Cluett, Peabody & Co. v. Commissioner

Cluett, Peabody & Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Cluett, Peabody & Co. v. Commissioner Docket No. 112444 United States Tax Court 3 T.C. 169; 1944 U.S. Tax Ct. LEXIS 204; January 31, 1944, Promulgated *204 Decision will be entered under Rule 50. The disposition to its shareholders of treasury shares among new shares in a readjustment of the corporation's capital, which treasury shares had been acquired in a prior year as a step in an employee profit-sharing plan which had not been carried out, held under the circumstances not to be a transaction the real nature of which was similar to a sale of the shares of another corporation, and the corporation did not realize a taxable gain. Regulations 94, art. 22 (a)-16. Norris Darrell, Esq., for the petitioner. Harold D. Thomas, Esq., for the respondent. Sternhagen, Judge. Opper, J., dissenting. Hill, J., agrees with this dissent. STERNHAGEN *170 A deficiency of $ 40,699.02 in 1937 income tax was determined as the result of several adjustments. The taxpayer assails only a determination that gain was realized on the sale of treasury stock. The case was submitted on a stipulation of facts, and they are found substantially as requested by the Commissioner. FINDINGS OF FACT. Petitioner is a corporation organized under the laws of the State of New York, with its principal office in Troy, New York. From October*205 1931 to and including March 1933, by authorization of its board of directors, petitioner purchased through brokers 4,100 shares of its own common stock for the purpose of utilizing them under a profit-sharing plan pursuant to which certain officers and employees were to receive a share of annual net profits in excess of a stipulated amount, payable at taxpayer's election in its own common stock. The net profits never exceeded the specified amount and no bonus distributions were ever made. The 4,100 shares purchased as aforesaid, together with one additional share subsequently purchased, remained in the petitioner's treasury at the time of the plan referred to below. In 1937 petitioner amended its charter and put through a plan whereby its 250,000 authorized common shares without par value were split three-for-one into 750,000 shares without par value, and the holders of the 564,870 new shares (188,290 old shares) outstanding in the hands of the public were offered rights to subscribe to one additional share for each five shares held. Such offering totaled 112,974 of the new shares, of which 100,671 shares represented authorized but unissued stock and the remaining 12,303 shares, *206 treasury stock. The offer was evidenced by transferable printed warrants issued to the stockholders. The sale of the unsubscribed portion of the common shares so offered to the stockholders was underwritten by bankers. In connection with the above plan and stock offering, a form letter dated May 11, 1937, signed by petitioner's president, was directed to all the stockholders, the material part of which was as follows: The Board of Directors of your Company has approved and recommended to the stockholders that each share of Common Stock without par value of the Company be subdivided into three shares of the same class without par value and, in that connection, that the statement respecting the capital of the Company contained in its Certificate of Incorporation, as amended, be changed appropriately. At the present time, the Company has 250,000 shares of Common Stock without par value authorized, of which 188,290 shares are issued and outstanding in the hands of the public and 4,101 shares are owned by the Company and held in its treasury. Upon subdivision of the shares of Common Stock as proposed, the Company will have 750,000 shares of the Common Stock without par value authorized, *207 of which 564,870 shares will be outstanding in the hands of the public and 12,303 shares will be owned by the Company and held in its treasury. In connection with the foregoing change, the capital of the Company in respect of the *171 shares of Common Stock is to be changed from an amount equal to $ 19.45 per share, as now provided in the Certificate of Incorporation, to an amount equal to $ 6.50 per share, after subdivision, or an aggregate of $ 3,751,624.50, which will represent a slight increase to avoid an awkward fraction. * * * As soon as practicable after the stockholders have authorized the proposed changes in the Certificate of Incorporation, the Company will give effect to the subdivision by distributing to stockholders certificates for two additional shares of Common Stock for each share at the time held. * * * As a result of the continued improvement in its business which has already been reflected in reports to stockholders, the Company requires additional working capital to provide for the corresponding increases in inventories and accounts receivable, as well as for certain necessary additions to plant facilities. In view of the undistributed