Before discussing this case, I want to point out the apparent cowboy motif in the opinion's opening paragraph. For example, the words or phrases: mounted a takeover, ride turned rough, pony up, and saddle are used to describe the crux of the case. Judge Holmes's clerk is either from the midwest or just using some creativity in the only place where allowed in a court opinion.
The events that follow occurred between 1999 and 2005.
Canterbury Holdings is a U.S. limited liability company with five members: three individuals, a trust, and a retirement plan. The individual members included an investment banker, a New Zealand business man, and Kenneth Kopp, founder of The North Face. Canterbury bought under-performing sports-apparel brands intending to make them profitable. One such brand was the Canterbury brand (hereafter "Brand"), a famous New Zealand rand that built its name focusing on rugby.
The Brand was owned by LWR Industries, Ltd. (LWR), a New Zealand publicly traded company. Approximately two-thirds of the outstanding shares were owned by Brierly Investments, Ltd. (BIL), and the remaining one-third traded on the New Zealand stock exchange, NZX. Canterbury's plan to purchase the Brand included a tender offer for the LWR shares traded on NZX and an option agreement with BIL for the remaining outstanding shares.
Canterbury feared the New Zealand public would not be receptive to a U.S. company owning one of its biggest and oldest brands. To address this concern, they formed a New Zealand shell company, Canterbury Holdings, Ltd. (Canterbury NZ), to purchase and hold LWR's stock. Canterbury NZ was capitalized by Canterbury's partners with NZ$10,000,000. NZ$ stands for New Zealand Dollars, and at the time of the tender offer the exchange rate was .5294 NZ$ for 1.00 US$. In 1999, the tender offer was successfully completed. LWR was subsequently delisted from the NZX, and BIL and Canterbury NZ executed an option agreement for the remaining shares.
Canterbury's three partners where in no position to manage and run LWR, consequently Canterbury NZ signed a management agreement with BIL to collectively manager LWR. The agreement provided that LWR would pay both BIL and Canterbury NZ for managing its operations. The Canterbury partners took up positions in Canterbury NZ and received a salary for their services.
In late 2000, LWR stopped paying BIL as provided in the agreement. Canterbury disputed the amount owed BIL, asserting BIL was not living up to its side of the agreement. BIL accepted NZ$ 4,010,000 as payment in full for its management services, and reduced the option agreement price from NZ$ 22,700,000 down to NZ$ 6,250,000. The option agreement was paid in cash and notes collateralized by purchased LWR securities. Canterbury, NOT Canterbury NZ, paid the NZ$ 4,010,000 to BIL, and Canterbury, NOT Canterbury NZ, paid the interest on the note.
Canterbury deducted both the management fees and the interest expense on its 2000 and 2001 partnership tax returns. The IRS denied both deductions and assessed section 6662 accuracy and underpayment penalties.
The Lohrke Test
As a general rule, shareholders cannot deduct expenses paid on behalf of a corporation. Instead, these amounts are considered capital expenditures under Regulation 1.263(a)-2(f).
But section 162(a) allows a deduction for ordinary and necessary trade or business expenses incurred or paid during the taxable year in carrying on any trade or business. "[A]ndthere is nothing in the Code that bars a shareholder from deducting payments from his corporation's expenses, if those expenses are also ordinary and necessary to his own trade or business." Lohrke v. Comm'r, 48 T.C. 679, 688-89 (1967).
The Lohrke test requires,
that a shareholder who wants a deduction for paying his corporation's expenses must show two things: (1) that his purpose was to protect or promote his own business, and (2) that the expenses paid were ordinary and necessary to that business. Lohrke at 688.
The Tax Court finds here that,
during the years at issue, Canterbury itself had no actual business apart from stitching a deal for, then managing LWR...[There] was no existing operating business, credit standing, or a preexisting reputation to maintain. Its desire to build a future reputation is simply not enough for us to grant its current deductions as "protecting and promoting its trade or business"...[A] more direction connection with an existing business is needed to sustain a deduction in this area.
Canterbury also argues that Canterbury NZ was merely a nominee that should be disregarded. This argument is rejected because Canterbury NZ served a useful business purpose, namely it provided a local presence in New Zealand.
At the end of the opinion, the Tax Court points out, "[T]he Code and caselaw simply do not allow Canterbury to ignore its organizational choices when convenient for tax purposes. Further, "[W]hile a taxpayer is free organize his affairs for as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice."