1940 BTA LEXIS 875">*875 Petitioner, though in arrears to the extent of $45.50 per share upon cumulative undeclared dividends on preferred stock, had only from operations in the taxable year a substantial earned surplus. Being desirous of applying same to expansion and operating expenses, a plan of recapitalization was carried out, under which the holders of all preferred stock except a small amount received, for the old stock and right to accumulated unpaid dividends, 1.4 shares of new preferred stock of $100 per share par value, and $5.50 in cash. The remaining stockholders did not enter the plan and received $45.50 per share in cash. Held, that the receipt of the new stock by the stockholders was not a taxable dividend nor essentially equivalent to a taxable dividend under section 115(a) and (g), Revenue Act of 1936, and therefore under section 27(h), Revenue Act of 1936, did not entitle the petitioner to dividends paid credit; held, further, that expense for attorneys' services in the transaction was capital expense and not deductible as ordinary and necessary expense. South Atlantic Steamship Line,42 B.T.A. 705">42 B.T.A. 705.
42 B.T.A. 1287">*1288 This proceeding involves deficiencies proposed of $55,726.29 in income tax and $706.87 in excess profits tax, for the taxable year 1937. A portion thereof has by abandonment been eliminated from consideration, as will be reflected in decision under Rule 50.
From evidence both oral and documentary we make the following findings of fact.
FINDINGS OF FACT.
1. Petitioner is a corporation, organized and existing under the laws of the State of Delaware, and has its principal office and place of business at 1201 Broad Street, Utica, New York. It filed its income tax return for the taxable year with the collector of internal revenue for the twenty-first New York district.
2. Prior to July 1, 1937, petitioner was authorized to issue 14,247 shares of convertible preferred stock of no par value. The issue was authorized about 1929 and on July 1, 1937, 5,632 shares were issued and outstanding. The remaining 8,615 were unissued. This convertible preferred stock, hereinafter sometimes referred to as the old preferred stock, was entitled to dividends, which were cumulative, at the rate of $7 per annum, 1940 BTA LEXIS 875">*877 payable quarterly, before any dividends could be paid on any other outstanding stock. In the event of voluntary dissolution the holders thereof were entitled to $110 per share and in case of involuntary dissolution to $100 per share, plus in each case, any cumulated dividends. Petitioner could redeem any part of such stock at any time on 60 days' notice at $110 per share plus any accumulation of dividends. The old preferred stock had no voting power unless four quarter-yearly dividends were in default, in which event it had equal voting power with the other classes of oustanding stock. At the option of the shareholder the old preferred stock was convertible into shares of common stock of no par value at the rate of two shares of common for one share of convertible preferred.
3. No dividends had been declared or paid on the said outstanding shares of petitioner's old preferred stock during the period from January 1, 1931, to July 1, 1937; and as of July 1, 1937, the arrears of dividend on said stock amounted to $45.50 per share, or an aggregate of $256,256 on the 5,632 shares of said stock issued and outstanding.
4. During the years 1931 to 1936, inclusive, with the exception1940 BTA LEXIS 875">*878 of the year 1933, petitioner had operated at a loss and at the close of 42 B.T.A. 1287">*1289 the year 1936 petitioner had a deficit in the amount of $15,802.63. For the fiscal year ended December 31, 1937, however, petitioner had net profits of $352,055.33. Early in the year 1937 the petitioner had plans for expansion, and cash was necessary for such expansion and operating capital. The officers and directors of petitioner gave consideration therefore to the matter of discharging liability on arrearages on dividends.
5. About April 1937 petitioner devised a plan of recapitalization. A printed circular letter and a printed copy of the plan, designated "Plan of Recapitalization", each dated April 27, 1937, were sent to each of the stockholders by printed circular letter bearing the same date. At that time in addition to the old preferred stock petitioner had outstanding 343,542 shares of common stock of no par value out of an authorized issue of 500,000 shares.
6. The circular letter recited in part as follows:
TO THE STOCKHOLDERS:
In view of the recent increased demand for rayon yarns and the need for enlarging the productive capacity of your Corporation by going forward with1940 BTA LEXIS 875">*879 proposed additions and improvements to the Corporation's manufacturing plant at Utica, New York, the Board of Directors has given consideration to the desirability of presenting to the stockholders for consideration and action at a meeting of stockholders to be held in connection with the annual meeting on May 26, 1937, a plan of recapitalization of the Corporation whereby the present Convertible Preferred Stock ( $7 Dividend, Cumulative) may be exchanged for a new Cumulative Prior Preferred Stock 5% Convertible Series, and an adjustment of the unpaid dividends on the present Convertible Preferred Stock may be effected.
The need for a plan of readjustment of the present capitalization arises principally as a result of the substantial amount of unpaid accumulated dividends on the outstanding Convertible Preferred Stock, which, as appears from the balance sheet dated December 31, 1936, previously sent to stockholders, should not be paid in cash at this time. Furthermore, it is also desirable that the Corporation retain its present working capital to finance the purchase of additional machinery and equipment required to handle the substantial increase in the volume of business which1940 BTA LEXIS 875">*880 is taking place.
* * *
Briefly stated, the offer provides for an exchange on the basis of 1.4 shares of the new Cumulative Prior Preferred Stock, 5% Convertible Series, plus $5.50 in cash, for 1 share of present Convertible Preferred Stock (as reclassified into Class A Preferred Stock) and a release of all claim to accumulated unpaid dividends on the present Convertible Preferred Stock on the conditions stated in the plan.
