                        T.C. Memo. 2001-122



                      UNITED STATES TAX COURT



AMBASE CORPORATION, f.k.a. THE HOME GROUP INC., INDIVIDUALLY, AND
   AMBASE CORPORATION, f.k.a. THE HOME GROUP INC., AS DESIGNATED
  AGENT OF CITY INVESTING COMPANY, Petitioner v. COMMISSIONER OF
                    INTERNAL REVENUE, Respondent



     Docket No. 11816-95.                          Filed May 23, 2001.



     M. Carr Ferguson, Jr., John A. Corry, Laura M. Barzilai, and

Marina A. Choundas, for petitioner.

     Elsie Hall and Dante D. Lucas, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GALE, Judge:   Respondent determined deficiencies in

petitioner’s Federal income taxes as follows:

               Year                   Deficiency

               1979                   $2,081,771
               1980                    3,660,891
               1981                    4,568,190
                                - 2 -

                1982                    4,052,244
                1983                    3,042,955
                1984                    2,493,442
                1985                    1,087,116

     The sole issue for decision is whether petitioner is liable

under sections 14411 and 1461 for withholding taxes on interest

payments made to nonresident aliens.

                         FINDINGS OF FACT

Petitioner and Other Entities

     Some of the facts have been stipulated and are so found.     We

incorporate by this reference the stipulation of facts and the

related exhibits.

     At the time of filing the petition, petitioner (AmBase

Corporation) was a Delaware corporation that maintained its

principal office in Greenwich, Connecticut.     Petitioner assumed

the Federal withholding tax liabilities of City Investing Co.

(City) upon the liquidation of City in 1985.

     City was incorporated in Delaware in 1967 and succeeded,

through a merger in 1968, to a corporation of the same name

incorporated in 1904.   During the late 1970's, City was a

multinational holding company with assets on a consolidated basis

exceeding $4.2 billion and net equity of approximately $800

million.   City engaged through its subsidiaries in manufacturing,

housing, insurance, and other financial enterprises.    City’s


     1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue.
                               - 3 -

principal manufacturing operations included the manufacture of

water heaters, steel drums and other containers, heating and air-

conditioning equipment and freezers, the printing of magazines,

and the modification and repair of aircraft.   Housing and related

activities included the manufacture of mobile homes, conventional

home building, the operation of a chain of budget motels, and a

59-percent interest in a Florida community builder.

     During the years at issue, City’s most significant

subsidiary was the Home Group, Inc. (HGI),2 which was wholly

owned by City.   HGI was the parent company of the Home Insurance

Co., which in 1975 was the 13th largest property and casualty

insurer in the United States on the basis of net premiums

written, the 15th largest in 1977 and 1978, and again the 13th

largest in 1979.   In 1976, HGI and its subsidiaries had assets of

approximately $2.5 billion and net equity of approximately $660

million.   In 1985, HGI together with its subsidiaries had assets

in excess of $5 billion and net equity in excess of $744 million.

     As the holding company for a multinational conglomerate,

City managed the group’s financial resources and needs.   During

the 1970's, City sought financing for its rapidly growing

subsidiaries by borrowing from various sources depending on where



     2
       Before 1978, the name of the Home Group, Inc., was
CityHome Corp. “HGI” refers to the entity CityHome Corp. before
1978 and to the succeeding entity the Home Group, Inc., from 1978
onward.
                                - 4 -

terms were most favorable.   In 1977, City had notes payable of

more than $70 million to U.S. banks pursuant to a revolving

credit agreement dated April 1, 1975.    The notes bore interest at

a floating rate of one-half percentage point above the prime

rate, and the notes had maturities of 3 to 7 years.     In order to

obtain long-term financing at a fixed rate and to reduce the

amount of indebtedness owed to the U.S. banks under the revolving

credit agreement, City sought access to the Eurobond market.

Eurobond Market/Use of Netherlands Antilles Finance Subsidiaries3

     During the years at issue, a major capital market outside

the United States was the Eurobond market.   The Eurobond market

was not an organized exchange but rather a network of

underwriters and financial institutions that marketed bonds

issued by private corporations (including, but not limited to,

finance subsidiaries of U.S. companies), foreign governments and

their agencies, and other borrowers.    In addition to individuals,

purchasers of the bonds included institutions such as banks

(frequently purchasing on behalf of investors with custodial

accounts managed by the banks), investment companies, insurance

companies, and pension funds.   There was a liquid and well-

capitalized secondary market for the bonds with rules of fair

practice enforced by the Association of International Bond



     3
       The description which follows is based upon the parties’
stipulations.
                                - 5 -

Dealers.    Although most of the bond issues in the Eurobond market

were denominated in dollars (whether or not the issuer was a U.S.

corporation), bonds issued in the Eurobond market were also

frequently denominated in other currencies.

       The practice in the Eurobond market was for issuers of

securities to provide indemnification for withholding taxes to

foreign investors.    Foreign investors would not have purchased

Eurobond obligations without such an indemnification because the

imposition of withholding taxes would decrease their return on

the Eurobond obligations.    If a withholding tax were imposed, the

indemnification would increase the issuer’s cost of borrowing,

inasmuch as the issuer would have to pay a higher rate of

interest to compensate debtholders for the 30-percent withholding

tax.

       According to an analysis prepared by the Joint Committee on

Taxation, in the 1960's the U.S. Government adopted a program

designed to curtail devaluation of the dollar by encouraging

overseas borrowing by U.S. companies.    One element of the program

was the enactment of the Interest Equalization Tax, which in

general imposed a tax on the acquisition by U.S. persons of

foreign securities from foreign persons.    By 1968, some U.S.

corporations had begun to obtain capital overseas in the Eurobond

market through the use of Netherlands Antilles finance

subsidiaries.    The Netherlands Antilles finance subsidiaries
                                - 6 -

issued debt in the Eurobond market, generally guaranteed by the

U.S. parent corporation, and lent the proceeds to the U.S. parent

or its affiliates.   Depending on the facts in a particular case,

the U.S. parent’s payment of interest on its indebtedness to the

Netherlands Antilles finance subsidiary might be exempt from

withholding tax by reason of the application of the U.S.-

Netherlands Income Tax Convention, as extended by protocol to the

Netherlands Antilles.

City’s Finance Subsidiary

     In June 1974, City organized a subsidiary in the Netherlands

Antilles named City Investing Finance N.V. (Finance) to

facilitate access to the Eurobond market.    At some point, 20

shares of Finance’s common stock at $1,000 par value were issued

to City.   City made a payment of $1,000 for 1 share of Finance’s

stock in May 1978; the remaining $19,000 due from City was

treated as a “subscription receivable” on Finance’s financial

statements.

     In 1977 and 1979, City undertook to raise approximately $30

million and $50 million, respectively, from sources outside the

United States by having Finance issue notes in these amounts in

the Eurobond market.    The payment of principal and interest on

these notes was unconditionally guaranteed by City.    Finance

immediately transferred the proceeds from the notes to City, in

exchange for City’s promissory notes.    Before issuance of
                               - 7 -

Finance’s notes on the Eurobond market, City, HGI, and Finance

entered into a series of transactions intended to capitalize

Finance, whereby the equity of Finance would consist of

promissory notes issued by HGI.

     1. 1977 Capitalization of Finance

     On April 26, 1977, City transferred $13,200,000 from its

bank account to Finance’s bank account as a contribution to

capital.   On the same day, Finance transferred the $13,200,000 to

HGI in exchange for a document captioned as a promissory note in

that amount from HGI (1977 HGI note).    The 1977 HGI note bore no

interest, was unsubordinated and unsecured, and was payable on

June 1, 1978, or upon demand thereafter.   Also on April 26, 1977,

HGI transferred to City the $13,200,000 received from Finance.

