                         T.C. Memo. 1999-334



                       UNITED STATES TAX COURT



 H GROUP HOLDING, INC. AND SUBSIDIARIES, FORMERLY HG, INC. AND
              SUBSIDIARIES, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos.    616-91, 2012-92,           Filed October 5, 1999.
                   7994-93, 2423-95,
                   8532-95.



     Harold J. Lipsitz, Robert A. Bedore, and Stephen Fedo, for

petitioners.

     Pamela V. Gibson, Donna C. Hansberry, and Steven W.

LaBounty, for respondent.




     1
        The following cases are consolidated for purposes of
trial, briefing, and opinion: H Group Holding, Inc. and
Subsidiaries, formerly HG, Inc. and Subsidiaries, docket Nos.
2012-92 and 7994-93; and AIC Holding Co. and Subsidiaries,
formerly Anartic Investment Co. and Subsidiaries, docket Nos.
2423-95 and 8532-95.
                                 - 2 -


             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:2     Respondent determined deficiencies in, and

additions to, Federal income tax and penalties as follows:

H Group Holding Inc. and Subsidiaries

          Taxable year
             ending              Deficiency

          Jan.   31,   1980      $7,681,409
          Jan.   31,   1981       5,658,067
          Jan.   31,   1982       6,677,731
          Jan.   31,   1983          40,311
          Jan.   31,   1984       6,768,120
          Jan.   31,   1985         799,024
          Jan.   31,   1986      19,397,355
          Jan.   31,   1987       9,153,141
          Jan.   31,   1988      13,176,113




     2
        These consolidated cases were reassigned to Judge Joel
Gerber by a Feb. 25, 1999, order, following the death of Judge
Theodore Tannenwald, Jr. The parties agreed that the issues
tried to the Court in the trials conducted by Judge Tannenwald
could be reassigned to another Judge without the need for a
retrial or the presentation of additional evidence.
                                - 3 -


AIC Holding Co. and Subsidiaries

     Taxable year                             Penalty
        ending            Deficiency         sec. 6689

     Dec.   31,   1976     $659,483             ---
     Dec.   31,   1977    1,798,443             ---
     Dec.   31,   1978    1,420,787             ---
     Dec.   31,   1979    3,160,729             ---
     Dec.   31,   1980   12,418,363          $23,145
     Dec.   31,   1981   10,660,213            5,227
     Dec.   31,   1982    3,885,657             ---
     Dec.   31,   1983    4,024,241             ---

     The issues relating to section 482,3 the subject of this

opinion, have been severed from the other issues in these cases.

The issues presented for our consideration are:

     (1)    Whether respondent’s allocations of income (a) for the

use of the Hyatt trade name and marks by Hyatt International

Corp. (HIC) and its subsidiaries, and (b) for management services

HIC provided to its subsidiaries were arbitrary, capricious, or

unreasonable; and

     (2) the amount of arm’s-length consideration, if any, for

such transactions.




     3
        Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                                - 4 -


                          FINDINGS OF FACT4

I.   Historical Background

      Hyatt Corp. (Hyatt Domestic) is a wholly owned subsidiary of

petitioner H Group Holding, Inc. and Subsidiaries (HGH).    HIC is

a wholly owned subsidiary of petitioner AIC Holding, Inc. and

Subsidiaries (AIC).    All of these entities were organized under

the laws of the State of Delaware, and their principal offices at

all pertinent times were located in Chicago, Illinois.    The

relevant consolidated corporate Federal income tax returns of HGH

and AIC (or their respective predecessors) were timely filed with

the Internal Revenue Service Center at Kansas City, Missouri.5

For the taxable periods in issue, Hyatt Domestic and HIC were

owned or controlled directly or indirectly by the same interests,

and said control satisfies the threshold for application of

section 482.6

      Hyatt Domestic was organized in 1957.   As of 1968, Hyatt

Domestic operated seven hotels in the United States with 2,431

rooms, collectively.   About one-half of the hotels and rooms were


      4
        The parties’ stipulations of facts and the attached
exhibits are incorporated by this reference.
      5
        The issues considered involve petitioners’ subsidiaries,
Hyatt Domestic and Hyatt International Inc. (HIC) (and its
subsidiaries).
      6
        Attached as an appendix is a diagram reflecting the
relationships of some of the more significant entities addressed
in this opinion.
                                - 5 -


in California.    At the end of 1968, Hyatt Domestic operated 11

hotels with 3,376 rooms, collectively.      As of January 1976, Hyatt

Domestic’s operation had grown to 45 hotels with approximately

20,000 rooms, collectively, and 14 motels, with approximately

1,500 rooms, collectively.

     HIC was established August 19, 1968, with the principal

purpose of owning and/or operating hotel properties outside the

continental United States under the Hyatt name.     HIC’s initial

shareholders were the same as the shareholders of Hyatt Domestic.

A. Peter di Tullio, (Mr. di Tullio), HIC’s first employee, was

hired as executive vice president to guide the international

venture.   Mr. di Tullio had experience as an international

hotelier and had spent the majority of his career with Hilton

International Hotels (Hilton International).     At the time he

started with HIC, Mr. di Tullio had been serving as a vice

president of Hilton International.      He had worked in Europe, the

Middle East, and, to a lesser extent, Asia, and as an area

director for Southern Europe, Africa, the Middle East, and

Southeast Asia.

     By July 31, 1969, Mr. di Tullio, who remained an employee,

had hired an assistant and an architect, and he focused on

establishing a European base of operations, with an office in

Rome.   Around 1971, however, HIC established its headquarters in

Chicago, and its three employees were moved from Rome.     By the
                                - 6 -


end of 1971, the Hyatt International group7 managed seven hotels

located in Hong Kong; Singapore; Manila, the Philippines;

Colombo, Ceylon (Sri Lanka); Acapulco, Mexico; Colon, Panama; and

Toronto, Canada.   Early in the 1970’s, Mr. di Tullio hired

Moustaffa Bakry, a former vice president of Hilton International

in Cairo, to assist in developing the Middle East.      By late 1972,

the Hyatt International group had executed nine management

contracts, and additional management contract negotiations were

in process.   By 1973, Mr. di Tullio had become president of HIC.

From 1969 through 1975, the number of hotels managed by the Hyatt

International group grew from a single property in Hong Kong to

19 hotels located on 4 continents.      As of the end of 1979, the

Hyatt International group managed 28 hotels in 19 different

countries.    Mr. di Tullio recruited Roland McCann, another former

Hilton colleague, to head the Hyatt International group’s efforts

in the Caribbean and Latin America.      During the period from 1976

through 1984, the Hyatt International group added 51 properties

in Europe, Africa and the Middle East, Mexico and Central

America, and Asia, in addition to those already managed.

     On November 29, 1968, Hyatt Domestic and HIC entered into a

licensing agreement for use of certain “Licensed Marks” owned by


     7
        We use the term “the Hyatt International group” to refer
to HIC and its subsidiaries collectively or some combination
thereof. That term is in contrast to “HIC” or other instances
where we have referred to a specific entity.
                               - 7 -


Hyatt Domestic.   These licensed marks were:   “Hyatt House

Hotels”, “H. H. & Designs”, and “Hyatt Lodges & Design”.      Hyatt

Domestic granted to HIC the exclusive license to use the marks

outside the United States and its territories and possessions,

the nonexclusive license to use the marks in Hawaii, Alaska, and

the U.S. territories and possessions, and the nonexclusive

license to use the marks on printed matter, brochures, and

similar products throughout the world.   The agreement also

allowed HIC to grant sublicenses to any entity in which it owned

at least a 50-percent interest.    HIC agreed that the standards of

services and the quality of products bearing a mark would be at

least equivalent to those adopted or used by Hyatt Domestic.     HIC

agreed to pay Hyatt Domestic $10,000 upon execution of the

agreement, plus $10,000 for each new hotel operated under the

name “Hyatt”.   The expenses of trademark and name registration in

foreign jurisdictions were the responsibility of HIC as were the

costs of any foreign trademark infringement litigation.    The

agreement was signed twice by Jay Pritzker, once as president of

Hyatt Domestic and a second time as president of HIC.

     On October 22, 1971, Hyatt Domestic authorized HIC to use

the “Regency” name in addition to the “Hyatt” name licensed under

the 1968 agreement.   The previously established $10,000 fee per

hotel, however, was not changed.   On September 24, 1976, the list
                                  - 8 -


of marks licensed was expanded to include various logo designs,

advertising slogans, restaurants, and other “Hyatt” names.

II.   Organizational Structure8

      The first international hotel property managed by the Hyatt

International group was an entity that became known as the Hyatt

Regency Hong Kong.   The owners and HIC entered into a management

agreement dated June 7, 1969.     Generally, the agreement followed

the form used by Hilton International, and the name “Hyatt” was

substituted for the name “Hilton”.        On October 28, 1969, Hyatt of

Hong Kong (HHK) was incorporated in Hong Kong as a wholly owned

subsidiary of HIC, and on October 30, 1969, HIC assigned its

interest in the management agreement for the Hyatt Regency Hong

Kong to HHK.   Mr. di Tullio hired Brian Bryce from Hilton

International to be the Hyatt Regency Hong Kong’s general manager

and the senior vice president of HHK.       The Hyatt Regency Hong

Kong began operations in November 1969, using the Hilton

International registration forms as a model.       Other members of

the Hyatt Regency Hong Kong executive committee staff were hired

from Hilton International, including Ken Mullins, Bernd

Chorengel, Larry Tchou, and David Chan.




      8
        Although the Hyatt International group consisted of
numerous legal entities, we limit our description to a sufficient
number of representative examples in order to provide an
understanding of the group structure.
                               - 9 -


     Generally, separate corporations were formed to execute

and/or hold each management contract.   Some of the more

significant purposes for forming separate entities were to limit

liability and take advantage of possible local tax benefits.    The

separate hotel management companies were usually made wholly

owned subsidiaries of either HIC or HHK, and most were

incorporated either in the country where the hotel was located or

in Hong Kong.   Generally, no consideration was paid when

management contracts were assigned from a signing entity to a

hotel operating entity.   On one occasion, however, Hyatt of

Singapore (HS) paid HIC $500,000 for the assignment of the

management agreement for the operation of the Hyatt Regency

Singapore.   In numerous instances, HIC guaranteed the performance

of the signing subsidiary.   HIC was involved in the development

of contract opportunities primarily in Central America, Europe,

Africa, and the Middle East, whereas HHK was active in the Asia-

Pacific area.   Ultimately, HHK evolved into a master hotel

management subsidiary responsible for the entire Asia-Pacific

region.

     Hyatt International Canada Ltd. was established in August

1969, as HIC’s Canadian subsidiary, and three ground-up hotels

were opened, two of which closed by 1979, and the remaining hotel

was transferred in exchange for consideration to Hyatt Domestic

in 1984.
                              - 10 -


     HS was incorporated in Singapore on August 14, 1970, as a

wholly owned subsidiary of HIC for the purpose of holding the

Hyatt Regency Singapore management contract.   The first

management agreement for the Hyatt Regency Singapore, dated May

27, 1970, was executed by HIC and contained a financial guaranty

regarding the amount of the hotel owner’s share of the gross

operating profits.   HS has been responsible for the operation of

hotels in Malaysia, Indonesia, and Thailand.   Although HS is a

subsidiary of HIC, it has always reported to HHK.   On the advice

of tax counsel, HS was assigned the Sydney, Australia, Kingsgate

management contract by Hyatt Regency Corp. Pty. Ltd., a wholly

owned subsidiary of HHK.

     The Hyatt Regency Acapulco (opened in Mexico in October

1971) was the first hotel outside of Asia managed by the Hyatt

International group.   Ken Mullins transferred from the Hyatt

Regency Hong Kong to become the Hyatt Regency Acapulco’s first

general manager.   HIC formed a local management company,

Servicios Internacionales Administrativos, S.A. de C.V. (SIASA),

a wholly owned subsidiary of HIC, to manage the hotel.     Mullins

was succeeded as the Hyatt Regency Acapulco general manager by

Fred Lederer, and both had been Hilton employees.

     On October 24, 1979, the Hyatt International group entered

into a joint venture with Valores Industriales S.A. (VIS),

Mexico’s largest brewer of beer, which already owned and operated
                               - 11 -


five hotels under its Exelaris banner.    The joint venture was

called Hoteles Exelaris, S.A. (HESA), and was owned 51 percent by

VIS and 49 percent by HIC (Mexico), a wholly owned subsidiary of

HIC.    HIC’s 49-percent ownership was, to some extent

unrepresentative in that HIC had contributed about 75 percent of

the value and was entitled to about 25 percent of economic

returns.    After 2 years the profit split was changed to 65

percent for HIC and 35 percent for VIS.    Mexican law did not

permit greater than 49-percent ownership by a foreign

corporation.    HESA was established and operated in Mexico; it was

a VIS-oriented chain, and it was VIS’ intention to exploit the

Exelaris name in the marketplace.    On each HESA hotel was the

name Exelaris, and underneath was the name Hyatt and the name of

the city.    VIS established an HESA office in Mexico City with

approximately 70 to 80 employees.    Fred Lederer, then general

manager at Hyatt Regency Acapulco, was named as the first

director general of HESA.    According to the agreement between VIS

and HIC (Mexico), Fred Lederer would continue serving as general

manager for 18 months, and, thereafter, he would work exclusively

for HESA.

       The Hyatt International group formed certain companies to

provide services that supported its hotel management activities,

to wit:    Support services companies, hotel consulting and project

development companies, and special purposes companies.    Support
                              - 12 -


service companies are principally involved in marketing, sales,

reservations, and computer support.    In most instances, these

support services were provided by staff at the local hotel level;

however, the Hyatt International group also provided support

services through separate entities; the most prominent of these

was Hyatt Chain Services, Ltd. (HCS).

     On January 19, 1971, HCS was incorporated in Hong Kong as a

wholly owned subsidiary of HHK.   Essentially a marketing

cooperative, HCS provided marketing, sales, and reservation

services to the hotels under contract to the Hyatt International

group.   HCS also provided guidance to the hotels regarding the

development of their own individual marketing programs.     The

services provided by HCS are commonly called “chain services” in

the hotel industry.   It is understood that chain services also

promote a particular hotel chain.   In keeping with industry

practice and pursuant to contractual agreements with hotel

owners, HCS provided its services at cost.    The costs for HCS

were totaled annually and shared pro rata by each hotel based on

its room revenue and total number of rooms, subject to

limitations based on a certain percentage of revenue.    Such

amounts were not considered as income or expense to HCS.     HCS’

total annual costs were as follows:9


     9
         Beginning with 1984, the totals are derived from
                                                    (continued...)
                                - 13 -


               Year             Amount

               1972       HK$     285,595
               1973       HK$     372,290
               1974       HK$     363,948
               1975       HK$     448,656
               1976       HK$   2,532,531
               1977       HK$   2,752,146
               1978       HK$   2,361,955
               1979       HK$   2,177,055
               1980       US$   1,921,907
               1981       US$   2,300,788
               1982       US$   2,990,913
               1983       US$   3,227,881
               1984       US$   4,681,778
               1985       US$   4,309,759
               1986       US$   5,934,852
               1987       US$   6,519,779

HCS maintained sales and marketing offices in several major

cities, including Frankfurt, London, New York, Chicago, Los

Angeles, Tokyo, Hong Kong, and Singapore.

     Hyatt Domestic and the Hyatt International group provided

chain services (i.e., marketing, sales, and reservations) for the

benefit of each other’s hotels.    On or about January 25, 1974,

Hyatt Domestic and HIC agreed to charging for the chain services

between domestic and international Hyatt hotels.    Hyatt Domestic

was to provide a certain amount of chain services for the Hyatt

International, to be negotiated annually.    For the services it



     9
      (...continued)
consolidated financial statements of HCS and its subsidiaries,
HCS GmbH and Hyatt Reservations SARL. The certified public
accountants who prepared the first consolidated statement
indicated that prior years’ comparative statements were
unnecessary because “The effect * * * is not material”.
                                  - 14 -


provided, Hyatt Domestic would charge the Hyatt International

group a prorated chain allocation10 on a per room basis as

follows:    Non-North American hotels to pay 50 percent of the

usual chain allocation; Canadian hotels to pay 75 percent; United

States hotels to pay 100 percent.      These percentages were based

on the perceived relative benefit received by each group of

hotels.    Effective February 1, 1980, HIC and Hyatt Domestic

agreed to represent each other in their respective geographical

markets and to separately control and account for their

respective expenses.       As of 1980, Hyatt Domestic concluded that

the exchanged benefits had equalized, so that no further charges

were allocated for chain expenses to Hyatt International hotels.

     Pursuant to the 1974 agreement, HIC charged Hyatt Domestic

the following amounts:

            Taxable year
               ending               Amount

           Dec.   31,   1975       $296,250
           Dec.   31,   1976        368,746
           Dec.   31,   1977        489,591
           Dec.   31,   1978        568,750
           Dec.   31,   1979        666,080
           Dec.   31,   1980         56,250

HIC’s charges for chain-type services were included in Hyatt

Domestic’s total chain expenses.      The total of chain services

expense was billed by Hyatt Domestic directly to Hyatt


     10
        “Chain allocation” refers to the amount determined by
the cost-sharing formula applied to chain services.
                              - 15 -


International group and domestic hotels based on their individual

chain allocations.   For 1978, 1979, and 1980, Hyatt Domestic

charged the Hyatt International group hotels approximately

$1,050,000, $1,200,000, and $1,375,000, respectively.

