Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Sep 10, 1952
18 T.C. 976 (U.S.T.C. 1952)

Docket Nos. 24452 24603.



Herbert W. Clark, Esq., and Leon de Fremery, Esq., for the petitioners. H. A. Melville, Esq., and Chas. H. Chase, Esq., for the respondent.

Held, the exchange by stockholders of half their stock in a corporation for the pro rata distribution of stock in a newly created corporation which transferred all its stock to the distributing corporation in exchange for property of the distributing corporation was an exchange upon which no gain or loss will be recognized under the provisions of section 112(b)(3), I.R.C. Herbert W. Clark, Esq., and Leon de Fremery, Esq., for the petitioners. H. A. Melville, Esq., and Chas. H. Chase, Esq., for the respondent.

The respondent determined deficiencies of $1,530.73 as to each of the petitioners' income taxes for the year 1943. The only remaining question after the abandonment by petitioners of several issues raised in the pleadings is whether the receipt of stock by petitioners was a taxable dividend, a nontaxable exchange or a capital gain or loss transaction.


The facts stipulated are so found.

The petitioners are husband and wife, residing in Glendale, California. Their income tax returns for 1943 were filed with the collector of internal revenue for the sixth district of California. In March 1930 the petitioners acquired, as community property, 10 shares of stock of the Western States Gasoline Corporation, hereinafter referred to as Western States. The petitioners acquired two more shares of Western States stock in March 1943. Chester E. Spangler was the auditor of Western States, and as such he was in charge of corporate accounting, insurance, taxes, and purchasing. Western States was incorporated in California in 1929, and its capital consisted of 3,000 shares of common stock of a par value of $100 per share. As of May 1, 1943, 2,990 shares of common stock were outstanding and the remaining 10 shares were held as treasury stock.

Western States was organized by Charles R. Gallagher, who had obtained contracts to manufacture casinghead gasoline from the natural gas (wet gas) produced in connection with the production of oil. The stockholders of Western States were required to execute a voting trust agreement with Gallagher as sole trustee. Gallagher was president and general manager of the corporation. Western States' first casinghead gasoline plant was constructed in the Kettleman Hills North Dome Area of California. An additional plant was later built in Ventura County, California. Western States treated the natural gas under contracts with various oil companies in both localities.

In 1934 Western States acquired almost 2,000 acres of oil leaseholds in California at a cost of $57,928.20. The total California oil leasehold acreage decreased after 1936 until, by 1942, only 80 acres were held, and the royalty from these California properties amounted to $523. In 1935 Western States began acquiring undeveloped oil and gas leases in the Slaughter Field in the State of Texas. In that year 12,014.19 wildcat acres were acquired at a cost of $15,075.01. Three leases (Coons, Frazier and Mallett) were developed and the first producing oil well was drilled on these properties in 1939. By May 1, 1943, a total of 43 producing wells had been drilled on the Texas properties. At that date Western States held 3,191 acres of producing leaseholds and 12,463.84 nonproducing acres in Texas. By May 1, 1943, the net expenditure made by Western States in connection with the Texas oil properties was $1,131,600.10. The monthly allowable oil production from the Texas properties for April 1943 was as follows:

+--------------------------------------------------------------+ ¦ ¦Coons ¦Frazier ¦Mallett (A)¦Mallett (B)¦ +--------------------+--------+--------+-----------+-----------¦ ¦Oil wells ¦5 ¦18 ¦3 ¦17 ¦ +--------------------+--------+--------+-----------+-----------¦ ¦Barrels of oil ¦2,980 ¦12,180 ¦1,300 ¦8,436 ¦ +--------------------+--------+--------+-----------+-----------¦ ¦Average well per day¦20 bbls.¦22 bbls.¦14 bbls. ¦15 bbls. ¦ +--------------------------------------------------------------+

The average price received for oil from these properties ranged from $.7649 per barrel in 1939 to $.9728 for the year 1943 up to May 1. The average price for this entire period was $.9258 per barrel of oil.