     In its general activity ledger, City recorded the

$13,200,000 transfer to Finance as a contribution to the capital

of Finance and the receipt of $13,200,000 from HGI as a dividend

received from HGI.

     HGI disclosed the 1977 HGI note as an obligation to Finance

on its audited financial statements for each of the years the

1977 HGI note was outstanding, which statements were submitted to

the Securities and Exchange Commission and various State

regulatory agencies.   HGI informed the group of banks with which

it had a revolving credit agreement of the issuance of the 1977

HGI note and the subsequent dividend to City.   On April 27, 1977,
                                - 8 -

HGI requested and received the consent of each of the banks to

the issuance of the 1977 HGI note, as required by the revolving

credit agreement.

     City prepared an offering circular for prospective

purchasers of the notes to be sold by Finance in 1977 which

disclosed that City’s $13,200,000 capital contribution to Finance

would be lent by Finance to HGI and that Finance’s capital

thereafter included the 1977 HGI note.    The audited financial

statements of both City and HGI were included in the offering

circular.

     2. Finance’s 1977 Issuance of Notes

     On May 5, 1977, Finance was the named issuer of $30 million

of 8-3/4-percent notes on the Eurobond market, due May 1, 1984

(8-3/4-percent notes).    Interest on the notes at the stated rate

was payable annually.    The 8-3/4-percent notes also provided that

the issuer would, in general, indemnify the holders with respect

to any withholding taxes that might be imposed by the United

States or the Netherlands Antilles with respect to the payments

under the 8-3/4-percent notes, by providing for the payment of

additional interest sufficient to make the interest payment equal

to the stated rate.4    Finance’s obligations to make principal and




     4
       The 8-3/4-percent notes further provided the issuer with a
right to redeem in the event that the foregoing additional
interest became payable.
                               - 9 -

interest payments under the 8-3/4-percent notes were

unconditionally guaranteed by City.

     On the same day the 8-3/4-percent notes were issued, Finance

transferred the $30 million proceeds to City.   City issued a

promissory note to Finance in the principal amount of $30 million

(1977 promissory note).   The 1977 promissory note provided that

the principal amount owed would become due and payable at exactly

the same time and in exactly the same amounts as the aggregate

principal obligations of the 8-3/4-percent notes issued by

Finance.   The 1977 promissory note also required City to pay

interest each year on any amount of indebtedness outstanding.

The interest was to be equal to the sum of:   (1) The total

interest payable by Finance on the 8-3/4-percent notes; (2) an

amount equal to one-fourth of 1 percent per annum of the

aggregate principal amount of the 8-3/4-percent notes

outstanding; and (3) an additional amount equal to the excess, if

any, of Finance’s annual costs of operation over its annual gross

receipts from all sources.

     The 1977 promissory note further provided that the portion

of the interest payable by City equal to that payable by Finance

on the 8-3/4-percent notes was due at the same time and in the

same amount as the interest payments became due and payable by

Finance on the 8-3/4-percent notes.    The balance of the interest
                              - 10 -

payable by City to Finance was due only upon Finance’s written

notice to City.

     3. 1979 Capitalization of Finance

     On July 31, 1979, City drew a check payable to the order of

Finance in the amount of $22 million as a contribution to

capital.   On the same day, the check was endorsed by Finance to

the order of HGI.   Also on the same day, the check was endorsed

by HGI to the order of City, and City recorded a $22 million

dividend from HGI on its general activity register.   HGI issued a

document captioned as a promissory note in the face amount of $22

million (1979 HGI note) to Finance in exchange for the

endorsement of the $22 million check.    The 1979 HGI note bore no

interest, was unsubordinated and unsecured, and was payable on

August 1, 1980, or upon demand thereafter.

     HGI disclosed the 1979 HGI note as an obligation to Finance

on its audited financial statements for each of the years the

1979 HGI note was outstanding, which statements were submitted to

the Securities and Exchange Commission and various State

regulatory agencies.

     City prepared an offering circular for prospective

purchasers of the notes to be sold by Finance in 1979 which

disclosed that City’s $22 million capital contribution to Finance

would be lent by Finance to HGI, that HGI would pay this amount

as a dividend to City, and that Finance’s capital thereafter
                              - 11 -

would include the 1977 and 1979 HGI notes.     The audited financial

statements of both City and HGI were included in the offering

circular.

     4. 1979 Issuance of Notes

     On August 1, 1979, Finance was the named issuer of $50

million of floating rate notes (FR notes) on the Eurobond market,

due August 1, 1986.   Interest on the FR notes was payable

semiannually at a rate equal to one-half percent above the London

interbank offered rate for 6-month Eurodollar deposits.     The FR

notes also provided that the issuer would, in general, indemnify

the holders with respect to any withholding taxes that might be

imposed by the United States or the Netherlands Antilles with

respect to the payments under the Notes, by providing for the

payment of additional interest sufficient to make the interest

payment equal to the stated rate.5     Finance’s obligations to make

principal and interest payments under the FR notes were

unconditionally guaranteed by City.

     On the same day the FR notes were issued, Finance

transferred the $50 million proceeds to City.     City issued a

promissory note to Finance in the principal amount of $50 million

(1979 promissory note).   As with the 1977 promissory note, the

1979 promissory note provided that the principal amount owed


     5
       The FR notes further provided the issuer with a right to
redeem in the event that the foregoing additional interest became
payable.
                               - 12 -

would become due and payable at exactly the same time and in

exactly the same amounts as the aggregate principal obligations

of the FR notes issued by Finance.      The 1979 promissory note also

required City to pay interest each year on any amount of

indebtedness outstanding.    The interest was to be equal to the

sum of:   (1) The total interest payable by Finance on the FR

notes; (2) an amount equal to one-fourth of 1 percent per annum

of the aggregate principal amount of the FR notes outstanding;

and (3) an additional amount equal to the excess, if any, of

Finance’s annual costs of operation over its annual gross

receipts from all sources.

     The 1979 promissory note further provided that the portion

of the interest payable to City equal to that payable by Finance

on the FR notes was due at the same time and in the same amount

as the interest payments became due and payable by Finance on the

FR notes.   The balance of interest payable by City to Finance was

due only upon Finance’s written notice to City.

     5. Consolidation of HGI Notes

     The 1977 HGI note and the 1979 HGI note had been

consolidated into a third document captioned as a promissory note

issued by HGI to Finance in an amount equal to the $35,200,000

combined face values of the first two notes (the consolidated HGI

note), with a stated interest rate of 5.2 percent,
                                - 13 -

by the end of 1981.6   The consolidated HGI note was

unsubordinated and unsecured, was dated as of January 1, 1980,

and was payable on August 1, 1980, or upon demand thereafter.

The stated interest rate on the consolidated HGI note was never

paid but instead was accrued by Finance as an additional asset.

     6. Operations of Finance

     The managing directors of Finance included a Netherlands

Antilles trust company and various officers of City.      Finance had

no employees during the period 1977 through 1985.      During the

years at issue, Finance held annual meetings of its shareholders

and prepared annual financial reports.   Finance also filed annual

tax returns with the Netherlands Antilles tax authorities.      City

paid the general and administrative expenses of operating

Finance, including the taxes owed by Finance to the Netherlands

Antilles.

     In general, when an interest payment on the 8-3/4-percent

notes or the FR notes was due and payable by Finance, City would

wire the amount of the interest payment into Finance’s bank

account, which would then be paid out to the fiscal agent in

charge of paying the note holders on the same day.      The remaining

interest due to Finance from City under the terms of the 1977 and



     6
       Petitioner has not been able to establish the exact date
of execution of the consolidated HGI note. The earliest document
in the record mentioning the consolidated HGI note is the 1981
annual report of HGI.
                               - 14 -

1979 promissory notes--that is, an amount equal to one-fourth of

1 percent per annum of the aggregate principal amount of the 8-

3/4-percent notes and FR notes outstanding and an amount equal to

any annual cost of operation exceeding gross receipts--was never

paid.    The monthly statements for Finance’s bank accounts

indicate that the monthly balance of the account never exceeded

$1,000, which was the amount paid by City for 1 share of

Finance’s common stock.