     During 1981, HCS contracted for the development of a

computerized reservation system to be called “IMAGE”.     David

Cook, an HIC employee, spent about a year and a half in Germany

training to become the systems manager for IMAGE.    During 1983,

Mr. Cook returned from Germany, and IMAGE was installed at Hyatt

Domestic’s information services headquarters.   Mr. Cook traveled

to various cities implementing the IMAGE system.    Another HIC

employee trained reservations personnel.   The IMAGE reservations

system was not fully implemented.   From 1981 through 1985, HCS

expended more than $4 million on the IMAGE system with funds that

had been advanced by HHK for the IMAGE system development.

     When the Hyatt International group executed a management

contract for a hotel that was to be constructed or when a hotel

under contract underwent a major renovation, the Hyatt

International group frequently provided design consulting

services, also known as technical services, to the hotel owners

in exchange for a fee.   The Hyatt International group was not

prohibited from supplying these services to hotels outside the

Hyatt chain.   These fees were earned by and payable to

International Project Systems, Inc. (IPS), which was incorporated
                               - 16 -


in Delaware on February 27, 1974, as a wholly owned subsidiary of

HIC.    IPS could provide either full or partial technical

assistance.    Full technical assistance involved comprehensive

support of the hotel owner’s designers and engineers from the

first architectural drawing to the last day of construction,

including writing specifications, reviewing internal documents,

and reviewing and critiquing back room operational designs.       In

contrast, partial technical assistance involved taking over a

project that is either under construction or fully built and

operating.

       IPS offered consulting services on a hotel’s design (by

approving or recommending the architect’s drawings), but it was

not responsible for overall design.     It also could recommend

sources for the wide range of items--from structural building

members to bedding--that a hotel might need.     Occasionally, IPS

subcontracted aspects of the project to other companies.     In most

cases, however, IPS established a flat fee for the specific

technical services it would provide to a hotel, purportedly based

on the Hyatt International group’s experience with the

anticipated expenses.    During most of the years at issue, IPS’

expenses exceeded its revenues.

       The Hyatt International group maintained an operational

structure allowing for general strategies to be created and

organized at the top corporate level.     The choice to implement
                               - 17 -


general strategy remained with the individual hotel’s management.

Rather than strive for uniformity of appearance and

accommodations in its properties, the Hyatt International group

was able to develop and manage unique hotel properties.    Each

property was fashioned to be culturally correct and

geographically distinct within a particular country.    Guests were

thereby permitted to recognize or appreciate a local character

while enjoying a high level of service.    In spite of that

flexibility, the Hyatt International group, in substantially all

cases, has used the name Hyatt in the hotel names and used the

Hyatt logos and slogans, such as    “Don’t you WISH YOU WERE HERESM”

and “touch of Hyatt”.

III.    Modus Operandi of Hyatt International Group

       While the Hyatt International group has taken some equity

positions and in limited circumstances has been involved in

hotel leases, its modus operandi has, generally, been to pursue

management contracts as a means to expand the Hyatt chain and to

increase profitability.    In the international hotel business, the

management contract approach places much of the operating risk on

the owner, not the manager.    Consequently, the owners’ rewards

are also greater, and they generally receive the larger share of

the hotel operating profits and the benefit from appreciation in

capital value.
                              - 18 -


     Basically, the hotels connected with the Hyatt International

group’s business can be classified in three general categories:

“takeover[s]”, “shell[s]”, and “new hotel[s]”.   Takeovers involve

hotels where one management company succeeds another in managing

a property that is fully operational.   When a management company

becomes involved during hotel construction, it is called a shell.

Because the shell’s building is partially constructed, the

fundamental design is incomplete, and the opportunity remains for

design revisions.   Through the mid-1980’s, the majority of the

Hyatt International hotels were either takeovers or shells,

leaving the Hyatt International group with little or no influence

over the design of the hotels.   In the case of “new or ground-up”

hotels the management company is involved from the start of the

hotel project design and prior to any construction.   Most of the

Hyatt International hotels opened after 1985 have been ground-up

properties where there was involvement in the design of the

hotel.

     To be effectively involved in the design, a hotel management

company must work closely with the hotel owner or its

representative, the architects, and the project manager.   The

hotel owner or its representative is the primary force behind the

hotel development, making the choice of architect, project

manager, and the type of property to be built.   For example, the

owner may choose a luxury, business, or economy-type hotel.   The
                               - 19 -


owner also chooses the basic image that the hotel property will

project.   The hotel architects receive design manuals and an area

program describing in great detail how the Hyatt International

group believes the hotel layout should blend with the management

agreement.    The architects, however, are generally free to design

the hotel according to their experience and imagination, combined

with the focus and intent of the owner.   The project manager is

the hotel owner’s on-site construction liaison, serving as the

link between the owner and the Hyatt International group.

     It takes about 3 to 4 years to develop a hotel.   The amount

of design consulting provided by the Hyatt International group

varied depending on the particular hotel, the nature of the Hyatt

International group’s relationship with the hotel owner, and the

owner’s requirements, and budget.   Though not all hotels choose

to utilize IPS’ consulting services in the facility design, the

Hyatt International group generally provided guidelines,

concepts, and recommendations throughout the process; it

established performance criteria and minimum requirements for

each hotel.   The design manuals provided to each hotel

owner/developer outlined the standards established by the Hyatt

International group for the property.   The standards were based

on service characteristics and the scope of operations of each

hotel; that is, the number of food and beverage outlets and

rooms.
                             - 20 -


     HIC issued a pro forma letter stating that the manuals are

guidelines and that the standards are not intended to be rigidly

applied by every hotel in every instance.    These guidelines

served as minimum specifications, essentially providing the Hyatt

International group with a way to withdraw from a project without

liability if the specifications are not met.    The guidelines were

developed over a period of years and contain a compendium of

Hyatt institutional experience.   HIC also provided hotel

equipment standards books containing the detail of the items

needed to stock and furnish the hotel exclusive of the guest

rooms, public areas, and major kitchen equipment.    At least one

volume of the three-volume book of equipment standards had to be

customized for a particular hotel.

     A significant strength of the Hyatt International group was

its capability to provide the hotel owner with an assembled work

force, including senior management, general managers, and behind

the scenes or back room service hotel personnel.    Hyatt

International group’s senior management consisted of HIC’s senior

executives, including the president and chief executive officer

as well as a number of vice presidents with functional

responsibilities for legal matters, finances, marketing,

technical services, and human resources.    It also included HIC

executives in charge of geographic regions, such as senior vice

presidents and their directors with functional responsibilities.
                              - 21 -


These executives, organized by geographic regions, either worked

for one of HIC’s master hotel management subsidiaries or for HCS.

Hyatt International group’s senior management assumed primary

responsibility for developing relationships with hotel owners and

maintaining their trust.   Generally, management contracts were

sourced in personal relationships with owners, and those

relationships were important to the success of the Hyatt

International group’s management and operational systems.

     The general manager, in effect, operated as the chief

executive officer of the hotel.   Each general manager had the

power to make day-to-day decisions, interact with the owner, and

generally run the hotel as an autonomous business.   Offers of

employment for general managers were prepared and executed by

authorized Hyatt International divisional or regional personnel

on divisional or regional letterhead.   Owners generally

recognized the general manager’s importance and tended to rely on

the Hyatt International group to provide personnel who would be

key to the hotel’s success.   The owners worked with the hotel’s

general manager to ensure that their interests were being pursued

and generally looked to the general manager when they had any

operational questions.   In general, the owner’s involvement was

limited to participation in general management activities, such

as budgeting and finances; original, amended, or renewed

management contracts; hotel design and renovations; general
                                - 22 -


manager appointments; and legal, economic, and political risks.

Owners relinquished day-to-day operations of the hotel to the

general manager and other members of the hotel’s executive

committee.

     While the general manager was principally responsible for

hotel management, the general manager relied upon the hotel

executive committee for operational and strategic support.     The

executive committee typically consisted of five to eight people:

Including the key department heads in the hotel, including the

resident manager; directors of rooms, food and beverage, human

resources, engineering, and sales/marketing; the executive chef;

and the financial controller.

     The general manager was responsible for recruiting

personnel, setting pay rates, labor union negotiations, and

conducting the initial training.    The general manager was

assisted in these matters by the Hyatt International group

management subsidiaries.   The hotel’s director of human resources

was responsible for the actual hiring of the operational

personnel and had to be aware of and sensitive to local working

conditions, labor laws, religious and cultural mores, which

differ from hotel to hotel.   The director of human resource

positions were filled through the coordinated efforts of the

general manager and the divisional director of human resources.
                               - 23 -


     The director of sales and/or marketing was responsible for

bringing in customers to the hotel, and was usually engaged about

6 to 9 months prior to a hotel’s opening in order to analyze the

business traveling pattern of the city and locate likely sources

of business.   Room revenues were usually derived from independent

travelers, tourists, incentive groups and tours, corporate rate

guests, and special rate guests, such as airline crews.   The

hotel had to find the appropriate market mix and aggressively

pursue new guest and customer markets in order to be successful,

remaining flexible and responding to any market shifts.   Some of

the business was generated locally from companies and local

travel agents.   The director of sales/marketing and the general

manager were responsible for negotiating with local companies and

travel agents and qualifying them for special rates in exchange

for the guaranty of a certain number of room nights.

     Marketing performed by individual hotels differs from chain-

service marketing.   For chain marketing, the strengths of a

particular property may be featured, but the overall purpose is

to promote the global chain.   For example, Hyatt International

group’s brochures may focus on a single hotel, but also provide

reservation information for other Hyatt International hotels and

publicize one or more Hyatt International hotels in the same

area.   Establishing a local presence was the general manager’s
                              - 24 -


responsibility with the assistance of the other members of the

executive committee.

     For the Hyatt International group, the food and beverage

revenue was as integral to a hotel’s success as the room revenue.

Decisions about what type of food and beverage service to offer

were made by the general manager and area directors; HIC did not

provide a master plan or instruct hotels as to the kind of

restaurant, bar, or cafe services to offer.

     “Back-of-the-house” operations refers to support services

that are performed behind the scenes in a hotel, including

engineering, maintenance, accounting, and management information

systems.   Back-of-the-house operations were within the exclusive

purview of the general manager and executive committee.   The

general manager and executive committee were also responsible for

managing other hotel departments, including telephones, foreign

exchange, laundry, and membership clubs such as fitness and/or

golf.

     The engineering or technical services departments of hotels

were responsible for hotel maintenance and safety.   That job is

basically standard from hotel to hotel, but may vary according to

local government rules, regulations, and license requirements.

     The hotel controller is responsible for the books and

accounts of the hotel operation and for maintaining the

accounting records of the hotel.   A uniform system of accounts
                               - 25 -


for hotels was used by all Hyatt International hotels.    Thousands

of transactions can take place during any given day.    For

example, if a 500-room hotel is 80 percent occupied with an

average of two occupants per room and each occupant purchases one

meal in the hotel per day, a total of 1,200 transactions takes

place during the day (400 rooms plus 800 food and beverage

transactions).    Each guest can generate additional transactions

by using the laundry, making purchases at the sundry store, and

using the business center, telephone, or health club.    Financial

controls at the local hotel level and its effect on the chain

operation are extremely important.

     The operational personnel consisted of individuals who

worked in nonexecutive hotel positions and reported to executive

committee members; e.g., front desk clerks, banquet captains,

restaurant waiters, bartenders, and maintenance personnel.    The

operational personnel represented the largest human resource

group in the Hyatt International group.    Recommendations

regarding the compensation of staff were made by the executive

committee and approved by the general manager.

     The hotel general manager and executive committee were

largely responsible for preopening activities, although certain

preopening responsibilities were undertaken at the divisional

level.    Included in successful preopening management activities

were:    Overall planning, staffing, setting up the physical plant,
                               - 26 -


and marketing.   Preopening activities were more important and

more elaborate for new hotels than for takeovers, although

takeovers did require some preopening preparation.   For a new

hotel, a general manager was generally designated and assigned 12

to 18 months prior to opening.

     The owner was responsible for paying preopening expenses,

including the cost of training.   After the opening, the owner was

responsible for paying management fees and hotel operating

expenses.   The Hyatt International group’s management fees

generally were expressed as a percentage of revenue and/or gross

operating profits.   To avoid certain countries’ local withholding

taxes, the management fees were characterized or described in a

few contracts as royalties.   Each hotel’s revenues, expenses

(including payroll), and assets were carried on its own books and

were not recorded by or shown in the books of any Hyatt

International entity.   The Hyatt International group, however,

was responsible for managing the employees and the assets and for

generating each hotel’s revenues.

     Hyatt International’s ability to retain management contracts

was dependent upon two factors:   (1) Satisfying hotel owners and

(2) generating sufficient revenue to ensure a successful

arrangement for both the owners and the Hyatt International

group.   For both of these factors, the hotel general manager

played a significant role.    Occasionally, management contracts or
                               - 27 -


leases were terminated for various reasons, including the

following:    (1) An owner might become dissatisfied with Hyatt

International’s management.    For example, the contracts for the

Hyatt Regency Toronto and Hyatt Vancouver Airport, two of the

three Canadian Hyatt International hotels, terminated due to the

owners’ dissatisfaction with the operating results and failure to

meet the contractual profit targets, respectively.   (2)

Conversely, the Hyatt International group might become

dissatisfied with the owner, including the owner’s unwillingness

to renovate the property.    (3) Forces of nature or the effect of

politics can be the cause of involuntary termination.

     A strong owner-management relationship is essential to

implement necessary improvements to hotels because owners are not

usually eager to bear the high costs of improvements.    By the

mid-1980’s, the Hyatt International group’s growth enabled it to

be more selective in its management relationships.   At that time,

the group began eliminating poor performing and below-standard

properties.

     The Hyatt International group played an important role in

the careers of the people hired and was responsible for

determining hotel employees’ compensation.   Employees hired for

management positions were subject to being reassigned to other

hotels.   The Hyatt International group identified promising hotel

staff members and positioned them for promotion at their current
                               - 28 -


or another hotel.   When planning a new hotel location, the Hyatt

International group looked for experienced chain employees for

the general manager and executive committee for the new hotel.

Generally, the general manager and area directors recommend

executive committee staff for transfer and promotion.    The

selection and transfer of general managers and certain executive

staff, however, required HIC’s approval.    Similarly, senior staff

recommendations for the general manager’s and executive committee

member’s compensation was also subject to HIC’s approval.      From

their first position, employees knew their career would be

determined by the Hyatt International group, not the hotel owner.

     The general manager and executive committee staff at certain

Asian flagship hotels, such as the Hyatt Regency Hong Kong and

the Hyatt Singapore, served concurrently in senior executive

positions with HHK and HS.    Initially, the salaries of HHK and HS

employees and related overhead expenses were paid entirely by the

hotels.   Later, a portion of those salaries was paid by the Hyatt

International master hotel management subsidiaries, after they

assumed increased responsibility for new hotels.    In the early

1980’s, HHK began to hire and pay full-time clerical staff and

specialists in positions such as marketing, food and beverage,

engineering, and finance.    For certain hotels, the executive

staff (usually general managers and controllers) continued to

have dual roles.    For example, Brian Bryce, the first general
                               - 29 -


manager at the Hyatt Regency Hong Kong, was also a vice president

for HIC; David Chan was controller at Hyatt Regency Hong Kong and

area controller for HHK; Bernd Chorengel was general manager at

Hyatt Regency Singapore at the same time that he was area

director, and then senior vice president, for Southeast Asia at

HS.

IV.   HIC’s Role Within the Hyatt International Group

      An attempt was made to insulate the Hyatt International

group from day-to-day hotel operations and from legal issues such

as guest complaints or injuries.    These matters were primarily

dealt with at the local hotel level by the general manager, the

owner’s representative, and/or the hotel’s counsel.     HIC rarely

became involved in these matters, although it was made aware of

significant developments by its master management subsidiaries

and/or the general managers.   “Slip-and-fall” personal injury

cases were handled at the hotel level and monitored by the

relevant management subsidiary or HIC.    The management

subsidiaries engaged their own legal counsel for employment

matters.   HHK used Hong Kong lawyers for tax advice and legal

liability concerns.   The subsidiary companies, therefore, while

relying on local counsel, involved HIC whenever there was a

question of exposure to liability for the subsidiary or the

entire Hyatt International group.    HIC coordinated the purchase

of business liability and other types of hotel operating
                               - 30 -


insurance for individual hotels, charging each hotel an allocated

portion of the cost.

     Prior to 1984, HIC’s senior vice president for development

reviewed management contracts because HIC did not have in-house

counsel.    For later years, when HIC had equity participation in a

hotel and/or Hyatt ’s money was at risk, HIC’s legal department

played an integral role in the legal aspects of the transaction.

Legal counsel promoted the formation of separate corporations

within the Hyatt International group so that the risk of legal

liability would fall on individual hotels instead of the group.

