Docket No. 31381.
Ralph W. Barbier, Esq., for the petitioner. Jules I. Whitman, Esq., for the respondent.
Ralph W. Barbier, Esq., for the petitioner. Jules I. Whitman, Esq., for the respondent.
In 1946, petitioner acquired the remaining 24 per cent minority interest in the capital stock of its foreign subsidiary and immediately liquidated the latter. At the time of such acquisition the subsidiary was insolvent, and the acquisition of the minority interest was without a business purpose.
Held, petitioner did not become affiliated with its subsidiary within the intent of section 23(g)(4) of the Internal Revenue Code. The loss sustained in 1946 by reason of the worthlessness of the capital stock of the subsidiary is a capital loss and not an ordinary loss.
Held, further, the phrase ‘paid or accrued,‘ as used in section 122(d)(6) of the Internal Revenue Code, has reference to the system of accounting used by the taxpayer. Lewyt Corporation, 18 T.C. 1245, followed.
This proceeding involves a deficiency in excess profits tax for the taxable year ended September 30, 1945, in the amount of $105,995,01. Petitioner claims an overpayment in excess profits tax in the amount of $5,276.43 for such taxable year.
The issues presented are (1) whether the loss occurring in the taxable year 1946 from the worthlessness of stock of petitioner's subsidiary corporation is an ordinary loss, under section 23(g)(4) of the Internal Revenue Code, or a capital loss, under section 23(g)(2) of the Internal Revenue Code; and (2) whether the amount of excess profits tax accrued by petitioner in the taxable year 1944 may be used to reduce the net income for such year in computing the net operating loss carry-back from the fiscal year 1946 to the fiscal year 1945, under the provisions of section 122(b) of the Internal Revenue Code.
Some of the facts have been stipulated and are found accordingly.
FINDINGS OF FACT.
Petitioner is a Delaware corporation having its principal office at Bristol, Pennsylvania. Its returns for the periods involved were filed with the collector of internal revenue for the first district of Pennsylvania, at Philadelphia, on an accrual basis, using a fiscal year ending September 30.
Manufacturera Universal, S.A., was a business corporation organized under the laws of Mexico to engage in the manufacture and sale of shotgun shells and light metal products. The Mexican corporation, hereinafter referred to as ‘MUSA,‘ had its principal place of business near Mexico City (D.F.), Mexico. It had only one class of capital stock. The books and records of MUSA were kept at its principal place of business.
Petitioner, during the period January 1945 to February 1946, acquired 15,250 shares of the total authorized and issued shares of 20,000, or approximately 76 per cent thereof, at a cost of $155,463.93.
In addition to its capital stock investment petitioner advanced funds to MUSA in substantial amounts and provided it with machinery and materials, the cost of which petitioner carried on its books as an account receivable from MUSA, in the approximate amount of $180,000.
On July 8, 1946, a special meeting of the petitioner's board of directors was held, at which the affairs and financial condition of MUSA were discussed in detail. At this meeting the directors were advised that a substantial amount of additional funds would be required to place MUSA in a position for a large scale profitable operation and that petitioner was not in a position to provide the funds. The directors were advised that the legal aspects, ‘from the tax angle,‘ of the various plans had been carefully investigated by two firms of attorneys and an accounting firm, and the general situation was exhaustively discussed. The plans mentioned in the minutes referred to the possibility of buying out the Mexican interests or selling to the latter. At this meeting the petitioner's president, Charles E. Hunter, was authorized to go to Mexico City and look into the situation. Hunter went to Mexico City, investigated the affairs of MUSA, which were found to be in a deplorable condition, and determined that the minority stockholders were not in a position to assist in the further financing of the company. He thereupon decided that it would be advisable to acquire the stock of the minority holders so as to facilitate the liquidation of the company.
On July 15, 1946, the petitioner acquired the remaining 4,750 shares held by the Mexican interest, for a consideration of $2,536.08, and petitioner thereby became the owner of the authorized and outstanding shares of the capital stock of MUSA. On July 15, 1946, petitioner filed a statement (Form 1138) for the purpose of extending the time for payment of taxes by corporations expecting carry-backs, which Hunter executed prior to his departure for Mexico City. The statement, inter alia, contained the following:
In addition to the above, a serious loss is about to be sustained by the Company in its investments in a Mexican enterprise, Manufacturera Universal, S.A. This company was formed approximately two years ago for the purpose of light manufacturing in Mexico City, particularly for manufacture of shot gun shells, for which there appeared to be a good market at fair prices. The inability to obtain special machinery or material for manufacture caused interminable delay and large additional expenses in equipping this company and its financing for actual operation, which did not start until the spring of this year and to date has not reached a break-even basis.
As a result of the operating experience of this enterprise, it has become evident that a large additional sum of money will have to be invested if it is to be brought to a volume production that would make it a substantial paying proposition, and this Corporation has no funds available for that purpose, and the Mexican group associated in the enterprise is not inclined to put any more money into it.
Therefore, an immediate liquidation is indicated to salvage whatever value there may be in the inventory and special machinery. Hunter Manufacturing Corporation has advanced to this company on open account the sum of $185,000.00 over the past one and one-half years, and the most optimistic estimate of recoupment in a liquidation, after paying off the local bank loan of the Mexican company and other expenses of liquidation, will be a maximum of $35,000.00 on this account, making an operating loss of $150,000.00 in this one item.
On July 20, 1946, a special meeting of the shareholders of MUSA was held in Mexican City. At this meeting it was unanimously voted to dissolve and to appoint Hunter as liquidator. At the time of dissolution the petitioner owned all of the shares of stock in MUSA. MUSA was dissolved and the assets were sold to an individual who purchased the machinery, equipment, and physical assets for 250,000 pesos, plus assumption of notes due the Banco Internacional, the purchaser to relieve MUSA of all obligation of quittance pay liability for its employees. This permitted petitioner to recover some $26,000 to be applied against its open account with MUSA. No property or money was distributed to petitioner as the sole stockholder of MUSA.
On July 26, 1946, a special meeting of petitioner's board of directors was held for the purpose of discussing a telephoned report from Hunter on the MUSA situation. A resolution was adopted ratifying the purchase of the shares of the Mexican interests and the liquidation of MUSA by Hunter. The liquidation of MUSA was completed by July 31, 1946. MUSA had ceased operations before July 11, 1946. From the commencement of business to the time of dissolution MUSA had been operated at a considerable loss.
The balance sheet of MUSA, as of June 30, 1946, shows assets and liability in Mexican currency as follows:
+--------------------------------+ ¦MANUFACTURERA UNIVERSAL, S. A. ¦ +--------------------------------¦ ¦ ¦ ¦ ¦ +--------------------------------+
June 30, 1946
Mexican currency Assets (Pesos) Cash 1,580.57 Notes and accounts receivable 86,918.47 Long term receivable 1,212.60 Inventories 246,623.00
Fixed assets Machinery and equipment 912,663.09 Construction work in process 66,995.18 Transportation equipment 21,769.81 Office furniture and fixtures 20,466.16 1,021,894.24 Deferred charges Leasehold and improvements 98,623.45 Organization expense 175,518.81 Experimental expense 179,084.78 Other deferred charges 111.71 453,338.75 Patents and trade marks 15,000.00 1,826,567.63
Mexican Liabilities currency (Pesos) Accounts payable 46,859.89 Notes payable 134,000.00 Accrued liabilities 13,961.99 Hunter Mfg. Corp 794,242.29 Capital stock 1,000,000.00 Surplus—deficit (162,496.54) 1,826,567.63
In excess of 90 per cent of the gross income of MUSA was derived from the sale of products manufactured by it, namely, shotgun shells and cigarette lighters.
The capital stock of MUSA was worthless prior to July 15, 1946, when the petitioner acquired the 4,750 shares, representing approximately 24 per cent of the authorized issued and outstanding shares of its capital stock.
The loss sustained in the year 1946 by the petitioner, as a result of the worthlessness of the shares of the capital stock of MUSA, was a capital loss and not an ordinary loss.
The primary question presented is whether the loss sustained by petitioner in 1946, as a result of the worthlessness of the capital stock of MUSA, is an ordinary loss within the purview of section 23(g)(4), as contended by the petitioner, or a capital loss under section 23(g)(2), as determined by the respondent.
The respondent contends that 76 per cent of the capital stock of MUSA owned by the petitioner was worthless prior to the petitioner's acquisition, for a nominal amount, of the remaining 24 per cent on July 15, 1946; that the purchase of the minority interest served no business purpose and was motivated solely for tax-reducing purposes, and, hence, the purported affiliation was not an affiliation within the intendment of section 23(g)(4) of the Code.
The petitioner contends that the evidence establishes that all of the conditions prescribed have been met to bring it within the statutory definition of an affiliate; and, since the minority shares were legally acquired, no business purpose need be shown.
While a taxpayer has the legal right to decrease the amount of what would otherwise be his taxes, or altogether avoid them by means which the law permits (Gregory v. Helvering, 293 U.S. 465, 469), since the substance and not the form controls, the realities of the transaction may be examined in order to determine whether a transaction is a mere formality without substance which may be disregarded for tax purposes. Higgins v. Smith, 308 U.S. 473, and Bazley v. Commissioner, 331 U.S. 737.
Section 23(g) deals with capital losses and limits the amount of the loss resulting from the sale or exchange of capital assets. Subdivision (4) of this section creates an exception to the general rule and provides that the capital stock of an affiliate, as defined in the act, shall not be deemed a capital asset.
SEC. 23. DEDUCTIONS FROM INCOME.In computing net income there shall be allowed as deductions:(g) CAPITAL LOSSES.—(1) LIMITATION.— Losses from sales or exchanges of capital assets shall be allowed only to the extent provided in section 117.(2) SECURITIES BECOMING WORTHLESS.— If any securities (as defined in paragraph (3) of this subsection) become worthless during the taxable year and are capital assets, the loss resulting therefrom shall, for the purpose of this chapter, be considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets.(3) DEFINITION OF SECURITIES.— As used in this paragraph (2) of this subsection the term ‘securities‘ means (A) shares of stock in a corporation, and (B) rights to subscribe for or to receive such shares.(4) STOCK IN AFFILIATED CORPORATION.— For the purposes of paragraph (2) stock in a corporation affiliated with the taxpayer shall not be deemed a capital asset. For the purposes of this paragraph a corporation shall be deemed to be affiliated with the taxpayer only if:(A) at least 95 per centum of each class of its stock is owned directly by the taxpayer; and(B) more than 90 per centum of the aggregate of its gross incomes for all taxable years has been from sources other than royalties, rents (except rents derived from rental of properties to employees of the company in the ordinary course of its operating business), dividends, interest (except interest received on deferred purchase price of operating assets sold), annuities, or gains from sales or exchanges of stocks and securities; and(C) the taxpayer is a domestic corporation.
Subsection (4) of section 23(g) was added by section 123 of the Revenue Act of 1942.
Assuming the petitioner has met all the conditions prescribed to constitute its subsidiary an affiliate, as defined in the act, we think it does not necessarily follow that it is entitled to the benefits the statute confers. The general rule is that the strict letter of the act must yield to its evidence spirit and purpose when this is necessary to give effect to the intent of Congress, and that unjust and absurd consequences are, if possible, to be avoided. Fleischmann Co. v. United States, 270 U.S. 349, 360.
To apply the strict letter of the statute as contended for by the petitioner would, under the facts disclosed by this record, lead to an unjust and unreasonable result that could not have been intended by Congress. The impartial mind rebels against the notion that Congress intended to permit such a facile and obvious opportunity to avoid or escape taxation.
The petitioner organized MUSA as a Mexican corporation in 1945. During the period January 1945 to February 1946, it acquired approximately 76 per cent of its authorized and issued capital stock at a cost of $155,463.93. Prior to July 1936 it advanced funds to MUSA in the amount of approximately $180,000. On July 15, 1946, the petitioner filed a statement with the taxing authorities for the purpose of extending the time for the payment of taxes. It therein stated that it expected to sustain a loss of approximately $150,000 on its open account with MUSA, in the amount of $185,000, and that the most optimistic estimate of recoupment in a liquidation would be a maximum of $35,000. It further stated that an additional large sum would have to be invested to make MUSA a paying proposition; that petitioner had no funds available for that purpose; and that the Mexican group is not inclined to pay any more into it. Since the petitioner had determined that it was about to sustain a very considerable loss as a creditor, it had knowledge that its stock investment was then valueless. MUSA had, since its organization, operated at a loss and upon the sale of its assets it recovered approximately $26,000, which was applied to reduce the indebtedness of MUSA to petitioner. Relying solely upon the book value of its fixed assets, as shown on the balance sheet of MUSA as of June 30, 1946, the petitioner argues that stock of MUSA had value. However, the record is devoid of any evidence as to the fair market value of the fixed assets on the critical date in question. In the light of the facts above set forth, we think it is obvious that the stock of MUSA was worthless prior to the acquisition of the 24 per cent minority interest to constitute MUSA an affiliate within the definition set forth in section 23(g)(4) of the Code. No purpose would be served here by discussing the maze of cases involving deductions for losses from stock becoming worthless. The worthlessness here is determined only for the purpose of its bearing on the motive for the acquisition of the minority interests.
