*961 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.
*705 This proceeding was brought for the redetermination of a deficiency in petitioner's income tax for the year 1937 in the sum of $630.60. By amended answer respondent asserted additional deficiencies in petitioner's income tax, excess profits tax, and surtax for the year 1937 in the amounts of $1,421.93, $26.14, and $495.45, respectively.
The first issue is whether or not noncumulative preferred stock received by petitioner in accordance with a recapitalization*962 of the company *706 which issued the stock was a corporate dividend taxable to petitioner in the year received. The second issue, which arises only if the Board holdes for respondent on the first issue, is whether or not a gain is recognizable on receipt of cash and securities under section 112(a) and 112(c)(1) and (2) of the Revenue Act of 1936. A third issue was abandoned by petitioner by stipulation.
FINDINGS OF FACT.
The facts were stipulated substantially as follows:
Petitioner is a corporation, organized under the laws of the State of Georgia, with its principal place of business in Savannah, Georgia.
On or about November 21, 1932, petitioner received, as part of a dividend from the Dixie Stevedoring Co., a wholly owned subsidiary of petitioner, 150 shares 8 percent cumulative preferred stock of the Southern Fertilizer & Chemical Co., hereinafter sometimes referred to as Fertilizer. At the time of the transfer to petitioner, the Fertilizer shares had a fair market value of $7,537.50. These shares were carried on petitioner's books at that value until a change in the capital structure of Fertilizer were effected.
Fertilizer was incorporated on September 25, 1905, under*963 the laws of the State of Georgia, with a capital of $40,000, which was paid in by March 27, 1906.
For the first five years of its existence the Fertilizer Co. operated a fertilizer mixing plant, but in the year 1909 it was decided to extend the operations of the company, thereby making necessary the building of a complete plant for the manufacture and curing of superphosphate and the enlargement of the mixing unit.
In order that funds might be available for building and raw materials, it was deemed advisable to declare stock dividends instead of cash dividends, thereby increasing the capital stock of Fertilizer.
In 1917 it was decided further to extend the operations of the company by adding to its properties a sulphuric acid plant.
Plant expenditures during the period from 1910 to 1918 appear on the books of the company as follows:
| Year | Item | |
| 1910 | Superphosphate and dry mixing plant | $54,023.47 |
| 1912 | Additional improvements | 8,255.09 |
| 1913 | do | 19,048.64 |
| 1914 | do | 762.68 |
| 1915 | do | 216.00 |
| 1917 | do | 196.71 |
| 1918 | do | 8,249.31 |
| Tools and equipment | 2,507.03 | |
| 1917 | Sulphuric acid plant | 211,166.34 |
| 1917-18 | Fish plant, St. Marys, Ga | 70,951.10 |
| Total | 375,376.37 |
*964 *707 The common capital stock of the company was increased as follows:
| Original cash subscription | $40,000 |
| March 31, 1910, stock dividend | 30,000 |
| August 4, 1910, stock dividend | 20,000 |
| March 15, 1911, stock dividend | 40,000 |
| October 24, 1911, stock dividend | 20,000 |
| May 31, 1916, stock dividend | 100,000 |
| July 7, 1918, stock dividend | 150,000 |
| August 1, 1918, stock dividend | 100,000 |
| Total | 500,000 |
These shares consisted entirely of common stock of the par value of $100 per share.
On February 14, 1919, fire destroyed the superphosphate and dry mixing plants, together with a large quantity of raw materials. All were fully covered by insurance and the company suffered no financial loss thereby.