The legal department tracked the registration of the Hyatt trade

names and marks in foreign jurisdictions, employing a U.S. law

firm, which in turn contracted with a foreign law firm to perform

the work.   The tracking was primarily for cost containment of

registration expenses.

     HIC’s chief financial officer was responsible for

maintaining the financial accounting records of HIC and its U.S.

subsidiaries within the consolidated group.    He was also

responsible for preparing consolidated financial statements for

use by HIC’s board and during the annual audit, preparing

Federal and State tax returns and meeting other governmental

filing requirements, and managing the annual certified audit

process.    HIC’s staff internal auditor was sent to review books

and records of hotels and subsidiaries.
                              - 31 -


     HIC coordinated the sales and marketing activities of its

subsidiaries, including the worldwide sales and reservations

offices, which fall under the responsibilities of the area

marketing directors.   The marketing vice president coordinated

the consistency of hotel advertising and graphic design and

conducted third-party marketing efforts with major airlines,

credit card companies, and travel consortia.   Hotel marketing

staff, however, wrote the advertising text, and individual local

hotels paid for advertising costs out of their own budgets.

     The hotel operations vice president supervised HIC office

functions, including marketing, personnel, food and beverage

planning, and systems analysis.   It was this vice president’s

responsibility, and that of HIC generally, to set standards of

service, but not to manage the hotels.   This vice president

received and reviewed the various hotel reports, including

budgets and monthly reports of activity.   He reviewed, discussed,

and made suggestions concerning these reports throughout all

organizational levels of the Hyatt International group.   In

accord with Hyatt International group operations, hotel and area

staff initiated and implemented the management plans, with HIC

providing final approval or mediating differences between hotels

or geographical areas on various topics, such as staff transfers.

HIC also maintained a food and beverage department that
                               - 32 -


coordinated and exchanged information throughout the chain

regarding that subject matter.

     HIC’s human resources vice president acted as the

clearinghouse for human resources policies and procedures,

personnel director for the HIC corporate office and the Hyatt

International sales offices located in the United States, and as

liaison to the third-party administrator for worldwide benefits

and retirement plans.   HIC instructed its hotels to buy life

insurance for the hotels' employees and arranged for a life

insurance provider.   HIC also arranged a provider for employee

medical insurance.    The hotel owners, however, paid the insurance

premiums.

     As of January 1, 1975, HIC established the “Hyatt

International Salaried Employees’ Retirement Plan”.   On or about

February 26, 1981, HIC initiated “The Money Accumulation Pension

Plan for Third Country National Employees of Hyatt International

Corporation”, effective January 1, 1980.   Contributions to the

plan were funded by the owners of the hotels at which the plan

participants were employed.

     In 1981, HIC inaugurated the HIC Incentive Compensation

Program for the general managers of Hyatt International hotels.

Under the program, a general manager could qualify for a monetary

award, which was paid by the employing hotel.   General manager
                                - 33 -


incentive compensation was measured by objective (operational

performance) and subjective evaluation by HIC personnel.

     The performance of general managers and executive committees

was considered to be good for most local personnel matters in the

Hyatt International group.   Training, on the other hand, was an

area in which they did not perform as well.    General managers and

executive committees did not have access to effective “off-the-

shelf” training material, and they did not have sufficient

resources or time to develop adequate in-house local personnel

training programs.   To remedy this, Hyatt International provided

the “Training for your future” program that was offered to hotel

employees worldwide beginning in 1985.

     Hyatt International group developed hotel management and

operation policy and procedures manuals.   HIC acted as a

clearinghouse for the preparation of the manuals, and portions

were written by area specialists and hotel staff.   HIC was

responsible for the distribution of manuals to new hotels and for

asking the field for updates.    After updates were prepared, HIC

coordinated the updates and distributed them to the appropriate

hotels.   General managers were responsible for their respective

hotel’s operating manuals, the food and beverage directors were

responsible for their departmental manuals, and the chefs were

responsible for their own menus and recipes.
                                - 34 -


     As early as March 1975, HIC distributed a controller’s

checklist for reports.   In 1981, HIC copyrighted a manual

entitled “Accounting and Internal Control Systems and

Procedures”.    This manual was written at the request of the area

and hotel accounting staff and was provided to hotel controllers

who also assisted in its review.    The manual provided

standardized reporting and accounting controls, facilitating a

uniform budget process and the ability to move accounting

personnel between hotels.    It was also used to train the

accountants in Mexico.   Effective March 1, 1983, HIC promulgated

materials describing specialized policies and procedures for the

areas of law and insurance, administrative/general, and finance/

accounting.    Some of the topics included:   Technical assistance

agreements, management agreement obligations, area vice president

hotel visits, annual business plan, reports schedules, and inter-

hotel financial transactions.

     HIC vice presidents would occasionally visit the hotels,

generally accompanied by the area vice presidents, to make

inspections and recommendations.    Periodically, the Hyatt

International group would hold meetings of general managers.    At

these meetings, general managers met with HIC and senior

executives of management subsidiaries to review the growth and

development of the Hyatt International group.    The general

managers also exchanged ideas and information on what made their
                              - 35 -


hotels successful.   Data were also exchanged on candidates for

promotion to various positions.

V. Agreements Between Hyatt International Group Entities and
Hotel Owners11

     A.   Hyatt Aryaduta Jakarta Agreement

     On December 18, 1975, the owners of the Aryaduta

(Ambassador) Hotel located in Jakarta, Indonesia, and HHK entered

into a 10-year management agreement.    The owners agreed to

refurbish the existing hotel and to complete certain unfinished

floors.   The parties agreed that the hotel name would be changed

to the “Hyatt Aryaduta Hotel”.    In the early 1980’s, Andre Pury,

the Hyatt International regional director for Indonesia,

initiated negotiations with the Hyatt Aryaduta Hotel owners for

further renovations and an extension of the management contract.

On October 16, 1981, the owners entered into an agreement with

IPS for the renovation, but the work was delayed for several

years.

     Around the same time, Mr. Pury located a group of investors

interested in constructing a new hotel in Jakarta to be known as

the Grand Hyatt Jakarta.   Included in the investor group was the

son of Indonesia’s President Suharto.    The new hotel was intended

to be at the top end of the Jakarta hotel market, in contrast to


     11
        Only selected agreements have been addressed in the
findings of fact to show patterns or the types of contractual
relationships that were utilized.
                               - 36 -


the Hyatt Aryaduta which was ranked fifth or sixth.      Near the

conclusion of the negotiations, the investor group demanded that

the Grand Hyatt Jakarta be the only Jakarta hotel to display the

Hyatt name.   Mr. Pury conveyed this demand to the Hyatt Aryaduta

owners, who were aware that President Suharto’s son was involved

in the new hotel.   On January 1, 1986, the Hyatt Aryaduta Hotel

owners agreed to permit HHK, at its election, to remove the Hyatt

name in exchange for a reduction in management fees from 3 to 2.5

percent and a reduction in incentive fees from 10 to 5 percent.

In addition, the Hyatt Aryaduta Hotel owners also agreed to

construct, furnish, and equip a 132-room extension.

     On January 14, 1986, HHK entered into a management agreement

for the Grand Hyatt Jakarta, which opened in March 1991.      Around

the same time, the Hyatt Aryaduta’s name was changed to The

Aryaduta.   Both hotels were very successful operations for HHK.

     B.   Century Hyatt Tokyo Agreements

     Odakyu, a Japanese conglomerate of public and private

companies, among its other business activities, provides travel

and construction services and owns real estate, department

stores, railway lines, and hotels.      Odakyu owned three hotels and

a national travel agency in Japan.      The hotels were operated

under the Century Hotel name and logo, which was registered by

Odakyu in Japan.    Typical of Japanese hotel owners, Odakyu did

not wish a management contract relationship and preferred a
                              - 37 -


franchise agreement.   The Hyatt International group, on the other

hand, was opposed to franchising.

     As a result, on March 16, 1979, a compromise agreement was

signed, under which Odakyu would operate the hotel, and the Hyatt

International group would provide sales, reservations and

information services, manuals, policies and training materials,

and related materials, all of which are made available to hotels

involved with the Hyatt International group.     In exchange, Odakyu

agreed to pay $300,000 per year for 3 years and the greater of

$300,000 per year or 10 percent of gross room revenues received

from non-Japanese guests thereafter.     In addition, at Odakyu’s

request, Hyatt International would make available numerous

optional services, including purchasing, operational management

services, and technical assistance for these services; generally,

Odakyu would pay at cost.   Odakyu was allowed the use of the

Hyatt names, with Hyatt International’s written approval prior to

using the Hyatt name on the hotel.     Odakyu agreed to promote

Hyatt International hotels by including the display of materials

in the rooms and lobby areas of its hotels and making

reservations for other Hyatt International hotels.

     An August 22, 1979, amendment replaced the $300,000/10-

percent terms with a fixed $100,000 annual royalty for a 10-year

term in exchange for Odakyu’s use of the Hyatt name.     In

addition, the amendment provided for Hyatt International to
                               - 38 -


receive, in return for performance of sales and reservation

services and information services outside Japan, $200,000 per

year for the first 3 years and thereafter the greater of $200,000

per year or 10 percent of annual gross room revenue of non-

Japanese guests.   After 3 years, the annual amount for services

was reduced to $100,000.    In this amendment, Hyatt International,

S.A., assigned the rights to the agreement to HHK, as permitted

by the original agreement terms.   In an October 1, 1984,

amendment, the fee for services was changed to a fixed fee of

Yen68,301,156 for the period September 15, 1983, to March 31,

1984, and the greater of $200,000 per year or 8 percent of annual

gross room revenue from nationals of countries other than Japan.

Here again the annual amount was reduced to $100,000 after March

31, 1984.

     C.   HESA Agreements

     On October 24, 1979, in conjunction with the establishment

of HESA by VIS and HIC (Mexico), HESA and HHK entered into a

consultancy agreement under which HHK was to provide management

services and preopening support.   HESA and HHK also entered into

an agreement for the use of the Hyatt names and marks and the

provision of chain services.   HESA agreed to pay HHK an amount

equal to 75 percent of the management fees received, less

administrative expenses incurred in the supervision of hotel

operations.   This agreement included a royalty of 2 percent of
                               - 39 -


the gross income for each HESA hotel that used the Hyatt names

and marks and for chain services.   In the case of the Hyatt

Regency Acapulco, however, which was already a Hyatt

International hotel, HIC (Mexico) would receive 90 percent of the

fees (including 15 percent for SIASA), without regard to the

administrative expenses incurred in connection with that hotel.

     During 1982, due to the increased number of hotels under

HESA management, the agreement between HESA and HHK was amended,

reducing the percentage HESA was to pay HHK as a fee for services

and reducing the royalty for the trade names and chain services

from 2 to 1 percent of hotel gross income.

     D.   Atrium Hyatt Budapest Agreements

     The Atrium Hyatt Budapest opened during June 1982.   The

agreement concerning this hotel was in the nature of a franchise.

The Hyatt International group agreed to provide technical

services, preopening services, management expertise, and chain

services, in addition to allowing the use of the Hyatt trade

names and marks.   The parties agreed that the general manager was

to be chosen by the hotel and trained by the Hyatt International

group.    The Hyatt International group agreed to provide training

at its existing hotels for other key personnel.   For 3 years, the

hotel agreed to pay $1.50 per day for each occupied room, plus a

percentage of room revenue for reservations booked through Hyatt

International services, and a percentage of revenue from room,
                                - 40 -


food and beverage, and incidentals for guest groups booked

through the Hyatt International group.   Effective July 1, 1985,

the parties amended the remuneration for another 3-year period at

a rate of $200,000 annually in exchange for management expertise

and chain services, including reservations.

     E.   Hyatt Regency Brussels Agreement

     On January 12, 1973, HIC entered into an agreement to manage

and lease a hotel that was to be constructed and would be known

as the Hyatt Regency Brussels.    The terms of the lease provisions

included a guaranteed rental to be paid to the hotel owner.      The

owner, Belgium Hotels Leasing Partnership, was owned by the

principal stockholders of HIC (95 percent) and Mr. di Tullio (5

percent).   The agreement was assigned by HIC to Hyatt Management,

Inc., a Delaware corporation wholly owned by HIC.    The hotel

operated at a loss from its 1976 opening through 1986.

     F.   Hyatt Regency Nice Agreement

     The Hyatt Regency Nice opened during July 1979 and closed

during November 1983.   Hyatt International (France) was created

in France in 1976 to hold the management contract for the Hyatt

Regency Nice.   Hyatt International (France) was owned 90 percent

by HIC and 10 percent by HHK.    The management agreement included

a minimum annual payment to the hotel owner from Hyatt

International (France) that was guaranteed by HIC.    The hotel,

Société d’Exploitation Niçoise, was owned 39.6 percent by the
                              - 41 -


principal stockholders of HIC, 10 percent by an HIC subsidiary,

and 50.4 percent by unrelated parties.

VI.   Financial Information

      The consolidated financial statements of HIC and its

subsidiaries reflect the following revenue and expenses:
                               - 42 -


                       Domestic1         Foreign      Total
1976
       Revenue        $1,624,803     $4,382,067     $6,006,870
       Expenses        2,623,993        423,064      3,047,057
                        (999,190)     3,959,003      2,959,813

1977
       Revenue         2,783,886        4,815,825    7,599,711
       Expenses        4,209,828          229,254    4,439,082
                      (1,425,942)       4,586,571    3,160,629

1978
       Revenue         4,580,779        6,363,780   10,944,559
       Expenses        5,231,623          719,237    5,950,860
                        (650,844)       5,644,543    4,993,699

1979
       Revenue         1,791,770     $8,665,739     10,457,509
       Expenses        5,478,207        552,785      6,030,992
                      (3,686,437)     8,112,954      4,426,517

1980
       Revenue         2,085,787     11,948,337     14,034,124
       Expenses        7,777,161        712,218      8,489,379
                      (5,691,374)    11,236,119      5,544,745

1981
       Revenue         3,324,344     13,434,924     16,759,268
       Expenses        7,079,795      1,285,992      8,365,787
                      (3,755,451)    12,148,932      8,393,481

1982
       Revenue         2,447,592     13,491,587     15,939,179
       Expenses        8,481,592      3,289,469     11,771,061
                      (6,034,000)    10,202,118      4,168,118
       1
      The category “Domestic” includes those Hyatt International
entities incorporated in the United States, including HIC, IPS,
and the management subsidiaries for hotels in Canada, Brussels,
and Central America.

       Included in the above expenses are losses on leased

operations and on guaranties for hotels in Brussels and Nice, as

follows:
                               - 43 -


                                   As percentage of expenses
       Year        Amount          Domestic      Consolidated

       1976        $648,604          25               21
       1977       1,841,960          44               41
       1978       2,269,444          43               38
       1979       2,075,582          38               34
       1980       3,749,346          48               44
       1981       2,600,408          37               31
       1982       1,343,006          16               11

       The financial statements of HHK and its subsidiaries and of

HS reflect the following revenue and expenses:

                     HHK and subs.           HS             Total
1976
       Revenue        $2,812,771          $668,338     $3,481,109
       Expenses          156,727            88,478        245,205
                       2,656,044           579,860      3,235,904

1977
       Revenue         2,899,989          1,211,452     4,111,441
       Expenses          136,544            142,185       278,729
                       2,763,445          1,069,267     3,832,712

1978
       Revenue         3,490,563          1,739,405        5,229,968
       Expenses          473,222            187,634          660,856
                       3,017,341          1,551,771        4,569,112

1979
       Revenue         5,119,704          2,174,035        7,293,739
       Expenses          448,755            205,822          654,577
                       4,670,949          1,968,213        6,639,162

1980
       Revenue         8,962,047          2,769,148    11,731,195
       Expenses          909,374            171,175     1,080,549
                       8,052,673          2,597,973    10,650,646

1981
       Revenue        10,684,784          2,832,835    13,517,619
       Expenses          937,873            283,106     1,220,979
                       9,746,911          2,549,729    12,296,640
                                  - 44 -


1982
       Revenue           10,413,189        2,294,179     12,707,368
       Expenses           2,834,416          272,547      3,106,963
                          7,578,773        2,021,632      9,600,405

       Beginning with 1983, HHK’s financial statements contained

the amount of overhead expenses allocated to HHK from HIC for

services performed on behalf of HHK.         The 1983 allocation

included payment for services performed in prior years and was

the result of an Internal Revenue Service audit.         The overhead

expenses allocated to HHK from HIC for services performed on

behalf of HHK were reflected as follows:

                  Year          Amount

                  1983        $2,503,692
                  1984           198,422
                  1985           228,740
                  1986           249,872
                  1987           261,361
                  1988           326,512

       HHK and HS had retained earnings before and after payment of

dividends to HIC.    The amount of the dividends and retained

earnings after dividend payments for the years 1976 through 1987

were as follows:
                                  - 45 -


                 Hyatt of Hong Kong           Hyatt of Singapore
                             Retained                      Retained
Year            Dividends    earnings       Dividends      earnings

1976                ---     $8,598,528     $1,181,383      $1,245,134
1977             $921,000   10,018,226        359,161          702,308
1978            2,100,000   10,521,245      1,288,798        1,248,311
1979            3,520,000   10,974,344        954,103        1,056,059
1980           11,099,930    6,477,453      1,481,926        1,624,401
1981            5,050,000   10,660,914           ---         1,625,955
1982                ---     17,783,063           ---         2,823,777
                                                           1
1983            2,038,283   18,926,781           ---         7,791,000
                                                           1
1984           16,325,000    9,723,525           ---         9,275,000
                                                           1
1985                ---      6,267,334           ---         9,606,000
                                                         1
1986            9,000,000    5,063,406           ---       11,666,000
                                              1          1
1987           10,150,000    9,206,112          91,000     11,853,000
       1
        Figures denominated in Singapore dollars.

