                    108 T.C. No. 15



                UNITED STATES TAX COURT



  NORWEST CORPORATION AND SUBSIDIARIES, Petitioner v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 20567-93, 26213-93.           Filed April 28, 1997.


                           I.
     Norwest Bank Nebraska, N.A., a subsidiary of
petitioner, removed asbestos-containing materials from
its Douglas Street building in connection with the
building's renovation and remodeling.       On its 1989
return, petitioner claimed a $902,206 ordinary and
necessary business deduction with respect to the
asbestos-removal expenditures.      In the notice of
deficiency, respondent disallowed the deduction.
     Held: The costs of removing the asbestos-containing
materials must be capitalized because they were part of
a general plan of rehabilitation and renovation that
improved the Douglas Street building.

                          II.
     Petitioner's subsidiary Norwest Bank Minneapolis
(NBM) owned "blocked deposits" at the Central Bank of
Brazil (Central Bank) consisting of principal repayments
of dollar-denominated loans previously made to Brazil in
the ordinary course of NBM's banking business. The
                          -2-

Central Bank prevented petitioner from repatriating these
deposits because Brazil had insufficient hard currency
(U.S. dollars) to make payments on the loans. In order
to reduce petitioner's blocked deposit holdings and
decrease its foreign debt exposure, petitioner entered
into a debt-equity conversion transaction in 1987 as
follows: $12,577,136 of petitioner's blocked deposits
was exchanged for a 14.361-percent interest in a
Brazilian company.    Petitioner agreed to maintain the
invested funds in Brazil for 12 years.
     On its consolidated 1987 return, P claimed a
$4,577,136 loss with regard to the debt-equity conversion
transaction. In the notice of deficiency, respondent
disallowed petitioner's claimed loss on the grounds that
petitioner did not establish that any deductible loss was
sustained in 1987.
     1.   Held:   The step transaction doctrine is not
applicable. The Central Bank converted the full face
value of petitioner's blocked deposits, plus accrued
interest, at the official exchange rate without
diminution or discount into cruzados, which were used to
pay a third party in exchange for its 14.361-percent
interest in the Brazilian company. The exchange of the
blocked deposits for the cruzados and the conversion of
the cruzados into stock was not a transitory step but
rather a substantive and significant element of the
conversion. Petitioner's loss, if any, is measured by
the difference between its basis in the blocked deposits
and the fair market value of the cruzados it received.
G.M. Trading Corp. v. Commissioner, 103 T.C. 59 (1994),
supplemented by 106 T.C. 257 (1996), on appeal (5th Cir.,
Oct. 4, 1996), followed. Petitioner did not realize a
loss because the basis of the blocked deposits and the
fair market value of the cruzados were identical on the
date of the transaction.
     2.   Held, further:      The 12-year repatriation
restriction imposed on petitioner's invested funds
warrants a 15-percent discount on the fair market value
of the cruzados P received, rendering a $1,886,570 loss
for petitioner's 1987 tax year.

                          III.
     In 1989, Norwest Financial Resources, one of
petitioner's affiliates, acquired the lease portfolio and
other assets of Financial Investment Associates, Inc.,
for $141,456,620. On its 1989 return, petitioner
allocated $131,513,038 of the $141,456,620 purchase price
to the lease portfolio. The purchase agreement provided
                               -3-

     that no part of the purchase price is attributable to
     goodwill. In the notice of deficiency, respondent
     determined that petitioner overstated the fair market
     value of the lease portfolio by $1,328,618, which amount
     should be allocated to goodwill, going-concern value, or
     other nonamortizable intangible assets.
          The   parties    presented   experts    who   valued
     petitioner's lease portfolio. The difference between the
     experts' valuations centers around the different discount
     rates they used (respondent's expert used a 15.6-percent
     discount rate, while petitioner's expert used an 11.5-
     percent discount rate).
          Held:   Giving consideration to all the evidence
     presented, 13 percent is determined to be the appropriate
     discount rate.



     Mark Alan Hager, Joseph Robert Goeke, Thomas C. Durham, David

Farrington Abbott, William Albert Schmalzl, Glenn A. Graff, Daniel

A. Dumezich, and Scott Gerald Husaby, for petitioner.

     Lawrence C. Letkewicz, Dana Hundrieser, and Gary J. Merken,

for respondent.




                             CONTENTS

                                                          Page

General Findings ......................................... 6

Issue I.    Removal of Asbestos-Containing Materials .....   6
            A. The Douglas Street Building ...............   7
            B. Remodeling Plans ..........................   7
            C. Use of Asbestos-Containing Materials in
               the Douglas Street Building ...............   8
            D. Federal Asbestos Guidelines ...............   8
            E. Testing at the Douglas Street Building and
               Decision To Remove Asbestos-Containing
               Materials .................................   10
            F. Contractors and Work Performed ............   13
            G. Health Concerns ...........................   15
                               -4-

            H. Liability Issues ..........................   16
            I. Tax and Accounting Matters ................   17
            J. Petitioner's Returns and Petitions ........   18
            K. Notice of Deficiency ......................   19
            Discussion....................................   19
            L. Capital Expenditures vs. Current
               Deductions ................................   19
            M. General Plan of Rehabilitation Doctrine ...   21
            N. The Parties' Arguments ....................   23
            O. Analysis ..................................   27

Issue II.   Brazilian Debt-Equity Conversion .............   29
            A. The Brazilian Debt Crisis .................   31
               1. Deposit Facility Agreements and
                  Blocked Deposits .......................   31
               2. The Cruzado Plan .......................   33
               3. Moratorium on Interest .................   34
            B. Petitioner's Blocked Deposits .............   34
            C. Papel e Celulose Catarinense, S.A. ........   36
               1. PCC's Expansion Plans ..................   38
               2. Petitioner's Internal Analysis of a PCC
                  Investment .............................   39
               3. Petitioner's Conclusions About the PCC
                  Investment .............................   40
            D. Steps Leading Up to the Conversion ........   41
            E. The Conversion Transaction ................   42
            F. Petitioner's Tax and Accounting Treatment
                  of the Conversion ......................   45
            G. Petitioner's Return and Petition ..........   46
            H. Notice of Deficiency ......................   47
            I. Subsequent Events .........................   47
            Discussion ...................................   47
            J. Respondent's Arguments ....................   47
            K. Petitioner's Arguments ....................   50
            L. Law and Analysis ..........................   52
                                    -5-

 Issue III. Allocation of Purchase Price .................              64
            A. FIA .......................................              64
            B. Federal's Acquisition of FIA ..............              66
            C. Petitioner's Acquisition of FIA ...........              67
            D. Petitioner's 1989 Return ..................              71
            E. Notice of Deficiency ......................              71
            Discussion ...................................              71
            F. Residual Value ............................              72
            G. Expert Witnesses ..........................              73
               1. Petitioner's Expert ....................              74
               2. Respondent's Expert ....................              75
               3. Critique of Experts ....................              77
            H. Conclusion ................................              80


                                  OPINION


     JACOBS, Judge:   In docket No. 20567-93, respondent determined

deficiencies in petitioner's 1987 and 1988 Federal income taxes in

the respective amounts of $93,413 and $3,999,398, as well as

additional interest under section 6621(c) for 1988. Pursuant to an

amended answer filed on September 23, 1994, respondent increased

the amount of the 1988 deficiency to $4,644,201.

     In docket No. 26213-93, respondent determined a deficiency in

petitioner's 1989 Federal income tax in the amount of $10,532,064.

Respondent   increased      the   amount    of    the    1989    deficiency   to

$22,757,717 pursuant to an answer filed on February 14, 1994, and

further increased the deficiency amount to $22,791,923 pursuant to

a September 22, 1994, amendment to answer.

     These   cases   were    consolidated        for    trial,   briefing,    and

opinion.
                                        -6-

     The issues for decisions are:1 (1) Whether petitioner is

entitled   to   deduct   the    costs    of   removing   asbestos-containing

materials from its Douglas Street bank building; (2) whether

petitioner realized a loss on a Brazilian debt-equity conversion;

and (3) whether any portion of the $141,456,620 petitioner paid to

acquire the assets of Financial Investment Associates, Inc., should

be   allocated    to     goodwill,      going-concern     value,   or   other

nonamortizable intangible assets.

     All section references are to the Internal Revenue Code in

effect for the years under consideration.           All Rule references are

to the Tax Court Rules of Practice and Procedure.

     For convenience and clarity, we have combined our findings of

fact and opinion with respect to each issue.              Some of the facts

have been stipulated and are found accordingly.             The stipulations

of facts and the attached exhibits are incorporated herein by this

reference.

                               General Findings

     Norwest Corporation (hereinafter petitioner or Norwest), a

Delaware corporation, had its principal place of business in

Minneapolis, Minnesota, at the time the petitions were filed.

Norwest is the parent company of a group of corporations that filed

     1
          With the exception of certain issues relating to
foreign tax credits and petitioner's claim for additional
research credits, all other issues have been resolved.
          The increased deficiencies asserted in the answers and
amended answers are not attributable to any issues before this
Court.
                                             -7-

consolidated corporate income tax returns for the years under

consideration (1987 through 1989). Petitioner reports its income on

a calendar-year basis, employing the accrual method of accounting.

Petitioner timely filed its U.S. Corporation Income Tax Returns for

1987, 1988, and 1989.

Issue I.      Removal of Asbestos-Containing Materials

      The first issue is whether petitioner is entitled to deduct

the   costs    of    removing      asbestos-containing          materials   from   its

Douglas    Street      bank   building.            Petitioner     argues    that   the

expenditures        constitute     section      162(a)    ordinary    and   necessary

expenses.     Respondent,        on    the    other     hand,   contends    that   the

expenditures must be capitalized pursuant to section 263(a)(1).

Alternatively, respondent contends that the expenditures must be

capitalized     pursuant      to      the    "general    plan   of   rehabilitation"

doctrine.

      A. The Douglas Street Building

      One of petitioner's subsidiaries, Norwest Bank Nebraska, N.A.

(Norwest Nebraska), owns a building at 1919 Douglas Street in

Omaha, Nebraska (the Douglas Street building or building). The

Douglas Street building is a three-story commercial office building

that occupies half a square block and has a lower level parking

garage. Norwest Nebraska constructed the building in 1969 at a

$4,883,232 cost.         During all relevant periods, Norwest Nebraska

used the Douglas Street building as an operations center as well as

a branch for serving customers.
                                         -8-

     B. Remodeling Plans

     In 1985 and 1986, Norwest Nebraska consolidated its "back

room" operations at the Douglas Street building. Pursuant to that

process, Norwest Nebraska undertook to determine the most efficient

means for providing more space to accommodate the additional

operations personnel within the building. The planning process

indicated       that    the   building   needed   a   major   remodeling.   (The

building had not been remodeled since its construction; Norwest

Nebraska usually remodels its banks every 10 to 15 years.) Thus, by

the end of 1986, petitioner and Norwest Nebraska had decided to

completely remodel the Douglas Street building. In December 1986,

both petitioner and Norwest Nebraska approved a preliminary budget

of $2,738,000 for carpet, furniture, and improvements.

     C. Use of Asbestos-Containing Materials in the Douglas Street
     Building

     The Douglas Street building was constructed with asbestos-

containing materials as its main fire-retardant material. (The

local    fire    code    required   that   buildings    contain   fireproofing

material.)        Asbestos-containing materials were sprayed on all

columns, steel I-beams, and decking between floors. The health

dangers of asbestos were not widely known when the Douglas Street

building was constructed in 1969, and asbestos-containing materials

were generally used in building construction in Omaha, Nebraska.

        A commercial office building's ventilation system removes

existing air from a room through a return air plenum as new air is
                                    -9-

introduced.    The returned air is subsequently recycled through the

building.    The area between the decking and the suspended ceiling

in the Douglas Street building functioned as the return air plenum.

The top part of the return air plenum, the decking, was one of the

components of the building where asbestos-containing materials had

been sprayed during construction.

     Over time, the decking, suspended ceiling tiles, and light

fixtures     throughout   the   building    became     contaminated.    This

contamination occurred because the asbestos-containing fireproofing

had begun to delaminate, and pieces of this material reached the

top of the suspended ceiling.

     D.     Federal Asbestos Guidelines

     In the 1970's and 1980's, research confirmed that asbestos-

containing materials can release fibers that cause serious diseases

when inhaled or swallowed. Diseases resulting from exposure to

asbestos can reach the incurable stage before detection and can

cause severe disability or death. Asbestosis is a progressive and

disabling lung disease caused by inhaling asbestos fibers that

become lodged in the lungs.          Persons exposed to asbestos may

develop lung cancer or mesothelioma, an extremely rare form of

cancer.

     On March 29, 1971, the Environmental Protection Agency (EPA)

designated    asbestos    a   hazardous   substance.    The   parties   have

stipulated that Federal, State, and local laws and regulations at

all relevant times did not require asbestos-containing materials to
                                    -10-

be removed from commercial office buildings if they could be

controlled in place.     Nevertheless, building owners had to take

precautions against the release of asbestos fibers.

     The presence of asbestos in a building does not necessarily

endanger the health of building occupants.         The danger arises when

asbestos-containing materials are damaged or disturbed, thereby

releasing asbestos fibers into the air (when they can be inhaled).

     The   Department   of     Labor,   Occupational   Safety     and    Health

Administration (OSHA), has established standards and guidelines for

permissible levels of employee exposure to asbestos.               Effective

July 21, 1986, the permissible exposure limit for employees was 0.2

fiber (longer than 5 micrometers) per cubic centimeter of air,

determined on the basis of an 8-hour time-weighted average.                  At

half of    the   permissible    exposure   limit   (0.1   fiber    per    cubic

centimeter of air), employers are required to begin compliance

activities such as air monitoring, employee training, and medical

surveillance.

     Moreover, the EPA has established standards and guidelines for

the general public's exposure to asbestos.2            The EPA-recommended

guideline for general occupancy and clearance of a building after

     2
          In assessing the potential for fiber release, the EPA
in 1985 recommended evaluating the current condition of asbestos-
containing materials based on evidence of: (1) Deterioration or
delamination; (2) physical damage (e.g., the presence of debris);
and (3) water damage as well as the potential for future
disturbance (based on proximity to air plenum or direct air
stream, visibility, accessibility and degree of activity, as well
as change in building use).
                                       -11-

construction activities involving asbestos-containing materials is

0.01 fiber per cubic centimeter of air.

     Asbestos    removal       must   be   performed    by    specially   trained

professionals wearing protective clothing and respirators.                   The

work area must be properly contained to prevent release of fibers

into other areas.        Containment typically requires barriers of

polyethylene plastic sheets with folded seams, complete with air

locks   and   negative    air    pressure      systems.      Asbestos-containing

materials that are removed must be wetted to reduce fiber release.

Once removed, the materials must be disposed of in leak-tight

containers in special landfills.

     E. Testing at the Douglas Street Building and Decision To
     Remove Asbestos-Containing Materials

     In October 1985, petitioner's general liability and property

damage insurer, the St. Paul Property and Liability Insurance Co.

