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January 29, 1976

Universal Drilling Co., Inc., Plaintiff
United States of America, Defendant

Rubin, District Judge.

The opinion of the court was delivered by: RUBIN

This income tax refund suit involves two separate matters. The first relates to whether a transaction involving an offshore drilling barge should have been treated as a sale or a lease; the second involves allocation of the purchase price paid for land and buildings for depreciation purposes. Of necessity, the issues are discussed separately.

 I. The Drilling Barge Transaction


 Universal owned a drilling barge known as the "MR. LOUIE." It had attempted unsuccessfully either to sell or to lease the barge. It had substantial funds invested in an unproductive asset. After considerable negotiations, it executed an agreement with Reading & Bates. Reading & Bates was a wholly owned subsidiary of Reading & Bates Offshore Drilling Company and Reading & Bates, Incorporated. It was created for the purpose of the drilling barge transaction and it had no other assets. While Universal wanted to make a sale to one or both of Reading & Bates' parent companies, the parent companies did not want to commit themselves to the debt that would have been required to acquire title to the barge, and Reading & Bates Offshore, one of the parent companies, was prohibited by its loan agreements from incurring any further liability. By creating and employing Reading & Bates as a "shell" corporation, the corporate owners would avoid any jeopardy from its financial failure. Since the company had no funds with which either to purchase or pay rental on the drilling barge, it intended to keep the agreement in effect only if the barge could be used to produce enough money to meet the scheduled payments. Universal was aware that the lessee was to be a shell corporation, and was concerned over that fact but accepted this as the best available transaction.

 The agreement between Universal and Reading & Bates was called a charter party; Universal was called "lessor," Reading & Bates "lessee." The charter party was for a term of seventy-two (72) calendar months commencing from the date of delivery of the drilling barge to a specified location, at a monthly rental of $67,565.

 The monthly payment was to be reduced to $20,000 for any calendar month during which the barge was inactive; there was also to be a proportionate reduction in payments during months in which the drilling barge was partially inactive. In addition, pursuant to a letter agreement executed between Universal and Reading & Bates on October 17, 1959, Reading & Bates was to pay certain sums of money each month to a "savings fund," until that fund reached a total of $750,000. Universal was given the right to withdraw $20,000 per month from the fund during those months in which the drilling barge was inactive (or a proportionate amount during those months in which the drilling barge was partially inactive).

 The purpose of this fund is not clear. However, since Reading & Bates had no other assets, it would have no resources to meet payments when the barge was idle if it dissipated funds earned while the barge was employed. The preponderance of the evidence indicates that the fund was intended primarily to provide funds for the payments during periods when the barge was inactive, and to build up a reserve to secure future performance of the agreement.

 The agreement gave Reading & Bates the right to purchase the drilling barge during the term of the lease for the sum of $4,750,000, less the charter hire credits reflected on a schedule that was furnished to the parties, but not attached to the agreement. If Reading & Bates exercised this option at the termination of the lease period, it was to pay to Universal the sum of $750,000, plus any unpaid rent. Of course, by that time, the fund would contain the requisite $750,000.

 Notwithstanding the ostensible lease created by the charter party, Reading & Bates treated the transaction as an acquisition of title. It did this on the advice of its accountant, who based his determination solely on accounting principles, with the result that Reading & Bates presented a better financial statement than if this transaction were treated as a lease. If it were acquiring title, it could, and did, show the barge as an asset, with a net equity created by the monthly payments. Since it had no taxable income, loss of a rental deduction for income tax purposes was of no consequence; a deduction could be obtained in any event, by treating the barge as an asset and deducting depreciation.

 The lawyer who represented Reading & Bates testified that it was his intention to prepare a true bareboat charter with an option to purchase. The lawyer who represented Universal testified that it was also his intention to prepare a bona fide lease.

 The agreement prohibited Reading & Bates from encumbering the drilling barge, but there was no stricture against encumbrance by Universal. In fact Universal mortgaged the barge as security for a debt in 1961.

 Reading & Bates had no responsibility to Universal or its underwriters for damages occasioned to the drilling barge regardless of the cause of or reason for the loss. While Reading & Bates incurred the obligation of purchasing hull insurance with reference to the drilling barge during the term of the lease (with Universal and Reading & Bates being named jointly as insureds), the ultimate risk of loss was placed upon Universal in the event that no proceeds would be forthcoming under the policies insuring the barge except in instances when damage or loss was occasioned to the drilling barge by the active negligence of Reading & Bates.