       For most of the taxable years under consideration, the

majority of HIC’s income consisted of dividends and the remainder

of HIC’s income consisted of operating income or interest.      For

most of the years, the reported expenses of IPS’ and HIC’s U.S.

hotel management subsidiaries exceeded their revenues.

VII.       Respondent’s Determinations

       Respondent determined, in the notices of deficiency sent to

HGH, increased income for Hyatt Domestic as follows:
                             - 46 -


                              Trade name
          Taxable year        adjustment

          Jan.   31, 1980     $2,159,000
          Jan.   31, 1981      3,266,000
          Jan.   31, 1982      4,603,000
          Jan.   31, 1983      5,279,000
          Jan.   31, 1984      5,548,000
          Jan.   31, 1985      6,070,000
          Jan.   31, 1986      5,735,687
          Jan.   31, 1987      5,935,143
          Jan.   31, 1988      7,333,495
                 Total        45,929,325

The October 12, 1990, notice of deficiency contained the

following explanation for the 1983 through 1985 tax years:

     It has been determined that an adjustment be made in
     accordance with the provisions of Internal Revenue Code
     Section 482 and the regulations thereinafter to
     increase your income for the value of the trade name
     “Hyatt”. Accordingly, your taxable income for year
     ended January 31, 1983; January 31, 1984 and January
     31, 1985 have been increased in the amounts of
     $5,279,000; $5,548,000 and $6,070,000 respectively.

The Explanation of Items in the October 28, 1991, notice of

deficiency for HGH’s taxable years 1980 through 1982 states:

     Hyatt Corporation (HC) engaged in transactions with
     Hyatt International Corporation (HIC), relating to
     HIC’s use of “Hyatt” trade names, trademarks, and other
     intangible assets, which were not at arm’s-length
     terms. Pursuant to section 482 of the Internal Revenue
     Code and Treas. Reg. §1.482-2(d), it is determined that
     an arm’s-length royalty or license fee for these
     transactions equals 1.5% of the gross revenues of each
     hotel operated under the “Hyatt” name by HIC or any of
     its subsidiaries. * * *

The January 27, 1993, notice of deficiency for HGH’s 1986 through

1988 tax years contained the same above-quoted explanation.
                                  - 47 -


       Respondent, in the notices of deficiency addressed to

petitioner AIC, determined that the income of its subsidiary HIC

income should be increased as follows:

 Taxable year                          Management    Total of
   ending               Trade name        fees      these items

Dec.   31, 1976        $982,000        $1,601,467   $2,583,467
Dec.   31, 1977       1,086,000         2,048,740    3,134,740
Dec.   31, 1978       1,495,000         2,296,218    3,791,218
Dec.   31, 1979       1,877,010         3,300,716    5,177,726
Dec.   31, 1980       3,094,935         5,070,618    8,165,553
Dec.   31, 1981       4,157,250         4,852,581    9,009,831
Dec.   31, 1982       4,838,580         4,946,904    9,785,484
Dec.   31, 1983       5,046,810         2,642,440    7,689,250
       Total         22,577,585        26,759,684   49,337,269

The November 18, 1994, notice of deficiency reflecting AIC’s 1976

through 1978 taxable years contains the following explanation for

the above-scheduled adjustments:

       Royalty Income-Trade Name

       You engaged in transactions with your subsidiaries,
       Hyatt of Hong Kong, Ltd. (HHK), Hyatt of Singapore, Ltd
       (HS), and Hyatt of Panama (HP) under which the
       operating subsidiaries were permitted to use the
       “Hyatt” trademarks and trade names, to which you held
       an exclusive license outside the territorial United
       States. Under section 482 of the Internal Revenue Code
       and Treasury Regulation section 1.482-2(d), it is
       determined that an arms’-length royalty equals 1.5% of
       gross revenues of HHK, HS and HP for each of the years
       1976, 1977 and 1978. * * *

       Management Fee

       It is determined that your attribution of substantially
       all management fees for the operations and management
       of foreign Hyatt hotels to Hyatt-Hong Kong, Hyatt-
       Singapore and Hyatt of Panama, respectively, fails to
       clearly reflect Hyatt International Corporation (HIC)
       income for 1976, 1977 and 1978. Pursuant to Internal
                                   - 48 -


     Revenue Code section 482 and Treasury regulation
     section 1.482(d), it is determined that an arm’s-length
     charge for management services performed by Hyatt-Hong
     Kong, Hyatt-Singapore and Hyatt-Panama equals
     $73,200.00 per hotel managed in 1976 through 1978.
     * * *

The management fees adjustments generally represent all of the

net income of the named subsidiaries in excess of respondent’s

determined per-hotel allowance, less the amount already

determined as trade name royalty.       The February 28, 1995, notice

for AIC’s 1979 through 1983 taxable years contained the same

explanations for these adjustments as the November 18, 1994,

notice, except that the per-hotel arm’s-length charges determined

by respondent were as follows:

                      Year         Amount

                      1979         $75,000
                      1980          87,500
                      1981         100,000
                      1982          62,000
                      1983          62,000

The number of hotels respondent used to compute the fee

adjustments were as follows:

               Year          HHK   HS   HP

               1976           6    2    1
               1977           6    2    1
               1978           7    2    1
               1979           9    3    1
               1980          20    3    1
               1981          28    2    1
               1982          14    2    1
               1983          17    2    1
                              - 49 -


These numbers were described in the explanation of items as

“counts any hotels actually managed by” the respective entity;

i.e., HHK, HS, or HP.

                              OPINION

I.   Preliminary Matters--Evidentiary Objections

     A. Documents Executed During or Pertaining to Taxable Years
Subsequent to Those in Issue

      Respondent objected, on the grounds of relevance, to the

admission into evidence of certain documents executed during

and/or pertaining to periods subsequent to the taxable years in

issue.   Alternatively, respondent objected on the grounds that

any probative value of such documents is outweighed by prejudice

or considerations of undue delay, waste of time, or the needless

presentation of cumulative evidence.    The documents in question

primarily include management agreements and financial statements

of Hyatt International hotels.

      Respondent’s objections, in essence, bear more heavily on

the probative weight of the documents than on their

admissibility.   It is noted that respondent did not object to

documents concerning subsequent periods when the documents

supported or were helpful to respondent’s expert’s opinion.

      Respondent relies on rules 401, 402, and 403 of the Federal

Rules of Evidence.   Under the circumstances here, we hold that

the documents to which respondent objected are relevant and
                                - 50 -


reflect a continuing pattern of activity.     Further, respondent

has not shown that the probative value of said documents “is

substantially outweighed by the danger of unfair prejudice,

confusion of the issues, * * * or by considerations of * * *

needless presentation of cumulative evidence.”     Fed. R. Evid.

403.

       Respondent’s objections are overruled, and the exhibits to

which respondent objected on relevance and related grounds are

part of the record in these cases.

       B.   Foreign Language Documents That Have Not Been Translated

       Respondent objected to certain foreign language documents

for which no English translation had been provided.     Respondent

contends that such documents could have no probative value to the

trier of fact.     This group of documents consists of financial

statements, management agreements, and preopening and technical

agreements.     Although the contents of these documents have not

been translated, the names of the parties involved and the place

and date of execution are discernible.     That information tends to

corroborate that the Hyatt International group entered into

certain agreements and/or operated certain hotels during the

years to which the documents pertain.     In addition, some of the

documents containing financial information are readily

discernible without the need for translation, but tend to be of

less value where the amounts have not been converted into U.S.
                                - 51 -


dollars.    Here, again, relying on rules 401 and 402 of the

Federal Rules of Evidence, respondent’s objections appear to go

more to the probative weight than the admissibility of these

documents.    Therefore, respondent’s objections are overruled.

       C.   Documents Prepared for Litigation

       Respondent objects to certain documents prepared for

purposes of this litigation on the grounds that they are hearsay

and irrelevant.     These documents consist of materials prepared

and supplied to petitioners’ expert Ernst & Young LLP (Ernst &

Young) to assist in the preparation of its expert report.      The

documents in question consist of various summaries of the Hyatt

International group data including expenses, sales, guests, and

employees.

       One of the significant distinctions between expert and fact

witnesses is that experts are permitted to rely on evidence

outside the trial record.     The evidence outside the record may be

hearsay and need not be otherwise admissible, but they may be

used by the expert to formulate an opinion.     See Fed. R. Evid.

703.

       Rules 702 and 703 [Fed. R. Evid.] do not, however,
       permit the admission of materials, relied on by an
       expert witness, for the truth of the matters they
       contain if the materials are otherwise inadmissible.
       See Paddack v. Dave Christensen, Inc., 745 F.2d 1254,
       1261-62 (9th Cir. 1984). Rather, “Rule 703 [Fed. R.
       Evid.] merely permits such hearsay, or other
       inadmissible evidence, upon which an expert properly
                              - 52 -


     relies, to be admitted to explain the basis of the
     expert’s opinion.” * * *

Engebretsen, et al. v. Fairchild Aircraft Corp., 21 F.3d 721,

728-729 (6th Cir. 1994).

    Accordingly, respondent’s objection is sustained in that such

documents are not received in evidence for the truth of their

contents.   Such documents, however, may be considered for

purposes of understanding or explaining the basis for the

expert’s opinion.

     D.   Revenue Agent's and Economists’ Reports

     Respondent objects to the admission of respondent’s in-house

economists’ reports and international examiner’s reports.

Respondent points out that these reports were prepared prior to

the issuance of the notices of deficiency and, further, that the

reports do not represent respondent’s final determination.    In

the vast majority of cases, we would agree that reports and

opinions of respondent’s employees prior to the issuance of the

deficiency notice are irrelevant to the proceeding.   In cases

involving respondent’s determinations under section 482, however,

taxpayers must establish that the Commissioner’s determinations

were arbitrary, capricious, or unreasonable.   That burden has

often been described as more difficult or heavier (than a mere

preponderance of the evidence) to carry.
                              - 53 -


      In cases where we have considered whether there has been an

abuse of the Commissioner’s discretion, we have occasionally

received pre-deficiency notice matter into evidence and looked

behind the notice.   See Capitol Fed. Sav. & Loan Association &

Sub. v. Commissioner, 96 T.C. 204, 214 (1991); Branerton Corp. v.

Commissioner, 64 T.C. 191, 200-201 (1975).   In this case, it is

appropriate to include in the record such evidence to enable

petitioners to have a fair opportunity to meet their burden.

Accordingly, respondent’s objection to these exhibits is

overruled.

II.   Factual Overview

      These cases present complex factually oriented section 482

reallocation and arm’s-length pricing issues.   The parties did

not detail, and we have not attempted to detail every aspect of

petitioners’ operations; i.e., HIC’s numerous second- and third-

tier subsidiaries, and the myriad individual hotel entities.    We

have found the essential and suitable representative facts to

explain and identify the entities and their practices and other

foundational facts to support our ultimate findings and holdings

on the issues.

      For trial purposes, the parties have generally focused on

the issues without attempting to distinguish one taxable year
                                - 54 -


from another.12   We have followed the parties’ lead and addressed

the Hyatt International group’s patterns of operation as carried

out by HIC, HHK, HS, and certain other master hotel management

and support services subsidiaries.

       The Hyatt International group consists of numerous related

companies engaged in the business of hotel management.    Hyatt

Domestic’s principal shareholders established HIC and started the

Hyatt International group operations by hiring an experienced

hotelier from the Hilton hotel chain, who in turn hired other

experienced individuals, many of whom were also from the Hilton

hotel chain.    HIC entered into an agreement with Hyatt Domestic

providing for the licensing of the Hyatt trade names and marks to

HIC.    Under the agreement, HIC was to pay Hyatt Domestic $10,000

for each Hyatt International hotel that HIC opened.    The Hyatt

International group and Hyatt Domestic exchanged reservations and

marketing services for their mutual benefit.

       The Hyatt International group established separate legal

entities for the management of and/or the provision of various

services to hotels.    Foremost among the hotel management

subsidiaries were HHK and HS.    HESA, another management entity,



       12
        Although respondent’s deficiency notice determinations
utilized different amounts for each year in computing the per-
hotel allowances for petitioner AIC’s management fee adjustment,
for purposes of trial, respondent’s methodology no longer relies
on differing annual amounts.
                               - 55 -


was established by means of a joint venture agreement with an

unrelated company, VIS, and was owned 49 percent by HIC (Mexico).

Service subsidiaries included HCS, a Hong Kong corporation, which

provided sales, marketing, and reservation services to all Hyatt

International hotels, and IPS, a U.S. corporation, which provided

technical assistance, also known as design services.

     As a management/services organization, the Hyatt

International group’s success was heavily dependent on its

employees.    Initially, the Hyatt International group’s size and

the volume of hotels managed increased because of employees’

efforts in cultivating relationships with hotel owners.     In the

beginning, staff was hired from other hotel chains and groomed

for advancement within the Hyatt International group.    As time

progressed and the new hotels were opened, expanding the Hyatt

group, executive staff could be chosen from within the ranks of

Hyatt International hotel personnel.

     Executive committees ran each hotel’s day-to-day operations.

The executive staff at the flagship hotels of the Hyatt Regency

Hong Kong and the Hyatt Regency Singapore also concurrently

served as area directors and as staff of the master hotel

management subsidiaries HHK and HS, respectively.    This

duplication of responsibilities was thought to lower operating

costs.   At first, employees received their salaries directly from

the hotels.   In time, the salaries were paid by HHK or HS for
                               - 56 -


their area work.   Generally, HHK, HS, HESA, and HIC supervised

hotels within their respective geographic regions--i.e., Asia-

Pacific, Southeast Asia, Mexico, and Central America, and Europe.

Each management subsidiary maintained staff specialists/employees

in the functional hotel management areas, including finance, food

and beverage, human resources, and clerical.   Unlike management

staff working for HHK and HS, HESA and HIC management staff did

not have dual roles and did not also serve as hotel staff.

     In addition to the direct supervision of particular hotels,

HIC provided all of the international group’s hotels with certain

services.   HIC was involved in coordinating insurance and

employee benefits and disseminating training materials.   It also

acted as a clearinghouse for the production, maintenance, and

distribution of the operations manuals.   HIC staff acted as

liaison to outside agencies, such as travel associations and

airlines, for the purpose of worldwide marketing.   HIC conducted

internal audits, budget and contract reviews, and made staffing

recommendations for its subsidiaries.   HIC set the service

standards for the Hyatt International group and, along with its

master hotel management subsidiaries, monitored the performance

of the Hyatt International hotels.

     Preopening and operating expenses of hotels were charged to

the hotel owners, including:   Hotel staff salaries and benefits;

marketing and sales expenses; and office, rooms, and restaurant
                               - 57 -


expenses.    Hotel owners were each apportioned an amount of HCS’s

expenses that were incurred in connection with the marketing and

reservations service.    Owners who chose to use the IPS’ design

services paid IPS a fee for the services.    IPS’ fees were set

based on estimated costs and, for most of the taxable years in

issue, IPS’ expenses exceeded its revenues.    Accordingly, the

preopening and operating expenses and IPS fees were not borne by

the Hyatt International hotel management subsidiaries.    The hotel

owners paid management fees directly to the hotel management

subsidiaries.

     We consider four categories of section 482 income

allocations:

     (1)    Management fee revenues from one subsidiary of the

Hyatt International group to another or, most commonly, to HIC,

based on respondent’s postulation that the latter entity was

wholly or partially “responsible for” the management or operation

of the hotel that generated management fees;

     (2)    Royalties from HIC to Hyatt Domestic for the use of the

Hyatt trade names, marks, and intangibles;

     (3)    Royalties from HHK and HS to HIC for the use of the

Hyatt trade names and marks; and
                                  - 58 -


       (4) Net management income from HHK and HS to HIC for

services provided by HIC.13

       In controversy are Hyatt Domestic’s taxable years ending

January 31, 1980, through January 31, 1988, and HIC’s taxable

years ending December 31, 1976, through December 31, 1983.

III.    Section 482--Background

       Under section 482, the Commissioner has broad authority to

prevent the artificial shifting of income and to allocate income

among commonly controlled corporations in order to place them on

a parity with uncontrolled, unrelated taxpayers.    See Seagate

Tech., Inc., & Consol. Subs. v. Commissioner, 102 T.C. 149, 163

(1994); Sundstrand Corp. v. Commissioner, 96 T.C. 226, 352-353

(1991); see also Bausch & Lomb, Inc. v. Commissioner, 92 T.C.

525, 581 (1989), affd. 933 F.2d 1084 (2d Cir. 1991); Edwards v.