Until this time the company had been extremely prosperous and prospects for continued successful operations were encouraging. A decision was made to replace the destroyed acidulating plant with a much larger building. Labor and material costs were at peak and in order to provide funds for the plant expansion, Fertilizer issued 8 percent cumulative preferred stock in the amount of $500,000. Dividends on these shares were payable quarterly on the first days*965 of January, April, July, and October of each year. The shares were to be redeemed on January 1, 1940, by the payment of par plus unpaid cumulative and accrued dividends. The preferred stock certificates also provided that:
So long as the dividends on the preferred stock are paid as contemplated the holders of the preferred stock shall have no voting power on any question; but should dividends on the preferred stock remain unpaid for the period of one year, then and so long as such dividends or any part thereof remain unpaid, holders of the preferred stock shall be entitled to the same voting powers as those belonging to the common stock. Upon the payment of such dividends in full the voting powers of the holders of the preferred stock shall again cease.
Of the $500,000 par value preferred stock issued in 1919, $477,562.50 was received in cash and $22,437.50 represented discount allowed purchasers on the issue.
The results of the operations of the company during previous years made the officers and stockholders of the company confident that there would be no difficulty in complying with the terms of the preferred stock certificates. This confidence was at first justified, *966 and during the succeeding year a net profit was earned of $219,350.37, whereby the company was able to pay not only dividends on the preferred stock in the amount of $58,850.55, but also a cash dividend on common stock in the amount of $50,000. These dividends, declared in June *708 1920 and November 1921, were the last dividends paid or declared on either class of stock, because of a period of deflation and depression that vitally affected the fertilizer industry. Manufacturers were caught with large stocks both of raw materials and of goods manufactured in preparation for the spring trade. Prices broke rapidly, so that by the time the shipping season arrived complete fertilizers were being sold at less than cost of production. Severe losses resulted.
It became difficult for Fertilizer to continue operation because of lack of funds. On February 1, 1924, in order to obtain new operating capital the company, with the consent of the preferred shareholders, issued first mortgage bonds with a face value of $500,000. The bonds bore 8 percent interest and matured serially, $50,000 each year, beginning December 1, 1927. The bonds were issued at 20 percent discount. As of*967 November 30, 1936, $125,000 face value of these bonds was still outstanding.
Unhappy conditions in the fertilizer industry continued until the fiscal year ended May 31, 1935. At that time the capital of the company consisted of 5,000 shares of the common stock and 4,742 shares of 8 percent cumulative preferred stock (258 shares of the cumulative preferred stock being held as treasury stock and never reissued), each of the par value of $100 per share.
As of May 31, 1935, unpaid accumulated dividends on the preferred stock which had never been expressly declared aggregated $537,426.66.
At a regular monthly meeting of the board of directors of Fertilizer held on April 15, 1935, the directors had an informal discussion concerning adjustment of the company's preferred stock and its accumulated dividends, but no action was taken at that time.
The directors first considered a plan for the readjustment of Fertilizer's capital structure recommended by A. Minis, Jr., an investment counsel. This plan was submitted to the shareholders of the company at the call of the annual meeting of the shareholders to be held July 2, 1935. The shareholders reacted adversely to the plan.
*968 At the annual meeting of the stockholders held July 2, 1935, one of the directors, J. Byron Glover, duly made a motion for the appointment of a joint committee of common and preferred shareholders to consider the problem of the readjustment of the company's capital stock. A large proportion of preferred stock was represented at this meeting, the holders thereof being entitled to vote under the provisions of the preferred stock certificates because of the company's failure to declare and pay dividends.
Before action was taken on Glover's motion, J. Ferris Cann, who by proxy represented 955 shares of preferred stock, offered as a substitute for Glover's motion resolutions for the appointment of separate committees representing preferred and common stockholders, respectively. These resolutions were adopted.
*709 In due course the preferred shareholders' committee retained Cann as legal counsel, and M. H. Barnes & Co. of Savannah, Georgia, as accountants for the committee.
During the early part of 1936 the preferred stockholders' committee sought the assistance of A. C. Read, of Savannah, Georgia, whom they considered fitted by ability and experience to give aid in the*969 solution of the committee's problem. Read in due course evolved a plan, which he submitted to the preferred stockholders' committee in April 1936. His plan formed the basis of the plan finally recommended by the committee and ultimately carried into effect.
