this case with the development of electronic fund transfer, the whole nature of banking may change.
You may have simply outlets and department stores and things and your bank may be out in a suburb.
Between the two, it is clear that the option to renew is probably, mathematically more advantageous than the option to buy, but it still does not follow that the option to renew the lease will be exercised and if the option to renew is not exercised, then Frank Lyon remains liable on the ground lease for various substantial amounts.
Now, the Government says that Frank Lyon is a mere conduct.
It relies on the fact that the rental payments from Worthen to Lyon are exactly the same as the amount due from Lyon to New York Life on the long term, no.
That simply means that they were not concerned with immediate cash flow.
What it means is that they were looking for protection on return to a combination of tax benefits in the early years or they could use as provided by law double declining balance depreciation and also to profitable operation potentially in the years following the 25 year period.
I have talked mostly about depreciation.
Let me talk briefly about interest deduction.
I do not see how there can be any question about that.
Section 163 of the Code provides that there shall be allowed as the deduction all interest paid or accrued in the taxable year on indebtedness.
Here Frank Lyon Co. an independent entity was indebted to First National City Bank and New York Life on its notes.
It borrowed the money and it paid interest.
Worthen did not borrow the money. Worthen was not liable on the notes and did not guarantee the notes.
It did not pay interest under the statute it seems to me clear the Frank Lyon Co. should be entitled to deduct the interest.
Lyon is not a finance company, it was a an entrepreneur in this transaction.
It invested a substantial amount of its own money and it undertook large liability on its notes and on the ground lease.
With reason and with the advice of counsel both parties proceeded on the understanding that Lyon is the owner of the building and is entitled to the depreciation deduction.
There is no reason in fairness nor in the terms of the Internal Revenue Code, why Lyon should not have the deduction.
There is no need to take the deduction away from Lyon in order to protect the revenue.
There is, I venture to say, no real justification for a system which says that the depreciation and interest deductions in such a case as this must wait until the final decision of the highest court.
Here, if it had been known that Worthen was entitled to the deduction as in effect held by the Court below despite the fact that Worthen could not legally be the owner of the building then the parties could have bargained accordingly.
The rent would necessarily have been that much higher.
It is important in a case like this, a three-party case, not a case like some of the others where they are just dealing with a finance company and in the Sun Oil case with a Tax Exempt Pension Fund, it is important in a case like this, a three-party case where the owner leaser is not a financing corporation that the transaction be given effect for tax purposes on the basis established by the agreement of the parties.
This is the conclusion which this Court reached in the Lazarus case.
There is no valid reason in tax policy for not applying that conclusion here.
The judgment below should be reversed and the judgment of the District Court should be affirmed.
Chief Justice Warren E. Burger: Well, Mr. Smith.
Argument of Stuart A. Smith
Mr. Stuart A. Smith: Mr. Chief Justice and may it please the Court.
The question in this case is simply whether this transaction resulted in Frank Lyon having an investment in this bank building that would support its claim, income tax deductions, the depreciation and mortgage interest.
As the arguments have thus far illuminated this particular species of transaction the sale and leaseback is no stranger to this Court, to the lower federal courts or to the tax bar.
For more than 40 years ago, this Court held in Lazarus that the statutory tax deductions attributable to the ownership of property do not follow legal title but turn on capital investment.
So the question really is who made the requisite capital investment in this bank building to justify depreciation and who --
Unknown Speaker: As I understand that the implication of what you have just said Mr. Smith and I guess it is clear in your brief, that you do concede that somebody is entitled to the deductions for interest and depreciation --
Mr. Stuart A. Smith: Absolutely.
Unknown Speaker: And you say it is Worthen?
Mr. Stuart A. Smith: We say it is Worthen.
Unknown Speaker: Right.
Mr. Stuart A. Smith: And who enjoyed the use of borrowed funds to justify the deduction for mortgage interest.
We submit that an analysis of the transaction compels the conclusion that the Court of Appeals properly applied the settled principles in this area so that Worthen Bank had the investment in the building because Frank Lyon when the transaction was properly analyzed did nothing more than lend Worthen Bank $500,000 to earn 6% interest.