Commissioner, 67 T.C. 224, 230 (1976); sec. 1.482-1(b)(1), Income

Tax Regs.    A business purpose for an arrangement or a set of

transactions does not by itself insulate a taxpayer from a

section 482 allocation.    See Sundstrand Corp. v. Commissioner,

supra at 353.


       13
        In the deficiency notices, respondent determined
allocations from Hyatt of Panama to HIC for both trade names and
marks and management services. Respondent’s trial position
included only allocations from the HHK and HS. Because
respondent no longer relies on or advocates the notice
determination on this aspect, we treat respondent’s abandonment
of the allocations from Hyatt of Panama as a concession of these
adjustments.
                                - 59 -


     Section 482 determinations are to be sustained absent a

showing that the Commissioner’s discretion was abused.    See

Paccar, Inc. v. Commissioner, 85 T.C. 754, 787 (1985), affd. 849

F.2d 393 (9th Cir. 1988).     Consequently, taxpayers bear a heavier

than normal burden of proving that the Commissioner’s section 482

allocations are arbitrary, capricious, or unreasonable.    See Your

Host, Inc. v. Commissioner, 489 F.2d 957, 960 (2d Cir. 1973),

affg. 58 T.C. 10, 23 (1972); Seagate Tech., Inc. & Consol. Subs.

v. Commissioner, supra at 164; G.D. Searle & Co. v. Commissioner,

88 T.C. 252, 359 (1987).    Whether the Commissioner’s discretion

has been abused is a question of fact.    See American Terrazzo

Strip Co. v. Commissioner, 56 T.C. 961, 971 (1971).    In reviewing

the reasonableness of the Commissioner’s allocation under section

482, we focus on the reasonableness of the result, not the

details of the methodology employed.     See Bausch & Lomb, Inc. v.

Commissioner, supra at 582; see also Eli Lilly & Co. v. United

States, 178 Ct. Cl. 666, 676, 372 F.2d 990, 997 (1967).    The

applicable standard is arm’s-length dealing between taxpayers

unrelated either by ownership or control.    See sec. 1.482-

1(b)(1), Income Tax Regs.14    Taxpayers bear the burden of showing

that the standard they used or that they proposed is arm’s



     14
        References to the income tax regulations under sec. 482
are to the 1968 regulations as amended and in effect for the tax
years under consideration.
                              - 60 -


length.   See Seagate Tech., Inc., & Consol. Subs. v.

Commissioner, supra at 164.

     If it is established that there was an abuse of the

Commissioner’s discretion and a taxpayer fails to show that

questioned transactions met an arm’s-length standard, then the

Court must decide the amount of an arm’s-length allocation.   See

Sundstrand Corp. v. Commissioner, supra at 354.

IV. Was the Commissioner’s Determination Arbitrary, Capricious,
or Unreasonable?

     A.   In General

     Petitioners argue that respondent has abandoned the grounds

for the determinations in the deficiency notice and, in effect,

conceded that the determinations are arbitrary, capricious, or

unreasonable.   Petitioners also argue that respondent’s

determinations were in other respects arbitrary, capricious, and

unreasonable.   Respondent disagrees and contends that no

abandonment of theory or methodology occurred and that the trial

position of respondent is compatible with the determinations in

the deficiency notice.   We consider this portion of the

controversy from two different perspectives.   First, we consider

the effect, if any, of respondent’s substitution of different

experts, for trial purposes, from those whose reports were used

for the bases of the determinations in the deficiency notice.

Then, we consider, generally, whether respondent’s determination
                              - 61 -


was an abuse of discretion (arbitrary, capricious, or

unreasonable).

     B.   Substitution of Experts’ Opinions

     Hyatt Domestic and HIC are subsidiaries of different parent

corporations, petitioners HGH and AIC, respectively.    Each

petitioner filed consolidated Federal income tax returns with its

U.S. subsidiaries.   In the notices of deficiency, respondent

determined that, for the taxable years ending January 31, 1980

through January 31, 1988, the income of Hyatt Domestic should be

increased to reflect royalties from HIC for the use of the Hyatt

trade names and marks.   The amount of the determined royalty was

equal to 1.5 percent of the gross revenues of each hotel operated

or managed by Hyatt International group.   Similarly, respondent

also determined that HIC’s income for its taxable years ending

December 31, 1976 through December 31, 1983, should be increased

by the same 1.5 percent of the gross revenues and that amount

should be allocated from HIC’s subsidiaries.

     Respondent also determined that HIC’s income should be

increased by allocating a certain portion of the management fee

income of its subsidiaries (HHK, HS, and HP).   The allocated

portion was the excess of the amount respondent determined as the

arm’s-length charge for management services performed by the

subsidiary, less the amount that was determined to be a royalty.

Respondent calculated arm’s-length charges for management
                               - 62 -


services that respondent allowed on a per-hotel basis times the

number of hotels managed.   The determinations of the per-hotel

amounts were based on the reports of respondent’s prenotice

economists, Dr. Joseph Mooney (Dr. Mooney) and David Burt (Mr.

Burt).    In addition, respondent determined that the subsidiaries

did not manage all of the hotels that remitted fees to them, and,

therefore, the number of hotel allowances was limited

accordingly.

     At trial, the reports of the above-referenced in-house

economists were not offered or relied on by respondent.   Instead,

respondent relied on Business Valuation Services’ (BVS) opinion,

in which a profit-split method15 of determining allocations was

utilized to produce an arm’s-length royalty for use of the trade

names and marks and arm’s-length fees for services performed.

The total allocations, as recommended in the BVS report, are as

follows:




     15
        “The profit split approach divides the related parties’
combined revenues based on an ad hoc assessment of the
contributions of the assets and activities of the commonly
controlled enterprises.” Eli Lilly & Co. v. Commissioner, 856
F.2d 855, 871 (7th Cir. 1988), affg. in part, revg. in part on
other issues and remanding 84 T.C. 996 (1985).
                                - 63 -


         Taxable year           From HIC to            From HHK/HS
           ending1            Hyatt Domestic             to HIC

     Dec.    31, 1976             $791,103             $2,164,604
     Dec.    31, 1977              954,126              2,501,906
     Dec.    31, 1978            1,092,387              2,992,556
     Dec.    31, 1979            1,302,797              4,316,952
     Dec.    31, 1980            1,731,902              7,565,475
     Dec.    31, 1981            1,985,825              9,054,035
     Dec.    31, 1982            1,750,500              7,377,525
     Dec.    31, 1983            1,832,550              6,150,778
     Dec.    31, 1984            1,926,900              7,781,600
     Dec.    31, 1985            1,889,100              1,536,910
     Dec.    31, 1986            2,218,500              8,703,363
     Dec.    31, 1987            2,712,150              9,573,138
     Dec.    31, 1988            3,488,100             11,759,205
             Total              23,675,940             69,718,842
     1
      Taxable year is that of HIC/AIC.       Hyatt Domestic/HGH’s
taxable year ends Jan. 31.

     Respondent’s notice determinations attributable to the

trademarks were as follows:

     Taxable year          From HIC to            From HHK/HS
        ending1          Hyatt Domestic             to HIC

             1976            ---                    $982,000
             1977            ---                   2,048,740
             1978            ---                   2,296,218
             1979            ---                   1,877,010
             1980         $2,159,000               3,094,935
             1981          3,266,000               4,157,250
             1982          4,603,000               4,838,580
             1983          5,279,000               5,046,810
             1984          5,548,000                   ---
             1985          6,070,000                   ---
             1986          5,735,687                   ---
             1987          5,935,143                   ---
             1988          7,333,495                   ---
                 Total    45,929,325              24,341,543
     1
      Hyatt Domestic’s fiscal year ends Jan. 31, and HIC was on a
Dec. 31 calendar year.
                                - 64 -


     Petitioners argue that respondent has, therefore, abandoned

the grounds for the section 482 allocations that were set forth

in the notices of deficiency.    Petitioners also argue that, by

abandoning the deficiency notice grounds, respondent has conceded

that the original determinations were arbitrary, capricious, or

unreasonable.   Respondent counters that the grounds for the

allocations have not been abandoned, that the underlying theories

are the same, and that the substitution of new expert reports,

per se, does not establish that the notice determinations were

arbitrary.   Respondent also points out that his trial experts’

report or opinion was affected by the acquisition of information

that was acquired after the issuance of the notice of deficiency

and therefore not available to the prenotice experts.16

     Prior to issuing the deficiency notices, respondent assigned

Dr. Mooney the task of analyzing whether and to what extent

section 482 allocations of income or deductions are warranted

between HIC and certain of its subsidiaries involving the

management of foreign hotels.    Dr. Mooney prepared a report

(Mooney report) dated February 15, 1986, entitled “Economic

Evaluation of the Performance of Hyatt of Hong Kong, Ltd.”      The

Mooney report was included as part of the revised International


     16
        In this regard, no claim is made here that respondent
was systematically kept from the information that would have had
an effect on the deficiency notice determinations. See, e.g.,
DHL Corp. v. Commissioner, T.C. Memo. 1998-461.
                               - 65 -


Examiner’s Report for the taxable years 1976 through 1981.      The

Mooney report served as one of the bases for respondent’s

deficiency notice determinations (addressed to petitioner AIC)

that HIC’s income be increased by allocations of income from

certain of its subsidiaries.

     The Mooney report, for the 1979 through 1981 tax years,

credited HIC with the development, implementation, and monitoring

of the Hyatt International management system (policies and

procedures) and of a set of standards for the operations of its

hotels.   It contained the statement that “Without these efforts

and intangible assets developed by HIC, HHK could not operate as

a hotel management firm.”   In deciding how to allocate income

between HHK and HIC, Dr. Mooney also determined a “normal return”

amount.   He further opined that amounts in excess of his

determined “normal return” should be attributed to the intangible

assets and services provided by HIC.

     To compute the “normal return”, Dr. Mooney first reviewed a

1980 study by James J. Eyster (Eyster study) containing the

information that chain operators generally require a per-hotel

management fee ranging from $65,000 to $120,000.      Dr. Mooney,

however, relied on two Hyatt International contracts that

specified minimum management fees:      one dated August 24, 1979,

providing for a $75,000 minimum annual fee per hotel in the

Philippines, and the other dated April 24, 1981, providing for a
                               - 66 -


$100,000 annual fee for a Saudi Arabian hotel.   Dr. Mooney,

considering these contracts with unrelated parties as the best

evidence of a normal return for HHK, set the allowable fees at

$75,000 per hotel for 1979, $87,500 for 1980, and $100,000 for

1981.   He recommended that any income above the allowable fees be

allocated from HHK to HIC.

     Mr. Burt, an industry economist employed by the IRS, was

assigned the task of analyzing whether and the extent to which

section 482 allocations of income or deductions should be made

among and between Hyatt Domestic, HIC, and certain subsidiaries

of HIC, attributable to the use of the Hyatt trade names,

trademarks, and/or other intangibles.   Mr. Burt prepared two

reports that were included as part of the revised International

Examiner’s Report for the taxable years at issue.   Mr. Burt’s

reports served as one of the bases for respondent’s deficiency

notice determinations allocating income from HIC to Hyatt

Domestic and from certain subsidiaries of HIC to HIC as a result

of the use of the Hyatt trade names, trademarks, and/or other

intangibles.

     In the first undated report (Burt report one), for the 1979

through 1981 tax years, Mr. Burt opined that 1.5 percent of gross

hotel revenue was an arm’s-length royalty for the use of the

Hyatt trade names and marks.   Mr. Burt’s use of the 1.5-percent

rate derived from franchise royalties rates charged by four
                              - 67 -


international hotel chains, as adjusted to eliminate inclusion of

advertising or reservations fees.    Mr. Burt located the rates he

thought to be comparable in a 1984 publication.    Franchise rates

were expressed as a percentage of room revenues; however,

available data suggested that room revenues for international

hotels were equal to half of total hotel revenues.    The other

half was attributable to food and beverage revenues.

     Mr. Burt’s second report (Burt report two), dated November

11, 1989, covered the 1982 through 1984 tax years.    Mr. Burt had

visited hotels in Hong Kong and Singapore during November 1988.

He observed that day-to-day operations were conducted under the

supervision of the general manager and staff, who made reports to

area and/or HIC personnel, but that “every Hyatt [sic] property

uses operating policies and procedures originally developed, or

modified and adapted, and then implemented by the Chicago-based

corporate parent and its staff.”    Mr. Burt observed:   “to the

extent management is exercised over hotel operations by HHK

and/or HS, it usually takes the form of ensuring correct

application of, or adherence to, HIC overall corporate philosophy

rather than direct management of each hotel’s day-to-day

operations.”   Mr. Burt concluded that each Asian Hyatt

International hotel be allowed “remuneration equivalent to that

received by an independent (rather than chain) hotel management

company”, which he suggested was $62,000 per hotel per year, due
                               - 68 -


to Hyatt International hotels’ status as luxury or resort hotels.

Mr. Burt located the $62,000 figure in the same Eyster study used

by Dr. Mooney.    The Eyster study provided information that

independent operators required $24,000 to $62,000 in annual

earnings based on a survey of 29 independent hotel operating

companies.   If fees exceeded $62,000, Mr. Burt advised that the

excess be allocated to HIC.    Mr. Burt also repeated his earlier

opinion that 1.5 percent of hotel gross revenue is an arm’s-

length royalty and would have been paid to Hyatt Domestic out of

this excess.

     For purposes of trial, however, respondent relied on the BVS

report/opinion.    That opinion was formulated by means of a four-

step process.    First, and prior to determining allocations for

royalties or management services income, BVS reassigned the

management fee income of certain hotels from one subsidiary to

another or to HIC based on BVS’ perceptions of the roles played

in developing the contract or in managing the hotel.    Second, BVS

employed a royalty equal to 15 percent of HIC’s revenues

(calculated after adjustments for all of the other types of

allocations) due from HIC to Hyatt Domestic.    The resulting

figure was thought to represent a profit split between HIC and

Hyatt Domestic.    The split was intended to account for Hyatt

Domestic’s contribution of its investment in chain services and

its position as the originator of the Hyatt trade name and marks
                               - 69 -


and the Hyatt International group’s contribution of capital and

personnel.   Third, BVS employed a royalty equal to 33 percent17

of management fees (after the first above-described adjustment)

that was to be allocated from HHK and HS to HIC.    This royalty is

for trade names and marks and to “provide a profit for the

reservations activities, cover corporate overhead and subsidize

the development activities.”   In addition, the royalty from HHK

and HS was also intended to fund or pass on the cost of the

royalties that would be due from HIC to Hyatt Domestic.     Fourth,

BVS concluded there should be an allocation from HHK and HS to

HIC, described as a profit split, of generally 50 or 65 percent

(depending on the year) of the operating income remaining after

expenses and the above royalties are deducted.   BVS intended the

profit split to cover the financial guaranties and differences in

assets, with HIC being considered the owner of the intangibles

and the financial capital.

     In deciding whether the Commissioner’s determination is

reasonable, courts focus on the reasonableness of the result, not

on the details of the methodology used.   See Seagate Tech., Inc.,

& Consol. Subs. v. Commissioner, 102 T.C. at 164.    In a

particular case, the Commissioner’s deficiency notice



     17
        It was contended that the 33 percent of the management
fee rate was the equivalent of 1 percent of gross hotel revenues
in comparison to Mr. Burt’s 1.5 percent rate.
                               - 70 -


determination was based upon one method and an amendment to

answer contained another method that resulted in an increased

deficiency from that determined in the deficiency notice.      See

Eli Lilly & Co. v. Commissioner, 84 T.C. 996, 1132 (1985), affd.

in part, revd. in part on other issues and remanded 856 F.2d 855

(7th Cir. 1988).    The Commissioner’s trial expert in that case

did not opine about either of these methods and, instead, relied

on two other methods to allocate income.    The taxpayer in Eli

Lilly & Co., similarly to petitioners here, argued that the

difference between the trial position and the deficiency notice

determinations caused the Commissioner’s determinations to be

arbitrary, capricious, and unreasonable.    As a result, the

taxpayer contended that the Commissioner’s determination should

not be entitled to the presumption of correctness.    The Court

disagreed, holding that the presumption of correctness afforded

to the Commissioner’s section 482 determinations is not to be

lost solely because of the use of differing methodologies.      The

Court reasoned that to hold otherwise would preclude the

Commissioner from using outside experts or making alternative

determinations.    In some circumstances, however, an abandonment

of methodology may support a finding in part or whole, that the

Commissioner’s determination was unreasonable, arbitrary, or

capricious.   See, e.g., National Semiconductor Corp. v.

Commissioner, T.C. Memo. 1994-195.
                              - 71 -


     Under the circumstances of this case, respondent’s

substitution or change of methodology, alone, does not result in

our finding or holding that respondent’s determinations are

arbitrary, capricious, or unreasonable.   There were certain

similarities in the approaches and methodologies used to

formulate respondent’s deficiency notice and those used by

respondent’s trial experts.

