                      T.C. Memo. 2005-254



                    UNITED STATES TAX COURT



CLAYMONT INVESTMENTS, INC., AS SUCCESSOR IN INTEREST TO NEW CCI,
              INC. AND SUBSIDIARIES, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket Nos. 14384-99, 9129-00.   Filed October 31, 2005.


         F is a foreign corporation. P, a U.S. subsidiary
    of F, is a film processing company. On its amended
    1992 and 1993 Federal income tax returns, P claimed
    sec. 165, I.R.C., loss deductions relating to the
    alleged termination of three customer relationships.
    In 1988, S1, a U.K. subsidiary of F, lent £29,498,525
    (i.e., the equivalent of $50 million) to S2, a
    subsidiary of P. In 1996, S2 and S3 (i.e., another
    subsidiary of P), entered into a note assumption
    agreement, which provided that S3 would assume S2’s
    obligations relating to the 1988 loan. Because of the
    favorable currency exchange rates (i.e., between the
    dollar and the pound), at the time of the assumption,
    S2 could have repaid S1 with $45,811,209 instead of $50
    million. As a result, S2 realized $4,188,791 in
    foreign exchange gain when its obligations were
    assumed. On its 1996 consolidated return, P reported
    the interest expense paid by S3 to S1 and deferred the
    foreign exchange gain relating to the intercompany
    transaction between S2 and S3. R determined that P was
                               - 2 -

     not entitled to the sec. 165, I.R.C., loss deductions,
     interest expense deduction, or deferral of foreign
     exchange gain.

     1.   Held: P did not establish that it had a tax basis
     in each of the three terminated relationships and,
     thus, is not entitled to deduct losses related to these
     relationships.

     2.   Held, further, R’s section 482, I.R.C.,
     adjustments, relating to the intercompany transaction,
     are arbitrary and capricious.

     3.   Held, further, the economic substance doctrine is
     inapplicable.

     4.   Held, further, pursuant to sec. 1.1502-13, Income
     Tax Regs., P is entitled to defer foreign exchange gain
     relating to the intercompany transaction between S2 and
     S3.



     William E. Bonano, Richard E. Nielsen, and Annie Huang

(specially recognized), for petitioners.

     James P. Thurston, Kevin G. Croke, and Usha Ravi, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     FOLEY, Judge:   The issues for decision are whether:

(1) Petitioners’1 claimed losses relating to customer




     1
        All references to petitioners are to Claymont
Investments, Inc., and its consolidated subsidiaries. All
references to petitioner are to Claymont Investments, Inc.
                               - 3 -

relationships are deductible pursuant to section 165;2 (2)

petitioners’ arm’s-length loan may, pursuant to section 482, be

recast as a new loan to reflect the interest rate at the time of

the subsequent assumption of the arm’s-length loan; and (3)

petitioners are allowed to defer recognizing foreign exchange

gain relating to 1996.

                         FINDINGS OF FACT

I.   The Technicolor Acquisition

     Carlton Communications Plc (Carlton), a United Kingdom (UK)

corporation, is the parent company of petitioner, Colorado

Acquisition Corp., and Technicolor Holdings, Ltd. (Holdings).3

Petitioner and Colorado Acquisition Corp. are U.S. corporations,

and Holdings is a U.K. corporation.    Carlton International Corp.

(CIC) and Carlton International Holdings, Inc. (CIHI), are wholly

owned U.S. subsidiaries of petitioner.

     On October 7, 1988 (the acquisition date), Colorado

Acquisition Corp. acquired from the Revlon Group, Inc., all the

stock of Technicolor Holdings, Inc. (Technicolor).4   The parties



     2
        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.
     3
         Holdings was formerly known as Colorado Holdings, Ltd.
     4
        As a result of several internal reorganizations of
Carlton’s domestic subsidiaries during the years in issue,
petitioner acquired the stock of Technicolor.
                               - 4 -

to the acquisition jointly elected, pursuant to section

338(h)(10), to treat the acquisition of the stock as an asset

acquisition.   At the time of the acquisition, Technicolor’s

primary activities were film processing and videocassette

duplication.   The film division provided film processing and

related services to major film studios.   The videocassette

duplication division manufactured prerecorded videocassettes for

home video and nontheatrical markets.