Justice William H. Rehnquist: Do you draw all of what you have said up to now out of the Lazarus case?
Mr. Stuart A. Smith: We think the Lazarus case established as the basic principles in the area, that the statutory right to deductions for the ownership of property do not follow the title but rather follow capital investment.
Justice William H. Rehnquist: Well, all of that said was that it was going to be treated as a mortgage under the traditional equitable rule what appeared to be a deed outright was going to be treated as a mortgage?
Mr. Stuart A. Smith: That is true Mr. Justice Rehnquist but I think it is --
Justice William H. Rehnquist: It is a two page or two-and-a-half page opinion?
Mr. Stuart A. Smith: That is true, but I think that the part of the opinion you have cited was authority to the Court adopting the federal tax, well, there was nothing unusual about the Court’s decision because essentially equity -- in real property had a similar rule but since the Lazarus case and I think this is really undisputed the lower federal courts, the circuits have uniformly applied the Lazarus principle to analyze the sale-and-leasebacks with the inquiry at who made the capital investment and that person or that entity should get the proper tax deductions.
I think the things starts from Lazarus but we now have a settled jurisprudence with the intermediate appellate courts, commissioners rulings and what have you which set forth the basic federal principles.
Unknown Speaker: Mr. Smith I am just curious, you just said that Worthen was entitled to it.
Does the record show or do you know whether the Worthen in fact has received the benefit of these deductions?
Mr. Stuart A. Smith: Well, the record does not show, although my information is that for this particular taxable year, Worthen was audited.
In other words, the audits proceeded side-by-side so that somebody would get it and that the Worthen case was settled in favor of Worthen.
Unknown Speaker: It is in the situation of the statute limitations having around as is usually the case?
Mr. Stuart A. Smith: No.
Unknown Speaker: Mr. Smith if the primary inquiry is as you phrase it, who made the capital investment will the Government’s position be precisely the same if there were no options involved in the case.
No options to renew or options to purchase?
Mr. Stuart A. Smith: It would be much harder case.
Unknown Speaker: And the capital considerations all not be precisely the same?
Mr. Stuart A. Smith: Oh, no well yes and no in the sense that I think one of the basic considerations in our conclusion, in Court of Appeals’ conclusion that Worthen Bank made the capital investment is that under the primary term of the lease that is the 25 year term, when Worthen was making these payments which although contractually it obligated itself that was paid by New York Life.
It paid via Frank Lyon.
It made the capital investment because it obligated itself, it locked itself into the deal.
In other words New York Life insisted that Worthen’s obligation to make the payments be absolute without any deduction to set off or counter claim and Frank Lyon assigned the lease to New York Life and assigned its right to modify or terminate the lease.
Worthen, in fact, in turn agreed to that assignment and agreed that it would not cancel the lease.
So you have a situation and I think that fact is significant that Worthen by making these payments and being legally obligated, the documents themselves make it legally obligated to make these payments which pay off the mortgage that in effect it has made the capital investment.
I think the answer to your question, the option price is established a second and basic point which the courts have emphasized in this area and that is the option prices demonstrate that there was no way that Frank Lyon Co. could get anymore than $500,000 compounded at 6% in this deal, because if Worthen exercised the option at any point down the line that is the 11th, 15th, 25th year, those option prices in the record is undisputed on this point were calculated precisely to give Frank Lyon $500,000 back compounded at 6% interest.
Unknown Speaker: Mr. Smith, in answering Justice Stevens’ question a moment ago you referred our conclusion and then you corrected yourself to say that the Court of Appeals’ conclusion --
Mr. Stuart A. Smith: Well, I think that that --
Unknown Speaker: Let me finish my question if I may -- just how free either you or the Court of Appeals or this Court to substitute judgments as to what the realities of a transaction was for the judgment of the District Court?
Mr. Stuart A. Smith: Well, I think Mr. Justice Rehnquist that there are two operative principles in this area established by this Court which make this question freely reviewable on appeal and let me just briefly mention the Lazarus case itself stated that in the field of taxation, administrators of the laws and the courts are concerned with substance and realities and formal written documents are not rigidly binding that we take that to mean and the courts have taken to mean that if Frank Lyon calls itself an owner in these documents and Worthen Bank calls itself a lessee that those labels, that nomenclature is not controlling.
