Taiyo Hawaii v. Comm.
In the case of Taiyo Hawaii Company, Ltd v. Commissioner (108 TC 590), Taiyo Hawaii, Ltd was a Japanese corporation, formed in 1985 that primarily conducted business in Honolulu. The corporation held a condominium in Waikiki, a 50% interest in a Hawaiian partnership, and two unimproved real estate properties in Hawaii, the Ginter and Gnomes properties. During the period of time in question, while there were plans to develop the two properties, neither property was improved due to various set backs. In 1995, almost a decade after Taiyo originally incorporated, the properties were sold to an unrelated development company.
After a merger in 1986, Seiyo Corporation, another Japanese corporation all of Taiyo’s capital stock, but continued to try to develop the property and otherwise follow the original business plan. In order to continue financing the real estate operations, Taiyo obtained loans from three unrelated banks, and received regular advances from Seiyo. Some of these advances were listed as payables, however, several were not listed on either Taiyo’s or Seiyo’s books. Only when Seiyo’s accountant requested a copy of all promissory notes did the remaining amounts get recorded on either company’s books. The term of all such notes provided for short-term prime rate of interest, with the payment of principal as the priority. In 1995, Seiyo listed over $18m as the loan balance with over $5.8M as the outstanding interest that was payable to Seiyo.
When making payments to the unrelated banks, Taiyo withheld 10% of the interest and remitted this tax to the United States. However, the interest accrued on the promissory notes were not paid and no tax was withheld or remitted. Finally, neither Taiyo nor Seiyo ever made a §882(d) election in order to treat the income from the real estate activity as effectively connected to a US trade or business.
When brought before the tax court, the petitioner tried three different arguments in order to show that the interest accrued should not have been subject to the §884 withholding tax. The first such argument was all such notes from Seiyo to Taiyo were really equity instead of debt. After having examined Taiyo’s books, outstanding loans, and income sources, Seiyo’s accountant did not believe that Taiyo could have made paid off all the debt that was outstanding without the advances that Seiyo had been making. However, since both Taiyo and Seiyo had been labeling the transactions as debt, and presented it as such on their books, income tax returns and financial statements, then the petitioner was stuck with this classification. The petitioner had the opportunity to structure the transfer of cash in any way they deemed necessary. The petitioner chose it as a debt transaction and must deal with the consequences of such a transaction. (Commissioner v. National Alfalfa Dehydrating & Milling Co. 417 U.S. 134)
The second argument relies on the fact that the interest was not deductible to the petitioner. In §267, the interest must have been paid in order for it to be deductible. Since this was not the case, the petitioner claimed that §884 only applied to deductible interest. However, the court did not agree with this argument. It found that both the statutory language and the Committee reports did not support this. The Committee report specifically addressed this argument, stating that the branch level interest tax was designed for interest actually paid while the excess interest statute was implemented to deal with interest allocated but not paid.
The third argument was involved the calculation of excess interest and the allowed election under §1.884-1(e)(3). Taiyo claimed that the undeveloped properties, Ginter and Gomes, should not have been included in the calculation of the US connected assets. Originally, both assets were included as US assets, increasing the US portion of the worldwide assets, as well as increasing the debt and allocable interest expense. Upon the commencement of the audit, Taiyo filed an amendment of the tax years under audit in order to recalculate the ratio of US assets to worldwide assets, by removing the two properties from the equation.
The election under §1.884-1(e)(3) would allow the corporation to reduce its US liabilities by any amount that would not exceed the excess of its US connected liabilities over the liabilities that are show on the books of the US business. However, the court found that the liabilities shown on the books were equal to the liabilities that were considered to be effectively connected US liabilities. With no excessive liabilities, the election becomes ineffective. However, the question of whether the two undeveloped properties should have been included still had to be resolved.
In order for an asset to be included in the calculation of excess interest, it must produce or be able to produce effectively connected income. (§1.882-5(b)) In order to determine if the asset generates effectively connected income, an asset must pass the use test the business activity tests which are described in §864(c)(2). The use test requires that assets was held for use in conduct of a US trade or business, while the activity test requires that the activities of such business are a material factor in the realization of the income generated by the property.
Taiyo made several claims about the nature of the property and its relationship to the active business. The first claim was that the land was not held as an asset for business use. Taiyo. The basis for this was that ownership alone did not qualify an asset to be considered connected to a trade or business, as was held in Neil v. Commissioner (45 BTA 197). However, the court found this case to be irrelevant to the issue since Taiyo was actively trying to develop the property in the course of its normal business.
The second claim that Taiyo made was that property could still be held for passive activities. However, in Maddux Constr. Co v. Commissioner (54 TC 1278) held that one could not hold real property intended to be sold to others and also hold real property that is only for investment purposes. The court also looked at the history of the property, and determined that the property had been held for development and a course of action had been pursued to accomplish this. Since this was the main business of Taiyo this would make the property effectively connected to its business. The based on this information the court held that both properties should be included in the calculations as it was done on the original tax return.
While Taiyo argued the validity of its defense from several angles, the results of the attempted election, and its subsequent denial by the courts, is the most relevant one. If Taiyo had been able to make the election and reduce the amount of assets and associated debt that was effectively connected then it would not have been in the position to have excessive interest. However, since the assets had not only been put forth as business assets, but also Taiyo had been actively trying to develop both properties in a manner that resembled their normal course of business, the court determined that the assets were directly connected to Taiyo’s business and the election would not allow any of Taiyo’s assets to be excluded from the equation.