1946 U.S. Tax Ct. LEXIS 170">*170 Judgment will be entered for the respondent.
Parent corporation owning 600 of 1,000 shares of common voting stock of a subsidiary desired to obtain the 95 percent ownership required for consolidated return purposes. Pursuant to plan, 398 shares of new class B preferred stock were issued by subsidiary and exchanged for 398 shares of its common stock held by two minority stockholders. Although the certificates for new stock stated that it was nonvoting, they provided that it could be converted into common stock, and that if a holder notified the secretary prior to any stockholders' meeting of his intention to convert, the meeting could not be held until the conversion had been accomplished. Coincident with the issuance of the new stock, the subsidiary notified the two stockholders in writing that in consideration for the surrender by them of common for class B preferred stock, it would pay them a sum equivalent to two-thirds of the dividends paid common stockholders as long as they held the new stock. Held, (1) the exchange of common stock for new stock effected a change in form but not in substance, and the new stock was not nonvoting stock limited and preferred as to dividends, 1946 U.S. Tax Ct. LEXIS 170">*171 and (2) the parent corporation did not have the 95 percent ownership of voting stock required for consolidated return purposes.
6 T.C. 1246">*1246 The Commissioner determined a deficiency in excess profits tax in the amount of $ 45,162.66 for the calendar year 1941. Petitioner contests this determination and claims it is entitled to a refund of excess profits tax in the amount of $ 1,983.97.
The question presented is whether petitioner and Cheney Brothers constituted an "affiliated group" as defined in section 730 (d) of the Internal Revenue Code during the period March 30 to December 31, 1941, and, as such, were entitled to exercise the privilege of making a consolidated return.
FINDINGS OF FACT.
Petitioner is a corporation, organized and existing under the laws of the State of Connecticut. On or about January 14, 1942, petitioner filed a corporation excess profits tax return for the period from January 1 to March 29, 1941, with the collector of internal revenue for the district of Connecticut. No additional separate corporate excess profits tax return was 1946 U.S. Tax Ct. LEXIS 170">*172 filed by the petitioner covering the balance of 1941.
However, Cheney Brothers, a Connecticut corporation, filed with the collector of internal revenue for said district a consolidated corporation 6 T.C. 1246">*1247 excess profits tax return and included therein the excess profits income of petitioner covering the period from March 30 to December 31, 1941.
The Commissioner determined a deficiency against the petitioner in the amount of $ 45,162.66 in excess profits tax liability on the ground that petitioner was not affiliated with Cheney Brothers within the meaning of section 730 (d) of the Internal Revenue Code during any portion of 1941.
Petitioner was originally incorporated in 1938 under the name of the Manchester Equipment Co., the purpose of incorporation being to permit Cheney Brothers to operate a parachute manufacturing business without involving Cheney Brothers in the risk of that business.
The originally authorized capital stock of the petitioner was 1,500 shares of preferred stock of $ 100 par value and 1,000 shares of common stock of $ 5 par value. The preferred stock carried 5 percent annual cumulative dividends and had no voting power, except to permit the preferred stockholders1946 U.S. Tax Ct. LEXIS 170">*173 to consent to the payment of dividends to the common stockholders and except as to matters upon which the state law required all classes of stock to have voting rights. Otherwise the common stock was the voting stock.
The preferred stock was issued to Cheney Brothers in consideration for cash advanced equivalent to its par value. Cheney Brothers also received 597 shares of the common stock as compensation for services in the organization of petitioner and it purchased 3 additional shares for the sum of $ 15 cash.
On or about December 14, 1938, Cheney Brothers entered into a contract with J. Floyd Smith and Lyman H. Ford whereby Cheney Brothers agreed, as owners of all of the outstanding voting stock of petitioner, that as soon as Ford and Smith entered into the employment of petitioner there should be issued to them 200 shares each of the common stock of petitioner, without charge and in addition to whatever compensation they should receive for their services. In this contract it was further provided that upon the issuance of this stock to Ford and Smith, Ford, Smith, and Cheney Brothers should each deposit in escrow 200 shares of the common stock of petitioner for a period of 1946 U.S. Tax Ct. LEXIS 170">*174 five years, the escrow condition being that, if any party desired to sell the escrowed stock, any other party to the escrow agreement would have the privilege of buying that stock at the bona fide offered price. Subsequently J. Floyd Smith requested that 50 of his shares be issued to his son, Prevost Floyd Smith, and this was done.
During 1940 the officers of petitioner became aware of the new provisions in the internal revenue law permitting consolidated returns of affiliated corporations and began planning to take advantage of this 6 T.C. 1246">*1248 law. On or about March 24, 1941, petitioner which by this time had changed its name to "Pioneer Parachute Co., Inc.," voted to amend its certificate of incorporation by changing the authorized capital stock to $ 156,990, consisting of 1,500 shares of preferred stock of $ 100 par value and 398 shares of class B preferred stock of $ 5 par value and 1,000 shares of common stock of $ 5 par value, and at the same meeting it was voted to authorize the directors to offer the new class B preferred stock to the common stockholders in a share for share exchange. The amendment to the articles of incorporation covering the class B preferred stock provides1946 U.S. Tax Ct. LEXIS 170">*175 as follows:
(b) Class B Preferred Stock. Three Hundred Ninety-Eight (398) shares of the par value of $ 5.00 per share. The holders of the Class B preferred stock shall be entitled to receive when and as declared by the Board of Directors from the surplus or net profits of the Corporation, subject to prior payment of dividends on the preferred stock, dividends at the rate of twenty-five cents (25 cents) per share per annum, which dividends shall be non-cumulative, and no more, payable within ninety (90) days after the close of each fiscal year and prior to the payment of any dividend on the common stock. The holders of Class B preferred stock shall have no voting rights whatever except as to those matters upon which a vote of all classes of stock is required by law but they shall be entitled to notice of all stockholders meetings as hereinafter provided. If any holder of Class B preferred stock surrenders his shares for conversion into common stock as hereinafter provided prior to any stockholders meeting, the common stock issued or to be issued in exchange for the Class B preferred shares surrendered for conversion shall have the right to vote at such stockholders meeting as fully1946 U.S. Tax Ct. LEXIS 170">*176 as other issued and outstanding common stock. In the event that a holder of Class B preferred stock notifies the Secretary of the Corporation in writing prior to any stockholders meeting that such holder intends to convert his Class B preferred stock into common stock prior to such meeting, such meeting shall not be validly held until such conversion has been accomplished. In the event of any liquidation or dissolution or winding up (whether voluntary or involuntary) of the corporation, the holders of the Class B preferred stock shall be entitled to be paid the amount of $ 5.00 per share for each share held, subject to the prior payment required to be made to the holders of preferred stock, before any amount shall be paid to the holders of the common stock; and after payment to the holders of the preferred stock and to the holders of Class B preferred stock, the remaining assets and funds of the Corporation shall be paid to the holders of the common stock pro rata according to their respective shares. Any holder of Class B preferred stock shall have the right at any time prior to December 1, 1949 to surrender the shares of such Class B preferred stock held by him and to receive1946 U.S. Tax Ct. LEXIS 170">*177 and accept in exchange therefor and in conversion thereof common stock, such exchange or conversion to be share for share. Following any such surrender of Class B preferred shares and the issuance of common shares in exchange therefor and in conversion thereof the Class B preferred shares surrendered shall be retired and cancelled and all rights of the holders thereof shall cease and determine. The Class B preferred stock may be issued by the Corporation from time to time for such consideration not less than the par value thereof as may be deemed advisable by the Board of Directors.
Thereafter the directors offered such an exchange to all of the common stockholders and the offer was accepted by J. Floyd Smith 6 T.C. 1246">*1249 for 149 shares, Prevost Floyd Smith for 50 shares, and Lyman H. Ford for 199 shares. Cheney Brothers declined to make such an exchange and retained their common stock.