     Technicolor, a leading film processing company, had an

experienced management team, sophisticated equipment, and

proximity to the studios’ filming locations.   In addition,

personal relationships, between Technicolor’s and the major film

studios’ executives, facilitated client development and

retention.

     The film processing market was extremely competitive, and

major studios used their strong bargaining power to negotiate

large up-front payments (e.g., Technicolor made a $65 million

payment to renew a contract with Walt Disney Pictures), volume

discounts, “most-favored-nation” provisions,5 and other

contractual concessions from film processing companies.

Technicolor’s major competitors were Deluxe Laboratories, Inc.




     5
        Most-favored-nation provisions ensured that a customer
would get the same pricing as any other customer ordering the
same volume of services.
                                - 5 -

(Deluxe); Metrocolor; and CFI, a division of Republic Pictures

Corp.

       A.   The Preacquisition Review

       Prior to the acquisition, Carlton hired Coopers & Lybrand

(C&L) to value Technicolor’s assets.    C&L allocated, pursuant to

section 1.338(b)-2T, Temporary Income Tax Regs., 51 Fed. Reg.

3591 (Jan. 29, 1986), in effect during 1988, $619,194,000 of the

proposed purchase price to the basis of Technicolor’s assets.

Section 1.338(b)-2T, Temporary Income Tax Regs., supra, required

that acquired assets be divided into four classes.    Class I

assets are cash and cash equivalents.    Class II assets are

certain liquid tangible assets including readily marketable

securities.    Class III assets are all assets other than those in

classes I, II, and IV.    Class IV assets are intangible assets

(i.e., in the nature of goodwill and going concern value) not

allocated to class I, II, or III.    The basis allocated to each

successive class is based on the fair market value (FMV) of a

company’s assets.

       Because there were no class I or II assets, C&L allocated

the basis attributable to Technicolor’s assets first to class

III.    Class III consisted of Technicolor’s tangible assets,

current assets (e.g., accounts receivable), investments in

subsidiaries, and amortizable intangibles.    C&L then allocated

the remaining basis to class IV.
                                - 6 -

     B.     Technicolor’s Customer Relationships

     In 1986, Paramount Pictures Corp. (Paramount), a

noncontractual customer of Technicolor since 1923, entered into

its first contract with Technicolor.    Under this contract,

Technicolor received one-half of Paramount’s film processing

business.    In 1987, Technicolor became Paramount’s exclusive film

processor.    In 1992, after the expiration of its contract with

Technicolor, Paramount entered into a contract with Deluxe.

After Paramount signed with Deluxe, it continued to do business

with Technicolor under an exception to an exclusivity provision

(i.e., a contractual provision in which a customer agrees to

purchase a particular product or service from only one company)

in Paramount’s contract with Deluxe.

     Metro-Goldwyn-Mayer/United Artists (MGM/UA) became a

Technicolor customer in 1924.    In 1987, MGM/UA split its film

processing work between Technicolor and Deluxe and became a

significant noncontractual customer of Technicolor.      At the time

of the acquisition, Technicolor did not have a film processing

contract with MGM/UA.    In addition, the preacquisition review did

not project 1989 revenues relating to MGM/UA.      In 1991, MGM/UA

entered into a contract with Deluxe, but continued to do business

with Technicolor.

     On October 21, 1988, Management Co. Entertainment Group,

Inc. (MCEG), a newly formed independent film production company,
                                - 7 -

entered into a film processing contract with Technicolor.

Technicolor lent MCEG $5.5 million to induce MCEG to enter into

the contract.    Because of concerns about MCEG’s long-term

viability, Technicolor secured the loan with video distribution

royalty rights from four MCEG films.    If the distribution

royalties were insufficient, MCEG was obligated to repay the loan

by October 31, 1991 (1988 loan).    Technicolor’s sales plan, dated

October 18, 1988, for fiscal year 1989, did not list MCEG as a

customer.    On October 31, 1990, MCEG was placed into involuntary

bankruptcy, and on March 19, 1992, the U.S. Bankruptcy Court

approved MCEG’s chapter 11 reorganization plan.    The successor

entity, MCEG Sterling, Inc., did not continue doing business with

Technicolor.

