Opinion
Docket No. 15243.
1950-01-27
SOUTHWEST NATURAL GAS COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
A. O. Dawson, Esq., and Paul Smith, Esq., for the petitioner. John W. Alexander, Esq., for the respondent.
REORGANIZATION— STATUTORY MERGER— SECTION 112(g)(1)(A), I.R.C.— In a statutory merger pursuant to state law, corporation A acquired all the assets of corporation B in exchange for a total consideration of $663,393.01, consisting of 16.4 per cent of A's common stock having a market value of $5,592.50 and a certain amount of A's bonds, cash, and the assumption of B's liabilities.
(1) Held, on authority of Roebling v. Commissioner, 143 Fed.(2d) 810, that in addition to the statutory merger and to constitute a ‘reorganization‘ within the Federal income tax statutes, the transaction must meet the test of the ‘continuity of interest‘ doctrine enunciated by the courts.
(2) Held, further, on authority of Le Tulle v. Scofield, 308 U.S. 415, that the bonds involved in the exchange did not represent a retained proprietary interest and that for purposes of this opinion the bonds are to be considered as the equivalent of cash.
(3) Held, further, on authority of Helvering v. Minnesota Tea Co., 296 U.S. 378, that the shares of stock involved representing the retained proprietary interest having a value of only $5,592.50 did not constitute a substantial part of the value of the assets transferred by corporation B and that accordingly there was no statutory merger within the meaning of the term ‘reorganization‘ as defined by section 112(g)(1)(A), I.R.C. A. O. Dawson, Esq., and Paul Smith, Esq., for the petitioner. John W. Alexander, Esq., for the respondent.
This proceeding involves deficiencies for the years and in the amounts as follows:
+--+ ¦¦¦¦ +--+
Year Tax Amount 1941 Income tax $22,475.33 1942 Declared value excess profits tax 1,452.24 1942 Excess profits tax 112,347.95
The only contested issue is whether respondent erred in his determination that a transaction alleged to have been a statutory merger, whereby the petitioner acquired all the assets and assumed all liabilities of the Peoples Gas & Fuel Corporation on December 28, 1940, did not constitute a ‘reorganization‘ within the meaning of section 112(g) of the Internal Revenue Code.
The parties have stipulated the figures to be used for computing petitioner's depreciation deductions and equity invested capital for the years in question, dependent upon the decision herein on the above mentioned reorganization issue, and, further, certain other assignments of error have been settled by stipulation to be given effect in a recomputation under Rule 50.
The proceeding has been submitted upon the pleadings, testimony, and a stipulation of facts, with appended exhibits.
FINDINGS OF FACT.
The facts as stipulated are so found.
Petitioner is a corporation, duly organized and existing under the laws of the State of Delaware. It was incorporated on April 17, 1928, under the name of Southwest Gas Utilities Corporation of Oklahoma, and subsequently, on April 23, 1937, its name was changed to Southwest Natural Gas Co. Petitioner is engaged in business as a natural gas operating public utility, with its principal office at Shreveport, Louisiana. For the calendar years 1941 and 1942, respectively, petitioner duly filed its corporation income and declared value excess profits tax returns, on Form 1120, and its corporation excess profits tax returns, on Form 1121, with the collector of internal revenue at New Orleans for the district of Louisiana.
Prior and leading up to the December 28, 1940, transaction here in question, certain undisputed transactions occurred involving petitioner and three other similar utility companies. As subsidiaries of the same parent holding company, which owned 100 per cent of the stock of petitioner and two others and 80 per cent of the stock of another, those four operating utility companies occupied the same office space in Shreveport and their business affairs were conducted by the same group of persons serving in the capacities of directors, officers, attorneys, accountants, and engineers. On September 30, 1935, the parent holding company distributed pro rato to its own stockholders all of the shares of stock held in the four subsidiaries, which continued operations as theretofore conducted, and the new stockholders of the four companies gave consideration to merging or consolidating them into one company. On April 22, 1937, one of those companies, the Southwest Gas Co., of Oklahoma, was merged with petitioner, which continued doing business at the Shreveport office and operated properties located in Texas and Oklahoma. Due to financial difficulties the other two companies, Northwest Louisiana Gas Co. and Peoples Gas & Fuel Co., were involved in proceedings under section 77-B of the Bankruptcy Act and, pursuant to an order of the court in such proceeding, were merged on November 30, 1938, into a new Delaware corporation duly organized in November, 1938, under the name of ‘Peoples Gas and Fuel Company, Inc. ‘ (hereinafter referred to as Peoples). The latter thereupon operated Louisiana properties from the Shreveport office.