profits tax, your*208 Directors believe that the expense to the Company of providing these funds solely from profits would be prohibitive. Accordingly, after the above mentioned changes in the Common Stock have become effective, the Company proposes to offer to its Common stockholders the privilege of purchasing additional shares of new Common Stock in the ratio of one share for each five shares of Common Stock held of record. The Company is taking steps to register this stock under the Federal Securities Act, and no offering of additional shares can lawfully be made until such registration statement becomes effective. According to present plans, it is expected that the registration statement will become effective, and the offering of the additional shares of Common stock will be made, during the latter part of June. Common stockholders will be informed of the details of the proposed offering in due course after they have been determined. The Company proposes to make arrangements with a group of investment bankers, headed by Goldman, Sachs & Co., whereby they will agree to purchase such of the additional shares offered to Common stockholders as are not subscribed for by them. On June 15, 1937, a form*209 letter signed by the president was directed to the common stockholders advising that the stockholders had approved the proposed division of each share of no par common stock, both issued and unissued, into three shares of common stock without par value, that the certificate of amendment necessary for effecting the change, providing for two additional shares for each share then held, would be filed in the office of the Secretary of State of New York on or about June 18, 1937, and that the certificates for additional shares would be mailed promptly thereafter. The letter also recited: At a meeting held Monday, June 14, 1937, your Board of Directors determined to sell 112,974 shares of Common Stock (after the three-for-one subdivision of the Common Stock has become effective), such shares first to be offered to Common Stockholders of the Company in the ratio of one (1) share for each five (5) shares held of record at 3 o'clock P. M., Eastern Daylight Saving Time, on Friday, June 25, 1937 at the price of $ 22.00 per share, which, of course, means the shares after their subdivision. The right of subscription will expire at 3 o'clock P. M., Eastern Daylight Saving Time, on Thursday July*210 15 1937. A registration statement with respect to the shares thus to be offered has been filed with the Securities and Exchange Commission and, subject to its becoming effective and the completion of certain other formalities, subscription warrants exercisable on or before 3 P. M., Eastern Daylight Saving Time, on *172 Thursday, July 15, 1937, together with a copy of the Prospectus relating to the shares, will be mailed on or about June 25, 1937. By letter of instruction dated June 25, 1937 from the president to the common shareholders each holder of common stock was furnished with a printed "Warrant to Subscribe for Shares of Common Stock without Par Value," which stated the number of shares for which the stockholder was "entitled to subscribe * * * upon the terms and conditions herein set forth and pursuant to the offer contained in the Prospectus." The letter of June 25 advised that the registration statement filed with the Securities and Exchange Commission became effective June 21, 1937, and recited that the warrants "are sent to you in connection with the offering of 112,974 shares * * * notice of which was given you by letters dated May 11, 1937, and June 15, 1937." The*211 letter of June 25 also contained the following: The offering of the above shares under such Registration Statement is made solely by the Prospectus, a copy of which is enclosed, and upon the information contained therein. The prospectus which was enclosed with the letter of June 25 set forth the business and history of the corporation, its "Properties," "Management," "Proceeds and Purpose of Financing," "Capitalization," "Earnings and Dividends," "Description of Capital Stock," and other provisions, including a statement that the underwriters had agreed to purchase at $ 22 a share the "unsubscribed portion" of the 112,974 shares of common stock. The prospectus contained the following recital: Of the consideration to be received by the Company for 100,671 out of the 112,974 shares of common stock, $ 6.50 per share, being the stated value thereof, is to be credited to capital, pursuant to the provisions of the Certificate of Incorporation, as amended, and the remainder is to be credited to capital surplus. The remaining 12,303 shares are now carried as treasury stock at their aggregate cost of $ 56,607.05 and are also included in the capital account at their stated value of $ 6.50*212 per share. Accordingly, of the consideration to be received for these 12,303 shares, $ 56,607.05 will be credited to the treasury stock account and the remainder to capital surplus. On