Kaufman, Chief Judge, Lumbard and Timbers, Circuit Judges. (dissenting in Part)
Petitioners-appellants, Your Host, Inc., and its affiliated companies, appeal from judgments of the United States Tax Court (Irwin, J.) which upheld determinations by the Commissioner of income tax deficiencies assessed for the years 1965 through 1968. Your Host, Inc., et al., 58 T.C. 10 (1972). The deficiencies were assessed pursuant to 26 U.S.C. § 482, which allows the Commissioner to allocate income among affiliated companies more properly to reflect the earning of income,*fn1 and pursuant to 26 U.S.C. § 269, which permits the Commissioner to deny tax exemptions and deductions where an affiliated company was "acquired" for tax avoidance purposes.*fn2 We affirm.
Your Host, Inc., and its affiliates, operate a restaurant chain and food business in the Buffalo area. From modest beginnings in a one-restaurant partnership of A. J. Durrenberger and R. T. Wesson in 1944, the business grew so that by the mid 1960's it consisted of sixteen interrelated corporations which operated some forty "Your Host" restaurants, a food supply commissary, a bakery, a real estate holding company, and a vending machine and leasehold operation.*fn3 All of these enterprises remained under the control of two original partners and later, after Wesson's death in 1956, under the control of Durrenberger alone.
Out of the sixteen companies the Commissioner, pursuant to 26 U.S.C. § 482, allocated the income of twelve of them to Your Host, Inc.*fn4 and the income of one of them (Your Host Bakery, Inc.) to Sher-Del Foods, Inc. He furthermore determined that, pursuant to 26 U.S.C. § 269, thirteen of the companies had been established for the principal purpose of tax avoidance and he accordingly denied them the corporate surtax exemption.*fn5
Upon review the Tax Court upheld the Commissioner's determinations under § 482 as to only two of the affiliated companies: the allocation of Chef Foods' income to Your Host, Inc., and the allocation of Your Host Bakery's income to Sher-Del Foods, Inc. The Tax Court held that the ten restaurant operating companies whose income had been allocated were "viable economic entities which earned their own income" and hence were not subject to income allocation.
The Tax Court also upheld the Commissioner's determinations under § 269 as to five of the affiliated companies: 309 Delaware Ave., Inc., Royal Host, Inc., Main Host, Inc., Telesnax, Inc., and Alro Realty, Inc. With respect to the other eight companies which had been denied surtax exemption, however, the court held as to six that the Commissioner had erred in finding that they had been established for the principal purpose of tax avoidance. The court did not assess the validity of the Commissioner's § 269 determinations as to Chef Foods and Your Host Bakery, having already sustained the Commissioner's 100% reallocation of the income of both companies under § 482.
Since the Commissioner has elected not to appeal the Tax Court's finding adverse to the government,*fn6 we need concern ourselves here only with the Tax Court's findings*fn7 sustaining the Commissioner's determinations. As to these we note at the outset that the Commissioners' determinations are to be set aside only if "unreasonable, arbitrary, or capricious," in the case of § 482 allocations, Wisconsin Big Boy Corp. v. C.I.R., 452 F.2d 137, 140 (7th Cir. 1971); Philipp Bros. Chemicals, Inc. v. C.I.R., 435 F.2d 53, 57 (2d Cir. 1970), and only if "clearly erroneous" in the case of denials of surtax exemptions under § 269, Dorba Homes, Inc. v. C.I.R., 403 F.2d 502, 505 (2d Cir. 1968); J. T. Slocomb Co. v. C.I.R., 334 F.2d 269, 273-74 (2d Cir. 1964).