Indeed, I suppose it, 'a' were to enter in to a document with 'b' and called it a lease and say, I am going to lease you these premises for $100,000 for one payment in perpetuity that that would be rent by the terms of the document but it would be clearly be a sale.
Now, the second point and this is a point which I think needs addressing because Mr. Griswold mentioned the party’s expectations that more than 17 years ago in the Duberstein case the Court said with some compelling force, I think that it scarcely needs adding that the party’s expectations or hopes as to the tax treatment of their conduct in themselves have nothing to do with the matter.
Unknown Speaker: But supposing you would take both of the principles, you have just stated as agreed to that still does not fully delineate the scope of what is finally concluded by the District Court’s findings and what Appellate courts and commissioner may and the taxpayer may speculate about as to probabilities of things happening on appeal?
Mr. Stuart A. Smith: I think that is right.
I think that the District Court had a role to play to here, but our point as we fully elaborated in our brief is that the District Court’s findings to -- whether they are accurate or not, did not analyze the transaction fully.
Let me elaborate on that if I may because it is a matter of some concern between the parties.
Unknown Speaker: In that process would you say specifically what was clearly erroneous in the District Court’s findings?
Mr. Stuart A. Smith: Yes, if I may call the Court’s attention to page 6 (a) of the Appendix we are actually going to the bottom of 5 (a) looking at the District Court’s findings.
The District Court makes findings as to the annual rent during the primary term --
Unknown Speaker: That is in volume 1, I take it?
Mr. Stuart A. Smith: No, I am sorry Mr. Chief Justice --
Unknown Speaker: Oh, yes.
Mr. Stuart A. Smith: It is in the Appendix to the petition.
This is finding number 6 at the bottom of 5 (a) actually.
The District Court said the annual rent for the first eleven years was so much and so much and the annual rent for the next 14 years was so much.
They went on to say, the rent on the building during the option periods totaling 40 years, turning over to 6 (a) is $300,000 per year.
The evidence reflected and the Court finds that the rent to be paid by Worthen during the term of lease is reasonable.
The fact not contested by the defendant.
Well, let me say two things about that.
The fact that the rents were reasonable during the primary term is the beginning of the inquiry and not the end of the inquiry because the District Court’s finding that the building rent of $300,000 a year for the next 40 years is reasonable, while not erroneous, misapprehended the fact that was brought out in the earlier part of the argument, the effect of the ground lease settled because as you can see on page 7 (a) the ground lease rents after the first 25 years started to mount up quite substantially and those sharp increases in the ground lease had the effect of sharply decreasing the building rent.
Unknown Speaker: Mr. Smith, is it correct as your adversary points out or says that had the option to renew not been exercised Lyon would have remained liable for these ground rents during that extent of period?
Mr. Stuart A. Smith: That is true and the footnote in our brief was inadvertent.
The ground lease would only terminate upon condemnation or taking or upon Worthen’s exercise of the options.
Unknown Speaker: But with that in mind it is true the District Court’s finding does not explain the fact that the net income will be the difference between the building lease and the ground lease but the finding is really a realistic finding under that --?
Mr. Stuart A. Smith: Well, no let me say this in response to Mr. Justice Stevens, I think that District Court’s finding can only be fairly read to say that the reasonable rent was $300,000 a year for 40 years.
Point of the matter was --
Unknown Speaker: Well, building in which the owner has to pay ground rent is of the certain amount.
Mr. Stuart A. Smith: Right but their point is that was not the real rent.
The real rent that Worthen was going to have to pay if it went into this option period, the renewal period was going to be first $200,000 a year and then ultimately for 25 years was only going to be $50,000 a year and Worthen’s own President characterize that as a very very cheap price.
Now, let me make another point --
Unknown Speaker: But is that fair, supposing they had rented a comparable building on some third party’s land and paid $300,000 for it and that was a fair price, they would still get income from the ground lease to Lyon to net it out anyway.
Do you not still look at the fair rental value of that which they are renting, because they always are going to get the ground rent?
Mr. Stuart A. Smith: Worthen is always going to get the ground rent if --
Unknown Speaker: Yeah, whether they would rent this building or they rent any building on neighboring property?