(St. Paul), tested a bulk sample of fire-retardant material from

the Douglas Street building's steel I-beams to determine whether

the building contained asbestos.              The results indicated that the

material contained 8 to 10 percent chrysotile asbestos, the most

common type of asbestos.

     Petitioner obtained its umbrella insurance policies through

Marsh & McLennan, which provided coverage over and above the St.

Paul policies. In January 1987, at Marsh & McLennan's request,

Clayton Environmental Consultants, Inc. (Clayton), conducted more

extensive     testing    for    the   presence     of   asbestos    at    Norwest
                                         -12-

facilities in South Dakota and Nebraska, including the Douglas

Street    building.     On    February      9,        1987,   petitioner        received

notification that the January testing indicated that the sprayed-on

fireproofing contained 8 to 10 percent chrysotile asbestos and the

ceiling tiles on the parking level contained 26-percent chrysotile

asbestos.    This confirmed the St. Paul results.

     At   the      request    of   Marsh    &    McLennan,       Clayton    conducted

extensive     additional          testing       for     airborne        asbestos-fiber

concentrations in the Douglas Street building.                      On February 25,

1987, Clayton collected air samples from the building.                          On April

14, 1987, it issued the results of its survey, which indicated that

the airborne asbestos fiber concentrations present during normal

occupancy of the Douglas Street building ranged from 0.0002 to

0.006 fiber per cubic centimeter of air. The highest level of

airborne fiber concentration at the Douglas Street building (0.006

fiber per cubic centimeter of air) did not exceed either the EPA or

OSHA guidelines.        There was, however, the expectation that the

airborne asbestos-fiber concentrations would continue to increase.

Moreover,    the    asbestos-containing          fireproofing       at    the    Douglas

Street Building had characteristics that the EPA had identified as

warranting      removal      of    the   material,        such     as    evidence     of

delamination, presence of debris, proximity to an air plenum, and

necessity of access for maintenance.

     After considering the circumstances, petitioner decided to

remove the asbestos-containing materials from the Douglas Street
                                       -13-

building (other than the parking garage) in coordination with the

overall remodeling project. Indeed, the remodeling could not have

been     undertaken     without      disturbing      the    asbestos-containing

fireproofing. Thus, because petitioner and Norwest Nebraska chose

to remodel, it became a matter of necessity to remove the asbestos-

containing       materials.        Petitioner      essentially    decided   that

"managing the asbestos in place" was not a viable option, given the

extent of remodeling that would disturb the asbestos.

        Removing the asbestos-containing materials from the Douglas

Street building at the same time as, and in connection with, the

remodeling was more cost efficient than conducting the removal and

renovations as two separate projects at different times.                It also

minimized the amount of inconvenience to building employees and

customers.

        As late as May 1988 (approximately 6 months after asbestos

removal began) petitioner and Norwest Nebraska did not intend to

remove     the   parking    garage    asbestos-containing        materials.    No

remodeling was planned for the garage, and the materials were in

sound      condition.   However,      petitioner      and     Norwest   Nebraska

subsequently      decided     to   remove   the    garage   asbestos-containing

materials as well, on the basis of their expectation that the

garage tiles would eventually deteriorate, as well as the fact that

it   was    financially     advantageous      to    conduct   this   removal   in

connection with the ongoing abatement activity.
                                      -14-

       F.   Contractors and Work Performed

       On August 4, 1987, Norwest Nebraska hired Hawkins Construction

Co. (Hawkins), as general contractor, to perform the remodeling

work at the Douglas Street building. On November 30, 1987, Norwest

Nebraska hired Waste Environmental Technology (WET) to remove the

asbestos-containing materials from the building.          Norwest Nebraska

also   hired      ATC   Environmental,   Inc.,   to   perform   on-site    air

monitoring        during   all   asbestos-abatement    activities     at   the

building.

       WET declared bankruptcy in 1988 and could not complete the

project.     On December 5, 1988, Norwest Nebraska hired Michael T.

Robinson Associates, Inc. (Robinson), to replace WET and complete

removal of the asbestos-containing materials from the Douglas

Street building.        At that time, Norwest Nebraska also replaced ATC

Environmental, Inc., with Chart Services, Ltd.

       The asbestos removal and remodeling were basically performed

in 13 phases; each phase involved a defined area of the Douglas

Street building.        For each phase, the asbestos-removal contractor

removed     the    asbestos-containing    materials    before   the   general

contractor began remodeling.         After setting up a containment area,

the asbestos removal contractor physically removed the walls,

floors, ceilings, and light fixtures, where necessary, to reach and

remove the asbestos-containing materials. Once all the asbestos-

containing materials had been removed from an area, the air was

tested for airborne-fiber concentration before the containment
                                      -15-

could    be   taken   down    and   the   general   contractor   could   begin

remodeling.

     Removing     all   the    asbestos-containing     materials    from   the

Douglas Street building was a large project, entailing an enormous

amount of work.       Nearly every suspended ceiling and light fixture

on all four levels of the building had to be taken down.            Asbestos-

containing materials were removed from the entire building.

        The asbestos fireproofing in the Douglas Street building was

replaced with Cafco,3 a mineral wool material.              The ceiling tiles

on the Farnam4 parking level, as well as the floor tiles in the

customer lobbies, were replaced with new, asbestos-free materials.

Hawkins' subcontractors installed the replacement fireproofing and

tiling.

        Norwest   Nebraska     representatives,       the    asbestos-removal

contractor, Hawkins, and Hawkins' subcontractors held meetings on

a regular basis to coordinate the schedule for the remodeling work

with the asbestos removal work. Petitioner had a financial interest

in ensuring that the asbestos removal work was performed in a

timely fashion and was properly coordinated with the remodeling

work.     (Delays caused by the asbestos-removal contractor resulted




     3
          At all relevant times, Cafco was not known to present
any health hazards.
     4
          Farnam is one of the streets adjacent to the Douglas
Street building.
                                 -16-

in additional costs to Hawkins, which passed those costs on to

petitioner.)

     The removal of the asbestos-containing materials from the

Douglas Street building was substantially completed by the end of

May 1989.    Following completion, Norwest Nebraska learned that the

two elevator lobbies in the parking garage contained vinyl asbestos

floor tile.    Petitioner hired Technical Asbestos Control to remove

and replace these tiles.

     The removal of the asbestos-containing materials from the

Douglas Street building did not extend the building's useful life.

     G.     Health Concerns

     In addition to removing the asbestos-containing materials on

account of the remodeling, petitioner also considered the health

and welfare of its employees and customers.    Even though the level

of airborne asbestos fiber concentrations in the Douglas Street

building did not exceed OSHA or EPA standards for exposure, the

presence of asbestos-containing materials in the return air plenum

nonetheless increased the possibility for release of asbestos

fibers into the air: (1) The flow of air through the return air

plenum made surface erosion of the asbestos-containing materials

more likely; (2) the asbestos-containing materials had already

started to delaminate or flake off, which was almost certain to

become progressively worse; and (3) the necessity for working above

the suspended ceiling in the return air plenum to replace light

fixtures or computer cables created greater chances for disturbance
                                      -17-

of the asbestos-containing materials, and made routine maintenance

more expensive.

     Petitioner     intended     to      create     a     safer    and    healthier

environment for the building employees by removing the asbestos-

containing materials.5      The building indeed became safer after the

asbestos-containing materials were removed.

     H. Liability Issues

     By removing the asbestos-containing materials from the Douglas

Street building, petitioner also intended to avoid or minimize its

potential    liability   for    damages      from       injuries    to   employees,

customers,    and   workers      resulting        from      asbestos      exposure.

Petitioner's general liability insurance policies in effect at all

relevant times contained an exclusion for damages attributable to

the discharge of pollutants.             Such exclusion would include the

circulation    of   asbestos     fibers      through       the     Douglas    Street

building's    ventilation      system.    Some      of    petitioner's       umbrella

insurance policies contained an additional endorsement specifically

excluding liability for damages caused by asbestos exposure.

     Injuries to Douglas Street building employees arising out of,

and in the course of, their employment are not covered under

petitioner's general liability or umbrella insurance policies.


     5
          Before the asbestos removal and remodeling work began,
John Cochran, president of Norwest Nebraska, wrote a memorandum
dated Oct. 28, 1987, to the Douglas Street building employees,
assuring them that Norwest Nebraska wanted their work environment
to be safe.
                               -18-

Workmen's compensation insurance is the only coverage available for

such injuries.   It is unclear whether damages for injuries to the

employees resulting from exposure to asbestos would be covered by

workmen's compensation insurance.      Nevertheless, petitioner was,

and continues to be, at risk with respect to asbestos damage claims

brought by Douglas Street building employees.

     Furthermore, by removing the asbestos-containing materials

from the building, petitioner intended to avoid or minimize a

potential increase in its premiums for workmen's compensation

insurance.   If asbestos damage claims filed by Douglas Street

building employees were, in fact, covered by workmen's compensation

insurance, the increase in petitioner's premiums could be sizable,

depending on the volume and magnitude of such claims.

     I.   Tax and Accounting Matters

     The total cost of renovating the Douglas Street building was

close to $7 million, comprising nearly $4,998,749 in remodeling

costs and approximately $1.9 million6 in asbestos removal costs.

     6
          According to a schedule petitioner prepared, entitled
"Norwest Bank Nebraska N.A.--Payments Related to the Asbestos
Abatement", petitioner's costs of removing the asbestos-
containing materials from the Douglas Street building were as
follows:

                 Year                  Amount

                 1987            $ 175,095.00
                 1988              861,471.30
                 1989              881,769.77
                   Total         1,918,336.07

                                                      (continued...)
                                     -19-

Petitioner considered the cost of all demolition done by the

asbestos removal contractors (including the cost of removing the

asbestos tiles) as a removal cost for both book and tax purposes.

Petitioner considered the cost of any demolition done by the

general contractor or one of the subcontractors a remodeling cost

for both book and tax purposes.

     All construction-related remodeling costs were added to the

basis of the building and depreciated on a straight-line basis over

31.5 years.    The portion of the remodeling costs for furniture and

fixtures was written off over 7 years.

     J. Petitioner's Returns and Petitions

     On its 1987 and 1988 returns, petitioner claimed neither

depreciation nor ordinary deductions with respect to the costs of

removing the asbestos-containing materials from the Douglas Street

building. On its 1989 return, however, petitioner claimed a $7,696

depreciation   deduction   and   a    $902,206    ordinary   and   necessary

business deduction with respect to such expenditures.

     Petitioner asserts in its petitions that it properly deducted

the $902,206 on its 1989 return.            In addition, petitioner claims

     6
      (...continued)
Respondent agrees that these amounts properly represent the
asbestos removal costs, except for $2,836.61 paid on Apr. 7,
1989, in settlement of a lien filed by a materialman.
     We note, however, that petitioner's general ledger reflects
a $1,945,816 total incurred for the asbestos removal between 1987
and 1989. This amount does not include the cost of replacing the
asbestos-containing materials with asbestos-free materials.
There is no explanation in the record for the discrepancy between
the $1,918,336.07 and the $1,945,816.
                                           -20-

that it    is    also      entitled   to    ordinary     and    necessary      business

deductions      for    the   costs    of    removing    the    asbestos-containing

materials from the Douglas Street building for tax years 1987 and

1988 in the respective amounts of $175,095 and $863,764 (which

amounts, petitioner claims, were inadvertently omitted from its

1987 and 1988 returns).

      K.   Notice of Deficiency

      In   the        notice    of     deficiency,       respondent          disallowed

petitioner's       $902,206     ordinary      and      necessary         deduction   for

asbestos-removal expenditures.

                                      Discussion

      At   issue      is   whether    petitioner's       costs      of    removing   the

asbestos-containing materials are currently deductible pursuant to

section 162 or must be capitalized pursuant to section 263 or as

part of a general plan of rehabilitation.

      L. Capital Expenditures vs. Current Deductions

      Section 263 requires taxpayers to capitalize costs incurred

for   permanent       improvements,        betterments,        or   restorations      to

property. In general, these costs include expenditures that add to

the value or substantially prolong the life of the property or

adapt such property to a new or different use.                  Sec. 1.263(a)-1(b),

Income Tax Regs.           In contrast, section 162 permits taxpayers to

currently deduct the costs of ordinary and necessary expenses

(including incidental repairs) that neither materially add to the

value of property nor appreciably prolong its life but keep the
                                     -21-

property in an ordinarily efficient operating condition.             See sec.

1.162-4, Income Tax Regs.

     Deductions are exceptions to the norm of capitalization.

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). An income

tax deduction is a matter of legislative grace; the taxpayer bears

the burden of proving its right to a claimed deduction.                  Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

     In Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103,

106 (1926), which involved the cost of shoring up a wall and

repairing     a   foundation    needed     to   prevent   a   building   from

collapsing,       the   Board   of   Tax    Appeals   drew    the   following

distinctions:

            To repair is to restore to a sound state or to
            mend,   while   a   replacement    connotes   a
            substitution. A repair is an expenditure for
            the purpose of keeping the property in an
            ordinarily efficient operating condition. * *
            *   Expenditures    for   that    purpose   are
            distinguishable from those for replacements,
            alterations, improvements or additions which
            prolong the life of the property, increase its
            value, or make it adaptable to a different use.
            The one is a maintenance charge, while the
            others are additions to capital investment
            which should not be applied against current
            earnings. * * *

The distinction between repairs and capital improvements has also

been characterized as follows:

                 "The test which normally is to be applied
            is that if the improvements were made to 'put'
            the particular capital asset in efficient
            operating condition, then they are capital in
            nature. If, however, they were made merely to
            'keep' the asset in efficient operating
                                          -22-

            condition, then             they   are   repairs    and   are
            deductible."

Moss v. Commissioner, 831 F.2d 833, 835 (9th Cir. 1987), revg. T.C.

Memo. 1986-128 (quoting Estate of Walling v. Commissioner, 373 F.2d

190, 192-193 (3d Cir. 1967), revg. and remanding 45 T.C. 111

(1965)).

     The Court in Plainfield-Union Water Co. v. Commissioner, 39

T.C. 333, 338 (1962), articulated a test for determining whether an

expenditure is capital by comparing the value, use, life expectancy,

strength, or capacity of the property after the expenditure with the

status of the property before the condition necessitating the

expenditure      arose    (the     Plainfield-Union      test).       Moreover,    the

Internal    Revenue      Code's    capitalization       provision      envisions    an

inquiry into the duration and extent of the benefits realized by the

taxpayer.    See INDOPCO, Inc. v. Commissioner, supra at 88.

     Whether an expense is deductible or must be capitalized is a

factual determination. Plainfield-Union Water Co. v. Commissioner,

supra at 337-338.         Courts have adopted a practical case-by-case

approach    in    applying        the    principles     of     capitalization      and

deductibility.      Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C.

