                        T.C. Memo. 2001-108



                      UNITED STATES TAX COURT



       NORTHERN TELECOM INC. & SUBSIDIARIES, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2045-97.                        Filed May 7, 2001.



     N. Jerold Cohen, W. Scott Wright, J.D. Fleming, Jr.,

Stephen F. Gertzman, Daniel R. McKeithen, and Walter T.

Henderson, Jr., for petitioner.

     Gary F. Walker and Nancy W. Hale, for respondent.



                        MEMORANDUM OPINION

     COHEN, Judge:   Respondent determined the following

deficiencies in petitioner’s consolidated Federal income tax:
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                  Year                    Deficiency

                  1981                  $ 12,593,692
                  1982                    51,639,634
                  1983                    82,327,873
                  1984                   153,418,047
                  1985                   223,328,166

     After concessions, the issue for decision is whether

petitioner sold property to its wholly owned subsidiary in

intercompany transactions pursuant to section 1.1502-13, Income

Tax Regs., where the subsidiary received its rights to acquire

the property by assignment from third parties who were not

members of petitioner’s consolidated group.     This issue is before

the Court on cross-motions for partial summary judgment pursuant

to Rule 121.   The record shows, and the parties agree, that there

is no genuine issue of material fact.     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.

                             Background

     Northern Telecom Inc. (petitioner) is the common parent of

an affiliated group of corporations, which, at the time of the

filing of the petition, had a principal place of business in

Nashville, Tennessee.    Petitioner is a corporation organized and

existing under the laws of the State of Delaware.      Petitioner and

its subsidiaries filed consolidated Federal income tax returns

during all of the years in issue.
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     During the years in issue, petitioner entered into purchase

agreements with third-party customers (who were not members of

petitioner’s consolidated group), by which petitioner would

design, manufacture, and install telephone systems.   Each

purchase agreement obligated petitioner to produce a telephone

system, provide a license for computer software that would run

the telephone system, provide patent infringement protection,

train employees of a customer to operate the system, and repair

any problems or defects that arose during a 12-month period

beginning when the system was placed in service.

     In exchange, each customer agreed to pay a set price for the

telephone system and to pay all taxes associated with the

transaction except for petitioner’s franchise and income tax

liabilities.   In some of the purchase agreements, the set price

was due in installments beginning with a downpayment paid on the

date when the purchase agreement was signed and ending with a

payment due on a date that was within 30 days of the system’s

being placed in service.   Other purchase agreements required the

set price to be paid in one lump sum due on the day that the

system was placed in service.   Each purchase agreement further

provided that risk of loss would switch to the customers upon

delivery of each component of the telephone system, title passage

would occur when the price and taxes were paid in full, and

petitioner would have a security interest in any delivered
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property until the set price was paid in full.   The third-party

customers were prohibited from assigning their rights under the

purchase agreement without the consent of petitioner.

     Northern Telecom Finance Corporation (subsidiary) is a

wholly owned subsidiary of petitioner.   In some situations, after

entering into a purchase agreement, petitioner and a third-party

customer entered into an agreement with the subsidiary titled

Assignment and Delegation.   Each assignment and delegation

agreement contains a choice of jurisdiction clause that subjects

the agreement to the laws of New York, Tennessee, or Texas.

     In each assignment and delegation agreement, the third-party

customer assigned to the subsidiary the customer’s rights under

the purchase agreement to receive title in the telephone system,

the license in the computer software, and the rights to patent

protection.   The assignment and delegation agreements also gave

the third-party customers the option to elect interim funding, in

which the subsidiary would pay the set price to petitioner.   If

interim funding was not elected, the third-party customer

retained the responsibility of paying the set price to petitioner

and the subsidiary was to reimburse the third-party customer at a

later date.

     Concurrent with the creation of each assignment and

delegation agreement, the third-party customer and the subsidiary

entered into a lease agreement, whereby the customer leased the
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telephone system from the subsidiary.    The lease of the system

was on a net lease basis such that the third-party customer was

responsible for all taxes, fees, and maintenance associated with

the system.

     Petitioner carried out other sales of telephone systems

during the years in issue, in which petitioner entered into

purchase agreements directly with the subsidiary rather than with

a third-party customer.   Respondent admits that these direct

sales of property to the subsidiary qualify as intercompany

transactions under section 1.1502-13, Income Tax Regs.

                            Discussion

     Respondent argues that, in form and substance, a sale of

property from one member of a consolidated group to another

member of the same group, within the meaning of section

1.1502-13(a)(1)(i), Income Tax Regs., did not occur in this case,

because the rights of the subsidiary to receive title in the

telephone systems were acquired by assignment from a third-party

customer rather than from petitioner by purchase.    Respondent

admits that, if the third-party customers had relinquished their

rights under the purchase agreements back to petitioner and if

petitioner and the subsidiary had executed new purchase

agreements for the telephone systems, an intercompany transaction

would have occurred.   However, respondent contends that

petitioner chose the manner in which the transactions were
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carried out and that petitioner must now accept the tax

consequences of that choice.   According to respondent, his

“argument stems solely from his legal proposition that the

transactional documents show that * * * [the subsidiary] did not

purchase the system from * * * [petitioner] within the meaning of

Treas. Reg. sec. 1.1502-13(a)(2).”