When this exchange was made petitioner corporation passed a resolution declaring that the certificates for common stock surrendered in exchange for the class B preferred stock should be canceled and the number of common shares so surrendered should be considered authorized but unissued and reserved1946 U.S. Tax Ct. LEXIS 170">*178 for issuance upon the exercise of the right of conversion granted to the class B preferred stockholders in the articles of incorporation above set forth.
The common stock so surrendered was retired and thereafter the outstanding common stock of the petitioner as shown by its books became 602 shares, of which 600 shares were owned by Cheney Brothers and one share each by Ford and Smith, to qualify them as directors.
Under date of March 24, 1941, the petitioner directed a letter to Lyman H. Ford and to the Smiths, as follows:
In consideration of the surrender by you of * * * shares of common stock of this Company in exchange for like respective amounts of the Class B preferred stock of this Company, this Company hereby agrees that as long as you are a holder of said Class B preferred stock or any part thereof this Company will pay to you for each share of Class B preferred stock so held by you a sum equivalent to two-thirds of the amount of all cash dividends which may be paid on each share of the common stock of this Company. Such payment shall be made at the time of payment of any such common stock dividend.
Yours very truly,
Pioneer Parachute Company, Inc.
By Henry R. Malloy, 1946 U.S. Tax Ct. LEXIS 170">*179 President.
Ford and the two Smiths continued to hold their class B stock throughout the taxable period involved in this case. They were also officers and directors of petitioner during that period.
The corporation excess profits tax return for 1941 filed by the Cheney Brothers, as parent corporation, on June 15, 1942, contains the following excess profits tax computation:
| Excess profits net income | $ 100,100.29 | |
| Less specific exemption | $ 5,000.00 | |
| Excess profits credit | 726,444.87 | |
| Excess profits credit carry-over | 762,922.28 | |
| $ 1,494,367.15 | ||
| Excess profits tax due | none |
In a petition filed under date of November 6, 1943, petitioner claims that it overpaid its excess profits tax liability for the three-month period from January 1, to March 31, 1941, in the amount of $ 1,983.97. Its corporation excess profits tax return for this three-month period was filed on March 16, 1942.
6 T.C. 1246">*1250 OPINION.
The pertinent provisions of the Internal Revenue Code are set forth in the margin. 1
1946 U.S. Tax Ct. LEXIS 170">*180 The respondent contends that because of the nature of the class B preferred stock issued to Ford and Smith, Cheney Brothers did not own 95 percent of the voting stock of the petitioner during 1941, and that stock which it did not own was also not limited and preferred as to dividends as required under section 730 of the code. Therefore respondent contends that these corporations were not entitled to join in consolidated returns for that year. In support of his contention respondent urges that the Government is not bound to recognize as genuine a change in capital structure which is without substance and designed solely so that the taxpayer might obtain a tax advantage without changing the true nature of its operation or organization. Respondent also urges that the true nature of the transaction presented by the petitioner is that Ford and Smith, who prior to 1941 had been the owners of 40 percent of the voting stock, which was not limited and not preferred as to dividends, never lost any of their rights and privileges as such common stockholders after they had "surrendered" their voting stock for a like number of shares of class B preferred stock; that the effort to simulate compliance1946 U.S. Tax Ct. LEXIS 170">*181 with the Internal Revenue Code by declaring in the amendment to the articles of incorporation that the class B stock should be nonvoting was a mere formalism, existing solely as an attempt to reduce petitioner's liability for taxes; and that the practical and legal effect of the power given to the holders of the class B preferred stock to convert the same instantly into voting nonpreferred stock was to make the preferred stock the equivalent in all respects to common stock.