1, 14 (1979). The decisive distinctions between current expenses and

capital expenditures "are those of degree and not of kind."                     Welch

v. Helvering, supra at 114.
                                -23-

     M.   General Plan of Rehabilitation Doctrine



     Expenses incurred as part of a plan of rehabilitation or

improvement must be capitalized even though the same expenses if

incurred separately would be deductible as ordinary and necessary.

United States v. Wehrli, 400 F.2d 686, 689 (10th Cir. 1968);

Stoeltzing v. Commissioner, 266 F.2d 374 (3d Cir. 1959), affg. T.C.

Memo. 1958-111; Jones v. Commissioner, 242 F.2d 616 (5th Cir. 1957),

affg. 24 T.C. 563 (1955); Cowell v. Commissioner, 18 B.T.A. 997

(1930).    Unanticipated   expenses    that   would   be   deductible   as

business expenses if incurred in isolation must be capitalized when

incurred pursuant to a plan of rehabilitation.        California Casket

Co. v. Commissioner, 19 T.C. 32 (1952).       Whether a plan of capital

improvement exists is a factual question "based upon a realistic

appraisal of all the surrounding facts and circumstances, including,

but not limited to, the purpose, nature, extent, and value of the

work done".   United States v. Wehrli, supra at 689-690.

     An asset need not be completely out of service or in total

disrepair for the general plan of rehabilitation doctrine to apply.

For example, in Bank of Houston v. Commissioner, T.C. Memo. 1960-

110, the taxpayer's 50-year-old building was in "a general state of

disrepair" but still serviceable for the purposes used (before,

during, and after the work) and was in good structural condition.

The taxpayer hired a contractor to perform the renovation (which

included nonstructural repairs to flooring, electrical wiring,
                                          -24-

plaster, window frames, patched brick, and paint, as well as

plumbing repairs, demolition, and cleanup). Temporary barriers and

closures were erected during work in progress. The Court recognized

that each phase of the remodeling project, removed in time and

context, might be considered a repair item, but stated that "The

Code, however, does not envision the fragmentation of an over-all

project for deduction or capitalization purposes."              The Court held

that the expenditures were not made for incidental repairs but were

part   of   an     overall    plan   of    rehabilitation,   restoration,   and

improvement of the building.

       N.   The Parties' Arguments

       Petitioner contends that the costs of removing the asbestos-

containing materials are deductible as ordinary and necessary

business expenses because: (1) The asbestos removal constitutes

"repairs"7 within the meaning of section 1.162-4, Income Tax Regs.;

(2) the asbestos removal did not increase the value of the Douglas

Street building when compared to its value before it was known to

contain a hazardous substance--a hazard was essentially removed and

the building's value was restored to the value existing prior to the

discovery     of    the      concealed    hazard;8   (3)   although   performed

       7
          Petitioner states in its opening brief that "The law
recognizes that removing an unsafe condition is a repair rather
than an improvement", citing Schmid v. Commissioner, 10 B.T.A.
1152 (1928).
       8
          Petitioner introduced the reports and testimony of two
expert witnesses concerning the impact of the asbestos removal
                                                   (continued...)
                                      -25-

concurrently, the asbestos removal and remodeling were not part of

a general plan of rehabilitation because they were separate and

distinct      projects,   conceived   of     independently,   undertaken   for

different purposes, and performed by separate contractors; and (4)

using the principles of section 213 (which allows individuals to

deduct certain personal medical expenses that are capital in nature)

and section 1.162-10, Income Tax Regs. (which allows a trade or

business to deduct medical expenses paid to employees on account of

sickness), the cost of removing a health hazard is deductible under

section 162.9

     Respondent, on the other hand, contends that the costs of

removing the asbestos-containing materials must be capitalized

because: (1) The removal was neither incidental nor a repair;10 (2)

     8
     (...continued)
costs on the value of the Douglas Street building. These experts
opined that the discovery of asbestos as a health hazard in
combination with the extent of asbestos present in the building
resulted in an immediate diminution in the value of the building.
(One of the experts testified that the building would be
appraised as if it did not contain asbestos, and then the amount
it would cost to repair the condition would be deducted from the
appraisal.) The expert testimony supports petitioner's argument
that the asbestos removal merely restored the original value of
the building (i.e., without hazardous fireproofing) but did not
enhance its value.
         9
          Petitioner also relies on Rev. Rul. 79-66, 1979-1 C.B.
114, which allows, under limited circumstances, a sec. 213
deduction for an individual taxpayer's costs of removing and
covering lead-based paint in a personal residence, to the extent
the costs exceed the increase in the residence's value.
         10
          Respondent contends that petitioner's reliance on
Schmid v. Commissioner, supra, is misplaced. The Board of Tax
                                                   (continued...)
                                         -26-

petitioner made permanent improvements that increased the value of

the property11 by removing a major building component and replacing

it with a new and safer component, thereby improving the original

condition of the building; (3) petitioner permanently eliminated the

asbestos hazard that was present when it built the building,

creating safer and more efficient operating conditions and reducing

the risk of future asbestos-related damage claims and potentially

higher      insurance   premiums;   (4)     the    asbestos   removal   and   the

remodeling were part of a single project to rehabilitate and improve

the building; (5) the purpose of the expenditure was not to keep the

property in ordinarily efficient operating condition, but to effect

a general restoration of the property as part of the remodeling; and

(6) section 213 and section 1.162-10, Income Tax Regs., are not

analogous to the present case.

      The parties also disagree as to whether the Plainfield-Union

test is appropriate for determining whether petitioner's asbestos

removal expenditures are capital.               Petitioner contends that it is

the   appropriate       test   because    the    condition    necessitating   the

      10
      (...continued)
Appeals held that the funds expended by the taxpayer in that case
were to "maintain * * * [a store] in a safe condition and may be
properly classified as repairs and deductible as an expense." 10
B.T.A. at 1152. Respondent posits that the operative word
leading to the Board of Tax Appeals' classification of the
taxpayer's expenditures as deductible repair expenses was
"maintain", and not the words "safe condition", as petitioner
suggests.
       11
          Respondent did not introduce any expert testimony
concerning the value of the Douglas Street building.
                                        -27-

asbestos removal was the discovery that asbestos is hazardous to

human    health.     Accordingly,       until   the   danger   was   discovered,

petitioner argues that the physical presence of the asbestos had no

effect on the building's value. Only after the danger was perceived

could the contamination affect the building's operations and reduce

its value.12

        Petitioner points to Rev. Rul. 94-38, 1994-1 C.B. 35, which

cites Plainfield-Union in addressing the proper treatment of costs

to   remediate     soil   and   treat   groundwater     that   a   taxpayer   had

contaminated with hazardous waste from its business.                 The ruling

treats such costs (other than those attributable to the construction

of groundwater treatment facilities) as currently deductible.

      Respondent, on the other hand, argues that the discovery that

asbestos is hazardous and that the Douglas Street building contained

that substance is not a relevant or satisfactory reference point.

Respondent contends that the Plainfield-Union test does not apply

herein because a comparison cannot be made between the status of the

building before it contained asbestos and after the asbestos was

removed; since construction, the building has always contained

asbestos. In cases where the Plainfield-Union test has been applied

(such as Oberman Manufacturing Co. v. Commissioner, 47 T.C. 471, 483

(1967); American Bemberg Corp. v. Commissioner, 10 T.C. 361, 370

        12
          In     its reply brief, petitioner states: "While in a
metaphysical     sense the Douglas Street Building may have been
contaminated     in 1970, such contamination had no discernable
impact until     the hazard became known."
                                        -28-

(1948), affd. 177 F.2d 200 (6th Cir. 1949); and Illinois Merchants

Trust    Co.   v.   Commissioner,      4   B.T.A.    103    (1926)),      respondent

continues, the condition necessitating the repair resulted from a

physical change in the property's condition.                   In this case, no

change    occurred      to   the   building's       physical       condition    that

necessitated the removal expenditures.                The only change was in

petitioner's awareness of the dangers of asbestos. Accordingly,

respondent argues that the Plainfield-Union test is inapplicable,

and the Court must examine other factors to determine whether an

increase in the building's value occurred.

       Respondent also disagrees with petitioner's reliance on Rev.

Rul.     94-38,     supra,    arguing      that     the    present     facts       are

distinguishable.        The remediated property addressed in the ruling

was not contaminated by hazardous waste when the taxpayer acquired

it.      The   ruling   permits    a   deduction     only    for    the    costs    of

remediating soil and water whose physical condition has changed

during the taxpayer's ownership of the property.                       Under this

analysis, the taxpayer is viewed as restoring the property to the

condition existing before its contamination.                   Thus, respondent

contends, unlike Rev. Rul. 94-38, petitioner's expenditures did not

return the property to the same state that existed when the property

was constructed because there was never a time when the building was

asbestos free.       Rather, the asbestos-abatement costs improved the

property beyond its original, unsafe condition.
                                        -29-

        O.    Analysis

      We believe that petitioner decided to remove the asbestos-

containing materials from the Douglas Street building beginning in

1987 primarily because their removal was essential before the

remodeling work could begin.        The extent of the asbestos-containing

materials in the building or the concentration of airborne asbestos

fibers was not discovered until after petitioner decided to remodel

the building and a budget for the remodeling had been approved.

Because petitioner's extensive remodeling work would, of necessity,

disturb the asbestos fireproofing, petitioner had no practical

alternative but to remove the fireproofing. Performing the asbestos

removal in connection with the remodeling was more cost effective

than performing the same work as two separate projects at different

times. (Had petitioner remodeled without removing the asbestos

first, the remodeling would have been damaged by subsequent asbestos

removal, thereby creating additional costs to petitioner.)                    We

believe that petitioner's separation of the removal and remodeling

work is artificial and does not properly reflect the record before

us.

      The parties have stipulated that the asbestos removal did not

increase     the   useful   life   of   the    Douglas   Street   building.   We

recognize (as did petitioner) that removal of the asbestos did

increase the value of the building compared to its value when it was

known to contain a hazard.         However, we do not find, as respondent

advocates, that the expenditures for asbestos removal materially
                                 -30-

increased the value of the building so as to require them to be

capitalized.    We find, however, that had there been no remodeling,

the asbestos would have remained in place and would not have been

removed until a later date. In other words, but for the remodeling,

the asbestos removal would not have occurred.13

     The   asbestos   removal   and     remodeling     were   part    of one

intertwined    project,   entailing   a   full-blown    general      plan   of

rehabilitation, linked by logistical and economic concerns.                 "A

remodeling project, taken as a whole, is but the result of various

steps and stages."     Bank of Houston v. Commissioner, T.C. Memo.

1960-110.14    In fact, removal of the asbestos fireproofing in the

Douglas Street building was "part of the preparations for the

remodeling project." See id. Before remodeling could begin, nearly

every ceiling light fixture in the building was ripped down and

crews removed all the asbestos-containing materials that had been

sprayed on the columns, I-beams, and decking between floors, as well

as the floor tiles in the customer lobbies.          Only then could the

remodeling contractor perform its work.        As described above, the

      13
          While no remodeling was done in the parking garage, the
record indicates that it was financially advantageous to remove
the asbestos-containing materials in the parking garage at the
same time as the abatement activity throughout the building.
      14
          Petitioner attempts to distinguish Bank of Houston v.
Commissioner, T.C. Memo. 1960-110, from the present case by
arguing that only one contractor was used in Bank of Houston
while it used two. We do not find that distinction to be of any
significance. Two different contractors were necessary in this
case because removing the asbestos-containing materials required
special skills that the remodeling contractor did not possess.
                                           -31-

entire project required close coordination of the asbestos removal

and remodeling work.

      Clearly,     the    purpose     of    removing   the    asbestos-containing

materials was first and foremost to effectuate the remodeling and

renovation of the building.             Secondarily, petitioner intended to

eliminate health risks posed by the presence of asbestos15 and to

minimize the potential liability for damages arising from injuries

to employees and customers.

      In    sum,   based     on   our      analysis    of    all   the     facts   and

circumstances, we hold that the costs of removing the asbestos-

containing materials must be capitalized because they were part of

a general plan of rehabilitation and renovation that improved the

Douglas Street building.

Issue II.    Brazilian Debt-Equity Conversion

      The second issue is whether petitioner realized a loss on a

1987 Brazilian debt-equity conversion.16               According to petitioner,

the   debt-equity        conversion     should    be   viewed      under    the    step

transaction doctrine as an exchange of petitioner's blocked deposits

at the Central Bank of Brazil (with a basis of $12,577,136) for


      15
          We reject petitioner's argument regarding sec. 213,
sec. 1.162-10, Income Tax Regs., and Rev. Rul. 79-66, 1979-1 C.B.
114. These provisions and ruling cannot convert the costs of
removing the asbestos-containing materials into current
deductions simply because petitioner's "concerns for the health
and welfare of its employees" partially motivated the removal.
      16
          A "debt-equity conversion" is also commonly referred to
as a "debt-equity swap".
                                          -32-

stock    in    a   Brazilian    company       (with     a    fair     market   value      of

$5,544,000). Consequently, the conversion produces a $7,033,136

loss.      By utilizing the step transaction doctrine, petitioner

essentially ignores the conversion of the Brazilian debt into

cruzados and simultaneously the payment of the cruzados for the

stock.

     Respondent,        on    the     other    hand,        asserts    that    the       step

transaction doctrine is inapplicable to petitioner's debt-equity

conversion. According to respondent, we should view the transaction

as an exchange of petitioner's blocked deposits for cruzados, which

were then used to purchase stock in a Brazilian company.                           Based on

this scenario, petitioner would recognize a loss on the exchange of

the debt for the cruzados only to the extent its adjusted basis in

the debt exceeded the fair market value of the cruzados. Respondent

contends that there was no excess (and thus, no loss) in this case:

petitioner exchanged blocked deposits with a $12,577,136 basis for

cruzados with a $12,577,136 fair market value.                        As an alternative

position, respondent claims that, assuming arguendo petitioner did

realize    a    loss,   the    loss    did     not     exceed   10     percent      of   the

investment, or approximately $1.25 million.

        A. The Brazilian Debt Crisis

        In the late 1970's, Latin American countries borrowed heavily

abroad.        As part of its response to higher world oil prices, the

Brazilian      Government      embarked       on   a   major    program       of   import-

substituting industrialization. This development strategy involved
                                       -33-

the potential risk of higher external indebtedness.              The extensive

borrowing made Brazil vulnerable when international interest rates

rose sharply in the early 1980's.             It was difficult for Brazil to

maintain sufficient foreign currency (such as the U.S. dollar) to

repay its foreign debts.

      In 1982, Mexico announced that it could not meet external debt

payments and declared a moratorium on its external indebtedness.

A   general    cutback   in   credit   to     most   Latin   American   nations,

including Brazil, followed.