When the annual meeting of the stockholders was held July 7, 1936, the committee was not yet ready to make recommendations, and accordingly the minutes of the meeting refer only to a report by the chairman of some progress. At this meeting the fiscal year of the company and the date of the annual meeting of stockholders were changed.
Under date of September 17, 1936, a call was issued for a special meeting of preferred stockholders to be held October 2, 1936, enclosed with which was a copy of the plan, now in tangible form, as approved and recommended by both the preferred stockholders' committee and the common stockholders' committee acting under the resolutions of July 2, 1935.
The plan of reorganization of Fertilizer, which was approved and unanimously recommended by the shareholders' committees, contemplated that the amount of $1,011,626.66 due the preferred shareholders, represented by par value of preferred stock*970 outstanding in the sum of $474,200 and cumulative dividends through May 31, 1935, in the amount of $537,426.66, should be settled as follows: In exchange for the outstanding 8 percent cumulative preferred stock the company should give to the holders thereof 25-year 5 percent coupon debenture bonds with a total face value of $474,200. In full payment of the arrears in dividends on outstanding preferred stock, the company should (a) pay to the preferred shareholders pro rata cash in the sum of $37,426.66; (b) issue to the preferred shareholders noncumulative preferred stock bearing from 4 to 6 percent interest, dependent upon net income, provided that the net profits of the company amount to $20,000, with a total face value of $474,200; and (c) issue scrip representing one-twentieth of a share for each share of preferred stock then owned in a total amount of $25,800.
The plan so submitted was, with very minor modifications, approved in substance at the meeting of preferred stockholders held October 2, 1936. Counsel for the company was instructed to prepare all necessary forms for submission and the meeting was adjourned to October 26, 1936. After conferences between counsel for*971 the company and several attorneys representing various preferred stockholders, *710 forms to be used in effecting the changes provided for in the submitted plan were duly prepared and made available to stockholders.
At a special meeting of common stockholders held October 20, 1936, the plan was accepted and approved in principle.
On October 26, 1936, the adjourned meeting of preferred stockholders of October 2, 1936, reconvened and considered the plan originally submitted as interpreted by the forms which had meanwhile been prepared. These were duly approved and accepted.
On the same day, at special meeting of stockholders, both common and preferred, the plan, together with the forms to be employed, were duly approved in form and substance, and resolutions were adopted as to necessary amendments to the company's charter, as to the appointment of a depositary for the purpose of effecting the exchanges provided for in the plan, and as to the appointment of trustees for the holders of the respective securities to be issued pursuant to the plan.
This action by the stockholders was formally noted by the directors at a meeting held immediately following the special meeting*972 of stockholders on October 26, 1936. Notice of the action, together with a call for the deposit of preferred stock for exchange under the plan, was mailed by the company to stockholders under date of November 2, 1936.
Although the response of preferred stockholders was encouraging, a certain number were hesitant about depositing their stock. Reports as to progress were made to the directors at meetings held on November 16 and December 21, 1936.
At the annual meeting of stockholders held January 12, 1937, after hearing a report as to the amount of stock deposited, the stockholders in the meeting manifested their impatience of delay in a resolution directing the officers to proceed as rapidly as practicable, even to the extent of proceeding, if necessary, under the amended bankruptcy law.
Further comment as to deposits of stock was made at directors' meetings held on January 18 and February 15, 1937. Finally, on February 23, 1937, the directors felt justified by the proportion of stock deposited and adopted a series of resolutions declaring the plan effective and authorizing the several acts necessary to its consummation.
Under date of February 23, 1937, a notice over*973 the signature of the president of the company was sent to depositors of stock, advising them of this action.
The sum of $37,426.66 was, in accordance with the plan, paid in cash by the company to its stockholders in 1937.