* * *
The important feature of the plan is the offer of exchange set forth in Section III of the plan, whereby, in the event that the plan is declared effective by the Board of Directors upon the terms and conditions stated in the plan, the holders of the shares of Convertible Preferred Stock now outstanding will be offered, in exchange therefor, shares of the new Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, on the basis stated in the plan and summarized above.
42 B.T.A. 1287">*1290 By accepting the offer and making the exchange, holders of the existing Cumulative Preferred Stock will thereby release their claim to all dividends accrued and in arrears on the outstanding Cumulative Preferred Stock.
* * *
7. The printed "Plan1940 BTA LEXIS 875">*881 of Recapitalization" recited that the board of directors had on April 21, 1937, voted to recommend to the stockholders a "plan for the recapitalization of the Corporation, hereinafter set forth", and later, under the heading "The Proposed Plan of Recapitalization", recited in part as follows:
(a) The 8,615 shares of the present Convertible Preferred Stock, without par value, authorized but unissued, will be changed and reclassified into 8,615 share of authorized new Preferred Stock designated Cumulative Prior Preferred Stock of the par value of $100 per share (hereinafter described) and the authorized amount of such stock will be increased by 20,000 additional shares, making a total of 28,615 shares of such stock authorized, all of which may be issued in series;
(b) The 5,632 shares of the present Convertible Preferred Stock, now issued and outstanding, will be changed and reclassified into a like number of shares of designated Class A Preferred Stock, all of which will then be issued and outstanding in the hands of the holders of the present Convertible Preferred Stock;
(c) All of the present authorized but unissued Common Stock (156,458 shares), as well as all of the issued1940 BTA LEXIS 875">*882 Common Stock (343,542 shares), without par value, will be changed and be reclassified into shares of Common Stock of the par value of $5 per share.
Under the proposed plan, the holders of the issued shares of the present Common Stock, without par value, will become holders of Common Stock of the par value of five dollars ( $5) each when the proposed amendment becomes effective and without the necessity of making any exchange of certificates. * * *
The following is a brief description of the new Preferred Stocks to be created under the plan:
(1) THE NEW CUMULATIVE PRIOR PREFERRED STOCK:
It is proposed that, by amendment of the Certificate of Incorporation of the Corporation, the stockholders shall authorize the creation of a new class of prior Preferred Stock to be designated "CUMULATIVE PRIOR PREFERRED STOCK", consisting of 8,615 shares of the par value of $100 each, to be created by a change and reclassification of the 8,615 shares of the present Convertible Preferred Stock, without par value authorized but unissued, and the increase in the authorized amount of such stock by an additional 20,000 shares, making the total of 28,615 authorized shares, all of which new Cumulative1940 BTA LEXIS 875">*883 Prior Preferred Stock will be issued in series, as provided in the proposed amendment.
The new Cumulative Prior Preferred Stock is to be entitled to preference, both as to dividends and assets, over the issued shares of Convertible Preferred Stock (as reclassified into shares of Class A Preferred Stock) and the Common Stock.
* * *
Shares of the Cumulative Prior Preferred Stock 5% Convertible Series, will be redeemable at the option of the Corporation, in whole or in part, at any time upon 60-days' previous notice at a price of $110 in cash per share, plus the amount of all unpaid accrued dividends thereon. The shares will also be entitled to receive the redemption price upon any voluntary liquidation of the 42 B.T.A. 1287">*1291 Corporation, and to receive $100 per share, plus the amount of all unpaid accrued dividends thereon in involuntary liquidation, dissolution or winding up of the Corporation.
* * *
(2) THE NEW CLASS A PREFERRED STOCK:
Upon the amendment to the Certificate of Incorporation becoming effective, each share of the issued and outstanding Convertible Preferred Stock will be changed and reclassified into 1 share of Class A Preferred Stock. Subject to the prior1940 BTA LEXIS 875">*884 rights of the Cumulative Prior Preferred Stock, dividends on the Class A Preferred Stock will be payable at the rate of 5% of par per annum. Dividends will be cumulative from July 1, 1937, and will be payable quarter-yearly on the first days of January, April, July and October in each year.
Subject to the prior rights of the Cumulative Preferred Stock, the Class A Preferred Stock will be redeemable at the option of the Corporation, in whole or in part, at any time upon 60-days' notice at $110 per share, plus the amount of all unpaid accrued dividends and subject, as aforesaid, will be entitled to the redemption price upon any voluntary liquidation and to receive $100 per share, plus the amount of all unpaid accrued dividends thereon in the case of involuntary liquidation, dissolution or winding up of the Corporation.
The holders of Class A Preferred Stock will have no voting power except upon default in the payment of 4 quarter-yearly dividends on such stock, whereupon the stock shall have equal voting power share for share with the Common Stock.
The Class A Preferred Stock will not be convertible into shares of Common Stock.
The reclassification of the outstanding shares1940 BTA LEXIS 875">*885 of Convertible Preferred Stock, without par value, into shares of Class A Preferred Stock of the par value of $100 per share and the reclassification of the outstanding shares of Common Stock, without par value, into shares of Common Stock of the value of $5 per share, will not effect any change in the capital of the Corporation represented by such outstanding shares.
* * *
The proposed amendment to the Certificate of Incorporation will not bring about any reduction in the capital of the Corporation.