The petitioner contends, on the other hand, that the actual facts and not the possibilities of the situation control in the matter of stock ownership for the purposes of consolidated returns; that the class B preferred stock was nonvoting stock and was limited and preferred as to dividends; that the provision whereby it might be converted into 6 T.C. 1246">*1251 common or voting stock did not in fact make it voting stock; and that the action taken by the parties was entirely proper and authorized by law.
Thus two questions are presented for disposal:
(1) Are the class B preferred stock shares nonvoting?
(2) Are said shares limited and preferred as to dividends?
The holders of the class B preferred stock were entitled to1946 U.S. Tax Ct. LEXIS 170">*182 notice of all stockholders' meetings the same as the holders of the common stock. Prior to any stockholders' meeting, a holder of any class B preferred stock was given the privilege of converting it into voting common stock, and upon such conversion he had the right to vote thereafter; and such preferred stockholder could serve a written notice of his intention to make such conversion and after such notice was given no action of the stockholders would be valid until such conversion was accomplished.
We have not been furnished by either the petitioner or the respondent with any direct authorities on the solution of the question with which we are confronted, and it is not our intention to indulge in any prolonged discussion of the authorities cited. However, the powers of the class B preferred stockholders in this case do bear considerable analogy to those of the holders of the voting trust certificates involved in the case of Kansas O. & G. Ry. Co. v. Helvering, 124 Fed. (2d) 460. In that case, pending a reorganization, the stockholders and bondholders of the petitioner railway delivered their stocks and bonds to a voting trustee to enable the trustee1946 U.S. Tax Ct. LEXIS 170">*183 to act in the contemplated reorganization. After the voting trust was terminated notice was sent to all of the stockholders to reclaim their stock, but a substantial percentage neglected to do so. However, a consolidated return was filed by the affiliated group of corporations, including the reorganized railway, and the Commissioner questioned the right to a consolidated return because, if the voting shares of stock held by the trustee but unclaimed by the owners were counted, the parent company would not own the necessary percentage of the voting stock to permit a consolidated return. The court held that the outstanding unclaimed stock should be so counted and denied the privilege of filing a consolidated return. In so holding the court said:
Nor is it of any consequence that the trust receiptholders cannot vote the stock to which they are entitled until stock certificates therefor have been issued to them. The stock is voting none the less. It is the voting privilege with which a particular stock issued is endowed and not whether it is voted which determines its voting character within the intent of the Revenue Acts of 1932 and 1934. [Italics supplied.]
In that case1946 U.S. Tax Ct. LEXIS 170">*184 the stockholder was required only to present his receipt and demand delivery of the voting stock from the voting trustee in order to acquire that stock. In the case at bar the holders of class B 6 T.C. 1246">*1252 stock at any time had only to present their class B stock to the secretary of the company and demand their common voting stock in order to acquire the same.
It will thus be seen that the situation of the class B preferred stockholders in the pending case is far different from that of the stock option holders in Commissioner v. Smith, 324 U.S. 177">324 U.S. 177, or in Doernbecher Mfg. Co., 30 B. T. A. 973 (also 80 Fed. (2d) 573), wherein the option holders had merely made a partial payment on the stock and could not obtain actual ownership of the same or actual voting power until the full payment was made and the stock certificates delivered. The option holders did not have title to the stock. They merely had a privilege of purchasing the stock in the future.
The case at bar is also very easily distinguishable from those cases in which the stock to which the stockholder has title may become voting stock1946 U.S. Tax Ct. LEXIS 170">*185 and may have the privilege of unlimited dividends, depending upon exigencies which are wholly beyond the control of the stockholders. Typical of such cases are Vermont Hydro-electric Corporation, 29 B. T. A. 1006, and Erie Lighting Co. v. Commissioner, 93 Fed. (2d) 882. Obviously, where the voting power of the stock or the limited and preferred nature of the dividends to which the stock is entitled may be changed by the happening of some event which is wholly beyond the control of the preferred nonvoting stockholders and which event may or may not ever occur, such a stockholder is not a holder of voting stock.