the balance sheet of December 31, 1936, the treasury shares did not appear as an asset. Relative to the proceeds and purpose of financing, the prospectus recited: The net proceeds to be received by the Company from the sale of the 112,974 shares of common stock, after deducting estimated expenses in connection therewith, are estimated at a maximum of $ 2,388,669.70 and a minimum of $ 2,332,182.70, depending upon the number of shares subscribed for by warrant holders. The proceeds from the exercise of the warrants will be received by the Company on or before July 15, 1937, the expiration date of the warrants. The period within which the Company will receive the proceeds from any unsubscribed shares of *173 common stock which may be purchased by the Underwriters is set forth under the caption, "Underwriting Arrangements." Approximately $ 550,000 of the net proceeds is to be used for additions and betterments to plant facilities, as described more fully below. The remainder, estimated at a maximum*213 of $ 1,838,669.70 and a minimum of $ 1,782,182.70, is to be used as additional working capital, principally for the purposes of carrying increased inventories and accounts receivable, necessitated by increased volume of business, and for the repayment of short term notes payable, outstanding as of June 1, 1937 in the amount of $ 1,350,000, which were incurred within one year for similar purposes. Of the notes payable, $ 750,000 consisted of commercial paper purchased and resold by Goldman, Sachs & Co. In addition to common stock, petitioner's capitalization also consisted of authorized preferred stock of 38,000 shares, of which 33,990 shares were outstanding in the hands of the public at the beginning of the taxable year. The underwriting agreement was with Goldman, Sachs & Co. of New York. Such agreement included a recital of the necessary acts to be accomplished, the agreement of the underwriters to purchase at $ 22 a share all of the 112,974 shares not taken by the stockholders, and a statement of the commissions payable to the underwriters. All of the 112,974 shares of common stock offered were subscribed for by stockholders in accordance with the terms of the offering, excepting*214 1,874 shares which the underwriters were called upon to take up. The net proceeds of the offering were intended to be and were used for the purposes specified in the prospectus. In delivering certificates for the 112,974 shares purchased under the offering, petitioner included the 12,303 trasury shares into which the above mentioned 4,101 shares had been converted, and took 100,671 shares out of authorized but theretofore unissued stock. At that time petitioner had 172,827 authorized but theretofore unissued shares. Of the consideration received by petitioner for 100,671 out of the 112,974 shares of common stock so offered, $ 6.50 per share, being the stated value thereof, was credited to capital, pursuant to the provisions of the certificate of incorporation, as amended, and the remainder was credited to capital surplus. Of the consideration received for the remaining 12,303 shares, which had been carried as treasury stock at their aggregate cost of $ 56,607.05 and also included in capital account at their stated value of $ 6.50 per share (after the three-for-one split), $ 56,607.05 was credited to the treasury stock account and the remainder to capital surplus. Respondent has*215 included in petitioner's gross income for 1937 the amount of $ 206,369.57 representing the difference between the cost of the 4,101 shares of petitioner's stock purchased by it and the sale price of the 12,303 shares of petitioner's treasury stock disposed of. *174 Petitioner in 1937 incurred a liability in the amount of $ 5,046.77 to its common stock transfer agent, Manufacturers Trust Co. of New York, for services rendered in connection with the issuance and sale of the stock described in the above transactions. No portion thereof has been allowed by respondent as a deduction from gross income for 1937. The portion of the $ 5,046.77 attributable to the shares of treasury stock involved in the transfer is $ 549.60. Petitioner's income tax return for the year 1937 was filed with the collector of internal revenue for the fourteenth district of New York, Albany, New York. Of the total deficiency of $ 40,699.02 asserted in the deficiency letter annexed to the petition herein as Exhibit A, $ 8,986.56 was paid to the said collector after the mailing of said notice of deficiency, to wit, on August 21, 1942. No part of the deficiency of $ 40,699.02 has been assessed. OPINION. The*216 excess ($ 206,369.57) over cost ($ 56,607.05) received by the taxpayer corporation for 12,303 shares among the 112,974 shares disposed of by it in 1937 to subscribing shareholders is treated by the Commissioner as taxable gain, and this the taxpayer challenges as contrary to Regulations 94, article 22 (a)-16. Both parties recognize that this article of the regulations is controlling. Cf. ; ; . The question for decision is therefore confined to whether the "real nature of the transaction" disposing of the 12,303 shares, "under all the facts and circumstances," was a dealing by the corporation in its own shares "as it might in the shares of another corporation." . Except for the fact that the corporation disposed of the shares for money, there is no similarity between this disposition and a sale of shares of another corporation. The corporation was not "dealing" in*217 its own shares. Neither the acquisition of the shares nor their disposition, although both were under different circumstances and with different motives and under different plans, could or would have been considered or carried out in the shares of another corporation. Profit was not behind the impulse to acquire these shares in the first place or behind the later impulse to distribute them to shareholders. The first was a step in a profit-sharing plan for employees, whereby the employees might acquire or enlarge their proprietor interest in the business. This could not have been achieved by acquiring the shares of another corporation. The profit-sharing plan was inoperative only because the necessary earnings upon which it was conditioned had not been realized. The disposition in 1937 was likewise not actuated by a motive to sell at a profit, but by the new general plan *175 to restate the corporation's capital and issue more shares as a method of procuring additional funds for capital purposes. The accounting for both these transactions manifests this absence of a profit motive as an explanation of the transactions. The shares were not carried as an asset. The cost was*218 kept in the treasury stock account and the excess received from the shareholders' subscriptions allocable to 12,303 shares was assigned to the capital and the capital surplus accounts, none of the proceeds being accounted for as earnings or profits or posted to the earned surplus account. If, however, the corporation had been dealing in the shares of another corporation, they would have been carried as an asset, the acquisition in the first place could not have appeared in the treasury stock account, and the proceeds of sale, whether to its shareholders, employees, or to outsiders, would have been credited to earnings and profits and posted to earned surplus. These bookkeeping matters are, of course, not controlling as to the legal or real nature of the transaction, but they are not without significance in considering whether the corporation was dealing in its own shares as it might in the shares of another corporation. The disposition of these shares may not be treated as if it were a separate and isolated transaction whereby 12,303 treasury shares were sold for cash. The regulations say that the characterization for tax purposes depends upon the real nature of the transaction. *219 The real nature of this transaction in so far as it relates to these 12,303 shares is that it was an incident of the adjustment of the corporation's capital stock as a means of getting new funds needed for capital purposes. Nothing in the record indicates that the 12,303 shares were being dealt with by themselves or that they would have been dealt with as a disposition of treasury shares if there had been no program of recapitalization. It was but part of a method of getting larger investments from the shareholders, after which the further capital needs were to be procured by selling additional new shares to bankers. To say that the whole refinancing is to be regarded as a means of selling these treasury shares at a profit and escaping tax upon the gain is to misplace the emphasis. The corporation might, to be sure, have accomplished its refinancing purpose without using these treasury shares, and if it had done so, the present controversy would not have arisen; but it seems to us unreasonable to say that the disposition of the treasury shares was a cleverly devised means of realizing a gain and avoiding tax upon it. The reference in the May 11, 1937, letter to the undistributed*220 profits tax has no more significance here than in the Dr. Pepper case. It simply meant that since the corporation could not avoid the undistributed profits tax by using its existing earned surplus for plant and equipment it might better procure its new working capital by the method of issuing new shares. This rationale does not *176 affect the characterization of the disposition of the 12,303 treasury shares as a step in that method. The real nature of the disposition of all the 112,974 shares was a means to procure additional capital, and in this the use of the treasury shares was a part. We hold that the corporation thereby realized no gain, and that the Commissioner's determination was incorrect. The facts and circumstances in the present case lead as directly to the conclusion that this was not a realization of gain as did those in the Dr. Pepper Bottling case, where the Commissioner's determination of gain was