* * *
III. OFFER OF EXCHANGE.If the stockholders approve the proposed amendment to the Certificate of Incorporation, and the increase, changes and reclassifications in the present authorized and issued shares of stock of the various classes, as contemplated by the plan, when such amendment shall have been effective, the Board of Directors will make the following offer of exchange, but conditioned upon the Board declaring the plan effective, as hereinafter provided:
Holders of the shares of Convertible Preferred Stock, now outstanding, will be offered in exchange therefor 1.4 shares of the CUMULATIVE PRIOR PREFERRED STOCK, 5% CONVERTIBLE SERIES, and $5.50 in cash, on the1940 BTA LEXIS 875">*886 terms and conditions hereinafter set forth.
By making the exchange, holders of the existing Cumulative Preferred Stock will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears on the outstanding Cumulative Preferred Stock.
* * *
42 B.T.A. 1287">*1292 IV. METHOD OF CARRYING OUT THE PLAN.
* * *
A stockholder who accepts the offer of exchange will be required, as the Directors may determine, either to submit his certificates for Convertible Preferred Stock for stamping with an appropriate endorsement evidencing such acceptance, or to deposit his certificates against the issuance of certificates for the new shares or a certificate of deposit entitling the holder to receive the new shares of Cumulative Prior Preferred Stock, 5% Convertible Series, and the cash payment at the rate of $5.50 per share, in accordance with the plan.
V. CONDITIONS UPON WHICH THE PLAN WILL BECOME EFFECTIVE.The aforesaid offers of exchange will be conditioned upon the plan being declared effective by the Board of Directors of the Corporation. * * *
8. A copy of the pertinent provisions of the proposed amendment to the certificate of incorporation was also1940 BTA LEXIS 875">*887 embodied in the printed "Plan of Recapitalization." In the accompanying letter of transmittal the provisions of the plan and the effect thereof were explained.
9. On May 26, 1937, a meeting of petitioner's stockholders was held at which stockholders, by the requisite vote, approved a certificate of amendment of the certificate of incorporation of petitioner, authorizing the increase and the changes and reclassification in the authorized and issued shares of petitioner's capital stock, as described in the plan. The filing of the certificate of amendment to the certificate of incorporation was deferred until the plan should be declared operative.
10. Following said meeting of petitioner's stockholders, a circular letter dated June 7, 1937, was sent to the holders of petitioner's convertible preferred stock, advising them that the plan of recapitalization dated April 27, 1937, previously submitted, and the proposed amendment to the certificate of incorporation had been approved, and in part reciting:
Therefore, in view of the action of the stockholders, the Board of Directors of the Corporation hereby offers to the holders of the Convertible Preferred Stock of the Corporation, 1940 BTA LEXIS 875">*888 until the close of business on July 15, 1937, to exchange each share of such stock for 1.4 shares of the new Cumulative Prior Preferred Stock, 5% Convertible Series and $5.50 in cash, on the terms and conditions set forth in Section III of the Plan.
By accepting the offer and making the exchange, holders of the Convertible Preferred Stock will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears on such Preferred Stock. In this connection it should be pointed out that, as provided in the Plan, dividends on the new Cumulative Prior Preferred Stock, 5% Convertible Series, will be cumulative from July 1, 1937, upon shares of such new stock issued prior to the payment of the initial quarterly dividend thereon which will become payable October 1, 1937.
11. The circular letter was accompanied by a form for use of the stockholder. The form contained an acceptance of "the offer of 42 B.T.A. 1287">*1293 exchange as set forth in the letter * * * dated June 7, 1937, and in the Plan of Recapitalization, dated April 27, 1937", and further recited:
Enclosed herewith you will find certificate(s) for said shares of Convertible Preferred Stock of Skenandoa1940 BTA LEXIS 875">*889 Rayon Corporation which are delivered to you to be exchanged for certificates for shares (and scrip in respect of fractions of shares thereof, if any) of Cumulative Prior Preferred Stock, 5% Convertible Series, of Skenandoa Rayon Corporation, and cash, in accordance with the provisions of the said offer of exchange and Plan of Recapitalization.
12. When a large percentage of the holders of the old preferred stock had accepted the proposal, the board of directors, at a meeting held on July 15, 1937, declared the plan of recapitalization operative. The amendment to the certificate of incorporation was filed in the office of the Secretary of State of Delaware on July 17, 1937. The holders of 5,553 shares of the old preferred stock eventually accepted the proposal and deposited their stock as provided in the letter to them of June 7. The holders of the remaining 79 shares of old preferred stock outstanding did not accept the offer.
13. At the meeting of the directors on July 15, 1937, after a resolution declaring the plan effective, it was also, in part, resolved:
FURTHER RESOLVED, that upon the Amendment to the Certificate of Incorporation of this Corporation, as approved1940 BTA LEXIS 875">*890 at the meeting of the Stockholders of this Corporation held May 26, 1937, becoming effective, the proper officers of this Corporation be and they hereby are authorized, empowered and directed to issue and deliver certificates for not to exceed a total of 7,885 shares of the par value of $100 each of the Cumulative Prior Preferred Stock, 5% Convertible Series, of this Corporation, with the preferences, relative participating, optional and other special rights, qualifications, limitations and restrictions thereof, as set forth in said Amendment of the Certificate of Incorporation of this Corporation, such stock to be issued in exchange for, and in consideration of the delivery to the Corporation for cancellation of, shares of the Convertible Preferred Stock outstanding (as reclassified into shares of Class A Preferred Stock of the par value of $100. each, upon the Amendment to the Certificate of Incorporation of the Corporation, hereinabove mentioned, becoming effective), on the basis of 1.4 shares of such new Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, for each share of said Convertible Preferred Stock (as reclassified into shares of Class A Preferred1940 BTA LEXIS 875">*891 Stock), subject in all respects to the terms, provisions and conditions as set forth in the said Plan of Recapitalization dated April 27, 1937.