Mr. Stuart A. Smith: Well, but the point is in this particular transaction, is it not the important point that Worthen was going to pay a sharply reduced building rent and that building rent when you figure it out over the 40 year period again was going to be downed to Frank that that was only going to pay off Frank Lyon to the $500,000 compounded at 6% interest.
Unknown Speaker: Is it even that completely correct, is it not correct that if there had not been an exercise, if all of the options have been exercised then the matter would run its course so that the end of the 65 year period Lyon owned the building and had the land there, it would not have not gotten its $500,000 plus 6% compounded unless it got some additional value during the ten year (Inaudible) is that not correct?
Mr. Stuart A. Smith: It would have been slightly sure at that point which seems to me that that indicates that it was not even going to get $500,000.
All my point was --
Unknown Speaker: So that is a risk as to whether they get the 6% in that?
Mr. Stuart A. Smith: Well, now that risk goes other, I mean our point is that the risk goes the other way.
In other words that Frank Lyon in this deal could only hope to get $500,000 compounded at 6% interest.
It might get back --
Unknown Speaker: Well, supposing the building turned out to be very very valuable at the end of the 65th year?
Mr. Stuart A. Smith: At the end of the 65th year they might get more if they could rented for more --
Unknown Speaker: So is it not conceivable with the said effects that depending on what happens, they could have gotten either more or less than $500,000 plus 6% compound?
Mr. Stuart A. Smith: May I suggest that if the building turned out to be terribly valuable that Worthen probably would have exercised its option to--
Unknown Speaker: You mean, the Lyon would have probably charged him a handsome rent for the last 11 years?
Mr. Stuart A. Smith: Assuming they wanted to be in the building.
I think the important point in our discussions indicated is that well, Frank Lyon had some upswing during that last ten years.
It was basically limited to $500,000, the whole deal was structured to permit it to receive no more than $500,000 compounded at 6% interest.
I think that that is demonstrated from the condemnation in taking provisions because at any point during the transaction, if the Government condemned or was destroyed Frank Lyon would -- first the mortgage would have to be paid off because New York Life was not going to jeopardize its position.
Then Frank Lyon would get $500,000 compounded at 6% interest and then any excess would go to Worthen.
The point that we think is significant here and the point that the Court of Appeals emphasized is that any appreciation, any upswing if this thing turned out to be terribly valuable Worthen would benefit from the appreciation, to us this is inconsistent with the notion of ownership of property, if you own real property and it goes up in value, if you are an owner you expect to be able to to benefit from that appreciation and the property but you do not expect have it be taken away from someone in a set of documents who calls itself a lessee, and if that someone can take it away, even though it calls itself a lessee we submit that that indicates that the transaction may simply be a loan and the --
Unknown Speaker: But look at it from the other side, Mr. Smith.
You say if it appreciated in value as likely Worthen would have exercised its options and retained control but supposing it went down in value farther than the parties anticipated who assumes the risk if that happened?
Mr. Stuart A. Smith: If it went down in value drastically went down in value then Frank Lyon would not get that.
Unknown Speaker: What is the purpose of the depreciation deduction to protect against increases or decreases in value?
Mr. Stuart A. Smith: The purpose of the depreciation deduction as Justice Brandeis said a long time ago in Moody is to permit a deduction for spreading the cost of an asset over the period of the investment, but the point is, Frank Lyon has put $500,000 in this building and has set up the transaction in a way to ensure that it will never have to pay a penny of its own money to pay off the mortgage.
Worthen is locked into paying off the mortgage and on this $500,000 investment it is seeking depreciation deductions in excess of $7 million.
To us there is something wrong with that and if you look at it from the other side of the coin --
Unknown Speaker: But my point earlier Mr. Smith well, and I want to be sure you have answered as to best you can, that would all be true even if there were no options to purchase or options to renew on the part of --?
Mr. Stuart A. Smith: That is true, but the options to purchase and the options to renew in our view, emphasize the fact that Frank Lyon was limited to what it could get out of his deal, limited to cover its $500,000 compounded at 6%, much like any note holder.
In other words, the way the deal really worked when you strip it down its essentials is that Worthen spent the first 25 years paying off the New York Life mortgage and then it was to going to spend the next 40 years if it did not exercise, if did not pay it off immediately paying off the Frank Lyon what I would call the Frank Lyon mortgage.
Unknown Speaker: Mr. Smith, let me ask just one other informational question, does the record tell us what the depreciable life of the building was?
Mr. Stuart A. Smith: The record does not tell us what the depreciable life of the building is but we have a reference to the fact that the appropriate treasury guidelines in this area call for a 45 year use for life for such an office building and that if I may let me pursue that for a moment Mr. Justice Stevens because I think it is significant where you have -- if taking it from the other side of the transaction, if you look at it from Worthen’s point of view, Worthen has in effect paid off a mortgage over 25 years and called it rent and in effect will be getting writing off, the cost of this building over 25 years, if this transaction has to be honored by the tax collector when the treasury use for life of this building is 45 years.
That leads me to a point I want to make about --
Unknown Speaker: Mr. Smith, before you move on to the next point, you assume of course that the bank will pay off its rental obligation and it is a likely assumption that I would concede but a number of banks do fail, including (Inaudible) in that event, who would be responsible for things --
Mr. Stuart A. Smith: If the bank failed Mr. Justice Powell, Frank Lyon will be looking down this note, we do not have any quarrel with that.
We think that since this has been mentioned that the Worthen bank is a substantial bank in Arkansas, I would think that that is despite the confusion over its capital I would submit that that is --
Unknown Speaker: I think you could name a substantial bank in New York city that --?
Mr. Stuart A. Smith: Oh, yes --
Unknown Speaker: And the amount of trouble could it not --?
Mr. Stuart A. Smith: But of course that is New York city --anything could happen there.
Unknown Speaker: Mr. Smith, since I have interrupted you let me come back to a fundamental of what policy that the United States and if the Internal Revenue Service is saved back this litigation, I understand you concede that someone is entitled.
I think you said the bank to the depreciation and the interest deductions.
Now granted in a particular case that it may fall in the Government’s favor or it may fall against the Government depending on the tax posture of the taxpayer at the moment, but what policy is that?
Mr. Stuart A. Smith: The policy Mr. Justice Powell we submit is that when Congress enacts these deductions and commits people to claim them, it assumes and is necessarily a rationale system has to assume this that the proper person is going to claim these deductions.
Now, in this --
Chief Justice Warren E. Burger: Well that starts with the conclusion proper person?
Mr. Stuart A. Smith: Well, in other words, I do not think it is a conclusion, in other words, if someone goes to the doctor and spends money for a doctor you would assume that that person would be eligible for the medical deduction.
Now, here we have a two-party transaction.
Worthen Bank and Frank Lyon, the depreciation deduction as I have mentioned is key to capital investment.
In other words, who made the capital investment?
Here is a situation where Worthen Bank has locked itself into a deal and committed itself to pay $7 million for a building over 25 years.
It has managed to call it rent in the documents but in fact it is buying a building.
We submit that it is the proper party to claim the depreciation deductions and the fact that it has bargained them away so to speak to someone else.
Unknown Speaker: But under the law of the state it could not buy a building of that cost --
Mr. Stuart A. Smith: Let me address that point Mr. Chief Justice, under the banking regulations petitioner has claimed that it could not own this building but as we read the statute and it is set forth in our brief, the banking regulations simply required that it seek permission from the federal banking authorities before it made an investment in its building in excess of its capital.
It sought that permission and the banking authorities gave its blessing to this arrangement and in fact called one of the letters called it a method of financing.
This is a very standard of financing a building but it must be looked at as simply that, a method of financing.
The courts have so looked at it.
The authorities, the articles have looked at it and in that sense Mr. Justice Powell we think the policy has to be that the proper person claimed the deduction.
Now, in the ordinary case, the record is silent on this point we do not know what the tax positions of Frank Lyon Co. and the Worthen Bank are for any of these years in issue, but I can say that my examination of the litigated cases and the Sun Oil case which we have cited and which we have set forth in a supplemental memorandum which the Third Circuits just decided, it specifically approved the kind of analysis that the Court below, the Court of Appeals engaged in that essentially, the tax policy has to be that the right person claims the deduction.
