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Rev. Rul. 82-78, 1982-1 CB 30

REV-RUL, Interest; installment sale of timber cutting rights., Rev. Rul. 82-78, 1982-1 CB 30, (Jan. 01, 1982)

Section 163.--Interest

26 CFR 1.163-1: Interest deduction in general.
(Also Section 263; 1.263(a)-1.)

[IRS Headnote] Interest; installment sale of timber cutting rights.--
A timber company assigned its right to cut timber on U.F. Forest Service land to a promoter who sold the rights to a limited partnership. Under the terms of the installment contract the total "interest" and principal payments the partnership will pay the promoter equal the promoter's obligation to the timber company plus an override. The amounts designated as "interest" are part of the sales price.

ISSUE

Under the circumstances described below, is a payment described as interest deductible as such under section 163 of the Internal Revenue Code?

FACTS

X, a timber company, successfully bid for a United States Forest Service contract right to cut timber on Forest Service land. X was required to make a deposit of 1x dollars, and the remaining amount, estimated at 22x dollars, is to become due and payable only as the timber is cut. If a greater or lesser volume of timber is harvested than was estimated by X and the Forest Service, the price is adjusted accordingly.

The contract with the Forest Service grants X the right to cut timber on the Forest Service land at any time within a 5-year period. The contract prohibits assignment without prior written Forest Service approval, and such approval would not relieve X of its responsibilities and liabilities under the contract. Title to the timber remains with the Forest Service until it is cut by X.

If X fails to cut the designated timber under the contract, the Forest Service may recover damages. However, the Forest Service bears the risk of loss of the timber by destruction or otherwise prior to its being cut by X.

Shortly after X secured its contract rights, A, a tax shelter promoter, took an assignment of the rights and obligations of X under the contract in return for 1x dollars. A then organized LP, a limited partnership, with A as the general partner. A purportedly sold the timber cutting rights that it had received from X to LP for installment payments totaling 16x dollars. In addition, LP agreed to pay X simple "interest" of approximately 8x dollars over the life of this sales contract. The installment obligation was secured only by the timber cutting rights transferred.

LP agreed to pay A 1x dollars in the first year of the contract, 2x dollars in year 2, 5x dollars in year 3, 1.5x dollars in year 4, and 6.5x dollars in year 5, plus "interest" yearly on the unpaid balance. The timing and amount of the payments were set to coincide with the proposed cutting schedule and, accordingly, with X's payments to the Forest Service. Thus, the amount of the payment was adjustable, based on the amount of timber actually cut during the year. Furthermore, it was agreed that if the timber was destroyed before cutting, any benefit to X of relief from its obligations to the Forest Service would be passed on to LP through a reduction in the purchase price from A.

In addition, X agreed to continue dealing with the Forest Service with respect to the contracts on behalf of A and LP. X agreed to perform for LP, in exchange for consideration, services generally co-extensive with its obligations under the contract with the Forest Service. Also, X agreed to act for LP (1) as timber manager, supervising the cutting of the timber, and (2) as sales agent, arranging log sales.

LAW AND ANALYSIS

Section 163 of the Code allows as a deduction all interest paid or accrued within the taxable year on indebtedness.

Interest within the meaning of section 163 of the Code is a charge for the use or forbearance of money. Deputy v. Dupont, 308 U.S. 488 (1940). An indebtedness, for purposes of section 163, is an unconditional and legally enforceable obligation for the payment of money. See Autenreith v. Commissioner, 115 F.2d 856 (3rd Cir. 1940).

Where property is purchased with the purchase price to be paid in installments, the obligation to make the installment payments normally constitutes the type of indebtedness that will support an interest deduction. However, it is the nature of the payment made and not the label affixed by the parties that is controlling. Autenreith, supra. In determining whether a payment constitutes interest on indebtedness, economic realities govern over the form in which a transaction is cast. Titcher v. Commissioner, 57 T.C. 315 (1971). Therefore, a payment designated as interest by the parties may be re-characterized if, economically, it constitutes part of the purchase price of the property. LaCroix v. Commissioner, 61 T.C. 471 (1974).

In the instant case, the economic reality of the transaction is that the 8x dollars designated as interest is part of the purchase price of the timber to LP. This is so because LP's right to the timber derives only from X's right. X, in turn, did not have title to the timber, but rather had the right to cut any time within the applicable period. For this right X agreed to pay an estimated additional 22x dollars on an "as-cut" basis,with adjustments based on volume of timber cut. Thus, it can be concluded that LP was not purchasing timber from either X or A, but was purchasing timber through X from the Forest Service on the same terms agreed to by X. Furthermore, the value of the contract right LP purchased from A cannot have been greater than 1x dollars, the total excess of payments made by LP over the payments that X was obligated to pay to the Forest Service. In essence, LP paid 1x dollars to put itself in the same position as X--i.e., in the position to receive the timber as cut and when paid for. The timing and amount of LP's payments are set to coincide with X's payments to the Forest Service. If the timber is destroyed before cutting, X's reduction in price is passed on to LP. The amount of LP's payments are adjustable based on the amount of timber actually cut during the year. Accordingly, LP's payments should be regarded as the same as X's--payments for the timber as it is cut. Since X had the right to cut at any time, the 23x dollars, representing the estimated total potential payment by X, did not include a charge for the use or forbearance of money. The additional 1x dollars paid to A to compensate it for the assignment fee paid to X should be regarded as a cost of the rights received by LP.

HOLDING

The 8x dollar payment is not deductible as interest under section 163 of the Code.