                       T.C. Memo. 1996-455



                    UNITED STATES TAX COURT




           MEDIEVAL ATTRACTIONS N.V.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 20532-91,   20533-91,   Filed October 9, 1996.
                 20534-91,   20535-91,
                 20537-91,   20538-91,
                 15975-92,   16122-92,
                  8587-93,    8923-93.



     Lawrence L. Hoenig, Stephen J. Martin, Lisa F. Cetlin,

A. Keller Young, and David I. Bass, for petitioners.



     1
      Cases of the following petitioners are consolidated
herewith: Medieval Attractions B.V., Successor in Interest to
Medieval Attractions N.V., docket No. 20533-91; Medieval Dinner &
Tournaments, Inc., Successor in Interest to Medieval Attractions
N.V., docket No. 20534-91; Medieval Attractions N.V., docket No.
20535-91; Medieval Attractions B.V., Successor in Interest to
Medieval Attractions N.V., docket No. 20537-91; Medieval Dinner &
Tournament, Inc., Successor in Interest to Medieval Attractions
N.V., docket No. 20538-91; Medieval Show, Inc., docket No.
15975-92; Medieval Show, Inc., docket No. 16122-92; Medieval
Dinner & Tournament, Inc., docket No. 8587-93; and Medieval
Dinner & Tournament, Inc., docket No. 8923-93.
                                    - 2 -

     Howard P. Levine, Benjamin A. deLuna, Kim A. Palmerino, and

Robert F. Conte, for respondent.

                           Table of Contents

FINDINGS OF FACT    . . . . . . . . . . . . . . . . . . . . . .                                      8

   I.   Background . . . . . . . . . . . . . . . . . . . . . .                                       9

  II.   Expansion to the United States . . . . . . . . . . . .                                      11
        A. Florida--Personnel and Pre-1986
              Corporate Structure . . . . . . . . . . . . . .                                       11
        B. California--Personnel and Pre-1986
              Corporate Structure . . . . . . . . . . . . . .                                       20

 III.   Continued Development       . . . . . . . . . . . . . . . .                                 25

  IV.   Contracts   . . . . . . . . . . . . . . . . . . . . . .                                     28

   V.   Coopers & Lybrand Planning and
          Petitioners' Documentation . . . . . . . . . . . . .                                      29

  VI.   Trademarks and Copyrights           . . . . . . . . . . . . . .                             52

 VII.   Section 351 Transfers       . . . . . . . . . . . . . . . .                                 54

VIII.   California and   New   Jersey Expansion                 .   .   .   .   .   .   .   .   .   59
        A. California    . .   . . . . . . . . .                .   .   .   .   .   .   .   .   .   59
        B. New Jersey    . .   . . . . . . . . .                .   .   .   .   .   .   .   .   .   60
        C. C&L Advice    . .   . . . . . . . . .                .   .   .   .   .   .   .   .   .   61

  IX.   Dividends   . . . . . . . . . . . . . . . . . . . . . .                                     64

   X.   Marketing Agreement     . . . . . . . . . . . . . . . . .                                   66

  XI.   Commercial Paper . . . . . . . . . . . . . . . . . . .                                      67

 XII.   Royalty Transactions Relied Upon in
          Federal Tax Returns . . . . . . . . . . . . . . . .                                       74

XIII.   Federal Tax Returns     .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   75
        A. MTNV/MSI . . . .     .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   75
        B. MANV/MDT . . . .     .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   78
        C. Eurotor . . . .      .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   80

 XIV.   Certified Audit    . . . . . . . . . . . . . . . . . . .                                    80

  XV.   IRS Audit   . . . . . . . . . . . . . . . . . . . . . .                                     81
                               - 3 -

OPINION    . . . . . . . . . . . . . . . . . . . . . . . . . .      83

   I.   Management and Consulting Fees . . . . . . . . . . .   .    83
        A. Eurotor . . . . . . . . . . . . . . . . . . . .     .    86
            1. Services . . . . . . . . . . . . . . . . . .    .    86
            2. Compensation in Proportion to Stockholdings     .    87
        B. Royal Catering . . . . . . . . . . . . . . . . .    .    92
        C. A. Gelabert, Santandreu, and Segui . . . . . . .    .    93

  II.   Franchise Transactions and Royalty Fees    . . . . . . .    95

 III.   Interest Expense and Guarantee Fees Resulting
          From Lump-Sum Franchise Payments . . . . . . . . . . 111

  IV.   Interest Deductions on the
          Section 351 Transactions . . . . . . . . . . . . . . 121

   V.   The $236,313 That MDT Paid to
          MSI as a Marketing Fee . . . . . . . . . . . . . . . 128

  VI.   New Jersey and California Expansion Expenses . . . . . 129

 VII.   Additions to Tax and Penalties   for
          Fraud and Negligence . . . .   . . . . . . . . . . . . 131
        A. Fraud . . . . . . . . . .     . . . . . . . . . . . . 131
        B. Negligence . . . . . . . .    . . . . . . . . . . . . 137

VIII.   Substantial Understatement and Increased Interest . . 142
        A. Substantial Understatement . . . . . . . . . . . . 142
        B. Increased Interest . . . . . . . . . . . . . . . . 143

  IX.   Withholding of Tax at the Source . . . . . . . . . . .     144
        A. Interest That MDT and MSI
              Paid to MABV and MTBV, Respectively . . . . . .      146
        B. Franchise Fees That Were Paid by MANV to Manver in
              Fiscal Year Ended November 30, 1987 . . . . . .      147
        C. MDT and MSI Payments to Manver in March 1988 . . .      148
        D. Amounts That MANV, MSI, and MDT Paid to Eurotor as
              Management and Consulting Fees . . . . . . . . .     149
        E. Guarantee Fees Paid to Dapy and
              Roundabout in Connection With the
              Commercial Paper Transactions . . . . . . . . .      150

   X.   Failure To Deposit Withholding Tax . . . . . . . . . . 151
                                                     - 4 -

                             Table of Entity Abbreviations

ANZ . . . .      .   .   .   .   .   .   .   .   .   Australia and New Zealand Bank
Amsrott . .      .   .   .   .   .   .   .   .   .   Amsrott, N.V.
Attractours      .   .   .   .   .   .   .   .   .   Attractours, N.V.
C&L . . . .      .   .   .   .   .   .   .   .   .   Coopers & Lybrand
CANV . . . .     .   .   .   .   .   .   .   .   .   Corporate Agents, N.V.
Calinvest .      .   .   .   .   .   .   .   .   .   Calinvest, N.V.
Celin . . .      .   .   .   .   .   .   .   .   .   Celin, N.V.
Dapy . . . .     .   .   .   .   .   .   .   .   .   Dapy, N.V.
Edemle . . .     .   .   .   .   .   .   .   .   .   Edemle, N.V.
Estaspan . .     .   .   .   .   .   .   .   .   .   Estaspan, Ltd.
Etano . . .      .   .   .   .   .   .   .   .   .   Etano, N.V.
Eurotor . .      .   .   .   .   .   .   .   .   .   Europea de Espectaculos,
                                                       Cenas y Torneo Medievales, S.A.
Futureprom   .   .   .   .   .   .   .   .   .   .   Futureprom, N.V.
GCI . . .    .   .   .   .   .   .   .   .   .   .   Glendale Castle, Inc.
Gatetown .   .   .   .   .   .   .   .   .   .   .   Gatetown Limited
Harris . .   .   .   .   .   .   .   .   .   .   .   Harris, Lippman & Co.
Holiday .    .   .   .   .   .   .   .   .   .   .   Holiday Tours, N.V.
Inverspan    .   .   .   .   .   .   .   .   .   .   Inverspan, N.V.
KDS . . .    .   .   .   .   .   .   .   .   .   .   Kingdom of Dancing Stallions
LL . . . .   .   .   .   .   .   .   .   .   .   .   Lyon & Lyon
Lebasi . .   .   .   .   .   .   .   .   .   .   .   Lebasi, N.V.
Lince . .    .   .   .   .   .   .   .   .   .   .   Lince, N.V.
MABV . . .   .   .   .   .   .   .   .   .   .   .   Medieval Attractions, B.V.
MANV . . .   .   .   .   .   .   .   .   .   .   .   Medieval Attractions, N.V.
MCI . . .    .   .   .   .   .   .   .   .   .   .   Meadowland Castle Inc.
MDT . . .    .   .   .   .   .   .   .   .   .   .   Medieval Dinner & Tournament, Inc.
MICV . . .   .   .   .   .   .   .   .   .   .   .   Manver International, C.V.
MSI . . .    .   .   .   .   .   .   .   .   .   .   Medieval Show, Inc.
MTBV . . .   .   .   .   .   .   .   .   .   .   .   Medieval Times, B.V.
MTNV . . .   .   .   .   .   .   .   .   .   .   .   Medieval Times, N.V.
Manver . .   .   .   .   .   .   .   .   .   .   .   Manver, N.V.
NCB . . .    .   .   .   .   .   .   .   .   .   .   National Community Bank
Primavert    .   .   .   .   .   .   .   .   .   .   Primavert, N.V.
Promidux .   .   .   .   .   .   .   .   .   .   .   Promidux, N.V.
Protravol    .   .   .   .   .   .   .   .   .   .   Protravol Limited
RC . . . .   .   .   .   .   .   .   .   .   .   .   Royal Catering, Inc.
Roundabout   .   .   .   .   .   .   .   .   .   .   Roundabout Tours, N.V.
SDCI . . .   .   .   .   .   .   .   .   .   .   .   San Diego Castle, Inc.
Slider . .   .   .   .   .   .   .   .   .   .   .   Slider, N.V.
Spectrust    .   .   .   .   .   .   .   .   .   .   Spectrust, N.V.
TM . . . .   .   .   .   .   .   .   .   .   .   .   Torneo Medieval, S.A.
Wayout . .   .   .   .   .   .   .   .   .   .   .   Wayout Tours, N.V.
                                - 5 -


              MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Chief Judge:    Respondent determined deficiencies and

additions to tax and penalties in petitioners’ Federal income

taxes as follows:

                         Docket No. 20532-91

Tax                                 Additions to Tax
Year                     Sec.            Sec.               Sec.
Ended       Deficiency   6653(a)(1)(A)   6653(a)(1)(B)      6661

11/30/87     $929,752       $46,488      50% of           $185,950
                                         interest due
                                         on $929,752

                         Docket No. 20533-91

Tax                                 Additions to Tax
Year                     Sec.            Sec.               Sec.
Ended       Deficiency   6653(a)(1)(A)   6653(a)(1)(B)      6661

11/30/87     $929,752       $46,488      50% of           $185,950
                                         interest due
                                         on $929,752

                         Docket No. 20534-91

Tax                                 Additions to Tax
Year                     Sec.            Sec.               Sec.
Ended       Deficiency   6653(a)(1)(A)   6653(a)(1)(B)      6661

11/30/87     $929,752       $46,488      50% of           $185,950
                                         interest due
                                         on $929,752

                         Docket No. 20535-91

           Year                           Deficiency

           1987                                $21,600

                         Docket No. 20537-91

           Year                           Deficiency

           1987                                $21,600
                                       - 6 -

                             Docket No. 20538-91

             Year                                   Deficiency

             1987                                      $21,600

                             Docket No. 15975-92
Tax                                       Additions to Tax
Year                   Sec.             Sec.             Sec.             Sec.
Ended     Deficiency   6653(b)(1)(A)    6653(b)(1)(B)    6653(b)(1)       6661

7/31/88    $808,755       $606,566      50% of               --         $202,189
                                        interest due
                                        on $808,755

7/31/89     869,682         --                 --          $652,261     217,420

                             Docket No. 16122-92

                                                        Addition to Tax
             Year                Deficiency             Sec. 6653(b)(1)

             1988                $1,378,634                $1,078,379

                              Docket No. 8587-93

                                Addition to Tax and Penalties
                              Sec.         Sec.        Sec.
Year        Deficiency        6653(a)      6656(a)     6662(a)

1988        $2,742,859        $137,143          $284,657        --
1989           428,739           --               52,009     $85,747


                              Docket No. 8923-93

Tax                           Additions to Tax and Penalty
Year                         Sec.           Sec.     Sec.
Ended        Deficiency      6653(a)(1)     6661     6662(a)

11/30/88     $2,526,905       $126,345         $631,726      --
11/30/89      2,929,741          --               --       $585,948


        After concessions, the issues remaining for decision are:

(1) Whether amounts deducted as management and consulting fees

are reasonable payments for services rendered; (2) whether the
                               - 7 -

franchise transactions petitioners entered into were bona fide so

that petitioners are entitled to deduct royalty payments, or

whether an adjustment under section 162 or 482 is warranted;

(3) whether amounts petitioners deducted as interest and

guarantee fees were associated with bona fide debt; (4) whether

amounts petitioners deducted as interest in section 351

transactions were associated with debt; (5) whether Medieval

Dinner & Tournament, Inc., is entitled to deduct $236,313 that it

paid Medieval Show, Inc., as a marketing fee; (6) whether

petitioners may claim as current deductions the costs associated

with New Jersey and California expansions; (7) whether some of

petitioners are liable for the additions to tax and penalties for

fraud, or in the alternative, negligence; (8) whether some of

petitioners are liable for the additions to tax for substantial

understatement of income tax liability and increased interest;

(9) whether some of petitioners are liable for withholding of tax

at the source for interest, debt guarantee, consulting and

management fees, royalty payments, and franchise fees; and

(10) whether Medieval Dinner & Tournament, Inc., is liable for

the section 6656 addition to tax for failure to deposit

withholding of tax.   Unless otherwise indicated, all section

references are to the Internal Revenue Code in effect for the

years in issue, and all Rule references are to the Tax Court

Rules of Practice and Procedure.
                               - 8 -

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.       The

evidence from 30 days of trial included 6,368 pages of transcript

and thousands of exhibits, many of which contained multiple parts

and/or were duplicates of other exhibits.     The failure of the

parties to engage in timely, good faith, voluntary and orderly

exchange of documents resulted in the necessity of 39 separately

filed stipulations through the course of the trial, without

logical or consistent sequence or organization.     It is not

reasonable to reproduce here all of the findings requested by the

parties.   Many of them are exaggerated extrapolations or

unrealistic interpretations of the evidence.     We have set forth

only those findings that are necessary to explain and dispose of

the issues for decision in these cases.     Detailed findings

concerning certain documents are necessary because of disputes as

to the sham or fraudulent nature of petitioners' transactions.

Documents and facts at times subsequent to the years in issue are

set forth because they are relevant in determining when or

whether other documents were prepared or events occurred.       The

other agreed facts are incorporated in our findings by this

reference.

                         FINDINGS OF FACT

     Petitioner Medieval Show, Inc. (MSI), is a corporation

organized under the laws of Florida with its principal place of

business in Kissimmee, Florida.   Petitioner Medieval Dinner &
                               - 9 -

Tournament, Inc. (MDT), is a corporation organized under the laws

of California with its principal place of business in Buena Park,

California.   MDT is a successor in interest to Medieval

Attractions, B.V. (MABV), a corporation organized under the laws

of The Netherlands, and MABV is a successor in interest to

Medieval Attraction, N.V. (MANV), a corporation organized under

the laws of the Netherlands Antilles.

I.   Background

      The concept for entertainment facilities that came to be

known as Medieval Times originated in Spain.   During the late

1960's and into the 1970's, Jose Montaner (J. Montaner) and his

sisters owned a successful barbeque in Son Termens, Spain.

J. Montaner’s family had lived for centuries on the island of

Mallorca off the coast of Spain.   J. Montaner’s mother was the

Countess of Peralada, and his family held the rights to use the

title of the Viscount of Rocaberti.

      J. Montaner had an interest in medieval history and

incorporated that interest into a dinner theater and medieval

show located in L’Alqueria in Spain.    After the L’Alqueria show

became successful, J. Montaner moved the show to Son Termens.

In July 1973, J. Montaner, his sisters, Francisco Bosch Oliver

(Bosch), and Jose Planas Llabres de Jornets incorporated

Son Termens, S.A., to operate a dinner theater in Son Termens.

The show at Son Termens featured a meal and medieval

entertainment that included period costumes, knights on
                                - 10 -

horseback, and jousting.   The show resembled scenes from the

movie “El Cid”, which J. Montaner had seen prior to creating the

show.   The show was run by the corporation, and J. Montaner was a

minority shareholder.

     Jaime Climent (Climent) had several businesses in Benidorm,

Spain, including a barbeque restaurant with seating for 2,000

people, called Rancho Grande.    Climent was familiar with

J. Montaner’s show and wanted to bring it to Benidorm.      Climent

contacted J. Montaner, and they agreed to open a show in

Benidorm.   On January 25, 1977, Torneo Medieval, S.A. (TM), was

incorporated in Spain.   The initial shareholders of TM were

Climent, 45 percent; J. Montaner, 13 percent; Juan Colom

Valcaneras, 15 percent; Juan-Pedro Rousselet Barbaud (Rousselet),

15 percent; and Bosch, 12 percent.       TM operated a medieval theme

dinner theater in Benidorm in a castle known as Castell Comte

D’Alfaz.

     Some of the Son Termens employees were transferred to

Benidorm to assist with opening the show.      The Benidorm show was

similar to the Son Termens show, and, over time, innovations were

incorporated into the Benidorm show.      The show in Benidorm became

profitable 2 to 3 years after it began operating.      Neither

J. Montaner, his sisters, nor the other shareholders of

Son Termens, S.A., were compensated by TM for the use of the

medieval dinner show concept.
                                - 11 -

II.   Expansion to the United States

      A.   Florida--Personnel and Pre-1986 Corporate Structure

      Cristobal Segui (Segui) was a successful Spanish

businessman.    He owned an interest in Son Amar, a large nightclub

operated on Mallorca that catered to tourists.     He also owned an

interest in La Granja, a medieval village on Mallorca.     Alfonso

Chavez (Chavez) was a U.S. citizen who lived in the same building

as Segui.    Chavez was interested in finding an attraction to take

to the United States and spoke to Segui about the show in

Benidorm.    J. Montaner also had been interested in opening a show

in the United States.    Segui discussed Chavez’s proposal with

J. Montaner, and they decided to put together a group of

investors interested in opening a medieval show in the United

States.    The original group consisted of J. Montaner; Segui;

Climent; Pedro Montaner (P. Montaner), J. Montaner’s nephew;

Johan Kahne (Kahne), a business associate of P. Montaner; and

Vincente Valiente (Valiente).    This group of investors and Martin

Santandreu (Santandreu), who joined the group later, comprised

the Spanish investors.

      The Spanish investors were successful businessmen, each with

a net worth exceeding $1 million.      Resumes provided to a bank in

a loan application filed by Inverspan, N.V. (Inverspan), during

1982 or 1983 contained personal information on the Spanish

investors and included the following:
                               - 12 -

     P. Montaner:    39 years old; lawyer; president of 12

companies; owns various parcels of land in Spain; personal estate

value of $6 million.

     J. Montaner:    61 years old; diploma in tourism; part owner

of a tourist complex that holds 3,000 people; owns flats and

plots of land; personal estate value of $3.5 million.

     Santandreu:    48 years old; bachelor's degree; 100-percent

owner of three perfume stores; 25-percent owner of a financing

company; 20- to 50-percent owner in several other businesses,

including nudist camps and nightclubs; owner of land and

property; personal estate value of $4.1 million.

     Segui:   41 years old; bachelor's degree; 100-percent owner

in two real estate companies; 25- to 50-percent owner in other

companies, including a museum, restaurant, and tourist

attractions; owner of land in Spain; personal estate value of

$2.75 million.

     Climent:    45 years old; business administration; part owner

of dinner show, hotel, jousting show; personal estate value of

$1 million.

     In 1980, Segui and J. Montaner traveled to the United States

to study the tourism market.    They visited Orlando, Florida, in

June 1980.    In October 1981, a group of the Spanish investors

came to the United States to find a location for the dinner show.

Climent noticed a suitable parcel of land on Highway 192 in
                               - 13 -

Kissimmee, Florida.    A sales contract was signed to purchase the

Highway 192 parcel in October 1981.

     The Spanish investors hired Chavez to assist with the

Florida plans.   Chavez and his wife were heavily involved in the

preliminary development and organization of the Florida operation

and frequently represented the Spanish investors.    Chavez’s

activities included buying land and looking for estimates,

contractors, engineers, architects, attorneys, accountants, and

banks.   Chavez signed the contract to purchase the Florida land

for the castle and located Charles H. Parsons (Parsons), a

Florida architect.    The land contract named the buyer as “an

Offshore Corporation to be formed”.

     In 1982, Parsons traveled to the Don Pancho Hotel in Spain

to meet with several of the Spanish investors regarding the

construction of the castle in Kissimmee.    Parsons viewed the

castle at Benidorm and was given preliminary drawings that a

Spanish architect had made of the Benidorm castle.    Chavez

eventually signed the contract hiring Parsons.    The Spanish

investors had several other meetings at the Don Pancho Hotel to

discuss the U.S. venture.    During one of these meetings,

Santandreu promised the Spanish investors that the American

company would compensate them for their work.

     The Spanish investors began to form several corporations to

develop the Florida project.    The first corporation, Inverspan,

was incorporated on November 19, 1981, in the Netherlands
                               - 14 -

Antilles with the assistance of Florida counsel, Thomas Allen

(Allen) of Maguire, Voorhis & Wells, and Netherlands Antilles

attorneys, L.A. Haley and Y.L. Cuales of Corporate Agents, N.V.

(CANV).   Inverspan was created to own the land and building used

for the Florida castle.    The shareholders of Inverspan were:

Chavez and Climent, 11.1 percent each; Kahne, J. Montaner, and

P. Montaner, 13.08 percent each; Santandreu and Segui,

12.62 percent each; and Valiente, 13.32 percent.    (Family members

such as husbands and wives who both held shares are included

under the family name.)

     Medieval Times, N.V. (MTNV), was incorporated in the

Netherlands Antilles on December 21, 1982, with the assistance of

Allen and CANV.   MTNV was formed to operate the Florida castle.

The MTNV shares were held by the same individuals and in the same

proportions as the Inverspan stock.     Inverspan paid the costs of

constructing the Florida castle with a $2.65 million loan from a

bank.   The MTNV-Inverspan shareholders pledged $1.4 million

collateral for the loan.

     Before the name “Medieval Times” was selected, the name

“El Cid” and “A Dinner Theater in a Castle” were considered.     The

movie “El Cid” had been released in 1961 and contained scenes

that depicted a medieval castle with towers, period costumes,

jousting, sword fighting, and knights, all of which became

elements of the Medieval Times show.    The Spanish investors

considered hiring Charlton Heston, the star of “El Cid”, to open
                               - 15 -

the MTNV castle in Florida, but they rejected the idea because of

the expense.

     The Spanish investors needed a vehicle in which to invest

and travel to the United States because it was illegal under

Spanish law for Spanish citizens to invest in the United States

without permission from the Spanish Government.    The Spanish

investors formed Europea de Espectaculos, Cenas y Torneo

Medievales, S.A. (Eurotor), in Spain on September 1, 1982, for

the purpose of carrying out, among other objectives, the

promotion and development of public entertainment either in Spain

or abroad.    Eurotor’s original shareholders were the Spanish

investors:    Climent, 25 percent; Valiente, 12.5 percent;

Santandreu, 12.5 percent; Segui, 12.5 percent; J. Montaner,

12.5 percent; P. Montaner, 12.5 percent; and Kahne, 12.5 percent.

Of this group, only J. Montaner and Climent were shareholders of

TM, which operated the show in Benidorm.

     In approximately November or December 1982, Eurotor

requested permission from the Spanish Government to invest in the

United States.    Permission was granted in March 1983.   The

Spanish investors had earlier chosen to invest in Inverspan and

MTNV without reporting their investments to the Spanish

Government.    They chose not to report because they believed the

process was complicated and difficult and because they thought

the response from the Spanish Government would be negative.
                              - 16 -

     Subsequent to the formation of MTNV, several more

Netherlands Antilles companies were formed from 1983 through 1986

for use by the Spanish investors.   The Spanish investors were

concerned about confidentiality and had the stock of all of the

corporations, including Inverspan and MTNV, issued in bearer form

to protect the identity of the shareholders.    The Spanish

investors decided to protect their identities further by using

corporations to represent their interests.   The corporations that

were created to represent the Spanish investors with their owners

were:   Spectrust, N.V. (Spectrust)--Valiente (Valiente died in

1988, and Climent married Valiente’s widow and took control of

Spectrust); Promidux, N.V. (Promidux)--P. Montaner; Dapy, N.V.

(Dapy)--Kahne; Attractours, N.V. (Attractours)--J. Montaner

(P. Montaner, J. Montaner, and Kahne acted as a group in

representing and voting the shares of Promidux, Dapy, and

Attractours); Roundabout Tours, N.V. (Roundabout) (and later

Primavert, N.V. (Primavert))--Santandreu; Holiday Tours, N.V.

(Holiday)--Segui; and Wayout Tours, N.V. (Wayout)--Climent.

     These corporations, each owned by a Eurotor shareholder,

were known as the Eurotor group of companies.    After the

corporations were formed, the bearer shares of MTNV stock that

were owned by each of the Eurotor shareholders were transferred

to each shareholder’s respective Netherlands Antilles

corporation.   After the stock transfers, the MTNV shareholders

consisted of the Netherlands Antilles corporations:    Spectrust;
                               - 17 -

Promidux; Dapy; Roundabout; Attractours; Wayout; Holiday; and, in

his individual capacity, Chavez.   Chavez, a U.S. citizen, was not

a Eurotor shareholder and did not have a Netherlands Antilles

corporation representing his interest in MTNV.

     Andres Gelabert (A. Gelabert) worked for Segui at Segui’s

nightclub in Spain.   He was sent to Florida to supervise

construction and to set up the operations of the Florida castle.

On May 16, 1983, Allen, on behalf of MTNV, offered to

A. Gelabert, in writing, the position of managing director of

MTNV.   The offer provided for a salary of $24,000 per year and

3 percent of gross revenues.   A. Gelabert’s duties included

supervising the construction of the castle in Florida; recruiting

and training 70 to 100 persons to be employed by MTNV,

particularly kitchen staff; ensuring all aspects of the

production, including verifying that the costumes and props were

historically accurate; and developing marketing and public

relations strategies.   The offer was contingent on A. Gelabert’s

getting approval from the U.S. Immigration and Naturalization

Service to work in the United States.

     Royal Catering, Inc. (RC), was incorporated in Florida by

Allen on June 30, 1983.   A. Gelabert was listed as the sole

corporate director.   A. Gelabert was the sole shareholder of RC

during the years in issue.   RC was purportedly established to

provide catering services to the castle.   Initially, RC was

actually used only as a vehicle to obtain U.S. visas for
                               - 18 -

A. Gelabert and Jose “Pepe” Sans (Sans).    The MTNV shareholders

loaned $100,000 to RC.   The loan was repaid between March and

June 1985.   The interest on the loans was paid from an MTNV

account.   During the years in issue, RC’s “books and records”

were petitioners’ books and records.

     In addition to A. Gelabert, Climent assembled other

personnel in Spain to bring to the United States to assist with

the Florida operation.   These individuals included George

Stonecrow (Stonecrow); Vicente Valiente, Jr. (Valiente, Jr.);

Jose “Pepe” Castro (Castro); and several knights (Tino Brana,

Victor Lara, Robin Brevik, and Javier Elvira).    Climent also had

140 crates of materials sent to Florida from Spain.   The

materials included costumes, weapons, objects for the horses, and

decorations.

     By the end of 1982, Chavez was no longer involved in the

daily Florida operation that was run primarily by A. Gelabert and

Castro.    A. Gelabert was in charge of the castle construction,

aspects of the show, and the food and beverages.    A. Gelabert and

Castro also secured construction bids, worked with the banks on

loans, worked with the engineers and contractors, applied for

licenses and certificates such as employer identification numbers

and liquor licenses, procured services, paid bills, purchased

restaurant equipment, provided for the care of the horses, and

coordinated the kitchen design and construction.
                               - 19 -

     Stonecrow was knowledgeable about the medieval era and

maintained the historical authenticity of the show.    Stonecrow

designed and sewed costumes and painted murals.    Stonecrow was

the producer of the MTNV show in Florida and was the master of

ceremonies when the Florida castle opened in December 1983.

     Charles C. Bellows (Bellows) was hired by MTNV as the

marketing manager in 1983.   Bellows heard about the castle’s

opening in Florida and contacted MTNV.   He met with Segui and

Santandreu, who offered him the position.    Bellows was

experienced in the entertainment market, having previously worked

for Holiday Inn Worldwide Sales and then for Ringling Brothers

Barnum & Bailey Circus World in Florida.    Bellows hired an

assistant, Andrea Kudlacz (Kudlacz), who had previously worked

for Disney World in Florida.   Bellows created a marketing plan

and budget, hired staff and marketing consultants, and made

contacts with the Florida tour industry.    He established

procedures for the marketing department.    He and his staff

developed brochures and other printed marketing materials.

Bellows and Kudlacz oversaw the production and purchase of print,

radio, and television advertising for MTNV.    Bellows’ wife

designed the letter style used to write the words “Medieval

Times”.   Bellows originally reported to Segui but began reporting

to A. Gelabert when A. Gelabert was appointed general manager of

the Florida operation.   In some instances, the Spanish investors

would review Bellows’ plans, give directions, and make
                               - 20 -

suggestions regarding marketing actions that they wanted Bellows

to take.    In 1985, Bellows set up an in-house advertising agency

at MTNV.

       Bellows monitored MTNV's competition in the central Florida

area.    The companies that MTNV considered as competition included

"King Henry's Feast", which was operating during the mid-1980's.

King Henry's Feast was a medieval dinner show that seated 600 to

700 customers.    The customers were served a meal and watched a

show that included sword fights with armor and acrobats.     For a

period of time, King Henry's Feast featured jousting, although it

was not part of the dinner show.

       Leandro Galindo (Galindo) met A. Gelabert while A. Gelabert

was working on the Florida castle.      A. Gelabert sent Galindo to a

horse training school in Florida for about 6 months so that

Galindo could become a knight.    A. Gelabert also asked Galindo to

set up a photography department.    Galindo researched equipment

and presented the information to A. Gelabert.     A. Gelabert chose

a photography equipment company that provided a 2-week training

session with the purchase of equipment.     To the best of Galindo’s

knowledge, no one at MTNV knew anything about photography

equipment.    Galindo set up the lab and hired and managed the six

employees who worked in the photography department.

       The general concept of taking pictures at the castle was not

new.    Photographs were taken and distributed to customers at

Son Termens in Spain.    The methods used to take the pictures and
                              - 21 -

the type of shots available to the customers, however, were new.

Galindo and his staff experimented with their own methods of

making photography sales profitable.   Some ideas were not

successful and some ideas, such as group shots, were successful

and became part of MTNV’s operation.

     Climent moved to Florida in the fall of 1983 and stayed

until the end of January 1984.   Segui, Santandreu, and

P. Montaner also came to the United States to assist with the

opening of the Florida castle.   After the Florida opening, the

Spanish investors returned to Spain.   Some of the investors

visited the United States occasionally after their return to

Spain.

     B.   California--Personnel and Pre-1986 Corporate Structure

     In the spring of 1985, the Spanish investors discussed the

possibility of expanding to California.   In June   1985, Bellows

and Kudlacz went to Southern California and met with Wesley

Taylor (Taylor), a commercial real estate broker.   Taylor had a

listing on property that had formerly belonged to a company

called the Kingdom of the Dancing Stallions (KDS) in Buena Park,

California.   In the fall of 1985, A. Gelabert met with Taylor to

discuss the KDS property.

     Initially, Kahne and J. Montaner advised against expanding

to California due to several factors, including the cost of a new

castle.   Santandreu and Segui, however, concluded that the cost

would be reduced by altering the existing building on the KDS
                                - 22 -

property to fit a medieval theme even though it would be

dissimilar to the Florida castle.    The reassessment of expenses

helped persuade the Spanish investors to proceed in California.

     A. Gelabert signed the contract to purchase the KDS property

on December 4, 1985.    Taylor did not meet with any of the Spanish

investors until January 1986.    Expenses incurred by Santandreu,

Segui, J. Montaner, and Kahne in connection with investigating

the California castle were paid by MTNV.

     The same type of corporate organization was used to operate

the California castle as the Florida castle.   On December 30,

1985, Calinvest, N.V. (Calinvest), was incorporated in the

Netherlands Antilles.   The purpose of Calinvest was to own the

land and building used for the California castle.   On

December 31, 1985, MANV was incorporated for the purpose of

operating the Buena Park castle.    The shareholders of Calinvest

and MANV were as follows:

                                Interest       Interest
     Name                       in MANV        in Calinvest

Dapy (Kahne1)                      12%              17%
Holiday (Segui1)                   12%              17%
Primavert (Santandreu1)            12%              20%
Promidux (P. Montaner1)            12%              17%
Roundabout (Santandreu1)           12%              17%
Spectrust (Valiente1)               5%               5%
Wayout (Climent1)                   5%               5%
Royal Catering (A. Gelabert1)       5%               2%
Estaspan, Ltd.                      5%               -
Santandreu                          5%               -
J. Montaner                         5%               -
Segui                               5%               -
Kahne                               5%               -
                              - 23 -
1
 Denotes the owners of the corporations who held the interests in
MANV and Calinvest.

     Estaspan, Ltd. (Estaspan), was a Bermuda corporation

controlled by Gavin H. Watson, Jr. (Watson).   Watson was MTNV’s

banker in Florida.   Chavez did not participate in the California

operation.   Chavez wanted to participate in California, but the

Spanish investors specifically excluded him.

     Sans, who had known Segui since childhood, came over from

Spain in late 1985 to run the Florida castle so that A. Gelabert

could go to California.   Sans took over as general manager of the

Florida operation.   He had no experience running a dinner show.

His experience was limited to operating a restaurant and tour

agency in Spain.

     A. Gelabert went to California in early 1986 to renovate the

existing KDS building and to set up the California operation.     He

hired a general contractor and a kitchen contractor and brought

Florida MTNV employees to work on the California castle.

A. Gelabert also brought several artists from Florida and hired

local artists to paint murals and crests at the California

castle.

     Bellows developed a marketing program for the California

castle prior to its opening in 1986.   He used the expertise he

had acquired in Florida and interviewed and hired new personnel.

The California market differed from the Florida market because
                               - 24 -

the California clients were primarily local residents and not

out-of-town tourists.

     TM did not send property or supplies to California.     The

Florida castle transferred horses and knights and other equipment

and employees to California.   Peter Woefel (Woefel), the food and

beverage manager of the Florida castle, moved to California to

become the food and beverage manager of the California castle.

Woefel oversaw the food preparation and kitchen operation and, in

May 1987, prepared a procedure review memorandum concerning

alcoholic beverage procedures for the California castle.

Stonecrow provided extensive services to the California castle

from 1986 to 1989.   Galindo sent one of his staff to California

to establish the California photography lab.     The California lab

was modeled after the Florida lab.      Galindo created an operations

manual for the California lab based on his experience in Florida.

When the California castle opened, the best knights from the

Florida castle were sent to California to work as knights and to

train other knights.
                                - 25 -

III.   Continued Development

       The Florida castle opened in December 1983.    Several

improvements and changes were made from 1985 to 1989, including

demolition of a ramp and a new entry to the existing building; a

new lounge; new heating and air conditioning; a new ticket

office; new offices; a new kitchen, including marinating tubes;

replacing electric stoves with gas stoves; new stables; and a

medieval village.

       The annual Florida attendance figures were as follows:

Year             Attendance           Year      Attendance

1984              183,272             1989       470,000
1985              257,350             1990       525,200
1986              308,391             1991       550,000
1987              388,071             1992       575,000
1988              399,776             1993       600,000

       The California castle opened in June 1986.    From 1986 to

1989, many renovations and additions were made to the California

castle.    A formal gift shop, Hall of Flags/Arms, and a torture

museum were added.    Renovations included a redesign of the

existing facility, remodeling the banquet facility with a dance

floor, and remodeling the kitchen, museum, and bathroom.

       RC and MDT entered into a Management Agreement that was

dated December 1, 1987.     A. Gelabert was the owner and president

of RC.    The agreement called for RC to manage its food and

beverage operation.    MDT was to provide all of the kitchen

facilities and to employ all of the wait staff.      RC was to

receive 5 percent of gross profits, and MDT was to reimburse RC
                              - 26 -

for “salary, payroll taxes, insurance and other related expenses

for president of Manager, food and beverage manager of Medieval

and assistant food and beverage manager of Medieval.”   The

agreement was notarized on March 8, 1988.

     Both the Florida and California operations were structured

into departments that included marketing, accounting, food and

beverage, show, sound and lighting, photography, gift shop, and

stables and knights.   The department heads reported to the

general manager of each castle.   The general manager approved

changes that were improvements in the operation of the castle and

did not substantially change the “theme” of the show.   The

general managers provided information on the operations to the

Spanish investors.

     Jack Rein (Rein) was a professionally trained actor and

dramatic writer.   He was hired by the California castle as the

emcee a month after it opened in 1986.   When Rein commenced his

employment, he was given a 10-page outline of the show.   Rein

began updating the script during 1987 and 1988, making it more

complete by adding dialogue for different characters and for the

emcee.   Every 6 months or so, the ending of the story was

changed, and changes were made to the script to reflect the

different endings.   Rein continued to update and vary the script

to reflect dialogue changes in the show.    In 1992, Rein prepared

a script that became the standard for all of the castles.
                               - 27 -

     Recorded music was used in the Medieval Times shows between

1983 and 1990, including excerpts from “El Cid” and “Conan the

Barbarian”.    Michael Schwartz (Schwartz) and Dan Friedman

(Friedman) composed a soundtrack in 1991 for the Medieval Times

shows that was used in all of the castles.    Schwartz was an

employee of MANV and approached A. Gelabert about the idea of

composing an original score.    Schwartz and Friedman prepared a

demonstration recording for A. Gelabert.    A. Gelabert liked the

demonstration, so Schwartz and Friedman composed music for the

entire show.    Schwartz and Friedman produced the music at their

own risk and presented it to the Spanish investors.    The Spanish

investors approved the score and paid Schwartz and Friedman

$18,000 for their finished product.     The fee was originally paid

by MANV through its successor in interest, MDT.

     In 1989, A. Gelabert met with Michael Hartzell (Hartzell),

who was the Director of Entertainment for the Excalibur Hotel and

Casino in Las Vegas, Nevada.    Hartzell was interested in locating

an independent contractor to produce a Medieval Times-type show

at the Excalibur.    The Excalibur opened the King Arthur's

Tournament Show (King Arthur's) in the hotel on June 15, 1990

without the assistance of A. Gelabert or the Medieval Times

companies.    King Arthur's seated 900 customers and featured a

meal, jousting, and knights.    The hotel also had a medieval

village with 22 shops and five specialty restaurants.    As of
                               - 28 -

1995, Medieval Times had not initiated any type of legal

proceeding against the Excalibur in relation to King Arthur's.

IV.   Contracts

      Before the Florida castle opened, the Eurotor shareholders

wanted assurances that they would be compensated for their

assistance in the development of Medieval Times.    Allen drafted

an agreement, dated January 24, 1983, between MTNV and Eurotor

and TM, with Eurotor and TM referred to collectively as Eurotor.

The agreement required that Eurotor open an office in Florida and

provide management and personnel to assist with the construction

and operation of the Florida castle.    MTNV agreed to compensate

Eurotor with payments of 2 percent of the total estimated cost of

the facility (excluding financing costs) during both the creation

and development phase of building the castle (for a total of

4 percent) and 50 cents per customer during the operational phase

of the castle.    The agreement stated that it was to be in effect

for a period of 10 years from the date of the agreement.      The

agreement did not refer to any other fee agreements.    The

agreement was signed by A. Gelabert for Eurotor, Climent for TM,

and Allen for MTNV.    The agreement did not mention or refer to a

franchise.

      Prior to drafting the January 24, 1983, contract, Allen had

written a list of items that he needed to include in the

document.    His notes did not contain a reference to any other
                               - 29 -

agreements.   A list of the documents that were in existence in

Kissimmee during 1983 referred to the January 24, 1983, contract.

V.   Coopers & Lybrand Planning and Petitioners' Documentation

      Coopers & Lybrand (C&L) is a “big six” accounting firm known

for its worldwide market.    C&L prepared all of the tax returns

for the Medieval Times companies beginning with the MTNV return

in 1982.

      In 1985, Santandreu sought the assistance of C&L in

Brussels, Belgium, to find a structure that could be used for the

nontaxable receipt of payments made to the Spanish investors by

MTNV.   C&L suggested the use of a nonresident United Kingdom

company to Santandreu in a letter dated August 6, 1985.

      Gatetown Limited (Gatetown) was a United Kingdom corporation

registered on or about May 1, 1985, by Nigel Leonard Blood.      In

March 1986, Segui’s father-in-law, Jose Garcia de Oteyza Romero

(de Oteyza), was in contact with Harris, Lippman & Co. (Harris),

an accounting firm in the United Kingdom.    In an April 1986

letter, de Oteyza sent funds to Harris to acquire Gatetown.      The

letter stated that “Gatetown Limited will take care of getting

paid Royalties and copyrights of a Dinner-Show situated in the

U.S.A.”    The correspondence also referred to a company called

Protravol Limited (Protravol) that would be used for the “buying

and selling from Spain to U.S.A. of souvenirs”.    The letter

informed Harris that the directors of both companies should be de
                              - 30 -

Oteyza and Jaime Antonio Mayol Castaner (Mayol), Segui’s brother-

in-law.

     In a letter to the United Kingdom taxing authority in 1987,

Harris represented that Gatetown commenced business March 1,

1986; that Gatetown’s registered office was in Palma de Mallorca,

Spain; and that the nature of the company’s activities was as

owner of royalty and copyright agreements.   Gatetown’s original

incorporators resigned on June 12, 1986, and Mayol and de Oteyza

were named as the officers.   The Gatetown stock, which consisted

of two shares, was held equally by Mayol and de Oteyza as

nominees.

     On May 1, 1986, A. Gelabert sent to Francois A. Nouel

(Nouel) of CANV a letter requesting that, among other things,

Nouel submit the names of Manver, Lince, and Attractours for

approval by the Chamber of Commerce of the Netherlands Antilles.

Attractours, Lince, N.V. (Lince), and Manver, N.V. (Manver), were

incorporated in the Netherlands Antilles on or about May 16,

1986.   Lince was owned by Holiday, Roundabout, Dapy, and

Promidux.   Manver was owned by Spectrust and Wayout.   Attractours

was owned by Promidux and Dapy.   The Manver incorporation fees

were paid by Wayout.   Lince was capitalized with $6,000 on

May 19, 1986, from an account maintained in the name of Holiday.

     Ian Forsyth (Forsyth) was the international tax partner at

the C&L Los Angeles, California, office from 1986 to 1989.    As

appears from his handwritten notes and related correspondence,
                               - 31 -

Forsyth was aware of the Medieval Times company early in 1986,

prior to purchase of the California castle.

     In May 1986, Forsyth met with representatives of the

Medieval Times companies at C&L in Los Angeles.      During the

numerous meetings that occurred, Forsyth met primarily with

Santandreu, Jeronimo Onate (Onate), and A. Gelabert.       Santandreu

and Onate represented the Medieval Times companies and Gatetown

or Manver or both.    Kenneth H. Kim (Kim) was employed at C&L as a

tax manager and assisted Forsyth in the representation and

meetings.

     During a May 20, 1986, meeting, the then-existing structure

of the Medieval Times companies was reviewed with Forsyth.

Forsyth began to design methods intended to improve the corporate

structure of the Medieval Times U.S. entities.      Forsyth thought

the “branch profits tax” in the Tax Reform Act of 1986, Pub. L.

99-514, 100 Stat. 2085, would make the existing structure of

Medieval Times undesirable.

     Forsyth took notes at these meetings.     Notes dated May 20,

1986, contain the following references:      “Royalties.   Recommend

trademark attorney.   None registered.   Which company should own

trademark - where? Copyright - Which Co.?      3 Spanish nationals

‘own’.   (Florida Co. Not now paying royalties)”.     The notes also

state:   “Trademark - offshore.   Objective:    10% [royalty] of pre-

tax [profit].   Problem:   Ownership of intangibles.”

Additionally, the notes reflect that the Spanish operation
                              - 32 -

trained the Florida personnel and provided technical and

logistical support but that the structure was set by the Florida

operation, which sent people to California.   Regarding a license

agreement, the notes state:   “License agreement from foreign

corp. to NV-Florida for UK Co.?”

     Forsyth wanted to determine a method to make payments to the

Spanish investors while incurring a minimum amount of U.S. tax.

Forsyth developed a plan that he outlined in a letter to

Santandreu dated June 4, 1986.   Forsyth recommended that the

Spanish investors set up a domestic corporation to operate the

Florida and California castles and utilize a three-tier corporate

operating structure.   Specifically, he recommended that MTNV

cease operating in the United States, transfer its assets to a

Dutch or other nationality subsidiary, and then have the

subsidiary transfer its assets to a new operating company

incorporated in Florida.

     Before Forsyth finalized his plan for corporate

restructuring, he was waiting for a final ratification of an

income tax treaty between the United States and The Netherlands.

Forsyth suggested that using a Dutch company as the intermediate

tier would have advantages.   Forsyth recommended the use of

section 351 to transfer the assets from the Netherlands Antilles

corporation to the intermediate-tier Dutch corporation and then

from the Dutch corporation to the new domestic operating company.
                              - 33 -

     Gordon Thring (Thring) worked in the C&L Los Angeles office.

He drafted a letter to Santandreu based on conversations he had

with Forsyth.   The letter to Santandreu was marked “September

draft”, and it stated that C&L had reviewed the advice from the

June 4, 1986, letter to take into account recent tax code changes

and the recently signed income tax treaty between the United

States and The Netherlands with respect to the Netherlands

Antilles.   The letter affirmed C&L’s recommendation for Medieval

Times to use a three-tier corporate structure as suggested in the

June 4, 1986, letter.   The ostensible advantages of the

three-tier structure included limiting U.S. withholding tax to

5 percent for dividends paid to Dutch companies and zero percent

for interest paid to Dutch companies, and dividend income from

the U.S. company would be tax-exempt in The Netherlands.

     A section in the September draft letter discussed royalty

payments on intangible assets.   The letter stated:   “We

understand that it is intended to license M.T.U.S. [Medieval

Times U.S.] to use the ‘Medieval Times’ concept and any material

that may be copyrighted.”   C&L suggested the use of a Barbados

company to license the intangibles to a Dutch company that would

in turn license them to the Medieval Times U.S. companies.   C&L

stated that the advantage to this arrangement was that the

royalty income would not be subject to withholding tax in the

United States or in The Netherlands.
                              - 34 -

     Forsyth responded to a request from Santandreu in an

October 8, 1986, letter that summarized the reasons C&L was

recommending the changes to the Medieval Times corporate

structure.   C&L stated that the problems with the current

structure were that a 30-percent withholding tax would apply to

royalty payments from MTNV and MANV and that a 30-percent branch

profits tax would apply on earnings and interest deemed

distributed by the existing Netherlands Antilles companies to

nonresidents.   C&L’s recommendation included transferring

existing operations and real estate to U.S. corporations owned by

Dutch holding companies that would in turn be owned by the

existing Netherlands Antilles companies.    The recommendation also

included borrowing in the United States to the maximum extent

possible through mortgage loans and working capital to maximize

tax benefits, with the funds used to pay dividends and/or reduce

capital prior to implementation of the reorganization and prior

to the effective date of the new tax act.   The result would be to

reduce the tax rates for interest from 30 percent to 8.7 percent,

for royalties from 30 percent to 2.94 percent, and for dividends

from 53.8 percent to 43.9 percent.

     The October 8, 1986, letter also included a list of things

to do to implement the plan, which included determining the

entity to own the intangibles (trademarks, copyrights, etc.) and

completing licensing agreements; implementing a borrowing

strategy; and targeting a completion date of December 31, 1986,
                              - 35 -

or a November 30 fiscal year for MANV and Calinvest to delay the

effect of the 1986 Tax Reform Act with respect to the 30-percent

withholding tax.   Forsyth listed the information that was

required as soon as possible, which included balance sheets;

profit and loss statements; profit forecasts; recent tax returns;

a listing of all agreements, licenses, etc., that would need to

be transferred to the new U.S. subsidiaries; and details of the

shareholdings of the Netherlands Antilles companies.   Forsyth

needed the information to prepare a tax benefit forecast and a

final version of the detailed letter he had reviewed with

Santandreu.

     During October 1986, it had not yet been determined who

would own the intangibles.   While C&L, with the Spanish

investors’ knowledge, was drafting documents that named Manver as

the “licensor” of the intangibles, the Spanish investors were

also taking steps to have Gatetown own the intangibles.    In an

October 22, 1986, letter from Harris, the United Kingdom

accountants, to “The Directors, Gatetown Limited, Euritor”,

Harris stated their understanding of the current situation and

the proposed steps to be taken with regard to the setting up of

the trading operation of Gatetown Limited in the United Kingdom.

The letter included the following information:

     An “NV” Corporation exists with 20% of that Corporation
     being owned by Spanish individuals and 80% by 7 “arms-
     length” “NV” Companies. * * * Gatetown Limited has
     agreed to buy the United States and Canadian copyright
     and Royalties from a Spanish Corporation in respect of
                               - 36 -

     ”Medieval Times” and this purchase will be financed by
     loans from the 7 “NV” Corporations.

The letter also noted that the two shares of Gatetown stock had

been increased to 100 shares with 50 each being held by Mayol and

de Oteyza.

     Jon Edwin Hokanson (Hokanson) was an intellectual property

specialist with the law firm of Lyon & Lyon (LL) in Los Angeles.

Hokanson was drafting licensing agreements between Manver and

MTNV for the use of the intangibles.     At this time, however, it

was still uncertain who would "own" the intangibles that were

being licensed.   Hokanson spoke with Forsyth on November 7, 1986,

regarding the licensing agreement.      In a letter to Forsyth dated

November 11, 1986, Hokanson enclosed a new draft of the licensing

agreement.   The new draft expanded the scope of services provided

to the licensee to include the right of the licensee to engage in

a business system, in addition to the right of the licensee to

use the servicemark. Hokanson believed that the transaction fell

within the California Franchise Law, and he had already advised

A. Gelabert of that opinion.   Hokanson stated that he was

forwarding a copy of the revised licensing agreement to

A. Gelabert.

     In addition to Hokanson, Forsyth spoke to Santandreu on

November 7, 1986.   In a November draft of a letter to Santandreu,

Forsyth recapped a November 7, 1986, conversation and supplied

further details on the proposed structure of Medieval Times.
                              - 37 -

Among other items, the letter specifically addressed the choice

of entity to own the intangible assets and the question of an

appropriate royalty and management fee rate.   The letter noted

that Manver currently owned the intangibles and should license

them to MANV and MTNV for the current year.    During the current

year, Forsyth believed that only 20 percent of the royalties

would be subject to tax.   Forsyth suggested that a new licensing

structure be implemented once the three-tier system was in place.