     C. Is Respondent's Determination in Other Respects
Arbitrary, Capricious, and Unreasonable?

     Background

     Next, we consider petitioners’ contentions that respondent’s

determinations were, considering all the circumstances, an abuse

of respondent’s discretion.   It appears that a primary basis for

respondent’s section 482 deficiency notice allocations was the

belief that HIC bore the majority of the consolidated expenses of

the Hyatt International group and that HHK and HS received the

majority of the revenue.   Respondent compared petitioners’

profitability ratios to those of other hotel companies.    In that

regard, the Hyatt International group’s accounting system does

not include expenses paid by the owner, whereas other hotel

companies that respondent treated as comparable, used

combinations of franchise, lease, and management contracts.
                              - 72 -


     Another variable here is that HIC acted as both management

entity and parent (individually), so that some of its expenses

were related to its activity as a parent company.    In addition,

HIC incurred expenses with respect to its involvement with hotels

in Brussels and Nice.   Respondent’s experts generally did not

recognize the contributions made by HHK and HS, because their

efforts were not evidenced by expenditures recorded on those

management subsidiaries’ books.   On those occasions where the

efforts of HHK and HS personnel were recognized, respondent’s

experts considered them to be performed on HIC’s behalf.    We now

consider, in particular, whether any of respondent’s

determinations were arbitrary, capricious, or unreasonable.

     1.   Allocations Between HIC and Hyatt Domestic

     HIC and Hyatt Domestic entered into a 1974 agreement for the

purpose of sharing the services of each other’s sales offices.

HIC billed Hyatt Domestic for a contractually agreed level of

support from the Hyatt International sales offices.    Hyatt

Domestic included these costs as part of its chain expenses and

billed each of its hotels and those of the Hyatt International

group for a share of the overall chain expenses.    The chain

allocation formula was based on the number of guest rooms.      In

accordance with the 1974 chain services sharing agreement, Hyatt

International hotels paid either 50, 75, or 100 percent of a full

chain allocation depending on the hotel’s geographical location.
                              - 73 -


This approach was used because it was thought that a hotel’s

geographical distance from Hyatt Domestic’s U.S. sales offices

would affect the benefits; i.e., the greater the distance, the

less the benefit.   Respondent, however, concluded that the

possibility for tax avoidance was lurking in these circumstances

under which many hotels were being charged less than an equally

apportioned share of the chain service allocation.   The use of

total rooms per hotel adjusted for the distance of a hotel from

the U.S. sales offices, to some extent, appears to reasonably

account for the circumstances.

     Beginning February 1, 1980, cross-billing and reimbursement

were discontinued under the assumption that the benefits

exchanged were equal, although both organizations continued to

share chain services.   Both Hyatt Domestic and the Hyatt

International group invested in establishing chain services and

made a business decision to share those services.    To the extent

that they exchanged services of equal value, we hold that no

allocation between HIC and Hyatt Domestic is warranted.     To the

extent that respondent’s determinations included allocations of

income between Hyatt Domestic and HIC for chain services it was

an abuse of discretion.   We note that any income allocation

between HIC and Hyatt Domestic would have been made under the 1.5

percent royalty adjustment.
                              - 74 -


     Respondent, in making the deficiency notice allocations,

relied on the fact that Hyatt International group hired staff

trained by Hyatt Domestic.   Due to differences in their

respective operations, however, HIC did not gain by hiring Hyatt-

Domestic trained staff rather than experienced staff from other

similarly situated hotels.   In other respects, the record does

not support a finding that the Hyatt International group received

anything else for which compensation would have been due to Hyatt

Domestic; e.g., training programs, innovative atrium and

restaurant designs, or manuals.   In addition none of the parties'

trial experts focused on these specific items.   Accordingly, we

find that respondent's determination with respect to these items

is arbitrary, capricious, and unreasonable.

     2. Notice Determinations for Hyatt Domestic’s Income
Allocations Attributable to Royalties for Trade Names and Marks

     For each of Hyatt Domestic’s taxable years, respondent

determined that 1.5 percent of the gross receipts each hotel

operated in the Hyatt International group be allocated to Hyatt

Domestic.   Two of the notices contain explanations that the

adjustment is a royalty for the use of Hyatt trademarks and other

intangibles.   One notice (for 1983, 1984, and 1985 taxable years)

contains the 1.5 percent adjustment, but states that it for use

of the trademark, without any reference to other intangibles.

For purposes of trial, respondent’s expert concluded that a
                               - 75 -


royalty of 15 percent of the net revenues should be allocated to

Hyatt Domestic.   Respondent’s expert concluded that the royalty

was an equivalent of a profit split accounting for HIC’s capital

and personnel to build an international chain and Hyatt Domestic

contributing chain services and its intangibles, including the

trademarks.

     The 1974 licensing agreement between HIC and Hyatt Domestic

was for the use of the various Hyatt trade names and marks.      HIC

agreed:   To pay Hyatt Domestic a one-time payment of $10,000 per

hotel opened; to pay the costs of registering the trade names and

marks; and that the standards of services and the quality of

products bearing a mark would, at very least, be equivalent to

those adopted or maintained by Hyatt Domestic.      For $10,000 per

hotel, HIC received a license to use Hyatt trade names and marks

in perpetuity from Hyatt Domestic.      Beyond that, however, the

Hyatt International group received relatively nominal amounts of

chain services from Hyatt Domestic in excess of services provided

for Hyatt Domestic.

     Respondent’s deficiency notice determination that Hyatt

Domestic and HIC’s income be increased by a royalty of 1.5

percent of the gross hotel revenues of the Hyatt International

group18 was based on hotel franchise rates.     Respondent’s


     18
          The amount of royalty determined to be included in HIC’s
                                                     (continued...)
                               - 76 -


prenotice expert adjusted these franchise rates to make them

exclusive of marketing and reservation charges, and ultimately we

have decided that the franchise rates respondent used in the

notice were overstated.   A franchisee, in exchange for a royalty,

receives trade names and marks, business systems and expertise,

and for additional fees may receive reservations and marketing

services.19   Hotel franchisors generally offer preopening

assistance with site selection and feasibility, design, obtaining

financing, and the hiring and training of staff.   The

consultation and technical services and training provided by the

franchisor continue after the opening of the hotel.   Neither HIC

nor the Hyatt International group as a whole, received the level

of intangibles and services from Hyatt Domestic that would

warrant the full charge for a franchise relationship.

Considering the relationship between the Hyatt International

group and Hyatt Domestic, it was unreasonable for respondent to

allocate income based on 100 percent of the hotel franchise

royalty rate.

     Respondent’s trial position relied on the BVS' allocation of

less than $24 million for use of the Hyatt trade names and marks



     18
      (...continued)
income would, in turn, be paid by HIC to Hyatt Domestic.
     19
        See Canterbury v. Commissioner, 99 T.C. 223 (1992), for
a description of franchising in the restaurant industry.
                                - 77 -


for Hyatt Domestic’s 9 taxable years.    This contrasts with the

nearly $46 million 9-year total set forth in the deficiency

notices.    Respondent’s trial position represents less than 40

percent of the original deficiency notice determinations.     Those

factors, coupled with the change of methodology and experts

supports our holding that respondent’s deficiency notice

determinations for the Hyatt trade names and marks were

unreasonable and an abuse of discretion as to respondent’s

determinations regarding royalty allocation to Hyatt Domestic.

See National Semiconductor Corp. v. Commissioner, T.C. Memo.

1994-195.

     3.    Allocations to HIC from Its Subsidiaries

     We next consider whether there was an abuse of discretion in

respondent’s royalty income allocations to HIC for its

subsidiaries’ use of the Hyatt trade names or marks.    HIC did not

receive any portion of the management fee income from the hotels

as operating revenue.20    Beyond expenses related to chain

services that were charged to the hotels through HCS, HIC did not

charge its subsidiaries for services provided.    During 1983,

however, there was a one-time “catch-up” charge on HHK’s books

for HIC’s overhead expenses from prior years.




     20
           HIC did, however, receive dividends from HHK and HS.
                              - 78 -


     Respondent’s adjustments to HIC’s income involve three types

of allocations:   (1) Royalty to HIC for its subsidiaries’ use of

trade names and marks, (2) allocation to HIC of its subsidiaries’

management fee revenues, and (3) allocation of management income

to reflect HIC’s relative contribution vis-a-vis the subsidiary

in operating the individual hotels.    Respondent’s royalty income

allocations for trade names and marks from HIC’s subsidiaries to

HIC are based on the same reasoning and were at the same

percentage as allocated from HIC to Hyatt Domestic.   Our

reasoning for the Hyatt Domestic/HIC royalty allocation also

applies to HIC and its subsidiaries.   Accordingly, we hold that

respondent’s determinations involving royalty income allocations

to HIC from its subsidiaries were an abuse of discretion.

     Respondent also determined that the management fee income

reported by HHK, HS, and HP above a “normal return” per hotel,

should be allocated to HIC.   In computing the subsidiary income

allowed, only those hotels respondent determined to be actually

managed by the respective subsidiary received an allowance.

Accordingly, some portion of the allocations represented income

from HIC’s subsidiaries with respect to those hotels that

respondent decided were not managed by the subsidiary.   Due to

respondent’s selectivity and the use of average allowances rather

than actual hotel revenues, there is no way accurately to
                              - 79 -


ascertain the portion of the adjustment for hotels not managed

from the “excess” income attributable to those respondent

determined were actually managed.   After computing the total

income to be allocated from the subsidiaries, respondent

subtracted the royalty for the use of the trade names and marks

to arrive at the amount allocated for services.

     In the reports that predated the deficiency notice, Mr. Burt

and Dr. Mooney opined that the amount earned by a hotel in excess

of the “normal return” was allocated to HIC in recognition of

HIC’s contribution of intangibles and services.   The theory

advanced for those allocations was that the excess over a “normal

return” was due to the benefit and advantages of being a part of

the chain, which were contributed by HIC.   In establishing a

“normal return”, both Mr. Burt and Dr. Mooney used amounts

reported by others as the minimum acceptable earnings.   One used

the independent hotel operator figure of $62,000, and the other

considered the chain operator’s figures ranging from $65,000 to

$120,000, but ultimately used the amounts reflected in two Hyatt

International contracts.   Mr. Burt used $62,000 for the years

1982 and 1983 (the latest years in issue) and increasing amounts

ranging from $73,200 for 1976 to $100,000 for 1980.   The use of

the $62,000 figure resulted in losses for the subsidiaries.

There was no apparent consideration of the sizes or locations of

the hotels used in the Eyster study, or of the hotels involved in
                              - 80 -


the Hyatt International contracts, relied upon by Dr. Mooney and

Mr. Burt.   Mr. Burt and Dr. Mooney did not give consideration to

the role played by HHK or HS in the development, implementation,

and monitoring of the Hyatt International group policies and

standards or in otherwise enhancing the performance of the hotels

they supervised.

     Overall, by means of the deficiency notices, respondent

determined $49,337,269 of allocations attributable to HIC.

Comparatively, BVS’s opinion recommends just over $30 million

attributable to HIC.   BVS analyzed the relationship between HIC

and its management subsidiaries and concluded that a profit-split

methodology should be used in constructing its recommendations.

Petitioners’ expert, Ernst & Young, concluded that management

fees were earned by the subsidiary that received them.     Because

of the approximate $2.5 million catchup overhead charge in 1983,

they recommended that no allocations were needed for support

services from HIC.   Ernst & Young also concluded that allocations

were unnecessary for IPS’s services, due to its limited influence

in the years involved, or for chain services, as costs were

covered and any profit on chain services should accrue to HCS, a

subsidiary of HHK.

     Ultimately, we hold that HHK and HS received the benefit of

certain services from HIC (as discussed infra) and that

allocation of income is necessary.     The reports, prior to the
                                - 81 -


issuances of the deficiency notices, were confronted with a

compelling financial picture.    For 1976 Hyatt’s domestic

(including HIC) operations reflected revenues somewhat over $1.5

million with expenses somewhat over $2.5 million, whereas the

amounts reflected for foreign operations income approached $4.5

million with expenses approaching $.5 million.    Accordingly

domestic operations had almost a $1 million loss and foreign

operations had almost a $4 million gain.    These differences

increased throughout the period, and in the 1982 year domestic

operations had about $2.5 million income and $8.5 million

expenses for about a $6 million loss.    The foreign operations,

for 1982, had about $13.5 million income and $3.3 million

expenses for about a $10 million gain.    Roughly, domestic

operation expenses averaged about double the amount of receipts

and foreign operation expenses were only about 50 percent of

their receipts.

     During the period under consideration, the foreign operation

receipts and profit was, in general, steadily increasing.     During

that same period, the domestic operation expenses were steadily

increasing in tandem with foreign receipts and profit, but

domestic receipts tended to be more static.    These circumstances

resulted in generally increasing losses for domestic operations

and generally increasing gains for foreign operations.

Throughout the period, HIC was involved in the management of its
                              - 82 -


subsidiaries and in the overall management of the Hyatt

International group.   Significantly, to the extent that services

were charged, they were at cost.   Under that combination of

circumstances these financial trends appear to be incongruent.

Confronted with that information and data gathered from other

hotel chains, respondent’s employees' evaluations and,

ultimately, respondent’s determinations were based on reasonable

assumptions and fell within reasonable limits.   After trial, we

were able to discern nuances and differences in petitioners'

operations that caused us not to sustain fully respondent's

notice or trial positions; however, we generally did not accept

petitioners' reporting or trial positions either.

     Accordingly, we do not find respondent’s determination with

respect to these allocations to be arbitrary, capricious, or

unreasonable.

     Having decided that some of respondent’s determinations were

arbitrary and capricious, petitioners are left with the burden of

showing that the amounts in question were for an arm’s-length

consideration.   If petitioners fail to show that their

transactions met the arm’s-length standard, then we must decide

the appropriate consideration; i.e., an arm’s-length rate between

unrelated parties.   Concerning the remainder of respondent's
                              - 83 -


section 482 determinations, petitioners must show an abuse of

respondent's discretion.21

V.   Arm’s-Length Consideration

     A. Respondent’s Allocations of Management Fee Revenue for
HHK, HS, and HIC

     HHK and HS received management fee revenue from hotels for

which HHK or HS did not provide services.   In this regard,

petitioners acknowledge that HIC was responsible for European and

Central American hotels throughout the years in issue (1976

through 1983).   Accordingly, we sustain respondent’s allocation

of income for these hotels to HIC.22

      HHK received consulting fees and royalties from HESA without

performing services for HESA or the Mexican hotels.   HESA managed

the hotels in Mexico and earned the management fees, and the

consulting agreement was merely a mechanism to reduce local



      21
       In the final analysis, it did not make a difference that
petitioner was unable to show that all of respondent's
determinations were arbitrary, capricious, or unreasonable. That
is so because, in those instances where we redetermined an arm’s-
length consideration, petitioners were not able to meet the
lesser standard of showing that their reporting or trial position
was for an arm’s-length consideration.
      22
        BVS recommended allocation of revenue from certain
hotels in the Middle East and North Africa. These particular
hotels were not in operation during the years affecting the
allocations to HIC (1976 through 1983), and allocation in the
later years that involve only Hyatt Domestic’s allocations
(through 1988) would not change the result because, ultimately,
the royalties were computed as a percentage of gross hotel
revenues rather than being based on HIC’s revenues. Thus, it is
not necessary to analyze the particulars of hotels managed in
those regions.
                               - 84 -


taxes.    Regardless of whether the income is HESA’s or HHK’s, it

is not HIC’s income.23   See Columbian Rope v. Commissioner, 42

T.C. 800, 812-813 (1964).   Accordingly, respondent’s allocation

concerning the Mexican hotels is an abuse of discretion and is

not sustained.

     BVS opined that the revenue for the Hyatt Kingsgate Sydney

should be allocated from HS to HHK.     Due to favorable tax

treaties, the Hyatt Kingsgate Sydney’s fees were assigned to HS,

although the hotel was supervised by HHK.     While this allocation

may have been part of the BVS profit-split analysis, it has no

impact on and is neutralized by our holdings concerning HIC’s

income.    See National Semiconductor Corp. v. Commissioner, supra.

     In addition to those hotels for which BVS recommended 100-

percent revenue allocation, smaller percentages were recommended

where some other entity was the contract source or provided some

small service.   This appears to be a new matter that was not

addressed in the deficiency notices.    The parties’ broad-based

approaches failed to address the specific details concerning each

hotel involved in these smaller allocations.    Irrespective of the

parties’ approach, allocations from one to another foreign entity

would not directly or adversely affect HIC’s U.S. income.      As for



     23
        HIC (Mexico) was, at that time, a 49-percent owner of
HESA. Any amount that would be paid from HESA as dividend income
to HIC (Mexico), a U.S. subsidiary of HIC, would be included in
the U.S. consolidated return with HIC.
                                - 85 -


those allocations that involve HIC, as discussed infra, we find

that the business development type activity constituted HIC’s

activity as a parent company.    Accordingly, these allocations

either are not in issue or have no effect on the outcome.

     B. Royalties Allocated to Hyatt Domestic for HIC’s Use of
the Hyatt Trade Names and Marks and Other Intangibles

     Hyatt Domestic, beginning in 1968, provided HIC with a

license to use the Hyatt trade names and marks.    In its 1980

taxable year, Hyatt Domestic provided more chain services to the

Hyatt International hotels than Hyatt Domestic had received.