              1. Deposit Facility Agreements and Blocked Deposits

      Brazil attempted to deal with its debt problems by negotiating

with its foreign creditors to reschedule its indebtedness. The

negotiations resulted in various agreements including the 1983 and

1984 Deposit Facility Agreements (DFA's), and a 1986 amendment to

the 1984 DFA (the 1986 DFA). Under the terms of these agreements,

the principal amount of the loans made by international banks to

Brazilian financial institutions maturing in 1983, 1984, and 198617

would not be paid to creditors outside Brazil but rather would be

deposited with the Central Bank of Brazil (the Central Bank)18 in

dollar-denominated accounts on behalf of the respective creditors.


      17
           Despite the lack of a formal renewal, this arrangement
was continued into 1985.
      18
          The Central Bank is the principal banking regulatory
agency in Brazil, as well as the agency in charge of implementing
and enforcing national monetary policy, regulating money supply,
and controlling foreign exchange.
                                   -34-

These were called "blocked deposits".         Under the DFA's and the 1986

DFA, the payment terms of the deposits were also rescheduled.

     Moreover, under the terms of these agreements, blocked deposits

relating to loans maturing in 1983, 1984, and 1985 could be re-lent

by the creditors to borrowers in Brazil. Blocked deposits for loans

maturing in 1986 (such as the deposits at issue herein) could not

be re-lent but could be used for equity investments in Brazilian

companies.   This   type   of   transaction    is   called   a   "debt-equity

conversion". In a debt-equity conversion transaction, non-Brazilian

currency-denominated blocked deposits at the Central Bank are

exchanged for cruzados at the official exchange rate, and thereafter

the cruzados are used as payment for equity interests in Brazilian

companies, subject to Central Bank guidelines and pursuant to the

DFA's and the 1986 DFA. Such a transaction can take place only after

negotiations with and agreement by the Central Bank.

     Blocked deposits at the Central Bank were bought and sold on

a secondary market at a discount to their face amounts. This

secondary market originally reflected rates at which banks exchanged

debt of one country against that of another, attempting to diversify

their portfolios.     Ultimately, the transactions on the secondary

market involved sales of all types of claims by banks wishing to

clear their portfolios of the specific loans.           Throughout most of

1986, Brazilian debt was trading in the secondary market at 75 cents

on the dollar, declining to 63 cents by April 14, 1987 (the date of
                                     -35-

the   transaction    herein,   discussed    infra).   In    April   1987,   the

majority of Brazilian debt was not traded on the secondary market.

      The Brazilian Government did not have access to the secondary

market because the debt restructuring agreements (such as the DFA's)

had sharing clauses requiring the recipient of any payments to share

the proceeds with all of the other creditors that were parties to

such agreements.

             2.   The Cruzado Plan

      In February 1986, Brazil adopted the "Cruzado Plan" as part of

an economic stabilization program to reduce the country's high

inflation. A price freeze took effect, and the cruzado replaced the

cruzeiro as Brazil's currency on February 28, 1986. The exchange was

made at one cruzado (Cz$) to 1,000 cruzeiros.19            Brazilian currency

was not freely exchangeable through official Brazilian channels into

non-Brazilian currency.        The Cruzado Plan was collapsing by late

1986.

             3.   Moratorium on Interest

      On February 20, 1987, Brazil declared a moratorium on the

payment of interest on its external indebtedness.             In response to

        19
          On Feb. 28, 1986, the official exchange rate of
cruzados to U.S. dollars was set at $1 to Cz$13.84. The 1986
average official exchange rate was $1 to Cz$13.654.
     The official rate was the dominant exchange rate in Brazil.
A "parallel" rate also existed (which was published in Brazilian
newspapers) but was technically illegal, and none of the hundreds
of Brazil's creditors, including petitioner, could exchange
blocked deposits for cruzados in the parallel market. The spread
between the official rate and parallel rate typically was
approximately 30 percent.
                                        -36-

this declaration, some U.S. banks, including petitioner, announced

that they would place a portion of their Brazilian loans on

nonaccrual status, recording interest income on such loans only as

payments were received. By November 1987, Brazil resumed partial

interest payments on its external indebtedness.

       B.    Petitioner's Blocked Deposits

       Petitioner's subsidiary, Norwest Bank Minneapolis, N.A. (NBM),

owned blocked deposits at the Central Bank in 1986 and 1987.20                       As

described above, these deposits consisted of principal repayments

of    dollar-denominated        loans   previously   made     to    Brazil    in   the

ordinary     course   of    NBM's   banking     business.     The    Central       Bank

prevented petitioner from repatriating these deposits because Brazil

had insufficient hard currency (U.S. dollars) to make payments on

the    loans. At petitioner's election, the blocked deposits accrued

interest at the U.S. domestic rate.

       In late 1986, petitioner began investigating the possibility

of using some of its Brazilian blocked deposits to make an equity

investment in a Brazilian company.                Darin P. Narayana managed

international banking for Norwest at this time and was in charge of

petitioner's Brazilian blocked deposits.             A debt-equity conversion

became      attractive     to   petitioner     because   it   would:    (1)    Allow

petitioner to regain control over some assets by placing them


       20
          Because NBM was a subsidiary of petitioner, for
convenience we sometimes refer to petitioner as owner of the
blocked deposits.
                                -37-

outside of Brazil's debt-restructuring process; (2) increase the

probability of repayment of a portion of its outstanding Brazilian

loans; and (3) reduce petitioner's obligation to make new loans to

Brazil sufficient to pay at least part of the interest due on old

loans.

     At this time (and until July 1987), Brazil's policies favored

debt-equity conversion transactions.    Creditors were permitted to

use 1986 deposits to invest in Brazilian companies.   If a creditor

decided to make such an investment, the Central Bank converted 100

percent of the face value21 of the deposits, plus accrued interest,

into cruzados at the official exchange rate. Pursuant to Central

Bank Circular 1.492 (the implementing measure concerning debt-equity

conversions), the creditor and the company in which it was investing

pledged "to keep the converted sums in Brazil for the minimum period

that may be established."      The debt-equity conversion policies

benefited Brazil by allowing it to extinguish its foreign debt by

the amount of the debt converted, thereby eliminating its foreign

exchange obligation with respect to that portion of its debt.

     The equity investment acquired as a result of a debt-equity

conversion was registered at the Central Bank as registered foreign

capital in the currency originally brought into Brazil by the

creditor.   The amount registered could be increased annually by the

amount of retained earnings.   Registration entitled the creditor to

     21
          In July 1987, the Central Bank ended the practice of
converting blocked deposits at full face value.
                               -38-

remit profits and capital outside Brazil at the official exchange

rate, avoid or reduce supplementary withholding taxes and, upon the

ultimate sale of the investment, remit the proceeds of the sale free

of tax up to the amount of registered foreign capital. In February

1987, when Brazil declared a temporary moratorium on interest

payments on its debt, foreign investors possessing a certificate of

registration were still able to receive dividends outside Brazil at

the official exchange rate.

     Petitioner had several options with respect to its 1986 blocked

deposits:22   (1) Hold the blocked deposits and participate in the

debt restructuring process; (2) sell the deposits on the secondary

market to another party; or (3) convert the deposits into an equity

interest in a Brazilian company pursuant to the Central Bank's debt-

equity conversion program.    The only options that would reduce

petitioner's blocked deposit holdings and decrease its foreign debt

exposure were selling the debt on the secondary market for cash or

swapping the debt for equity in a Brazilian company.

     C. Papel e Celulose Catarinense, S.A.

     Petitioner decided to engage in a debt-equity conversion and

in that regard began examining investment possibilities in Brazilian

companies. In November 1986, petitioner received an Information




      22
          Petitioner could only use 1986 deposits to participate
in the debt-equity conversion at issue in this case. These
deposits were governed by the 1984 and 1986 DFA's.
                                  -39-

Memorandum23   regarding   a   Brazilian   company,   Papel   e   Celulose

Catarinense, S.A. (PCC), prepared by Banco Bozano, Simonsen de

Investimento, S.A. (Banco Bozano) and Morgan Grenfell & Co., Ltd.24

The   International   Finance    Corporation   (IFC),25   a   World   Bank

affiliate, engaged these firms to market its 28.7-percent interest

in PCC.26   IFC's asking price for its 28.7-percent interest in PCC

was $25 million.

      PCC, headquartered in San Paulo, was a subsidiary of Industrias

Klabin Papel e Celulose, S.A. (IKPC), a Brazilian corporation

incorporated in 1934. IKPC was the largest pulp and paper producer

in South America and among the 100 largest in the world. Prior to

the transaction at issue herein, PCC's stock was owned as follows:

IKPC--70.9 percent; IFC--28.7 percent; and PCC's Administration


      23
          The Information Memorandum did not by its terms limit
the offering to prospective purchasers who intended to engage in
a debt-equity conversion.
      24
          At the time petitioner was considering an investment in
PCC, it was also reviewing a possible investment in Medtronic do
Brazil, as well as the purchase of Mellon Bank's 12.5-percent
interest in Banco Bozano.
      25
          IFC aids in the development of private sector projects
in developing countries, such as providing "seed capital" to
private ventures and projects. IFC focuses its assistance on
those projects which, while economically and financially
attractive, cannot by themselves attract enough managerial,
technical, or financial resources to be implemented. Once these
projects reach success and maturity, IFC expects to divest and
redeploy its assets to assist the development of new attractive
ventures.
      26
          PCC was IFC's oldest equity investment, dating back to
the late 1960's. By 1986, IFC had decided that PCC's operational
and financial maturity warranted the sale of its interest.
                                     -40-

Council--.4 percent. PCC stock was not publicly traded, whereas IKPC

stock was listed on the Brazilian stock exchanges.

       PCC was engaged in the production of unbleached and bleached

kraft paper and bleached fluff pulp as well as multiwall paper bags

and envelopes. PCC's management and the management of its principal

subsidiaries were fully integrated with that of its parent, IKPC.

PCC's directors had all been in the Klabin group for more than 30

years.

       Paper consumption is closely linked to economic activity.

Consequently, swings in economic activity place pulp and paper

manufacturers at risk.         Prior to 1986, PCC had been consistently

profitable.      (For example, its 1985 net income was $13,453,000.)

From 1976 through 1985, PCC paid dividends averaging approximately

31 percent of its net profits.        In 1986, PCC was cash rich and had

only a small amount of long-term indebtedness.        As of December 31,

1985, PCC had cash and short-term financial investments totaling

$11,430,000; long-term loans totaled $2,166,000. PCC's shareholders'

equity at the end of 1985 was approximately $125 million.

            1.    PCC's Expansion Plans

       The Brazilian pulp and paper industry operated at or close to

full   capacity    in   1985   and   1986.   Additional   investments   in

productive capacity were needed to meet Brazil's 7-percent annual

growth in paper demand. PCC planned to expand its production

capacity from 80,200 to 178,700 tons per year in order to meet

expected demand. By early 1987, the cost of PCC's planned expansion
                                    -41-

was $115 million. PCC intended to finance this expansion with a $55

million loan from the Brazilian National Development Bank, a $30

million loan from IFC, and $30 million from internally generated

cash flow.

       On November 19, 1986, PCC acquired 80 percent of Bates' stock,

one of its principal Brazilian competitors. The purchase price was

approximately $9 million.        The Bates acquisition enabled PCC to

expand its capacity in the multiwall-paper-bag market.

            2.    Petitioner's Internal Analysis of a PCC Investment

       At the request of NBM's International Department, Norwest

Corporate Finance27 evaluated IFC's 28.7-percent equity interest in

PCC at the beginning of 1987. The evaluation resulted in a February

1987   study     (Corporate   Finance   study).   At   this   time,   NBM   was

contemplating the acquisition of IFC's entire 28.7-percent interest.

       Norwest Corporate Finance reviewed the forecast prepared by

PCC's management and found it reasonable, based on the available

information.       It found that the projected level of sales and

profitability from the planned increase in capacity was reasonable

and concluded that PCC was not underperforming in comparison with

its Brazilian competitors.

       The Corporate Finance study used both the market and income

approaches to value IFC's interest in PCC. The market approach


       27
          Norwest Corporate Finance was responsible for the
corporation's policies with regard to the deployment of its
assets and liabilities.
                                   -42-

involved the application of a price/earnings ratio based on U.S.

companies in the pulp and paper industry to a 3-year weighted

average of historical earnings, while the income approach discounted

PCC's expected dividends to present value at a 24-percent rate. The

Corporate Finance study concluded that IFC's 28.7-percent interest

in PCC had a value of $22,783,000 under the market approach and

$16,884,000 under the income approach.        In attempting to harmonize

the two methods, the study accorded the income approach twice the

weight of the market approach and concluded that the 28.7-percent

interest in PCC had a $18,850,000 value. The study did not consider

the repatriation restriction or the foreign exchange political risks

associated with owning a Brazilian investment.

     As holder of more than 10 percent of PCC's share capital,

petitioner would be entitled, as a matter of Brazilian law, to elect

a representative to each of the two councils responsible for PCC's

management, the Council of Administration and the Fiscal Council.

Petitioner anticipated receiving fees for each of the two seats on

PCC's management councils in the amount of $7,500 per month in

cruzados,   or   the   cruzado   equivalent   of   $180,000   annually.   By

February 23, 1987, petitioner had revised its value for IFC's 28.7-

percent interest in PCC to $24 million by adding the director's fees

from one board seat to projected dividends from PCC under the

Corporate Finance study's income approach.
                                    -43-

            3.   Petitioner's Conclusions About the PCC Investment

     Petitioner concluded that the acquisition of a 14.361-percent

equity    interest   in   PCC   (rather    than   the   entire   28.7-percent

interest) was an attractive investment.           It based its conclusions

on PCC's: (1) Strong professional management; (2) solid financial

condition; (3) history of profitability and dividends; (4) dominant

position in the markets for its products; (5) growth potential; and

(6) relationship with IFC, both past and future.            As of April 14,

1987, petitioner could have sold $12,577,136 of its Brazilian debt

on the secondary market for 63 percent of face value and received

$7,923,596 million in return, but it chose not to do so. Petitioner

believed that a 14.361-percent equity interest in PCC through a

debt-equity conversion (in which it would receive 100 cents on the

dollar) was more profitable than the cash it could have received on

the secondary market.

     D.    Steps Leading Up to the Conversion

     On February 24, 1987, NBM sent to Banco Bozano a proposal to

purchase 14.35 percent of PCC's equity for a purchase price not to

exceed $12.5 million.28 The other 14.361 percent was to be acquired

by the Bank of Scotland and its affiliate, Balmoral Industria e

Comercio, Ltda. (Balmoral), as a result of a debt-equity conversion


     28
          The proposal states that the purchase is to "be
effected by means of a conversion" of blocked deposits with a
$12.5 million face value.
                                            -44-

which would occur simultaneously with petitioner's debt-equity

conversion. Petitioner negotiated the purchase of IFC's PCC stock

at arm's length.

       Once the parameters of the acquisition had been established,

NBM wrote to the Central Bank on April 2, 1987, seeking its consent

to engage in a debt-equity conversion (pursuant to Central Bank

Circulars 1.125 and 1.492, Central Bank Resolution 1.189, and the

1986 DFA) that would enable the use of blocked deposits with a face

amount of approximately $12.5 million to acquire 32,524,650 shares

of PCC common stock (the 14.361-percent equity interest).