     C.     The 1989 Asset Valuation

     On June 23, 1989, C&L prepared a valuation report (1989

Valuation) that determined the FMV of Technicolor’s assets for

purposes of allocating the purchase price to those assets.     C&L

divided the acquired assets into four classes, discussed supra in

section I.A.    Class III included Technicolor’s customer

relationships.    C&L determined the value of the relationships by

computing the present value of the net realizable earnings that

these assets would generate over their remaining lives.     The

remaining lives were determined by adding a 3-year projected

extension to each relationship’s termination date.    The remaining
                               - 8 -

lives for the Paramount, MGM/UA, and MCEG relationships were

6.25, 6.33, and 6.08 years, respectively.   Beginning in 1989,

Technicolor claimed amortization deductions based on the values

C&L determined for the Paramount, MCEG, and MGM/UA relationships.

Petitioners, on their 1992 tax return, deducted the remaining

adjusted basis of the Paramount relationship.   Similarly, on

their 1993 tax return, petitioners deducted the remaining

adjusted bases of the MGM/UA and MCEG relationships.

     D.   The Closing Agreement

     During the examination of petitioners’ 1988 through 1992

returns, respondent challenged the bases and lives ascribed to

the relationships.   The parties resolved the valuation dispute

under the Intangibles Settlement Initiative Program.   In a

closing agreement (i.e., executed on September 16, 1994, by

petitioners and April 29, 1997, by respondent) the parties agreed

to reduce the bases of the relationships by 15 percent with no

adjustment to the remaining lives as determined in the 1989

Valuation.   In addition, the parties agreed that the basis

amounts allocated to the class IV nonamortizable intangible

assets would be increased by $36,458,000.

     E.   The 1994 Goodwill Valuation

     In a letter dated September 30, 1994 (1994 Valuation), C&L

determined the value of film customer relationships acquired in

the purchase of Technicolor.   In preparing the 1994 Valuation,
                               - 9 -

C&L relied on the 1989 Valuation and the preacquisition review.

C&L determined a total value of the customer relationships using

a capitalization of earnings approach.   It further determined

that the appropriate earnings stream to a potential acquirer of

these relationships would be the after-tax earnings generated by

each relationship projected into perpetuity.   Thus, it assigned

value to the portions of the relationships extending beyond the

initial periods Technicolor attributed to the relationships.     In

both the 1989 and 1994 valuations, C&L used projected annual

pretax earnings to value the Paramount, MCEG, and MGM/UA customer

relationships.   After it valued the customer relationships, C&L

subtracted the value of the customer relationships (i.e., as

modified by the closing agreement) and determined that the values

of the Paramount, MCEG, and MGM/UA customer relationships were

$27,496,000, $5,569,000, and $2,698,000, respectively.

     On July 7, 1997, petitioners filed amended tax returns

relating to fiscal years ending September 30, 1992 and 1993, and

claimed deductions based on the 1994 Valuation.   On their amended

return for 1992, petitioners reported a $27,496,000 loss

deduction attributable to the alleged termination of the

Paramount relationship.6   Similarly, on their amended return

relating to 1993, petitioners reported a $5,569,000 loss


     6
        The $27,496,000 claimed loss contributed to a net
operating loss that petitioners carried forward and deducted in
the fiscal years ending Sept. 30, 1993 and 1994.
                                  - 10 -

deduction attributable to the alleged termination of the MCEG

relationship and a $2,698,000 loss deduction attributable to the

alleged termination of the MGM/UA relationship.7

II.    Loan Assumption and Foreign Exchange Gain Deferral

       On October 7, 1988, Holdings and CIC entered into a note

purchase agreement (Holdings/CIC transaction).       The agreement

provided that Holdings would lend CIC £29,498,525 (i.e., the

equivalent of $50 million) in exchange for a promissory note

(note).       The note had a 10-year term and required interest

payments calculated at an 11.5-percent rate, compounded semi-

annually and payable annually.       All principal and accrued and

unpaid interest were due on October 7, 1998, but the principal

could be repaid at any time without penalty.