At meetings held on December 5, 1940, the board of directors of petitioner and the board of directors of Peoples, respectively, unanimously adopted a resolution approving and authorizing the execution of a proposed agreement of merger, dated December 5, 1940, which provided the terms of a merger of Peoples with and into petitioner as the continuing corporation pursuant to chapter 65 of the Revised Code of Delaware. At the same meetings there were adopted resolutions calling for due notices of special meetings of the stockholders of the two corporations to vote thereon. Following those meetings the under date of December 5, 1940, the directors of petitioner and the directors of Peoples, respectively, made and entered into the agreement of merger. At special meetings of the stockholders of petitioner and of Peoples, held on December 28, 1940, respectively, more than two-thirds of the common and preferred stock of petitioner and of the common stock of Peoples, issued, outstanding, and entitled to vote, voted in favor of the agreement of merger and authorized the officers to do all acts necessary to consummate it.
On December 28, 1940, the agreement of merger between petitioner and Peoples was duly executed on behalf of each corporation by the proper officers and under the corporate seal thereof, together with certifications as to the adoption thereof by the stockholders of each corporation, and the agreement was filed in the office of the Secretary of State of Delaware and recorded in the office of the Recorder of the County of New Castle, Delaware, in which petitioner and Peoples had their original certificates of incorporation recorded. On February 3, 1941, such agreement of merger was filed in the office of the Secretary of State of Louisiana and recorded in the record of charters of that state.
Prior to the statutory merger of petitioner and Peoples pursuant to the laws of Delaware as above mentioned, petitioner was the larger of the two companies. Their respective balance sheets as of October 31, 1940, show total assets and liabilities in the amounts of $4,352,033.26 for petitioner and $1,682.008.91 for Peoples. The assets of both companies shown on those balance sheets consisted principally of tangible property, plant, equipment, etc. In the prior 77-B proceeding which resulted in the organization of Peoples, the holders of all types of stocks, bonds, and other securities of Peoples' predecessors received shares of common stock of Peoples which remained free of any bonded indebtedness, and its liabilities shown on its balance sheet embraced, inter alia, an authorized 25,000 shares of common stock, par value $1 each, not all of which were issued and outstanding, and a paid-in and earned surplus of $1,438,020.69. Petitioner's liabilities as shown on its balance sheet embraced, inter alia, Southwest Gas Co. of Oklahoma 6 per cent first mortgage bonds due May 1, 1954, in the amount of $1,419,150, less treasury bonds amounting to $376,000, which bond issue had therefore been assumed by petitioner; certain other long term debts; an authorized capital stock of 20,000 shares of $6 dividend cumulative preferred stock, series A, par value $10 each, and 1,200,000 shares of common stock, par value 10 cents each, not all of which preferred and common stock was issued and outstanding; and a paid-in and earned surplus of $324,243.50.
As of December 7, 1940, the petitioner had issued and outstanding in the hands of the public 9,590 shares of preferred stock which was $12.75 per share in arrears on dividends, and also 566,150 shares of common stock, which had a market value of 5 cents a share. As of the same date, Peoples had issued and outstanding in the hands of the public 17,769 shares of common stock which has a market value of $30 a share. Of such 566,150 shares of common stock of petitioner, 480,813 shares were held by persons who also owned 6,291 shares of common stock of Peoples, that is, the same group of people owned approximately 85 per cent of the common stock of petitioner and 35 per cent of the common stock of Peoples. There was no substantial change in the record of stockholders of either company between December 7 and December 28, 1940.
In connection with the drafting of the proposed agreement of merger, it was necessary to consider the difficulties presented by the variation in the capital structure and in the market value of the common stock of the two companies. An exchange of common stock for common stock was not feasible because on the basis of market value it would have required 600 shares of petitioner's to equal in value one of Peoples' and, further, petitioner's common stock was subordinate to its long term debt and preferred stock outstanding. Accordingly, the plan devised and incorporated in the terms of the agreement of merger was that the common stockholders of Peoples would have the option to receive in exchange for each share of Peoples either (A) 10 shares of petitioner's common and $33 principal amount of petitioner's bonds, with a cash adjustment equivalent to 90 per cent of the principal amount of bonds of less than $50 denomination, or (B) cash in the amount of $30 per share. All shares of stock of petitioner outstanding at the time of the agreement were to remain outstanding; and no new securities were to be issued to the then holders thereof in connection with the merger. In addition the group of persons who held substantial amounts of common stock in and exercised actual control over the operations of both companies agreed among themselves that they would exercise their respective options in such manner that the total exchanges consummated in the merger would come within the respective amounts of petitioner's common shares, bonds, and cash available therefor.