*711 The surplus account has not been credited at any time with the $500,000 of $100 par value common stock canceled in 1937, nor has surplus been debited with any amount as the result of issuing 5,000 shares of no par value common stock.
Surplus and undivided profits earned by Fertilizer since March 1, 1913, and remaining accumulated on the date the old stock was exchanged for the new securities and cash were in the sum of $335,603.71.
As a result of the financial adjustment of Fertilizer's capital structure petitioner received in exchange for the 150 shares of 8 percent cumulative preferred stock owned by it the following:
(a) Cash of $7.89 per share on each of the 150 shares of 8% cumulative preferred stock or a total of $1,183.50. This amount has been reported by petitioner in its income tax return as dividends.
(b) 150 shares noncumulative preferred stock of a par value of $100 per share and a market value of $20 per share at the date*974 received in 1937.
(c) Right to 7 shares of scrip of a par value of $100 actually issued as 7 shares of preferred stock and having a market value of $20 per share at the date received in 1937.
(d) $15,000.00 par value debenture bonds having a market value of $75 for each $100 par value.
Petitioner's position in regard to Fertilizer stock before and after the capital adjustment of Fertilizer was as follows:
| Face value of securities | |||
| Before | After | Market value | |
| 150 shares 8% cumulative preferred stock | $15,000.00 | ||
| Accumulated dividends on above (about $113 per share) | $16,883.50 | ||
| 5% debenture bonds | $15,000.00 | $11,250.00 | |
| Cash on 150 shares ($7.89 each) | 1,183.50 | 1,183.50 | |
| 150 shares 5% preferred stock | 15,000.00 | 3,000.00 | |
| 7 additional shares received by petitioner on basis of scrip rights in accordance with the plan | 700.00 | 140.00 | |
| Total | 31,883.50 | 31,883.50 | 15,573.50 |
Until May 31, 1936, the fiscal year of Fertilizer ended on May 31. Thereafter, by amendment to the bylaws of the company, the fiscal year was fixed as closing on November 30 of each year.
OPINION.
VAN FOSSAN: The first issue for our determination is whether or*975 not new preferred stock of the Fertilizer Co. received by petitioner in accordance with a recapitalization of that company was a dividend taxable to petitioner under section 115 of the Revenue Act of 1936. Petitioner contends that the change in capital structure of the Fertilizer Co. constituted a reorganization and gain is recognizable on the exchange of the old stock for new stock, bonds, and cash only to *712 the extent of the cash received. Respondent argues, however, 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 second issue, which respondent urges in the alternative, is whether or not petitioner realized recognizable gain on the receipt of new preferred stock, debenture bonds, and cash other than to the extent of the cash received.
The latter issue is the more broad and, since its determination will narrow the field of inquiry, will be considered first. Petitioner contends that gain is recognized on the transaction only to the extent of the cash received. In order that petitioner may be sustained on this point it must show that there was a reorganization*976 within the meaning of the statute and that the exchange comes within one of the specific exceptions to the recognition of gain under section 112 of the Revenue Act of 1936.
The readjustment of the Fertilizer Co.'s capital structure is clearly a recapitalization and is within the statutory definition of reorganization provided by section 112(g)(1)(D) of the Revenue Act of 1936. There was a definite plan of reorganization for the Fertilizer Co. and the exchange of securities here under consideration was made pursuant to that plan. We are of the opinion that the exchange of cumulative preferred stock for securities and cash of the Fertilizer Co. comes squarely within the terms of section 112(b)(3) and 112(c)(1), 1 which provide that, where stock or securities of a corporation are exchanged pursuant to a plan of reorganization for stock or securities of that corporation plus cash or other property, gain may be recognized, but only to the extent of the cash or fair market value of the other property received.