       In 1996, Carlton’s board of directors decided to acquire RSA

Advertising, Ltd. (RSA), and Cinema Media, Ltd., a subsidiary of

RSA.       A portion of this acquisition would be funded with funds

from CIHI.       On June 28, 1996, CIC and CIHI entered into a note

assumption agreement (CIC/CIHI transaction).       This agreement

provided that CIC would pay CIHI $49,784,881 in exchange for

CIHI’s assumption of CIC’s obligations to Holdings.       The

$49,784,881 was the amount necessary to pay off the outstanding


       7
        In a third amendment to petition, petitioner, in the
alternative, contends that the loss relating to MCEG is properly
deductible for the year ending Sept. 30, 1992, 1993, or 1995.
With respect to MGM/UA, petitioner contends that the loss is
properly deductible for the year ending Sept. 30, 1992.
                              - 11 -

principal and accrued interest due on the note (i.e., principal

of £29,498,525, then equivalent to $45,811,209, and accrued

interest of $3,973,672).   The note assumption agreement further

provided that CIC remained liable to Holdings but had recourse

against CIHI if CIHI defaulted.   CIHI performed all of its duties

pursuant to the terms of the agreement.   Holdings was not a party

to the agreement.

     The dollar gained value relative to the pound from the date

Holdings and CIC executed the note (i.e., on October 7, 1988, $1

was equivalent to £.59050) to the date CIHI assumed the note from

CIC (i.e., on June 28, 1996, $1 was equivalent to £.6460).    On

the latter date, CIC realized a $4,188,791 foreign exchange gain

(i.e., on June 28, 1996, CIC could have repaid the principal

balance of £29,498,525 with $45,811,209 rather than $50 million).

Petitioners, on their 1996 consolidated return, which included

CIC and CIHI, reported the foreign exchange gain and, pursuant to

section 1.1502-13, Income Tax Regs., deferred recognition of the

gain as an intercompany transaction (i.e., a transaction between

corporations that are members of the same consolidated group).

     On June 2, 1999, and August 30, 2000, respondent issued

notices of deficiency to petitioners relating to tax years ending

September 30, 1993, 1994, and 1995,8 and 1996, respectively, and

determined the following deficiencies in Federal income taxes:


     8
         The 1995 taxable year is no longer at issue.
                                - 12 -

                    Year         Deficiency

                    1993         $4,196,196
                    1994          2,626,712
                    1995            307,496
                    1996         34,839,469

In the August 30, 2000, notice of deficiency, respondent,

pursuant to section 482, made adjustments to reflect the arm’s-

length interest rate applicable at the time of the assumption and

determined that petitioners should recognize the foreign exchange

gain realized in 1996.     On November 6, 2000, the Court granted

the parties’ joint motion to consolidate docket Nos. 14384-99

(i.e., relating to 1993 through 1995) and 9129-00 (i.e., relating

to 1996) for purposes of trial, briefing, and opinion.    In

respondent’s amendment to answer in docket No. 9129-00, filed

July 16, 2002, respondent asserted the economic substance

doctrine as an alternative theory in support of his determination

that the assumption agreement between CIC and CIHI should be

restructured.

     Petitioner’s principal place of business was Claymont,

Delaware, at the time the petition was filed.

                                OPINION

I.   The Valuation of Customer Relationships

     Section 165(a) allows a deduction for a business loss

sustained during a year where the loss is not compensated for by

insurance or otherwise.    The amount of a deduction pursuant to
                                 - 13 -

section 165(a) is limited to the taxpayer’s adjusted tax basis in

the asset lost.   Sec. 165(b).

     Petitioners contend that, pursuant to section 165, they are

entitled to deduct the losses attributable to their customer

relationships with Paramount, MGM/UA, and MCEG because the

relationships were irrevocably lost when Paramount and MGM/UA

executed film processing contracts with Deluxe and MCEG went

bankrupt.   Respondent contends that petitioners have not

accurately established their adjusted tax bases in the

relationships.