     Petitioner argues that the transactions in question were

intercompany transactions under section 1.1502-13(a)(1)(i),

Income Tax Regs., because the subsidiary obtained, from the

third-party customer, the right to acquire the systems directly

from petitioner before any sale of the telephone systems could

occur pursuant to the purchase agreements.

     Pursuant to section 1.1502-13(c)(1)(i), Income Tax Regs.,

gain or loss that is recognized on the sale of property in a

qualifying deferred intercompany transaction between corporations

who are members of the same consolidated group shall be deferred

by the selling member.   See Textron Inc. v. Commissioner,

115 T.C. 104, 110 (2000).   Generally, the gain or loss is

deferred until the occurrence of a triggering event, such as a

disposition of the property in a subsequent transaction outside

the consolidated group or depreciation allowed to a member of the

consolidated group with respect to the property.   The policy

behind the deferment rule is that a consolidated group should be

viewed as a single taxable enterprise.   Thus, the tax liability
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of a consolidated group should be based on dealings with

outsiders rather than on transactions within the group.    See id.

     Section 1.1502-13(a)(2), Income Tax Regs., defines a

“deferred intercompany transaction” to include the sale or

exchange of property or any other expenditure in which the amount

of the expenditure is capitalized in an intercompany transaction.

An intercompany transaction includes:

     [A] transaction during a consolidated return year
     between corporations which are members of the same
     group immediately after such transaction. Thus, for
     example, an intercompany transaction would include a
     sale of property by one member of a group (hereinafter
     referred to as the “selling member”) to another member
     of the same group (“purchasing member”), the
     performance of services by one member of a group * * *
     for another member of the same group * * *, or the
     payment of interest by one member of a group * * * to
     another member of the same group * * *, during a
     consolidated return year. [Sec. 1.1502-13(a)(1)(i),
     Income Tax Regs.; emphasis added.]

     Respondent argues that petitioner did not have ownership

rights in the telephone systems as the systems were being

produced.   Instead, respondent asserts that the rights of the

third-party customers in the telephone systems were superior to

those of petitioner during the period of production because of

the commitments under the purchase agreements.   Respondent

contends that petitioner was never free to sell the telephone

systems to the subsidiary or anyone else.   Thus, respondent

argues that the third-party customers were the source of the
                               - 8 -


rights in the telephone systems that were transferred to the

subsidiary.

     Generally, State law determines what rights and interests

are transferred by contract for Federal income tax purposes.     See

Hoven v. Commissioner, 56 T.C. 50, 55 (1971).   Although the

record does not reveal the jurisdiction to which the purchase

agreements are subject, we assume that the purchase agreements

are subject to the same jurisdictions as the assignment and

delegation agreements.   Those jurisdictions are New York,

Tennessee, or Texas.   Each of these States has enacted statutes

declaring that an agreement that purports to sell property in the

future, when the property is either nonexisting or unidentified

at the time of agreement, does not constitute a sale of

underlying property.   See N.Y. Com. Law sec. 2-105 (McKinney

1962); Tenn. Code Ann. sec. 47-2-105 (1963); Tex. Bus. & Com.

Code Ann. sec. 2.105 (West 1967).   Instead, a present sale of

nonexisting property or goods operates as a contractual

obligation to buy and sell property at a later date.   A

contractual right to purchase nonexisting property in the future

is not a property interest in the underlying property.     See Hoven

v. Commissioner, supra at 56-57; Armstrong v. Commissioner, 6

T.C. 1166, 1173-1174 (1946), affd. 162 F.2d 199 (3d Cir. 1947).

     The critical question is whether, in entering into the

assignment and delegation agreements, the subsidiary received
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property interests in the telephone systems from the third-party

customers or whether the subsidiary received a contractual right

to purchase the telephone systems in the future.    If the

subsidiary received a contractual right to purchase nonexisting

property in the future, then an intercompany transaction would

have occurred because the actual sale of the telephone systems

would have occurred at a later date with petitioner acting as the

seller and the subsidiary acting as the buyer.   See Hoven v.

Commissioner, supra at 56-57; Armstrong v. Commissioner, supra at

1173-1174.

     Analysis of whether the subsidiary received contractual

rights to purchase nonexisting property in the future or whether

the subsidiary received property interests in the telephone

systems depends on the nature of the property that was acquired

by the third-party purchaser in the purchase agreement.      If the

third-party customer acquired only contractual rights to purchase

nonexisting property in the future, then, in the assignment and

delegation agreements, the nature of the property that was

transferred from the third-party customers to the subsidiary was

contractual rights to purchase nonexisting rights in the future.