*977 Respondent argues that even if we should find that there was a reorganization, the receipt of stock, bonds, and cash by petitioner is not within the terms of section 112(c)(1). He contends that although gain will not be recognized where stock or securities of the corporation in reorganization are exchanged are exchanged for stock or securities of that corporation, in the present case not only stock but also a right to *713 receive arrears in dividends was given in exchange for new securities and cash. His position is that the right to undeclared accumulated dividends is separate and apart from the preferred shares and consequently outside the statutory exception.
In Commissioner v. Food Industries, Inc., 101 Fed.(2d) 748, the holders of preferred shares of a corporation 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. The Circuit Court of Appeals for the Third Circuit held that by virtue of section 112(b)(3) of the Revenue Act of 1928 2 the receipt of common stock and sinking*978 fund debentures was not taxable. The right to arrears and dividends was not considered apart from the stock upon which the arrearages arose. 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. 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. Here the problem is more simple than that before the courts in the cited cases. The dividends of the Fertilizer Co. were in arrears but had not been declared. Although common stock dividends could not be paid without prior payment of arrears in preferred stock dividends, the right of the shareholders to the undeclared dividends was not in the nature of a debt. In brief, the right of the preferred shareholders to receive the dividend arrears was not one which could be divorced from the shares upon which it was based.
*979 Respondent has raised the question of whether the 25-year debenture bonds received by petitioner in exchange for its stock were "stock or securities" or "other property." Debenture bonds are securities of the issuing corporation. Karl B. Segall,38 B.T.A. 43">38 B.T.A. 43; Commissioner v. Food Industries, Inc., supra. Petitioner, therefore, comes within the terms of section 112(c)(1).
Section 112(c)(2) of the Revenue Act of 1936 3 is not applicable. There is no indication that receipt of new stock or securities by petitioner had the effect of a taxable dividend. The fact that the new *714 preferred shares were received in exchange for the right to dividend arrears does not give the new shares the effect of a taxable dividend.
*980 We now turn to the first issue. Respondent urges that since the new preferred stock was received in exchange for the dividend arrears on the old shares it is either a dividend taxable under section 115(a) of the Revenue Act of 1936 4 or a redemption of stock taxable as a dividend under section 115(g). 4
*981 In either case, the taxable distribution is limited to the extent that it represents a distribution out of earnings and profits of the corporation accumulated after February 28, 1913, or out of earnings and profits of the taxable year. The effect of subsections (a) and (g) of section 115, however, is limited by subsection (h) of section 115. 5 The latter section provides that a distribution by a corporation of its stock or securities shall not be a distribution out of earnings or profits if no gain to the distributee from the receipt of the stock or securities is recognized by law. We have already determined that by virtue of section 112(c)(1) gain to petitioner is recognized only to the extent of the cash received. It follows, therefore, that the preferred stock received by petitioner was not a dividend under section 115(a) nor "essentially equivalent to the distribution of a taxable dividend" under section 115(g).
*982 *715 We hold that receipt of the noncumulative preferred shares by petitioner was not a dividend nor essentially equivalent to a taxable dividend. We further hold that the Fertilizer Co. in the course of reorganization distributed stock, securities, and cash to petitioner and that gain on that distribution is recognized to petitioner only to the extent of the cash received.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(b) EXCHANGES SOLELY IN KIND. -
* * *
(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 os 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. ↩
2. This section is identical with section 112(b)(3) of the Revenue Act of 1936. ↩
3. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(c) GAIN FROM EXCHANGES NOT SOLELY IN KIND. -
* * *
(2) If a distribution made in pursuance of a plan of reorganization is within the provisions of paragraph (1) of this subsection but has the effect of the distribution of a taxable dividend, then there shall be taxed as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be taxed as a gain from the exchange of property. ↩
4. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
(a) DEFINITION OF DIVIDEND. -
The term "dividend" when used in this title (except in section 203(a)(3) and section 207(c)(1), relating to insurance companies) means any distribution made by a corporation to its share holders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.
* * *
(g) REDEMPTION OF STOCK. -
If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend. ↩
5. 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 earnings 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. ↩