     7. Dissolution of Finance

     On May 1, 1984, the aggregate principal on all of the 8-3/4-

percent notes outstanding became due.    City transferred

$27,405,000 into Finance’s bank account which on the same day was

transferred to the fiscal agent to repay the principal in the

amount of $25,200,0007 and make the final interest payment of

$2,205,000.

     After the 8-3/4-percent notes matured, Finance distributed

$20,500,000 of the consolidated HGI note to City as a return of

capital.   On September 6, 1985, City liquidated and dissolved

Finance.   In connection with the liquidation, Finance distributed



     7
       Of the $30 million of debt issued, $4.8 million had been
canceled. City entered into agreements with Blyth Eastman Dillon
& Co. International Ltd. in connection with the 8-3/4-percent
notes and with the Banque de Paris in connection with the FR
notes to purchase in the open market up to maximum specified
amounts of the notes under certain circumstances, which after
purchase would be canceled and destroyed. City used its own
funds to pay for these purchases.
                              - 15 -

the remaining $14,700,000 of the consolidated HGI note to City as

a return of capital.8   In the case of each distribution by

Finance, City recorded capital contributions to HGI of the

amounts of the consolidated HGI note distributed by Finance.

HGI, in turn, recorded the extinguishment of the amounts of the

consolidated HGI note transferred by Finance to City.

Tax Reporting of the Transactions

     City filed Forms 1042, U.S. Annual Return of Income Tax To

Be Paid at Source, for the taxable years ended December 31, 1979

through 1985, attached to which were Forms 1042S, Income Subject

to Withholding Under Chapter 3, Internal Revenue Code, for each

year reporting gross amounts of income paid to Finance and

claiming a zero-percent rate of withholding tax for such payments

based on Forms 1001, Ownership, Exemption, or Reduced Rate

Certificate.

     Respondent subsequently issued petitioner a statutory notice

of deficiency, determining additional amounts of tax required to

be withheld by City for the years at issue.

                              OPINION

     Sections 871(a)(1) and 881(a)(1) generally impose a tax of

30 percent on amounts received as interest from sources within

the United States by nonresident alien individuals and foreign



     8
       The record does not indicate what was done with the FR
notes upon the liquidation of Finance.
                              - 16 -

corporations.   Payers of such interest are generally required

under sections 1441 and 1442 to deduct and withhold therefrom an

amount equal to the tax imposed by sections 871 and 881, and in

the event that they fail to do so they are liable for those

withholding taxes under section 1461.

     In 1984 Congress repealed the 30-percent withholding tax

imposed by sections 871 and 881 with respect to certain interest

paid on portfolio debt, referred to as “portfolio interest”.9

Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec. 127,

98 Stat. 494, 648.   Repeal, however, was only prospective in

effect, applying to interest payments made with respect to debt

obligations issued after July 18, 1984, the date of enactment of

DEFRA.   See DEFRA sec. 127(g)(1), 98 Stat. 652.   For preexisting

obligations, DEFRA provided special transitional relief from

withholding taxes applicable to interest payments made on

obligations issued before June 22, 1984 (the date of conference

action), by corporations in existence on or before that date that

met requirements based on the “principles” of certain previously




     9
       Portfolio interest generally refers to interest payments
made to a nonresident alien individual or foreign corporation
(owning less than 10 percent of the payer entity) pursuant to
debt obligations that are sold exclusively to non-U.S. persons
with proper precautions taken that such debt obligations will not
be held by U.S. persons. See secs. 871(h), 881(c), 163(f)(2)(B).
                               - 17 -

revoked revenue rulings issued in connection with the Interest

Equalization Tax.10   DEFRA sec. 127(g)(3), 98 Stat. 652.

     In the instant case, the parties dispute whether petitioner

qualifies for the transitional relief provided in DEFRA section

127(g)(3).   In addition, the parties dispute whether, if

petitioner is not eligible for relief under DEFRA section

127(g)(3), petitioner is nonetheless exempt from withholding

liability pursuant to article VIII(1) of the income tax treaty

between the United States and the Netherlands, as extended to the

Netherlands Antilles (U.S.-Netherlands income tax treaty).11

     Some background is helpful in understanding the transition

provisions of DEFRA section 127(g)(3).    In the 1960's, U.S.

companies began to raise capital through the Eurobond market by

using specialized finance subsidiaries.    Such a finance

subsidiary was organized exclusively to issue debt in the

Eurobond market and lend the proceeds to its U.S. parent or

domestic or foreign affiliates in exchange for a promissory note.

The U.S. parent or other affiliate would typically guarantee the



     10
       The Interest Equalization Tax was enacted in the Interest
Equalization Tax Act, Pub. L. 88-563, 78 Stat. 809 (1964), and
expired on June 30, 1974.
     11
       Convention with Respect to Taxes on Income and Certain
Other Taxes, Apr. 29, 1948, U.S.-Neth., 62 Stat. 1757, TIAS 1855
(extended to the Netherlands Antilles by Protocol, June 15, 1955,
6 U.S.T. 3696, TIAS 3366; amended by Protocol, Oct. 23, 1963, 15
U.S.T. 1900, TIAS 5665; modified and supplemented by Convention,
Dec. 30, 1965, 17 U.S.T. 896, TIAS 6051).
                              - 18 -

Eurobond obligations of the finance subsidiary, and it was the

strength of this guaranty on which the holders of the

subsidiary’s Eurobond obligations relied.   Moreover, the U.S.

parent (or affiliate) would make interest and principal payments

on its promissory note to the finance subsidiary that generally

mirrored the subsidiary’s obligations to the Eurobond holders,

and the subsidiary would use those payments to fund its payments

to the bondholders.   If the finance subsidiary was incorporated

in a foreign jurisdiction, such as the Netherlands Antilles,

having a tax treaty with the United States providing for an

exemption from withholding tax on U.S.-source interest paid to a

resident of the foreign jurisdiction, eligibility for such an

exemption would typically be claimed with respect to the U.S.

parent’s payment of interest to the foreign finance subsidiary.

See Joint Comm. on Taxation, Tax Treatment of Interest Paid to

Foreign Investors, at 8-9 (J. Comm. Print 1984).

     As recounted in the legislative history of the repeal of the

withholding tax on portfolio interest, the use of such finance

subsidiaries originally arose as a result of

     a change in the ruling policy of the IRS which
     encouraged foreign borrowings through finance
     subsidiaries. In the case of finance subsidiaries,
     domestic or foreign, the IRS was prepared to issue
     private rulings that no U.S. withholding tax applied if
     the ratio of the subsidiary’s debt to its equity did
     not exceed 5 to 1 and certain other conditions were
     met. Numerous private rulings were issued on this
                             - 19 -

     basis. Finance subsidiaries were also sanctioned by a
     number of published rulings.5
          5
       Rev. Rul. 73-110, 1973-1 C.B. 454; Rev. Rul. 72-416,
     1972-2 C.B. 591; Rev. Rul. 70-645, 1970-2 C.B. 273;
     Rev. Rul. 69-501, 1969-2 C.B. 233; Rev. Rul. 69-377,
     1969-2 C.B. 231. [Id. at 9.]

