Newton Trust v. Commissioner

JAMES Q. NEWTON TRUST, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. JAMES Q. NEWTON, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Newton Trust v. Commissioner Docket Nos. 97324, 97325. United States Board of Tax Appeals 42 B.T.A. 473; 1940 BTA LEXIS 997; August 6, 1940, Promulgated *997 Corporation A owned all the stock of B. In 1913 it had acquired substantially all the assets of B. B owed to holders of bonds $27,633,000, principal amount of first mortgage bonds. A also was a debtor to the holders of the bonds, having guaranteed payment of both principal and interest. When the bonds matured in 1934 A and B defaulted on both principal and interest, and filed petitions for corporate reorganization under section 77B of the Bankruptcy Act. The District Court for Colorado approved a plan of reorganization. Pursuant to this plan all the assets of A and B were transferred to C, a new corporation. The holders of the above bonds received stock and bonds of C in exchange for their bonds and immediately controlled C. Held, the reorganization under section 77B of the Bankruptcy Act constituted a reorganization under section 112(b)(3) of the Revenue Act of 1936, coming within the definition of a reorganization in section 112(g)(1)(C). Richard M. Davis, Esq., and Quigg Newton, Jr., Esq., for the petitioners. Angus R. Shannon, Jr., Esq., and Carroll Walker, Esq., for the respondent. HARRON *474 In Docket No. 97324, James*998 Q. Newton trust, the Commissioner determined a deficiency in income tax for the year 1936 in the amount of $12,325.60. Petitioner denies that there is a deficiency in tax and alleges that it has overpaid tax in the amount of $29,941.07. In Docket No. 97325, James Q. Newton, Jr., the Commissioner determined a deficiency in income tax for the year 1936 in the amount of $690.84. Petitioner denies that there is a deficiency in tax and alleges that he has overpaid tax in the amount of $296.59. Each petitioner concedes that some of the adjustments giving rise to the deficiencies have been determined correctly. The only question involved is whether the exchange of bonds of the Colorado Industrial Co. for stock and bonds of the Colorado Fuel & Iron Corporation, a newly organized corporation, pursuant to a plan of reorganization under section 77B of the Bankruptcy Act, constituted a reorganization under section 112(b)(3) of the Revenue Act of 1936. FINDINGS OF FACT. The James Q. Newton trust is a fiduciary trust, with its principal office at Denver, Colorado. Prior to September 10, 1936, the James Q. Newton trust owned $152,000 face amount of Colorado Industrial Co., first mortgage*999 5 percent bonds due August 1, 1934. James Q. Newton, Jr., is an individual residing in Denver, Colorado. Prior to September 10, 1936, he held $10,000 face amount of the same bonds of the Colorado Industrial Co. The Colorado Industrial Co., hereinafter called Industrial, was a Colorado corporation. It was wholly owned by the Colorado Fuel & Iron Co., hereinafter called Fuel & Iron, a Colorado corporation, which owned all of its capital stock, consisting of 200 shares. *475 Fuel & Iron had been engaged in the manufacture and sale of steel and iron products. Industrial was not engaged in any active business and had no assets of any substantial value, having transferred substantially all of its assets to Fuel & Iron in the year 913. Under date of August 1, 1904, Industrial issued bonds, generally known as first mortgage 5 percent bonds, which were secured by a mortgage or deed of trust of Industrial. The bonds matured August 1, 1934. These bonds of Industrial were unconditionally guaranteed both as to principal and interest by Fuel & Iron. These bonds were Industrial's only securities outstanding in the hands of the public. The total face amount of these bonds held*1000 by the public on August 1, 1934, was $27,633,000; in addition, Fuel & Iron owned $7,741,000 face amount. Industrial defaulted in the payment of interest on these bonds due on August 1, 1933, and on subsequent interest installments; and Fuel & Iron defaulted under its guarantee of interest payments. Fuel & Iron had outstanding in the hands of the public in 1933 $4,500,000 face amount of bonds known as general mortgage 5 percent bonds. On August 1, 1933, Fuel & Iron defaulted in the payment of the semiannual interest due on its bonds. On the same day a receiver for the properties of Fuel & Iron was appointed by the United States District Courts of Colorado and Wyoming. Following the receivership of Fuel & Iron committees were constituted for the purpose of representing bondholders and stockholders of Fuel & Iron and for the bondholders of Industrial. There was outstanding stock of Fuel & Iron consisting of 20,000 shares of 8 percent cumulative preferred stock, $100 par value per share, and 340,505 shares of common stock, no par value. The preferred stock was entitled to cumulative dividends at the rate of 8 percent per annum, but ranked equally with the common stock in the distribution*1001 of assets. Dividends had not been paid on the preferred stock since November 25, 1931. On August 1, 1934, when Industrial and Fuel & Iron defaulted on Industrial's first mortgage 5 percent bonds, each company filed petitions with the United States District Court for Colorado instituting proceedings for reorganization under section 77B of the Federal Bankruptcy Act. The previously appointed receiver of Fuel & Iron was appointed trustee of the properties of both companies in the reorganization proceedings. A plan of reorganization of Fuel & Iron and Industrial, dated March 1, 1935, was drafted by the reorganization managers at the request of the separate committees for the bondholders of the two companies, and this proposed plan, pursuant to section 77B of the Bankruptcy Act, was filed with the District Court. On May 1, 1935, an order of the District Court was entered finding and decreeing that *476 the plan complied with the provisions of subdivision (b) of section 77B of the Bankruptcy Act, and that it had been duly prepared in accordance with subdivision (d) of section 77B. Among other things the court directed the trustee to mail copy of the plan and forms of acceptance*1002 of the plan to holders of bonds and stocks of Fuel & Iron, and of bonds of Industrial; which was done. Acceptances of the plan were filed by the holders of Industrial bonds and of the preferred and common stock of Fuel & Iron as follows: Security Amount outstanding Plan approved by holders of - Industrial bonds $27,633,000 75.7% Fuel & Iron pfd. stock 20,000 shares 61.3% Fuel & Iron com. stock 340,505 shares 53.2% On April 25, 1936, the District Court entered its order confirming the plan. By this order the court approved the certificate of incorporation of a new corporation, the Colorado Fuel & Iron Corporation, hereinafter referred to as the new company. That certificate had been filed in the office of the Secretary of State of Colorado on April 16, 1936. The authorized capital of the new company was 1,000,000 shares of common stock without par value. On June 20, 1936, the District Court entered its order approving forms of documents and directing, among other things, the transfer of all of the assets of Fuel & Iron and Industrial to the new company, which was done by executing proper conveyances. The purpose of the reorganization plan was*1003 as follows: (1) To strengthen the capital structure of the enterprise, through drastic reduction of fixed charges and the provision of a financing medium for future financial requirements. (2) To give full recognition to the paramount rights of bondholders. (3) To enable the stockholders to regain an interest in the enterprise upon a basis which takes account of the present junior rank of the stockholders and of the relative rights and priorities of the two classes of stock. The effect of the plan was to give to the holders of Industrial's bonds the entire ownership and control of the new company, subject to $4,500,000 bonds of Fuel & Iron which were not to be disturbed in the reorganization. Since the Industrial bonds were in default on both principal and interest, the only stock of the new company to be issued was 552,660 shares which were to be issued to the holders of Industrial bonds in exchange. Under the approved plan of reorganization and orders of the District Court the following was done: *477 (1) As of July 1, 1936, the assets of Fuel & Iron and of Industrial were transferred by proper conveyances to the new company. (2) The new company issued*1004 552,660 shares of its stock to be distributed to holders of bonds of Industrial, reserved 315,379 shares to be applied against warrants, and reserved the remaining 131,961 shares for corporate purposes. It issued $11,053,200 principal amount of 5 percent income mortgage bonds due April 1, 1970, to be distributed to Industrial's bondholders. It assumed payment of $4,500,000 general bonds of Fuel & Iron, which bonds were not affected by the reorganization plan. If issued warrants for the purchase, on or before April 1, 1950, of 315,379 shares of its stock at $35 a share to be distributed to the preferred and common stockholders of Fuel & Iron. The warrant agreement entered into between the new company and the Chase National Bank of New York, warrant agent, under date of July 1, 1936, provided that the Holders of warrants should not have the right to vote or to receive notice as stockholders, and should have no rights whatsoever as stockholders of the new company. The option price under the warrants was considerably higher than the opening market price for shares of the new company. (3) The reorganization managers gave notice to the holders of Industrial's bonds and Fuel & *1005 Iron's stock that the new securities would be available for distribution on September 1, 1936. (4) At or about that date the holders of Industrial bonds surrendered their bonds for cancelation in exchange for income mortgage bonds and stock of the new company upon the basis of (a) $400 principal amount of income bonds and (b) 20 shares of common stock for each $1,000 principal amount of Industrial bonds. Immediately after the consummation of the plan all of the issued stock of the new company, 552,660 shares of common stock, belonged to the former holders of bonds of Industrial. No stock was issued to parties other than such bondholders until October 23, 1936, when 37 shares were issued upon the exercise of warrants, and by June 30, 1938, only 465 shares had been issued upon the exercise of warrants. (5) At or about the same date warrants to purchase common stock of the new company were distributed to preferred and common stockholders of Fuel & Iron as follows: For each share of preferred stock of Fuel & Iron, one warrant to purchase, on or before February 1, 1950, three shares of common stock of the new company at $35 per share. For each share of common stock of Fuel & Iron*1006 there was given one warrant to purchase three-fourths of one share of common stock of the new company at $35 a share. (6) The capital stock of Industrial was canceled. Also, $7,741,000 principal amount of Industrial's bonds owned by Fuel & Iron were canceled. The first mortgage of Industrial which had secured its bonds *478 was satisfied and discharged. These bonds had been held in Fuel & Iron's treasury, but they had not been set up as an asset or liability on the books. The amount of Industrial's bonds that had been carried on Fuel & Iron's books as a liability was $27,633,000. 1 On September 10, 1936, petitioner, the James Q. Newton trust, surrendered its Industrial bonds in the face amount of $152,000 and received in exchange $60,800 face*1007 amount of income mortgage bonds and 3,040 shares of stock of the new company. On September 10, 1936, the petitioner, James Q. Newton, Jr., surrendered his Industrial bonds in the face amount of $10,000 and received in exchange $4,000 face amount of income mortgage bonds and 200 shares of stock of the new company. On the date of exchange the fair market value of the securities of the new company received in exchange by petitioners was $79 for each $100 face amount of income mortgage bonds and $27.25 for each share of stock. The total fair market value on the date of exchange of the securities of the new company received by the James Q. Newton trust was $130,872, and the total fair market value on the date of exchange of the new securities received by James Q. Newton, Jr., was $8,610. OPINION. HARRON: The petitioners contend that the reorganization of Fuel & Iron and Industrial under section 77B of the Bankruptcy Act, which resulted in an exchange of bonds of Industrial for bonds and stock of the new company, constituted a reorganization as defined in either provision (A) or (C) of section 112(g)(1) 2 of the Revenue Act of 1936, so that recognition of gain or loss is precluded*1008 under section 112 *479 (a) and (b)(3) 3 of the same act. The petitioners further contend that, if the transaction did not constitute a "reorganization" within the meaning of the above sections, nevertheless any gain resulting therefrom is nontaxable under section 112(b)(5) of the Revenue Act of 1936. 4 *1009 The respondent contends that there was not a "statutory merger or consolidation" within (A) of section 112(g)(1), since the facts fail to show that the plan of reorganization under section 77B was executed by a merger or consolidation in pursuance of the laws of Colorado or Federal law. Respondent relies upon the statement in article 112(g)-2 of Regulations 94 that, "The words 'statutory merger or consolidation' refer to a merger or a consolidation effected in pursuance of the corporation laws of the United States or a Stae or Territory or the District of Columbia." The respondent also contends that the reorganization under section 77B of the Bankruptcy Act does not come within the definition of a reorganization in the applicable revenue act, within (C) of section 112(g)(1). Respondent argues that the bondholders of Industrial may not be considered as the "stockholders of the transferor." He relies on the fact that stockholders of Feul & Iron were given warrants to buy stock in the new company. But, conceding for purposes of argument, that the stockholders of the transferor lost their equity in the properties transferred to the new company and that this case comes within the rule*1010 of ; certiorari denied, , respondent argues that the opinion in , strongly indicates that the Kitselman case was wrongly decided. Respondent concedes that the facts in the LeTulle case differ from and are not analogous to the facts in the Kitselman case or in this case. *480 Petitioner urges at length that there was a "statutory" consolidation of Industrial and Fuel & Iron under a Federal statute, namely, subsection (b)(9) of section 77B of the Bankruptcy Act. See United States Statutes at Large, 73d Cong., vol. 48-1, pp. 912-914. 5 We do not agree with this contention. First, in our opinion the Commissioner's statement in article 112(g)-2 of Regulations 94, quoted above, appears to be correct and a statement of the obvious. Second, the power to effect a consolidation of corporations "must be derived from the law of the sovereignty or state which creates the corporation seeking to exercise it", Fletcher, Cyclopedia of Corporations, vol. 15, ch. 61, sec. 7048, and the steps and proceedings to effect a consolidation are*1011 formal and must be in accordance with the law of the jurisdiction. Fletcher, Cyclopedia of Corporations, supra, secs. 7066-7074. While a corporation formed to carry out steps in a plan of reorganization under section 77B of the Bankruptcy Act may be under the control of the Federal District Court having jurisdiction, a new corporation can come into existence only in compliance with state authority. . In the proceedings involved here, the charter of the new company was obtained from the State of Colorado. The statutes of Colorado prescribe the way in which a consolidation may be consummated. Comp. Laws of Colorado, 1921, ch. 38 D., p. 754, sec. 2287; 1935 Colorado Stats. Ann., ch. 41, sec. 54. So far as the facts show, no articles of consolidation or merger were filed in the proper state office. The plan of reorganization approved by the District Court does not refer to a consolidation as the means of executing the plan. The provisions of subsection (b)(9) of section 77B of the Bankruptcy Act provide for several permissive methods of executing a plan of reorganization, among which are a merger or consolidation. *1012 But it may not be assumed that a "statutory merger or consolidation" was effected merely from the general facts relating to the way in which a reorganization under section 77B is executed. It is a matter to be proved whether such a plan of reorganization was executed by a statutory merger or consolidation, and, in our opinion, petitioner has not so proved in this case. See also Report of Committee on Ways and Means, No. 704, 73d Cong., 2d sess., p. 14, for the reasons for inserting the word "statutory" before "merger or consolidation" in section 112(g)(1)(A) of the Revenue Act of 1934. *481 However, we are of the opinion that the reorganization under section 77B of*1013 the Bankruptcy Act constituted a reorganization under section 112(b)(3) of the Revenue Act of 1936, within (C) of section 112(g)(1). In our opinion the situation here is very much like the situation in the Kitselman case, supra, and the question is controlled by that case. In the Kitselman case, after the various steps had been taken the bondholders of the old company were in control of the new company, and this somewhat unusual situation presented difficulty because section 112(g)(1)(C) predicates a reorganization on the requirement that the transferor or the stockholders of the transferor be in control of the new company. The court reasoned that where the old company is insolvent and its assets are transferred to a new company formed by the bondholders' representatives, the bondholders occupy a status somewhat akin to that of preferred stockholders, for all practical purposes. The court stated the following: Bondholders ordinarily are viewed as creditors, but when the assets of the corporation are less than its obligations, the bondholders are in actuality and for all practical purposes pretty much the corporation. * * * It is clear that the bondholders*1014 were the moving spirit and were treated as the owners in fact, and it follows that they must be viewed as a class of "stockholders" somewhat akin to preferred stockholders with cumulative dividend rights. * * * Where the assets of the corporation fall far below the amount required to pay the bondholders in full, the bondholders in bankruptcy reorganization supersede the stockholders. They acquire the stockholders' rights to manage the corporate affairs. There is a difference between the position of stockholders in a case like the present one and stockholders of a corporation in bankruptcy proceeding under section 77B (U.S.C.A. § 207) to a reorganization, but the analogies are sufficient to justify a study of the decisions in the latter field. The above reference in the quotation to a reorganization under section 77B of the Bankruptcy Act is significant here. In our opinion the situation in this case is as favorable, if not more favorable, to petitioner's contention than was the situation in the Kitselman case, because here there was a reorganization under section 77B of the Bankruptcy Act. As in the Kitselman, case, the difficulty is that of determining whether the*1015 holders of the Industrial bonds were the "transferor or its stockholders" within that clause in (C) of section 112(g)(1). The situation is somewhat more complex here because there were two transferors, Industrial and Fuel & Iron, albeit they were subsidiary and parent corporations, and the holders of the Industrial bonds were creditors of both companies, Fuel & Iron having acquired substantially all the assets, securing the bonds under a first mortgage, and having unconditionally guaranteed the interest and principal of the bonds of Industrial. However, this complexity is not important, *482 in our opinion. Neither the bondholders nor the stockholders of either of the old companies received any profit from the reorganization. The old companies transferred all their assets to the new company and immediately thereafter the old companies, through the bondholders, were in control of the corporation to which the assets were transferred. The holders of Industrial bonds were creditors having claims aggregating $27,633,000 for principal due, and $2,763,300 for interest due. They were the creditors with prior claims, secured by a first mortgage on assets in the hands of Fuel & *1016 Iron, and they were treated as the owners in fact of the assets transferred to the new company. It must follow here, as in the Kitselman case, that the holders of the Industrial bonds be viewed as a class of "stockholders." So viewed, they come within (C) of section 112(g)(1). The following is pointed out in support of the above conclusion. Industrial and Fuel & Iron had been placed in receivership and had petitioned for a reorganization under section 77B of the Bankruptcy Act. The stockholders of both of the companies had lost their equity. This was recognized by the plan of reorganization, under which the entire ownership of the new company was turned over to the holders of Industrial bonds, and the stockholders were given, merely, warrants entitling them to purchase stock in the new company at a price considerably above the then market value. The treatment accorded various security holders of the old companies is described in the plan of reorganization as follows: Under the Plan, the Industrial Bondholders are to receive for each $1,000 principal amount of Bonds (together with the unpaid interest thereon which amounted to 10% to February 1, 1935): (a) $400 principal*1017 amount of new 5% Income Mortgage Bonds and (b) 20 shares of new Common stock. The Industrial Bondholders are to receive all of the new Income Mortgage Bonds and all of the new Common Stock of the New Company to be presently issued in the reorganization. The entire issue of Industrial Bonds outstanding in the aggregate principal amount of $27,633,000 is in default. Interest on the Industrial Bonds accrued and unpaid to February 1, 1935 amounts to $2,763,300. Accordingly, in the first instance, the Plan gives to the holders of the IndustrialBonds the entire ownership and control of the New Company, subject to $4,500,000 of Fuel Bonds which are undisturbed in the reorganization. The Plan, however, does not in its effect on stockholders operate as a strict foreclosure, since the stockholders are to receive Warrants entitling them at their option to purchase, at any time until February 1, 1950, a stock equity in the New Company at $35 per share. The price at which stockholders, under the terms of such Warrants, may regain an equity position in the enterprise, takes into consideration the basis upon which the Industrial Bondholders are to receive shares of new Common Stock*1018 in exchange for that part of their debt not covered by new Income Mortgage bonds. [Emphasis supplied.] The assets of the old companies were transferred to the new company, and immediately thereafter the bondholders were in control of the new company by virtue of the immediate transfer of 552,660 shares *483 of stock of the new company to the reorganization managers, who were the agents of the bondholders. The holders of warrants to purchase new stock in the new company had no control. Control relates to issued, not to authorized, stock. ; . Clearly there was an exchange of securities in one corporation a party to a reorganization, in pursuance of a plan of reorganization, solely for securities in another corporation a party to the reorganization. (Sec. 112(b)(3).) All three corporations were parties to the reorganization. (Sec. 112(g)(2).) The bondholders of Industrial retained a substantial stoke or proprietary interest in the enterprise. There was a continuity of interest of the transferors in the transferee, evidenced*1019 by stocks and bonds of the new company. The holders of Industrial bonds acquired the stockholders' right to manage the corporate affairs. With respect to the argument of respondent that the opinion in the LeTulle case indicates that the decision in the Kitselman case is wrong, and that , also points that way, we believe the argument without merit. The fact that the bondholders herein retained a proprietary interest in the enterprise is a material difference between the factual situation in this case and the factual situation in either the LeTulle case or the Tyng case. Such cases are therefore clearly distinguishable and not applicable here. In the LeTulle case when a stockholder of the transferor received bonds and cash of the transferee in exchange for his stocks, there was no continuity of interest. In the Tyng case, where the stockholders of the transferors received cash and long term indebtedness of the transferee in exchange for their stock, there was no continuity of interest. In both the LeTulle case and the tyng case stockholders of the transferor became mere creditors of the transferee, *1020 whereas in this case creditors (the Industrial bondholders) became stockholders of the transferee, and after the transfer they were in control of the corporation to which the assets were transferred. Also, we believe that , cited by respondent, is not applicable here. The point in this case is that the bondholders received all the presently issued stock of the new company, thereby gaining control thereof. It is held that the reorganization under section 77B of the Bankruptcy Act was executed so as to constitute a reorganization as defined in section 112(g)(1)(C), and the gain or loss resulting therefrom is not recognizable under section 112(b)(3). See also ; ; Edith M. Greenwood, 41 %.b.t.a./ 664; . *484 In view of the foregoing it is not necessary to consider whether or not the transactions come within section 112(b)(5). Reviewed by the Board. Decision will be entered under Rule 50. VAN FOSSAN, LEECH, TURNER, *1021 and DISNEY dissent. MURDOCK dissents for reasons expressed in his dissent in . Footnotes 1. The aggregate amount of Industrial's bonds in default on August 1, 1934, carried on Fuel & Iron's books was $27,633,000. The Industrial bonds had been set up on Fuel & Iron's books as a liability in the following way: ↩ Industrial bonds authorized $45,000,000 Issued 39,000,000 Redeemed and canceled 3,626,000 35,374,000 Less - held in treasury 7,741,000 Principal amount in default 27,633,000 2. SEC. 112. RECOGNITION OF GAIN OR LOSS. * * * (g) DEFINITION OF REORGANIZATION. - As used in this section and section 113 - (1) The term "reorganization" means (A) a statutory merger or consolidation, * * * or (C) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred, or (D) a recapitalization, or (E) a mere change in identity, form or place of organization, however effected. ↩ 3. SEC. 112. RECOGNITION OF GAIN OR LOSS. (a) GENERAL RULE. - Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section. (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. ↩ 4. SEC. 112. RECOGNITION OF GAIN OR LOSS. * * * (b) EXCHANGES SOLELY IN KIND. - * * * (5) TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR. - No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange to two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. ↩ 5. SEC. 77B. CORPORATE REORGANIZATIONS - * * * (b) A plan of reorganization within the meaning of this section * * * (9) shall provide adequate means for the execution of the plan, which may include the transfer of all or any part of the property of the debtor to another corporation or to other corporations, or the consolidation of the properties of the debtor with those of another corporation, or the merger or consolidation of the debtor into or with another corporation or corporations, or * * *. ↩