     Forsyth stated in the draft that, as they had previously

discussed, a “super royalty” fee could be justified if

above-normal profits were due to the nature of the intangible

asset.   Forsyth discussed the new provisions to section 482 in

the 1986 Tax Reform Act, supra, and stated, among other things:

     To set the appropriate royalty rate would require a
     detailed analysis of the worth of the intangible asset
     and the effect of the intangibles on the profitability
     of the two operating entities. * * * As a working
     guide, perhaps a rate somewhere between 10-15% would
     seem reasonable. However, before a rate is decided
     upon, we will require further consultations with you.

     It is important in justifying this high rate that the
     franchise agreement between the owner of the
     intangibles and the U.S. operating entities detail
     precisely the distinctive type of restaurant and
     entertainment services being franchised as the
     “Medieval Times concept”. We consider that the draft
     franchise agreement forwarded under cover of Lyon &
     Lyon’s, Attorneys, letter of November 11, 1986 is
     appropriate subject to a few general comments. We
     consider that reference should be made to the script
     document (as amended), called the “copyright book”,
     which details the sequence of the performance. In
     addition, we consider that the agreement should specify
     some of the services that the licensor shall provide to
     the licensee. This will include such things as
                              - 38 -

     assistance in the design of costumes and training of
     horses and actors. Finally, we consider that the
     license should be an exclusive license for a limited
     area (e.g. Orange County, California) rather than the
     nonexclusive license for the whole of the U.S. as is in
     the current draft agreement.

     The retention by the licensor of quality control
     powers, extensive cancellation rights and the right to
     sublease in the U.S. will assist the argument for a
     super royalty. These all point to the licensor
     retaining control of the future marketing, development
     and profitability of the licensed concept.

     We consider that the proposed widely worded franchise
     agreement will restrict the basis on which a management
     fee may be charged. However, it is still possible to
     enter into an independent management agreement and to
     charge a separate management fee. We suggest that such
     a fee be limited to either a cost plus basis or a
     relatively low rate, say no more than 2% of gross
     revenue. We emphasize that the services provided
     should go beyond the normal stewardship functions that
     shareholders may exercise. These include ensuring that
     the information provided to shareholders is adequate
     and even the selection of senior personnel. The
     management agreement should emphasize services that a
     independent management consultant may provide such as
     detailed advice on:

          (i) the accounting and administration system;

          (ii) a financing strategy; and

          (iii) personnel selection at all levels.

     We do not recommend charging a separate management fee
     on top of a “super royalty” under the proposed
     franchise agreement. However, if you wish to have a
     separate management fee charged to the U.S. operating
     companies, we would appreciate the opportunity of
     reviewing the draft agreement prepared by your
     attorneys.

     The draft listed actions that needed to be completed,

including actions that needed to be commenced immediately after a

November 20, 1986, meeting.   The matters that still needed to be
                              - 39 -

resolved included the ownership of the intangible assets and

licensing structure and clarification of the process of

transferring the intangible assets to the owner; the royalties

and management rates and contents of the supporting agreements;

and the method by which it was intended to repatriate the

“royalty” income to the beneficial owners of intangible assets,

who C&L understood were largely Spanish residents.

     Louis deVries (deVries) was working with Medieval Times at

the C&L office in The Netherlands.     deVries met with Santandreu

and Onate on November 19 and 20, 1986.    At the meeting, they

discussed the “draft version of Ian Forsyth’s letter”.

Santandreu and Onate had specific questions about certain items

in the letter.   Santandreu was of the opinion that the suggested

10- to 15-percent royalty rate discussed in the draft letter

should be calculated on gross income.

     On December 9, 1986, Forsyth sent to deVries a memorandum

stating that C&L and Medieval Times had decided to use Manver to

hold the intangibles and to go ahead and try to get a tax ruling

for Manver from the Netherlands Antilles.    Forsyth promised

deVries that he would forward a timetable of all of the actions

to be taken on behalf of Medieval Times in the next few days.

     On December 11, 1986, the C&L office in the Netherlands

Antilles sent a letter to the Netherlands Antilles Inspector of

Taxes.   The letter stated that Manver was going to be receiving

royalties from two NV companies that were operating amusement
                               - 40 -

parks in the United States.    C&L wanted a ruling that only

20 percent of the royalties paid to Manver would be subject to

tax.    C&L received the favorable ruling on Manver on January 13,

1987.

       On December 12, 1986, C&L received documents from Medieval

Times for the first time.    The documents represented, among other

things, that the Medieval Times organization was a franchise.

Onate sent copies of six documents to Forsyth, only one of which

was signed.

       The first document, dated January 20, 1983, purported to

create a joint venture between Eurotor and TM.    Although it

discussed payments to be received from MTNV, MTNV was not a party

to the agreement.    The stated purpose of the agreement was to

join TM and Eurotor together with the object of providing to

MTNV:

       the right to use the FORMULA created to put in motion
       and exploit the DINNER-SHOW and TOURNAMENT, THAT IS
       DEVELOPED IN A MEDIEVAL ATMOSPHERE, for such end, the
       necessary information will be ceded to MEDIEVAL [MTNV]
       for the organization, ambientation and launching,
       through an operations manual in which all will be duly
       detailed, likewise the orientations and consultations
       that might proceed the construction of the castle where
       the FORMULA will be promoted, administered and managed.

       The document initially established the same fee arrangement

as in the January 24, 1983, contract that Allen drafted,

2 percent of the total estimated cost of the facility during the

creation and development stages (for a total of 4 percent) and

50 cents per client when the castle is operational.    The document
                              - 41 -

provided for payment by MTNV to Eurotor and TM jointly “but it

will be exclusively EUROTOR that will have the rights to them

during the entire time that this contract might last”.

     The document then varied from the January 24, 1983, document

in that it further stated that, once MTNV had “achieved a daily

average, in the last fiscal year, of 700 clients”, Eurotor and TM

would separate, “nullifying, with all effects, their merger.”

After the separation, TM was to receive from MTNV 10 percent of

MTNV’s “gross production”.   TM was to take “exclusive charge of

technical assistance, not management.”      TM was to contribute to

MTNV the use of the name, trademark, and idea; the handbook or

formula; all of its experience with respect to choreography,

lights, and sound; the making and maintaining of the costumes and

wardrobe; all that is relevant to the equestrian section of the

program; all that is relevant to the fights, duels, and selection

and control of the weapons; its knowledge with respect to the

serving of food and drink (catering); an assessment with respect

to the promotions and publicity; and effect a “persual [sic]” and

control of quality and advise on the modifications that ought to

be carried out to which MTNV would always be heedful.

     Eurotor was to contribute to MTNV its “experience in the

management of companies”, including finance, administration, and

personnel.   The document further stated:    “By express desire of

EUROTOR and TORNEOS [TM], it is put in evidence that TORNEOS [TM]

is the exclusive owner of this FORMULA, that in other countries
                                - 42 -

is named Franchising.”   The document listed Santandreu as the

representative for Eurotor and J. Montaner as the representative

for TM.

     The second document was a copy of the January 24, 1983,

contract that Allen drafted, discussed earlier.   It was the only

signed document.

     The third document was dated February 1, 1983, and titled

“CONTRACT BETWEEN TORNEO MEDIEVALES S.A. AND MEDIEVAL TIMES N.V.”

This document purported to bind MTNV to the 10 percent of gross

production to which Eurotor and TM agreed in the January 20,

1983, agreement.   It provided for TM to license to MTNV, for a

period of 5 years beginning February 1, 1983, “that the latter

may use the name of MEDIEVAL TIMES, trademark, idea, guide and

operations manual, which are the property of TORNEOS [TM] in the

territory of the United States of America and Canada, of the

DINNER SHOW, OF A MEDIEVAL THEME WITH TOURNAMENTS OF THE SAME

PERIOD, (herein called ‘FORMULA’)”.

     MTNV would be required to pay to TM 10 percent of its gross

income beginning when MTNV reached a daily average of 700 clients

per day, as set forth in the January 20, 1983, joint

venture agreement between TM and Eurotor.   TM was to assist MTNV

with choreography, design and upkeep of the costumes and

accessories, the equestrian part of the show, fights and duels

and selection and control of the weapons, and catering (system of

preparing and serving meals).    TM was also to be responsible for
                              - 43 -

quality control.   MTNV “promises to respect all the rules and

standards registered in the FORMULA (and operations manual) of

which it will have received the relevant copy from TORNEOS [TM]”.

J. Montaner was listed as the representative for TM and

A. Gelabert as the representative for MTNV.

     The fourth document was dated May 26, 1986, and was an

agreement between Manver and TM whereby TM “is the owner of the

Idea, the name MEDIEVAL TIMES, Trademark, Guide and Operations

Manual of the DINNER-SHOW, OF A MEDIEVAL THEME WITH TOURNAMENTS

OF THE SAME PERIOD, (hereinafter ‘FORMULA’)”.   The document

referred to the February 1, 1983, agreement between TM and MTNV

and stated that, as of the date of this agreement, May 26, 1986,

the 700-client per day average had not yet been reached.   It

further recited:

     [TM] acquired great and grave responsibilities with
     respect to the services loaned for the granting of the
     LICENSE to MEDIEVAL TIMES N.V. and in view of the
     growth of MEDIEVAL TIMES N.V. and through the pertinent
     studies, the following conclusions have been reached
     that

          a. by its own means it will be impossible [for
          TM] to comply with its obligations of the
          contract, if this should occur.

          b. obtaining these means through a third party
          would be highly costly and will produce little
          profit.

          7. Whereas considering the aforestated the
     decision has been taken to SELL to MANVER all the
     rights of the FORMULA, in the territory of the United
     States of America and Canada.
                               - 44 -

     As of January 1, 1988, Manver was to pay to TM 1,000,000

pesetas.   TM was to “deliver, authentically, the name, trademark

and hand-book of the FORMULA to MANVER, in the act of signing

this contract.”   The contract was not signed.   The

representatives were J. Montaner for TM and Mayol for Manver, and

the parties were to have been assembled in Alfaz del Pi, Spain.

     The fifth and sixth documents were purportedly management

contracts between Eurotor and MANV and Eurotor and MTNV,

respectively.   The Eurotor and MTNV document was dated August 1,

1986, and named Sans as the representative for MTNV and

Santandreu for Eurotor.    It stated that, as of July 31, 1986, the

joint venture between Eurotor and TM (the January 20, 1983,

agreement) was terminated.    The document referred to the

January 24, 1983, management agreement between Eurotor and MTNV

that was drafted by Allen and stated that the management

assessment provided to MTNV by Eurotor continues to be

“essential” to MTNV.    MTNV agreed to pay to Eurotor, effective

August 1, 1986, for a period of 1 year, 2 percent of its gross

production.   Eurotor was to provide, among other things,

assessment on finance, administration, marketing, licensing and

franchising, personnel, and budgets.    These services, allegedly

provided under the January 24, 1983, management agreement, were

the same services Forsyth specified in his November 1986 draft

letter to Santandreu.
                               - 45 -

     The management agreement between Eurotor and MANV was dated

February 1, 1986, and named as representatives A. Gelabert for

MANV and Segui for Eurotor.    It did not mention any of the other

agreements but provided for the same arrangement, i.e., 2 percent

of gross production with a 1-year duration.   The services that

Eurotor was to provide were the same as in the agreement with

MTNV.

     There were additional documents related to TM, Eurotor,

Gatetown, and Manver that were dated 1986 but not provided to C&L

in 1986.   There were also documents dated 1986 that were actually

drafted sometime during 1987 and later.   Two documents, both in

Spanish, reflect a sale by TM to Gatetown of the Medieval Times

formula.   TM was to deliver, pursuant to the sale, the name,

trademark, and handbook of the formula to Gatetown.   The two

documents are virtually identical in language and terms, and both

are dated March 1, 1986.   The only difference is that one

document reflects a sales price of $7,312 and is signed by Mayol

for Manver and by J. Montaner for TM.   The other document

reflects a sales price of 3,000,000 pesetas (approximately

$26,000) and was not signed.   The language in both documents,

except for the sales price, was the same language in the document

provided to C&L on December 12, 1986, that purported to represent

a sale of the Medieval Times formula from TM to Manver for

1,000,000 pesetas.
                                - 46 -

     An unsigned letter dated March 1, 1986, notified MTNV that

TM had sold its rights to the Medieval Times formula to Gatetown.

The letter was addressed to the attention of A. Gelabert.

     Two letters dated May 27, 1986, on Manver stationery,

notified MTNV that Manver had purchased the rights to the

Medieval Times formula.   Both letters referred to the document

between MTNV and TM dated February 1, 1983.    One letter,

addressed to Sans, was in Spanish and informed MTNV that Manver

purchased the formula from TM.    It was signed by Mayol for

Manver.   The other letter, addressed to Sans, was in English and

informed MTNV that Manver purchased the formula from Gatetown.

It was signed by Mayol for Manver and by Sans for MTNV.

     A Bill of Sale, dated May 27, 1986, purports to represent a

sale from Gatetown to Manver of all the rights to the “patent,

trademark, copy right, trade secret, contracts, * * * including

the goodwill, services, production, advertising, distribution,

marks, ideas, concept, operations manuals, show scripts, and the

name MEDIEVAL TIMES, which are identified by the marks ‘MEDIEVAL

TIMES’ and ‘MEDIEVAL TIMES WITH DESIGN’.”    The sale was in

consideration of 200 shares of stock and an obligation to pay

$3.8 million (U.S. dollars) for a total value of $5.6 million.

The $3.8 million was to be paid in five annual installments of

$760,000 each, with the first payment commencing on June 1, 1987.

The document was signed by Mayol for Gatetown and by Nouel (an

attorney at CANV) for Manver.
                              - 47 -

     An annex to the Bill of Sale between Gatetown and Manver

provided that the annual installments of $760,000 beginning

June 1, 1987, should have added to them simple interest of

9 percent per year payable monthly on the outstanding balance.

The document was dated June 30, 1986, and was signed by Mayol for

Gatetown and by Onate for Manver.

     An agreement dated July 25, 1986, between Eurotor and MTNV

purported to amend the January 20, 1983, document notwithstanding

that MTNV was not a party to the January 20, 1983, document.    The

original construction on the castle had been completed prior to

the castle’s opening in December 1983, 2-l/2 years before July

1986.   The amendment was allegedly necessary because “the

scheduled time to finish the constitution [sic] was delayed for

about six months or more.   The two parties agree that because of

the reasons mentioned above instead of an accrued 4% as seen in

the agreement signed of 1/20/83, it would be 10% (ten) of the

total estimated cost of the facility.”   The agreement was signed

by Sans for MTNV and by Santandreu for Eurotor.

     Manver purportedly entered into licensing agreements with

MTNV and MANV in 1986.   Both documents granted the licensees

(MANV and MTNV) the exclusive right to use the licensed services

described as “the Licensed Servicemarks and the Distinctive

Services in connection with the sale, offering for sale and

advertising of restaurant and entertainment services using the

Distinctive Services”.   Both documents required that the
                               - 48 -

licensees pay to Manver a royalty fee equal to a percentage of

the total gross sales derived from the services listed

thereunder, with the percentage established as 10 percent for the

first year, 12.5 percent for the second year, and 15 percent for

each year thereafter.   The percentages were within the range

suggested by Forsyth in the November 1986 draft letter. The draft

letter was prepared several months after the date placed on the

licensing agreements.   The agreements were for a duration of

5 years.

     The MANV licensing agreement was dated May 27, 1986, with

payments beginning November 30, 1987.     The MTNV licensing

agreement was dated August 1, 1986, with payments beginning

July 31, 1987.   Both documents stated:    “The first payment is due

183 days after commencement of operations by LICENSEE.”     The MTNV

agreement was signed by Mayol for Manver, Sans for MTNV, and

Watson as a witness.    Watson dated his signature March 30, 1987.

The MANV agreement was signed by Mayol for Manver and by

A. Gelabert for MANV.   The language in both of the documents was

substantially identical to the language in the draft of a

licensing agreement prepared by Hokanson and forwarded to Forsyth

on November 11, 1986, which was several months after the date of

the licensing agreements.    The differences between Hokanson’s

drafts and these two licensing agreements were the parties’

names, dates, and payment terms.

     Gatetown’s stock was held by de Oteyza and Mayol into 1987.
                              - 49 -

Futureprom, N.V. (Futureprom), was a Netherlands Antilles entity

incorporated on or about June 10, 1982.   On June 10, 1987, Onate

sent a letter to Sans requesting that Sans check to see if Allen

had the share certificates and articles for Futureprom.      On

August 17, 1987, the two shares of Gatetown were transferred from

de Oteyza and Mayol to Lince and Futureprom.   Lince and

Futureprom each received one of the two Gatetown shares.      On the

same date, de Oteyza resigned as a director of Gatetown and was

replaced by Onate.   After de Oteyza and Mayol transferred their

stock, the owners of Gatetown, through their ownership of Lince

and Futureprom stock, were Attractours (J. Montaner), Dapy

(Kahne), Holiday (Segui), Roundabout (Santandreu), Spectrust

(Valiente), Wayout (Climent), Promidux (P. Montaner), Primavert

(Santandreu), and Chavez.

     Harris sent correspondence to "HM Inspector of Taxes" in

London that detailed Gatetown’s activities.    Among the documents

were the Bill of Sale from Gatetown to Manver of the rights to

the Medieval Times concept and the annex that added the interest

payment.   Three additional documents were enclosed.   The

documents attempted to bind Gatetown to pay 95 percent of the

payments it received from Manver to Lince and Futureprom.      The

first agreement stated:

     In consideration of the receipt of 10.968 dolars, being
     an unsecured loan, with no interest or fixed repayment
     date, GATETOWN LIMITED, the borrower agrees to pay
     FUTUREPROM, N.V., the lender, 95% (ninety-five) of any
     future royalties, franchise fees, sale proceeds or any
                              - 50 -

     other income or interest whatsoever arising from the
     purchase by GATETOWN LIMITED of the rights to TORNEOS
     MEDIEVALES, S.A. OF ALL PATENT, TRADEMARK, COPYRIGHT,
     * * * INCLUDING THE GOODWILL, SERVICES, PRODUCTION,
     ADVERTISING, DISTRIBUTION, MARKS, IDEAS, CONCEPT,
     OPERATION MANUALS, SHOW SCRIPTS AND THE NAME MEDIEVAL
     TIMES, WHICH ARE IDENTIFIED BY THE MARKS “MEDIEVAL
     TIMES” AND “MEDIEVAL TIMES WITH DESIGN”, which it
     [Gatetown] has today purchased by the assistance of the
     above mentioned loan from * * * [FUTUREPROM].

The document was dated February 26, 1986, and was signed by Mayol

for Gatetown and by Nouel of CANV for Futureprom.

     The second document was almost identical to the first

document except that the loan was from Lince to Gatetown for

“21.936$ dolars”.   The remaining terms and conditions were the

same.   It was dated February 26, 1986, 3 months before Lince was

incorporated.   It was signed by Mayol for Gatetown and by Segui

for Lince.

     The third document referenced the first and second documents

and provided that, in consideration of the loans provided to

Gatetown by Lince and Futureprom whereby Gatetown agreed to pay

95 percent of any royalties, franchise fees, etc., to Lince and

Futureprom, Gatetown was now agreeing to pay to Lince 95 percent

of all of the income received from Medieval Attractions, N.V.

(Buena Park, U.S.A.), and to pay to Futureprom 95 percent of all

of the income received from Medieval Times, N.V. (Kissimmee,

U.S.A.).   The document was signed by Segui for Lince and by Nouel

for Futureprom.   It was dated June 1, 1986.
                             - 51 -

     Gatetown's existence was reflected in other documents

maintained by Harris, including a copy of the Spanish version of

the agreement whereby TM sold its rights to the Medieval Times

concept to Gatetown for 3,000,000 pesetas.    The “loans” from

Lince and Futureprom totaled $32,904.

     Another document in Harris’ possession was titled “Gatetown

Limited Accounts for the Period Ended 30th April 1988".    That

document contained the following:

     PRINCIPAL ACTIVITY AND BUSINESS REVIEW

     The principal activity of the Company is that of owners
     of royalty and copyright agreements.

     The Company acquired the rights to certain trade marks,
     patents etc. which were transferred and assigned to the
     Subsidiary Company [Manver] in exchange for the entire
     issued Share Capital (the Subsidiary Company not having
     any assets or liabilities previously) in addition to an
     obligation to pay to the Company $760,000 each year for
     5 years.

     The Company is under obligation to its two shareholders
     Futureprom N.V. and Lima [sic] N.V. to pay 95% of its
     income to the two Companies.

     The Company has had a satisfactory year and looks
     forward to the future with confidence.

The document listed as Gatetown’s 1988 assets:    $1.8 million as

“Investment in Subsidiary” and $3,131,200 as “Amounts owed by

Subsidiary Company”.

     The October 8, 1990, letter from Harris to "HM Inspector of

Taxes" included the following information on royalty payments by

Gatetown:
                               - 52 -

                                      1988               1989

Futureprom N.V.                   $  786,085          $1,678,138
Lince N.V.                         1,172,763           3,735,209

      Manver International, C.V. (MICV), and Manver Global, B.V.,

were incorporated in 1990.    Santandreu and Onate were members of

MICV’s Executive Committee.   Lince and Futureprom each owned

48.5 percent of MICV stock.   A document dated October 17, 1990,

purported to transfer from Manver to MICV:

      all world wide rights to the intellectual property and
      franchising rights with respect to the idea, concept
      and Operating Manuals concerning a Dinner and
      Tournament Show Restaurant in medieval style and/or
      villa’s Medieval style under the names “Medieval Times”
      and/or “Medieval Life”, and all related rights
      including but not limited to trademarks, tradenames,
      copyrights, goodwill, licenses and physical ownership
      of documents embodying any right of intellectual
      property and franchising rights etc., hereinafter
      referred to as “The Intellectual Property” * * *

      In consideration of the sale, MICV agreed to pay to Manver

$64.1 million by “way of two promissory notes which will be

issued upon signature of this agreement.”      The document was

signed by Onate for Manver and by Santandreu for MICV.

Subsequently, a 1990 financial statement for MICV reflected a

$64.1-million note payable.   In 1991, the $64.1 million was

reflected as capital stock.

VI.   Trademarks and Copyrights

      In December 1982, Castro filed an application for a post

office box in Kissimmee, Florida, in the name of Medieval Times.

The name Medieval Times had not been used previously in the
                                - 53 -

United States or Spain.   In December 1983, A. Gelabert filed an

application for a business license with the State of Florida.

The business name on the application was Medieval Times.    From

1983 to 1987, the Medieval Times trademark and logo continued to

evolve and the stationery and business cards bore different

lettering styles and designs.    The Rocaberti shield was used in

some instances, and, in other instances, a picture of a castle

was used on stationery.

     Hokanson, at LL, performed trademark and copyright

registration work for the Medieval Times companies in 1986 and

1987.   Originally, MANV was identified as the client.    Invoices

for LL’s services on October 24, 1986, and May 22, 1987, were

sent to MANV in Buena Park, California.    Hokanson relied on the

information provided to him by A. Gelabert, Forsyth, Santandreu,

and Onate with regard to the ownership of the trademark.

Hokanson made no independent inquiries into the ownership of the

trademarks.

     A letter dated October 17, 1986, from A. Gelabert to

Hokanson stated:    “Names of corporation which will register the

trademark of Medieval Times will be GATETOWN LTD. (Limited),

incorporated in England on June 22, 1985.”

     LL filed to register the marks “Medieval Times” and

“Medieval Times with Design” in California and Florida in

February 1987.   The Medieval Times mark consisted of the words

“Medieval Times”.   The Medieval Times with design mark consisted
                                 - 54 -

of the words “Medieval Times” and the Rocaberti shield.      The

California marks were successfully registered in California in

May and October 1987.   The Florida marks were successfully

registered in March 1987.     The applications for California and

Florida named Manver as the applicant.

      LL applied to register the marks with the U.S. Patent and

Trademark Office in September 1987.       The marks were successfully

registered in November and December 1988.      The applications named

Manver as the applicant.      In January 1989, Onate sent a letter to

Sans stating that the new registered marks should be included on

all documents printed in the future.      In February 1989, Sans

informed Bellows about the requirement to include the registered

marks on all future printing.

II.   Section 351 Transfers

      As part of the plan to restructure the Medieval Times

companies, C&L prepared a valuation of the tangible and

intangible assets of Medieval Times.      As of January 31, 1987, C&L

concluded that the fair market value of MANV’s assets was

$6,174,800 and the value of MTNV’s assets was $4,358,380.      The

amount of fair market value attributed to goodwill was $5,582,577

for MANV and $3,670,936 for MTNV.     The valuation reports stated:

      Goodwill is defined as that favorable disposition which
      customers entertain toward a particular enterprise
      which may induce them to continue giving their
      patronage to it. The existence of goodwill of an
      enterprise is evidenced by earnings in excess of those
      normally encountered in that company’s particular
      industry.
                              - 55 -

Information about the valuations was provided to A. Gelabert in

letters dated March 1987.   The letters also stated:

     We define fair market value as the price at which
     property is exchanged between a willing buyer and a
     willing seller, neither being under compulsion to act
     and both having reasonable knowledge of relevant facts
     and market conditions. Our estimate of fair market
     value does not reflect synergies and efficiencies that
     a specific buyer may contribute.

In a November 16, 1987, letter, C&L advised A. Gelabert that the

fair market value of MANV as of September 30, 1987, had increased

to $14 million.   C&L valued MANV goodwill as of September 30,

1987, at $13,696,767.   The companies that C&L used as comparables

in its valuation included TGI Friday’s, Inc.; International

King’s Table; Jerrico; and Vicorp.

     MSI was incorporated in Florida by Allen on January 20,

1987.   MDT was incorporated in California on or about August 3,

1987.   MSI and MDT were going to be the U.S. operating companies

as required by the C&L plan for a three-tier corporate structure

for the Medieval Times companies.

     MABV and Medieval Times, B.V. (MTBV), were incorporated in

The Netherlands on September 29, 1987, and July 31, 1987,

respectively.   MABV and MTBV were to be the middle tier in the

three-tier structure proposed by C&L.

     Throughout 1987 and until December 12, 1988, the various C&L

offices involved in implementing the three-tier restructuring

plan corresponded with drafts of agreements, promissory notes,

and timetables in anticipation of the section 351 transfers.     In
                              - 56 -

July 1988, C&L Amsterdam sent to Forsyth drafts of promissory

notes that were dated 1987.

     The correspondence was dominated by discussions on tax

rulings from the Netherlands Antilles.   Randolph M. Th. de Cuba

of C&L sent letters dated September 30, 1988, to the Inspector of

Taxes in the Netherlands Antilles requesting tax rulings on

behalf of Manver, MTNV, and MANV.   C&L wanted rulings for Manver

on the tax treatment of royalties, income, and whether or not

interest would be imputed on non-interest-bearing loans.     The

ruling requests for MANV and MTNV concerned income, dividend

income from MABV, and whether or not interest would be imputed on

non-interest-bearing loans.   The letters also provided that

Manver held the shares of MANV and MTNV, that MANV held all of

the shares of MABV, and that MTNV held all of the shares of MTBV.

C&L received the rulings it desired from the Inspector of Taxes

on October 6, 1988.   The Inspector of Taxes agreed, among other

things, that interest would not be imputed on the specified non-

interest-bearing loans.

     Some of the documents that purported to effectuate the

section 351 transfers were executed no earlier than late 1988,

although they were dated 1987.   The documents for the Florida

side of the double section 351 transactions were dated August 1,

1987, one day after incorporation of MTBV.   The documents

provided that, on that date, MTNV ceased doing business and

transferred its assets and business, subject to its liabilities,
                               - 57 -

to MTBV for a total consideration of $4.4 million (U.S.).    Of

this amount, 1.723 million Dutch Guilders was paid in stock of

MTBV, 1.953 million Dutch Guilders was paid in an

interest-bearing note, and $2.64 million (U.S.) was paid in a

non-interest-bearing note.    The 1.953 million Dutch Guilders note

was payable in 10 years upon presentation of the note.    The

interest was payable on the Dutch Guilders note quarterly at a

rate of 9.5 percent, with the principal due in 10 years upon

presentation of the note.    The non-interest-bearing $2.64 million

loan was “payable in ten years on presentation of this promissory

note”.

     MTBV immediately transferred the assets and business it

received from MTNV to MSI for a total consideration of

$4.4 million.   Of the $4.4 million, $1.1 million was paid with

MSI stock and $3.3 million was paid with a negotiable interest-

bearing promissory note.    The terms of the promissory notes

varied among the drafts from 5 years to 10 years.    Interest at a

rate of 9.5 percent was to be paid quarterly, with the principal

due at the end of the term of the note.

     The documents for the California side of the double section

351 transaction were dated December 1, 1987.    The documents

recited that, on that date, MANV ceased doing business and

transferred its assets and business, subject to liabilities, to

MABV for a total consideration of $14 million (U.S.).    Of the

$14 million, 4,879,875 Dutch Guilders was paid in stock of MABV.
                              - 58 -

MABV issued an interest-bearing note in the amount of 5,530,525

Dutch Guilders with 9.5-percent interest due quarterly and the

principal due in 10 years on presentation of the promissory note.

MABV also issued a non-interest-bearing note for $8.4 million

(U.S.) that was payable in 10 years upon presentation of the

note.

     MABV immediately transferred the assets it received from

MANV to MDT for a total consideration of $14 million.   Of this

amount, $3.5 million was paid with MDT stock and $10.5 million

was paid with an interest-bearing note.   The interest-bearing

note had a rate of 10 percent.   The interest was due quarterly,

and the principal was due in 5 years.

     After the section 351 transfers, MTNV held all the stock of

MTBV, which held all the stock of MSI.    MANV held all the stock

of MABV, which held all the stock of MDT.   The C&L September 30,

1988, letter to the Inspector of Taxes stated that Manver held

all the shares of both MANV and MTNV.

     MSI and MDT signed licensing contracts with Manver that were

substantially the same as the Manver-MTNV/MANV contracts.   The

MSI and MDT documents were dated August 1, 1987, and December 1,

1987, respectively.   MSI and MDT signed new management contracts

with Eurotor dated August 1, 1987, and December 1, 1987,

respectively.
                                  - 59 -

VIII.    California and New Jersey Expansion

        A.   California

        The Medieval Times group began to expand its operations.     On

December 15, 1987, Glendale Castle, Inc. (GCI), was incorporated

in California.      GCI filed 1987 (fiscal year December 23, 1987, to

November 30, 1988) and 1988 Federal tax returns that stated that

GCI was an inactive corporation.      GCI’s articles were amended on

December 13, 1988, to change the name of GCI to the San Diego

Castle, Inc. (SDCI).      The amendment stated that it had been

approved by the board of directors.        In December 1988, GCI/SDCI

entered into a lease, signed by A. Gelabert, for vacant land in

Carlsbad, California.      A. Gelabert also signed papers in the name

of GCI/SDCI on an application for a change of zoning to

accommodate the new castle facility and on an agreement for the

payment of a public utilities fee.

        MDT maintained an account entitled “Advances - San Diego

Castle”.      The first entry was June 15, 1988, and the last entry

was November 30, 1990.      The expenses included payments to the

City of Carlsbad, C&L, an engineering company, and marketing fees

to RC.       MDT deducted these expenses on its Federal tax returns in

the amounts of $18,633 and $128,775 in 1988 and 1989,

respectively.

        In December 1989, after the Carlsbad Planning Commission

denied GCI/SDCI’s project because of traffic problems, GCI/SDCI

withdrew its application from the planning commission.       A
                              - 60 -

planning commission letter dated December 14, 1989, accepted the

withdrawal.   The letter also listed previous actions related to

the application, including that the commission had passed a

motion on October 18, 1989, to discuss the traffic issues

associated with the application.   After the December 14, 1989,

letter, Taylor, with Santandreu’s knowledge, continued to look

for sites in San Diego on which to build a castle.

     A document entitled “Resolution of the Board of Directors of

Medieval Dinner & Tournament, Inc.” resolved that the corporation

(MDT) immediately abandon the Carlsbad project “considering the

fact that the corporation failed to get the necessary approval by

the Carlsbad Planning Commission”.     It was dated October 17,

1989, Palma de Mallorca (Spain), and was signed by Santandreu,

A. Gelabert, Segui, P. Montaner, Kahne, and Climent.

     B.   New Jersey

     In December 1987, Meadowlands Castle Inc. (MCI) was

incorporated in New Jersey for the purpose of opening a castle in

New Jersey.   MCI retained a New Jersey law firm to represent it

before various city, county, and State authorities.     By this

time, Watson was working for the Medieval Times companies and had

an ownership interest in MANV through Estaspan.     Watson went to

New Jersey to assist with the development.     He opened bank

accounts at National Community Bank (NCB) in New Jersey in MCI’s

name; made a presentation to the City Council of Lyndhurst, New

Jersey; and negotiated with a landlord for a lease in the name of
                                - 61 -

MCI.    On July 20, 1988, A. Gelabert directed the Australia and

New Zealand Bank (ANZ Bank) to transfer $45,000 from the "Wayout

dividend account" to MCI’s account at MCI’s New Jersey bank.     MCI

had several accounts at NCB.    MDT transferred money to MCI

accounts, including a $100,000 transfer on April 12, 1988, and a

$127,000 transfer on September 15, 1988.    MCI maintained an

insurance policy in its name.

       In September 1988, Watson, on behalf of MCI, obtained a

letter of credit from ANZ Bank for $325,000.    In December 1988,

Santandreu, A. Gelabert, Segui, P. Montaner, Kahne, and Climent

were elected to the board of directors of MCI.    On March 20,

1989, A. Gelabert, as MCI president, signed a construction

contract to build the New Jersey castle.    The New Jersey castle

was subsequently built with funds supplied by MDT.    Various

contracts, invoices, and correspondence continued to use the name

MCI after March 20, 1989.

       C.   C&L Advice

       In a letter to Santandreu dated August 31, 1988, C&L

responded to Santandreu’s questions about equity contributions to

MCI.    The letter stated that MCI would be owned 87 percent by MDT

and 13 percent by minority shareholders.    The letter further

stated:

       Instead of discussing ways to make equity contributions
       by respective shareholders, this letter discusses the
       merits of operating new castles as divisions of MDT
       rather than separate subsidiaries, at least until the
       operation at each castle commences.
                              - 62 -

     ISSUE

     Can MDT currently deduct the pre-operating expenditures
     incurred for the Glendale and Meadowlands castles and
     amortize under IRC Section 1253(d)(2) the franchise
     rights it acquired from Manver, N.V. (MNV) before the
     operation at each castle commences?

     C&L's letter recited several facts, including:    MDT entered

into a contract with Manver to amortize franchise rights for MDT,

GCI/SDCI, and MCI; GCI/SDCI and MCI were both incorporated in

December 1987 to operate castles; GCI/SDCI and MCI were both

currently negotiating leases for land to build castles; MCI had

already incurred $200,000 in startup expenses, which were paid

with advances from MDT and contributions of capital from 13

minority shareholders; it was expected that both sites would

incur substantial additional preoperating expenses; and MDT was

planning to contribute its capital share (87 percent of

$1.5 million) to MCI in the near future.

     The letter continued with an assessment of various Internal

Revenue Code sections and case law.    It pointed out that costs

incurred before the actual commencement of a trade or business

(i.e., startup costs) are "clearly not deductible since such

expenses are not incurred in 'carrying on a trade or business'

under IRC section 162."   However, it noted that expansion costs

incurred by an ongoing business enterprise are incurred in

"carrying on a trade or business" under section 162 and will

therefore be currently deductible as long as they are not capital

expenditures.
                              - 63 -

     With regard to the deduction for the amortization expense,

C&L noted that, for the deduction to be taken, the transferee of

a franchise must also be conducting a trade or business.   It

explained that the trade or business requirement allows

deductions for expenses incurred only when business operations

commence and activities for which the trade or business was

formed are performed.   C&L stated that there was an issue as to

whether or not a trade or business existed with respect to MCI

and GCI/SDCI because the actual operations of the castles would

not commence for at least a year.

     C&L addressed a resolution for both issues and stated:

     However, if we assume that both MC [MCI] and GC
     [GCI/SDCI] can be operated as divisions of MDT instead
     of separate subsidiaries, an argument can be made for
     amortizing the franchise rights before the commencement
     of operations at MC and GC. It can be argued that MDT
     acquired the additional franchise rights in order to
     expand into other territories and as such the
     amortization of the additional franchise rights are
     "ordinary and necessary" expansion costs incurred by an
     ongoing business enterprise in "carrying on a trade or
     business."

C&L concluded that “there appears to be relatively strong support

for deducting pre-operating expenses at MC [MCI] and GC [GCI] and

amortizing the franchise rights for the Glendale and Meadowlands

sites as long as both castles are operated as divisions of MDT,

not as separate subsidiaries.”   C&L recommended a number of

actions, which included:

     Operate the two additional castles as divisions of MDT
     and delay equity contributions to MC [MCI] and GC [GCI]
     until after the operation commences at each location.
                                   - 64 -

      Andres Gelabert indicated that the minority
      shareholders would have no objection to this idea.
      * * *

           *       *      *         *        *      *      *

      Do not treat any of the monies spent already as either
      advances to or equity contributions to MC [MCI] or GC
      [GCI]. Instead, MDT should treat its advances or
      potential equity contributions as divisional
      expenditures and the “equity” contributions from the
      minority shareholders, if needed, should instead be
      treated as loans to MDT which, in turn, were used in
      the divisional projects.

IX.   Dividends

      MTNV paid dividends from the 1983 through 1985 profits on

January 27, 1986, and May 1, 1986.          The payments consisted of the

following:

                  Spectrust             $ 31,070.42
                  Promidux                45,676.99
                  Dapy                    45,674.67
                  Roundabout              29,413.55
                  Holiday                 29,413.55
                  Wayout                  25,892.41
                  Alfonso Chavez          12,946.21
                  Gloria Chavez           12,946.20
                                        $233,034.00

The payments were approximately in proportion to each payee’s

ownership interest in MTNV.

      MTNV paid dividends on 1986 profits on October 7, 1986, in

the following amounts:
                                - 65 -

               Spectrust             $ 82,200.95
               Promidux                80,151.01
               Dapy                    80,151.01
               Attractours             81,830.97
               Roundabout              77,817.47
               Holiday                 77,817.47
               Wayout                  68,501.82
               Gerard Chavez           12,331.56
               Alfonso Chavez          28,085.13
               Gloria Chavez           28,085.13
                                     $616,972.52

The payments were approximately in proportion to each payee’s

ownership interest in MTNV.

     A. Gelabert, as managing director of MTNV, directed Sans, in

a letter dated June 17, 1987, to pay additional dividends.     The

dividends were paid in June 1987 as follows:

               Spectrust             $ 66,665.00
               Promidux                52,502.50
               P. Montaner             12,250.00
               Dapy                    52,502.50
               Kahne                   12,250.00
               Roundabout              50,610.00
               Roundabout               1,055.55
               Santandreu              12,250.00
               Holiday                 50,610.00
               Holiday                  1,055.55
               Segui                   12,250.00
               Wayout                  55,555.00
               Attractours             66,000.00
               Gerard Chavez            9,800.88
               Alfonso Chavez          22,321.51
               Gloria Chavez           22,321.51
                                     $500,000.00

The payments were approximately in proportion to each payee’s

ownership interest in MTNV.   The 1987 dividends were the last

dividends paid by MTNV.   No dividends were paid by MSI from

incorporation through at least 1991.
                                - 66 -

      MANV paid dividends once, during the fiscal year ended

November 30, 1987.     The dividends totaled $2.5 million.   No

dividends were paid by MDT from incorporation through at least

1991.

X.   Marketing Agreement

        A 1986 C&L letter addressed to Santandreu, marked "September

draft", addressed the best method of “structuring the arrangement

between A and B so that profits and losses are shared equally and

Company A retains the benefit of appreciation in the property.”

In the draft letter, C&L pointed out the disadvantages of

operating as a partnership and suggested the use of a management

agreement:

        A simpler way to structure the agreement and still
        accomplish the objectives of the property owner would
        be for MANV to retain ownership of the property and
        contract with MTNV to manage the project. Under this
        approach, if profits and losses are shared equally by
        the two companies, the possibility exists however, that
        the Internal Revenue Service could determine that the
        arrangement is actually a joint venture taxable as a
        partnership. Thus, extra care would need to be taken
        in drafting the management agreement. For example, a
        management agreement between MANV and MTNV could be
        drafted allowing the compensation of MTNV to be based
        on a percentage of gross receipts, or a percentage of
        net cash flow (i.e. gross receipts less operating
        expenses). Depreciation and amortization would thus be
        allocated entirely to MANV as property owner.

        In 1989, an agreement between MANV and MTNV dated March 4,

1986, was sent to MSI.     The agreement was structured in

accordance with the advice that C&L rendered to the Spanish

investors in October 1986 and required MANV to pay to MTNV

10 percent of MANV’s profits after taxes during MANV’s 1986
                                - 67 -

fiscal year.     The agreement stated that the payment was to be

paid in return for services that MTNV provided to MANV regarding

the:

       technique in marketing, promotion and publicity of a
       dinner tournament business, and for taking its
       representation to assist in fairs, conventions and
       other mass meetings relating to the business of M.A.
       [MANV], with enough powers and authorization to
       contract in the name of M.A., travel agency groups,
       company groups and others, always under the economical
       conditions marketed by M.A.

The payment was to be due “not later than one year after the

filing by M.A. [MANV] of its 1986/1987 Tax Return to the Internal

Revenue Service in the USA.”     MANV filed its 1986 Federal tax

return on June 7, 1988.

       A fax cover sheet dated June 22, 1989, from Onate to Bertha

Moreno at MANV/MDT stated:     “We are faxing you the Agreement

regarding the invoice of US $236,313.30 for Marketing Consulting

between Medieval Times and Medieval Attractions.”     Onate sent to

Mary Ann Powell at MDT/MANV a letter dated July 3, 1989, in which

Onate enclosed a copy of the marketing agreement for her files.

MDT/MANV paid to MSI/MTNV $236,313.30 by check dated July 3,

1989.     The check reflected an amount equal to 10 percent of MDT’s

profits after taxes as stated on MDT’s fiscal year 1986

(December 1, 1986, to November 30, 1987) Federal tax return.

XI.    Commercial Paper

        During 1987, the U.S. Treasury Department announced its

intention to terminate several of the tax treaties that existed

between the United States and the Netherlands Antilles.     The
                             - 68 -

termination would have had an effective date of January 1, 1988.

Because the termination would have affected the Medieval Times

companies, C&L advised them to consider accelerating any payments

that were scheduled to be made to the Netherlands Antilles

companies after January 1, 1988.    Among the alleged various

payments that the Medieval Times companies had to make after

January 1, 1988, were amounts under the licensing agreements

between Manver and MDT and between Manver and MSI.    Pursuant to

the Manver-MANV/MDT agreement, MANV had paid Manver $1,441,924 as

franchise fees for 1987, but MANV/MDT and MSI purportedly still

owed the balance of the contracts to Manver.

     C&L and Santandreu determined that it would be possible for

the licensees (MDT and MSI) to prepay the royalties that were due

under the 5-year licensing agreements.    The prepayment plan would

require the licensees to prepay the royalties in a lump sum up

front by financing the prepayment amounts with promissory notes

that allowed the licensee to pay interest only for 5 years, with

a balloon principal payment due at the end of the 5 years.

     C&L advised that the lump-sum payment amount would have to

represent the discounted present value of the expected royalty

stream for the prepayment period.    The information about the

income stream was provided to C&L by Medieval Times personnel.

In addition to the Florida and California lump-sum amounts,

lump-sum amounts were determined for the New Jersey and

Glendale/San Diego castles, even though these castles were not
                               - 69 -

operating at the time.   C&L used 3-year income streams on the two

nonoperating castles instead of the 5-year income streams used on

the operating castles.   The New Jersey and Glendale/San Diego

castle amounts were added to the MDT lump-sum amount for a total

of $15.75 million.    The MDT discounted present value amounts were

computed as:   Buena Park, $9.9 million; New Jersey,

$3.15 million; and Glendale/San Diego, $2.7 million.    The

lump-sum amount for MSI was $7 million.    Under this plan, MSI and

MDT would have collectively given Manver promissory notes for

$22.5 million in 1987 and paid interest on the promissory notes

monthly.    The principal would have been due in 5 years.

     Under the lump-sum plan, MSI and MDT would have been subject

to withholding tax on the interest payments to Manver.      C&L

therefore suggested that the withholding could be avoided through

the use of commercial paper.    C&L advised that there was an

exemption in the U.S. tax law that excused the withholding tax on

interest on promissory notes (commercial paper) with a term of

less than 183 days.

     Forsyth dealt primarily with Santandreu and Onate concerning

the commercial paper.    The procedure required issuing an initial

round of commercial paper (tranche) with a maturity of less than

183 days.   Prior to maturity, the tender panel manager must have

the cash available to repay the first tranche.    The cash could

come from a new issue of commercial paper, or, alternatively, the

tender panel manager could call on the guarantor or the company
                               - 70 -

to provide additional funds.   Either way, the tender panel

manager had to have the cash prior to the maturity of the first

tranche to repay that tranche.   Forsyth advised that C&L would

like a substantial part of the placement made to unrelated

parties but that related parties could be investors in the

program.   Forsyth advised that the guarantors should not purchase

the commercial paper directly or indirectly.      Forsyth also

advised that it would be better for a purchaser holding notes in

an expiring round not to purchase notes in the replacement round.

     Forsyth inquired about how much cash the Spanish investors

could provide as part of the commercial paper arrangement.       At

this time, the Spanish investors had $10 to $20 million in their

bank accounts.   It was decided that $10 million cash would be

provided by the Spanish investors through their controlled

Netherlands Antilles corporations.      MSI and MDT were to issue

commercial paper sufficient to borrow the $10 million, which

would be paid to Manver before December 1987.      The remaining

$12.5 million would be financed by the issuance of promissory

notes to Manver.   In December 1987, $5 million was transferred

from the J. Montaner-controlled entities, primarily Dapy, and

$5 million was transferred from the Santandreu-controlled

entities, primarily Roundabout, to Gatetown.      On December 22,

1987, MSI and MDT issued negotiable commercial paper promissory

notes, in $500,000 increments, to five entities to finance the

$10-million payment.   The five entities were companies controlled
                              - 71 -

by the Spanish investors:   Lince; Protravol; Edemle, N.V.

(Edemle); Attractours; and Futureprom.   These five companies did

not transfer money to MSI or MDT as purchase money for the notes.

The commercial paper notes matured June 17, 1988, because, in

accordance with C&L’s form, the notes could not have a maturity

date over 183 days.

     On December 29 and 30, 1987, Gatetown transferred $7,136,376

of the $10 million to MDT and $2,854,599 to MSI.   On December 29

and 30, 1987, MDT transferred $6.9 million cash and issued three

negotiable promissory notes totaling $8.6 million to Manver.    MSI

transferred $3.1 million cash and issued a negotiable promissory

note in the amount of $3.9 million to Manver.   After these

transactions, Manver had been paid the $22.5 million.   The

payments consisted of the $10 million cash that originated from

the Dapy and Roundabout entities, for which the commercial paper

was issued, and $12.5 million in promissory notes.

     Amendments were drawn up to the MDT/Manver and MSI/Manver

licensing agreements to reflect the new lump-sum payment terms.

The amendments provided for 10-percent interest on the unpaid

balance, interest only payable monthly, and the entire balance

due in 5 years.   An additional term was added to both amendments

that required MDT and MSI to pay to Manver 15 percent of gross

sales that were in excess of base amounts set forth in the

agreements.   The base amounts were:
                               - 72 -

     Year                  MDT Base             MSI Base

     1988                $17,800,000         $11,700,000
     1989                 20,000,000          13,400,000
     1990                 22,300,000          15,200,000
     1991                 24,500,000          17,300,000
     1992                 24,500,000          18,200,000

     Santandreu decided to refinance the $12.5-million promissory

notes with commercial paper to avoid the withholding, as was

accomplished on the $10 million.   On March 23 and 24, 1988,

Manver deposited $9.03 million with Gatetown.   On March 24, 1988,

the refinancing was accomplished by the following transactions:

Gatetown transferred approximately $4.03 million to Lince, which

transferred the same amount to Roundabout; Roundabout transferred

$2.673 million to Gatetown; Gatetown transferred approximately

$7.672 million to MDT, which then transferred this amount to

Manver.

     Manver started the circle again by transferring

$2.672 million to Gatetown, which transferred that sum to Lince.

Lince transferred $1.41 million to Primavert, which transferred

that sum to Protravol.   Lince transferred another $1.262 million

to Roundabout.   Roundabout then transferred approximately

$1.944 million to Protravol.   Protravol transferred approximately

$3.354 million to Gatetown, which transferred it to MSI, which,

in turn, transferred it to Manver.

     By shifting the funds, which originated with Manver, through

the various entities, MSI and MDT used $7.672 million to reduce
                                - 73 -

the debts to Manver by $11 million.      MSI issued $3.5 million and

MDT issued $8 million in commercial paper to six entities--

Protravol; Attractours; Futureprom; Amsrott, N.V. (Amsrott);

Celin, N.V. (Celin); and Slider, N.V. (Slider)--to account for

the $11 million paid to Manver, even though none of the six

companies provided any of the funds to pay the Manver debt as the

funds originated from Manver.

     The original $10 million that was transferred to Gatetown

from Dapy and Roundabout was returned to Dapy and Roundabout in

May and June 1988.   The first tranche of commercial paper that

was issued December 22, 1987, was to mature on June 17, 1988.       On

that day, $2.391 million was channeled through various entities

in order to retire the first tranche of commercial paper totaling

$10.5 million.   At the same time, another tranche of commercial

paper totaling $10 million was issued.

     As each tranche of funds matured, a new set of transactions

occurred that retired the old paper, issued new paper, and paid

amounts that were associated with the issuance of the paper, such

as Original Issue Discount interest and guarantee fees.       The

commercial paper carried an interest rate of 1 percent over

London Interbank Offered Rate (LIBOR).     The interest and

guarantee fees were transferred from the controlled entities

receiving the payments to the Spanish investors' Eurotor

companies in proportion to the Spanish investors' interests in

MTNV and MANV.
                                - 74 -

       Dapy and Roundabout acted as guarantors on the commercial

paper transactions and received fees for the service.      Although

the fees were paid to Dapy and Roundabout, the fees were

ultimately distributed to the group of Spanish investors.

Neither Dapy nor Roundabout was actually required to make a

payment as a guarantor.

       Subsequent tranches of commercial paper were issued on dates

including September 17, 1988; December 14, 1988; March 15, 1989;

June 11, 1989; September 10, 1989; March 6, 1990; August 30,

1990; November 26, 1990; and later.      These transfers used the

same type of circular funding.    The only differences were the

dates, bank accounts, amount of money, and which entities were

used.

       The companies that participated in the commercial paper

transactions and the companies that acted as guarantors of the

paper were controlled by the Spanish investors.      Primarily,

Santandreu directed and A. Gelabert and Onate carried out various

aspects of the commercial paper transactions.      Santandreu owned

an interest in a finance company and had been represented by the

other Spanish investors to be an expert in international finance.