The published rulings cited in the footnote were issued in

connection with various issues raised by the Interest

Equalization Tax, but a central conclusion in each was that

indebtedness issued by a finance subsidiary in circumstances

similar to those just described would be treated as its own and

not the parent’s, provided the ratio of the subsidiary’s

outstanding debt to its equity did not exceed 5 to 1.   After

expiration of the Interest Equalization Tax, the Commissioner in

Rev. Rul. 74-464, 1974-2 C.B. 46, revoked four of the foregoing

revenue rulings12 on the grounds that expiration of the Interest

Equalization Tax

     eliminated any rationale for treating finance
     subsidiaries any differently than other corporations
     with respect to their corporate validity or the
     validity of their corporate indebtedness. Thus, the
     mere existence of a five to one debt to equity ratio,
     as a basis for concluding that debt obligations of a
     finance subsidiary constitute its own bona fide
     indebtedness, should no longer be relied upon. [Id.,
     1974-2 C.B. at 47.]

     As further recounted in the legislative history,

notwithstanding the Commissioner’s unwillingness to issue rulings


     12
       The remaining ruling, Rev. Rul. 72-416, 1972-2 C.B. 591,
was revoked by Rev. Rul. 74-620, 1974-2 C.B. 380, on the basis of
the same rationale as in Rev. Rul. 74-464, 1974-2 C.B. 46.
                              - 20 -

after 1974, U.S. companies continued to raise capital in the

Eurobond market in the ensuing 10 years, employing finance

subsidiaries incorporated in the Netherlands Antilles for this

purpose and claiming exemption from withholding tax under the

U.S.-Netherlands income tax treaty for interest paid to the

Antilles finance subsidiary by its U.S. parent, on the basis of

opinions of counsel.   See S. Prt. 98-169 (Vol. I), at 418-419

(1984).

     In 1984 when Congress acted to repeal the withholding tax

for portfolio interest, it was aware that the use of Antilles

finance subsidiaries to avoid the withholding tax during the

prior decade, without favorable letter rulings, was subject to

challenge under then-applicable law.   The Senate Finance

Committee, where repeal originated, stated in its report on the

legislation that

          Because of a finance subsidiary’s limited
     activities, the lack of any significant earning power
     other than in connection with the parent guarantee and
     the notes of the parent and other affiliates, and the
     absence of any substantial business purpose other than
     the avoidance of U.S. withholding tax, offerings by
     finance subsidiaries involve difficult U.S. tax issues
     in the absence of favorable IRS rulings. Since the
     marketing of a bond offering is based upon the
     reputation and earning power of the parent, and since
     the foreign investor is ultimately looking to the U.S.
     parent for payment of principal and interest, there is
     a risk that the bonds might be treated as, in
     substance, debt of the parent, rather than the
     subsidiary, and thus withholding could be required.3

          * * * Nevertheless, these finance subsidiary
     arrangements do in form satisfy the requirements for an
                              - 21 -

     exemption from the withholding tax and a number of legal
     arguments would support the taxation of these arrangements
     in accordance with their form. * * *
      3
        Compare, e.g., Aiken Industries, Inc., 56 T.C. 925
     (1971), and Plantation Patterns, Inc. v. Commissioner,
     462 F.2d 712 (5th Cir. 1972), 72-2 U.S.T.C. Paragraph
     9494, cert. denied, 406 U.S. 1076, with Moline
     Properties, 319 U.S. 436 (1943), 43-1 U.S.T.C.
     Paragraph 9464 and Perry R. Bass, 50 T.C. 595 (1968).
     [Id. at 419].

See also Staff of Joint Comm. on Taxation, General Explanation of

the Revenue Provisions of the Deficit Reduction Act of 1984, at

390 (J. Comm. Print 1984) (hereinafter General Explanation).

     Concluding that tax-free access to the Eurobond market for

U.S. companies should be direct, rather than through finance

subsidiaries, the Finance Committee decided to repeal the

withholding tax on portfolio interest paid to foreign

corporations and nonresident alien individuals.   The Committee

was “concerned, however, that repeal of the withholding tax,

without a transitional period, may have a substantial negative

impact on the economy of the Netherlands Antilles” because “the

use of the Antilles as a financial center is likely to be

substantially reduced”.   S. Prt. 98-169 (Vol. 1), supra at 420.

Therefore, the Committee “[provided] for a gradual phase-out,

rather than immediate repeal, of the withholding tax” on interest

paid with respect to portfolio debt, in the form of a reduction

in the rate from 30 percent to 5 percent on interest received
                              - 22 -

after the date of enactment, followed by a gradual reduction to

zero over a 4-year period.   Id. at 421.

     The House version of the legislation did not provide for

repeal.   At conference, a measure to repeal the withholding tax

on portfolio interest was adopted, but the transitional

provisions of the Senate version were replaced.    Instead of a

phase-out of the withholding tax on all interest paid after

enactment, the final conference version provided for immediate

repeal, but only with respect to interest paid on obligations

issued after the date of enactment.    The withholding tax would

continue to apply to interest on obligations issued before that

date.   However, a transition rule (DEFRA section 127(g)(3), at

issue in this case) provided that interest paid on obligations

issued before June 22, 1984, by foreign finance subsidiaries in

existence on or before that date would be treated as paid to a

resident of the country of the finance subsidiary’s incorporation

(and therefore eligible for applicable treaty exemptions) if the

finance subsidiary “[satisfied] requirements based upon the

principles set forth in” four revenue rulings.    H. Conf. Rept.

98-861, at 938 (1984), 1984-3 C.B. (Vol. 2) 1, 192.    These four

revenue rulings were those issued in connection with the Interest

Equalization Tax that in general recognized the corporate

existence of a finance subsidiary if it maintained a debt/equity

ratio not exceeding 5 to 1; i.e., Rev. Rul. 73-110, 1973-1 C.B.
                                - 23 -

454; Rev. Rul. 70-645, 1970-2 C.B. 273; Rev. Rul. 69-501, 1969-2

C.B. 233; and Rev. Rul. 69-377, 1969-2 C.B. 231.

     The General Explanation states that the conference approach

–-i.e., repeal of withholding for prospective obligations,

coupled with transitional relief for preexisting obligations

still subject to withholding-–was prompted by the same concern

expressed in the Senate explanation; namely, to avoid an overly

adverse impact on the Netherlands Antilles economy by providing

“a gradual and orderly reduction of international financing

activity in the Netherlands Antilles * * * [that would] mitigate

any economic hardship that the withholding tax repeal might

indirectly impose on that country.”      General Explanation at

393.13

     DEFRA section 127(g)(3), 98 Stat. 652-653, provides as

follows:

          (3) Special rule for certain United States affiliate
     obligations.--

          (A) In general.--For purposes of the Internal Revenue
     Code of 1954, payments of interest on a United States
     affiliate obligation to an applicable CFC[14] in existence on


     13
       The General Explanation also states one other rationale
for prospective-only repeal: in the case of preexisting
obligations that had been issued directly by U.S. persons and
were held by foreign persons, retroactive repeal would produce
windfall tax reductions for such foreign persons since the price
of, and rate of return on, the obligations were set assuming that
a withholding tax would apply. See General Explanation at 392.
     14
          A “United States affiliate obligation” for this purpose
                                                      (continued...)
                              - 24 -

     or before June 22, 1984, shall be treated as payments to a
     resident of the country in which the applicable CFC is
     incorporated.

          (B) Exception.--Subparagraph (A) shall not apply to any
     applicable CFC which did not meet requirements which are
     based on the principles set forth in Revenue Rulings 69-501,
     69-377, 70-645, and 73-110.

     The parties do not dispute that subparagraph (A) has been

satisfied in this case.   Their dispute concerns whether Finance,

an applicable CFC, falls within the exception to relief provided

in subparagraph (B) because of a failure to satisfy requirements

based on the principles of the applicable revenue rulings.

     The General Explanation states that the principles of the

revenue rulings listed in DEFRA section 127(g)(3)(B) (hereinafter

listed rulings) “include, among other things, the maintenance of

a specified debt-equity ratio.”   General Explanation at 397.