14. On or about July 22, 1937, petitioner caused to be sent to its stockholders a circular letter dated July 22, 1937, advising the stockholders that the plan of recapitalization had been declared effective and that the capital stock of the petitioner had been changed and reclassified, as provided in the plan and certificate of amendment to the certificate of incorporation. The circular letter provided in part:
In the event that holders of Convertible Preferred Stock (reclassified into Class A Preferred Stock) desire to present their shares for acceptance by the Board of Directors, to be exchanged for shares of the new Cumulative Prior 42 B.T.A. 1287">*1294 Preferred Stock, 5% Convertible Series, and the amount of the cash payment to which they may be entitled under the Plan of Recapitalization, they should promptly present the certificates for their present stock, with specific instructions in acceptance of the Offer of Exchange or accompanied by an executed copy of the Letter of Transmittal, the form of which was sent to the holders of Convertible1940 BTA LEXIS 875">*892 Preferred Stock with a circular letter dated June 7, 1937, addressed to such stockholders.
15. Accompanying said circular letter dated July 22, 1937, was a form letter for the use of the holders of certificates of shares of convertible preferred stock not desiring to accept the offer of exchange and/or for the holders of common stock whereby they might surrender their certificates for such stocks to petitioner in exchange for certificates representing shares of reclassified stocks.
16. On or about July 22, 1937, petitioner also caused to be sent to the holders of certificates of deposit for shares of its old preferred stock a printed notice advising holders of such certificates of deposit that the plan of recapitalization had been declared effective and that certificates for new shares of cumulative prior preferred stock, 5% convertible series, and checks in payment of the amount of cash (at the rate of $5.50 per share) to which each such certificate holder was entitled were ready for delivery upon surrender of certificates of deposit.
17. Accompanying said notice dated July 22, 1937, was a form letter of transmittal for the use of holders of said certificates of deposit1940 BTA LEXIS 875">*893 surrendering such certificates of deposit for shares of new cumulative prior preferred stock, 5% convertible series, and cash, as provided in the offer and plan. The form letter of transmittal recites, in part:
The above-mentioned Certificate(s) of Deposit is (are) surrendered to be exchanged for a certificate for full shares (and scrip in respect of fractions of a full share, if any) of the new Cumulative Prior Preferred Stock, 5% Convertible Series, on the basis of 1.4 shares of Cumulative Prior Preferred Stock, 5% Convertible Series, for each share of Convertible Preferred Stock represented by the Certificate(s) of Deposit surrendered, and a payment at the rate of $5.50 for each share of Convertible Preferred Stock, all in accordance with the provisions of the said Plan of Recapitalization, dated April 27, 1937.
18. In carrying out the plan the holders of 5,553 shares of old preferred stock (reclassified as class A preferred) surrendered their certificates for said shares of old preferred and received 7,774.2 shares of new cumulative prior preferred stock and $30,541.50 in cash, the cash figure being at the rate of $5.50 for each old preferred share surrendered. The holders1940 BTA LEXIS 875">*894 of 79 shares of old preferred then held the same number of shares of class A preferred into which the old preferred had been reclassified; and the holders of 343,542 shares of common stock of no par value became the holders of a similar number of shares of common stock of a par value of $5 per share. In determining the amount of dividends paid credit the Commissioner has 42 B.T.A. 1287">*1295 allowed the $5.50 cash paid to the holders of each share of old preferred stock.
19. In further carrying out the plan, pursuant to such consent and the action of petitioner's board of directors, the proper officers of petitioner canceled the capital stock liability on the books of petitioner in an amount of $100 for each share of its old preferred stock (reclassified as class A preferred stock) deposited in accordance with the plan, and debited the capital stock account of petitioner with an amount of $100 for each share of new cumulative prior preferred stock, 5% convertible series, of the par value of $100 each, issued in exchange therefor.
20. Entries to reflect the transaction were on August 31, September 20, and November 5, 1937, made upon petitioner's books as follows: The old $7 cumulative1940 BTA LEXIS 875">*895 preferred stock was, in six items, credited with a total of $777,420 and class A preferred stock was credited with $6,900. Capital stock was debited for the old convertible $7 preferred stock in three items, with a total of $562,200; and earned surplus was debited in three items with a total of $222,120 (in addition to another item of $30,976), which under date of August 31, 1937, was recorded as "To deduct from Earned surplus $5.50 per share of $7 prfd. adjustment on exchange of shares." Other items, also entered on August 31, 1937, were recorded as:
| To reflect exchange of $7 preferred into new $5 series | |
| as at Aug. 31, 1937. | |
| 5506 shares of $7 pfd. exchanged | $550,600 |
| for 7649 shares $5 Pfd. | 764,900 |
| and 13.80 shares $5 pfd. scrip | 1,380 |
| The resulting difference in value of capital stock | |
| $215,680 is hereby in this entry taken out of Earned | |
| surplus. |
The $215,680 item debited to earned surplus, and debits to earned surplus of $5,360 on September 20, 1937, and $1,080 on November 5, 1937, total the $222,120 to which reference is made above. The items entered on September 20, 1937, were recorded as: "To set up $7.00 preferred stock exchanged as at Sept. 20, 1937 for1940 BTA LEXIS 875">*896 $5.00 preferred and charge difference to 'Earned Surplus.'" The items entered on November 5, 1937, were recorded as: "To reflect status of capital stock account as of October 31, 1937."