The amount was stipulated to be $180,000.
The record shows that prior to July 15, 1946, the petitioner obtained legal and accounting advice and was well aware that, in order to secure a tax benefit from losses on its investment in the capital stock of MUSA, it would be necessary to acquire sufficient shares to increase its holdings to 95 per cent of the outstanding stock so as to qualify its loss as an ordinary loss rather than a capital loss. Very soon after Charles E. Hunter, the petitioner's president, arrived in Mexico City, Mexico, he instituted negotiations for the purchase of the minority interests and acquired the remaining 4,750 shares for $2,536.08. The petitioner then owned all of the capital stock. A special meeting of the shareholders was held in Mexico City on July 20, 1946, at which it was voted to dissolve. Hunter was appointed liquidator and he sold all of the physical assets of MUSA to an individual purchaser.
The petitioner argues that if it is necessary to establish that the 24 per cent minority interest was acquired for a business purpose, the fact that the acquisition of the additional shares enabled it to liquidate its subsidiary promptly and without possible interference from minority stockholders establishes such a purpose. Since petitioner already owned 76 per cent of the outstanding shares it was in control, and we think such argument is without substance. In view of the financial condition of MUSA any interference from dissident stockholders appears to be an unwarranted assumption.
This record, as we view it, contains no evidence to support a business purpose in the acquisition of the minority interest but rather conclusively established the contrary. There is no indication that the petitioner had any plan or bona fide intention to reorganize or rehabilitate the subsidiary with a purpose of continuing the business. The realities of the situation here disclosed show that such a contingency was not a reasonable probability.
In our opinion, the only reasonable inference to be drawn from this record is that the additional 24 per cent of the outstanding stock of MUSA was acquired solely for tax-reducing purposes. We find no merit in the petitioner's contention that since the statute provides no period of time during which the 95 per cent stock interest is to be held to qualify it as an affiliate, none may be implied. We think the absence of a fixed holding period is of no significance. Congress was well aware of the doctrine in Gregory v. Helvering, supra, and cognate cases. As stated by Judge Learned Hand in Commissioner v. Transport Trad. & Term. Corp. 176 F.2d 570, the doctrine of Gregory v. Helvering:
means that in construing words of a tax statute which describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation. * * *
Congress, in enacting section 23(g)(4) of the Code, undoubtedly had in mind a true affiliation which would serve a business purpose.
Research has revealed no decision where the business purpose rule has been applied to section 23(g)(4) of the Code. The rule was applied by this Court in the case of J.D. & A.B. Spreckels, 41 B.T.A. 370, which involved the construction of section 141 of the Code granting the privilege of an affiliated group to file consolidated returns. Although the Spreckels case pertained to another section of the Code, the issue involved is analogous to that presented in the instant case and, we think, its rationale is applicable here.
We hold that the affiliation effected under the facts and circumstances disclosed by this record is not the kind of affiliation that the statute had in mind. We, therefore, sustain the respondent's determination that the loss sustained by the petitioner in the year 1946, as a result of the worthlessness of its investment in the capital stock of MUSA, was a capital loss and not an ordinary loss.
The final issue presented is whether the excess profits tax accrued within the taxable year 1944 may be used to reduce the net income for such year in computing the net operating loss carry-back from the fiscal year 1946 to the fiscal year 1945, under the provisions of section 122(b) and (d)(6) of the Code. The excess profits tax accrued in the year 1944 was extinguished by reason of a net operating loss carry-back from 1946 to 1944. The facts pertinent to this issue have been stipulated. A similar issue was determined adversely to the taxpayer in Lewyt Corporation, 18 T.C. 1245 (on appeal, C.A. 2), and that holding will be followed here. We are not unmindful that the Court of Claims has held to the contrary in Olympic Radio & Television v. United States, 110 F.Supp. 600 (certiorari applied for), upon which the petitioner relies. We, however, prefer to follow our own precedent.
Reviewed by the Court.
Decision will be entered for the respondent.