       In   order    to   execute       the      transaction,    on    April    7,    1987,

petitioner      formed      a    wholly     owned     Cayman    Islands       subsidiary,

Minnetonka Overseas Investment, Ltd. (MOIL), which in turn formed

a wholly owned Brazilian subsidiary, Minnetonka Representacoes

Comerciais, Ltda. (MRC). (MOIL and MRC are controlled foreign

corporations within the meaning of subpart F of the Internal Revenue

Code.)      Petitioner chose this arrangement in order to allow it the

maximum flexibility in the future disposition of its investment.

       Also on April 7, 1987, MOIL notified the Central Bank that

NBM's blocked deposits would be converted into MRC risk capital.

This   capital      would       be   used   to     purchase    the    PCC    stock.      The

conversion was to occur on April 14, 1987. Petitioner, through MRC,

requested     that   the        Central     Bank    register    MRC's       investment    as
                                   -45-

registered   foreign   capital   within    30   days   of   the    investment.

Moreover, NBM, MOIL, and MRC agreed to maintain the invested funds

in Brazil "for a period of twelve (12) years", which was the "period

to which funds relative to deposits made in 1986" were subject.

      On April 10, 1987, NBM and MOIL instructed the Central Bank to

transfer $12,577,13629 of blocked deposits to the "name of MRC".

      E.   The Conversion Transaction

      On April 14, 1987, IFC, NBM, MOIL, MRC, the Bank of Scotland,

and   Balmoral   executed   a    Share    Purchase     Agreement    (Purchase

Agreement). In relevant part, the Purchase Agreement states as

follows:

           Each of the Purchasers shall pay to the
           Seller at the place and to the person or
           account in Brazil designated by the Seller
           the purchase price for the Relevant
           Purchaser's Shares, equal to the Brazilian
           Cruzado   equivalent     of   US$12,500,000
           without    any    deduction,    setoff   or
           withholding     whatsoever,   obtained   by
           converting     into    Cruzados   Brazilian
           Sovereign Debt * * *

Under the Purchase Agreement, IFC was entitled to either the

immediate remittance in dollars in New York of $25 million or the

deposit of the sale proceeds in a dollar-denominated account

satisfactory to IFC at the Central Bank.



      29
           We note that $77,136 of the $12,577,136 was used to
pay legal expenses and the buy/sell foreign exchange rate
differential.
                                      -46-

     As contemplated, petitioner's blocked deposits totaling $12.5

million were converted on April 14, 1987, at the official exchange

rate of 23.616 cruzados to one U.S. dollar, into Cz$295,200,000.

MRC in turn transferred the cruzados to IFC in consideration for 50

percent of IFC's equity interest in PCC, some 32,524,650 shares.

IFC provided MRC a receipt acknowledging this payment.30 This

transaction      extinguished   the     $12.5    million     debt;   moreover,

petitioner agreed to maintain its equity investment in Brazil for

12 years.

     Also   on    April   14,   1987,    IFC    and   MOIL   entered   into   a

Repatriation Guarantee Agreement, whereby IFC guaranteed that in

the event MOIL sold the PCC stock and was unable to repatriate the


     30
            The receipt states, in relevant part, as follows:

              IN THIS FORM, INTERNATIONAL FINANCE
              CORPORATION ("IFC"), * * * acknowledges
              receipt of Cz$ 295.200.000,00 (Two
              hundred, ninety five million, two
              hundred thousand cruzados), equivalent
              to US$ 12,500,000 (twelve million five
              hundred thousand dollars) as of this
              date of April 14 at the exchange rate of
              Cz$ 23,616 from MINNETONKA
              REPRESENTACOES COMERCIAIS LTDA.
              ("MINNETONKA"), * * * for the sale to
              the latter of 32,524,650 shares from the
              capital stock of PAPEL E CELULOSE
              CATARINENSE S.A., * * * of which shares
              IFC is the legal owner, * * * for which
              receipt IFC hereby grants MINNETONKA
              total, general and irrevocable quittance
              for said sale of shares.
                                        -47-

sale proceeds, IFC would purchase, for U.S. dollars outside of

Brazil, MOIL's share holding in MRC equal to MOIL's remittance

interest, up to $12.5 million.           This guaranty would be reduced by

any earlier sale or disposition of any part of the shares and would

apply only during the convertibility period (the 18-month period

beginning    on   the     12th    anniversary    of   the     PCC    purchase).

(Petitioner's blocked deposits at the Central Bank had no such

guaranty.)

     Following     the    debt-equity      transaction,   IKPC      held   70.842

percent of PCC's voting capital, and MRC and Balmoral each held

14.361 percent. The three parties entered into a Shareholders

Agreement on April 30, 1987, whereby IKPC and Balmoral had a right

of first refusal with respect to the sale of petitioner's PCC

stock.

     Due     to   the    manner    in    which   petitioner      arranged    the

transaction, it could sell its investment indirectly, through the

sale of MOIL, at any time and without restriction, for U.S. dollars

outside Brazil.         The buyer would have to maintain the invested

funds in Brazil for whatever portion of the 12-year waiting period

remained, but it would be free to dispose of the investment

indirectly, in the same manner as petitioner. Moreover, petitioner

could dispose of the investment by causing MOIL to sell the stock

of MRC, without restriction, to a buyer in Brazil for cruzados.
                                   -48-

The cruzado proceeds would remain subject to the same prohibition

on repatriation, until April 14, 1999.

     F. Petitioner's Tax and Accounting Treatment of the Conversion

     NBM's chief financial officer and comptroller, Phil Williams,

reviewed and analyzed the Corporate Finance study. Two days after

the conversion he concluded that the estimated fair market value of

petitioner's 14.361-percent equity interest in PCC was between

$12.4 million and $12.6 million.          Mr. Williams arrived at this

conclusion by using the price/equity ratio and discounted cash-flow

approaches, as well as adding a third approach, based on the net

book value of PCC. He then weighted the three approaches equally.31

Mr. Williams recommended that the investment be recorded at par.

In April 1987, Mr. Narayana (who was in charge of petitioner's

Brazilian blocked deposits) agreed with Mr. Williams' conclusion.




     31
          Mr. Williams determined the fair market value of
petitioner's interest in PCC as follows (numbers are in
thousands):

     Method                      Total Company            Norwest's Share

Price/earnings ratio        $ 79,385      x   14.361% =      $11,400

Discounted cash-flow             79,790   x   14.361% =       11,459
                             1
Net book value                100,386     x   14.361% =        14,416

Weighted average            $ 86,520                         $12,425
     1
          Discounted 20 percent.
                                       -49-

     Norwest's      International         Department       was      responsible         for

monitoring the value of petitioner's PCC investment on a quarterly

basis.    Petitioner       periodically         reviewed      all      of   its    lesser

developed country debt. On July 3, 1987, Mr. Williams wrote a

memorandum, on behalf of International Management, reassessing the

value of petitioner's PCC equity interest. Based on a June 12,

1987, Proposed Practice Bulletin issued by the American Institute

of Certified Public Accountants and its own analysis that the true

fair market value of the debt surrendered would be 85 percent of

par, petitioner       decided     to   write    down    its      PCC    investment       to

approximately $10.7 million, based on a 15-percent discount.

     At the end of 1987, petitioner again reduced the value of the

PCC investment to $8 million for financial purposes.                        This value

was based on the secondary market value of the $12,577,136 debt and

on petitioner's Tax Department's analysis of the tax implications

resulting from the debt-equity transaction.

     G.   Petitioner's Return and Petition

     On its 1987 Federal income tax return, petitioner claimed a

$4,577,136 loss (the difference between its $12,577,136 of blocked

deposits and     $8    million,    the    secondary     market         price      for   the

$12,577,136    of     Brazilian    debt    as    well   as    petitioner's          final

valuation for book purposes of the PCC stock received in the debt-

equity conversion).       Petitioner asserted in its petition: "Since
                                      -50-

the PCC stock was valued at $8,000,000 when it should have been

valued at $681,099, Petitioner is entitled to an additional loss

deduction of $7,318,901 for 1987."

     H.    Notice of Deficiency

     In    the     notice    of      deficiency,      respondent       disallowed

petitioner's claimed $4,577,136 loss.               The notice explains that

petitioner did not establish that any deductible loss was sustained

in 1987.

     I.    Subsequent Events

     Petitioner attempted to sell its interest in PCC several weeks

after the conversion. Then, in 1992 or 1993, petitioner engaged

Eden International to assist in the sale of its PCC stock.                     On

December 1, 1994, petitioner entered into a Deferred Stock Sale

Agreement with Tiquie, S.A., a subsidiary of IKPC located in

Uruguay,    agreeing   to     sell    the    MOIL    shares    to     Tiquie   for

$10,500,000, consisting of $1,150,000 in cash and a $9,350,000

note, plus interest on the outstanding balance of the purchase

price.     By    selling    its   entire     interest   in    MOIL,    petitioner

indirectly sold the 14.361-percent equity interest in PCC, as well

as cash equivalents of approximately $658,000. Petitioner incurred

$260,000 in closing costs.

     Petitioner sold its remaining blocked deposits for 47 cents on

the dollar in January 1988.
                                 -51-

                             Discussion

     J. Respondent's Arguments

     Respondent contends that petitioner did not realize a loss on

the debt-equity conversion because it simply exchanged blocked

deposits in which it had a $12,577,136 basis for cruzados worth the

same amount.    Respondent relies upon Rev. Rul. 87-124, 1987-2 C.B.

205, and G.M. Trading Corp. v. Commissioner, 103 T.C. 59 (1994),

supplemented by 106 T.C. 257 (1996), on appeal (5th Cir., Oct. 4,

1996), to support its position.

        In Rev. Rul. 87-124, supra, a U.S. commercial bank holds

dollar-denominated debt at the central bank of a foreign country.

The foreign country has a program that allows the commercial bank

to exchange the debt for local currency if it uses the local

currency to invest in a company (the foreign company) organized and

engaged in business in the foreign country.     In situation 2, the

commercial bank delivers the dollar-denominated debt to the central

bank.    The central bank credits the account of the foreign company

and the foreign company in turn issues its capital stock to the

commercial bank.    (Respondent contends that the facts herein are

similar except that petitioner paid the local currency, cruzados,

to a third party, IFC, in exchange for the stock.)       The ruling

treats the commercial bank as if it received local currency from

the central bank in exchange for the debt and then contributed the
                                -52-

local currency to the foreign company in exchange for its stock.

The commercial bank also recognizes a loss on the exchange of the

debt for the local currency to the extent of the excess of its

adjusted basis in the debt over the fair market value of the local

currency.   The ruling assumes that the fair market value of the

stock is equal to the fair market value of the foreign currency for

which it was exchanged.

     By applying the test enunciated in this ruling, respondent

argues that petitioner did not realize a loss on its exchange of

blocked deposits for cruzados because it received local currency

(cruzados) equal in value to its basis in the blocked deposits.

Moreover, respondent contends that petitioner recognizes no gain or

loss on the exchange of the cruzados for the PCC stock because the

ruling assumes that the value of the cruzados and the value of the

stock are identical.

     Respondent   also    contends   that   G.M.     Trading   Corp.   v.

Commissioner, supra, supports its position.        G.M. Trading involved

a U.S. taxpayer that participated in a Mexican debt-equity swap.

In order to participate in the transaction, the taxpayer, a U.S.

company, formed a Mexican subsidiary, Procesos.        The U.S. company

then purchased a previously issued $1.2 million Mexican Government

debt from an unrelated bank for $634,000 (which reflected the

market discount rate of approximately 50 percent of the debt's
                                      -53-

principal face amount).           103 T.C. at 62, 65.               The taxpayer

exchanged the $1.2 million debt for 1,736,694,000 pesos (Mex$),32

and   the   Mexican     Government    deposited      the   pesos   in    Procesos'

restricted bank account.          The pesos were to be used to build a

lambskin processing plant.        Procesos issued shares of its stock to

the Mexican Government, which in turn transferred the shares to the

taxpayer. The U.S. company surrendered the debt to the Mexican

Government, which then canceled it.                 Id. at 63-64.        The Court

rejected the taxpayer's view that the transaction was a tax-free

contribution to the capital of the Mexican subsidiary.                   The Court

declined to disregard the taxpayer's exchange of U.S. dollar-

denominated debt for Mexican pesos and held that the taxpayer

realized a $410,000 gain on the exchange, equal to the difference

between the taxpayer's basis in the debt ($634,000) and the fair

market     value   of   the   pesos   for   which    the   debt    was   exchanged

(Mex$1,736,694,000 with a fair market value of $1,044,000 on the

date of the transaction).         Id. at 68-71.

      By analogy to G.M. Trading, respondent asserts that in the

instant situation we should decline to disregard petitioner's



      32
          The Mex$1,736,694,000 had a $1,044,000 fair market
value at the official exchange rate. The $1.2 million debt had a
fair market value of $1,044,000 because of a 13-percent discount
rate of the debt's face value. G.M. Trading Corp. v.
Commissioner, 103 T.C. 59, 63 (1994), supplemented by 106 T.C.
257 (1996), on appeal (5th Cir., Oct. 4, 1996).
                                      -54-

exchange of blocked deposits for cruzados. Accordingly, respondent

claims we should hold that petitioner's exchange of blocked assets

for cruzados created no loss because the basis of the blocked

assets and the fair market value of the cruzados were identical.

     K. Petitioner's Arguments

     At trial and on brief, petitioner contends that the conversion

produced a $7,033,136 loss.          Petitioner argues that it exchanged

$12,577,136 of blocked deposits, which had a secondary market value

of $7,923,596, for Brazilian stock worth $5,544,000. Petitioner

first argues that Rev. Rul. 87-124, supra, supports its position

rather than that of respondent. Petitioner claims that because the

value of the stock is presumed to equal the value of the local

currency given in exchange, petitioner is justified in looking to

the fair market value of the stock it received in determining the

extent of its loss.

     Petitioner also argues that we should not follow the analysis

and reasoning      of    G.M.    Trading because       the    facts     therein   are

distinguishable:        (1)   Petitioner     entered    into    the     debt-equity

conversion as a means of cutting its losses on a deteriorating

investment, not as the first step in making a profitable new

investment,   as    in    G.M.    Trading;    (2)   the      cruzados    petitioner

received were used to acquire stock in a Brazilian company, while

the pesos the taxpayer received in G.M. Trading were used to
                                     -55-

acquire    land   and   construct   a   plant;   and    (3)    petitioner   was

committed to retain the PCC investment for 12 years, while no

similar mandatory holding period existed in G.M. Trading.