     Petitioners’ expert determined that immediately prior to the

Technicolor acquisition the total value of the Paramount, MGM/UA,

and MCEG relationships was $23,882,000.9    In determining the

value of the relationships, he assumed that each relationship

would continue in perpetuity.     He asserted that his assumption

was based on Carlton’s expectation at the time of the acquisition

and stated that “it is reasonable and likely, that Carlton’s

management in reviewing the acquisition, would have assumed that

the historical patterns of long-term client relationships would

be expected to continue.”   We disagree.



     9
        Petitioners, in accordance with their expert’s analysis,
reduced the value attributable to the Paramount, MGM/UA, and MCEG
customer relationships from $27,496,000, $2,698,000, and
$5,569,000 (i.e., the amounts calculated in the 1994 Valuation
and claimed on petitioners’ amended 1992 and 1993 returns) to
$18,328,000, $1,814,000, and $3,740,000, respectively.
                               - 14 -

     In the 1980s, the film processing industry became extremely

competitive, and studios were readily changing film processing

companies and negotiating lower prices, large up-front incentive

payments, and most-favored-nation provisions.    As a result,

Technicolor was experiencing a high rate of client turnover.     In

fact, only 2 of Technicolor’s 12 major contractual customers in

1983 was a customer on the acquisition date.    Carlton’s

expectation that MCEG, MGM/UA, and Paramount would remain

customers in perpetuity is unreasonable and not supported by the

evidence.

     With respect to MCEG, petitioners’ expectation is

unreasonable because MCEG did not, prior to the acquisition date,

have a contractual relationship with, or generate any income for,

Technicolor.   Moreover, MCEG had no track record, a dubious

future, and no film processing history with Technicolor or any

other film processing companies.   Indeed, Technicolor had

concerns about MCEG’s long-term viability (i.e., subsequently

validated by MCEG’s 1992 bankruptcy) and required MCEG to

collateralize the 1988 loan.   Thus, petitioners failed to

establish a value relating to the MCEG relationship.     See Rule

142(a)(1); Newark Morning Ledger Co. v. United States, 507 U.S.

546, 566 (1993).

     Similarly, petitioners’ expectation, that MGM/UA and

Paramount would remain customers in perpetuity, was unreasonable.
                              - 15 -

Bernard Cragg, Carlton’s finance director, testified that at the

time Carlton agreed to the purchase price of the acquisition, he

did not know exactly how long Paramount or MGM/UA would remain a

customer, and that Carlton did not have detailed information

relating to Technicolor customers.     In addition, with respect to

MGM/UA, documents contemporaneous with the acquisition stated

that Technicolor’s relationship with MGM/UA was “uncertain”.    For

example, the disclosure schedule to the stock purchase agreement

and the preacquisition review stated that “MGM/UA is a company in

a state of change”, “Technicolor has no written agreement with

MGM/UA”, and “it is unclear whether Technicolor will receive any

business from MGM/UA at all in the future.”    Furthermore, with

respect to Paramount, although it had a history of doing business

with Technicolor at the time of the acquisition, it had been a

contractual customer for less than 2 years.    At trial, Earl

Lestz, president of Paramount’s Studio Group, testified that

Paramount never gave Technicolor or Carlton any reason to expect

that Paramount would remain a customer for any extended period of

time.   Mr. Lestz’s testimony, the competitive nature of the film

processing market, and Technicolor’s high client turnover rate

before the acquisition, establish that Carlton’s expectation of a

permanent relationship with Paramount was not reasonable.

     In short, petitioners did not establish tax bases with

respect to the customer relationships with MCEG, Paramount, and
                                - 16 -

MGM/UA.     See Newark Morning Ledger Co. v. United States, supra at

566; Capital Blue Cross & Subs. v. Commissioner, 122 T.C. 224,

248 (2004).     Moreover, we are unable to ascribe to any of the

relationships a limited useful life of a specific duration.       Cf.

Capital Blue Cross & Subs. v. Commissioner, supra at 255-257.

Accordingly, we sustain respondent’s determinations disallowing

petitioners’ claimed deductions.

II.   Tax Consequences of the Loan Assumption

      Respondent, relying on section 482, contends that the

CIC/CIHI transaction was not arm’s length and should be:

      recast * * * [as] a payment by CIC of $49,784,881 to
      Holdings to fully extinguish its debt followed by a new
      loan from Holdings to CIHI in the same amount at the
      arm’s length rate of 8%. The excess 3.5% interest paid
      by CIHI to Holdings should be disallowed as a deduction
      and deemed distributed by CIHI to Petitioner and by
      Petitioner to Carlton followed by a constructive
      contribution of this amount by Carlton to Holdings.