Difficulties were encountered in shipping the oil produced out of the oil field. Shipments were first made by tank truck, then by means of a 2-inch or 3-inch pipeline which required Western States to take its turn with other companies in shipping oil. The income from working interest barrels of oil during the period from 1939 through the first third of 1943, was as follows:

+------------------------------+ ¦1939 ¦$60,726.14¦ +-------------------+----------¦ ¦1940 ¦--- ¦ +-------------------+----------¦ ¦1941 ¦169,789.01¦ +-------------------+----------¦ ¦1942 ¦245,221.46¦ +-------------------+----------¦ ¦1943 (1/1 to 4/30) ¦83,942.31 ¦ +------------------------------+

In 1938 Western States paid cash dividends totaling $321,790. In 1939 and 1940, $119,200 and $77,840, respectively, were paid in dividends. In 1941 cash dividends totaled $35,760; in 1942 and 1943 no dividends were paid. From 1929 until the end of 1942 Western States had paid $3,389,955 in dividends out of earnings of $4,974,689.04 for that period. The earned surplus carried on the corporate books at the end of 1938 was $1,878,116.63. The earned surplus on the records as of April 30, 1943, was $1,647,415.24. As of August 31, 1944, the earned surplus was $1,153,445.50. Dividends were not paid in 1942 because the company was pouring all available money into the Texas operation. The earnings available for Texas oil operations during the years 1939 to May 1, 1943, were as follows:

+-----------------------------------------------------------------------------+ ¦ ¦1939 ¦1940 ¦1941 ¦1942 ¦1943 ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦(to Apr. ¦ ¦ ¦ ¦ ¦ ¦ ¦30) ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Earnings: ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Natural Gasoline:¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Kettleman ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Hills ¦$463,071.29¦$272,583.81¦$261,119.94¦$274,231.70¦$116,142.47¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Ventura ¦(6,615.34) ¦(1,703.33) ¦(3,828.67) ¦17.739.97 ¦12,219.86 ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Oil Operations ¦(38,856.73)¦(26,301.53)¦(17,703.49)¦(7,293.47) ¦(2,160.87) ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Total earnings ¦$417,599.22¦$244,578.95¦$239,587.78¦$284,678.20¦$126,201.46¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Administrative ¦ ¦ ¦ ¦ ¦ ¦ ¦and ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦general expense ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦of Texas ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦and California ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦operations ¦$102,868.29¦$103.127.10¦$107.584.64¦$107,788.48¦$53,085.42 ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦Earnings ¦ ¦ ¦ ¦ ¦ ¦ ¦available ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦for Texas ¦ ¦ ¦ ¦ ¦ ¦ +-----------------+-----------+-----------+-----------+-----------+-----------¦ ¦operations ¦$314,730.93¦$141,451.85¦$132,003.14¦$176,889.72¦$73,116.04 ¦ +-----------------------------------------------------------------------------+

The net income and cost for the Texas oil operations during these years were as follows:

+-----------------------------------------------------------------------------+ ¦ ¦1939 ¦1940 ¦1941 ¦1942 ¦1943 ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦ ¦ ¦ ¦ ¦ ¦(to Apr. ¦ ¦ ¦ ¦ ¦ ¦ ¦30) ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦Operating ¦ ¦ ¦ ¦( ¦ ¦ ¦income or ¦($137,591.01)¦($75,267.74) ¦($199,484.12)¦$216,409.07)¦$21.201.80 ¦ ¦(loss) ¦ ¦ ¦ ¦ ¦ ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦Outlay for¦ ¦ ¦ ¦ ¦ ¦ ¦Texas ¦ ¦ ¦ ¦ ¦ ¦ ¦lease and ¦(61,363.84) ¦(44,262.80) ¦(162,576.13) ¦(159,558.41)¦(12,832.15)¦ ¦oil well ¦ ¦ ¦ ¦ ¦ ¦ ¦equipment ¦ ¦ ¦ ¦ ¦ ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦Net ¦ ¦ ¦ ¦ ¦ ¦ ¦operating ¦($198,954.85)¦($119,530.54)¦($362,060.25)¦( ¦$8,369.65 ¦ ¦income or ¦ ¦ ¦ ¦$375,967.48)¦ ¦ ¦(loss) ¦ ¦ ¦ ¦ ¦ ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦Excess of ¦ ¦ ¦ ¦ ¦ ¦ ¦earnings ¦ ¦ ¦ ¦ ¦ ¦ ¦available ¦ ¦ ¦ ¦ ¦ ¦ ¦for ¦ ¦ ¦ ¦ ¦ ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦Texas ¦ ¦ ¦ ¦ ¦ ¦ ¦operations¦ ¦ ¦ ¦ ¦ ¦ ¦over net ¦ ¦ ¦ ¦ ¦ ¦ ¦income ¦ ¦ ¦ ¦ ¦ ¦ +----------+-------------+-------------+-------------+------------+-----------¦ ¦or (loss) ¦ ¦ ¦ ¦( ¦ ¦ ¦from Texas¦$115,776.08 ¦$21,921.31 ¦($230,057.11)¦$199,077.76)¦$81,485.69 ¦ ¦operations¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+