Under these standards of review, we cannot say that the Commissioner's § 482 determinations were arbitrary or unreasonable. In the case of Chef Foods, Inc., whose income was allocated to Your Host, Inc., for the four years in question, it was found that Chef Foods was originally formed in 1958 to provide a vehicle for developing catering services in industrial plants. This line, however, was never developed. Instead Sher-Del Foods acquired all the stock of Chef Foods for $6,000. Chef Foods was then used to purchase cigarette vending machines which were placed only in "Your Host" restaurants. It purchased cigarettes wholesale and sold them through vending concessions at the restaurants, the profits being shared through concession commissions to each restaurant. Chef Foods also acquired refrigeration and storage facilities in Buffalo, almost all of which were leased to Sher-Del Foods and to Your Host Bakery. For these operations, Chef Foods utilized one employee, a vending machine repairman, whose salary and expenses constituted virtually all of the operating expenses of the company. Otherwise Chef Foods shared its aliquot portion of taxes, insurance, utility, and other costs along with the other corporations as summarily determined by the common executive management of the companies. The portion of Chef Foods' profit which Durrenberger, then the surviving original partner, took as his salary was also similarly determined. Chef Foods' income from the vending machine sales and from rents averaged roughly $160,000 for each year between 1965 and 1968, with approximately 75% coming from the vending machines sales. Thus while it is true, as the dissent suggests, that Chef Foods conducted sizeable business operations in terms of cash flow, the very imbalance between the firm's posture on its balance sheets and the actual scope of its operations, in terms of its labor force, capitalization, work site, and so forth, suggests that the firm was kindred in nature to the kind of sham enterprise which this court held properly subject to income allocation in Philipp Bros. Chemicals, Inc. v. C.I.R., supra. At least, given Chef Foods' position within the "Your Host" group, it was not unreasonable for the Commissioner to have allocated the income of Chef Foods as he did. See also Wisconsin Big Boy Corp. v. C.I.R., supra; and Hamburgers York Road, Inc., 41 T.C. 821 (1964).
For the same reasons we are constrained not to disturb the Commissioner's allocation of the income of Your Host Bakery, Inc., to Sher-Del Foods, Inc. The bakery sold its products only to Sher-Del. Sher-Del in turn sold these products to the various "Your Host" restaurants but at the same price at which it had bought them. The entire profit of the baking part of the enterprise thus went to the bakery even though Sher-Del Foods was the seller to the rest of the chain. In addition, although the bakery did employ a sizeable work force (unlike Chef Foods), it did share the same top-level management as Your Host, Inc., and Sher-Del Foods, Inc., with similar apportionment of salaries and expenses. Furthermore, it shared the same premises with Sher-Del Foods.
Although not conceding the point, appellants contend that under these circumstances the Commissioner was at best entitled to allocate the bakery's income to Sher-Del only to the extent of determining a reasonable profit to Sher-Del for its services in distributing the bakery's products to the "Your Host" chain. The dissent endorses this position, and cites in support of it language in our decision in W. Braun Co. v. C.I.R., 396 F.2d 264 (2d Cir. 1968). However, in view of the highly integrated nature of the business enterprise, we do not believe that it was unreasonable for the Commissioner to have concluded that all of the bakery's income should be attributable to Sher-Del. As we said in the later case of Philipp Bros. Chemicals, Inc. v. C.I.R., supra, at 59:
The taxpayer had the burden of showing that the 100% allocation of income to the [parent] corporation was unjustified. Taxpayers ask us to remand the case in order to allow them an opportunity to establish that the 100 per cent allocation was unreasonable and to show what a reasonable allocation would be. We see no reason for according them another chance. . . . .
The petitioners here having similarly failed to demonstrate the reasonable allocation which they claim was their due, we believe our position as stated in the Philipp case is controlling. See also Wisconsin Big Boy Corp. v. C.I.R., supra, at 140; Ballentine Motor Co. v. C.I.R., 321 F.2d 796 (4th Cir., 1963); Hall v. C.I.R., 294 F.2d 82 (5th Cir. 1961).
The Commissioner's determinations under 26 U.S.C. § 269, to disallow the surtax exemption for five of the appellants' corporations, were also within permissible limits.*fn8 We note that four of these five (Telesnax, Inc., Royal Host, Inc., Main Host, Inc., and 309 Delaware Ave., Inc.) were merely alternate vehicles for operating additional "Your Host" restaurants. They were all thinly capitalized. They were all financed by substantial loans from Your Host, Inc., and from Sher-Del Foods, Inc., loans either not evidenced by notes or established through a system of delayed billing. More importantly, in none of these four instances were the appellants able to proffer reasons for their separate incorporation other than a desire to limit liability for its own sake (which is in any event a necessary consequence of incorporation) and, in the case of Telesnax, the additional desire to give Wesson and Durrenberger's accountant a capital share in the business. Unlike the situation regarding the six "Your Host" companies where the Tax Court found the principal purpose of incorporation to have been other than tax avoidance, for these four restaurant operating corporations the appellants cited no unusual risks incumbent on the ventures, such as location in an untried shopping center development or in a community with strong pre-established competition, nor any other factors, such as the need to protect a corporate name not already protected or to protect the goodwill of a particular restaurant, which might have ...