21. The provisions of the new cumulative prior preferred stock which were issued in the exchange were substantially the same as those of the old preferred stock except that the dividend rate on the new stock was $5 per annum instead of $7. The holder of new preferred which was issued in the exchange could convert his new shares into common stock at the rate of two shares of common for one share of new preferred except that if the conversion was made on or before January 1, 1939, the rate of conversion was four shares of 42 B.T.A. 1287">*1296 common for each share of the new series and if the conversion was made at any time after January 1, 1939, and on or before July 1, 1940, the rate was three for one.
22. Subject to the rights of the holders of the new convertible series and in subordination thereof the holders of the new class A preferred stock were entitled to receive, when and as declared by the board of directors, dividends at the rate of $5 per annum payable quarterly before any dividends could1940 BTA LEXIS 875">*897 be paid upon the common stock. The dividends were cumulative. The provisions of this class A preferred stock with respect to dissolution and voting power were substantially the same as those for the new cumulative prior preferred stock.
23. For the first quarter of 1937 petitioner's net profits before deduction for Federal income taxes amounted to $148,383.16. The net profits for the first two quarters or to June 30, 1937, before deduction for Federal income taxes, amounted to $320,392.51. The net profits for the first three quarters similarly computed were $470,020.50, and for the whole year, after deduction for Federal income taxes, the net profits amounted to $352,055.33.
24. Petitioner's books as at December 31, 1936, showed a deficit account in the amount of $15,802.63. Its deficit from operations as at that date was, however, much greater. On its Federal income tax returns for 1930, 1931, and 1932, petitioner reported net losses of $85,783.44, $213,985.08, and $213,791.05, respectively. At the beginning of 1933 petitioner had an operating deficit of $404,379.61. For 1933 petitioner reported a profit of $29,151.71; for 1934 and 1935, losses in the amounts of $89,199.311940 BTA LEXIS 875">*898 and $67,643.49, respectively, and for 1936, a profit of $26,111.19. The operating deficit as at December 31, 1936, was in excess of $500,000.
25. In connection with the preparation and carrying out of the plan of recapitalization petitioner sought advice of counsel and was guided thereby in connection with the plan. In advance of the meetings of directors and stockholders forms of minutes were provided by counsel. The plan was carried out as provided, by the use of various documents and form letters. The attorneys, for their services in connection with the plan of recapitalization, were paid $15,000, which was the reasonable value of such services. The Commissioner in the notice of deficiency disallowed the $15,000 as a deduction in computing taxable net income.
The Commissioner allowed petitioner's claim of dividends paid credit to the extent of the $5.50 cash per share paid on the old preferred stock, but denied the claim to the extent of $222,120 (representing $40 per share on 5,553 shares of the old preferred stock). The Commissioner's denial also of claim of dividends paid credit for $3,160 (representing $40 per share on 79 shares of the stock) has been abandoned1940 BTA LEXIS 875">*899 by him on brief. The Commissioner also denied claim of deduction of $15,000 expenses for attorneys' services.
42 B.T.A. 1287">*1297 OPINION.
DISNEY: There are left for our consideration only two questions: (1) Whether the petitioner is entitled to dividends paid credit, and (2) whether it is entitled to deduction of attorneys' fees as ordinary and necessary expenses. Other issues have been eliminated and will be reflected in decision under Rule 50.
1. There is little, if any, dispute about the facts on the question as to whether the petitioner is entitled to dividends paid credit under section 27 of the Revenue Act of 1936. In sum, the pertinent facts may be stated as follows: Being in arrears for several years upon payment of dividends upon its $7 cumulative preferred stock, the arrears amounting to $45.50 per share in the taxable year, and having earned in the taxable year substantial amounts which were, however, desired for use in operating and expanding the business, the petitioner, with the primary object of relieving itself from the burden of the arrears in dividends on the preferred stock, entered into a recapitalization. The effect of the recapitalization was that the1940 BTA LEXIS 875">*900 holders of the preferred stock surrendered same with the understanding that they were also surrendering their rights to accumulated undeclared and unpaid dividends, all in consideration of the receipt of 1.4 shares of a new issue of new preferred stock (which differed from the old in some respects and incident rights), plus $5.50 per share in cash, for each share of the old preferred. Out of 5,632 shares of preferred stock so held, all stockholders, except the holders of 79 shares, participated, surrendered their old stock, and received the new stock; that is, the holders of 5,553 old shares received 7,774.2 shares of the new preferred stock, and $5.50 per share in cash for each of the 5,553 shares. The holders of 79 shares refused to take stock and received $45.50 cash per share, and contention as to them has been abandoned by the respondent. The old preferred stock was of no par value, but was by amendment of certificate of incorporation converted into class A preferred stock of $100 par value (which will, however, be hereinafter referred to as the old stock). The petitioner contends that when the holders of the old preferred stock (as changed) received 1.4 shares and $5.50 cash1940 BTA LEXIS 875">*901 for each of the old shares, they in effect received a dividend of $40 for the .4 share received and $5.50 in cash, or a total dividend of $45.50, in the same way as did the nonparticipating holders of the 79 shares, amounting to $222,120; that such constituted a "dividend paid" within the language of section 27(a) of the Revenue Act of 1936, 1 and the petitioner is therefore entitled to dividends paid credit in the amount of $222,120. The earnings of the taxable year were more than that amount. Although 42 B.T.A. 1287">*1298 the respondent contends that, considering the fact of deficits in earlier years and their absorption by the application of capital thereto, there were in fact and in effect not sufficient earnings against which to charge the alleged dividend in the taxable year, it is not necessary, in view of the conclusion to which we have come, to consider that phase of the matter.