 The value of the barge indicated by the charter party was $4,750,000. This appears to have been a realistic appraisal. Lease payments, if fully and promptly paid, would amount to $4,000,000. The balance, $750,000, is substantial, both in absolute and relative terms.

 The economic life of the barge could not be accurately determined in advance. The barge was experimental. Many movable rigs had capsized or had broken apart at about the time that the MR. LOUIE was constructed. The new barge incorporated a structural design that was not previously in use. Indeed many in the industry doubted that the barge would actually work.

 For financial reporting purposes, Universal depreciated the barge over a period of six years (the life of the charter party) so as to allow the undepreciated cost at the expiration of the charter party to approximate the purchase price under the option. For income tax purposes, Universal depreciated the barge over an estimated life of 12 years, by the double declining-balance method.

 There is evidence that the total monthly payment of $67,565 was composed of two elements, $64,440 plus $4,125. The government asserts that $64,440 represents the monthly principal and interest payment on a $4,000,000 loan to be paid off over 72 months at five percent interest; and that $3,125 represents five percent interest per annum, paid monthly on $750,000. No evidence was offered, however, about the rate of interest that would have been charged by parties dealing at arm's length in 1959 had the transaction been a sale, nor how these figures were in fact reached. Apparently, none of the witnesses were examined about these figures.

 On August 28, 1964, Reading & Bates exercised its option to purchase the drilling barge and agreed to pay Universal the sum of $2,150,000. The savings fund had reached its scheduled maximum, $750,000, and this sum was applied to the purchase price.

 For both accounting and tax purposes, Universal consistently treated the bareboat charter as a lease and reported the monthly payments received by it from Reading & Bates as rental income. It reported the August, 1964, transaction as a sale.

 The government contends that the transaction was not a bareboat charter, but was a sale in 1959 and should have been treated as a sale for tax purposes. Universal paid the tax deficiency assessed and sues to recover it.


 The substance of a transaction controls its tax consequences, notwithstanding the form in which it is arranged or the label placed on it by the parties. Commissioner of Internal Revenue v. P.G. Lake, Inc., 1958, 356 U.S. 260, 2 L. Ed. 2d 743, 78 S. Ct. 691. Thus, where what is called "rental" under an agreement actually pays for the transfer of ownership of the property, and not merely for its use, the law requires that, for tax purposes, the transaction be treated as a sale rather than a "lease." M & W Gear Co. v. Commissioner of Internal Revenue, (7 Cir. 1971) 446 F.2d 841; Oesterreich v. Commissioner of Internal Revenue, (9 Cir. 1955), [55-2 USTC P 9733] 226 F.2d 798. See also Estate of Hedrick v. Commissioner of Internal Revenue, (9 Cir. 1969) 406 F.2d 587, which traces the entire history of the Oesterreich litigation.

 It is not always easy to determine the substance of a transaction, and there is no tax spectroscope that will enable us to examine the essence of a commercial deal negotiated between business men with differing interests. All of the various aspects of the arrangement must be examined to form a judgment of its true nature. The ultimate inquiry is an effort to divine the true intention of the parties, no matter how it may have been plated by words. See Oesterreich, supra, at p. 801; Benton v. Commissioner of Internal Revenue, (5 Cir. 1952) 197 F.2d 745. The analysis focuses on whether the parties intended merely to negotiate for the use of property or for transfer of its ownership.

 The test is not "what the parties call the transaction nor even what they may mistakenly believe to be" its name. The criterion is what the parties intend to be the legal effect of the transaction; it should be examined on the basis of what they intended to happen. Oesterreich v. Comr., C.A. 9, 1955, 226 F.2d 798, 801. In this inquiry it is necessary to examine the economic nature of the payments. Rental is a payment merely for the use of property, and it contemplates return of the rented property at the termination of the lease. On the other hand, if payments, though denominated rental, are required to be made in amounts that actually cover the full economic value of the property, and ownership will ultimately be transferred, they are a payment for ownership.

 Thus, we look to whether the user of the property is in fact acquiring an economic equity in the property by virtue of the payments. If the property will be worth substantially more than the price to be paid upon exercise of the so-called option to purchase, then the user will have been building up a true economic interest in the property. See ...

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