      Under section 482, the Commissioner has the authority to

reallocate income among members of a controlled group where a

controlled taxpayer’s taxable income is not equal to what it

would have been had the taxpayer been dealing at arm’s length

with an uncontrolled taxpayer.     Sec. 1.482-1(f)(1), Income Tax

Regs.     If the Commissioner, however, abuses his discretion and

makes a determination that is arbitrary, capricious, or

unreasonable, that determination will not be sustained.     See

Seagate Tech., Inc. v. Commissioner, 102 T.C. 149, 164 (1994);
                              - 17 -

Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989),

affd. 933 F.2d 1084 (2d Cir. 1991).

     A.   The Applicability of Section 1.482-2(a)(1), Income Tax
          Regs., to the Holdings/CIC Transaction or CIC/CIHI
          Transaction

     Section 482 allows the Commissioner to make adjustments to

reflect an arm’s-length rate of interest “Where one member of a

group of controlled entities makes a loan or advance * * * or

otherwise becomes a creditor of, another member of such group and

* * * charges interest at a rate which is not equal to an arm’s

length rate of interest”.   Sec. 1.482-2(a)(1)(i), Income Tax

Regs.; Latham Park Manor, Inc. v. Commissioner, 69 T.C. 199, 210-

211 (1977), affd. without published opinion 618 F.2d 100 (4th

Cir. 1980).

     Section 1.482-1(i)(7), Income Tax Regs., broadly defines a

transaction as “any sale, assignment, lease, license, loan,

advance, contribution, or any other transfer of any interest in

or a right to use any property * * * or money”.   Because the

Holdings/CIC transaction was a loan and CIC/CIHI transaction

involved a transfer of an “interest in or a right to use * * *

money”, both transactions meet that definition.   The Holdings/CIC

and CIC/CIHI transactions, however, are separate transactions.

The CIC/CIHI transaction was entered into 8 years after the

Holdings/CIC transaction, and there is no evidence that this

transaction was under consideration at the time Holdings lent the
                                - 18 -

$50 million to CIC.    Thus, the Holdings/CIC transaction and the

CIC/CIHI transaction must be analyzed separately.    See sec.

1.482-1(f)(2)(i), Income Tax Regs. (stating transactions will be

analyzed on a transaction by transaction basis unless “such

transactions, taken as a whole, are so interrelated that

consideration of multiple transactions is the most reliable means

of determining the arm’s length consideration for the controlled

transactions”).

          1.      Holdings/CIC Transaction

     In 1988, Holdings lent £29,498,525 (i.e., $50 million) to

CIC at an 11.5-percent interest rate.    Both parties agree that,

at the time of the loan, 11.5 percent was an arm’s-length

interest rate.    Thus, section 1.482-2(a)(1), Income Tax Regs., is

inapplicable to the Holdings/CIC transaction.

          2.      CIC/CIHI Transaction

     CIC and CIHI, petitioner’s subsidiaries, are members of the

same consolidated group.    In 1996, CIC and CIHI executed an

assumption agreement in which CIHI agreed to assume all of CIC’s

obligations, pursuant to the note, in exchange for $49,784,881.

Both parties agree that, at the time of the transfer, CIHI could

have borrowed the $49,784,881 at an arm’s-length rate of 8,

rather than the 11.5, percent.    Pursuant to the assumption

agreement, if CIHI failed to make any of its payments, CIC was

entitled to seek legal recourse against CIHI.    Section 1.482-
                               - 19 -

2(a)(1), Income Tax Regs., is applicable to the CIC/CIHI

transaction because CIC became a creditor of CIHI and the 11.5-

percent interest rate was not arm’s length.   Del. Code Ann. tit.

6, sec. 1301(3) and (4) (2005) (a creditor is defined as a person

who has a right to payment).