XII.    Royalty Transactions Relied Upon in Federal Tax Returns

        The positions taken by the Medieval Times entities on their

Federal tax returns with regard to royalty payments were based on

the following series of purported transactions:      Gatetown’s

purchase of the Medieval Times concept from TM on March 1, 1986,
                                - 75 -

for $7,312; Manver’s purchase of the Medieval Times concept from

Gatetown on May 27, 1986, for $5.6 million; MSI’s right under the

Manver license to use the Medieval Times concept from Manver for

$7 million on December 22, 1987, and the related commercial paper

used to finance the transaction; and MDT’s right under the Manver

license to use the Medieval Times concept from Manver for

$15.75 million on December 22, 1987, and the related commercial

paper used to finance the transaction.

XIII.    Federal Tax Returns

        A.   MTNV/MSI

        The MTNV Federal tax returns for fiscal years ended July 30,

1987, and August 1987 (partial year return), and the MSI returns

for the fiscal years ended July 31, 1988, and July 31, 1989, were

prepared by the C&L Orlando office.      Statements attached to the

returns indicated that MTNV transferred its assets to MTBV and

that MTBV transferred its assets to MSI, in section 351

transactions for stock and securities.     The statements reported

that all future operations would be reported by MSI.     The

statements reflected the property received, stock and securities

issued, and liabilities assumed:    “Medieval Times B.V. has

assumed all of the liabilities of Medieval Times, N.V.”
                               - 76 -

       MTNV/MSI reported the following on its Federal tax returns:

                                                                     Royalties/
FYE          Gross           Total               Taxable             Franchise
July         Receipts        Income              Income              Payments

1986        $ 7,048,767    $3,836,276        $     636,795               --
1987          8,880,965     5,884,314            1,308,856           $ 888,513
1988         11,338,915     7,522,728            1,485,473             489,190
                                                                       855,023
1989         12,714,857     8,401,603            1,815,541           1,400,000
                                                                        15,728
1990         13,413,711     8,526,965            1,636,788           1,400,000

12/31 Calendar Year

1990          4,290,024     2,696,365              205,292              583,333
1991         11,759,972     7,710,400            1,754,155            1,400,000

MSI deducted as consulting fees to Eurotor:

MSI                                       1988                1989

Eurotor                                 $232,549             $86,341

       Included in the 1987 through 1989 returns were additional

deductions for management fees and royalty payments to Manver.

The 1988 and 1989 returns also contained deductions for debt

guarantees, franchise amortization, and interest including

Original Issue Discount.

       The taxable income of MTNV/MSI for years ended 1984 through

1991 totaled $9,024,857.    The total royalty/franchise payment

paid to Manver for that period was $7,031,787.         Of the preroyalty

payment profits, 56 percent went to MTNV/MS and 44 percent went

to Manver as royalty and franchise payments.

       In August and September 1985, J. Russell Hamlin (Hamlin) of

C&L Orlando sent two letters to Lesley Gelabert (L. Gelabert),

A. Gelabert’s wife, at Inverspan, regarding Inverspan, MTNV, and
                              - 77 -

Eurotor.   The letters informed L. Gelabert that the Internal

Revenue Service (IRS) had issued new reporting requirements for

U.S. corporations and foreign corporations operating in the

United States that are owned by a foreign person.   The

requirement was that a reporting entity had to report each

transaction with a “related party” on IRS Form 5472, Information

Return of a Foreign Owned Corporation.   One letter stated that

transactions were defined broadly and included commissions,

interest, rents and royalties paid and received, loans, sales,

purchases, and services performed by or for the reporting entity.

The letter continued:

     Separately, it is expected that the IRS will utilize
     the information contained on Form 5472 to determine
     whether the reported transactions were conducted at
     “arms-length”. Thus, in reviewing transactions for
     preparation of the Form 5472, the vulnerability to
     attack by the IRS under the Section 482 arms-length
     standard should also be considered.

Hamlin sent a final IRS proof copy of Form 5472 with

instructions.   Hamlin also offered to assist L. Gelabert in

reviewing transactions to determine whether they must be reported

and “to further assist in minimizing the exposure to future IRS

audit adjustments under Section 482.”

     No Forms 5472 were filed with the MTNV 1987 Federal return.

Neither MTNV nor MSI filed Forms 5472 with their Federal returns

for fiscal years ended 1988 and 1989 for transactions engaged in

with Manver, Gatetown, Lince, Futureprom, Attractours, Edemle,

Celin, Amsrott, Slider, Protravol, Etano, N.V. (Etano), or
                                  - 78 -

Lebasi, N.V. (Lebasi).       Linda Parks (Parks) of C&L Orlando

prepared and signed the MSI 1988 return.       It was also signed by

Sans.       At the time she prepared the return, Parks was aware of

the Form 5472 requirement but did not know that the franchise fee

was being paid to a related party.

       B.     MANV/MDT

        The MANV/MDT Federal tax returns for fiscal years ended

November 30, 1987 through 1990, were prepared by the Los Angeles

C&L office.       Statements attached to the returns indicated that

MANV transferred its assets to MABV and that MABV transferred its

assets to MDT, in section 351 transactions for stock and

securities.       The statements included information that MABV had

assumed all of the liabilities of MANV.

        MANV/MDT reported the following on its Federal tax returns:

                                                            Royalties/
FYE            Gross           Total         Taxable        Franchise
Nov. 30        Receipts        Income        Income         Payments

1987          $14,409,710    $10,601,670    $4,347,581     $1,441,924
1988           18,665,675     13,836,206     1,183,497      3,719,321
1989           21,278,643     15,537,012     1,054 389      5,148,541
1990           31,251,794     22,688,216     5,563,637      2,975,726

12/31 Calendar Year:

1990            2,367,034      1,730,776       442,963        248,004
1991           34,793,808     24,047,269     2,817,007      4,396,287

Additionally, petitioners MANV/MDT claimed deductions for

payments it made as management and consulting fees in the amounts
of:
                               - 79 -

MANV/MDT             1987               1988          1989

Eurotor            $271,041         $373,854        $ 37,546
RC                  132,937          380,096         228,128
A. Gelabert          16,580           17,215          21,877
Santandreu           37,000           21,069           8,000
Segui                44,000


Included in the 1987 through 1990 returns were additional

deductions for royalties/franchise fees and interest expenses.

The 1988 and 1990 returns also claimed deductions for guarantee

fees.

     For fiscal years ended 1986 through 1991, MANV/MDT’s taxable

income totaled $15,738,227.    During the same period, payments to

Manver for franchise/royalties fees totaled $18,336,335.       Of the

preroyalty payment profits, 46 percent went to MANV/MDT and

54 percent went to Manver.

     No Forms 5472 were filed by MANV/MDT on its 1986 through

1991 income tax returns for transactions with Manver, Gatetown,

Lince, Futureprom, Attractours, Edemle, Celin, Amsrott, Slider,

Protravol, Etano, or Lebasi.   Forsyth reviewed and signed the

Federal returns for 1986 through 1989.     Forsyth believed that

Manver and MDT were related, but Onate informed him in August

1987 that Manver and MDT were not related.     On August 11, 1989,

Forsyth signed the MDT Federal income tax return for the fiscal

year ended November 30, 1988, which was filed without Forms 5472.

August 11, 1989, was less than 2 weeks after the November 30,

1988, MDT certified audit report was issued that disclosed that

Manver was a related party.
                                - 80 -

       C.   Eurotor

       Eurotor's Federal income tax returns for the fiscal years

ended July 31, 1986, and July 31, 1987, reported income

effectively connected with a trade or business in the United

States.     Eurotor's Federal income tax return for the fiscal year

ended July 31, 1988, was marked "Final Return" and contained the

following statement:

       Eurator S.A. (XX-XXXXXXX) is not effectively connected
       with the conduct of a trade or business accordingly,
       Eurator S.A. is not required to file a U.S. income tax
       return of a foreign corporation (Form 1120F).

The return did not report any effectively connected income for

1988.

XIV.    Certified Audit

       Forsyth and Kim were involved in the C&L audits of the

Florida entities.     They provided information to C&L in Florida.

Kim sent to C&L in Florida a related-party list in which he

indicated that Eurotor, Futureprom, Gatetown, Lince, Primavert,

RC, Estaspan, and Manver were not related parties.     Kim also

crossed off the Spanish investors’ names as owners of their

respective Netherlands Antilles corporations.

       A C&L employee prepared a workpaper entitled “Related

Parties”.     The initial determination of related parties included

Manver, Gatetown, Futureprom, and Lince.     The employee noted

that, after subsequent discussions with the client, it was

determined that Manver, Gatetown, Futureprom, and Lince were not

related.     C&L was advised in the MDT audit for the fiscal year
                                - 81 -

ended November 30, 1988, that the commercial paper debt was owed

to unrelated parties.    The reports for the audits of MSI for the

fiscal years ended July 31, 1989 through 1993, did not reflect

that Manver, Gatetown, or the commercial paper companies were

related to, or an affiliate of, MSI.

XV.   IRS Audit

      Internal Revenue Agent Gary F. Herold (Herold) worked on the

Medieval Times examinations from September 1988 until the summer

of 1991.   Herold worked with Sans, Parks, Kim, and Melody Blunk

on the examinations.    Kim had left C&L and was then employed by

the Medieval Times companies.    IRS international examiner Michael

Bruton (Bruton) used information provided to him by the Medieval

Times representatives to prepare date schedules and

organizational charts.    During the examination, Bruton was not

given a signed contract between TM and Gatetown dated March 1,

1986, for consideration of $7,312.       Santandreu informed Bruton

and Herold that Gatetown and Manver were owned by de Oteyza

(45 percent), Mayol (45 percent), and Santandreu (10 percent).

Santandreu provided a document to the IRS that stated that he did

not know the shareholders of several corporations, including

Dapy, Promidux, Lince, and Manver, because “these are private

companies who are doing services for us.”

      Between 1982 and 1991, A. Gelabert, Santandreu, and Segui

held positions as officers, directors, attorneys in fact, powers

of attorney, or trustees in the listed companies as follows:
                              - 82 -

A. Gelabert--Attractours, Calinvest, Dapy, Holiday, Inverspan,

Lince, MTNV, Primavert, Promidux, Roundabout, RC, Spectrust, and

Wayout; Santandreu--Amsrott, Attractours, Calinvest, Celin,

Etano, Futureprom, Gatetown, Inverspan, Lebosi, Lince, MICV,

Manver, MABV, MANV, MTBV, MTNV, Primavert, Protravol, Roundabout,

and Slider; Segui--Calinvest, Futureprom, Holiday, Inverspan,

Lince, Manver, MTNV, Primavert, and TM.

     Formal document requests were made to Kim for the MTNV stock

and minute books and Manver’s tax returns.   Neither Herold nor

Bruton received these documents.   In an October 8, 1990, letter

to Bruton, Forsyth stated:

          You should also note that to the best of our
     knowledge, Manver N.V. has only one minority
     shareholder in common with Medieval Times N.V.
     Therefore, Medieval Times, N.V. is not in a position to
     compel Manver N.V. to produce the requested tax
     returns. * * *

     On June 2, 1992, Greg Cox, an international examiner with

the IRS, sent to MDT a notice stating that MDT had been assessed

a penalty for not filing certain Forms 5472 as required by

section 6038A(b).   The notice also stated that further penalties

would be assessed if the forms were not submitted for

transactions between MDT and MABV, Calinvest, RC, Eurotor,

Manver, and Gatetown.   Kim submitted the forms on behalf of MDT.

Some of the forms had disclaimers attached that stated:

          It is our opinion that Medieval Dinner &
     Tournament, Inc. and * * * do not meet any of the
     definitions defining the boxes in Part II, 3. By
     filing the attached Form 5472, Information Return of a
     Foreign Owned Corporation, pursuant to Section 6038A,
                                - 83 -

       Medieval Dinner & Tournament, Inc. is not admitting
       that * * * was a “related party” of Medieval Dinner &
       Tournament, Inc. during the period * * * under Sections
       6038, 6038A or any applicable Section, law or code; and
       Medieval Dinner & Tournament, Inc. is not admitting
       that there exist any “reportable transactions” between
       Medieval Dinner & Tournament, Inc. and * * * for the
       period * * * under Sections 6038, 6038A or any
       applicable Section, law or code.

There were disclaimers for transactions with RC, Eurotor, Manver,

and Gatetown.

                                OPINION

      With the exception of the additions to tax and penalties for

fraud, petitioners have the burden of proving that respondent’s

determinations as made in the notice of deficiency are erroneous.

Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); Rockwell v. Commissioner, 512 F.2d 882, 886 (9th Cir.

1975), affg. T.C. Memo. 1972-133.

I.    Management and Consulting Fees

       Petitioners MANV/MDT and MSI claimed deductions for payments

made for management and consulting fees in the following amounts:

MANV/MDT               1987               1988       1989

Eurotor              $271,041          $373,854    $ 37,546
RC                    132,937           380,096     228,128
A. Gelabert            16,580            17,215      21,877
Santandreu             37,000            21,069       8,000
Segui                  44,000

MSI                                        1988      1989

Eurotor                                 $232,549    $86,341

With the exception of a portion of MANV/MDT’s 1987, 1988, and

1989 payments to Eurotor, respondent determined that the above
                               - 84 -

amounts are not deductible under section 162(a) because the

payments represented a distribution of profits.

     Section 162(a) allows deductions for all “ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business”.     Management expenses are

among the items included in business expenses.     Sec. 1.162-1,

Income Tax Regs.   The test of deductibility of payments made for

services, whether compensation or management, is whether the

payments are reasonable and are in fact payments purely for

services.   Achiro v. Commissioner, 77 T.C. 881, 903 (1981); sec.

1.162-7(a), Income Tax Regs.   A bona fide contract for management

services may be a factor in establishing deductibility.      Achiro

v. Commissioner, supra.   Whether an expense that is claimed

pursuant to section 162(a) is compensation for services rather

than a distribution of profits is a question of fact that must be

decided on the basis of the particular facts and circumstances.

Paula Constr. Co. v. Commissioner, 58 T.C. 1055, 1058-1059

(1972), affd. without published opinion 474 F.2d 1345 (5th Cir.

1973).   If the corporation is closely held and the persons

receiving the payments are shareholders, the payments are subject

to close scrutiny to determine whether the alleged compensation

is in fact a distribution of profits.     Elliots, Inc. v.

Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983), revg. and

remanding on other grounds T.C. Memo. 1980-282.     Management fees

paid to related parties in excess of reasonable arm's-length fees
                               - 85 -

are not deductible.    Latham Park Manor, Inc. v. Commissioner, 69

T.C. 199, 218 (1977), affd. without published opinion 618 F.2d

100 (4th Cir. 1980).

     The cases contain a lengthy list of factors that are

relevant in the determination of reasonableness of compensation,

including:   The employee’s qualifications; the nature, extent,

and scope of the employee’s work; the size and complexities of

the business; a comparison of salaries paid with gross income and

net income; the prevailing general economic conditions; a

comparison of salaries with distributions to stockholders; the

prevailing rates of compensation for comparable positions in

comparable concerns; the salary policy of the taxpayer as to all

employees; and the amount of compensation paid to the particular

employee in previous years.    Mayson Manufacturing Co. v.

Commissioner, 178 F.2d 115, 119 (6th Cir. 1949), revg. a

Memorandum Opinion of this Court dated Nov. 16, 1948.

     Petitioners applied to the facts in the instant cases the

factors listed in Mayson Manufacturing Co. and conclude in their

brief that “it is clear that the management and consulting fees

at issue were ordinary, necessary, reasonable and consistent with

an arm’s-length charge.”   The facts on which petitioners base

their conclusion include Eurotor’s oversight of the Medieval

Times operations, RC’s catering and ranch operations, and Segui’s

and Santandreu’s positions as members of various boards of
                                - 86 -

directors and their assistance with the New Jersey and California

expansions.

     Respondent’s primary arguments to support her determination

that the fees paid as management and consulting fees were

disguised dividends are:     (1) Petitioners failed to establish

that services were provided as required by section 162(a);

(2) payments were made in proportion to stockholdings; and (3) it

is unclear in what capacity RC, A. Gelabert, Santandreu, and

Segui were performing various tasks.

     A.   Eurotor

            1.   Services

     The preponderance of evidence is that substantial services

were provided to petitioners by various persons who also were

directly or indirectly owners of petitioners.     The Eurotor

shareholders were successful businessmen who possessed a myriad

of skills from management to financing.     The Eurotor

shareholders’ ability to select key management employees,

suitable locations, and apply their knowledge of the tourist and

restaurant industries were services that were valuable.     The

shareholders' experience with an existing enterprise in Spain on

which this venture was modeled added to the value of the

services.     Santandreu and Segui spent considerable time in the

United States, assisting with operations and providing management

services.     Unlike dividends, the payment of management fees was

not dependent on earnings and profits.     The Eurotor shareholders
                                 - 87 -

provided services, and, whether the business was profitable or

not, they were entitled to reasonable compensation for their

services.    See Achiro v. Commissioner, supra.

     We believe the January 24, 1983, Eurotor contract with MTNV

was bona fide.     Although not in effect during the years in issue,

it corroborates petitioners' assertions.     See Paula Constr. Co.

v. Commissioner, supra.      Allen testified that he drafted the

document in 1983.     A list of documents that was kept at MTNV’s

offices in 1983 included the January 24, 1983, contract.        (The

contract did not mention a franchise or refer to any other

contracts or agreements.)     The contract embodied Santandreu’s

promise to the Eurotor shareholders that they would be

compensated for bringing the Medieval theme show to the United

States.     The management contract that was in effect during the

years in issue was substantially a renegotiation of the

January 24, 1983, contract.

             2.   Compensation in Proportion to Stockholdings

     Respondent argues that a distribution of management fees in

proportion to stockholdings is indicative of disguised dividends.

“As the regulations explain, however, even payments made to

shareholders in proportion to their ownership are, as a general

rule, improper only if they are in excess of what is usually paid

for similar services.”      Owensby & Kritikos, Inc. v. Commissioner,

819 F.2d 1315, 1325 (5th Cir. 1987), affg. T.C. Memo. 1985-267;

sec. 1.162-7(b), Income Tax Regs.
                              - 88 -

     We are guided by prior cases in reviewing the evidence here.

If payments in dispute are contingent compensation pursuant to a

contract, the circumstances to be taken into consideration are

those existing at the date when the contract for services was

made, not those existing at the date when the contract was

questioned.   American Foundry v. Commissioner, 59 T.C. 231, 244

(1972), affd. in part and revd. in part 536 F.2d 289 (9th Cir.

1976); sec. 1.162-7(b)(3), Income Tax Regs.   The past and present

financial condition of the company is relevant.    Home Interiors &

Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1156 (1980).

Evaluating the compensation as a percentage of net income, rather

than of gross receipts, is in most cases more probative because

it more accurately gauges whether a corporation is disguising the

distribution of dividends as compensation.    Owensby & Kritikos,

Inc. v. Commissioner, supra at 1325-1326.

     The Eurotor/MTNV January 24, 1983, contract for management

services established a fee of 50 cents per patron.   The

attendance figures and profitability of the company were unknown

at the time of the contract because the Kissimmee castle did not

open until December 1983.   The MSI contract, which was in effect

during the years in issue, was essentially a renegotiation of the

January 24, 1983, contract.   The MSI contract changed the fee

from 50 cents per client to a fee of 2 percent of gross

production.   Based on MSI’s 1988 and 1989 tax years, during which

gross production was $11,338,915 and $12,714,857, respectively,
                                - 89 -

the renegotiation resulted in additional fees of approximately

$20,000 per year.

     The Eurotor MANV/MDT management contract also had a fee of

2 percent of gross production.    Notwithstanding that the contract

was probably not ratified until 1987, the castle opened in 1986

and the operation’s profitability was untested at the time the

fee was determined.

     In Good Chevrolet v. Commissioner, T.C. Memo. 1977-291, this

Court addressed the reasonableness of compensation paid to two

employees of an automobile dealership.    The two employees held

100 percent of the corporation’s stock.    The issue was whether

bonuses that constituted predetermined percentages of profits

were reasonable.    The facts that tended to support a finding of

excess compensation included:    The two shareholders controlled

the corporation's finances; the amount of net income paid out as

bonuses during the years in issue approximated 60 percent per

year; and the success of the business was due in part to

fortuitous economic conditions and not to altered or augmented

endeavors by them.    The facts that tended to support the

reasonableness of the compensation included:    The business was

extraordinarily successful, due in part to programs instituted by

the shareholders; the shareholders were astute, aggressive

businessmen; and, although a percentage of the profits was

determined before one shareholder had a controlling interest in
                               - 90 -

the corporation, that shareholder did not change the percentage

once he obtained control.

     In reaching our conclusion, we considered that, “Though the

officers were also shareholders of the petitioner, they are

entitled to reasonable compensation for services actually

rendered."   Good Chevrolet v. Commissioner, supra (citing

Commercial Iron Works v. Commissioner, 166 F.2d 221, 224 (5th

Cir. 1948)).   Contingent compensation paid pursuant to a free

bargain between the parties before services are rendered should

be allowed as a deduction even though in the actual working out

of the contract it may prove to be greater than the amount that

would ordinarily be paid.    Sec. 1.162-7(b)(3), Income Tax Regs.

The arrangement also may result in lesser compensation in less

successful years.   Finally, we noted “this is not a case in which

the controlling officers annually draw all, or virtually all, of

the profits of the business in the form of bonuses."      Good

Chevrolet v. Commissioner, supra; cf. Boyle Fuel Co. v.

Commissioner, 53 T.C. 162, 171 (1969); see Owensby & Kritikos,

Inc. v. Commissioner, T.C. Memo. 1985-267, affd. 819 F.2d 1315

(5th Cir. 1987) (the contracts did not create a situation where

virtually all of the taxable income was paid out as

compensation).   We concluded that compensation paid to

shareholder-employees constituting approximately 60 percent of

net income was reasonable.    Good Chevrolet v. Commissioner,

supra.
                              - 91 -

     Here, as in Good Chevrolet, the Eurotor shareholders

controlled the entity paying the management fees.   However, the

compensation that was paid to Eurotor as management fees under

both the MSI and MANV/MDT contracts, expressed as a percentage of

net income, was substantially below 60 percent:

                     1987             1988          1989

     MSI              --              15.0%         4.7%
     MANV            6.2%              --            --
     MDT              --              31.5%         3.5%

     The Medieval Times companies successfully tapped into the

tourist markets in Florida and California, and the success was

due in part to the Eurotor shareholders’ selection of locations

and employees.   The California management contract that

established a 2-percent-of-gross-production fee was effective

before the profitability of the business was known and was not

modified after the business became profitable.

     The facts support the conclusion that the amounts paid to

the Eurotor shareholders were not in excess of compensation that

would be paid for similar services.    Therefore, that the payments

were made in proportion to stockholdings does not make the

payments improper.   Owensby & Kritikos, Inc. v. Commissioner, 819

F.2d at 1324; sec. 1.162-7(b), Income Tax Regs.

     We are persuaded that the MSI and MANV/MDT payments made to

Eurotor as management and consulting fees during the years in

issue were reasonable and for services as required by section

162; therefore, the deductions will be allowed.
                                - 92 -

     B.   Royal Catering

     A. Gelabert was the 100-percent owner of RC.    RC was a

5-percent owner in MANV/MDT.    RC’s 1987 management agreement with

MDT, which called for RC to receive 5 percent of MDT's gross

profits, was the vehicle through which A. Gelabert was to receive

his 5-percent ownership interest in MDT.

     It is undisputed that A. Gelabert provided valuable services

to the Medieval Times operation.    Petitioners state on brief that

A. Gelabert “was compensated primarily through the management

fees paid to Royal Catering, which he owned.”    Pursuant to the

RC/MDT management agreement, MDT was to reimburse RC for amounts

RC paid as wages to RC employees, specifically A. Gelabert.      The

management agreement provided for RC to receive fees under the

contract for “services” and also to receive amounts as

reimbursement for wages paid.    Therefore, the nonreimbursed

amounts were not wages.    Petitioners have failed to substantiate

which, if any, amounts paid to RC were reimbursable wages.      We

conclude that the services that A. Gelabert provided to MDT,

through the RC/MDT management agreement, were to protect or

enhance A. Gelabert’s investment in MDT.    See Olton Feed Yard,

Inc. v. United States, 592 F.2d 272 (5th Cir. 1979).

     RC had been used as a vehicle by petitioners on several

previous occasions.   MTNV loaned to RC $100,000 and then paid the

interest on the loan.   RC was used to obtain visas for

A. Gelabert and Sans.   RC did not have its own books and records;
                                - 93 -

its ledgers were part of MANV/MDT’s ledgers during the years in

issue.    Petitioner MANV/MDT has not persuaded us that the

payments to RC were business expenses and not dividend payments

to A. Gelabert.    Because the payments to RC were not ordinary and

necessary business expenses, as required under section 162, they

were not deductible.    Accordingly, respondent’s determination on

this issue will be sustained.

     C.    A. Gelabert, Santandreu, and Segui

     Petitioners argue that Santandreu and Segui were entitled to

compensation because they were directors of MANV and worked on

the expansion of the Medieval Times companies and that

A. Gelabert was entitled to compensation because of the services

he provided to MANV.

     Respondent contends that petitioners have a "hat problem"

with regard to the payments to A. Gelabert, Santandreu, and Segui

because it is unclear why MDT made the payments.