Otherwise, neither the statute nor the legislative history

provides guidance as to the content of the other “principles” or

contains any further gloss on the meaning intended by


     14
      (...continued)
means an obligation of (and payable by) a United States person
that is a related person (within the meaning of sec. 482, I.R.C.
1954) to an “applicable CFC”. DEFRA secs. 127(g)(3)(C)(ii),
121(b)(2)(E) and (F), 98 Stat. 653, 640. An “applicable CFC” for
this purpose means generally any controlled foreign corporation
of which at least 50 percent of all voting power of all stock
entitled to vote is owned by a U.S. shareholder and whose
principal purpose is (1) to issue debt obligations that are sold
exclusively to non-U.S. persons with appropriate precautions
taken that such debt obligations will not be held by U.S. persons
and (2) to lend the proceeds of such debt obligations to its
affiliates. DEFRA secs. 127(g)(3)(C)(i), 98 Stat. 653;
121(b)(2)(D),(G), 98 Stat. 640-641; secs. 957 and 958.
                                 - 25 -

“requirements which are based on the principles set forth in” the

listed rulings.

     The parties agree that one principle set forth in the listed

rulings is that the debt of a finance subsidiary will be treated

as its own if the subsidiary maintains a ratio of debt to equity

that does not exceed 5 to 1.15    Beyond this point, the parties

disagree.   Respondent, while acknowledging that a test of the

debt/equity ratio, rather than conventional substance-over-form

principles, is to be used in determining whether a finance

subsidiary should be disregarded as a conduit, nevertheless

argues that the finance subsidiary’s capitalization for purposes

of the debt/equity ratio must withstand scrutiny under substance-

over-form doctrine.   Respondent contends that the listed rulings’

principles require that a finance subsidiary’s equity capital

“must exist not only in form but also in substance” and that

Finance’s capitalization lacks the requisite substance.    In

respondent’s view, the capitalization of Finance was

“meaningless” because it was accomplished through a circular

cash-flow; namely, the capitalization of Finance in connection

with the issuance of both the 8-3/4-percent notes and the FR

notes was accomplished by a transfer of cash from City to Finance


     15
       This principle appears implicitly in the first two listed
rulings, Rev. Rul. 69-377, 1969-2 C.B. 231, and Rev. Rul. 69-501,
1969-2 C.B. 233, and explicitly in the two later listed rulings,
Rev. Rul. 70-645, 1970-2 C.B. 273, and Rev. Rul. 73-110, 1973-1
C.B. 454.
                              - 26 -

(as a purported capital contribution), followed by a transfer of

this cash from Finance to HGI in exchange for HGI’s promissory

notes, followed by a dividend of the cash from HGI to City, all

accomplished within the same day as prearranged.    Moreover,

respondent contends, the HGI notes were “highly irregular”:

interest was either not charged or below market and was never

paid; there was no collateral or fixed schedule for repayment;

and the notes were ultimately canceled without payment.    The

notes were unenforceable, respondent contends, for lack of

consideration.   Thus, respondent concludes:   “Finance did not

receive the actual benefit of the purported contribution to

capital”.   Accordingly, in respondent’s view, Finance’s

capitalization with the HGI notes should be disregarded,

resulting in Finance’s failure to satisfy the 5-to-1 debt/equity

ratio mandated in DEFRA section 127(g)(3)(B).

     Petitioner contends that Finance’s equity capital consisted

of the promissory notes of a creditworthy affiliate (HGI), the

value of which at all times substantially exceeded 20 percent of

Finance’s outstanding indebtedness to the Eurobond holders.

Accordingly, petitioner argues, Finance’s capitalization

conformed with the principles of the listed rulings which permit,

inter alia, a finance subsidiary to invest its equity capital in

the stock or debt of an affiliate and do not further restrict or
                             - 27 -

specify how the affiliate may use its capital.    For the reasons

discussed below, we agree with petitioner.

     We start with the observation that, since DEFRA section

127(g)(3)(B) articulates the test as “[meeting] requirements

which are based on the principles set forth in” the listed

rulings, whatever requirements must be met by the instant

transactions to qualify for relief must be found in the

principles of the listed rulings themselves.    The point is that

it should not be assumed that substance-over-form principles,

ordinarily applicable in construing a tax statute, automatically

apply in interpreting the listed rulings.    We reach this

conclusion because it is clear that in crafting the relief in

DEFRA section 127(g)(3), Congress intended to displace, in

important respects, conventional substance-over-form principles.

The legislative history previously discussed reveals that

Congress was well aware of the risk that typical finance

subsidiaries would be disregarded as conduits under substance-

over-form principles of tax law.   Congress declined, however, to

draw a conclusion regarding the appropriate outcome under the

prior law, choosing instead to provide a “safe harbor” under

which a finance subsidiary would be recognized as the issuer of

its debt if it met the debt/equity ratio and other requirements

based on the “principles” of the listed rulings.    The listed

rulings, by making a corporation’s debt/equity ratio a
                              - 28 -

dispositive factor in determining conduit status, constitute a

departure from the conventional substance-over-form approach.16

We think there is considerable doubt that Congress, having set

aside the otherwise applicable substance-over-form test for

determining a conduit, nevertheless intended substance-over-form

principles to govern the alternative “safe harbor” test provided

in DEFRA section 127(g)(3)(B).   Instead, we think that Congress,

by articulating the standard with the somewhat cumbersome phrase

“[meeting] requirements which are based on the principles set

forth in” the listed rulings, intended to confine the applicable

principles to those that could be derived from the listed

rulings.   Thus, we conclude that substance-over-form principles

apply in construing the relief available under DEFRA section

127(g)(3) only to the extent that such principles may fairly be

inferred from an examination of the listed rulings.

     For this reason, we reject at the outset respondent’s

attempt to test the capitalization of Finance under case law

involving substance-over-form doctrine, circular cash-flows, the

step transaction doctrine, and similar theories.   The cases

applying such doctrines are simply inapposite in determining the


     16
       The Commissioner acknowledged as much when he revoked the
listed rulings upon the expiration of the Interest Equalization
Tax in 1974, observing that there was no longer any rationale
“for treating finance subsidiaries any differently than other
corporations with respect to their corporate validity or the
validity of their corporate indebtedness.” Rev. Rul. 74-464,
1974-2 C.B. 46, 47.
                               - 29 -

principles of the listed rulings.   The listed rulings were

entirely administrative in origin, and their treatment of

debt/equity ratios as dispositive on conduit status was otherwise

without foundation in tax law.   See Northern Ind. Pub. Serv. Co.

v. Commissioner, 105 T.C. 341, 350-351 (1995), affd. 115 F.3d 506

(7th Cir. 1997).   As petitioner points out, at the same time the

Commissioner was issuing the listed rulings (from 1969 through

1973), he obtained an important litigation victory supporting the

application of substance-over-form or conduit theories to

disregard transactions involving a corporation functioning as a

conduit for interest payments to obtain treaty exemptions.    See

Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971).

Although Aiken Industries addressed essentially the same issue as

the listed rulings, the case is not mentioned in the rulings

issued after it was decided.   The rulings after Aiken Industries

instead reaffirmed the primacy of the debt/equity ratio

established in the listed rulings issued before the decision in

that case.   Clearly the Commissioner considered the principles of

the listed rulings as distinct from the substance-over-form

principles applied in Aiken Industries.   In DEFRA section

127(g)(3)(B), Congress adopted the former and not the latter in

defining the scope of the intended relief.

     Respondent also argues, however, that the substance-over-

form principles he seeks to apply to Finance’s capitalization can
                              - 30 -

be found in the listed rulings.   We disagree.   As the ensuing

discussion will show, the listed rulings’ application of

substance-over-form principles to the capitalization of a finance

subsidiary is decidedly more lax-–that is, more deferential to

form than substance–-than the position urged by respondent in

this case.

     The seminal listed ruling, Rev. Rul. 69-377, 1969-2 C.B.