And as I was saying to pick up the point that normally in these situations, the tax positions of the parties are entirely diverse and what you have is a situation where corporation in a lower effective bracket, once they finance a building and trades off its tax deductions to a wealthy individual.
Down the row, this is a long deal, a bank like Worthen Co. after all, banks are subject to special tax treatment and have special ways to write off bad debts, the Worthen bank may have losses at some point.
It may have anticipated that it had losses and this was a kind of deal that it could arrange with someone like Frank Lyon Co. which was a burgeoning and profitable business to shelter its income because what happens at the end of this whole deal is Frank Lyon Co. has $3 million of deductions over the first 11 years of this deal.
Unknown Speaker: Mr. Smith that you have answered my question at some length of that policy I am not sure I understand your answer but let me move to another semi policy question.
The federal reservoir approved this transaction, if it had not, the bank would have been in violation of the Federal Reserve Act.
It had conceded the transaction was made but a bona fide transaction.
The another agency of the Government comes along and says in effect, number one, the transaction was really illegal because your position is that the bank still owns a building, if it owns a building it is in violation of the Federal Reserve Act.
Now, what parties do in these circumstances when one arm of the Government tells them go ahead with the transaction we have examined it and we have approved it, the Internal Revenue Service comes along several years later and takes a different view?
Mr. Stuart A. Smith: I do not think if I may that that is what happened, the banking authorities simply permitted the Worthen Bank to finance this building in this particular sort of way.
In giving its approval to this transaction the banking authorities in no sense so to speak to what the tax consequences of the deal would be.
Unknown Speaker: That was not my suggestion.
Mr. Stuart A. Smith: And I do not think that there is a --
Unknown Speaker: The banking authorities were interested to own the building and that is the bad rock of your case?
Mr. Stuart A. Smith: Own the building for tax purposes, In other words, --
Unknown Speaker: Oh, you are saying that the distinction between legal ownership of the building and ownership of --
Mr. Stuart A. Smith: Well, I am saying is that the bank -- well first let me repeat a point I made earlier, and that is I do not think it was illegal for the bank to own this building.
That is not the way we read Title 12 of U.S.C. 371 (d).
Unknown Speaker: It would have required --
Mr. Stuart A. Smith: They were required to give approval.
Unknown Speaker: Yes.
Mr. Stuart A. Smith: And the banking authorities gave that approval.
Now, in giving that approval to this mode of transaction, I think what the banking authorities were concerned with is making sure that Worthen Bank did not carry this building on its books and they were able to satisfy the banking authorities that it would not be doing that indeed it is not the nominal title holder but the Court in Lazarus 40 years ago, said that nominal title holding is not significant in terms of who gets tax deductions attributable to the ownership of property.
Unknown Speaker: Have you not got something more here than nominal title, would it be prudent banking to have a bank own a building valued at about twice its capitalization?
Do you think any banking authority would have approved that?
Mr. Stuart A. Smith: Mr. Chief Justice, I think that the banking authorities permitted the transaction as we see it and the undisputed --
Unknown Speaker: Are you suggesting that the banking authorities were simply winking at the idea?
Mr. Stuart A. Smith: I think that the banking authorities were addressing themselves to entirely different point.
I think that they were concerned, we are making sure that the bank was not over extending itself in someway to the detriment of its depositors and I think that the bank convinced them that this would not be a problem, but in fact the bank if you look at the undisputed legal import of the deal as the parties made it, the bank obligated itself to pay rent absolutely without any set off or deduction for the first 25 years of the term and that obligation had the effect of paying off the New York Life mortgage.
From the tax collectors’ point of view that obligation looks very much not like rent.
Let me close if I may.
Unknown Speaker: What happens if you have so much in lots of other places where the Government rents a whole building, what happens to the taxes on that?
Mr. Stuart A. Smith: When the Government rents --
Unknown Speaker: A whole building.
Mr. Stuart A. Smith: A whole building.
Unknown Speaker: Like (Inaudible) a point.
Mr. Stuart A. Smith: Yes.
Unknown Speaker: Leases a whole building?