Petitioner lays great stress upon the fact that the holders of the class B preferred stock never anticipated any dividends and never intended to vote the stock, and that therefore the class B preferred stock should not be considered voting stock or stock entitled to unlimited dividends. The basis of his argument is the fact that one of the stockholders so testified at the time of the hearing. Unfortunately for this position, section 730 of the code does not make the intention of the stockholders a controlling, 1946 U.S. Tax Ct. LEXIS 170">*186 or even a relevant, factor in determining the voting or nonvoting character of the stock. Obviously, it is the provisions of the stock itself that control. However, there is substantial evidence, despite the testimony of the class B preferred stockholder at the hearing, that these class B stockholders intended at all times to keep and exercise every power with which they had originally been vested as common stockholders and that they had no intention of losing either their voting rights or a material part of their rights to dividends along with the common stockholders. It is interesting to note how Ford and Smith and Cheney Brothers were each very careful to protect all of their rights in relation to the other. Witness the escrow agreement at the time of the organization of the Pioneer Parachute Co. They had mutually agreed that none of them would 6 T.C. 1246">*1253 sell their common stock to an outsider until the offer to sell was presented to the other members of the triumvirate. However, they were obviously not willing to trust the agreement of each other in this regard and, therefore, each required the other to deposit his stock with an escrow agent so that it would be impossible1946 U.S. Tax Ct. LEXIS 170">*187 to violate this agreement. Another interesting sidelight on the attitude of Ford and Smith at the time that they accepted their class B preferred stock is the letter from petitioner to them guaranteeing that in the event dividends were paid to the common stockholders they should be compensated also. At any time, furthermore, that Ford and Smith considered their position becoming precarious, or at any time they should desire to protect their rights as common stockholders in petitioner corporation, their class B preferred stock certificates and the amendment to the certificate of incorporation of petitioner granted them full power to become common stockholders with full voting power and unlimited dividend privileges at once. When they accepted class B preferred certificates they surrendered nothing but the shadow of their rights as common stockholders. They retained all of the substance of those rights.
In fact, this whole reorganization plan had nothing to do with the advancement of the business operations of petitioner and it did not bring the capital stock structure within the manifest purpose of section 730 of the code, permitting the filing of consolidated returns. The reorganization1946 U.S. Tax Ct. LEXIS 170">*188 merely injected into the capital structure 398 shares of class B preferred stock which did nothing to the capital of the corporation and in no way promoted the business purposes of the corporation. The fact that the number of class B preferred shares was limited to 398, which is the exact number of shares to be exchanged by Ford and Smith, is a revealing light on the materiality and bona fides of this reorganization scheme. It was provided in the resolution that the offer to convert the common stock to class B preferred stock should be made to all stockholders, but there were just enough class B preferred stock shares authorized to absorb the common stock of Ford and Smith. Most opportunely and conveniently, Cheney Brothers refused to take advantage of the offer to convert. The effect of this transaction was merely to set up the appearance of a new type of stockholder without affecting the substantial rights of that stockholder. "The government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of1946 U.S. Tax Ct. LEXIS 170">*189 the tax statute." Helvering v. Smith, 308 U.S. 473">308 U.S. 473.
In the case at bar the large excess profits carry-over which was available to petitioner and Cheney Brothers, provided this plan for a 6 T.C. 1246">*1254 temporary conversion of common stock into class B preferred stock could be made to have the semblance of reality, would cause any court to look upon this plan with careful scrutiny, and, when no other obvious purpose is achieved beyond the salvaging of this large excess profits carry-over, the good faith of the whole transaction is very questionable.
The case of Commissioner v. Court Holding Co., 324 U.S. 321">324 U.S. 321, is considerably in point. In that case a corporation, under a designation of "liquidating dividends" transferred real estate to its two stockholders, who forthwith sold this real estate and realized the gain involved as individuals, thus attempting to avoid a taxable gain to the corporation. The Court held that such a transfer was a mere subterfuge, designed to cover up the real nature of the transaction, and was not a genuine business operation. See also Gregory v. Helvering, 293 U.S. 465">293 U.S. 465,1946 U.S. Tax Ct. LEXIS 170">*190 where the Court said on page 469:
The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes or altogether avoid them, by means which the law permits, cannot be doubted. * * * But the question for determination is whether what was done apart from the tax motive was the thing the statute intended.