     Respondent cites section 1.482-1(d)(3)(ii)(B) and

(f)(2)(ii), Income Tax Regs., as authority for restructuring the

transfer between CIC and CIHI as a new loan between Holdings and

CIHI.   Section 1.482-1(d)(3)(ii)(B), Income Tax Regs., states:

     The contractual terms, * * * agreed to in writing * * *
     will be respected if such terms are consistent with the
     economic substance of the underlying transactions. In
     evaluating economic substance, greatest weight will be
     given to the actual conduct of the parties, and the
     respective legal rights of the parties * * *. If the
     contractual terms are inconsistent with the economic
     substance of the underlying transaction, the district
     director may disregard such terms and impute terms that
     are consistent with the economic substance of the
     transaction.

     Respondent contends that the terms of the transaction are

inconsistent with the transaction’s economic substance.

Respondent further contends that arm’s-length parties would not

have entered into this transaction because the market rate of

interest was 8 percent at the time of the assumption.    As a

result, respondent recast the CIC/CIHI transaction as a repayment

by CIC to Holdings of the $49,784,881 followed by a new loan from

Holdings to CIHI at an 8-percent interest rate.   Respondent

further asserts that the excess 3.5 percent interest paid to
                              - 20 -

Holdings by CIHI must be redistributed as a “deemed * * *

[distribution] by CIHI to Petitioner and by Petitioner to Carlton

followed by a constructive contribution of this amount by Carlton

to Holdings.”   We disagree for reasons set forth below.

     First, the interest rate Holdings charged CIC was arm’s

length and, as a result, section 1.482-2(a)(1), Income Tax Regs.,

is not applicable to the Holdings/CIC transaction.    Because the

Holdings/CIC and CIC/CIHI transactions are separate transactions,

respondent may make reallocations only between CIC and CIHI.

Respondent, however, seeks to consolidate and recast both

transactions as a repayment of the loan between Holdings and CIC

followed by a new loan between Holdings and CIHI, thus triggering

the recognition of foreign exchange gain by CIC.

     Second, respondent was not authorized, pursuant to section

1.482-1(d)(3)(ii)(B), Income Tax Regs., to recast the

Holdings/CIC and CIC/CIHI transactions because these transactions

had economic substance.   Respondent does not contend that the

Holdings/CIC transaction lacked economic substance.   Moreover,

CIC’s and CIHI’s conduct established that the terms of their

agreement were consistent with the economic substance of the

underlying transaction.   See sec. 1.482-1(d)(3)(ii)(B), Income

Tax Regs.   In 1996, Carlton contemplated various financing

options to acquire RSA and Cinema Media, Ltd.   One of those

options was to fund a part of the acquisition internally with
                               - 21 -

funds from CIHI.   On June 28, 1996, CIC and CIHI signed an

assumption agreement in which CIC agreed to transfer $49,784,881

to CIHI in exchange for CIHI’s assuming all of its obligations

relating to the note.    Subsequent to the agreement, CIC

transferred the $49,784,881 to CIHI, and CIHI began making

payments pursuant to the terms of the agreement.    Although the

note provided that the principal and accrued interest were not

due until October 7, 1998, CIHI paid the note in full on November

17, 1997.    From June 28, 1996, through November 17, 1997, CIHI

performed all of its duties pursuant to the terms of the

agreement.   Had CIHI not performed all of its duties, CIC had a

legal right to enforce the terms of the agreement.    Furthermore,

petitioners were aware that by delaying repayment of the note

they could take advantage of the favorable fluctuations in the

currency exchange rates (i.e., the repayment amount could

continue to decrease if the dollar strengthened relative to the

pound).   Petitioners raised, and respondent failed to adequately

refute, these factors.    Accordingly, we conclude that the

contractual terms were consistent with the economic substance of

the transaction.

     Finally, because the transaction had economic substance,

section 1.482-1(f), Income Tax Regs., prohibits respondent from

restructuring the terms as if his alternative had been adopted by
                              - 22 -

petitioners.   More specifically, section 1.482-1(f)(2)(ii),

Income Tax Regs., provides:

    the district director will evaluate the results of a
    transaction as actually structured by the taxpayer
    unless its structure lacks economic substance.
    However, the district director may consider the
    alternatives available to the taxpayer in determining
    whether the terms of the controlled transaction would
    be acceptable to an uncontrolled taxpayer faced with
    the same alternatives and operating under comparable
    circumstances. In such cases, the district director
    may adjust the consideration charged in the controlled
    transaction based on the cost or profit of an
    alternative as adjusted to account for material
    differences between the alternative and the controlled
    transaction, but will not restructure the transaction
    as if the alternative had been adopted by the taxpayer.
    * * * [Emphasis added.]