     We agree with respondent that petitioners have a "hat

problem".    Between 1982 and 1991, A. Gelabert, Santandreu, and

Segui held positions as officers, directors, attorneys in fact,

powers of attorney, or trustees in the listed companies as

follows:    A. Gelabert--Attractours, Calinvest, Dapy, Holiday,

Inverspan, Lince, MTNV, Primavert, Promidux, Roundabout, RC,

Spectrust, and Wayout; Santandreu--Amsrott, Attractours,

Calinvest, Celin, Etano, Futureprom, Gatetown, Inverspan, Lince,

MICV, Manver, MABV, MANV, MTBV, MTNV, Primavert, Protravol,
                              - 94 -

Roundabout, and Slider; and Segui--Calinvest, Futureprom,

Holiday, Inverspan, Lince, Manver, MTNV, Primavert, and TM.     The

individuals were working in several different capacities

concurrently, and it is unclear in which capacity they were

working at any particular time.   Additionally, the individuals

were also shareholders in many entities.   Santandreu and Segui

were shareholders in MANV and Eurotor.   A. Gelabert was a

shareholder in MANV.   If they were acting in their capacity as

shareholders, the services they provided to protect their

interests as shareholders are not deductible under section 162.

Olton Feed Yard, Inc. v. United States, supra.    We conclude that

the amounts paid to A. Gelabert were wages, and the amounts paid

to Santandreu and Segui were dividends for the following reasons.

     A. Gelabert was hired to run the castle.    He was in charge

of renovating the castle and getting the operation off the

ground.   He was entitled to payment for his services as an

employee of MANV.   The amounts paid to A. Gelabert were not

dividends because, as we have previously concluded, he was

receiving his dividends through RC.

     Eurotor was entitled to receive compensation for the

management services it provided to petitioners.   In order to

provide those services, it had to have representatives working

with petitioners.   Santandreu and Segui spent considerable time

in the United States assisting with operations and providing

management services.   We conclude that Santandreu and Segui were
                              - 95 -

working in their capacity as Eurotor representatives; they were

not entitled to additional compensation from petitioners.    The

additional payments they received were dividends.    Therefore, the

amounts paid to Santandreu and Segui individually were dividends

for their interests as shareholders in MANV.

II.   Franchise Transactions and Royalty Fees

      Petitioners deducted the franchise and royalty expenses on

their Federal tax returns as “ordinary and necessary” business

expenses under section 162(a).   Petitioners have elected to apply

the 1994 Intercompany Transfer Pricing Regulations (secs. 1.482-1

to 1.482-8, Income Tax Regs.) to each of the taxable years in

issue as permitted under sec. 1.482-1(j)(2), Income Tax Regs.

Petitioners argue that the deductions satisfy the section 482

regulations on valuation and that no allocation is justified.

They argue on brief that the “pivotal issue here is the value of

the intellectual property that was transferred to the

petitioners, not the nature of the transactions by which they

preserved their rights to use it.”     Petitioners maintain that the

extraordinary profitability of the Medieval Times companies

confirms the economic substance of their arrangement with Manver.

      Petitioners presented expert testimony and information on

alleged comparables to support the argument that the income that

petitioners attributed to the intangible was justified.    The

thrust of petitioners' position is that they could pay unlimited

royalties so long as they received an adequate rate of return;
                                - 96 -

and the reported and taxed income was an adequate rate of return

by comparison to various industry standards.    Respondent argues

and, for reasons appearing below, we agree that we need not

belabor or even discuss this evidence.

     Respondent determined that the amounts that petitioners

deducted under section 162(a) as franchise and royalty payments

to Manver were not “ordinary and necessary” business expenses

under section 162(a).   Respondent’s main contention is that the

transactions that were the basis for the deductions were not bona

fide arm’s-length transactions at fair market value and that the

transactions had no economic purpose or substance.    Respondent

further determined that the amounts deducted represented income

to nonresident alien individuals/foreign corporations and that

distribution, apportionment, or allocation is necessary in order

to prevent evasion of taxes and to reflect income clearly as

authorized under section 482.

     On brief, respondent agrees with petitioners that

conceptually section 482 would apply because of petitioners’

common control, the shifting of income and deductions, and the

need to reflect income clearly.    Respondent contends, however,

that there is no need to resort to allocations under section 482

because the Medieval Times companies owned the intangibles that

they were purporting to license and there was no economic

substance to the transactions.
                             - 97 -

     Section 482 permits respondent to make adjustments to

petitioners' Federal tax returns:

     SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG
     TAXPAYERS.

          In any case of two or more organizations, trades,
     or businesses (whether or not incorporated, whether or
     not organized in the United States, and whether or not
     affiliated) owned or controlled directly or indirectly
     by the same interests, the Secretary may distribute,
     apportion, or allocate gross income, deductions,
     credits, or allowances between or among such
     organizations, trades, or businesses, if he determines
     that such distribution, apportionment, or allocation is
     necessary in order to prevent evasion of taxes or
     clearly reflect the income of any such organizations,
     trades, or businesses.

          In the case of any transfer (or license) of
     intangible property (within the meaning of section
     936(h)(3)(B)), the income with respect to such transfer
     or license shall be commensurate with the income
     attributable to the intangible.

     Section 936(h)(3)(B) defines intangible property:

                    (B) Intangible property.--The term
               “intangible property” means any--

                         (i) patent, invention, formula,
                    process, design, pattern or knowhow;

                         (ii) copyright, literary, musical,
                    or artistic composition;

                         (iii) trademark, trade name, or
                    brand name;

                         (iv) franchise, license, or
                    contract;

                         (v) method, program, system,
                    procedure, campaign, survey, study,
                    forecast, estimate, customer list, or
                    technical data; or

                         (vi) any similar item,
                              - 98 -

                which has substantial value independent of
                the services of any individual.

     Section 1.482-1(i)(5), Income Tax Regs., defines a

controlled taxpayer as follows:

          (5) Controlled taxpayer means any one of two or
     more taxpayers owned or controlled directly or
     indirectly by the same interests, and includes the
     taxpayer that owns or controls the other taxpayers.
     * * *

     In determining the true taxable income of a controlled

taxpayer, the standard to be applied in every case is that of a

taxpayer dealing at arm’s length with an uncontrolled taxpayer.

Sec. 1.482-1(b), Income Tax Regs.   The “arm’s-length” test

commonly associated with section 482 is equally applicable in

ascertaining the “ordinary and necessary” character of a payment

to a related party that is deducted under section 162(a).     R.T.

French Co. v. Commissioner, 60 T.C. 836, 849 (1973).   A

controlled transaction meets the arm’s-length standard if the

results of the transaction are consistent with the results that

would have been realized if uncontrolled taxpayers had engaged in

the same transaction under the same circumstances (arm’s-length

result).   Sec. 1.482-1(b), Income Tax Regs.

     Petitioners argue that the "White Paper", "A Study of

Intercompany Pricing Under Section 482 of the Code," I.R.S.

Notice 88-123, 1988-2 C.B. 458, referred to legislative rejection

of R.T. French Co.   The White Paper addressed only the view that

a long-term fixed rate royalty agreement could not be adjusted

under section 482 based on actual events.   Notice 88-123, 1988-2
                              - 99 -

C.B. at 477. This Court has long recognized the use of an "arm's-

length" standard to determine the ordinary and necessary

character of a payment to a related party under section 162(a)

(and its predecessor, section 23(a)).   Differential Steel Car Co.

v. Commissioner, 16 T.C. 413, 423-425 (1951); Granberg Equip.,

Inc. v. Commissioner, 11 T.C. 704, 713-714 (1948); Nestle Co. v.

Commissioner, T.C. Memo. 1963-14.

     Section 482 sets forth two requirements with respect to

intangibles:   (1) A transfer or license of the intangible and

(2) the income received because of the transfer must be

commensurate with the income attributable to the intangible.

Petitioners assert that there was a transfer of intangibles,

i.e., the Medieval Times concept from TM to Gatetown and from

Gatetown to Manver.   Petitioners further assert that, once Manver

owned the intangibles, MSI and MDT were obligated to enter into

licensing agreements with Manver in order to use the Medieval

Times concept.   Petitioners’ primary arguments begin at this

point and focus on whether the amounts paid under the licensing

agreements are commensurate with the income attributable to the

intangibles.   Petitioners rely on the section 482 regulations,

which provide several different methods to determine whether a

transaction is at arm’s length.   The methods address the “income

attributable to the intangible” language of section 482.

     Before we can ascertain if the income with respect to a

transfer is commensurate with the income attributable to the
                              - 100 -

intangible, however, we must first identify a transfer of the

intangible as required by section 482.   Petitioners’ discussion

of whether or not a transfer of the intangible occurred is

cursory at best.

     The essence of a transfer, as respects taxation, is the

passage of control over the economic benefits of property rather

than any technical changes in its title.   Estate of Sanford v.

Commissioner, 308 U.S. 39, 43 (1939); Burnet v. Guggenheim, 288

U.S. 280, 287 (1933).   The word “transfer”, as used in the tax

law, has its ordinary significance and means the handing over or

parting with property with intent to pass it, or certain rights

in it, to another, who becomes the transferee.    In re Gould’s

Estate, 156 N.Y. 423, 51 N.E. 287, 288 (1898).

     Inherent in the definition of transfer is the concept that

the transferor must control or own the rights or economic

benefits that the transferor desires to transfer to the

transferee.   To establish that a transfer has occurred, we must

identify who owns the rights and economic benefits of the

property that is the subject of the transfer.    Section 1.482-

4(f)(3)(ii)(B), Income Tax Regs., defines ownership as follows:

          (B) Intangible property that is not legally
     protected. In the case of intangible property that is
     not legally protected, the developer of the intangible
     will be considered the owner. * * *. Ordinarily, the
     developer is the controlled taxpayer that bore the
     largest portion of the direct and indirect costs of
     developing the intangible, including the provision,
     without adequate compensation, of property or services
     likely to contribute substantially to developing the
     intangible. A controlled taxpayer will be presumed not
                                - 101 -

     to have borne the costs of development if, pursuant to
     an agreement entered into before the success of the
     project is known, another person is obligated to
     reimburse the controlled taxpayer for its costs. * * *

     Intangible assets that are legally protected include

patents, trademarks, and copyrights.      The Medieval Times

intangibles were not legally protected until the trademarks were

registered in California and Florida in 1987 and registered with

the U.S. Patent and Trademark Office in 1988.

     We must ascertain who bore the largest portion of the

development costs of the Medieval Times “formula”.      Petitioners

argue that the formula was the intangible transferred for

arm’s-length value.   The facts overwhelmingly support the

conclusion that MTNV, from 1983 through 1986, developed the

Medieval Times formula.   A. Gelabert was hired and paid by MTNV

to run the Florida operation.    MTNV paid the salaries of the

employees who were responsible for developing the Medieval Times

concept, including:   Stonecrow, who designed and produced the

costumes for the show; Bellows and Kudlacz, who developed the

marketing plans; and Galindo, who established the photography lab

and pioneered the use of group photographs.

     The construction costs for the Florida castle were paid by

Inverspan.   Inverspan received the funds from a loan guaranteed

by the Spanish investors who were also the MTNV and Inverspan

shareholders.   The costs to modify the facility from 1983 through

1986 to reflect the ongoing development of MTNV were paid by

MTNV.   Those modifications included work on the kitchen, the
                                - 102 -

stables, the entry to the castle, and the addition of a medieval

village.   Additionally, MTNV had a contract to pay Eurotor for

management and consulting services.

     The “Medieval Times” name was first used in the United

States in December 1982 when Castro filed an application for a

post office box in Kissimmee.    From 1982 until the purported

licensing agreements with Manver, MTNV conducted business using

the “Medieval Times” name and the “formula” without paying

compensation to any other person or entity.    Petitioners argue

that the agreements between MTNV and TM dated February 1, 1983,

bound MTNV to compensate TM for the use of the intangibles.

     The language in the two contracts between MTNV, Eurotor, and

TM, dated February 1, 1983, and January 20, 1983, is virtually

identical to the language in Forsyth’s November 1986 draft letter

to Santandreu.   Forsyth’s letter was a recap of a conversation

between Forsyth and Santandreu.    In the letter, Forsyth discussed

the franchise agreement, the script document, and the need to set

out TM’s responsibilities as licensor of the Medieval Times

concept.   The letter stated that TM should include with its

duties assistance with the design of costumes, with training

horses and actors, and with quality control.

     On cross-examination, Forsyth was asked about his notes

taken on or about May 20, 1986.    His testimony proceeded as

follows:
                               - 103 -

          Q Okay. Did you understand at the time you made
     these notes that there was an agreement to transfer
     those intangibles?

          A I don't know whether there was an agreement to
     transfer the intangibles at that time.

          Q Okay. Well, you indicated that if you had an
     agreement you could prepare a document later and have
     it signed effective as of the date of the agreement,
     correct?

          A   Correct.

          Q Okay. Do you have a recollection at this
     point, the effective date of this transfer of
     intangibles?

          A No, I don't know the effective date of the
     transfer.

          Q Okay. So if the effective date of the transfer
     was prior to the time that you took these notes, then
     would that indicate to you that you were advised that
     there was an agreement in effect?

          A   An agreement for which?

          Q   For the transfer of the intangibles?

          A I can't comment.     I   that was not my
     understanding.

          Q It was not your understanding that there was an
     agreement in effect at the time you made these notes?

           A I'm not aware that there was   aware that there
     was an agreement to transfer the intangibles at that
     time.

          Q   Okay.   Were you not aware, one way or the
     other?

          A One way or the other. I would     my assumption
     at the time and now is that I was not aware of any
     agreement to transfer.

     Forsyth discussed a possible management contract, in

addition to the franchise agreement, and stated that the
                              - 104 -

management agreement must emphasize that the services provided in

the management agreement extend beyond the normal stewardship

functions that the shareholders may exercise.   The management

services that Forsyth suggested included providing detailed

advice on accounting and administration, financing, and personnel

selection.   Forsyth recommended a fee of 10 to 15 percent for the

franchise agreement and 2 percent for the management agreement.

     C&L received unsigned copies of agreements dated January 20,

1983, and February 1, 1983, for the first time on December 12,

1986, a month after Santandreu received Forsyth’s letter.     The

January 20, 1983, document stated that TM was to take "exclusive

charge of technical assistance, not management," and to

contribute the use of the name, trademark, handbook, or formula;

experience with respect to choreography, lights, sound, and the

making and maintaining of costumes and wardrobes; and quality

control.   TM was to receive as compensation 10 percent of MTNV’s

gross production.

     The February 1, 1983, agreement stated that Eurotor was to

contribute experience in the management of companies, including

finance, administration, and personnel.   The other documents

received by C&L on December 12, 1986, included management

agreements between Eurotor and MANV and Eurotor and MTNV dated

February 1, 1986, and August 1, 1986, respectively.   These

agreements also contained language identical to Forsyth’s
                              - 105 -

November 1986 letter and provided for MANV and MTNV to each pay

Eurotor 2 percent of their gross production.

     It is not credible that the similarity in language and fees

in the 1983 agreements and the 1986 letter were purely

coincidental.   This is particularly so because the similar

language, and the concept of franchising, are absent from the

January 24, 1983, management contract between Eurotor and MTNV.

Additionally, the agreements provided for licensing the use of

the trademarks, and there were no registered trademarks in 1983.

The January 24, 1983, contract was the only document that was

signed, and Allen testified that he drafted the document in 1983.

The alleged draftsman of the other documents was Jose Luis

Fernandez (Fernandez) an "economist and tax adviser" who was only

beginning his professional business in 1982 and 1983.     Fernandez

was a relative of Segui, and Fernandez testified that Segui came

to him instead of a lawyer because "it was easier for him to

direct me."   Fernandez testified that he used the word

"franchising" in the contracts because Segui directed him to use

that specific word.   However, Kim testified that, prior to 1986,

the Medieval Times organization was not called a franchise.

Hokanson at LL did not form an opinion that the Medieval Times

transactions fell within the California Franchise Law until 1986,

at which time he advised A. Gelabert of that opinion.

Fernandez's testimony as to the dates of his drafts was not

credible.   We conclude that the January 20, 1983, and February 1,
                               - 106 -

1983, documents are a belated attempt by petitioners to

manipulate or manufacture the facts to fit the form suggested by

C&L.

       Putting aside the unreliable documentation, we must consider

the substance of the relationship.    The MTNV shareholders brought

an idea from Spain to the United States.    It was not a

proprietary concept.    At the same time that MTNV was opening,

another group of investors could have opened a dinner theater

with a medieval theme without infringing on the rights of TM.

The existence of similar shows, such as King Henry's Feast and

King Arthur's Tournament, is evidence undermining petitioners'

claims that the medieval dinner theater idea was uniquely

valuable.    The name “Medieval Times” did not exist prior to

MTNV’s use of it in 1982.    If another group had trademarked the

name before MTNV started to use it, TM would have had no recourse

because TM did not own the name.

       TM did not have any recourse against MTNV for the use of the

name “Medieval Times” or for the use of the idea to open a

medieval theme dinner theater.    Therefore, MTNV had no reason to

compensate TM.    If TM and MTNV had not been related, MTNV would

not have agreed to compensate TM for the use of an intangible

that was not yet developed and that TM did not own.

Additionally, because TM did not own the intangibles, TM would

not have been able to transfer the rights to the intangibles.
                              - 107 -

     Other facts indicate that TM did not own the intangibles.

In the purported sale of the intangibles from TM to Gatetown,

Gatetown acquired the intangible rights of TM for $7,312 on

March 1, 1986 (the document is dated approximately 1 year earlier

than it was drafted).   For the fiscal year ended July 31, 1986,

MTNV’s gross receipts were $7,048,767, and its taxable income was

$636,795.   Petitioners acknowledge the nominal consideration and

explain on brief that, “since 80 percent of the Eurotor

shareholders also held Torneo stock, the only Torneo shareholders

who were being bought out were Mr. Rousselet and Mr. Celedonio”

(Celedonio).

     Petitioners allege that Rousselet was compensated because he

was given two other companies to operate and that Celedonio was

compensated by a 10-percent profits interest and manager position

in TM.   Other than Santandreu’s testimony, there is no evidence

in the record to corroborate the allegations of compensation for

Rousselet and Celedonio.   Additionally, Celedonio was not an

original shareholder of TM, and we do not know when or if he

became a shareholder.   When asked why TM sold the formula to

Gatetown for $7,312, J. Montaner testified:   “Well, my nephew

told me this was right, because in practice the people who are

selling it were actually also the people who were buying it.”

Petitioners state on brief:   “it is undisputed that the Torneo-

Gatetown-Manver transactions were between largely related parties

and that the non-continuing Torneo shareholders were separately
                              - 108 -

compensated for their interests.   Thus, neither price is reliable

evidence of the value of the intangibles.”

     Petitioners’ declaration that the price was an unreliable

measure of the value of the intangibles because the parties were

related undermines their position.   Every transaction that

occurred between TM, Gatetown, Manver, MTNV/MSI, MANV/MDT, etc.,

involved related parties because all or substantially all of the

shareholders in the companies were the same.    Extending

petitioners’ analysis, the price in all of the transactions

between the parties would be unreliable.    We believe that the

subsequent sale of the intangibles from Gatetown to Manver for

$5.6 million not more than 3 months after Gatetown purchased the

intangibles for $7,312 is evidence of the unreliability of the

transaction price and evidence that the transactions were not at

arm’s length.

     The subsequent transactions that affected the years in issue

are based on these original transactions.    The attempt to create

a chain of possession of the intangibles from TM to Gatetown to

Manver is implausible for several reasons.    The foremost reason

is that MTNV, and not TM, owned the intangibles.    Additionally,

the documents were backdated, many of them were unsigned, and

there were numerous versions of documents purporting to represent

the same transactions.   The documents that were received by C&L

on December 12, 1986, contained an agreement dated May 26, 1986,

where TM purportedly sold the rights to the intangibles to Manver
                               - 109 -

for approximately $8,700.   Except for the price and the parties,

this document was virtually identical to the agreement dated

May 1, 1986, where TM purportedly sold the rights to the

intangibles to Gatetown.

     In some instances, the corporate parties to an alleged

agreement were not in existence on the date of the document.        An

example is a document dated February 26, 1986, whereby Lince

loaned money to Gatetown, and Gatetown agreed to pay Lince

95 percent of Gatetown’s income.    Lince was not incorporated

until May 16, 1986.    Petitioners attempt to justify backdating as

a common practice to memorialize agreements.      In these cases,

however, the pattern of backdating was so pervasive as to cast

doubt on the reliability of petitioners' representations as to

what was agreed, when, and by whom.      The only intent that is

clear is the intent to conform to C&L's proposals to minimize or

avoid tax liability.

     When the intangibles became legally protected by the

registration of the trademarks in 1987 and 1988, there was no

consideration paid to MTNV/MSI.    C&L and the Spanish investors

were undecided as to whether Manver or Gatetown should hold the

trademarks in their name.   The decision to hold the trademarks in

Manver’s name was not made until December 1986, when C&L received

a favorable tax ruling from the Netherlands Antilles.      The

licensing agreements between Manver and MSI and Manver and MDT

were dated May and July 1986, several months before the final
                              - 110 -

decision to use Manver was made.   Additionally, the language in

the licensing agreements was almost verbatim language from a

draft licensing agreement that Hokanson at LL provided to the

Spanish investors on November 11, 1986.

     The chronology shows that the trademarks could have been

registered in the name of any of the entities controlled by the

Spanish investors.   The decision was driven by tax considerations

and had no relation to who actually developed the intangibles.

The choice of which corporate entity to use occurred, and the

chain of possession, and the subsequent licensing agreements were

created after the favorable tax ruling and attempted to alter the

facts to fit the tax planning.

     "The freedom to arrange one's affairs to minimize taxes does

not include the right to engage in financial fantasies with the

expectation that the Internal Revenue Service and the courts will

play along."   Saviano v. Commissioner, 765 F.2d 643, 654 (7th

Cir. 1985), affg. 80 T.C. 955 (1983).    Courts have never regarded

"the simple expedient of drawing up papers" as controlling for

tax purposes when the objective realities are to the contrary.

Commissioner v. Tower, 327 U.S. 280, 291 (1946); Falsetti v.

Commissioner, 85 T.C. 332, 347 (1985).    If MTNV and Manver had

not been related, MTNV would not have allowed the intangibles to

be registered in Manver’s name without compensation to MTNV.

Neither MTNV/MSI nor MANV/MDT had a business reason to pay Manver

for intangible rights that Manver did not own.
                               - 111 -

       We are satisfied that the development of the intangibles was

paid for by MTNV and that MTNV was the owner of the intangibles

as defined in section 1.482-4(f)(3)(ii)(B), Income Tax Regs.    To

that extent, we agree with respondent that the structure

supporting the payment of royalties or franchise fees was a sham.

There was no “arm’s-length” reason for MTNV/MSI or MANV/MDT to

compensate Manver for the use of intangibles that Manver did not

create, develop, or, in substance, have the ability to transfer.

Accordingly, the expenses were not “ordinary and necessary”

business expenses deductible under section 162(a).    R.T. French

Co. v. Commissioner, 60 T.C. 836, 849 (1973).    Respondent’s

determinations with respect to the franchise and royalty payments

to Manver will be sustained.

III.    Interest Expense and Guarantee Fees Resulting From Lump-Sum
        Franchise Payments

       Petitioners deducted amounts as interest and guarantee fees

in connection with the promissory notes and the lump-sum royalty

payments to Manver.    Petitioners argue that there were business

reasons for the financing arrangements, that the debt was bona

fide, and that the "economic substance sought by the parties was

accomplished."    Petitioners support their argument by pointing

out that the 12.5- to 15-percent royalty rates made it difficult

for petitioners to finance their planned expansion and that the

financing allowed them to control the royalty payments during the

expansion period.    Petitioners further attempt to support their

argument that there was economic substance to the transactions on
                              - 112 -

the basis that "Manver gave up the right to substantial pay-as-

you-go royalties for several years and instead received cash and

promissory notes."

     With respect to the guarantee fees, petitioners argue that,

because the guarantee fees paid on the commercial paper "did not

exceed the amounts that would be charged by an unrelated party,

those fees were reasonable for purposes of section 162(a) and

consistent with arm's-length amounts for purposes of section

482."

     Respondent contends that there was no genuine indebtedness

underlying the interest payment, as required by section 163, and,

therefore, the transactions were shams.   Respondent asserts that

the transactions lacked economic substance and were entered into

solely for tax-avoidance purposes.   Respondent further contends

that there was no economic substance to the guarantee fees

because there was no bona fide debt to guarantee and because the

guarantor controlled the ability of petitioners to repay the debt

and the ability of the creditor to enforce the debt and the

guarantee.

     For interest to be deductible under section 163(a), it must

be paid on genuine indebtedness, i.e., an indebtedness in

substance and not merely in form.    Knetsch v. United States, 364

U.S. 361, 366 (1960).   Transactions that lack economic substance

and are conducted for the sole purpose of reducing tax liability

are disregarded as shams by the courts.   Knetsch v. United
                              - 113 -

States, supra; Saviano v. Commissioner, supra; Falsetti v.

Commissioner, supra.   In Frank Lyon Co. v. United States, 435

U.S. 561, 573 (1978), the Supreme Court stated:

     In applying this doctrine of substance over form, the
     Court has looked to the objective economic realities of
     a transaction rather than to the particular form the
     parties employed. The Court has never regarded “the
     simple expedient of drawing up papers,” Commissioner v.
     Tower, 327 U.S. 280, 291 (1946), as controlling for tax
     purposes when the objective economic realities are to
     the contrary. “In the field of taxation,
     administrators of the laws and the courts are concerned
     with substance and realities, and formal written
     documents are not rigidly binding.” Helvering v.
     Lazarus & Co., 308 U.S. [252] at 255 [(1939)]. See
     also Commissioner v. P.G. Lake, Inc. 356 U.S. 260, 266-
     267 (1958); Commissioner v. Court Holding Co., 324 U.S.
     331, 334 (1945). Nor is the parties’ desire to achieve
     a particular tax result necessarily relevant.
     Commissioner v. Duberstein, 363 U.S. 278, 286 (1960).