The oil leaseholds in Texas adjoined the properties of other oil companies, some of which were leaders in the industry. If oil was struck near the boundary line by others, a well would have to be drilled by Western States on its own property to offset the well of the other company to protect its interest in the oil reserve. An oil well cost between $30,000 and $35,000.

All of Western States' contracts with other companies for the processing of wet gas, except two contracts, required Western States to process all that was offered. The contract between Western States and the Seaboard Oil Corporation provided for termination of the contract on August 16, 1944, if a processing plant had then been built at Kettleman Hills to be owned jointly by Seaboard and the Texas Oil Corporation. Investment in the plant at Kettleman Hills increased from $698,091.53 at the end of 1938 to $923,845.20 by the close of 1942. Investment in the Ventura plant rose from $189,836.76 at the end of 1938 to $202,450.54 by 1943.

For its Texas operations Western States maintained a division office at Lubbock, Texas, which was 45 miles from the oil properties in the Slaughter fields. There were no telephone or telegraph operations between Lubbock and the oil field. The means of communications were by United States mail and by automobile. The accounting for the Texas operations was done in Los Angeles under the supervision of petitioner Chester E. Spangler. The reports and information originated in the field and were forwarded to Lubbock and from there to Los Angeles. Some reports were sent daily. In cases of incomplete information and errors, correspondence was had with the division office in Lubbock. Monthly accounting reports were made to the president of the corporation by Spangler, but he was, at times, unable to give complete information because of delays in receiving the correct information. Chester E. Spangler made three or four trips a year to Texas to clear up accounting difficulties. A new system of accounting was installed in March 1941, which was amended in 1942. Charles R. Gallagher, the president of Western States, who, together with his wife, owned 1,509 shares of stock in the corporation, moved to Lubbock, Texas, in 1942 in order to organize and centralize the Texas operations, and he remained there for 2 years. In making purchases of supplies for the oil producing operations, the approval of the Petroleum Administrator for War was obtained by preparing an application in Lubbock, sending it to Los Angeles and then to the P.A.W. office in Houston, Texas. Spangler suggested to the president of Western States that the accounting could not be handled satisfactorily unless it was close to the source of operations. He did not think it would be a satisfactory solution to the accounting difficulties to send an assistant accountant to Lubbock to take charge of the accounting.

By the end of 1942 Charles R. Gallagher had decided to form a new corporation for the Texas operations. He discussed the proposal with his counsel, who concurred in the plan, and with a tax counsel, who also concurred. The tax counsel pointed out that when the Texas properties produced taxable income, proration of income within and outside of California would be required by the California taxing authorities. Gallagher was advised by his tax counsel that no tax problems would arise because of the formation of the new corporation but that Western States would lose the tax benefit of the losses on the Texas properties which might not be chargeable against any taxable income if the prospective corporation did not realize taxable income within 2 years.

A plan of reorganization to take effect on May 1, 1943, was approved by the board of directors of Western States on March 27, 1943. On April 15, 1943, a letter was written to the stockholders of Western States proposing the creation of a new corporation for the Texas activities in order to provide local management and accounting. The stock of the new corporation was to be distributed among the present shareholders in redemption of one-half of their stock in Western States according to the letter. Further information concerning the transaction was sought by one stockholder and this request was complied with. The plan of reorganization provided for the transfer by Western States to a new company— the Permian Oil Corporation— hereinafter called Permian, of all of the Texas properties, together with $400,000 par value in United States Government bonds in exchange for 2,990 of the authorized 3,000 shares of Permian stock which was then to be distributed by Western States in redemption of one-half of the 2,990 outstanding shares of Western States' capital stock. Permian was incorporated in Delaware on April 13, 1943. On April 22, 1943, the board of directors of Permian agreed to the transaction. On May 1, 1943, the transfer of Western States' Texas property for all of Permian's outstanding stock took place. On August 10, 1943, after the stockholders of Western States had endorsed the voting trustees' receipt, Western States distributed the 2,990 shares of Permian stock and received 1,495 of the 2,990 shares of Western's stock which were thereupon canceled. Gallagher was made voting trustee of the Permian stock. The petitioners surrendered six shares of Western States' stock and received 12 shares of Permian stock of a value of $589.79 per share. Charles R. Gallagher was of the opinion that distribution of the Permian stock to the shareholders of Western States was necessary in order to avoid the necessity of the parent company endorsing loans which the subsidiary might seek. He was advised that any dividends paid by Permian would have been subject to a California franchise tax had Western States retained the Permian stock.

The transfer of the Texas properties and Government bonds was recorded on the books of both companies as a nontaxable exchange. All of the assets, reserve accounts and depreciation were recorded on Permian's books in the same amount and on the same basis as they had been carried on the records of Western States. The $400,000 par value Government bonds transferred to Permian by Western States was composed of $300,000 in bonds due in 1945-1947 and $100,000 in bonds due in 1951-1954. Western States retained $400,000 par value Government bonds which were due in 1951-1954. The transfer was carried out in this manner in order to give Western States the long term interest bonds and to give the short term bonds to Permian to provide working capital. Permian sold one $100,000 bond for $104,250 on May 3, 1943, and another for $109,531.25 in October 1943.

After May 1, 1943, Permian acquired 12,371.06 acres of wildcat oil leaseholds at a cost of $34,950.98. No wells were drilled on this acreage nor were any drilled on the properties transferred to Permian by Western States, with the exception of 13 wells on the Mallett leases which increased the number of operating wells to 56 by August 31, 1944. Permian's gross income from crude oil sales between May 1, 1943, and the end of that year, was $236,183.35, and net income was $12,064.09. Permian wrote off intangible drilling costs in the amount of $119,239.59. For the year 1944, Permian's crude oil sales rose to $528,835.54 with a net income of $184,180.76. Intangible drilling costs of $175,751.92 were written off in that year. The average price per barrel of oil increased from $.9538 in May 1943, to $.9673 at the end of that year. The average price from January 1, 1944, to August 31, 1944, was $.9581.

The allowable monthly oil production for the three operating leaseholds increased in 1943 and 1944 so that by the end of June 1944, it was as follows:

+----------------------------------------------------+ ¦ ¦Coons¦Frazier¦Mallett (A)¦Mallett (B)¦ +--------------+-----+-------+-----------+-----------¦ ¦Oil wells ¦5 ¦18 ¦3 ¦27 ¦ +--------------+-----+-------+-----------+-----------¦ ¦Barrels of oil¦8,046¦32,967 ¦3,429 ¦36,342 ¦ +----------------------------------------------------+

The income from working interest barrels of oil for 8 months from May 1, 1943, to the end of that year, was $236,145.31. For the next 8 months to August 31, 1944, the total income from working interest was $462,146.23. A 16-inch pipeline was built in the field and another pipeline was constructed in the summer of 1944, enabling more oil to be shipped.

Charles R. Gallagher became president and general manager of Permian upon its organization. Chester E. Spangler became comptroller of Permian but his office remained in Los Angeles, and E. C. McCleary, an accountant in Western States' Los Angeles office prior to May 1943, was transferred to Lubbock, Texas. Spangler made three or four trips to Texas a year after the reorganization. A telephone line was built to the field after the necessary priority to secure the materials needed was obtained. Purchase orders and P.A.W. requests for the new corporation were issued at Lubbock instead of Los Angeles.

In October of 1943, C. P. Watson, vice president of the Seaboard Oil Company of Delaware, asked Gallagher if a sale of Western States' gasoline extraction plant at Kettleman Hills could be arranged. He was told that Western States was not interested. In May 1944 Gallagher told Watson that an offer would be considered for the sale of the stock of Western States. In July of that year an offer was made for all the stock by four companies, members of the Kettleman Hills North Dome Association. This offer was accepted in August 1944, and 100 per cent of the stock of Western States was bought by the General Petroleum Corporation, Continental Oil Company, Seaboard Oil Company of Delaware, and Honolulu Oil Corporation.