In the case at bar the statute intended that corporations so completely affiliated by the interownership of at least 95 percent of the voting stock as to constitute in actuality one industrial economic unit should be taxed as one industrial economic unit. However, when the voting controls of affiliated corporations are not so closely held as to amount practically to one economic unit, there is no expressed intent in the revenue laws to permit a partial tax exemption, nor would any such purpose be justified. In the case at bar Cheney Brothers actually owned only 60 percent of the voting stock of petitioner corporation and did not own 95 percent thereof. Therefore the requirements of the statute have obviously not been satisfied in this case.
Judge Hand, in the case of Commissioner v. Manus-Muller & Co., 79 Fed. (2d) 19; 1946 U.S. Tax Ct. LEXIS 170">*191 certiorari denied, 296 U.S. 657">296 U.S. 657, forcibly expressed the situation when he said: "Affiliation is a privilege in any case akin to an exemption and doubts go against the taxpayer."
It is therefore our decision that the class B preferred stock of Pioneer Parachute Co. must be treated as voting stock.
While the determination of the second question presented, pertaining to the limited or unlimited character of the dividends to which the holders of the class B stock are entitled, becomes of minor importance in view of our holding that said stock must be treated as voting stock for the purpose of filing consolidated returns, nevertheless, we must also hold that the so-called class B preferred stock was not in fact limited as to dividends. This holding is based upon the contents of the letter of March 24, 1941, sent by the Pioneer 6 T.C. 1246">*1255 Parachute Co. to Ford and Smith, by which letter the company entered into a contract with Ford and Smith, "in consideration of the surrender" by Ford and Smith of their common shares, to pay Ford and Smith for each share of the class B preferred stock held by them or either of them two-thirds of any dividend which might be declared1946 U.S. Tax Ct. LEXIS 170">*192 in the future on each of the common stock shares remaining outstanding. The enforceability of this contract has not been questioned and the payments to be made by the Pioneer Parachute Co. to Ford and Smith were to be in direct proportion to the number of shares which they held and were to be limited only by the amount of dividends which the common shareholders were to receive. Such amount to be received by the class B preferred shareholders was not limited and, since it was in direct proportion to the number of shares held, such payments would in fact be dividends, regardless of the bookkeeping process by which the payments were made or the name by which they were designated. See Twin City Tile & Marble Co., 6 B. T. A. 1238; Gould-Mersereau Co., 21 B. T. A. 1316, at page 1325; and Bruckner Realty Corporation, 20 B. T. A. 419, at page 426.
It follows that Cheney Brothers did not own 95 percent of the voting stock of the petitioner which was not limited and not preferred as to dividends during the period from March 30 to December 31, 1941, and it was not entitled to join with petitioner 1946 U.S. Tax Ct. LEXIS 170">*193 in a consolidated return.
Judgment will be entered for the respondent.
Footnotes
1. SEC. 730. CONSOLIDATED RETURNS. * * *
(a) Privilege to File Consolidated Returns. -- An affiliated group of corporations shall, subject to the provisions of this section, have the privilege of making a consolidated return for the taxable year in lieu of separate returns. * * *
* * * *
(d) Definition of "Affiliated Group." -- As used in this section, an "affiliated group" means one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation if --
(1) At least 95 per centum of each class of the stock of each of the includible corporations (except the common parent corporation) is owned directly by one or more of the other includible corporations; and
(2) The common parent corporation owns directly at least 95 per centum of each class of the stock of at least one of the other includible corporations. As used in this subsection, the term "stock" does not include non-voting stock which is limited and preferred as to dividends.↩