Respondent, relying on the BVS report, contends that a 15-percent

royalty should be allocated from HIC to Hyatt Domestic based on

HIC’s revenues.   The proposed allocation, according to

respondent, represents a profit split between HIC and Hyatt

Domestic reflecting Hyatt Domestic’s contribution of its

investment in chain services, Hyatt Domestic’s originator status

regarding the Hyatt trade name and marks, and HIC’s contribution

of capital and personnel.

     Petitioners, relying on the Mercer Management Consulting

(Mercer) report, contend that the Hyatt name had little or no

value and did not increase the Hyatt International group’s

income-generating capability.    The parties and their experts did

not focus on the specific factors that might influence the

amounts or the operation of the royalties.    Instead, in a broad-
                              - 86 -


brushed manner, each side generally sought to convince us that

there should or should not be a royalty allocation.   In that

setting, we undertake our analysis of the value of royalties

attributable to the names and marks.

     In a recent Memorandum Opinion of this Court, a trademark

was described as:

     a marketplace device by which consumers identify goods
     and services and their source. In the context of
     trademark nomenclature, a trademark symbolizes
     “goodwill” or the likelihood that consumers will make
     future purchases of the same goods and services. In a
     licensing arrangement, the goodwill symbolized by the
     trademark is owned by the licensor, even though created
     by the licensee’s efforts. See, e.g., Cotton Ginny,
     Ltd. v. Cotton Gin, Inc., 691 F. Supp. 1347 (S.D. Fla.
     1988).

DHL Corp. v. Commissioner, T.C. Memo. 1998-461.

     In another Memorandum Opinion, it was explained that:

     Trademark recognition develops from years of adver-
     tising, consistent packaging, promotional campaigns,
     customer service, and quality control. Depending on
     the strength of a trademark, the maintenance of the
     desired consumer awareness level generally requires
     significant, continuing advertising investment and
     product renovation. Trademarks lose substantial value
     without adequate investment, management, marketing,
     advertising, and sales organization.

Nestle Holdings, Inc. v. Commissioner, T.C. Memo. 1995-441, revd.

and remanded on other grounds 152 F.3d 83 (2d Cir. 1998).

     Petitioners’ expert (Mercer) found little evidence of any

value of the Hyatt trade names and marks when used by Hyatt

International hotels.   This conclusion was based on Mercer’s
                               - 87 -


postulations:   that, generally, brand name is a less significant

factor to hotel guests than location; chain hotels constitute a

much smaller percentage of the international market than that of

the U.S. hotel market; smaller hotel chains have lower brand

awareness; there was no premium paid for Hyatt International

hotel rooms over competitors’ rooms; there was a small number of

guests from the United States (who would be familiar with the

Hyatt name) traveling to the Asia-Pacific area where most Hyatt

International hotels were located; the percentage of U.S. guests

in most Hyatt International hotels was below market average; and

the Hyatt International group management fees were lower than

average.

     We do not accept the Mercer conclusion that the Hyatt name

has no value in the context of international operations.   Hotel

location may be an important or possibly even a primary factor in

a guest’s hotel selection; however, it has been shown that brand

name is an important factor in attracting certain categories of

guests.    BVS found that trade names are important for incremental

business, even where most of the reservations were secured

through local contacts.   Petitioners argued that Hyatt

International hotels earned no premium on the rates they charged

as compared to other competing hotels.   Hyatt International

hotels, however, competed favorably with luxury hotels, including

those run by Hilton International, reflecting that the Hyatt
                                - 88 -


brand was valuable and, to some extent, was a drawing factor for

potential customers.   The affiliation with a major chain also has

a beneficial effect on Hyatt hotel owners’ attempts to secure

financing.   Petitioners’ experts minimized and attempted to play

down the fact that some Hyatt International hotel guests were

from the United States.24    Hyatt Domestic’s promotion of the

Hyatt name and referral of guests to Hyatt International

contributed some value to the Hyatt trade names and marks to

Hyatt International, especially when viewed 10 years out and

later.25   Overall, we disagree with petitioners and hold that the

Hyatt trade names and marks had some importance or value to the

Hyatt International group.

     In the event that we might decide the Hyatt names and marks

had value, petitioners advanced the alternative argument that the

Hyatt International group’s use of the names and marks represents

the arm’s-length consideration and provides reciprocal benefits

to Hyatt Domestic.   While it is possible that a similar benefit


     24
        As would be expected, the percentage varied from
location to location, particularly in Mexico, Puerto Rico, and
Central America.
     25
        We reiterate that $10,000 was paid for each hotel
without regard for the time value of money or the passage of
time. As of the years under consideration, when the number of
hotels had increased and the name use and recognition must have
increased, the $10,000 was the standard, unchanged from 1968. In
1975 there were 19 hotels, and by 1988 about 40 (without
considering those in Mexico). From 1975 to 1988 HIC's gross
management revenue increased fivefold.
                               - 89 -


could have enured from Hyatt International’s use of the name

(i.e., where guests staying at Hyatt Domestic hotels were

familiar with Hyatt International hotels), petitioners have

presented no evidence, one way or the other, on the origin of

guests staying at Hyatt Domestic hotels or any other measure of

any such benefit from the Hyatt International group’s operations

to Hyatt Domestic.26   As a second alternative, petitioners argue

that the Hyatt International group assisted in the development of

the trade names and is entitled to a setoff for that under

section 1.482-2(d)(1)(ii)(b), Income Tax Regs.     Petitioners,

however, have presented no evidence of the costs or outlays that

may have been incurred in order to measure and reach such a

determination.   See sec. 1.482-2(d)(1)(ii)(c), Income Tax Regs.

     Respondent relies on the fact that Hyatt Domestic initiated

lawsuits to protect its trade name.     Respondent argued that such

action is evidence that the Hyatt name had great value.

Instituting suits, however, does not automatically reflect that

the name or mark has great value.   Such suits may be brought to

protect marginal values, because failure to act against

infringements could lead to loss of the trade name protection.




     26
        Nor did petitioners present evidence showing that the
$10,000 amount per hotel provided for in the licensing agreement
was an arm’s-length consideration within the meaning of sec.
1.482-2(d)(2), Income Tax Regs.
                                - 90 -


Winget Kickernick Co. v. La Mode Garment Co., 42 F.2d 513, 514

(N.D. Ill. 1930).

     Having held that the Hyatt trade names and marks do have

value in the context of the international operations, we now turn

to evaluating the amount of arm’s-length consideration that

should have passed from HIC to Hyatt Domestic for the use of the

Hyatt names and marks.     The parties placed heavy reliance on

their respective expert witnesses in arguing what is the correct

amount of arm’s-length consideration for use of the names and

marks.     In reaching our holding:

     We weigh expert testimony in light of the expert’s
     qualifications as well as all the other credible
     evidence in the record. Estate of Newhouse v.
     Commissioner, 94 T.C. 193, 217 (1990). We are not
     bound by the opinion of any expert witness, and we will
     accept or reject that expert testimony when, in our
     best judgment, based on the record, it is appropriate
     to do so. Estate of Newhouse v. Commissioner, supra;
     Chiu v. Commissioner, 84 T.C. 722, 734 (1985). While
     we may choose to accept the opinion of one expert in
     its entirety, Buffalo Tool & Die Mfg. Co. v.
     Commissioner, 74 T.C. 441, 452 (1980), we may also be
     selective in the use of any portion of that opinion.
     Parker v. Commissioner, 86 T.C. 547, 562 (1986).

Sundstrand Corp. v. Commissioner, 96 T.C. at 359.     A review of

the royalty, marketing, and reservations charges of U.S.-based

hotel franchises by respondent’s expert (BVS) resulted in

combined average rates ranging from 3 to 7 percent of gross room

revenue.    Generally, as a percentage of gross room revenues,

royalties ranged from 4 to 5 percent, typical marketing fees
                              - 91 -


ranged from 1 to 3 percent, and reservations fees ranged from 1

to 2 percent.   Finding no completely comparable transaction, BVS

used the royalty of 1 percent of gross hotel revenue that HESA

paid HHK.   BVS then calculated that 15 percent of HIC’s net

adjusted revenues (after all other allocations) approximated the

1 percent of gross hotel income HESA paid as a royalty.   That

amount and most of respondent’s notice determinations included

within the royalty the use of the trademarks/trade names and

other intangibles.

     The original HESA agreement provided for royalties of 2

percent of hotel gross income within the context of a consulting

fee in the amount of 75 percent of HESA’s management fee revenue.

As more hotels were added to the venture, royalties were reduced

to 1 percent.   Although petitioners have put their spin on the

reasons for the rate reduction, it is not entirely clear why BVS

chose the 1-percent, rather than the 2-percent, rate.   The HESA

royalty included use of the trade names and marks and all Hyatt

chain services.   We note that Hyatt Domestic licensed the use of

its names and marks but provided only a portion of the Hyatt

International group’s chain services, and the latter was, to some

extent, balanced by the Hyatt International group’s reciprocation

of similar services.

     Importantly, the HESA agreements reflect a relationship that

is quite different from the relationship between Hyatt Domestic
                                - 92 -


and HIC.   The HESA royalty agreement was part of a group of

simultaneously executed contracts establishing a joint venture

relationship between HIC and VIS.    We also note that although 15

percent of HIC’s adjusted net revenues, as calculated by BVS,

might have been equivalent to 1 percent of hotel gross income, we

do not accept all of the management fee allocations BVS made, and

therefore the use of BVS’s 15-percent equivalence does not have

adequate support in the record.

     With the parties going off in opposite directions and

reaching diametrically opposed positions, neither of which is

wholly supportable, we do not place complete reliance on either

party’s expert.   Petitioners’ expert denies any but a de minimis

value, a position we have rejected.      In that same vein, we have

found respondent’s expert’s premises to be only partially

acceptable.

     Section 1.482-2(d), Income Tax Regs., provides a framework

for determining an arm’s-length consideration for the transfer,

sale, assignment, loan, or other use of intangible property or an

interest therein between related entities.     An arm’s-length

consideration for intangible property is defined as “the amount

that would have been paid by an unrelated party for the same

intangible property under the same circumstances.”     Sec. 1.482-

2(d)(2)(ii), Income Tax Regs.    The best indication of such arm’s-

length consideration generally is the amount of consideration
                                - 93 -


paid for transfers by the same transferor to unrelated parties

involving the same or similar intangible property under the same

or similar circumstances.   See id.      If no sufficiently similar

transfers can be found, section 1.482-2(d)(2)(iii), Income Tax

Regs., sets forth a list of factors that may be considered in

arriving at the amount of the arm’s-length consideration.      The

arm’s-length nature of an agreement is determined by reference

only to facts in existence at the time of the agreement.      See

Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 601 (1989),

affd. 933 F.2d 1084 (2d Cir. 1991).

     No evidence of similar intangibles being transferred to an

unrelated party was produced.    Hyatt Domestic’s transaction with

HIC and HIC’s with its subsidiaries concerned services and other

aspects, in addition to the names and marks.      In each instance,

the names and marks were part of a larger package including the

provision of various services.    Accordingly, we utilize the

factors specified in section 1.482-2(d)(2)(iii), Income Tax

Regs., to formulate our holding, noting that the parties’ experts

have not specifically addressed those factors.

     One significant factor to consider would be the prevailing

rates in the industry.   Ideally, the 1968 rates for trade names

and marks in the hotel industry would be a starting point.      The

hotel franchise rates presented in the record, however, cover the

period 1979 through 1988.   The licensing agreement here was
                               - 94 -


granted in perpetuity in exchange for a $10,000 flat fee payable

for each new hotel.   The terms of the licensing agreement do not

include a consideration of time factors, such as the amount of

time the hotel was to be operated.      The license transferred was

for exclusive use outside the United States.     The Hyatt

International group was required to pay for the registration of

the trade names and marks in the countries of its operation, a

factor that may be considered.   See sec. 1.482-2(d)(2)(iii),

Income Tax Regs.

     Petitioners dispute the appropriateness of the use of

comparables based on franchise rates principally because the

Hyatt International group operated under management agreements,

not franchise agreements.   Although a franchise analogy does not

present a completely suitable comparison with the existing

relationship between the Hyatt International group and the hotel

owners, a franchise analogy does more accurately fit the

relationship between HIC and its hotel management subsidiaries.

A franchise relationship normally includes a license to use the

franchisor’s name and marks.   That type of license was provided

by Hyatt Domestic to HIC, which in turn provided it to HIC’s

subsidiaries.   Franchise rates, however, normally include much

more than the rights or licenses transferred by Hyatt Domestic;

e.g., providing business systems and expertise and providing

reservations, marketing, and technical services.     Thus, we must
                              - 95 -


separate the value attributable to trade names and marks from the

other items normally included in a franchise rate or agreement.

     The parties’ experts appear to agree that the franchise

rates for luxury hotels charged by U.S.-based hotel chains were

the equivalent of about 2 percent of gross hotel revenue.27    In

determining the arm’s-length charge for the Hyatt trade names and

marks, we begin with a franchise rate of 2 percent of gross hotel

revenues.   The Mercer report included a presentation of Hilton

franchise revenue and expenses from 1987 through 1990.

Approximately one-half of the Hilton franchise revenues were used

for expenses, exclusive of taxes.   If approximately one-half of

franchise revenues represent expenses, the other half, or 1

percent of gross hotel revenues, remains for allocation to profit

on reservations, marketing, expertise, and other services, as

well as a royalty for trade names and marks.   Of the 1 percent

representing profit, we attribute .5 percent to royalties and .5

percent to other items.

     Based on the information available, we hold that the

appropriate arm’s-length charge for the Hyatt trade names and

marks and the chain services provided by Hyatt Domestic is two-



     27
        Accepting the premise that room revenues and food
revenues each comprise, on average, half of an international
hotel’s gross revenue, a franchise rate of 4 percent of room
revenues translates to a rate of 2 percent of hotel gross
revenues.
                               - 96 -


fifths of 1 percent (.4 percent) of the gross revenue of each

Hyatt International hotel.28   The .4 percent franchise rate, in

addition to accounting for an approximate division of the

elements in the franchise rate including use of the marks and

other intangibles, favors petitioners’ position in one important

respect.   In particular, our allocation or reduction of the

franchise rate recognizes, to some extent, that marks and names

are less important in the international hotel marketplace.

     C. Allocations of Royalty Income for Trade Names and Marks
to HIC From Its Subsidiaries

     HIC’s subsidiaries did not pay HIC royalties for the use of

the Hyatt trade names and marks.   In the notices of deficiency,

respondent determined that HIC’s income should be increased for

royalties from HHK, HS, and HP of 1.5 percent of their gross

revenues, the same rate as respondent’s determined royalties from

HIC to Hyatt Domestic.   At trial, respondent relied on the BVS

recommendation that a royalty of 33 percent of management fees,

as adjusted, should be allocated from HHK and HS to HIC.    The

proposed royalty is to account for trade names and marks and to

“provide a profit for the reservations activities, cover

corporate overhead and subsidize the development activities.”      It




     28
        The royalty allocations should be offset by the $10,000
per hotel license fees that HIC paid to Hyatt Domestic during the
years in issue.
                               - 97 -


also was intended to cover the cost of royalties from HIC to

Hyatt Domestic.

     Mirroring their argument with respect to respondent’s

royalty determination between HIC and Hyatt Domestic, petitioners

argue that these intangibles have no value, or that it was the

subsidiaries (HHK and HS) that created the value.    In this

setting, however, petitioners also rely on Your Host, Inc. v.

Commissioner, 58 T.C. 10, 27-28 (1972), affd. on other issues 489

F.2d 957 (2d Cir. 1973), for the proposition that, even in a

chain operation, a trade name may have little value.

     Your Host, Inc. v. Commissioner, supra, involved 11

restaurant corporations with common ownership and senior

management that operated a total of 40 restaurants with the name

of Your Host Restaurant.    All but three of the restaurants were

located in the Buffalo, New York, area, with the remainder in

Rochester, New York.    Two of the three Rochester restaurants

closed after 6 years.    All of the restaurants were similar in

appearance, served identical menus at the same prices, and were

open 24 hours a day.    They advertised as being part of a chain

under the same management.    For economy of scale, a master policy

for liability insurance and workmen’s compensation was obtained

for all the corporations.    The premium for the coverage was

advanced by Your Host corporation and was reimbursed by the other

corporations in apportioned amounts based on each corporation’s
                              - 98 -


payroll.   All employees were paid from a special payroll account

maintained by the Your Host corporation.    The individual

corporate entities would deposit the funds needed to pay the net

wages of their respective employees and then Your Host

corporation paid out the wages, leaving a zero balance in the

payroll account.   Each restaurant had a manager; however, the

manager could not change the menu or hours of business, nor

purchase supplies from other than the related supplier.      The

costs of the administrative staff, insurance premiums,

administrative office expenses, advertising, and maintenance and

supervisory staff generally were allocated among the corporations

according to gross sales, except the Rochester corporation did

not share in advertising costs because its restaurants did not

benefit from Buffalo area advertisements.    The Commissioner

allocated all of the income and deductions of all 11 corporations

to the Your Host corporation pursuant to section 482.