      Moreover, petitioner contends that unlike G.M. Trading, the

step transaction doctrine applies herein; thus, the exchange of

debt for cruzados and the cruzados conversion into stock should be

ignored. Therefore, according to petitioner, the gain or loss

should be measured by the difference between the basis in the debt

and the fair market value of the stock received.              In order to place

a value on the stock, petitioner submitted the expert report of

Nancy Czaplinski, who valued petitioner's interest in the PCC stock

as of the transaction date at $5,544,000. Petitioner also submitted

the expert report and testimony of Steven J. Sherman, who valued

the same interest at approximately $6.77 million.33

      Finally, petitioner claims that the value of its blocked

deposits on the secondary market is directly relevant to the value

of   its equity    interest   in    PCC.    According   to    petitioner,   the

$12,577,136 of blocked deposits had a $7,923,596 value on the




      33
          Respondent's appraisal experts, Scott Hakala and
William Cline, valued the interest at $12 million and $12.5
million, respectively.
                               -56-

secondary market, which represents a ceiling on the value of

petitioner's PCC equity interest.34

     L.   Law and Analysis

     The loss from a sale of property is the excess of the

property's adjusted basis over the amount realized. Sec. 1001(a).

An equal exchange results in neither gain nor loss.   Because debt

is considered property in the hands of the holder, an exchange of

debt for other property is usually treated as a section 1001

taxable exchange. Cottage Sav. Association v. Commissioner, 499

U.S. 554, 559 (1991); G.M. Trading Corp. v. Commissioner, 103 T.C.

at 67. Federal tax law principles require that foreign currency be

considered property.    FNMA v. Commissioner, 100 T.C. 541, 582

(1993); sec. 1.1001-1(a), Income Tax Regs.

     The step-transaction doctrine is a rule of substance over form

that treats a series of formally separate "steps" as a single

transaction if they are in substance integrated, interdependent,

and geared toward a specific result.   Tandy Corp. v. Commissioner,

92 T.C 1165, 1171 (1989). The step-transaction doctrine is a

manifestation of the more general tax law principle that formal

distinctions cannot obscure the substance of a transaction. Id.



     34
          Respondent counters by arguing that the value of the
blocked deposits on the secondary market is irrelevant because
petitioner chose to partake in a debt-equity conversion rather
than sell the debt on the secondary market.
                                        -57-

       Like petitioner herein, the taxpayer in G.M. Trading argued

that its exchange of debt for foreign currency should be ignored

under the step transaction doctrine.               The Court in G.M. Trading

rejected the taxpayer's argument in its Supplemental Opinion, as

follows:

           a step in a series of transactions or in an
           overall transaction that has a discrete
           business purpose and a discrete economic
           significance, and that appropriately triggers
           an incident of Federal taxation, is not to be
           disregarded. Further, the simultaneous nature
           of a number of steps does not require all but
           the first and the last (or "the start and
           finish") to be ignored for Federal income tax
           purposes. * * *

106 T.C. at 267.

       We likewise refuse to apply the step transaction doctrine

herein.    We     agree   with    respondent       that   the     substance   of

petitioner's      transaction    was     consistent   with   its    form.     The

Central Bank converted the full-face value of petitioner's debt,

plus    accrued    interest,     into    Cz$295,200,000      at    the   official

exchange rate without diminution or discount.                MRC received the

cruzados from the Central Bank (exchanged at the official exchange

rate) and paid the cruzados to a third party (IFC) in exchange for

its     14.361-percent     equity       interest     in   PCC.     Contrary    to

petitioner's contention, the exchange of the debt for the cruzados

and the conversion of the cruzados into stock did not constitute

a transitory step but rather a substantive and significant element
                                -58-

of the conversion, having a discrete business purpose and economic

significance: (1) Petitioner needed the cruzados to pay the agreed

purchase price to IFC and pay its other transaction expenses; (2)

the Central Bank was entitled to extinguish approximately $12.5

million of Brazil's foreign debt; (3) the Central Bank did not

need to use its limited supply of U.S. dollars at this time; (4)

the Central Bank received petitioner's assurance that its equity

investment would remain in Brazil for 12 years; and (5) IFC could

use the cruzados without restriction.

     Thus, taking into account the cruzados' independent economic

significance,   petitioner's   exchange   of   blocked   deposits   for

cruzados and the conversion of the cruzados into stock cannot be

ignored under the step transaction doctrine.         Accordingly, we

follow the analysis in G.M. Trading35 and hold that petitioner's

loss, if any, is measured by the difference between its basis in

the blocked deposits ($12,577,136) and the value of the cruzados

($12,577,136 before any discount, see infra) on the date of the

transaction. Because we hold that the step transaction doctrine is

inapplicable herein, we need not determine the fair market value




     35
          While we agree with petitioner that the facts in G.M.
Trading Corp. v. Commissioner, 103 T.C. 59 (1994), are not
identical to those herein, the legal propositions stated in G.M.
Trading are nonetheless applicable herein.
                              -59-

of petitioner's 14.361-percent equity interest in PCC,36 including

any possible marketability discount attributable to that interest.

We reject petitioner's argument that Rev. Rul. 87-124, 1987-2 C.B.

205, supports its position.

     At this point, we must address petitioner's argument that the

$12,577,136 of blocked deposits had a secondary market value of

$7,923,596. We agree with respondent that the value of the blocked

deposits on the secondary market is irrelevant to this case.

Petitioner did not engage in a transaction on the secondary



     36
          Assuming arguendo that the step transaction doctrine
applies, we would hold that the PCC stock had a $12.5 million
fair market value on Apr. 14, 1987, based upon the following:
     After considering for several months whether to invest in
PCC, petitioner concluded that the 14.361-percent equity interest
was worth $12.5 million. Petitioner negotiated the purchase of
the PCC stock with IFC (an unrelated party, which has a strong
institutional incentive to charge a fair price) at arm's length,
even though the Latin American debt crisis placed petitioner in a
position with limited options. Petitioner was not under a
compulsion to buy. In fact, two of petitioner's experts
testified that if we find that IFC sold its stock in an arm's-
length transaction and petitioner was not under a compulsion to
buy, the price at which the transaction occurred would provide
the best evidence of fair market value. The amount paid for
property generally is probative evidence of its fair market
value. See, e.g., United States v. Cartwright, 411 U.S. 546, 551
(1973).
     Just 2 days after petitioner acquired the interest in PCC,
Phil Williams, NBM's chief financial officer, concluded that the
fair market value of the PCC stock was between $12.4 and $12.6
million. He reached this conclusion after analyzing and revising
the study prepared by Norwest Corporate Finance. We consider
petitioner's subsequent reductions in value for financial
reporting purposes not relevant to the purchase-date fair market
value of the PCC stock.
                                      -60-

market. It chose to participate in the government repurchase

market where the Central Bank paid full face value for the debt.

Our task is to decipher the events that did occur, rather than

those that        could   have   occurred.     Mr.    Narayana,     petitioner's

officer charged with overall responsibility for the debt-equity

conversion, testified that petitioner considered the conversion

more beneficial than a sale of the debt on the secondary market.

Furthermore, as the Court's Supplemental Opinion in G.M. Trading

acknowledges, a creditor is motivated to engage in a debt-equity

conversion by the additional value the transaction creates, above

and beyond the secondary market sale of the debt.              If not for this

added value, a creditor would have no reason to spend the time and

resources necessary to complete the transaction.              106 T.C. at 260-

261.

       It   is    clear   that   petitioner    engaged   in   the   debt-equity

conversion because it concluded, after extensive investigation and

analysis     of     the   investment,   that     a    14.361-percent      equity

investment in PCC was worth more than the approximately $8 million

cash petitioner could have received from a secondary market sale.

Contrary to        petitioner's    argument,    the   value   of    the   blocked

deposits on the secondary market is not relevant to the value of

petitioner's PCC equity interest and does not represent a ceiling

on that value. While we acknowledge that had petitioner sold the
                                        -61-

blocked deposits on the secondary market, it probably would have

been obligated to make new loans to Brazil, petitioner anticipated

receiving a "better deal" through the debt-equity conversion.

      Our analysis does not, however, end here.                         We must now

determine whether any discount should be applied to the fair

market value of the cruzados petitioner received on account of the

restrictions in this case.

      Two restrictions existed with regard to petitioner's debt-

equity conversion.           The first required petitioner to invest the

cruzados in a Brazilian company.                This restriction has no greater

significance than the restrictions placed upon the taxpayer's use

of the pesos by the Mexican Government in G.M. Trading.                       The Court

in G.M. Trading declined to discount the value of the pesos

received in exchange for the debt on the grounds that the Mexican

Government    restricted        their     use    to    the   construction       of    the

processing    plant.     The    Court     held     that      this    restriction      was

consistent with the parties' purpose and objective and was not

substantially different from disbursements of loan proceeds by

financial institutions. 106 T.C. at 262. In other words, the

restriction only reflected the foreign currency's intended use.

103   T.C.   at    70-71.     In   fact,    the       restriction      served    as    an

enhancement       to   the   value   of    the     pesos     by     opening   business

opportunities for the taxpayer in Mexico.                    106 T.C. at 264.
                                       -62-

     We   acknowledge     that    due    to     the   Brazilian      debt   crisis,

petitioner    had    limited     options      with    regard    to   its    blocked

deposits.     However, once petitioner decided to engage in a debt-

equity transaction, it was free to use its blocked deposits to

invest in any Brazilian company. Moreover, the value of the

cruzados here was enhanced because petitioner's investment was

made at the official exchange rate, entitling it to the benefits

of registered foreign capital.             In sum, as in G.M. Trading, we

hold that the restriction on use of the cruzados herein does not

require a discount.

     The second restriction involved the 12-year repatriation

restriction. It is clear from the record before us that this

restriction    was   a   preexisting       limitation,     as    articulated     in

Central Bank Circular 1.492 and the 1986 DFA.              It was not a result

of negotiations or bargaining by the parties. The restriction

reduced the value of petitioner's property right by prohibiting

petitioner from repatriating its capital for 12 years.                      Despite

the manner in which petitioner arranged the transaction (with the

creation of MOIL and MRC), we believe that the 12-year restriction

warrants a discount on the fair market value of the cruzados

petitioner received, reflecting the preexisting restriction. See,

e.g., Landau v. Commissioner, 7 T.C. 12, 16 (1946) (the Court

imposed   a   discount    on     the    value    of   South     African     pounds,
                                 -63-

reflecting preexisting restrictions imposed upon foreign exchange

by South Africa).     Accordingly, we will present the analyses of

the   parties'   experts   regarding     the    effect   of    the   12-year

restriction.

      Respondent argues that assuming arguendo petitioner realized

a loss as a result of its debt-equity conversion, the loss did not

exceed 10 percent of its investment (approximately $1.25 million)

on account of the 12-year restriction.            This argument is based

upon the report and testimony of respondent's expert, Dr. William

R. Cline.      Dr. Cline received a Ph.D. in economics from Yale

University in 1969, is a senior fellow at the Institute for

International     Economics,   and     has     approximately    25   years'

experience in the area of international debt, particularly Latin

American and Brazilian debt.    Dr. Cline concluded that petitioner

realized no loss on its debt-equity conversion.                However, he

recognized that petitioner may be entitled to a small discount on

the fair market value of the cruzados it received, attributable to

its agreement to maintain its equity investment in Brazil for 12

years, despite its creation of MOIL and MRC in order to minimize

the effects of the 12-year restriction.

      Dr. Cline determined a discount on account of the restriction

by considering the spread between the interest rates on a 3-month

U.S. Treasury bill and a 10-year U.S. Treasury bond between 1964
                                     -64-

and 1987.    For this period, the average annual interest rate on

10-year U.S. Treasury bonds exceeded the rate on 3-month U.S.

Treasury bills by 1.1 percent.            This is the annual premium for

short-term liquidity versus illiquidity over a 10-year period.

Dr. Cline determined that the differential, if compounded over a

12-year period, amounts to a multiple of 1.14, and that the

general market preference for liquidity means that the 12-year

encumbrance is worth a 12.3-percent discount.             He then decreased

the 12.3-percent discount to 10 percent based on his belief that

the spread between the bill and the bond represented not only a

liquidity premium, but also a risk premium for interest rate

fluctuations.

     Petitioner introduced a rebuttal witness, Dr. Kenneth Froot,

of the National Economic Research Associates, Inc. Dr. Froot

received a Ph.D. in economics from the University of California at

Berkeley    in   1986.   He   has   no   direct   experience   with   Brazil.

Petitioner also introduced Nancy Czaplinski, a chartered financial

analyst    and   an   engagement     director     with   American   Appraisal

Associates, Inc.      Ms. Czaplinski has an M.B.A in finance from the

University of Wisconsin at Milwaukee and is a C.P.A.

     Dr. Froot first criticized Dr. Cline's use of U.S. Treasury

bills and bonds because they are both highly liquid instruments.

Ms. Czaplinski also criticized Dr. Cline's use of the interest
                                   -65-

rate spread between the bill and the bond between 1964 and 1987

because it was significantly less than the actual spread at the

valuation date, the average spread for 1987, and the average

spread for 1983 through 1987. After correcting the spread used in

Dr. Cline's analysis, Ms. Czaplinski used Dr. Cline's formula to

arrive at a 25-percent discount solely attributable to liquidity

in the U.S. Treasury market on the valuation date.37

     Dr. Froot also insisted that Dr. Cline's 10-percent discount

was too low.   Froot concluded that a total 54.5-percent discount

was more appropriate for the following reasons: (1) The "swap

equity" was akin to restricted stock, which trades at 26- to 40-

percent   discounts;   (2)   a   significant   discount   is   applicable

because the official and parallel exchange rates could be expected

to merge over a period of time, so that petitioner would not have

the benefit of a favorable cruzado-to-dollar exchange rate at the

end of the 12-year waiting period;38 and (3) a discount rate


     37
          In response to the criticism of both Dr. Froot and Ms.
Czaplinski, Dr. Cline testified that even though the 10-year bond
is highly liquid, the buyer faces the same waiting period before
maturity as the seller, and his discount represents an inherent
penalty for the waiting period.
     38
           At the time of the transaction, the official exchange
rate was 23.616 cruzados to one U.S. dollar, while the parallel
rate was 32.250 cruzados to one U.S. dollar.
     Dr. Froot opined that if a convergence of the official and
parallel Brazilian exchange rates occurred, petitioner would pay
a 100 million cruzado "penalty" upon entering the debt-equity
                                                  (continued...)
                                     -66-

adjustment was necessary for the risk associated with the official

rate premium.

            We believe that the 12-year waiting period was not a

restriction on sale but rather a restriction on repatriation of

dollars out of Brazil.       Even if petitioner could not take the sale

proceeds out of Brazil in dollars, it could sell MRC at any time

to a buyer in Brazil paying cruzados.          Petitioner could also sell

MOIL    for     dollars   outside   Brazil.     Petitioner's   PCC   equity

investment was not equivalent to restricted stock.