Mr. Stuart A. Smith: Yeah, the Government is a good tenant, I am sure what --
Unknown Speaker: I think your point is that in the Government ownership means something in one department, there is something else in another department?
Mr. Stuart A. Smith: Well, I think that --
Unknown Speaker: But why should you submit that?
Mr. Stuart A. Smith: I think that the banking authorities were interested in who was carrying this bank on its books.
I think the tax authorities are concerned with who is obligated to pay off this thing and be obligated to that extent I suppose that is right but I do not think that is a confusion that necessarily operates to the detriment of private parties.
It seems to me that the principles in this area have been settled for a long time.
Unknown Speaker: Mr. Smith let me ask --?
Chief Justice Warren E. Burger: Since Lyon Co. signs a personal note for the (Inaudible) building that they did not have a right to think that they were buying?
Mr. Stuart A. Smith: When the Lyon Co. signs a personal note for this building but manages to hook on the Worthen Bank and lock it into the deal and say you got to pay me every month.
Unknown Speaker: Then what good was the note?
Mr. Stuart A. Smith: The note was simply the nomenclature --
Unknown Speaker: The note had built so that it felt through Lyon got to pay?
Mr. Stuart A. Smith: Absolutely.
If the Bank defaulted Lyon would have to pay.
Unknown Speaker: But did they own it?
Mr. Stuart A. Smith: But they did not own it because they locked in Worthen Bank to pay off.
It is simply Lyon is really in the posture of a guarantor because Worthen Bank has to make these payments.
It is a substantial entity and if for some reason it fails then the guarantor has to take over but guarantors are not entitled to deductions until the operative facts upon which they guarantee is premise to rises.
That is our point if essentially, if Frank Lyon Co. ultimately found itself holding the bag on this thing then and then only would it be entitled to a depreciation deduction because it would then be forced to have an investment in this building until then we submit that it was really simply a passerby who was receiving these rental payments from Worthen Bank and transmitting them by contractual arrangement to New York Life Insurance Company.
If the court has no further questions.
Chief Justice Warren E. Burger: You have an extra 3 minutes here Mr. Griswold do you wish to--
Rebuttal of Erwin N. Griswold
Mr. Erwin N. Griswold: Very briefly Mr. Chief Justice.
First I would like to correct one thing in the record.
The question as to what Worthen Bank has been doing with this depreciation does appear in the record.
It is at the bottom of page 201 and the top of page 202 where about two inches below the top of page 202, counsel for the Government says, I believe the bank has continued to treat the transaction as it was treated originally and though that is perhaps a little inconclusive, it was tied up by trial counsel Mr. Williamson, on page 216 of the record where he asked the present of Worthen Bank, has Worthen Bank contested that determination or agreed to it and President Pennick(ph) said we have contested it.
Worthen Bank is not accepting the determination.
Now, with respect to depreciation, I think that Mr. Smith has been a little glib in talking about 45 years, a building has lots of components including plumbing and mechanical and electrical and elevators and the depreciation period for them is 15 years for architectural and general construction it is 33 years, and finally for the structural frame it is 40 years.
The fact is that a very high proportion of this total depreciation is available within 25 years more than close to 90% and there is not much difference over the 25 years between double declining balance and straight line depreciation and then finally I would like to say that it is perfectly plain here Mr. Smith keeps saying in his brief here that permission was sough and it was given.
Well, it was given for the sale-leaseback arrangement.
Permission was sought to build the building and own it and it was refused and it is not a purely cosmetic matter of the banking officials trying to keep this from appearing on balance sheet.
If Lyon’s liability is as lessee and that is the way in which Worthen supported Lyon’s liability, the same way that any building owner looks to his tenants to pay the rent in order that he can pay the bank but he has to have -- if Worthen went insolvent, I am not instantly familiar with the immediate details of the bankruptcy law but my recollection is that there would be a claim on behalf of the depositors for two years rent but not for all the future.
On the other hand, if Worthen Bank was liable on the note, there would be a claim in its bankruptcy for the entire amount of the note and that is a very real difference and the reason why the banking officials rightly would not allow Worthen to own the bank.
Chief Justice Warren E. Burger: Thank you gentleman, the case is submitted.