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because (as discussed in this section) the evidence strongly
suggests an intent to distribute profits to Mrs. Harrison in the
guise of compensation, we find that an independent investor in
petitioner would object to the size of Mrs. Harrison’s
compensation, even assuming arguendo that petitioner’s retained
earnings for the audit years represented a reasonable return on
shareholder equity when viewed in relation to the ROE at
comparable companies. Thus, application of this factor furnishes
additional evidence that Mrs. Harrison was greatly
overcompensated during the audit years.6
6 Even assuming petitioner’s ROE were relevant to our
decision in this case, petitioner’s computation of ROE during the
audit years is open to question.
Petitioner argues that ROE represents net profit (after
taxes) divided by equity (defined as invested capital plus
retained earnings less treasury stock), and that petitioner’s ROE
for the audit years was either 22 percent (using beginning year
equity) or 12.3 percent (using the average of beginning year and
yearend equity). Petitioner stresses that either result compares
favorably with the 14.9 percent ROE for comparably sized
companies during the same period as compiled by Mr. Carey.
Petitioner ignores ROE derived from using yearend equity,
presumably because, under that approach, average ROE for the
audit years is 7.4 percent, substantially below the 14.9 percent
average ROE for comparably sized companies. In fact, it is
unclear which of the three approaches is proper in this case
because it is not known which approach was used in the
computation of ROE for the comparably sized companies reflected
in Mr. Carey’s report.
Another reason to question the use of petitioner’s annual
ROE in evaluating shareholder return is the inability to follow,
on the basis of the returns as filed, all of the year-to-year
changes in equity. For several years, those changes cannot be
explained by the income (or loss) for the year, and the
description of the reconciling item is either unclear or not
(continued...)
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