In early 1944, A. C. Mattei, president of the Honolulu Oil Corporation and a stockholder in Western States and Permian, asked Gallagher if he wished to sell Permian. Gallagher informed him that he did not. Later in February 1944, Gallagher refused another offer for all the shares of Permian made by the president of Stanolind Oil & Gas Company. Later in the summer a mutually satisfactory price was agreed upon between Stanolind and the stockholders of Western States. On July 24, 1944, the stockholders of Permian adopted a resolution for the liquidation of Permian upon the insistence of counsel for Stanolind. In the summer of 1944, all of the stock in Permian was sold by the stockholders to Stanolind Oil & Gas Company. Prior to May 1, 1943, Charles R. Gallagher and Chester E. Spangler did not have an intention so sell the assets or stock of either company. Prior to the creation of Permian the tax counsel consulted by Gallagher inquired whether there was any intention to sell the properties or stock of either company and he was told that there was no such intention.



The only issue in this proceeding is whether the petitioners' exchange of 6 shares of Western States stock for 12 shares of Permian stock is taxable, and, if so, whether as capital gain or as ordinary income. The petitioners contend that the transaction was in pursuance of a plan of reorganization and that no gain or loss is to be recognized. Alternatively, they argue that the distribution was in partial liquidation. Respondent urges that the distribution of Permian stock to the shareholders of Western States was a taxable property dividend under section 115(a) of the Internal Revenue Code and, also, that the transaction constituted a redemption of the stock accompanied by a distribution essentially equivalent to a taxable dividend within the meaning of section 115(g), I.R.C.

SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(a) DEFINITION OF DIVIDEND.— The term ‘dividend‘ * * * means any distribution made by a corporation to its shareholders, 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. * * *

SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(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.

The entire transaction consisted of two exchanges. Western States first exchanged its Texas properties and Government bonds for all of Permian's outstanding stock. Section 112(b)(4), I.R.C., is applicable to this transaction if the exchange was made by parties to and in pursuance of a plan of reorganization. The subsequent exchange consisted of distributing the Permian stock to the shareholders of Western States for half of their stock in that corporation. Section 112(b)(3), I.R.C., is applicable here if the distribution of Permian stock for the Western States shares constituted an exchange and if the corporations were parties to and the exchange made in pursuance of a plan of reorganization.

SEC. 112. RECOGNITION OF GAIN OR LOSS.(b) EXCHANGES SOLELY IN KIND.—(4) SAME— GAIN OF CORPORATION.— No gain or loss shall be recognized if a corporation a party to a reorganization exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization.

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.

Sections 112(b)(3) and 112(b)(4) both require that the exchanges be made in pursuance of a plan of reorganization and involve stocks, securities or property of a corporation a party to a reorganization. A reorganization is defined in section 112(g)(1)(D) as ‘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 shareholders or both are in control of the corporation to which the assets are transferred * * * .‘ The present transaction meets this definition in that after the transfer of oil properties and bonds for Permian stock Western States controlled the new corporation by the ownership of all of its stock and within 4 months thereafter the shareholders of Western States owned all of the Permian stock. Since the exchange was made as part of the plan of reorganization and both Western States and Permian were parties to the reorganization the exchange falls within the terms of section 112(b)(4) if there are no other requirements.

SEC. 112. RECOGNITION OF GAIN OR LOSS.(h) DEFINITION OF CONTROL.— As used in this section the term ‘control‘ means the ownership of stock possessing at least 80 per centum of the total combined voting power of all classes of stock entitled to vote and at least 80 per centum of the total number of shares of all other classes of stock of the corporation.

SEC. 112. RECOGNITION OF GAIN OR LOSS.(g) DEFINITION OF REORGANIZATION.— As used in this section (other than subsection (b)(10) and subsection (1)) and in section 113 (other than subsection (a)(22))—(2) The term ‘a party to a reorganization‘ includes a corporation resulting from a reorganization and includes both corporations in the case of a reorganization resulting from the acquisition by one corporation of stock or properties of another.

The delay of 3 months and 10 days in obtaining the necessary endorsements of trustee's receipts does not preclude the subsequent stock redemption exchange from being in pursuance of the plan of reorganization. The plan had included this distribution of Permian stock as evidenced by the letter to the stockholders. D. W. Douglas, 37 B.T.A. 1122. Transfers made pursuant to a plan or reorganization are ordinarily parts of one transaction and should be so treated. Starr v. Commissioner, 82 F.2d 964. Since the shares transferred were in corporations which were parties to the reorganization the literal requisites of section 112(b)(3) have been met and we turn to respondent's arguments.