The Supreme Court, in concluding that the transactions there in

issue were to be recognized for tax purposes, held that, where:

     there is a genuine multiple-party transaction with
     economic substance which is compelled or encouraged by
     business or regulatory realities, is imbued with tax-
     independent considerations, and is not shaped solely by
     tax-avoidance features that have meaningless labels
     attached, the Government should honor the allocation of
     rights and duties effectuated by the parties. * * *
     [Id. at 583-584.]

This Court has articulated a definition of “‘sham in substance’

as the expedient of drawing up papers to characterize

transactions contrary to objective economic realities and which

have no economic significance beyond expected tax benefits.”

Falsetti v. Commissioner, supra at 347; see Rice's Toyota World,

Inc. v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985), affg.

in part and revg. in part 81 T.C. 184 (1983).   In Falsetti, we
                              - 114 -

considered the totality of the facts and circumstances and

determined that the purported purchase of certain real property

was a sham because of the absence of transfer of legal title or

other indicia of arm’s-length dealing, drastically inflated sales

prices, and complete disregard of contractual terms.

     In these cases, we have considered the entire record and

conclude that the financing arrangements for the royalty payments

to Manver lacked economic substance and were shams, entered into

solely for tax-avoidance purposes.   This conclusion is based on

many factors, including the lack of arm's-length dealing,

circular money movements, and other questionable business

practices.

     A close examination of the entities involved in the

purported transactions reveals a complete lack of arm's-length

dealing.   See Karme v. Commissioner, 73 T.C. 1163, 1186 (1980),

affd. 673 F.2d 1062 (9th Cir. 1982).    The Spanish investors

controlled every entity involved in the transactions.    They

controlled the companies that were the source of the payments,

the companies that were to receive the payments, and the

companies through which the payments passed as part of the

commercial paper and other transactions.    See Pittler v.

Commissioner, T.C. Memo. 1986-320.     Petitioners argue that the

transaction had economic substance because it was difficult to

finance petitioners' planned corporate expansion and pay

royalties of 12.5 to 15 percent to Manver simultaneously.
                              - 115 -

Petitioners' argument is unpersuasive for several reasons.     As we

concluded earlier, Manver did not own the rights to the

intangibles so there was no reason for MSI and MDT to pay

royalties to Manver.   The heavy burden imposed by the alleged

royalties simply casts further doubt on whether the rates were

reasonable.   In fact, because Manver, MSI, and MDT were all

controlled by the same individuals, the alleged financial

hardship was self-imposed and could easily have been remedied by

reducing the royalty rates.   The record is replete with

additions, alterations, and revisions to agreements.   Petitioners

included in the lump-sum amounts royalty payments of

$5.85 million for a second California castle and a New Jersey

castle, neither of which was built yet.   The second California

castle never opened.   There is neither credible evidence nor

reason to believe that an unrelated party would have been willing

to pay $5.85 million in advance for royalty payments on

speculation as to possible future need for the intangibles.

     Petitioners' position is further weakened by the amendments

to the MSI/MDT and Manver royalty agreements that provided for

payments in excess of the lump-sum amounts if either MDT's or

MSI's gross sales exceeded certain base amounts.   The amendments

provided that MSI and MDT were to pay Manver 15 percent of their

gross sales that were in excess of the base amounts.   An

agreement to pay additional royalties, in excess of the lump-sum

amounts, is inconsistent with the claim that the original lump-
                               - 116 -

sum amount created such a hardship to petitioners' expansion

plans.   It appears more likely that it was just another avenue

for the Spanish investors to receive corporate distributions.

     Petitioners also argue that there was economic substance to

the transactions because Manver gave up the right to substantial

pay-as-you-go royalties for several years and instead received

cash and promissory notes.   Petitioners point out that Manver

agreed to accept a lesser sum in exchange for receiving the

payments up front.   The difference in the amounts was determined

by petitioners at the time of the transactions and represented

the discount on the total payments, if made over time, to their

present value.   The purpose of discounting money to its present

value is to equalize the current value with the future value.

Petitioners imply that there was a disadvantage to the up-front

payment because it partially consisted of promissory notes.     The

Spanish investors, however, owed the notes to the Spanish

investors and therefore controlled the risk of loss.    Any

disadvantage to Manver is illusory.

     The circular transfer of money through related parties to

create the illusion of payment is an indication of sham

transactions.    Karme v. Commissioner, 73 T.C. at 1186-1187.    In

the instant cases, enormous circular money movements between

entities controlled by the Spanish investors occurred

approximately every 183 days so that the interest on the payments

would qualify for the exemption on withholding tax.    In Monahan
                             - 117 -

v. Commissioner, T.C. Memo. 1994-201, affd. without published

opinion 86 F.3d 1162 (9th Cir. 1996), we found that the

taxpayer's transactions lacked economic substance and stated:

          The various transfers among entities controlled or
     owned by * * * [the taxpayer] are reminiscent of those
     with which we have previously dealt. See, e.g., Karme
     v. Commissioner, 73 T.C. 1163, 1171, 1173-1174 (1980)
     affd. 673 F.2d 1062 (9th Cir. 1990); Bail Bonds by
     Marvin Nelson, Inc. v. Commissioner, T.C. Memo. 1986-
     23, affd. 820 F.2d 1543 (9th Cir. 1987); see also
     Schiavenza v. United States, 52 AFTR2d 83-6364, 85-1
     USTC par. 9155 (N.D. Cal. 1984). In those cases, the
     taxpayers used foreign and domestic entities to make
     prearranged "money movement[s]" within the "system" of
     entities. Karme v. Commissioner, supra at 1169. The
     funds involved in those money movements never left the
     system of controlled entities. Typical of the
     transactions in those cases were key documents that
     "were not executed, and sometimes not even written in
     final form, until long after their purported dates",
     id. at 1191, loans and transfers that were made between
     system entities to negate risk of loss; lenders that
     were "continu[ing] to enjoy the use" of funds supplied
     to other entities, id. at 1193; and back-to-back
     transfers of funds made within hours of each other all
     resulting in no net outlay of money by any single
     entity or person. See Bail Bonds by Marvin Nelson,
     Inc. v. Commissioner, supra. As in those cases, "It is
     apparent that * * * [taxpayer's] transactions * * *
     'did not appreciably affect [his] beneficial interest
     except to reduce [his] tax'." Bail Bonds by Marvin
     Nelson, Inc. v. Commissioner, supra (citing Knetsch v.
     United States, 364 U.S. 361, 366 (1960), quoting
     Gilbert v. Commissioner, 248 F.2d 399, 411 (2d Cir.
     1957)).

     Here, too, the transfers are "reminiscent" of those with

which we have previously dealt.   Domestic and foreign entities

were used to make prearranged money movements within the system

of entities controlled by the Spanish investors.   In December

1987, the J. Montaner-controlled companies, primarily Dapy, and

the Santandreu-controlled companies, primarily Roundabout,
                               - 118 -

transferred $10 million to Gatetown.      Gatetown transferred the

money to MDT and MSI.   MDT and MSI issued commercial paper to

five entities that were controlled by the Spanish investors,

notwithstanding that the five entities did not contribute any

funds to MDT or MSI.    MDT and MSI used the $10 million combined

with promissory notes to pay Manver a total of $10 million cash

and $12.5 million in promissory notes.

     To avoid withholding on the interest on the $12.5 million in

notes to Manver, a round of commercial paper was issued.      During

March 1988, Manver transferred $9.03 million to Gatetown.      The

funds went through a myriad of controlled entities, within a day

or two, and ended with MDT's transferring $7.672 million to

Manver as payment on the royalties.      Manver then transferred

$2.672 million to Gatetown, which then transferred the money

through a series of controlled entities, eventually to have

$3.354 million transferred back to Gatetown, which transferred it

to MSI, which in turn transferred it to Manver.      Petitioners

effectively used $7.672 million of funds supplied by Manver to

reduce debts to Manver by $11 million.

     As subsequent rounds of commercial paper were issued, the

interest payments that were made to the controlled entities were

then distributed to the Spanish investors' Eurotor companies.

The use of the commercial paper not only provided an opportunity

to avoid withholding on the interest, it also provided a method
                              - 119 -

for the Spanish investors to receive corporate distributions tax

free.

     We examined similar facts in Erhard v. Commissioner, T.C.

Memo. 1991-290, modified by T.C. Memo. 1992-376, supplemented by

T.C. Memo. 1993-25, affd. 46 F.3d 1470 (9th Cir. 1995), where we

concluded:

     Moreover, the record clearly shows that the money
     movement technique made possible a group of
     transactions with a total value far in excess of the
     actual cash involved. The circular money movements
     here involved generally began and ended with system
     entities, with no change in the economic position of
     the system viewed as a whole. Quite often, the money
     movements occurred in a single day. The stream of
     money flowing through the intermediate entities,
     supported by mere bookkeeping entries or by the devices
     of back to back loans, was without economic substance.
     See Karme v. Commissioner, supra.

We found that the circular money movement amounted to a sham in

substance and underscored a complete lack of economic substance

to support an interest expense deduction.    Erhard v.

Commissioner, supra.

     Petitioners attempt to distinguish the instant cases from

the other circular money movement cases.    They argue that, in the

instant cases, there is real value underlying the lump-sum

royalty payments.   Petitioners contend that the real value

consisted of the right to use the payee's valuable intangibles

for an extended period.   As we concluded earlier, Manver did not

own or transfer the intangibles, and, therefore, petitioners

could have used the intangibles without paying Manver.
                               - 120 -

Petitioners have failed to persuade us that we should treat their

circular money movements as anything other than shams.

     Additionally, petitioners have failed to persuade us that

the transactions were entered into for reasons other than tax

avoidance.   Petitioners admit on brief that "had they been

informed that the Netherlands Antilles treaty exemption for

interest would not expire on January 1, 1988 * * * they would

have simply signed the notes to Manver, paid interest thereon

until the notes were paid off, and completely avoided the

commercial paper headaches."   Santandreu testified that the

reason the commercial paper was issued was "to have the

advantages of not paying withholding on the interest."    Both of

these explanations support the conclusion that the transactions

were entered into solely for tax-avoidance purposes.

     Petitioners deducted the guarantee fees as an "ordinary and

necessary" business expense under section 162.   Petitioners rely

on A.A. & E.B. Jones Co. v. Commissioner, T.C. Memo. 1960-284,

and argue that, because the amount of the guarantee fees did not

exceed amounts that would have been charged to an unrelated

party, the fees were reasonable for purposes of section 162(a).

In that case, surety companies would not issue bonds to cover

corporate contracts without the personal guarantees of the Jones

brothers.    While we looked at the reasonableness of the guarantee

fees, there was no issue as to whether the guarantee fees were

ordinary and necessary.
                               - 121 -

      Those facts are easily distinguishable from the facts in

these cases.    Here, petitioners have failed to show that the

commercial paper would not have been issued without the guarantee

fees.   The Spanish investors, through Dapy and Roundabout,

provided the money and controlled the entities through which the

money flowed.    Dapy and Roundabout also guaranteed the issuance

of the commercial paper and received the guarantee fees.     The

guarantee fees were not a condition of the issuance and did not

alter the economic substance of the transaction because the fees

did not change the level of risk for any of the participants.

Dapy and Roundabout had the $10 million that was originally

advanced to Gatetown returned to them approximately 6 months

after it was advanced.    Additionally, the transactions underlying

the guarantee payments were shams that were entered into solely

for tax-avoidance purposes.

      The interest was not paid on genuine indebtedness as

required by section 163.    There was no ordinary and necessary

business purpose for the guarantee fees as required by section

162(a).   Therefore, petitioners cannot deduct the interest and

guarantee expenses on the lump-sum royalty payments.

Accordingly, we sustain respondent's determinations as to those

issues.

IV.   Interest Deductions on the Section 351 Transactions

      Petitioners deducted interest payments on the promissory

notes given in exchange for assets in the section 351
                              - 122 -

transactions.   Petitioners argue that the section 351

transactions established an unconditional obligation to pay and

that the promissory notes were valid debt notwithstanding the

year-long delay in finalizing the notes.

     Respondent contends that the amounts in issue should be

treated as equity because petitioners lacked the intent and

ability to repay the funds, and, therefore, the funds were at the

risk of the business.

     The classic debt is an unqualified obligation to pay a sum

certain at a reasonably close fixed maturity date along with a

fixed percentage in interest payable regardless of the debtor's

income or lack thereof.   Gilbert v. Commissioner, 248 F.2d 399,

402 (2d Cir. 1957), remanding T.C. Memo. 1956-137 on another

issue, affd. 262 F.2d 512 (2d Cir. 1959).

     In Gregory v. Helvering, 293 U.S. 465 (1935), the Supreme

Court disregarded a corporate reorganization because, although

the transaction was in form a reorganization, in substance there

was no business purpose other than tax avoidance.   The Court

recognized the legal right of a taxpayer to decrease the amount

of taxes owed by means that the law permits.   However, the Court

qualified the right of the taxpayer to reduce taxes, stating "But

the question for determination is whether what was done, apart

from the tax motive, was the thing which the statute intended."

Id. at 469.
                              - 123 -

     The principle set down in Gregory is not limited to

situations where the issue is whether or not a transaction is to

be completely ignored for tax purposes.   The court in Gilbert v.

Commissioner, 248 F.2d at 406, stated:

     The principle is fully as applicable where there is no
     doubt that a very real transaction has taken place and
     the question is whether the characterization urged by
     the taxpayer accords with substantial economic reality.
     In either case the taxpayer must show that his
     treatment of the transaction does not conflict with the
     meaning the Congress had in mind when it formulated the
     section sub judice.

     The court in Gilbert acknowledged that statutory terms

should not be interpreted independent of their context and

underlying policy, concluding that "not every advance cast in the

form of a loan gives rise to an 'indebtedness' which will justify

a tax deduction."   Id. at 440.

     In Gilbert v. Commissioner, 248 F.2d at 406-407, the court

addressed the issue of what principle is to be applied by the

finder of facts in determining whether a given advance of money

by a shareholder to a closely held corporation is a loan within

the meaning of the Internal Revenue Code.   After evaluating

various criteria, the court stated:

     Congress evidently meant the significant factor to be
     whether the funds were advanced with reasonable
     expectations of repayment regardless of the success of
     the venture or were placed at the risk of the business
     * * *

          From the point of view of the corporation, the
     Code allows a deduction for "interest paid * * * on
     indebtedness," yet it allows no deduction for dividends
     paid. Thus, where a corporation pays for the use of
     money which it will return, it is in effect allowed a
                              - 124 -

     deduction for a business expense, just as it is allowed
     a deduction for the expense of renting a building.
     Where, however, a corporation pays dividends, it is not
     incurring a business expense; it is distributing
     profits. While interest and profits are not always
     distinguishable, they are distinct concepts, and the
     distinction, however imperfect it may be in a
     particular case, lies in the degree of risk involved.
     Thus, it would do violence to the congressional policy
     to permit an "interest" deduction where the "loan" is
     so risky that it can properly be regarded only as
     venture capital. [Id. at 406-407.]

     Applying these principles to the instant cases, we do not

have to set aside or disregard the section 351 transactions as a

prerequisite to evaluating the interest deductions.   We must

decide whether the loans as they existed comport with the

legislative intent behind section 163 and, specifically, whether

the funds were advanced with reasonable expectations of repayment

regardless of the success of the venture or whether the funds

were placed at the risk of the business.

     According to petitioners' form, after the double section 351

transactions were complete, MSI had $4.4 million worth of assets,

of which approximately $3,670,936 was goodwill, and MDT had

$14 million in assets, of which approximately $13,696,767 was

goodwill.   Conversely, MSI's and MDT's tangible assets were

valued at approximately $729,064 and $303,233, respectively.

     In exchange for the $729,064 in tangible assets and

$3,670,936 of goodwill, MSI transferred to MTBV stock that it

valued at $1.1 million and a negotiable promissory note valued at

$3.3 million.   The note bore interest at 9.5 percent, interest

only paid quarterly.   There were several versions of the note
                              - 125 -

with different terms including 5 and 6 years.    The note did not

state on its face that it was secured.

     In exchange for the $303,233 in tangible assets and

$13,696,767 of goodwill, MDT transferred to MANB stock that it

valued at $3.5 million and a negotiable promissory note valued at

$10.5 million.   The note bore interest at 10 percent, interest

only paid quarterly, with the principal due in 5 years.    The note

did not state on its face that it was secured.

     Nassau Lens Co. v. Commissioner, 308 F.2d 39, 47 (2d Cir.

1962), remanding 35 T.C. 268 (1960), articulated the evaluation

criteria set forth in Gilbert v. Commissioner, stating:     "The

starting point is, of course, whether there is an intent to

repay, for in the absence of that no debt can be said to exist."

In reaching a conclusion as to petitioners' intent to repay, we

gave substantial weight to petitioners' delay in finalizing the

promissory notes until December 1988, over a year after the

section 351 transactions occurred.

     Petitioners rely on several cases to argue that the courts

have held that absence of a formal writing does not affect the

validity of the underlying debt.   See, e.g., Nat Harrison

Associates, Inc. v. Commissioner, 42 T.C. 601, 622 (1964);

Baldwin v. Commissioner, T.C. Memo. 1993-433.    However, these

cases are primarily concerned with entities changing from

partnerships to corporations and do not involve such lengthy time
                               - 126 -

periods or promissory notes based on intangible assets that are

not owned by the taxpayer.

     Respondent contends, and we agree, that the reason the notes

were not finalized was because C&L was waiting for tax rulings

that would determine how the interest payments would be taxed.

There were no discussions on the repayment of the debt or on

obtaining security for the promissory notes.    Petitioners argue

that the reason that there were no discussions as to repayment is

"obvious".   Petitioners' obvious reason is that there was never

any question that the debt was intended to be repaid.    It appears

equally obvious that petitioners were not concerned with

repayment.   The delay in finalizing the promissory notes supports

respondent's view.

     The delay in finalizing the promissory notes also indicates

a lack of arm's-length dealing.    Advances to a closely held

corporation by its shareholders are subject to particular

scrutiny:    "The absence of arm's-length dealing provides the

opportunity to contrive a fictional debt shielding the real

essence of the transaction and obtaining benefits unintended by

the statute."    Gilboy v. Commissioner, T.C. Memo. 1978-114.    An

unrelated third party would not transfer substantial assets over

a year in advance of receiving the promissory notes.    An

unrelated third party would be concerned about repayment of the

notes when the asset supporting the notes consisted primarily of
                               - 127 -

goodwill in the form of tradenames and trademarks that, according

to petitioners' form, the obligee did not own.

       We do not believe outside investors would have made similar

advances.    The notes were unsecured, and the "leased" intangibles

were 98 percent and 83 percent of the total value of MDT and MSI,

respectively.    In the event petitioners were unable to repay, a

creditor would have little, if any, chance of recovering the

loan.    Additionally, an outside investor would want to have the

"value" of the entities substantiated.    The "value" of MANV

increased from $6,174,800 on January 31, 1987, to $14 million on

September 30, 1987.

       Although tax savings motives are not given conclusive

weight, they should be given weight commensurate with the extent

to which "they contribute to an understanding of the external

facts of the situation."    Gilbert v. Commissioner, 248 F.2d at

407.    The facts overwhelmingly support that the motive for the

section 351 transactions was tax avoidance.    The finalization of

every document was predicated on tax rulings from various foreign

entities.    The corporate planning was centered around methods to

repatriate funds without paying tax.     As we discussed previously,

the form to avoid taxes was created by petitioners and C&L, and

the documents were created to fit that form, notwithstanding the

substance of the arrangements.

       The preponderance of the evidence supports the conclusion

that the funds were placed at the risk of the business and
                              - 128 -

repayment was dependent on the success of the venture.    We reach

that conclusion because petitioners lacked the intent to repay,

the transactions were not at arm's length, an unrelated creditor

would not have made similar advances, and the transactions were

driven solely by tax-avoidance motives.     Gilbert v. Commissioner,

supra; Gilboy v. Commissioner, supra.     Accordingly, the treatment

of the loans as valid indebtedness would not comport with the

intent of section 163.   Therefore, respondent's determinations

will be sustained as to this issue.

V.   The $236,313 That MDT Paid to MSI as a Marketing Fee

      Petitioners deducted $236,313 as a marketing expense on

their fiscal year 1987 (December 1, 1986, to November 30, 1987)

Federal tax return.   Petitioners argue that MDT paid MSI the

money as compensation for the use of MSI personnel in connection

with opening the California castle.

      Respondent contends that the payments were an attempt to

split profits between MSI and MDT and, as such, were not

deductible.   Respondent also contends that the documents

memorializing the transaction were backdated.

      Petitioners sought advice from C&L on how to structure an

arrangement where two entities could share profits and losses

equally while one company retained the benefit of appreciation in

the property.   In October 1986, C&L gave petitioner advice that

consisted of warnings about tax implications and a suggestion to

set up a management agreement with fees contingent on profits.
                              - 129 -

During June or July 1989, a document dated March 1986 appeared.

The document contained the advice that C&L rendered 7 months

after the date on the document.   We are unpersuaded that the

similarities were coincidental.   Additionally, the payment term

of not later than 1 year after MANV filed its 1986 tax returns

would have required a payment no later than June 7, 1989.

MDT/MANV paid MSI/MTNV with a check dated July 3, 1989.      We are

persuaded that the documents were backdated.   Although backdated

documents may imply fraudulent intent, it does not necessarily

mandate a denial of petitioners' deduction.    Bradford v.

Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo.

1984-601; Baldwin v. Commissioner, T.C. Memo. 1993-433.

Petitioners, however, have the burden of proving that the

payments were for marketing fees.   Because of the lack of

credible evidence to support petitioners' position and the

unreliability of the backdated documents, we conclude that

petitioners have not met their burden of proof.      Accordingly, we

sustain respondent's determination with respect to this issue.

VI.   New Jersey and California Expansion Expenses

      Petitioners deducted expenses incurred with the development

of two new castles in California and New Jersey.     Petitioners

argue that these amounts were expended for their own benefit and

account in the expansion of their existing business to new

locations.
                             - 130 -

     Respondent disallowed the deductions on the basis that the

expenses did not belong to MDT but were startup expenses of

separate entities, GCI/SDCI and MCI.   Petitioners agree that the

subsidiaries were separate legal entities but argue that the

issue is whether the expansion was carried out by GCI/SDCI and

MCI or by petitioners.

     "While a taxpayer is free to organize his affairs as he

chooses, nevertheless, once having done so, he must accept the

tax consequences of his choice, whether contemplated or not,

* * * and may not enjoy the benefit of some other route he might

have chosen to follow but did not."    Commissioner v. National

Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974).      The

issue is whether petitioners may retroactively change their form

once petitioners realized that there was a tax advantage to a

different type of organizational structure.

     A taxpayer generally may not successfully contend that the

substance of a transaction was other than the form he chose:

     As a general rule, the government may indeed bind a
     taxpayer to the form in which he has factually cast a
     transaction. The rule exists because to permit a
     taxpayer at will to challenge his own forms in favor of
     what he subsequently asserts to be true "substance"
     would encourage post-transactional tax-planning and
     unwarranted litigation on the part of many taxpayers
     and raise a monumental administrative burden and
     substantial problems of proof on the part of the
     government. * * * [Citations omitted.]

In re Steen, 509 F.2d 1398, 1402-1403 n.4 (9th Cir. 1975); J.A.

Tobin Constr. Co. v. Commissioner, 85 T.C. 1005, 1021 (1985).

C&L's August 1988 tax planning letter to Santandreu set out the
                                 - 131 -

then current structure of GCI/SDCI and MCI, i.e., separate

corporations for each castle--the format adopted for the Florida

and Buena Park castles.     The letter stated that they were

separate entities that had, and were currently incurring, startup

costs.      The C&L letter recommended that MDT recharacterize

previous advances made to the separate entities as "divisional

expenditures" and operate the two entities as divisions, noting

that "Andres Gelabert indicated that the minority shareholders

would have no objection to this idea."     The reason for making

these recommendations was solely to achieve tax benefits.        The

anticipated benefits were that MDT could deduct MCI's and

GCI/SDCI's startup expenses and lump-sum franchise payments.

       Both MCI and GCI/SDCI continued to operate in their own

names after C&L suggested the divisional changes.     GCI/SDCI had

board of directors meetings into October 1989.     MCI continued to

do business and enter into contracts in its own name until the

New Jersey castle opened.     Based on petitioners' documentation

and their conduct, we are persuaded that MCI and GCI/SDCI were

separate entities that incurred their own startup costs.

Accordingly, respondent's determination as to this issue will be

sustained.

VII.    Additions to Tax and Penalties for Fraud and Negligence

       A.   Fraud

       Respondent determined that some of petitioners are subject

to additions to tax and penalties for fraud and, in the
                               - 132 -

alternative, negligence.    The addition to tax in the case of

fraud is a civil sanction provided primarily as a safeguard for

the protection of the revenue and to reimburse the Government for

the heavy expense of investigation and the loss resulting from

the taxpayer's fraud.    Helvering v. Mitchell, 303 U.S. 391, 401

(1938).

     Respondent has the burden of proving fraud by clear and

convincing evidence.    Sec. 7454(a); Rule 142(b).   Specifically,

respondent must prove (1) an underpayment of tax and

(2) fraudulent intent.    Respondent cannot rely on petitioners'

failure to overcome the normal presumption of correctness of the

notice of deficiency as to any of the elements necessary to

proving fraud.   Otsuki v. Commissioner, 53 T.C. 96, 106 (1969);

Klein v. Commissioner, T.C. Memo. 1984-392, affd. 880 F.2d 260

(10th Cir. 1989).   Thus our disallowance of various disputed

deductions does not satisfy respondent's burden of proving, by

clear and convincing evidence, an underpayment to which the

addition to tax for fraud applies.