231, afforded recognition to a finance subsidiary’s role as the

issuer of debt in the following circumstances.    A domestic

corporation, X, formed a wholly owned domestic finance

subsidiary, Y, for the purpose of Y borrowing funds from foreign

persons to be re-lent to or invested in certain foreign

affiliates of X.   X contributed $5,000x to the capital of Y.      Y

then sold $25,000x of 20-year debt obligations to foreign persons

through a public offering in foreign countries and invested in or

lent to the foreign affiliates of X the funds thus derived.       The

debt obligations sold by Y were convertible into the capital

stock of X, and X guaranteed repayment as well as performance of

the conversion feature.

     The ruling recognized the debt obligations sold by Y but

guaranteed by X as the indebtedness of Y, the finance subsidiary.

As two of the subsequent listed rulings make clear,17 the basis



     17
       See Rev. Rul. 70-645, 1970-2 C.B. 273; Rev. Rul. 73-110,
1973-1 C.B. 454.
                               - 31 -

in Rev. Rul. 69-377, supra, for recognizing the indebtedness as

that of Y was Y’s maintenance of a ratio of outstanding debt to

equity no greater than 5 to 1.   Y’s equity for this purpose was

measured by the $5,000x in cash contributed to it by X.

Significantly, however, Y’s cash equity was promptly lent to or

invested in X’s foreign affiliates.     As the ruling makes clear:

          Y invested the net proceeds from the sale of the
     debt obligations and the cash contributed by X in
     foreign corporations [i.e., foreign affiliates of X] by
     acquiring the stock or debt obligations of such foreign
     corporations. [Id., 1969-2 C.B. at 232; emphasis
     added.]

     Rev. Rul. 69-377 was subsequently amplified in Rev. Rul. 72-

416, 1972-2 C.B. 591.18   In the latter ruling, the Commissioner

held that it made no difference to the result reached in Rev.

Rul. 69-377, supra, whether the finance subsidiary was initially


     18
       Although Rev. Rul. 72-416, 1972-2 C.B. 591, is not one of
the four rulings listed in DEFRA sec. 127(g)(3)(B), it is an
amplification of one such ruling (Rev. Rul. 69-377, 1969-2 C.B.
231). According to the Commissioner, an amplification of a
revenue ruling

     describes a situation where no change is being made in
     a prior published position, but the prior position is
     being extended to apply to a variation of the fact
     situation set forth therein. Thus, if an earlier
     ruling held that a principle applied to A, and the new
     ruling holds that the same principle also applies to B,
     the earlier ruling is amplified. * * * [“Definition of
     Terms”, 1976-2 C.B. iv.]

Given the Commissioner’s policy on amplifications, Rev. Rul. 72-
416, supra, constitutes a further illustration of the principles
of Rev. Rul. 69-377, supra, and is appropriately employed to
delineate and clarify those principles.
                              - 32 -

capitalized with cash or with the parent’s common stock where the

stock was publicly traded and had a readily ascertainable value.

     The second listed ruling, Rev. Rul. 69-501, 1969-2 C.B. 233,

concerned what apparently came to be known as the bank-loop

transaction.   In that ruling, a domestic parent formed a foreign

finance subsidiary and capitalized it with cash equal to 20

percent of the face amount of parent-guaranteed debt obligations

that the subsidiary would subsequently sell in a foreign public

offering.   The cash for this purpose was borrowed by the parent

from a foreign financial institution.    Upon receipt of the cash,

the finance subsidiary deposited it with the same foreign

financial institution.   The subsidiary’s right to withdraw the

deposit was not contingent upon the parent’s repayment of its

loan from the financial institution, and the deposit did not

serve as collateral for the loan.   On this basis, the ruling held

that the subsidiary was sufficiently capitalized to be recognized

as the issuer of the debt obligations.

     With respect to the third listed ruling, Rev. Rul. 70-645,

1970-2 C.B. 273, neither party argues that its fact pattern has

any direct bearing on the issues in this case, and we agree.19


     19
       Rev. Rul. 70-645, 1970-2 C.B. 273, did not address the
particulars of a finance subsidiary’s capitalization, as the
finance subsidiary therein received a cash capital contribution
which, so far as the ruling indicated, it retained throughout the
period it had debt outstanding. The ruling instead addressed
whether a finance subsidiary may use a portion of its borrowings
                                                   (continued...)
                              - 33 -

The fourth ruling, Rev. Rul. 73-110, 1973-1 C.B. 454, concerned

the appropriate computation of a finance subsidiary’s debt/equity

ratio where its capital contribution is made in one currency and

its borrowings are made in another.    Where different currencies

are involved, an initial contribution to capital that is equal to

20 percent of the debt to be issued by a finance subsidiary may

cease to be so as a result of fluctuating currency values.   Rev.

Rul. 73-110, supra, held that, in these circumstances, the

debt/equity ratio need only be recomputed to reflect then-

prevailing currency exchange rates if (1) the finance subsidiary

undertakes additional borrowings or (2) the parent withdraws

equity capital for any reason, such as a reduction in the finance

subsidiary’s outstanding indebtedness.   Otherwise, the failure to

maintain the required debt/equity ratio after the initial

contribution is immaterial.

     We believe the listed rulings evidence principles that are

in clear conflict with many of respondent’s arguments.   Though



     19
      (...continued)
from third parties to make a capital contribution to a second-
tier finance subsidiary. The ruling concluded that the first-
tier finance subsidiary’s debt/equity ratio was not adversely
affected by its use of a portion of its third-party borrowings to
make a capital contribution to a second-tier finance subsidiary,
so long as neither the first-tier finance subsidiary nor its
parent provided any guaranty with respect to the second-tier
finance subsidiary’s borrowing.
                              - 34 -

respondent contends that Rev. Rul. 69-377, 1969-2 C.B. 231,

stands for the proposition that a finance subsidiary’s equity

“must exist not only in form but also in substance”, we think the

capitalization of the finance subsidiary in that ruling is itself

highly artificial and formalistic.     The capitalization of the

finance subsidiary with cash was entirely transitory; that is,

the finance subsidiary’s exchange of the parent’s cash for the

securities of affiliates appears to have been contemplated from

the outset.   The finance subsidiary’s exchange of the cash

capital contribution for the affiliates’ securities did not

affect the ruling’s conclusion.   Also, it was the finance

subsidiary’s transitorily held cash that was counted for purposes

of the subsidiary’s meeting the 5-to-1 debt/equity ratio in the

ruling; the stock or debt of the affiliates for which the finance

subsidiary exchanged the cash was not evaluated for this purpose.

Indeed, where the cash was exchanged for affiliates’ stock, it is

difficult to see how the stock could have been counted for this

purpose because the stock was not publicly traded and presumably

had no readily ascertainable value.    Cf. Rev. Rul. 72-416, supra

(parent’s publicly traded stock, because it has a readily

ascertainable value, may be substituted for cash in the

capitalization of a finance subsidiary).     Further, the ruling

does not address the consequences for the debt/equity ratio

requirement in the event the value of the affiliates’ stock
                              - 35 -

declines.   The failure to address issues arising from any change

in the value of the equity capital, once invested in other

assets, suggests the ruling’s emphasis falls entirely on the

nominal amount of initial paid-in capital, a highly formalistic

approach.   This principle is reinforced in Rev. Rul. 73-110,

supra, which held that if changes in relative currency values

after the initial contribution to capital cause a finance

subsidiary to fail to meet the required debt/equity ratio, the

failure can be disregarded unless the subsidiary undertakes

additional borrowing or the parent withdraws capital.   Both

rulings’ “snapshot” approach of testing the ratio only at the

time of the capital contribution or withdrawal is artificial and

formalistic.   Under such an approach, which treats subsequent

changes in the value of the equity capital as largely irrelevant

to the debt/equity ratio, we do not believe much economic

substance inheres in a finance subsidiary’s capitalization.

     Overall, the inherent artificiality of the finance

subsidiary’s capitalization in Rev. Rul. 69-377, supra, is

highlighted when one considers that the purpose of the whole

undertaking was to obtain capital for the foreign affiliates,

which is precisely where the cash used to capitalize the finance

subsidiary ended up.   The finance subsidiary thus functioned as a

conduit both with respect to the borrowed funds and with respect

to the contribution to its capital.
                              - 36 -

     As part of his argument that Finance’s capitalization lacked

substance, respondent also contends that Finance received no

benefit from the contribution to its capital.   Rev. Rul. 69-377,

supra, provides no basis for such a requirement and indeed is

counter to it.   In the ruling, the cash transferred to the

finance subsidiary as a capital contribution could be invested in

the stock of affiliates.   There is no discussion of the

affiliates’ dividend-paying history or capacity.   Absent such a

showing, we are unable to see how the finance subsidiary in Rev.

Rul. 69-377, supra, benefited from holding affiliates’ stock in

any greater degree than Finance benefited from holding the non-

interest-bearing notes of HGI.

     In a similar vein, respondent argues that the lack of

commercially reasonable terms for the HGI notes further indicates

that the notes lacked substance and should be disregarded as

equity capital for purposes of DEFRA section 127(g)(3).    Rev.

Rul. 69-377, supra, however, permitted a finance subsidiary’s

capital to be invested in either debt or stock of affiliates.

Given this indifference to the choice of debt or equity, we do

not believe the failure to provide for interest on the HGI notes

is fatal under the principles of that ruling.   The HGI notes

contained other characteristics of indebtedness.   Each was

unsubordinated and contained an unconditional promise to pay at a

time certain or upon demand thereafter by a creditworthy obligor.
                             - 37 -

Although unsecured, the amounts of the obligations ($13,200,000

and $22 million) were small in relation to HGI’s assets.     HGI was

the parent corporation of the Home Insurance Co., one of the 15

largest property and casualty insurers in the United States at

the time, and had assets of over $2.5 billion and net equity of

approximately $660 million in 1976, which increased to assets of

over $5 billion and net equity of over $744 million in 1985.      The

HGI notes were disclosed on HGI’s audited financial statements

required to be submitted to the Securities and Exchange

Commission and various State regulatory agencies.    HGI’s

financial statements were also included in the offering circulars

pertaining to Finance’s Eurobond borrowings, suggesting the

relevance of HGI’s financial condition to prospective investors.

In the case of its issuance of the 1977 HGI note, HGI was

required to, and did, obtain the consent of several banks with

which it had a revolving credit agreement.

     Respondent also contends that the HGI notes’ lack of

substance is illustrated by the fact that they were ultimately

canceled without any repayment.    The listed rulings, however,

clearly contemplate the parent’s withdrawal of the finance

subsidiary’s equity capital upon the full or partial retirement

of the subsidiary’s borrowing.    Rev. Rul. 73-110, 1973-1 C.B.

454, specifically addressed this point, citing the parent’s

withdrawal of capital from a finance subsidiary upon the
                               - 38 -

subsidiary’s reduction of its debt load as one of the two

occasions when a recomputation of the debt/equity ratio based on

then-prevailing currency values was required.   In the instant

case, a portion of the HGI notes was transferred by Finance to

City as a return of capital after repayment of the 8-3/4-percent

notes.   The remainder of the HGI notes was transferred from

Finance to City in connection with Finance’s liquidation.    In

each instance, City contributed the HGI notes to the capital of

HGI, and HGI extinguished them.   The extinguishment of the HGI

notes without payment was consistent with the principles of the

listed rulings, which permit the withdrawal of a finance’s

subsidiary’s equity capital so long as the required ratio is

maintained.

     Respondent argues that the amplification of Rev. Rul. 69-

377, 1969-2 C.B. 231, in Rev. Rul. 72-416, 1972-2 C.B. 591, to

allow a finance subsidiary to be capitalized with the parent’s

publicly traded stock rather than cash also supports his position

that a finance subsidiary’s capitalization must have economic

substance.    In respondent’s view, since the finance subsidiary’s

capital in Rev. Rul. 72-416, supra, consisted of “marketable

securities” (respondent’s term on brief), it has economic

substance, apparently because of the liquidity of such assets.

We believe this interpretation overlooks the peculiar features of

a finance subsidiary.    Since a finance subsidiary’s sole function
                              - 39 -

is to issue debt and facilitate repayment, the only substantive

role of its equity capital is to serve as security for the

holders of its debt; i.e., as an avenue of recourse in the event

of a default.   Also central to the arrangement involving a

finance subsidiary is the parent’s guaranty of the debt, on which

the lenders to the subsidiary are in fact relying.   In this

context, it does not appear that capitalizing the finance

subsidiary with the common stock of its parent adds significant

economic substance to the rights of the holders of the

subsidiary’s debt.   If the parent is unable to meet its

obligations under the guaranty, the fact that the subsidiary has

equity capital in the form of the parent’s stock (as opposed to,

e.g., cash or publicly traded securities of some other entity)

adds little to the substantive economic position of the

debtholders.

     In addition, respondent’s characterization of the parent

stock in Rev. Rul. 72-416, supra, as “marketable securities”, a

term that does not appear in the ruling, may misread the

significance of the stock’s publicly traded status to the

ruling’s conclusion.   While respondent infers that the

contributed stock’s publicly traded, and therefore readily

marketable, status gives the stock independent economic substance

as equity capital, we think the ruling’s language suggests that

the significance of the contributed stock’s being publicly traded
                                - 40 -

lies in its being readily valued.     Unless the initial capital

contribution made to the finance subsidiary is susceptible of

ready valuation, the subsidiary’s debt/equity ratio cannot be

computed.    Thus, in concluding that the parent’s stock can be

substituted for cash as the initial paid-in capital, the ruling

states:

            Since * * * [the parent’s] common stock is daily
       traded on the stock exchange, it has a readily
       ascertainable value. Therefore, it is immaterial
       whether cash or the common stock of * * * [the parent]
       is contributed to * * * [the finance subsidiary].

            Accordingly, the holdings in Revenue Ruling 69-377
       are equally applicable in the instant case. [Id.,
       1972-2 C.B. at 592; emphasis added.]


       Rev. Rul. 69-501, 1969-2 C.B. 233, adds little to

respondent’s case.     From the standpoint of economic substance,

the bank-loop transaction sanctioned in that ruling is a curious

one.    Cash borrowed from a bank was redeposited with the same

bank.     Presumably this circular flow of cash within the same

financial institution reduced the parent’s cost for the capital

contribution effected thereby to the spread between the interest

rate charged for the loan and the rate paid out for the deposit.

(The ruling does not address whether the finance subsidiary

received interest on the deposit or, if so, whether the

subsidiary retained it.)     While the equity capital in Rev. Rul.

69-501, supra, consisting of an unrestricted claim to a third-

party bank deposit, contains more substance than that of the
                              - 41 -

other listed rulings discussed, we do not think Rev. Rul. 69-501,

supra, can be reconciled with the other listed rulings to derive

a “principle” or “requirement” to the effect that a finance

subsidiary’s capitalization must have economic substance to the

extent urged by respondent herein.     The other rulings, especially

Rev. Rul. 69-377, supra, concede too much to the contrary.