     In Your Host, Inc. v. Commissioner, supra, we held that each

of the corporations was a viable business entity that paid its

own expenses.   Although the restaurants opened over a 25-year

period, with the openings of the first restaurant for each

corporation over a 13-year period, we found that the restaurants

operated by the Your Host corporation were, on average, no older

and no better established than those operated by the other

corporations.   Thus, the later-established restaurants were not
                              - 99 -


found to have traded upon the goodwill generated by the Your Host

corporation’s restaurants; all of them generated goodwill that

they shared equally.   We found that the advantage of being a Your

Host Restaurant flowed primarily from the local advertising and

shared management.   This was supported by the fact that the

Rochester restaurants nearly failed due to absentee management

problems.   The Tax Court concluded that the Your Host corporation

provided no service or benefit to the other 10 corporations for

which it was not already adequately compensated.29

     Here, the hotels operated by the Hyatt International group

have only a limited amount of similarity to the restaurants in

Your Host, Inc. v. Commissioner, supra and the same result does

not obtain.   HHK and HS through management and local advertising

generated goodwill that benefited Hyatt International hotels and

entities in their regions and beyond.    We have held that the

arm’s-length royalty for the Hyatt trade names and marks from HIC

to Hyatt Domestic is .4 percent of the Hyatt International

group’s total hotel gross revenues.    As the holder of the

international license to the Hyatt trade names and marks, HIC’s

income should be increased by two-fifth of 1 percent of the gross

revenues of those hotels whose management fees, taking into


     29
        As previously noted, the parties posed an all-or-nothing
type question to the Court on the sec. 482 issues. See Your
Host, Inc. v. Commissioner, 58 T.C. 10, 29 n.4 (1972), affd. 489
F.2d 957 (2d Cir. 1973).
                              - 100 -


consideration the adjustments for the allocation of fees, were

remitted to HHK and HS.30

     D.   Allocation to HIC for Management Services

     Beyond limited expense allocations, HIC’s subsidiaries did

not pay for services provided by HIC.   Respondent determined that

income should be allocated to HIC from its subsidiaries for

management services.   Respondent relies on the provision of the

following services in support of allocations:   Manuals, training,

human resource development, employee benefits, contract review,

financial systems and advice, business development assistance,

preopening services, owner relations, marketing, and HIC's

efforts at building the IMAGE reservations system.

     Petitioners contend that, for the most part, all management

fees were reported by the entity that earned them.    Petitioners

also argue that what HIC did for its subsidiaries was stewardship

or duplication and as such is not subject to section 482

allocations.   Petitioners assert that the design and chain

services were provided to and paid for separately by the hotel

owners, not the subsidiaries, and thus were by definition arm’s-

length transactions not subject to section 482.   Petitioners also



     30
        This allocation is for the Hyatt trade names and marks.
We consider the other items proposed by respondent, through his
expert BVS, in the royalty--i.e., corporate overhead and
development activities--under the topic of management services,
below.
                                - 101 -


allege that there was little IPS activity during the years in

issue.

     Allocations may be made where one member of a controlled

group performs services for the benefit of, or on behalf of,

another member of the group.    See sec. 1.482-2(b)(1), Income Tax

Regs.    “Allocations will generally not be made if the service is

merely a duplication of a service which the related party has

independently performed or is performing for itself.”    Sec.

1.482-2(b)(2)(ii), Income Tax Regs.; see Young & Rubicam, Inc. v.

Commissioner, 187 Ct. Cl. 635, 410 F.2d 1233 (1969).    In

addition, section 482 allocations are inappropriate for

stewardship activities because the benefit is to the parent

entity.    See Young & Rubicam, Inc. v. United States, 410 F.2d at

1245-1247; Eli Lilly & Co. v. Commissioner, 84 T.C. at 1154;

Columbian Rope Co. v. Commissioner, 42 T.C. at 813-814.      We find

that items such as HIC’s audits, reporting requirements,

reviewing contracts, and providing for consistency of accounting

systems are supervisory functions that benefited the parent

company and are not management services.    See Young & Rubicam,

Inc. v. United States, 410 F.2d at 1245-1247.    Likewise, business

development activities, financial guaranties, and owner relations

are to the benefit of the parent company and not subject to

allocation.    See id.   However, we are, likewise, not persuaded by

petitioners’ argument that chain and design services should not
                              - 102 -


be subject to section 482 allocation because they were provided

to the owners, who are unrelated parties.   Although the charges

for these services were billed to the owners, the services were

provided as part of the Hyatt International group’s hotel

management business.   However, any allocation must take into

account the costs that have already been paid.   Accordingly, the

remaining arm’s-length issues for our consideration involve:    The

services HIC performed with respect to worldwide marketing, chain

and design services, and coordination of human resources,

insurance, and employee benefits.

      First, however, we consider petitioners’ assertion that the

appropriate measure of arm’s-length consideration for the

services provided by HIC is cost.   Section 1.482-2(b)(3), Income

Tax Regs., defines an arm’s-length charge for services rendered

as:

      the amount which was charged or would have been charged
      for the same or similar services in independent
      transactions with or between unrelated parties under
      similar circumstances considering all relevant facts.
      However, except in the case of services which are an
      integral part of the business activity of either the
      member rendering the services or the member receiving
      the benefit of the services (as described in
      subparagraph (7) of this paragraph), the arm’s length
      charge shall be deemed equal to the costs or deductions
      incurred with respect to such services by the member or
      members rendering such services unless the taxpayer
      establishes a more appropriate charge under the
      standards set forth in the first sentence of this
      subparagraph. * * * [Emphasis added.]
                                 - 103 -


Thus, petitioners are correct that, under certain circumstances,

the cost of providing the services may be treated as the arm’s-

length consideration in lieu of the amount that an unrelated

party would charge.    This is permitted where the services are not

an integral part of the business of either the renderer or the

recipient of the services.      Respondent argues that all of the

services provided by HIC were integral to its business.

Conversely, petitioners argue that none of the services were

integral to the business.

     Section 1.482-2(b)(7)(i) through (iv), Income Tax Regs.,

describes situations in which services shall be considered an

integral part of the business activity of a member of a group of

controlled entities.31


     31
        In pertinent part, the section 1.482-2(b)(7)(i) through
(iv), Income Tax Regs. provides:
          (i) Services are an integral part of the business
     activity of a member of a controlled group where either
     the renderer or the recipient is engaged in the trade
     or business of rendering similar services to one or
     more unrelated parties.

          (ii) Services are an integral part of the business
     activity of a member of a controlled group where the
     renderer renders services to one or more related
     parties as one of its principal activities.

           *       *        *       *      *     *      *

          (iii) Services are an integral part of the
     business activity of a member of a controlled group
     where the renderer is peculiarly capable of rendering
     the services and such services are a principal element
                                                   (continued...)
                              - 104 -


     Petitioners’ expert conceded that the services of IPS were

integral in that those services were provided to unrelated

parties, although petitioner’s expert also concluded that IPS’

activities were minimal during the years in issue.   It appears

that IPS was uniquely capable of providing its services since the

design manuals and area programs, although tailored to suit a

particular hotel, were intended to exemplify how a Hyatt

International hotel should be constructed or operated.   No other

design company would have access to this information.    Thus, we

find the activities of IPS are integral.   Other services,

including marketing and coordination of insurance and benefits

were performed and may be integral, but there is no way to

distinguish the costs of the other services provided to HHK and

HS from the total costs to the Hyatt International group

entities.   The subsidiaries or the hotel owners paid the direct

costs; however, the indirect costs (i.e., overhead) were not

included.   Thus, whether we conclude that such services were or

were not integral, we are effectively unable to determine the



     31
      (...continued)
     in the operations of the recipient.

          (iv) Services are an integral part of the business
     activity of a member of a controlled group where the
     recipient has received the benefit of a substantial
     amount of services from one or more related parties
     during its taxable year. * * *
                              - 105 -


costs for the services rendered to HHK and HS.32    Accordingly, we

use a different approach in measuring arm’s-length consideration

for HIC’s services.

     The BVS report contains the conclusion that a royalty

consisting of 33 percent of adjusted management fees be paid by

HHK and HS to HIC, plus a profit split of 50 or 65 percent

(depending on the year) of their operating income remaining after

expenses and the above royalties are deducted.     The royalty

allocation was for trade names and marks, profit on reservations,

and overhead.   BVS intended the profit split to cover the

financial guaranties and differences in assets, with HIC being

the owner of the intangibles and the financial capital.

     A major impetus for BVS’ allocations appears to be the

opinion that HIC bore the majority of the consolidated expenses

of the Hyatt International group and that HHK and HS received

most of the revenue.   BVS’ choice of percentages appears to be

based on the above-stated premise.   In particular, the BVS report

contains the statement:

     The reallocation process yields a much more balanced
     distribution of operating income and adjusted operating
     income. * * * It is only after the profit-sharing and


     32
        Although petitioners have argued that the one-time
overhead charge in 1983, as a result of challenged deductions, is
the appropriate amount, they have provided us with no factual
predicate for accepting this argument. Obviously, respondent’s
determinations reflect disagreement about the sufficiency of the
one-time charge.
                              - 106 -


     royalties are adjusted for, that HIC, HHK and HS appear
     to have the proper relationships in terms of adjusted
     operating income. * * *

     The perceived imbalance was due to the absence of hotel

expenses on the management subsidiaries’ books and the fact that

numerous HHK’s and HS’ expenses were absorbed by the flagship

hotel’s sharing of space and employees.   Some of HIC’s expenses,

however, were attributable to its role as a parent organization

and as the management entity for hotels in Europe, Central

America, and parts of the Middle East and would not be

attributable to HHK and HS.   BVS considered the expenses of HIC

and its U.S. subsidiaries but limited the comparison to the

operating revenues.33   BVS did not consider the fact that HIC

received dividends as a “parent” and that some of the dividend

income could be associated with the management relationship.

Significantly, BVS’ profit-split methodology was intended to

reflect the proportion of assets each entity had contributed.

That narrowly focused approach overlooks the contribution of

labor and expertise, which are the most important elements in a

service industry.   Although BVS' methodology was designed to rely

on asset proportioning, BVS’ conclusion essentially relies on




     33
        It appears that BVS’ analyses exclude the losses
incurred from the expenses of HIC for the hotels in Brussels and
Nice.
                               - 107 -


guideline transactions rather than on the entities’ comparative

asset holdings.

     BVS selected certain Hyatt International agreements as

guideline transactions and concluded that there were implied

royalties of 33 percent in the Aryaduta agreement and 25 percent

in the HESA agreements.   The 33-percent royalty derives from the

potential decrease of revenue that would have occurred had the

name change negotiated in January of 1986 been implemented for

1988 and 1989.    The name, however, did not change until 1991 when

the second Hyatt International hotel opened in Jakarta.   Given

that the Hyatt International group needed the hotel owners of the

Aryaduta to agree to drop the name in order to secure the deal

for the newer and potentially more profitable Grand Hyatt, the

transaction should not be considered an arm’s-length transaction

with neutral parties who are under no compulsion to engage in the

transaction.

     Further complicating the Aryaduta transaction, the

management fee rates were negotiated downward to reflect removal

of the Hyatt name, and the hotel owners agreed to add rooms to

their hotel, thus increasing the revenue base by the time the

name change occurred.   There were other similar instances where

fees, expressed in percentages, were scheduled to decrease when

the number of rooms managed increased; e.g., the HESA agreements

and agreements with owners of multiple hotels.   The BVS report
                              - 108 -


does not contain an explanation of the reason the implied 33-

percent royalty rate (for name only in the Aryaduta transaction)

was selected over the implied 25-percent rate for trade names,

marks, and chain services (HESA).   The BVS report merely contains

the statement that:

     A royalty rate of 33% was found to have still allowed
     both HHK and HS to produce a very high return on assets
     and high overall profitability. A royalty rate as high
     as 50% could have been supported in certain periods.

     In support of its approach on the profit split, BVS stated

that:

     The approximately 50% split in the net revenue of HESA
     provides a guideline uncontrolled transaction that
     suggests that, at most, HHK and HS would have been
     entitled to half of the value of their respective
     adjusted operating incomes after royalties. * * *

For HHK, BVS used a 65-percent split, to be allocated to HIC for

the years 1976 through 1981, with 50 percent for the remaining

years.   For HS, BVS used a 75-percent split for 1976, 65-percent

for 1977 through 1982, and 50-percent thereafter.

     These profit splits, according to respondent’s expert,

recognized HIC’s contribution of intangibles.   We note that was

also one of the purposes of the 33-percent royalty.   BVS

references the split as being “approximately 50%,” but it

actually used 75, 65, and 50 percent (depending on the specific

year).   These percentages more closely resemble the consulting

fee paid by HESA to HHK, which we have found to be an arrangement
                              - 109 -


for the purpose of reducing foreign tax.    In connection with the

HESA joint venture, the Hyatt International group provided the

local staffing and management talent, while VIS provided the

hotel contracts.   We have found that HHK and HS played important

roles in both of these functions within their territories.     Thus,

the relationship between HIC and VIS does not resemble the

relationship between HIC and HHK or HS.    In addition, the

ownership share of HIC (Mexico) in HESA was 49 percent.    A

corporate shareholder/owner is entitled to a portion of any

dividends distributed.   As HHK and HS are wholly owned

subsidiaries of HIC, HIC would be entitled to 100 percent of

their dividends.   Those considerations, however, do not address

the share, if any, of operating income that HIC should receive.

In these respects, the BVS report was not helpful and did not

assist us in our consideration of an appropriate arm’s-length

consideration for the services provided by HIC.34

     Once again, we are left stranded in a “sea of expertise” and

must navigate our own way through a complex record to decide what

constitutes an appropriate arm’s-length consideration.    For the

reasons we have explained, the parties' notice and trial

positions do not properly address the type of circumstances we


     34
        Since the parties have not provided adequate factual
basis for differentiation among the several years in issue, we
disregard BVS’ approach of allocating different percentages in
different years.
                               - 110 -


have found.   Accordingly, we looked for other alternatives.   The

Budapest agreement resembled the type of package that the Hyatt

International group provided to those hotels where local

management was not provided.   It included preopening and

technical services, management expertise, chain services, and the

trade names and marks.   The Odakyu agreement provided for the use

of the names and marks, chain services, manuals, among other

things, and provided us with some guidance.   The hotels involved

in that agreement used their Century names in conjunction with

the Hyatt names and also had the benefit of Hyatt chain services.

Unfortunately, there is insufficient information to enable the

fee structure for the Budapest or Odakyu agreement to be

translated, extrapolated, and applied to the other transactional

relationships in the Hyatt International group.

     As we have already explained, the franchise relationship is

analogous to the relationship between HIC and its hotel

management subsidiaries.   HIC did not operate the hotel; it

provided services to the management companies.    Accordingly, we

see the franchise rates as the most indicative of arm’s-length

consideration for the services that HIC provided.   We also

recognize, however, that the master hotel management subsidiaries

such as HHK and HS worked in conjunction with HIC to provide

those franchise type intangibles and services to the hotel

operators under their supervision, assisting in the writing of
                              - 111 -


the manuals and consulting with the local hotel executive staff.

Yet petitioners have provided precious little guidance for us to

determine an appropriate offset for the services supplied by HHK

and HS.35   We are satisfied, however, that our holding allows HHK

and HS reasonably adequate compensation for their efforts as

hotel management companies, unlike respondent’s notice of

deficiency determinations.

     As already discussed, franchise rates during the relevant

period were equivalent to about 2 percent of hotel gross

revenues.   We have held that the arm’s-length charge for the

Hyatt trade name and marks is .4 percent of hotel gross revenues.

That holding was based on a 2-percent franchise rate, with 1

percent being attributable to expenses and the other 1 percent to

profit on reservations, marketing, expertise, other services, and

a royalty for trade names and marks.    We considered one-half of

1 percent as the limit attributable to the royalties.   In

arriving at a two-fifths of 1-percent royalty rate we favored

petitioner’s position that trade names and marks are less

important in the international marketplace.   The reallocable

services provided by HIC coincide with those provided in a



     35
        Part of this is due to HHK and HS’s use of hotel staff
in dual capacities and their ability to pass on expenses to the
hotel owners in most of years in issue herein for which they
supplied no records of hours spent or costs incurred, leaving us
without the means to measure their contributions.
                                - 112 -


franchise arrangement.   Therefore, we hold that HIC’s income

should be increased by 1.5 percent of the gross revenues of those

hotels whose management fees were remitted to HHK and HS, taking

into consideration the adjustments already discussed.36      The 1.5-

percent rate consists of 1 percent for expenses and .5 percent

for profit based on a franchise model.

     To reflect the foregoing and considering the parties’

stipulations of settled issues and the fact that additional

issues remain for resolution,


                                      An appropriate order

                                 will be issued.




     36
        This allocation should be offset by the overhead charges
already taken in 1983.
                                  - 113 -

                                  APPENDIX



                                                   AIC Holding (US)
 H Group Holding                                         (AIC)
       (US)
      (HGH)
                                                      Hyatt Int’l.
                                                        Corp.(US)




   Hyatt Corp.
       (US)                                  Int’l.Proj.            Hyatt of
                    HIC(Mexico)
(Hyatt Domestic)                               Sys.(US)       Singapore(Singapore)
                                                (IPS)                 (HS)


                                                Hyatt of Hong Kong(Hong Kong)
                                                            (HHK)

                   HESA(Mexico)
                        49%

                                                    Hyatt Chain Services
                                                        (Hong Kong)
                                                            (HCS)