     Fraudulent intent may be inferred from various kinds of

circumstantial evidence, or "badges of fraud", including

understatement of income, inadequate records, implausible or

inconsistent explanations of behavior, concealing assets, or

failure to cooperate with tax authorities.    Spies v.

Commissioner, 317 U.S. 492, 499 (1943); Bradford v. Commissioner,

796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601.
                              - 133 -

     Respondent cites numerous badges of fraud, such as the

creation and backdating of documents, false statements in

documents, the use of nominees, and the failure to disclose

related-party information to the IRS.    The facts indicate, and we

have concluded in previous portions of this opinion, that

petitioners backdated and created documents, put false

information in documents, used nominees to sign documents, and

presented the false documents to the IRS.   However, the presence

of badges of fraud will not automatically negate an alternative

explanation for petitioners' actions.    Ishijima v. Commissioner,

T.C. Memo. 1994-353; Klein v. Commissioner, supra.

     Petitioners argue that they are not liable for additions to

tax and penalties for fraud or negligence because they reasonably

and in good faith followed the advice of C&L and other

professionals.   In their brief, petitioners state "they had no

reason to believe that the advice they received was incorrect,

nor did they have the knowledge or experience to second-guess

that advice" (citing   United States v. Boyle, 469 U.S. 241, 251

(1985)).

     Respondent argues that petitioners were sophisticated

businessmen who were able to function in a highly competitive

environment, and, therefore, they cannot claim reliance on their

advisers, particularly if petitioners failed to provide the

advisers with correct and complete information.   See Pessin v.

Commissioner, 59 T.C. 473, 489 (1972).    Additionally, respondent
                                - 134 -

points out that petitioners did not always follow the advice of

their advisers.

     In all their business planning, petitioners had as a goal

reducing their taxes.    Tax reduction is an acceptable goal as

long as the reduction involves transactions with substance and is

by a legal means.     Frank Lyon Co. v. United States, 435 U.S. 561,

583-584 (1978).   C&L offered tax planning that would reduce

petitioners' taxes.    Throughout C&L's engagement with

petitioners, C&L suggested various organizational changes and

structures that would reduce petitioners' taxes.    The badges of

fraud occurred after C&L suggested a new organizational structure

or change for petitioners.    C&L suggested that petitioners'

organization was a franchise, and backdated documents appeared,

specifically the January 20 and February 1, 1983, agreements.

Those 1983 agreements attempted to substantiate a franchise

arrangement and contained the same language that was in a tax

planning letter that C&L sent to petitioners in 1986.      C&L

obtained tax rulings on which company should own the intangibles,

and, subsequently, backdated documents appeared that attempted to

substantiate the chain of sale of the intangibles from TM to

Gatetown to Manver.    C&L suggested licensing agreements for the

intangibles, and, subsequently, backdated documents appeared,

containing the same language that was in a draft letter written

6 months after the date on the licensing agreements.      C&L
                               - 135 -

suggested commercial paper as a method to avoid withholding tax,

and petitioners engaged in circular financing transactions.

     On numerous occasions, C&L received information from

petitioners that was contradictory to information that C&L

already knew or that did not fit with the tax plan.    When the

information was subsequently changed to fit the tax plan, C&L

never questioned it.    In December 1986, C&L received documents

that included a contract for the sale of intangibles from TM

directly to Manver.    Later, that contract was replaced by two

contracts that represented a sale of the intangibles from TM to

Gatetown and then from Gatetown to Manver.    In C&L's files, there

are notes that indicate the actual ownership of many of the

corporations involved in the various transactions.    C&L prepared

petitioners' returns without disclosing the related-party

information.   C&L's California office misled or failed to advise

its Florida office of certain material facts.    C&L knew that

GCI/SDCI and MCI were operating as separate entities.    When C&L

determined that taxes could be avoided, it advised petitioners to

recharacterize the entities to divisions.

     C&L apparently put its own pecuniary interest and its desire

to continue working for petitioners over its duty to reasonably

ascertain the true facts and fully to inform petitioners of the

consequences of following C&L's advice.    Petitioners provided

information to C&L, albeit not all correct information, and C&L

chose to be selective with the information.    C&L chose to use the
                               - 136 -

information that assisted C&L with petitioners' tax planning

strategy and to claim ignorance of any other information.    Cf.

United States v. Jewell, 532 F.2d 697, 700 (9th Cir. 1976)

(defining "willful blindness"); United States v. Aleman, 728 F.2d

492, 494 (11th Cir. 1984).

     C&L suggested tax-avoidance strategies, and petitioners

tried to comply with C&L's recommendations, even when petitioners

believed that compliance involved fabricating documents.    C&L

failed to advise petitioners fully as to their obligations and

failed to make any effort to obtain the correct facts.    These

failures, coupled with C&L's use of the "form" created by the

false documents, amounted to tacit advice by C&L that

petitioners' actions were not only acceptable but desired.     C&L's

tacit approval caused petitioners to continue in the practice--

C&L suggested the plan, petitioners responded, and C&L continued

with the next tax planning strategy.     The Spanish investors were

sophisticated businessmen, but they relied on C&L to advise them

with respect to the requirements of U.S. law.

     We agree that there are many badges of fraud present in

these cases.   We conclude, however, that respondent has not

negated the alternative explanation, petitioners' reliance on

C&L, by clear and convincing evidence.    Moreover, respondent has

not proven the falsity of the disallowed deductions by clear and

convincing evidence.   The additions to tax and penalties for

fraud will not be sustained.
                               - 137 -

     B.   Negligence

     Section 6653(a)(1) imposes an addition to tax in an amount

equal to 5 percent of the underpayment if any part of the

underpayment is due to negligence or disregard of rules or

regulations.   Section 6653(a)(1) applies to tax returns with a

due date prior to December 31, 1989.     The section was repealed

December 31, 1989, and recodified in section 6662.     Section

6662(a) imposes a penalty in an amount equal to 20 percent of the

portion of underpayment which is attributable to negligence or

disregard of rules or regulations.

     "Negligence" is defined as the "lack of due care or failure

to do what a reasonable and ordinarily prudent person would do

under the circumstances."    Neely v. Commissioner, 85 T.C. 934,

947 (1985) (quoting Marcello v. Commissioner, 308 F.2d 499, 506

(5th Cir. 1967)).   Negligence includes any failure to make a

reasonable attempt to comply with the provisions of the internal

revenue laws or to exercise ordinary and reasonable care in the

preparation of a tax return, including any failure by the

taxpayer to keep adequate books and records or to substantiate

items properly.    Secs. 6653(a)(3), 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs.    "Disregard" includes any careless, reckless, or

intentional disregard of rules or regulations.     Secs. 6653(a)(3),

6662(c); sec. 1.6662-3(b)(2), Income Tax Regs.

     Petitioners argue that they should not be liable for the

negligence penalty because they relied on their advisers.
                                - 138 -

Petitioners state that the reliance was reasonable given

petitioners' language problems, lack of U.S. business experience,

and total unfamiliarity with U.S. tax laws.

     Respondent contends that petitioners disregarded rules or

regulations and were negligent when they created false and

backdated documents, submitted false information on their tax

returns and to the IRS during audit, and claimed deductions based

on the false information.     Respondent states that petitioners

cannot claim reliance on their advisers because petitioners

provided incomplete and incorrect information to C&L and

disregarded C&L's advice.

     Petitioners rely on United States v. Boyle, 469 U.S. 241

(1985).   In Boyle, the Supreme Court stated that it is reasonable

for a taxpayer to rely on an accountant or attorney who advises a

taxpayer on a matter of tax law.     Id. at 251.   However, "Reliance

by a lay person on a lawyer is of course common; but that

reliance cannot function as a substitute for compliance with an

unambiguous statute."   Id.    In Boyle, the taxpayer failed to file

an estate tax return.   The Supreme Court stated that it takes no

special training or effort to ascertain a deadline and make sure

that it is met.   The Court held that the taxpayer's failure to

file was not excused by the taxpayer's reliance on an agent.

     In these cases, petitioners failed to comply with

unambiguous information requests on their Federal tax returns and

during the IRS audit.   As early as 1985, petitioners were
                              - 139 -

notified by C&L's Orlando office that a reporting entity had to

report each transaction with a related party on a Form 5472,

which should be filed with their tax returns.   The Federal tax

forms specifically requested information about related parties.

Petitioners failed to disclose all of the required information

and to file the appropriate Forms 5472.   Taxpayers cannot hide

behind a claim that they were not aware of the need to provide

the information because they did not read their returns.     The

voluntary failure to read a return and blind reliance on another

for the accuracy of a return are not sufficient bases to avoid

liability for negligence additions to tax.    Bailey v.

Commissioner, 21 T.C. 678, 687 (1954).    Additionally, petitioners

continued to withhold related-party information.   During the IRS

audit, Santandreu provided a document to the IRS that stated that

he did not know the shareholders of Dapy, Manver, Lince, and

Promidux.

     Petitioners were owned and operated by sophisticated

businessmen.   They did not have to have knowledge of U.S. tax

laws or any special training to understand the significance of

creating and backdating documents.   A central figure with respect

to the backdated documents, Onate, was not called by petitioners

to testify, notwithstanding the Court's expressed interest in

having him called as a witness.   Respondent was unable to

effectuate service on Onate because Onate was out of the country.

Petitioners also did not call A. Gelabert or Segui to testify.
                               - 140 -

At the time of trial, Kim testified as an officer of petitioners.

His testimony concerning what he, Forsyth, and others knew in

1986 and what he knew when he signed returns as a corporate

officer was evasive, ambiguous, and inconsistent.

     In these cases, the volume of backdated documents in

evidence was substantial and included:   1983 contracts, 1986

licensing agreements, contracts for the sale of the TM

intangibles, and the promissory notes in the section 351

transactions.    In addition to the versions of the documents that

petitioners claim are authentic, there are numerous versions of

many of the documents that contained varying price terms, party

names, interest rates, and maturity dates.

     Respondent failed to prove by clear and convincing evidence

that petitioners' claimed reliance on C&L was fictitious.

However, for reliance to be a defense to negligence, petitioners

must prove that the reliance was reasonable.    Freytag v.

Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991).

     Petitioners cannot claim reliance on their advisers' advice

if they failed to follow it.   C&L advised that it was better not

to have related parties in the commercial paper transactions and

as guarantors.   Forsyth testified that he had specifically

discussed the use of related parties with Onate and that

Forsyth's preference "was that the majority of the investors be
                              - 141 -

or the substantial part of the investment be purchased by

unrelated parties."   Petitioners used related parties anyway.

     In one of Forsyth's draft letters, which recounted meetings

with Santandreu, C&L advised against claiming a "super royalty"

franchise payment and management fees.2    Petitioners claimed a

super royalty, i.e., 15 percent, in addition to 2 percent

management fees.   Forsyth testified that documents marked "draft"

were used for discussion purposes.   Notes of a subsequent

meeting, contained in C&L's files and introduced into evidence by

petitioners, specifically refer to discussions of the royalty

rates and management fees by reference to the draft document.

Thus, we believe that petitioners were aware of and disregarded

C&L's advice.

     Petitioners also rely on Heasley v. Commissioner, 902 F.2d

380, 383-384 (5th Cir. 1990), revg. T.C. Memo. 1988-408, and

argue that petitioners did not have the knowledge or experience

to question their advisers.   See Vorshek v. Commissioner, 933

F.2d 757, 759 (9th Cir. 1991).   We find material distinctions

between the Heasleys and the officers of petitioners.    Here,

petitioners' officers had considerable business experience and

were given specific requests and advice.    Petitioners' officers

were able to understand what was expected of them.


     2
       Petitioners contend that respondent's argument on this
last point is based on an exhibit that was not received in
evidence. We rely, however, on Exhibit BGS, which was received
on May 1, 1996, and is quoted in our findings.
                               - 142 -

     We are not persuaded that petitioners' claimed reliance on

their advisers was reasonable.    The record contains numerous

instances where petitioners' officers were aware of the rules and

regulations and either disregarded them or did not make a

reasonable attempt to comply with them.    Therefore, we sustain

respondent's determination as to the negligence penalties.

VIII.   Substantial Understatement and Increased Interest

     A.    Substantial Understatement

     Section 6661 imposes an addition to tax in an amount equal

to 25 percent of the underpayment of income tax if the

underpayment is attributable to a substantial understatement.

Section 6661 applies to tax returns with a due date prior to

December 31, 1989.    The section was repealed December 31, 1989,

and recodified in section 6662.

     Section 6662(a) imposes a penalty in an amount equal to

20 percent of the portion of underpayment which is attributable

to any substantial understatement of income tax.

     For purposes of sections 6661 and 6662(a), an understatement

is substantial if it exceeds the greater of 10 percent of the

correct tax or $5,000 or, in the case of a corporate taxpayer,

$10,000.    Secs. 6661(b)(1)(A) and (B), 6662(d)(1)(A) and (B).

The term "understatement" is defined as the excess of the amount

of tax required to be shown on the return for the taxable year

over the amount of tax shown on the return for the taxable year

reduced by any rebate.    Secs. 6661(b)(2), 6662(d)(2)(A).   In
                               - 143 -

calculating understatements, items for which there was

substantial authority or adequate disclosure are not to be

considered.   Secs. 6661(b)(2)(B)(i) and (ii), 6662(d)(2)(B)(i)

and (ii).

     Petitioners argue that there was no understatement, and, if

the Court determines that there was a substantial understatement,

the addition to tax should be waived because there was reasonable

cause for the understatement and petitioners acted in good faith.

     We are not persuaded that petitioners acted in good faith or

that they had reasonable cause for the understatements.

Petitioners' failure to submit Forms 5472 was an attempt at

concealment, not disclosure.   Accordingly, respondent's

determination will be sustained.

     B.   Increased Interest

     Former section 6621(c) applies to tax returns with a due

date prior to December 31, 1989, and provides for an increase in

the rate of interest on underpayments.   The rate is increased to

120 percent of the statutory rate on underpayments that exceed

$1,000 and are attributable to tax-motivated transactions.

Tax-motivated transactions include "any sham or fraudulent

transaction."   Sec. 6621(c)(3)(A)(v).

     Petitioners argue that they are not liable for the increased

rate because they did not engage in any sham or fraudulent

transactions.   We have previously concluded that petitioners

engaged in several tax-motivated transactions that lacked
                               - 144 -

economic substance.    Such transactions are sham within the

meaning of section 6621(c).    Skeen v. Commissioner, 864 F.2d 93,

96 (9th Cir. 1989), affg. Patin v. Commissioner, 88 T.C. 1086

(1987); DeMartino v. Commissioner, 88 T.C. 583 (1987), affd. 862

F.2d 400 (2d Cir. 1988), affd. without published opinion sub nom.

McDaniel v. Commissioner, 862 F.2d 308 (3d Cir. 1988).    The

underpayments attributable to those transactions will bear

additional interest, as will any others where petitioners have

not specifically proven that respondent's determination was

erroneous.

IX.   Withholding of Tax at the Source

      Sections 1441 and 1442 provide for a 30-percent withholding

tax on foreign individuals and corporations as follows:

      SEC. 1441.   WITHHOLDING OF TAX ON NONRESIDENT ALIENS.

           (a) General Rule.-- * * * all persons, in whatever
      capacity acting (including lessees or mortgagors of
      real or personal property, fiduciaries, employers, and
      all officers and employees of the United States) having
      the control, receipt, custody, disposal, or payment of
      any of the items of income specified in subsection (b)
      (to the extent that any of such items constitutes gross
      income from sources within the United States), of any
      nonresident alien individual or of any foreign
      partnership shall (except as otherwise provided in
      regulations prescribed by the Secretary under section
      874) deduct and withhold from such items a tax equal to
      30 percent thereof * * *

           (b) Income items.--The items of income referred to
      in subsection (a) are interest (other than original
      issue discount as defined in section 1273), dividends,
      rent, salaries, wages, premiums, annuities,
      compensations, remunerations, emoluments, or other
      fixed or determinable annual or periodical gains,
      profits, and income * * *
                                - 145 -

     SEC. 1442.   WITHHOLDING OF TAX ON FOREIGN CORPORATIONS.

          (a) General Rule.--In the case of foreign
     corporations subject to taxation under this subtitle,
     there shall be deducted and withheld at the source in
     the same manner and on the same items of income as is
     provided in section 1441 a tax equal to 30 percent
     thereof. * * *

     Respondent determined that petitioners were liable for

withholding tax on the deficiencies related to:

     (a) Interest that MDT and MSI paid to MABV and MTBV,

respectively;

     (b) franchise fees that MANV paid to Manver in the fiscal

year ended November 30, 1987;

     (c) amounts that MDT and MSI paid to Manver in March 1988;

     (d) amounts that MANV, MSI, and MDT paid to Eurotor as

management and consulting fees;

     (e) guarantee fees that MDT and MSI paid to Dapy and

Roundabout in connection with the commercial paper transactions;

     (f) interest that MDT and MSI paid to the commercial paper

holders; and

     (g) fees that MANV paid to Santandreu and Segui in the

fiscal year ended November 30, 1987.

The aggregate amounts for MSI and MDT are approximately as

follows:
                                  - 146 -

                      Year              Total Adjustments

           MSI        1988                  $4,595,445.79
                      1989                   1,044,273.46

           MANV/MDT   1987                   1,644,863.00
                      1988                   9,142,864.57
                      1989                   1,429,130.80

A substantial portion of the amounts that constituted the total

adjustments listed as items (a) through (g) above was ultimately

paid to the Spanish investors through the various entities

representing them.    In contrast, total dividend payments were

approximately as follows:

                      Year(s)           Total Dividends Paid

           MTNV       1983-1987              $1,350,006.52
           MSI        1987-1991                   -0-

           MANV       1986-1987               2,500,000.00
           MDT        1987-1991                   -0-

Petitioners have conceded items (f) and (g); therefore, only

issues (a) through (e) remain for decision.

     A.   Interest that MDT and MSI Paid to MABV and MTBV,
          Respectively

     Petitioners argue that the interest paid on the promissory

notes that were exchanged in the section 351 transactions was not

subject to withholding because interest was exempt under a Dutch

Treaty in existence at the time.      Petitioners argue that MABV and

MTBV were viable business entities and that the debt owed to them

was bona fide.

     Respondent contends that, to the extent the Court finds that

the payments are return of equity and not interest, petitioners
                              - 147 -

are liable for withholding because they have not established any

treaty exemption.

     We concluded earlier that the amounts that were paid from

MDT and MSI to MABV and MTBV were not interest because there was

no debt as required under section 163.   In reaching our

conclusion, we did not have to make a decision about the

viability of MABV and MTBV as business entities, and we do not

have to do so now.   The payments that MDT and MSI made to MABV

and MTBV, respectively, were paid in relation to an equity

contribution from MABV and MTBV to MDT and MSI, respectively.

Accordingly, the payments are subject to the withholding tax, and

respondent's determination is sustained.

     B.   Franchise Fees That Were Paid by MANV to Manver in
          Fiscal Year Ended November 30, 1987

     Petitioners argue that Manver was a corporation validly

formed under the laws of The Netherlands and that the payments

were exempt under a treaty with The Netherlands.

     Respondent contends that the payments were disguised

dividends that were paid to the Spanish investors, and,

therefore, petitioners are not entitled to a benefit under the

treaty.

     We concluded earlier that Manver did not own the

intangibles, and, therefore, there was no "arm's-length" reason

to make franchise payments, and the payments were not "ordinary

and necessary" under section 162(a).    Because MANV had no reason

to compensate Manver, the MANV payments were dividends to the
                              - 148 -

shareholders of MANV.   Although the dividends in form passed

through Manver, the ultimate payees were the MANV shareholders.

Accordingly, the payments are subject to withholding tax, and

respondent's determination is sustained.

     C.   MDT and MSI Payments to Manver in March 1988

     Petitioners argue that the March 1988 transactions in

connection with the up-front royalty payments were not shams, and

the cash payments should be recognized.    Petitioners further

argue that there is no withholding applicable because the

significant event for withholding tax purposes was the lump-sum

payment in December 1987.

     Respondent contends that the up-front payments were illusory

and shams, and, therefore, those payments were not subject to

withholding.   Respondent asserts that the withholding would apply

later when petitioners repatriated the funds as dividends through

the guise of loan payments.

     We concluded previously that the transactions in connection

with the up-front royalty payments were shams that were entered

into solely for tax-avoidance purposes.    We agree with respondent

that the payments were illusory and are not subject to

withholding.   We also agree that the amounts paid out as loan

payments on the transactions were dividends and were subject to

withholding when the payments were made.    Accordingly,

respondent's determination is sustained.
                              - 149 -

     D.   Amounts That MANV, MSI, and MDT Paid to Eurotor as
          Management and Consulting Fees

     Petitioners argue that the management and consulting fees

that were paid to Eurotor represent income effectively connected

with the conduct of Eurotor's trade or business; that the income

was reported on income tax returns filed by Eurotor in the United

States; and, therefore, that no income tax withholding was

required under section 1442(a).

     Respondent contends that the amounts paid were for services

or dividends and, because they are U.S. source income, are

subject to the withholding.

     Section 1441(c)(1) provides an exception to the withholding

rules under sections 1441 and 1442:

          (1) Income connected with United States
     business.--No deduction or withholding under subsection
     (a) shall be required in the case of any item of income
     (other than compensation for personal services) which
     is effectively connected with the conduct of a trade or
     business within the United States and which is included
     in the gross income of the recipient * * * for the
     taxable year.

     Section 1442(a) incorporates the section 1441(c) exclusion

as it applies to corporations.    We have previously concluded that

the management and consulting fees paid to Eurotor were

reasonable and for management services as required by section

162, and, accordingly, we have allowed the deductions.    As

petitioners point out, the income must be effectively connected

with a trade or business and included in the gross income of the

recipient.   Eurotor's Federal tax returns for fiscal years ended
                              - 150 -

July 31, 1986, and July 31, 1987, reported income effectively

connected with a trade or business in the United States.

Eurotor's Federal tax return for the fiscal year ended July 31,

1988, was marked "Final Return" and contained the following

statement:

     Eurator S.A. (XX-XXXXXXX) is not effectively connected
     with the conduct of a trade or business accordingly,
     Eurator S.A. is not required to file a U.S. income tax
     return of a foreign corporation (Form 1120F).

The return did not report any effectively connected income for

1988, and there is no evidence that a 1989 return was filed.

Therefore, to the extent that Eurotor reported the management and

consulting fees on its 1987 Federal tax return, petitioners are

entitled to the exemption from withholding.   For 1988 and 1989,

petitioners are not entitled to the exemption from withholding

because the management services were U.S. source income and there

was no effectively connected income included in the gross income

of the recipient.

     E.   Guarantee Fees Paid to Dapy and Roundabout in Connection
          With the Commercial Paper Transactions

     Petitioners argue that the guarantee fees were not

specifically sourced under section 861 or 862 and urge the Court

to characterize the payments as for services or to adopt an

insurance premium analogy.

     Respondent contends that, to the extent the Court concludes

that the payments are dividends, the payments are subject to

withholding.   We concluded earlier that the payments underlying
                                - 151 -

the guarantee fees were shams and that there was no "ordinary and

necessary" business purpose for the guarantee fees as required by

section 162.   The amounts paid to Dapy and Roundabout, and

subsequently distributed to the Spanish investors as guarantee

fees, were dividends.    Accordingly, respondent's determination

will be sustained.

X.   Failure To Deposit Withholding Tax

      Respondent contends that petitioners are liable for a

penalty under section 6656 because they "failed to withhold and

periodically deposit withholdings of tax".    Respondent asserts

that the penalty applies to the extent that the Court concludes

that the MDT payments to various foreign entities and individuals

were subject to the 30-percent withholding under section 1442 and

petitioners failed to withhold.

      Section 6656, as it applies to returns with a due date prior

to December 31, 1989, states:

      SEC. 6656.   FAILURE TO MAKE DEPOSIT OF TAXES OR
                   OVERSTATEMENT OF DEPOSITS.

           (a) Underpayment of Deposits.--In case of failure
      by any person required by this title or by regulation
      of the Secretary under this title to deposit on the
      date prescribed therefor any amount of tax imposed by
      this title in such government depositary as is
      authorized under section 6302(c) to receive such
      deposit, unless it is shown that such failure is due to
      reasonable cause and not due to willful neglect, there
      shall be imposed upon such person a penalty of 10
      percent of the amount of the underpayment. For
      purposes of this subsection, the term "underpayment"
      means the excess of the amount of the tax required to
      be so deposited over the amount, if any, thereof
      deposited on or before the date prescribed therefor.
                              - 152 -

     Petitioners rely on Rev. Rul. 75-191, 1975-1 C.B. 376, to

support their position that the penalty is not applicable.

Petitioners' reliance is misplaced because Rev. Rul. 75-191

addresses employee and employee Federal Insurance Contributions

Act (FICA) and income taxes, which are not in issue here.

Petitioners argue further that "the facts and law were

sufficiently doubtful that there was reasonable cause for MDT's

failure to withhold, and MDT relied on the advice of C&L."

     As we concluded earlier, the facts and law were not

sufficiently doubtful as to petitioners' obligation to withhold.

Petitioners misrepresented the facts and disregarded the rules,

the regulations and the advice of C&L's Florida office.    The

preponderance of the evidence supports the conclusion that

petitioners' failure to withhold and deposit was not due to

reasonable cause.   See Ellwest Stereo Theaters v. Commissioner,

T.C. Memo. 1995-610.   Accordingly, respondent's determination as

to this issue is sustained.

     To reflect the foregoing and concessions of the parties,

                                         Decisions will be entered

                                    under Rule 155.