            By focusing on Dr. Froot's opinion that the fair market

value of the cruzados should be determined by reference to the

parallel market exchange rate, petitioner attempts to escape the

tax consequences of its bargain.39          While we agree with Dr. Froot



       38
      (...continued)
conversion because it was "forced" to use the official exchange
rate and would receive none of this "penalty" back if the
official and parallel rates converged prior to the end of the 12-
year period. Dr. Froot believed that the spread was likely to
narrow.
     In April 1987, Dr. Cline would have predicted that the
spread between the official exchange and parallel rates was
likely to continue for a considerable period of time because
Brazil had imbedded indexation as a result of chronic inflation.
Also, Mr. Narayana believed that a spread would persist for a
long time in the absence of drastic action by the Brazilian
Government. In fact, a spread still existed in 1995.
       39
          See G.M. Trading Corp. v. Commissioner, 106 T.C. at
263-264 (where the taxpayer was unsuccessful in attempting to
disavow the price that the Mexican Government had agreed to pay
and the taxpayer had agreed to accept in exchange for the debt).
                                           -67-

that petitioner could have obtained more cruzados at the parallel

market rate than at the official rate, the Central Bank required

that the conversion take place at the official exchange rate.

This was not a penalty; it was a requirement of engaging in the

debt-equity     conversion.           As    part     of    the    conversion      terms,

petitioner agreed that blocked deposits would be converted into

cruzados   at   the       official     exchange      rate    on     April   14,    1987.

Petitioner also agreed, as part of the Purchase Agreement, that it

would pay IFC, in exchange for the PCC stock, the cruzados

equivalent of $12.5 million, without any deduction, setoff, or

withholding whatsoever, obtained by converting Brazilian blocked

deposits   into      cruzados    at     the       official    exchange      rate.     IFC

acknowledged receipt of this cruzado payment and the fact that it

was the equivalent of $12.5 million at the official exchange rate

on April 14, 1987. Thus, we reject Dr. Froot's recommendation of

a   discount    on    account     of       the    official       and   parallel     rate

differentials        as    an   after-the-fact            attempt      to   revalue     a

transaction contrary to its agreed-upon terms.

     Moreover, investments made in Brazil at the official exchange

rate were entitled to the benefits of registered foreign capital

status; investments made at the parallel rate were not.                        In this

sense, the Cz$295,200,000 that petitioner obtained by converting

its blocked deposits could easily have the same, if not greater,
                                        -68-

value    than    an   identical    amount      of   cruzados   obtained      on   the

parallel market for fewer U.S. dollars.

        Finally, we agree with Dr. Cline that no discount should be

applied for the possible elimination of the official rate premium

at the end of the 12-year waiting period.              Foreign investors, such

as   petitioner,      who   received    dividends      from    their    registered

investments would continue to receive the benefits of a favorable

cruzado-to-dollar exchange rate during the years that the official

rate premium was shrinking.          Dr. Cline believed that a narrowing

of the spread between the official and parallel market rates would

likely be       accompanied   by   an    overall     improvement       in   economic

conditions, which would have a positive impact on the value of

equity investments.         In this regard, Dr. Cline testified that he

would forgo a 25-percent exchange rate premium for a 100-percent

increase in the value of his investment.

        Determining an appropriate discount rate with mathematical

precision is impossible.           "Valuation is * * * necessarily an

approximation * * *.         It is not necessary that the value arrived

at * * * be a figure as to which there is specific testimony, if

it is within the range of figures that may properly be deduced

from the evidence."         Anderson v. Commissioner, 250 F.2d 242, 249

(5th Cir. 1957), affg. in part and remanding in part T.C. Memo.

1956-178; see also Estate of Barudin v. Commissioner, T.C. Memo.
                                         -69-

1996-395.        While we find Dr. Cline's analysis generally sound,

based    on   all     of   the    evidence      before   us,   we   believe,   and

accordingly       hold,    that   the    12-year    repatriation     restriction

warrants a 15-percent discount, rendering a $1,886,570 loss for

petitioner's 1987 tax year.

Issue III.       Allocation of Purchase Price

     The final issue concerns the value of a lease portfolio

petitioner acquired from Financial Investment Associates, Inc.

(FIA). In this regard, we must determine whether any portion of

the $141,456,620 petitioner paid in 1989 to acquire the assets of

FIA should be attributed to goodwill, going-concern value, or

other nonamortizable intangible assets.              Petitioner contends that

none of the $141,456,620 it paid for FIA's assets should be

allocated        to    goodwill,        going-concern      value,     or   other

nonamortizable intangible assets. Respondent, on the other hand,

contends that $1,328,618 of the $141,456,620 should be allocated

to nonamortizable intangible assets.

        A. FIA

     FIA, a medical equipment leasing company, was founded by Fred

Rafanello in 1977. At FIA's incorporation, Mr. Rafanello was its

sole owner, president, and chief executive officer (CEO). FIA's

principal executive offices were located in Northfield, Illinois.
                                      -70-

FIA specialized in the leveraged purchase and leasing of high-tech

diagnostic medical equipment to hospitals and clinics.

      FIA's leases typically ran for 60 months, which was less than

the estimated useful life of the leased equipment.               FIA financed

its equipment purchases using a combination of debt and equity.

Debt (which generally represented approximately 90 percent of the

cost of equipment) was typically in the form of a 60-month,

nonrecourse     loan    from   a   money-center   bank.      Prior     to   FIA's

acquisition by Commercial Federal Corp., discussed infra, FIA

obtained     equity    financing     from    syndications,40    assembled     by

investment bankers.

      FIA customarily received an up-front fee or commission from

the syndications, out of which the investment bankers received

their fee.     At the expiration of the lease term, the debt incurred

to   acquire   the     equipment    being    leased   was   retired,    and   the

syndications' investors owned the equipment outright.

      High-tech medical diagnostic equipment, particularly of the

type leased by FIA, tends to have higher residual values than most

other kinds of leased equipment. FIA projected the residual value

of the equipment it leased to be in the range of 20 to 35 percent




      40
          FIA was a general partner in the syndications and
received additional remuneration by sharing in the residual value
of the leased equipment with the syndications' investors.
                                  -71-

of the equipment's cost. But, in fact, the equipment's residual

values generally exceeded the amounts projected.41

     FIA converted the equipment's residual value into cash at the

end of the lease in a number of ways:           Sale or renewal of the

lease to the original lessee; sale or lease to another, generally

smaller, hospital; or return of the equipment to the manufacturer

as a trade-in. FIA's experience was that 85 to 90 percent of the

equipment was purchased or released by the original lessee.             In

this regard, approximately 70 to 80 percent of the leases were

renewed, which was more profitable for FIA than a sale of the

equipment to the original lessee or a sale or lease to another

hospital.

     The amount of revenue that FIA could earn after the lease

expiration   depended   largely   on     the   residual   value   of   the

equipment.   The residual value of the equipment was the source for

over two-thirds of FIA's cash-flow before expenses and represented

the principal source of FIA's profit.            Thus, the equipment's

residual value was the key to FIA's business.

     B. Federal's Acquisition of FIA

     Commercial Federal Corp. (Federal), the holding company of

Commercial Federal Savings & Loan Association (CFSLA), was one of



     41
          Through Dec. 31, 1987, FIA achieved gains of 29 percent
over book residual values.
                                -72-

the largest retail financial institutions in the Midwest. On

November 7, 1986, Federal, through another of its subsidiaries,

Commercial   Federal   Investment   Associates,   Inc.   (Commercial),

acquired all of FIA's outstanding stock from Mr. Rafanello. The

purchase price, approximately $5.3 million, included a 25-percent

premium over FIA's book value.42

     After the acquisition, FIA operated its business affairs with

no significant changes.    Mr. Rafanello remained FIA's president

and CEO. At this time, FIA had 70 to 75 employees and financed $50

million of new equipment leases per year.43

     Federal became FIA's source of equity financing, making funds

available in the form of short-term intercompany loans.       FIA had

a $40 million line of credit with CFSLA, which it used to obtain

funds for the purchase of equipment.    Loans made under this credit

line were secured by the equipment and the lease revenues.

     FIA achieved higher residual values after its acquisition by

Federal than prior to the acquisition.

     C. Petitioner's Acquisition of FIA

     On December 29, 1988, Norwest Leasing, Inc. (NLI), one of

petitioner's affiliates, made an exploratory proposal to purchase


     42
          Mr. Rafanello testified that the 25-percent premium was
paid for FIA's intangible assets.
     43
          By 1988, FIA financed more than $100 million of new
equipment leases.
                               -73-

FIA's assets.   The proposal contemplated a purchase price premium

of $2 to $5 million above FIA's net asset value44 which, at the

time, was approximately $17.5 million. The proposal also stated

that NLI would pay FIA's $15 million intercompany debt to Federal.

     By early February 1989, petitioner had decided it was willing

to pay only a $1 million premium above book value for FIA's

assets.     Petitioner thereafter negotiated an additional price

reduction of $400,000 due to fluctuations in the bond market

(which increased the cost of funding the acquisition).

     Finally, on March 31, 1989, Norwest Financial Resources

(NFR), another of petitioner's affiliates, entered into a purchase

agreement (the March Agreement) with FIA and Commercial in which

it agreed to acquire substantially all of FIA's receivables and

assets.45   NFR specifically agreed to acquire FIA's approximately


     44
          The term "net asset value" refers to the book value or
stockholders' equity of a company that appears on its balance
sheet. Net asset value is a reference for determining how much a
potential buyer might be willing to pay for assets on a going-
concern basis.
     45
          The March Agreement defines "Receivables" and "Assets"
as follows:

     The term "Receivables" shall mean the operating leases
     and the underlying equipment or other property subject
     to such operating leases owned by the Company on the
     Closing Date; the leasing receivables (including
     leases, fair market value leases and direct finance
     leases), conditional sale contracts, secured loans and
     other commercial finance receivables of the Company on
                                                  (continued...)
                               -74-

$100 million worth of equipment held under operating leases and

leasing, and other commercial finance receivables, and to assume

the    nonrecourse   indebtedness     and   other   liabilities   of

approximately $52 million to which such assets were subject.      The

acquired assets represented over 98 percent of FIA's total assets.



      45
       (...continued)
      the Closing Date; and any instruments or collateral
      securing the same and any equipment or property leased
      or otherwise financed and files and other records owned
      or in the possession of the Company or any of its
      affiliates relating thereto. Such receivables shall
      include (but not be limited to) all lease agreements,
      conditional sale contracts, notes, evidences of
      indebtedness, personal guarantees, corporate
      guarantees, letters of credit and other documents
      representing or backing up such receivables.
      Receivables shall not, in any event, include Excluded
      Assets.

      The term "Assets" shall mean the Receivables; equipment
      or other property held in inventory for future sale or
      lease; all furniture, fixtures, equipment and the
      Company's rights in leasehold improvements; leasing and
      lending transactions in process for prospective lessees
      or borrowers and the related files, applications and
      other documentation; the Company's general partnership
      interests in partnerships and co-ownership interests in
      participation or like arrangements, its rights to
      receive fees, distributions and other revenues
      therefrom in the future, and any rights it has under
      management or supplier agreements related thereto; and
      any other assets owned by the Company on the Closing
      Date, other than Excluded Assets.

     The "Excluded Assets" that NFR did not acquire consisted
solely of notes receivable and any other amounts due FIA from its
affiliates and other related parties as of the closing date. As
of Dec. 31, 1988, notes receivable were $192,708, and amounts due
FIA from its affiliates or other related parties were $540,520.
                                     -75-

The March Agreement included the following provision with regard

to goodwill (the goodwill provision):

                   It is understood that there is no good
             will [sic] or similar intangible assets
             included in the purchase and sale covered by
             this Agreement and that no part of the purchase
             price shall be attributed or allocated in any
             way to good will [sic].

      In addition, the March Agreement allowed NFR to designate an

affiliate (or affiliates) to complete the purchase. NFR designated

NLI   and    Dial   Bank   (Dial),   NFR's   State   banking   subsidiary.

Consequently, on June 12, 1989, NLI and Dial completed the purchase

from FIA and Commercial in an arm's-length transaction.46         NLI and

Dial paid $77,952,168 and $63,504,452, respectively, for a total

purchase price of $141,456,620.       The purchase price was calculated

as follows:

             Stockholder's equity (based on historical balance sheet
               values, before purchase accounting adjustments)
 -           Excluded assets
 +           FIA notes payable to Commercial or its affiliates
 +           Income taxes (as shown on historical balance sheet)
 +           Other liabilities NFR did not specifically assume
 +          $390,000 ($100,000 for use of trade name and $290,000 for
               noncompete agreement)
             ___________________________________________________
  =          Total purchase price per purchase agreement




      46
          While NFR actually entered into the March Agreement and
designated NLI and Dial to complete the purchase, these entities
were affiliates of petitioner, and for convenience we sometimes
refer to petitioner as the purchaser of FIA's assets.
                                          -76-

Petitioner paid $100,000 in consideration for the right of NFR (or

its affiliates) to use the FIA name (or any similar name) for a

period of 5 years, and $290,000 for a covenant not to compete by

FIA and Commercial, also for a period of 5 years.                    Pursuant to an

agreement separate from the March Agreement, petitioner made a

$210,000    payment     to     Mr.   Rafanello    in     consideration       for    his

agreement not to compete for a period of 3 years.47

     Moreover, petitioner was given the opportunity to employ some

of FIA's marketing staff and equipment experts, many of whom had 15

or more years of experience in the medical equipment leasing

industry.    As of June 8, 1989, 23 of FIA's 65 employees became NLI

employees. (Mr. Rafanello did not become an employee of NLI or any

of its affiliates after the acquisition.)

     Petitioner        intended      to   fund   the   acquisition      by   issuing

commercial paper. Funds so obtained were to be transferred by

petitioner to NLI as intercompany debt and to Dial as a combination

of debt and shareholder equity.              Petitioner calculated that the

lease revenues would provide a 15-percent rate of return on the

amount petitioner provided to Dial as shareholders' equity, plus a

profit    from   the    cost    of   money   it   lent    to   NLI    and    Dial   as

intercompany debt.        Petitioner expected the overall yield on the


     47
          Any amortization deductions petitioner claimed with
respect to the $100,000, the $290,000, and the $210,000 are not
in dispute.
                               -77-

FIA leases to be 11.49 percent annually. The purchase price set

forth in the March Agreement was subject to reduction in the event

that the yield on the leases, computed as of February 28, 1989, was

less than 11.49 percent.   The purchase price was to be reduced by

the amount needed to produce an 11.49-percent yield.48   However, no

purchase price adjustments were subsequently needed.

     D. Petitioner's 1989 Return

     On its 1989 return, petitioner allocated $131,513,038 of the

$141,456,620 it paid for FIA's assets to the lease portfolio. None

of the purchase price was allocated to goodwill.         The present

dispute centers around the correctness of petitioner's allocation.

     E. Notice of Deficiency

     Respondent determined that petitioner overstated the fair

market value of (and thus its basis in) the lease portfolio by

$1,328,618, which respondent determined should be allocated to

goodwill, going-concern value, or other nonamortizable intangible

assets.