While respondent was not authorized to restructure the

transaction as if petitioners had adopted his proposed

alternative, he could have adjusted the terms of the CIC/CIHI

transaction (e.g., reduced the interest rate).   Id.   Instead,

respondent seeks to collapse two separate transactions (i.e., the

Holdings/CIC and CIC/CIHI transactions), which were 8 years apart

in execution, and create a contractual relationship (i.e.,

between Holdings and CIHI) that never existed.   Accordingly, we

conclude that respondent exceeded his section 482 grant of

authority, and his determination is arbitrary and capricious.

     B.   The Economic Substance Doctrine Is Inapplicable

     In the alternative, respondent contends that the economic

substance doctrine is applicable because “the transaction was

structured * * * solely to generate an inflated interest
                               - 23 -

deduction and defer recognition by Petitioner of a currency

exchange gain.”   Respondent further contends that the CIC/CIHI

transaction should be restructured because it had no objective

economic consequences.   Respondent concedes that his economic

substance contention is a new matter and, as a result, he bears

the burden of proof.   We conclude that respondent has failed to

carry his burden and that the economic substance doctrine is

inapplicable.

     In determining whether the CIC/CIHI transaction has

sufficient economic substance for tax purposes, the Court must

consider both the objective economic substance and the subjective

business motivation behind the transaction.   See IRS v. CM

Holdings, Inc., 301 F.3d 96, 102-103 (3d Cir. 2002).   If the

transaction has no substance other than to create deductions, it

must be disregarded for tax purposes.   See United States v.

Wexler, 31 F.3d 117, 122 (3d Cir. 1994).

     There is no credible evidence that the Holding/CIC and

CIC/CIHI transactions were designed solely for the reduction of

taxes or that the above-market interest rate alone would have

precluded an arm’s-length party from entering into a similar

transaction.    Indeed, petitioners had independent and legitimate

business purposes for the CIC/CIHI transaction.   As previously

discussed in section II.A.2, Carlton decided to fund a portion of

the RSA and Cinema Media, Ltd. acquisition with funds from CIHI
                              - 24 -

and wanted to delay repayment of the note to take advantage of

the favorable fluctuations in the currency exchange rates.

Respondent failed to adequately refute either purpose.    See Frank

Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978) (genuine

multiple-party transactions with economic substance compelled by

business realities, imbued with tax-independent considerations,

and shaped not solely by tax avoidance features should be

respected for tax purposes); IRS v. CM Holdings, Inc., supra at

102-103.

     C.    Deferral of Foreign Exchange Gain

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

members of a consolidated group can generally defer the

recognition of gain relating to intercompany transactions until

entering into a transaction with a nonmember.    In 1996, CIC could

have retired the note by paying $49,784,881 to Holdings.    Upon

repayment of the note, CIC would have recognized a $4,188,791

foreign exchange gain (i.e., on June 28, 1996, CIC could have

repaid the principal balance of £29,498,525 with $45,811,209

rather than $50 million).   See sec. 988(a).   This gain, however,

was deferred, until 1997, as a result of the CIC/CIHI

transaction.   Consistent with our holding, respondent was not

authorized, pursuant to section 482 or the economic substance

doctrine, to restructure the assumption as the repayment of the

loan by CIC, a member of petitioner’s consolidated group, to
                              - 25 -

Holdings, a nonmember, followed by a new loan from Holdings to

CIHI.   Because there was an intercompany transaction between CIC

and CIHI, pursuant to section 1.1502-13(b)(1)(i), Income Tax

Regs., petitioners were entitled to the deferral of foreign

exchange gain.

     Contentions we have not addressed are irrelevant, moot, or

meritless.

     To reflect the foregoing,


                                         Decisions will be entered

                                    under Rule 155.