The respondent concedes that the exchange of oil properties for Permian stock maintained a continuity of interest but denies the existence of the required business purpose. Gregory v. Helvering, 293 U.S. 465; Regs. 111, sec. 29.112(g)-1. It is to be noted that the drilling of oil wells upon unproven leaseholds is a different and more speculative business than manufacturing casinghead gasoline on a contract basis. The division of a business carrying on more than one type of operation into independent entities, engaged separately in the same undertakings, has been recognized for tax purposes. Buffalo Meter Co., 10 T.C. 83; Miles-Conley Co., 10 T.C. 754, affirmed 173 F.2d 958. We are of the opinion that there were adequate financial as well as inherent industrial reasons for separating Western States' oil operations in Texas from the gasoline processing operations in California. Corporate surplus had declined since commencement of the Texas operations, and, although it remained over $1,000,000, dividends had declined until none were paid in 1942. Earnings from California operations were insufficient to cover the operating losses from the Texas properties in 1941 and 1942. The allowable production of oil and ability to ship oil were curtailed by the small pipeline outlet. The threat of necessarily making sizeable drilling expenditures if oil was struck by competitors on adjacent leaseholds existed at the same time that Western States was required to process, in wartime, all the gas offered by their contractual customers in California. The possibility of a new processing plant being built by others to offset the demand upon Western States' facilities was diminished because of the difficulties in procuring necessary materials in time of war.

After Permian was formed, it increased its output and prospered. Had it been known in advance that it would prove so successful, the same financial reasons of avoiding a drain upon Western States' resources might not have existed. However, it could not be foreseen with accuracy if and when pipeline facilities could be obtained following the entry of the United States into the war in 1941. It was uneconomical to drain off California earnings to drill more oil wells at a time when the oil could not be shipped. Since Western States' accounting difficulties could have been overcome by providing local accounting for that corporation, we do not believe that accounting and managerial reasons necessitated the separation. Local management existed to some extent since the president of Western States lived at the site of the Texas operations. However, it is also true that if the Texas operations produced taxable income Western States would have to prorate its income for the California franchise tax.

Permian was financed with $400,000 in Government bonds and, if it was thought worth while to expand Permian's drilling operations, new capital might be required. Western States wished to avoid the necessity of guaranteeing loans sought by the new corporation as a subsidiary and, for this reason, the Permian stock was distributed to Western States' shareholders. As it turned out, Permian did not need to cash all the bonds for working capital. But this is known only with the benefit of hindsight.

Another business reason for the distribution of Permian stock to the shareholders of Western States is that this distribution avoided the subjection of dividends paid by Permian to the California franchise tax.

Upon all the facts, it appears that the reorganization of the two types of operations into separate corporate entities, possessed the necessary business purpose and was not ‘ * * * merely a vehicle, however elaborate or elegant, for conveying earnings from accumulations to the stockholders.‘ Bazley v. Commissioner, 331 U.S. 737, 743. The separation continued the same two businesses under a changed form which was introduced for reasons ‘ * * * germane to the conduct of the venture in hand.‘ Helvering v. Gregory, 69 F.2d 809.

The respondent contends that because the shareholders of Western States maintained the same proportional interests in Western States before and after the pro rata redemption they gave up nothing in giving back half of their stock. Nothing, therefore, it is said, was received by Western States to constitute an exchange within the meaning of section 112(b)(3). We do not so construe the statute nor do we agree with respondent that the distribution was a dividend within the purview of section 115(a). The distribution of assets held by the corporation for half of its outstanding stock was much the same as a distribution in partial liquidation under sections 115(c) and 115(i, I.R.C. The existence of earnings and profits does not preclude a partial liquidation. Joseph w. Imler, 11 T.C. 836. The exchange of stock for the distribution is the difference between a taxable dividend and a partial liquidation in such an instance, but the pro rata exchange does not alter the shareholders' proportional interests. In so far as sections 115(c) and 115(i) are applies, the distribution here in question qualifies as a partial liquidation. As such, ‘ * * * amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. * * * . ‘ Thus, section 115(c) limits recognition of gain or loss to the distributee of a partial liquidation to the extent provided in section 112. A partial liquidation in which no gain or loss is recognized because of section 112(b) would, of necessity, be the type of reorganization we have here. Similar pro rata distributions of stock and reduction of capitalization by the distributing corporation qualified as exchanges under section 112(b)(3). Hortense A. Menefee, 46 B.T.A. 865; W. N. Fry, 5 T.C. 1058.

SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(c) DISTRIBUTIONS IN LIQUIDATION.— Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. * * *(i) DEFINITION OF PARTIAL Liquidation.— As used in this section the term ‘amounts distributed in partial liquidation‘ means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock.

Nor do we agree with respondent's argument that the distribution was essentially equivalent to a dividend under section 115(g). Although there is no established weighted formula to resolve this issue, Flanagan v. Helvering, 116 F.2d 937, the determinative criteria set forth in Joseph W. Imler, supra, do not bring us to that conclusion. There was a valid business purpose in separating the speculative Texas oil venture from the California operations. The motive in distributing the Permian stock was to keep control of the new corporation in the hands of the same stockholders. The surplus of Western States which had declined since 1938 remained over $1,000,000 after the reorganization. The past dividend policy had been liberal, and the significant special circumstances attending the distribution was the creation of a new entity for the oil business to be owned by the same interests. A dividend would not achieve this end. Section 115(g) being inapplicable, we conclude that the literal and substantive requirements of the statute have been met.

A further argument by respondent is based upon the legislative history of the statute. It is said that a reorganization in which part of the assets of a corporation are transferred for stock in a new corporation, following which the original corporation distributes this stock to its shareholders, receiving at the same time a pro rata portion of its own stock, is termed a ‘split-off.‘ This type of reorganization, it is contended, is indistinguishable from a ‘spin-off‘ which Congress intended to tax. The reorganization in question here is said to be a ‘split-off,‘ differing from a ‘spin-off‘ only by the fact that in the ‘spin-off‘ the stock in the new corporation is distributed by the original corporation without surrender of stock by its shareholders. A ‘spin-off‘ type of divisive reorganization is said to have been held taxable in Rockefeller v. United States, 257 U.S. 176. Because a similar result could be obtained without tax under the then existent statute by means of a ‘split-up,‘ wherein two new corporations are created to which the original company transfers its assets for their stock which is then distributed to its shareholders in exchange for stock of the original corporation, Congress, in 1924, granted nonrecognition to the distributee in ‘spin-offs.‘ 1939-1 C.B. (Part 1) 251, 276. Section 203(c) of the Revenue Act of 1924 provided, as follows:


SEC. 203. * * *

(c) If there is distributed, in pursuance of a plan of reorganization, to a shareholder in a corporation a party to the reorganization, stock or securities in such corporation or in another corporation a party to the reorganization, without the surrender by such shareholder of stock or securities in such a corporation, no gain to the distributee from the receipt of such stock or securities shall be recognized.

In 1934 this provision was eliminated and the ‘spin-off‘ lost its nonrecognition status. Samuel L. Slover, 6 T.C. 884. Respondent urges that because the pro rata redemption of shareholders' stock in a ‘split-off‘ is without economic effect, it is meaningless and the transaction must be treated as if it were a ‘spin-off.‘ The lack of economic effect may exist, but if Congress has designated the distinction for tax purposes upon the basis of an exchange, we need not look for others. The exchange of stock for stock in the pro rata redemption meets the concept of an exchange as used in the statute and in the Fry and Menefee decisions. The existence of the exchange distinguishes the present facts from the ‘spin-off‘ and places them within the statutory rule for nonrecognition.

We find further evidence of this conclusion in the definition of a reorganization in section 112(g)(1)(D). A statutory reorganization results if both the transferor and its shareholders are in control of the transferee immediately after the transfer. For this to occur, the transferee must either make the exchange of its stock for the transferor's assets with both the transferor and its shareholders or else the transferee must exchange its stock for the assets with the transferor which then distributes the stock to its shareholders. The latter transaction includes ‘split-ups,‘ ‘spin-offs,‘ and ‘split-offs‘ within its scope. The respondent concedes the nonrecognition of gain or loss in the ‘split-up.‘ The ‘split-off‘ meets the requisites of sections 112(b)(3) and 112(b)(4) because there are two exchanges as in the ‘split-up.‘ The ‘spin-off‘ does not meet the requirements of section 112(b)(3) because there is no exchange of stock or securities for stock or securities.

Upon this basis we can but conclude that the petitioners received the stock in a reorganization in which there is no recognition of gain or loss. Petitioners' alternative argument need not be considered.

Reviewed by the Court.

Decisions will be entered under Rule 50.