     48
          The required yield of 11.49 percent meant that lease
rents, plus book residual values, less nonrecourse debt payments,
when discounted to present value of 11.49 percent, had to equal
$39,788,569. If the discounted present value using 11.49 percent
was less than $39,788,569, the purchase price was to be reduced
by the amount of the difference.
                                           -78-

                                      Discussion



       Preliminarily,      we     note     that   we    are   not   bound     by   the

representation      made     in      the   goodwill    provision    of   the   March

Agreement, namely, that petitioner did not acquire any goodwill in

its purchase of FIA's assets.                 It is well established that the

substance of a transaction, rather than its form, governs the tax

consequences. Garcia v. Commissioner, 80 T.C. 491, 498 (1983)

(citing Commissioner v. Court Holding Co., 324 U.S. 331 (1945));

see also Gregory v. Helvering, 293 U.S. 465 (1935); Golsen v.

Commissioner, 54 T.C. 742, 754 (1970), affd. 445 F.2d 985 (10th

Cir. 1971).

       F. Residual Value

       The parties agree that the residual value method under section

1060     is    appropriate      in     this    case.      Under     section    1060,

consideration is allocated to four classes of assets in descending

order of priority: Class I (e.g., cash and demand deposits); class

II (e.g., certificates of deposit, Federal securities, readily

marketable stock and securities, and foreign currency); class III

(e.g.,    accounts    receivable,          equipment,     buildings,     land,     and

covenants not to compete); and class IV (goodwill and going-concern

value).       Sec. 1.1060-1T(a)(1), (b)(1), (d), Temporary Income Tax
                                    -79-

Regs., 53 Fed. Reg. 27039-27040 (July 18, 1988).49           After being

reduced by the amount of class I assets, consideration is allocated

among assets in class II in proportion to the fair market values of

such assets on the purchase date, then among class III assets in

proportion to the fair market values of such assets on that date.

Sec. 1.1060-1T(d)(2), Temporary Income Tax Regs., supra.               The

amount of consideration so attributed to an asset in classes I

through III may not exceed the fair market value of the asset on

the   purchase   date.    All   remaining   consideration,   or   residual

consideration, must be allocated to class IV assets. See, e.g.,

East Ford, Inc. v. Commissioner, T.C. Memo. 1994-261.

      Petitioner did not allocate any portion of the purchase price

to class IV assets. If we determine that petitioner overvalued the

FIA lease portfolio on its 1989 tax return, then the difference

between the fair market of the lease portfolio and the purchase

price must be allocated to class IV assets.

      Petitioner claims it neither acquired a trade or business when

it purchased FIA's assets, nor paid a premium for FIA's assets, nor

acquired goodwill.       Respondent, on the other hand, contends that




      49
          This temporary regulation was amended on Jan. 16, 1997.
See 62 Fed. Reg. 2267 (Jan. 16, 1997). Because the amended
regulation is effective for asset acquisitions completed on or
after Feb. 14, 1997, it is inapplicable herein.
                                    -80-

petitioner acquired a trade or business,50 paid a premium, and

acquired goodwill. The parties presented expert witnesses to value

the lease portfolio and thereby determine whether petitioner paid

for any goodwill or going-concern value when it purchased FIA's

assets.

     G. Expert Witnesses

     As the trier of fact, we must weigh the evidence presented by

the experts in light of their demonstrated qualifications in

addition to all other credible evidence.             Estate of Christ v.

Commissioner, 480 F.2d 171, 174 (9th Cir. 1973), affg. 54 T.C. 493

(1970).   However, we are not bound by the opinion of any expert

witness when that opinion is contrary to our judgment.             Estate of

Kreis v. Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg.

T.C. Memo. 1954-139; Chiu v. Commissioner, 84 T.C. 722, 734 (1985).

We may accept or reject expert testimony as we find appropriate in

our best judgment.      Helvering v. National Grocery Co., 304 U.S.

282, 294-295    (1938);   Seagate    Tech.,   Inc.   &   Consol.   Subs.   v.

Commissioner, 102 T.C. 149, 186 (1994).

     Petitioner claims that the value of the lease portfolio is

$134,383,364,   while     respondent   contends      that   the    value   is


     50
          Respondent points to the fact that in its Application
to the Board of Governors of the Federal Reserve System,
petitioner sought approval "to acquire substantially all of the
assets and assume substantially all of the liabilities (to
unrelated parties) of a going concern". (Emphasis added.)
                                 -81-

$130,184,420.      The $4,198,944 difference between the parties'

valuations is explained by the different discount rates used by

their experts (respondent's expert used a 15.6-percent discount

rate, while petitioner's expert used an 11.5-percent discount

rate).

           1. Petitioner's Expert

     Petitioner's expert, Peter S. Huck, of American Appraisal

Associates, has an M.B.A. from Marquette University and is a senior

member of the American Society of Appraisers. He wrote a direct

report and testified regarding the fair market value of FIA's lease

portfolio.51    Using the discounted cash-flow method, he determined

a $134,383,364 value for the FIA lease portfolio on June 12, 1989,

by taking the sum of scheduled lease payments and book residual

values, less third-party debt service payments, and then discounted

the final amount to present value using an 11.5-percent rate.52   To

the result of that calculation, $45,460,848, Mr. Huck added the

principal balance of the debt associated with the leases, for a


      51
          At trial, Mr. Huck acknowledged that the transaction
herein involved a lease portfolio but "included a business--
aspects of a business."
      52
          In selecting an 11.5-percent discount rate, Mr. Huck
relied upon the following: (1) The Annual Percentage Rate (APR)
on FIA lease transactions for the first and second half of 1989;
(2) the relationship between the leases' APR and 5-year
Government bonds; (3) the 11.49-percent yield specified in the
March Agreement; and (4) the rates used in other lease
transactions in the marketplace at the time of the transaction.
                                  -82-

total value of $134,383,364.53      Mr. Huck testified that the 11.5-

percent discount rate he determined was based on the "receivable

yield amount" or "receivable yield". In his view, the 11.5-percent

discount rate is consistent with the 11.49-percent yield on the

leases discussed in the March Agreement.

     Mr.   Huck   based   his   analysis   on   financing   for   the   net

receivables with both debt and equity.          He concluded that, under

the residual method, the purchase price ($141,456,620) was less

than the sum of the fair market value of the lease receivables and

the other tangible assets acquired ($144,343,582), and hence no

portion of the purchase price should be allocated to goodwill or

going-concern value.

           2. Respondent's Expert

     Respondent's expert, David N. Fuller, of Business Valuation

Services, Inc., has an M.B.A. from Southern Methodist University.

He is a chartered financial analyst and an accredited senior

appraiser certified by the American Society of Appraisers. Mr.

Fuller wrote a rebuttal report54 and testified regarding the fair


     53
          Mr. Huck initially made a mathematical error of
approximately $700,000 (with regard to cash inflow) but
subsequently corrected the error.
     54
          Mr. Fuller only prepared a rebuttal report because he
believed the information petitioner provided contained
insufficient and questionable data to determine a precise value
for the lease portfolio. Based on the record, we believe the
                                                  (continued...)
                                    -83-

market value of the FIA lease portfolio.        He determined that the

fair market value of FIA's lease portfolio, as of June 12, 1989,

did not exceed $130,184,42055 ($4,198,944 less than Mr. Huck's

valuation).   Consequently, Mr. Fuller attributed $1,328,618 of the

purchase price to goodwill.     Mr. Fuller arrived at the value for

the lease portfolio through his "sensitivity" analysis by applying

a 15.6-percent rate to discount the same cash-flow Mr. Huck used

(lease payments plus book residual values less nonrecourse debt

service payments). The 15.6-percent rate represented the cost of

equity capital, which Mr. Fuller computed using the capital asset

pricing model. This analysis was based on the assumption that, with

regard to a hypothetical buyer, the portion of the lease portfolio

not financed by nonrecourse debt would be financed entirely by

equity.

     Mr.   Fuller   opined   that    his   15.6-percent   rate   compares

favorably with the 15-percent rate of return on equity that FIA


     54
      (...continued)
information provided to both experts may have been, to a certain
extent, unreliable.
      55
           Mr. Fuller believed that the value of FIA's lease
portfolio could be less than $130,184,420 but was unable to
refine this belief due to lack of data (as discussed supra note
54). His value of $130,184,420 for the FIA lease portfolio, when
added to the agreed value of $9,943,582 for FIA's other assets
acquired by petitioner (the noncompete agreement with FIA and
Commercial, the license to use the FIA name, and the other
assets) totals $140,128,002, or $1,328,618 less than the purchase
price.
                                      -84-

generally exceeded (both before and after its acquisition by

Federal)    and    the   15-percent    rate    of   return   on    equity   that

petitioner projected its proposed acquisition of FIA would produce.

        In sum, Mr. Fuller testified that Mr. Huck overvalued FIA's

lease portfolio by approximately $4 to $5 million, which results in

approximately $1.2 to $2.2 million in intangible assets.

            3. Critique of Experts

     Not    unexpectedly,    each     expert   criticized    his     colleague's

analysis.    The     following      points     highlight     these    disparate

perspectives.

     Mr. Fuller opined that Mr. Huck simply used the portfolio's

expected yield (the rate at which petitioner expected the portfolio

to earn income) as the appropriate discount rate. Use of the

portfolio's expected yield, he insisted, assumes that no other

assets are necessary to realize that yield and treats the portfolio

as the equivalent of a fixed-income instrument.              According to Mr.

Fuller, Mr. Huck ignored the fact that petitioner purchased a going

concern; the purchase included the FIA portfolio in addition to

other FIA assets, and the right to hire FIA's expert personnel (who

originated the equipment leases and turned the residual value into

profits). The presence of these other business assets, in Mr.

Fuller's opinion, was necessary to produce income at the yield

rate.    Mr. Fuller contended that the 11.49-percent yield required
                                   -85-

by the March Agreement, while providing a mechanism for a downward

adjustment   to   the   purchase   price,   was   not   indicative   of   the

appropriate discount rate.

     Mr. Huck countered these arguments by reiterating that he did

not simply rely on the expected yield rate but used several factors

(enumerated supra note 52) to reach his conclusion. These factors,

he believed, clearly indicate that an 11.5-percent discount rate

represents the current market rate for comparable assets.

     Mr. Fuller also believed that instead of using a cash inflow

analysis, Mr. Huck should have used a cash-flow analysis (referring

to the net cash-flow generated after considering all expenses and

necessary adjustments). And, according to Mr. Fuller, Mr. Huck

erred by not using the capital asset pricing model to determine the

appropriate discount rate to be applied to cash-flow attributable

to invested capital.56    Finally, Mr. Fuller criticized Mr. Huck for

failing to include capital charges in his analysis.57


     56
          Mr. Huck testified that he did not use the capital
asset pricing model because he considered it inappropriate
herein.
     57
          Mr. Fuller testified that the premise of a capital
charge is that other assets besides the asset being valued (such
as the lease portfolio herein) are necessary to produce the
business cash-flow. Capital charges take into account the
presence of these other assets by assigning a portion of the
cash-flow to them, leaving only the cash-flow attributable to the
asset being valued. Mr. Fuller did not take this approach in his
report (which would have had the effect of reducing the value of
                                                  (continued...)
                                  -86-

     Mr. Huck criticized Mr. Fuller's rebuttal report, claiming:

(1) Rather than doing an independent valuation, Mr. Fuller merely

used Mr. Huck's analysis and applied an incorrect discount rate

(equity rate of return) to those numbers; (2) Mr. Fuller did not

consider recourse debt in determining cash-flow, but rather assumed

that any portion of the purchase price not funded with nonrecourse

debt would be funded with equity; and (3) a typical buyer of the

lease portfolio would finance its acquisition with a combination of

nonrecourse   debt,   recourse   debt,   and   equity.   While   Mr.   Huck

discounted "gross" cash-flows (net only of nonrecourse debt) based

on the market rate for such assets (which reflected the required

blended cost of capital), Mr. Fuller discounted the same cash-flows

using an equity rate.    These cash-flows did not consider recourse

debt service, operating expenses, and taxes.         Because Mr. Fuller

did not apply his equity rate against equity cash-flows, Mr. Huck

believes that Mr. Fuller's analysis is seriously flawed. Simply

put, Mr. Huck claims that Mr. Fuller used an equity rate for

purposes of discounting the lease portfolio's cash-flows, whereas

those cash-flows included a return on debt.         In Mr. Huck's view,

Mr. Fuller should have based his discount rate on the market

receivable yield which accounts for the expected debt leveraging.


     57
      (...continued)
the portfolio below $130,184,420) because he did not believe he
had sufficient information to do so.
                                     -87-

     Mr. Fuller acknowledged at trial that normally a purchaser

would not finance the acquisition of a lease portfolio with 100

percent equity.       He admitted that if a mixture of debt and equity

were used, he would be forced to lower the 15.6-percent discount

rate he had determined.        However, Mr. Fuller believed that the net

cash-flow from FIA's lease portfolio is, for the most part, an

equity cash-flow to the holder of the net equity investment in the

portfolio, which requires an equity rate of return to properly

discount it to present value.

        Finally, petitioner criticized Mr. Fuller's use of the 25-

percent premium Commercial paid in 1986 as another basis for

determining    the     value   of   FIA's   intangible     assets    in   1989.

Petitioner    first    complains    that    Mr.   Fuller   ignored   industry

practice, which is intended to reflect the negotiated value of

intangible assets as an amount over and above net asset value.             And

second, petitioner maintains, circumstances were different in 1986

and 1989 because when Commercial purchased FIA in 1986, it acquired

the services of Mr. Rafanello, FIA's most important employee,

whereas petitioner did not acquire Mr. Rafanello's services in

1989.

     H. Conclusion

     We have considered the qualifications and experience of the

parties' experts, as well as the substance and reasoning of their

reports.     The difference in their respective valuations of FIA's
                                    -88-

leasehold portfolio is explained by the different discount rates

they used (15.6 percent by respondent's expert, Mr. Fuller; 11.5

percent by petitioner's expert, Mr. Huck).              As discussed above,

both expert reports are susceptible to criticism.             While we find

Mr. Huck's analysis generally sound,         Mr. Fuller established that

Mr. Huck's 11.5-percent discount rate should be adjusted upward.

Both    experts    admitted   at   trial    the    inexactitude     of   their

methodologies:     Mr. Huck conceded that, in light of the imprecise

nature of valuing assets, the appropriate discount rate herein

could be anywhere from 11.5 to 13 percent; and Mr. Fuller conceded

that his 15.6-percent discount rate could be reduced somewhat to

properly reflect debt and equity financing. Thus, in consideration

of all the evidence presented, and in light of both experts'

forthright flexibility, we adopt 13 percent as the appropriate

discount rate herein.58

       Because    other   issues   remain   to     be   resolved    in   these

consolidated cases,


                                                        Appropriate orders

                                                  will be issued.




       58
          We expect the parties' Rule 155 computations to utilize
the 13-percent discount rate to determine the exact value of the
lease portfolio and any remaining value to be attributed to
goodwill or going-concern value. We expect the parties to
correct, in their Rule 155 computations, any overstatement of
cash inflows and mathematical errors Mr. Huck made.