The petitioner must show that under section 27 of the Revenue Act of 1936 there1940 BTA LEXIS 875">*902 was a dividend and that it was paid, and, under subsection (h) of the statute, 2 that it was a "taxable dividend." There was in fact no payment in this case, but the petitioner contends that the effect is the same as if a dividend had been paid. Although attention was upon brief paid to the question of stock dividend, that question is not before us, since at trial it was stated by petitioner's counsel that there was no contention that a stock dividend was paid, and evidence was not adduced to show the fair market value of such stock dividend. We therefore confine ourselves to the question as to whether the transaction which took place should be given the effect of a cash dividend, taxable and paid. The petitioner's idea is, in effect, that, since the primary object of the recapitalization was to eliminate the arrears in unpaid accumulated dividends upon the preferred stock, and since the petitioner had the current earnings with which to pay them, the stockholders simply surrendered their rights to $45.50 per share dividends in consideration of the .4 per share of new stock which was a capitalization of $40 of earnings and $5.50 cash; and that therefore they in effect received a1940 BTA LEXIS 875">*903 dividend of $45.50. The respondent allowed the dividends paid credit in the amount of $5.50 per share, but disallowed it as to the $40. He contends in substance that the transaction was what it was called in the plan, a recapitalization, and therefore a reorganization under the definition laid down in section 112(g)(1)(D); that sections 112(b)(2) and (3) and (c)(1) of the Revenue Act of 1936 3 apply; that under the provisions thereof there was no 42 B.T.A. 1287">*1299 recognition of gain or loss upon the exchange of stock for stock in the same corporation, except upon the cash received; that therefore under section 27(h) of the Revenue Act of 1936 the distribution was not a "taxable dividend"; and that therefore dividends paid credit can not be allowed.
1940 BTA LEXIS 875">*904 That the transaction was a recapitalization can not be denied in view of the repeated use of that expression throughout the documents by which the plan is evidenced. Thus, in the letter to the stockholders proposing the plan it is stated that the board of directors has given consideration to the desirability of presenting to the stockholders "a plan of recapitalization of the Corporation * * *", and in effect the same expression is again more than once used. Likewise it can hardly be denied and in fact is not denied that there was an "exchange", for in the same letter and in the same paragraph just referred to the "plan of recapitalization of the Corporation" was stated as: The preferred stock "may be exchanged for a new Cumulative Prior Preferred Stock, 5% Convertible Series and an adjustment of the unpaid dividends on the present Convertible Preferred Stock may be effected." The expression "exchange" is thereafter repeatedly used. It thus appears to be incontrovertible that at least within the language of section 112(b)(2) and (3) "preferred stock in a corporation is exchanged * * * for preferred stock in the same corporation", and that under section 112(c)(1), since the exchange1940 BTA LEXIS 875">*905 was not solely for stock, $5.50 in cash being received upon each share, gain or loss was limited to recognition of the cash received. The respondent further relies upon the language of section 115(h) of the Revenue Act of 1936, 4 pointing out that a distribution 42 B.T.A. 1287">*1300 by a corporation "of its stock or securities * * * shall not be considered a distribution of earnings or profits * * * if no gain to such distributee from the receipt of such stock or securities was recognized by law, * * *"; that therefore section 112(b)(2) and (3), having provided that shall be no such recognition of gain to the distributee, the distribution can not be considered one from earnings or profits and therefore is not a dividend within the definition of section 115(a) providing that a dividend "means any distribution made by a corporation * * * out of its earnings or profits accumulated after February 28, 1913, or * * * out of earnings or profits of the taxable year * * *."
1940 BTA LEXIS 875">*906 To all of this the petitioner's position and answer is in sum that the prime purpose of the whole plan was the elimination of the liability of the corporation for the accumulated unpaid dividends on the preferred stock, and that, such primary intent having been accomplished when the stockholders received four-tenths of a share of the new stock and $5.50 in cash instead of their former right to unpaid accumulated dividends, and the former stock having been set up of a value of $100 per share, and that amount of earnings transferred to capital, it is as though they received $45.50 in consideration of the surrender of the right to receive the accumulated dividends in that amount, with the same effect as if they had in fact received such amount in cash and had then purchased the four-tenths of the shares of the stock therewith.
It is true that the primary purpose of the recapitalization was to eliminate the liability for unpaid dividends upon the preferred stock, in order to apply the funds on hand to business purposes. The initial letter to the stockholders proposing the change says:
The need for a plan of readjustment of the present capitalization arises principally as a result1940 BTA LEXIS 875">*907 of the substantial amount of unpaid accumulated dividends on the outstanding Convertible Preferred Stock which, as appears from the balance sheet dated December 31, 1936, previously sent to stockholders, should not be paid in cash at this time. Furthermore, it is also desirable that the Corporation retain its present working capital to finance the purchase of additional machinery and equipment required to handle the substantial increase in the volume of business which is taking place.