See Johnson v. Commissioner, T.C. Memo. 1973-159.

     Respondent argues that petitioner lost its ability to act as

the seller-transferor of the telephone systems after entering

into the purchase agreements.   The purchase agreements in issue
                               - 10 -


obligated petitioner to design and manufacture telephone systems

that were not in existence at the time of contracting.    Thus, the

purchase agreements are contracts to sell nonexisting property in

the future, and the agreements do not give the third-party

customers an ownership interest in the telephone systems.      See

Beck v. Commissioner, T.C. Memo. 1987-359.

     Each purchase agreement bound petitioner to supply a

telephone system that met certain requirements on a date

specified.    Until that date, each telephone system and each

component that made up the system were the exclusive property of

petitioner.    When the third-party customers entered into the

assignment and delegation agreements with the subsidiary, the

subsidiary received the third-party customer’s contractual right

to receive nonexisting property in the future.    The third-party

customer could not transfer ownership interests in property that

it had not yet acquired itself.    Instead, the subsidiary’s

ownership interests in the telephone systems were derived by

sales from petitioner.    The subsidiary did not receive its

ownership interest in the telephone systems until the burdens and

benefits of ownership shifted from petitioner, as seller, to the

subsidiary, as purchaser.

     Reliance by respondent on First Am. Natl. Bank v. Chicken

Sys. of Am., 616 S.W.2d 156 (Tenn. Ct. App. 1980), is misplaced.

In First Am. Natl. Bank, an owner of real estate (lessor) entered
                               - 11 -


into a lease agreement with a lessee.    The lessee then assigned

its leasehold interest to an assignee.    The Tennessee Court of

Appeals stated:

          Before there is privity of contract between the
     assignee and the lessor, there must be an actual
     assumption of the lease. In the case at bar there was
     not an actual assumption, only a mere acceptance of an
     assignment. [Id. at 161.]

Respondent argues that, by analogy, the subsidiary is in the same

position with petitioner as was the assignee with the lessor in

First Am. Natl. Bank.    Respondent claims that the subsidiary

received no rights from petitioner because the subsidiary had no

direct sales agreement with petitioner, just as the assignee had

no lease agreement with the lessor in First Am. Natl. Bank.

     First Am. Natl. Bank involved a leasehold interest in real

property that existed at the time of contracting.    Thus, when the

lessor and lessee entered into the original lease agreement, the

lessee received a leasehold property interest in the real estate.

In the case at hand, the telephone systems were not in existence

when petitioner and the third-party customers entered into the

purchase agreements.    Thus, there was no property in which the

third-party customers could acquire property interests.    The

third-party customers received only contractual rights to

purchase the telephone systems at a later date.    Before the

property came into existence, the third-party customers assigned

their contractual rights to the subsidiary.    When the property
                              - 12 -


finally came into existence and property interests changed hands

by virtue of the purchase agreements and the assignment and

delegation agreements, the transfer occurred between petitioner,

as seller, and the subsidiary, as buyer.

     The next argument of respondent is that, even if the

subsidiary received contractual rights to purchase nonexisting

property in the future from the third-party customers followed by

receipt of property interests in the telephone systems from

petitioner, the transaction was not an intercompany transaction.

Essentially, respondent contends that the transactions were

three-party transactions in which the subsidiary received its

rights through the third-party customers, and, thus, not all

parties of the transaction were members of one consolidated

group.

     Section 1.1502-13(a)(1)(i), Income Tax Regs., states that

“an intercompany transaction would include a sale of property by

one member of a group * * * to another member of the same group.”

(Emphasis added.)   Thus, in determining whether a sale occurred

between members of the same consolidated group, we look at the

participants to the sale of the property.   As already set forth

above, under the State law governing these transactions, a

transfer of a contractual right to purchase nonexisting property

in the future is not a part of the sale of the underlying

contractual property.   The parties to the sale, which occurred
                              - 13 -


when the burdens and benefits of ownership of the telephone

systems changed hands, were petitioner, as seller, and the

subsidiary, as buyer.   The third-party customer, who held a

contractual right prior to the sale, was not a party to the sale

of the underlying contractual property.   The intermediary

ownership by the third-party customers of a contractual right to

receive property in the future is ignored in determining whether

an intercompany transaction occurred.

     We have considered all remaining arguments made by

respondent for a result contrary to that expressed herein, and,

to the extent not discussed above, they are irrelevant or without

merit.   Petitioner’s motion for partial summary judgment will be

granted, and respondent’s motion for partial summary judgment

will be denied.

     To reflect the foregoing,

                                          An appropriate order will

                                    be issued.