reversed. The purpose of the purchase of the corporation's shares, in that case, was a redistribution of shares among the shareholders; here it was a plan for profit sharing among the officers and employees. The purpose of the sale, in that case, of the*221 treasury shares although it was a departure from the original purpose was a readjustment of capital, and the undistributed profits tax threatened if the earnings were used for capital purposes instead of being distributed; the same is true in the present case. In both cases, the threefold criterion of the real nature of the transaction is present. See also . The cases of ; ; , and , are all cases where the sale of the corporation's treasury shares was merely a sale, albeit, in the three earlier cases to employees, and there were no circumstances which gave it a character or effect different from a sale of the shares of another corporation. In none of them were the circumstances such as to establish that the sale was not a mere sale but was instead an element in the *222 readjustment of the corporation's capital. The taxpayer, as a precautionary second point, pleaded the deductibility of a payment of transfer agent's fees of $ 5,046.77, but concedes that if it is successful in overcoming the determination as to the $ 206,369.57 such a deduction is not available to it. Decision will be entered under Rule 50. OPPER Opper, J., dissenting: If we were free to follow our own judgment on this subject, I should be more inclined to accept the Court's disposition of the present proceeding. But it seems to me the prevailing opinion can not be reconciled with the principle established by the decisions of the five Circuits which have now considered the question; and I do not think we are at liberty to disregard those decisions. See Commissioner v. Woods Machine Co. (C. C. A., 1st Cir.), 57 Fed. (2d) 635; certiorari denied, 287 U.S. 613; Allen v. National Manufacture *177 (C. C. A., 5th Cir.), 125 Fed. (2d) 239; certiorari denied, 316 U.S. 679. Had petitioner adhered to its original program, no taxable income*223 would have resulted, and the present question would not have arisen. But that would have been the effect of the provisions of the plan which made it impossible for petitioner to realize any gain, since the stock was to be distributed at or below cost. It would not have followed from the character of the transaction. If the original program had been changed merely to the extent of permitting distributions to employees at a profit, instead of at cost, the result would have fallen squarely within the decisions of the Second and Eighth Circuits in , and Brown Shoe Co. v. and 575, respectively. Certainly, the mere purpose of employee stock participation does not mark the operation as an adjustment of capital. Cf. Judge Learned Hand's dissent in Commissioner v. Air Reduction Co. The further change culminating in the sale of the stock, not only at a profit but to different distributees, makes the petitioner's case even weaker and brings it within the recent decision of*224 the Sixth Circuit in , where, also, the ultimate sale took place because the taxpayer "found itself in need of additional capital to finance an expansion program." The situation is only superficially like that in . The adjustment of capital which the petitioner there accomplished by the original purchase of its stock was completed according to plan. It was not subsequently changed, and it did not contemplate an ultimate disposition as did the original plan of this petitioner. We were able to say in that case that there was "no inference that it was significant whether the stock was retained in the corporation's treasury or definitively retired." Here the stock would never be retired while the original plan persisted; and when that plan was abandoned in mid-course because petitioner needed cash, it was transmuted into one for handling the same shares in a manner comparable to any other property or to those of any other corporation -- one which readily could and actually did result in unmistakable profit. Petitioner was *225 not compelled by the terms of its employee participation plan to acquire the stock in the first place, for, unlike the situation in the Brown Shoe Co. case, for example, it could have discharged the obligation to its employees by the payment of cash. Thus, its purchase must have been due, it seems to me, like that in Dow Chemical Co. v. Kavanaugh, to the fact that petitioner "having idle funds not needed in its operations, and knowing the value of its own stock, *178 did what any other prudent investor would have done -- bought it when its price was low." I conclude, at least under the now outstanding decisions, that when a corporation buys its stock with a view to future distribution and, in fact, engages in that future distribution at a profit, whether originally so designed or not, it has dealt in its stock as it would in other property and has subjected itself to tax. I respectfully dissent.