In the same instrument we find the following language:
The important festure of the plan is the offer of exchange set forth in Section III of the plan, whereby, in the event that the plan is declared effective by the Board of Directors upon the terms and conditions stated in the plan, the holders of the shares of Convertible Preferred Stock now outstanding will be offered, in exchange therefor, shares of the new Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, on the basis stated in the plan and summarized above.
By accepting the offer and making the exchange, holders of the existing Cumulative Preferred Stock will thereby release their claim to all dividends accrued1940 BTA LEXIS 875">*908 and in arrears on the outstanding Cumulative Preferred Stock.
42 B.T.A. 1287">*1301 Nevertheless, after much consideration of all the facts, the primary intent of the plan, and the statutes, we do not think the result desired by the petitioner can be said to follow. In the first place, it can not accurately be said that the four-tenths share of new preferred stock was issued in consideration of the surrender of the right to the accumulated dividends. The record made by the parties at the time shows that the consideration for the stock and cash received was not divided, but was both the surrender of the old stock and the surrender of the right to accumulated dividends. Thus the initial letter to the stockholders of April 27, 1937, to which reference is made above, provides "a plan of recapitalization * * * whereby the present Convertible Preferred Stock * * * may be exchanged for a new Cumulative Prior Preferred Stock * * * and an adjustment of the unpaid dividends on the present Convertible Preferred Stock may be effected." Later the same instrument recites:
Briefly stated, the offer provides for an exchange on the basis of 1.4 shares of the new Cumulative Prior Preferred Stock, 5%1940 BTA LEXIS 875">*909 Convertible Series, plus $5.50 in cash, for 1 share of present Convertible Preferred Stock (as reclassified into Class A Preferred Stock) and a release of all claim to accumulated unpaid dividends on the present Convertible Preferred Stock on the conditions stated in the plan.
Under this language it appears that there was an exchange of 1.4 shares of new stock and $5.50 in cash for one share of old stock "and a release of all claim to accumulated unpaid dividends" (italics supplied) on the old stock, and that four-tenths share of stock was not exchanged merely "for the release of all claim to accumulated unpaid dividends" on the old stock. The printed "Plan of Recapitalization" under the heading "Offer of Exchange" provides that the holders of old stock "will be offered in exchange therefor 1.4 shares of the Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, on the terms and conditions hereinafter set forth"; and that:
By making the exchange, holders of the existing Cumulative Preferred Stock will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears on the outstanding Cumulative Preferred Stock.
From this1940 BTA LEXIS 875">*910 language it appears that by making the exchange of stock for stock the holders of the old stock "will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears" [italics supplied] on the old stock. Another letter to the stockholders of June 7, 1937, says that "By accepting the offer and making the exchange, holders of the Convertible Preferred Stock will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears on such Preferred Stock." A resolution of petitioner's board of directors on July 15, 1937, declaring the "Plan of Recapitalization" effective as approved by the stockholders on May 26, 1937, and referring to the new stock, says: "* * * 42 B.T.A. 1287">*1302 such stock to be issued in exchange for, and in consideration of the delivery to the Corporation for cancellation of, shares of the [old stock] * * * on the basis of 1.4 shares of such new Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, for each share of" the old stock. The same resolution recites "that in the opinion of this Board of Directors the present value of the full consideration, i.e., shares without par value1940 BTA LEXIS 875">*911 [of the new stock] * * * together with the release and discharge of all claims to accrued unpaid dividends [on the old stock] * * * amounting to $45.50 per share * * * to be received by this Corporation for the issuance of its shares of new Cumulative Prior Preferred Stock * * * is not less than $140 per share for each share of such Convertible Preferred Stock and the said release so to be received as the consideration for the issuance of the shares of new Preferred Stock." In the face of this language, we think it can not with reason be considered that there was, separate from the exchange of stock for stock, such an exchange of four-tenths share of stock for the right to unpaid accumulated dividends as to constitute payment of dividends to the extent of $45.50. Either the consideration for the 1.4 shares of new stock and $5.50 was one share of old stock and the release of the right to accumulate dividends, or the stock was exchanged for stock, thus complying with the text of section 112(b)(2), (3) and (c)(1) and "thereby" there was effected the discharge of the right to dividends - which in effect is the same thing. One consideration appears for both the release of the1940 BTA LEXIS 875">*912 old stock and the release of the right to accumulated dividends.
From all this we conclude that a consideration for the exchange is not separable between old stock and the right to dividends accumulated thereon. Recently, in South Atlantic Steamship Line,42 B.T.A. 705">42 B.T.A. 705, we had before us a situation very analogous to that herein present, and held:
In the course of readjustment of the capital structure of a corporation petitioner exchanged preferred stock upon which dividends were in arrears for new stock, bonds, and cash. Held, that receipt of the new stock was neither a dividend nor essentially equivalent to a dividend under section 115(a) and 115(g) of the Revenue Act of 1936; held, further, that the stock, debenture bonds, and cash were received by petitioner in the course of a reorganization and gain is recognized under section 112(c)(1) only to the extent of the cash received.