     In the instant case, Finance was capitalized by means of two

transfers of cash from City to Finance, which cash was

immediately transferred20 by Finance to HGI in exchange for

promissory notes of equal face value, followed by HGI’s transfer

of the note proceeds back to City as a dividend.    City’s cash

capital contributions to Finance ($13,200,000 in 1977 and $22

million in 1979), as well as the face value of the HGI notes

received by Finance in exchange for the cash, constituted 44

percent of the amounts borrowed by Finance on the Eurobond market

($30 million in 1977 and $50 million in 1979), well within the

required 5-to-1 ratio.   Insofar as the capitalization of Finance

consisted of contributions of cash followed by the investment of

that cash in the securities of an affiliate, the transaction

conforms with Rev. Rul. 69-377, supra.     However, the Finance

transaction contains an additional feature, not present in Rev.



     20
       In one instance, the cash was transferred into and out of
Finance’s bank account in the same day; in the other instance, a
check from City was endorsed by Finance to the order of HGI,
without the funds moving through Finance’s bank account.
                              - 42 -

Rul. 69-377, supra; namely, the immediate cycling back to the

parent of its cash contribution to the finance subsidiary’s

capital, via a series of steps in which Finance transferred the

cash received from City to HGI in exchange for HGI’s notes,

followed by HGI’s transfer of the cash to City as a dividend.

This circular cash-flow distinguishes the capitalization of

Finance from that in Rev. Rul. 69-377, 1969-2 C.B. 231, and is at

the core of respondent’s contention that the capitalization

should be disregarded.

     Respondent’s contention raises the question of whether a

capitalization involving a circular cash-flow-–for example, where

a finance subsidiary lends its cash capital contribution back to

the parent–-would be prohibited under the principles of the

listed rulings.   The listed rulings do not address the point

directly.   The listed rulings clarify various ways that a finance

subsidiary may reinvest the cash contributed to it, such as in

the stock or debt of affiliates (Rev. Rul. 69-377, supra) or a

bank deposit (Rev. Rul. 69-501, supra), but contain no

prohibitions.   As we observed in Northern Ind. Pub. Serv. Co. v.

Commissioner, 105 T.C. at 352 n.10, “nothing in * * * [the

listed] rulings indicates the manner in which a financing

subsidiary is required to invest its capital.”   However, Rev.

Rul. 72-416, 1972-2 C.B. 591, which permitted the parent’s own

stock to serve as the equity capital for a finance subsidiary,
                              - 43 -

clarifies the principles of the listed rulings in a manner which

indicates that a circular cash-flow would not be proscribed.    If

the parent may contribute its own stock as the equity capital, we

see no principled reason why the parent’s debt could not be

substituted for this purpose, particularly given that Rev. Rul.

69-377, supra, allowed a finance subsidiary’s capital to be

invested in an affiliate’s stock or debt.   If a finance

subsidiary may be capitalized with parent debt, then it would

follow that a finance subsidiary receiving a cash capital

contribution from the parent could re-lend that cash to the

parent for the parent’s note, resulting in a circular cash-flow.

A circular cash-flow is therefore not inconsistent with, or

implicitly prohibited by, the principles of the listed rulings.21

Respondent’s argument that the capitalization of Finance should

be disregarded for purposes of DEFRA section 127(g)(3) because it

involved a circular cash-flow is unavailing.22   Finance’s


     21
       We note in this regard that the Commissioner reached the
same conclusion in several private letter rulings issued during
the period when the listed rulings were effective, where he held
that a cash capital contribution to a finance subsidiary could be
lent back to the parent without adversely affecting the
subsidiary’s equity capital for purposes of the 5-to-l
debt/equity ratio.
     22
       We reach the same conclusion regarding an alternative
argument of respondent’s to the effect that Finance’s
capitalization with the HGI notes should be disregarded because
the notes were unenforceable because of a lack of consideration.
This argument is merely a different iteration of the contention
that the circular cash-flow should cause Finance’s capitalization
                                                   (continued...)
                               - 44 -

investment of the cash it received from City in the notes of HGI

conforms to Rev. Rul. 69-377, supra, and the cycling back of that

cash from HGI to City is not inconsistent with the principles

revealed in the amplification of that ruling in Rev. Rul. 72-416,

supra.    The principles of these and the other listed rulings

recognize highly artificial transactions with elements of

circularity.    This was the administrative position of the

Commissioner with respect to recognizing the debt of finance

subsidiaries as their own during the pendency of the Interest

Equalization Tax, and in DEFRA section 127(g)(3)(B) Congress

adopted that position as the standard for extending relief from

withholding tax obligations.

     This interpretation of the phrase “requirements which are

based on the principles set forth in Revenue Rulings 69-501, 69-

377, 70-645, and 73-110" as used in DEFRA section 127(g)(3)(B) is

consistent with the legislative history of that section, which

indicates that Congress intended broad relief under the provision


     22
      (...continued)
to be disregarded. Respondent’s assertions notwithstanding, HGI
did receive consideration for its notes; namely, cash.
Respondent’s argument concerning lack of consideration comes down
to the claim that because HGI immediately (and as prearranged)
transferred the cash received as consideration to City as a
dividend, HGI’s receipt of the cash should be ignored, resulting
in a lack of consideration for the notes. We think this argument
is merely a variant of the circular cash-flow critique, and we
reject it for the same reason: under the principles of the
listed rulings, transactions designed to capitalize a finance
subsidiary are not disregarded because they contain elements of
circularity.
                               - 45 -

and contemplated coverage for transactions involving what were

essentially conduit devices.   The legislative history indicates

that Congress was concerned about the impact on the economy of

the Netherlands Antilles if the use of finance subsidiaries

incorporated there were terminated too abruptly.   Congress

therefore intended to effect “a gradual and orderly reduction of

international financing activity in the Netherlands Antilles”.

General Explanation at 393; see also S. Prt. 98-169 (Vol. 1), at

420-421 (1984).   Repeal of the withholding tax on pre-existing

obligations was rejected because it

     could have prompted U.S. corporations that had
     previously issued obligations through Antilles finance
     subsidiaries in an effort to avoid the tax to assume
     those pre-existing obligations directly and, thus,
     discontinue finance operations in the Antilles well
     before the obligations mature. * * * [General
     Explanation at 392.]

Congress contemplated that a “gradual and orderly” reduction in

the use of finance subsidiaries would be achieved by generally

allowing existing obligations to mature under a regime where

withholding taxes could be avoided by use of a Netherlands

Antilles finance subsidiary.   Further, the drafters acknowledged

that this approach might permit exploitation of treaty exemptions

through conduitlike arrangements for a limited period.   As stated

in the General Explanation:

     Congress believed that, while offshore financings
     generally should be scrutinized closely by the IRS and
     tax treaties should not be used as a basis for
     establishing conduits whose existence results in a
                               - 46 -

     transfer of revenues from the U.S. Treasury, the
     Antilles should have some time to adjust to tax law
     changes that affect its economy. [Id. at 392-393.]

See also S. Prt. 98-169 (Vol. 1), supra at 420-421.   In the

transition relief provided in DEFRA section 127(g)(3), Congress

thus struck a balance between the generally disfavored use of

conduitlike arrangements to secure treaty benefits and a desired

adjustment period.

     We conclude that the circular cash-flow involved in the

capitalization of Finance is not contrary to the principles of

the listed rulings and accordingly that Finance’s debt/equity

ratio did not exceed 5 to 1.   We therefore hold that Finance

satisfies requirements based on the principles set forth in the

listed rulings, which qualifies City’s payments of interest

during the years at issue for the relief provided in DEFRA

section 127(g)(3); namely, deemed treatment as made to a resident

of the Netherlands Antilles and therefore exempt from tax under

article VIII(1) of the U.S.-Netherlands income tax treaty.23

Petitioner is therefore not liable for withholding taxes under

section 1461.




     23
        In light of our holding, we need not address petitioner’s
alternative argument that, absent qualification under DEFRA sec.
127(g)(3), Finance “derived” interest from City within the
meaning of article VIII(1) of the U.S.-Netherlands income tax
treaty.
                        - 47 -

To reflect the foregoing,

                                  Decision will be entered

                             for petitioner.