The petitioner urges that the question there was merely one of recognition or nonrecognition of gain or loss under the sections of the statute above noted in the quotation, while here we have a different question, that is, whether there is a right to dividends paid credit1940 BTA LEXIS 875">*913 under section 27. But petitioner's right to a dividends paid credit depends fully upon whether the distribution is taxable under section 27(h). If it were true that the distribution is a "dividend" it must 42 B.T.A. 1287">*1303 still be taxable under section 27(h), and in the South Atlantic Steamship Line case, supra, we held that it is not. Therefore it seems inescapable that the South Atlantic Steamship Line case is controlling here, for there, as here, there was exchange of preferred stock upon which dividends were in arrears for new stock and cash (and bonds not here involved). The respondent there took the position which petitioner takes herein, that is, "that the noncumulative preferred stock was received by petitioner in exchange for arrears in dividends on the old stock and is taxable as a corporate dividend." The respondent also urged that the petitioner there realized recognizable gain "on the receipt of new preferred stock, debenture bonds, and cash." The petitioner contended that the gain was recognized only to the extent of the cash received. We held that the readjustment of capital structure was recapitalization within the statutory definition of section 112(g)(1)(D) 1940 BTA LEXIS 875">*914 and that the exchange of securities was made pursuant to that plan and under sections 112(b)(3) and 112(c)(1). Further, upon respondent's contention "that the right to undeclared accumulated dividends is separate and apart from the preferred shares" and therefore essentially equivalent to a dividend, we cited Commissioner v. Food Industries, Inc., 101 Fed.(2d) 748, where the holders of preferred stock upon which dividends were accrued but unpaid "received common stock of a new corporation in exchange for the preferred stock and also received sinking fund debentures of the new corporation for the arrearages in dividends" and where the court held that the receipt of common stock and sinking fund debentures was not taxable. Commenting on the Food Industries case, we said: "The right to arrears and dividends was not considered apart from the stock upon which the arrearages arose." We called attention to the fact that the same reorganization with respect to other shareholders was considered "by the Circuit Courts of Appeals for the First, Second, Fourth, and Ninth Circuits with the same result. 1940 BTA LEXIS 875">*915 Commissioner v. Whitaker, 101 Fed.(2d) 640; Helvering v. Schoellkopf, 100 Fed.(2d) 415; Helvering v. Leary, 93 Fed.(2d) 826; Commissioner v. Kolb, 100 Fed.(2d) 920."
From the above it appears that there was more reason in Commissioner v. Food Industries, Inc., supra, to separate the arrearages in dividends from the stock than there is here, because there they were exchanged not for the stock, but for "sinking fund debentures of the new corporation" while here they were exchanged for a consideration common to them and to the old stock.
Being unable to distinguish the present proceeding in principle from the authorities above cited, we conclude and hold that there was a nontaxable exchange within the purview of sections 112(b)(2), (3) and (c)(1) and 112(g)(1)(D) of the Revenue Act of 42 B.T.A. 1287">*1304 1936, and that therefore under the provisions of section 27(h) of the same act no dividends paid credit is allowable to the petitioner, and that the respondent did not err in denying the credit claimed.
2. Our conclusion on the first issue is decisive of the second, wherein petitioner1940 BTA LEXIS 875">*916 claims deduction as ordinary and necessary expenses of $15,000 paid for attorneys' fees in connection with the transaction hereinabove discussed. The parties agree that the amount was reasonable for the services rendered in the matter. Since we have above held the transaction to be a reorganization by recapitalization under section 112(g)(1)(D) of the Revenue Act of 1936, it follows that the amounts paid therefor are capital expenditures. Holeproof Hosiery Co.,11 B.T.A. 547">11 B.T.A. 547; Odorono Co.,26 B.T.A. 1355">26 B.T.A. 1355. We hold that the respondent did not err in denying the deduction.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 27. CORPORATION CREDIT FOR DIVIDENDS PAID.
(a) DIVIDENDS PAID CREDIT IN GENERAL. - For the purposes of this title, the dividends paid credit shall be the amount of dividends paid during the taxable year. ↩
2. (h) NONTAXABLE DISTRIBUTIONS. - If any part of a distribution (including stock dividends and stock rights) is not a taxable dividend in the hands of such of the shareholders as are subject to taxation under this title for the period in which the distribution is made. no dividends paid credit shall be allowed with respect to such part. ↩
3. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(b) EXCHANGES SOLELY IN KIND. -
* * *
(2) STOCK FOR STOCK OF SAME CORPORATION. - No gain or loss shall be recognized if common stock in a corporation is exchanged solely for common stock in the same corporation, or if preferred stock in a corporation is exchanged solely for preferred stock in the same corporation.
(3) STOCK FOR STOCK ON REORGANIZATION. - No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.
* * *
(c) GAIN FROM EXCHANGES NOT SOLELY IN KIND. -
(1) If an exchange would be within the provisions of subsection (b)(1), (2), (3), or (5) of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
* * *
(g) DEFINITION OF REORGANIZATION. - As used in this section and section 113 -
(1) The term "reorganization" means * * * (D) a recapitalization * * *. ↩
4. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
* * *
(h) EFFECT ON EARNINGS AND PROFITS OF DISTRIBUTIONS OF STOCK. - The distribution (whether before January 1, 1936, or on or after such date) to a distributee by or on behalf of a corporation of its stock or securities or stock or securities in another corporation shall not be considered a distribution of earnngs or profits of any corporation -
(1) if no gain to such distributee from the receipt of such stock or securities was recognized by law, or
(2) if the distribution was not subject to tax in the hands of such distributee because it did not constitute income to him within the meaning of the Sixteenth Amendment to the Constitution or because exempt to him under section 115(f) of the Revenue Act of 1934 or a corresponding provision of a prior Revenue Act.
As used in this subsection the term "stock or securities" includes rights to acquire stock or securities. ↩