On December 28, 1940, there was a total of 18,875 shares of common stock of Peoples entitled to participate under the agreement of merger. The holders of 7,690 of such shares exercised option B of that agreement and received $30 in cash for each share, or a total of $230,700. The holders of 11,185 shares of Peoples' common stock (or 59.2 per cent of the total outstanding) exercised option A and received in exchange therefor under the agreement of merger, the following: $349,350 principal amount of petitioner's 6 per cent first mortgage bonds of the market value of 90 cents on the dollar, or a total value of $314,415; $17,779.50 cash for fractional bond interests; and 111,850 shares of petitioner's common stock having a market value of 5 cents per share, which shares represented 16.4 per cent of petitioner's outstanding common stock immediately after the merger transaction was consummated.
On December 28, 1940, all of Peoples' assets were transferred to petitioner and the liabilities of Peoples, amounting to $94,906.01, were assumed by petitioner in connection with the merger. On the same date all of Peoples' assets, depreciable and undepreciable, in its hands had an unadjusted basis of $1,724,468.62 and an adjusted basis of $938,912.68. The parties have stipulated the adjusted basis for depreciation in the hands of Peoples of its depreciable property on December 28, 1940, and they have further stipulated with respect to Peoples' property in the hands of petitioner, and, if the merger transaction on that date was a reorganization within the meaning of the Internal Revenue Code, the amounts of depreciation deductions allowable to petitioner for each of the years 1941 and 1942, and also the amounts, respectively, to be used in determining petitioner's equity invested capital for 1941 and 1942 and borrowed invested capital for 1941.
Prior to the transaction on December 28, 1940, petitioner and Peoples maintained a common principal place of business at Shreveport, had the same four men as their respective officers, had the same men as principal employees, and conducted their affairs as an integrated business, and those circumstances constituted the reasons for the statutory merger of the two companies, under the laws of Delaware, for the purpose of better integration and greater efficiency. Following the transaction, the petitioner conducted the business as it had been previously conducted, petitioner's officers and principal employees were the same persons as previously employed, and petitioner's board of directors was substantially an amalgamation of the prior boards of directors of petitioner and Peoples. After the transaction, individuals who had theretofore owned a substantial amount of stock in Peoples owned approximately 88 per cent of petitioner's outstanding common stock as a result of the stock they received in the merger transaction plus their prior stockholdings in petitioner, and those same individuals continued in active control of the merged business enterprise.
In asserting the deficiencies involved herein, the respondent determined that the transaction of December 28, 1940, whereby petitioner acquired the assets of Peoples, did not constitute a reorganization within the meaning of section 112(g) of the Internal Revenue Code and that the basis of such assets was the cost thereof to petitioner, as follows:
+----------------------------------------------------+ ¦Cash paid ¦$248,479.50¦ +----------------------------------------+-----------¦ ¦Liabilities assumed ¦94,906.01 ¦ +----------------------------------------+-----------¦ ¦Bonds issued (principal amount) ¦349,350.00 ¦ +----------------------------------------+-----------¦ ¦Stock issued (market value 5¢ per share)¦5,592.50 ¦ +----------------------------------------+-----------¦ ¦Total ¦698,328.01 ¦ +----------------------------------------------------+
The parties have stipulated that if the December 28, 1940, transaction between petitioner and Peoples was not a reorganization within the meaning of the Internal Revenue Code the petitioner's cost basis for depreciable assets acquired therein and allowable depreciation deductions thereon for 1941 and 1942 are in the respective amounts as determined by respondent in the deficiency notice.
OPINION.
TYSON, Judge:
The only contested issue presented for decision is whether the statutory merger of Peoples with petitioner on December 28, 1940, constituted a purchase by petitioner of the assets of Peoples as determined and herein contended by respondent, or, as contended by petitioner, constituted a ‘reorganization‘ within the meaning of that term as defined by subsection (g)(1)(A) of section 112 of the Internal Revenue Code,
which section provides the general rule for the recognition of gain or loss upon the sale or exchange of property and for the exceptions thereto in specifically described exchanges incident to readjustments of corporate structures or corporate reorganizations.
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))—(1) The term ‘reorganization‘ means (A) a statutory merger or consolidation * * *
The facts herein establish, and the respondent does not contend otherwise, that the petitioner and Peoples, both Delaware corporations, duly complied with the provisions of the Revised Code of Delaware of 1935, chapter 65, section 59, pertaining to the procedure for consolidation or merger of corporations and pursuant thereto duly effectuated a statutory merger of Peoples with and into the petitioner as the continuing corporation, on December 28, 1940. Accordingly, in the instant proceeding we have a statutory merger of Peoples with petitioner under state law and a compliance with the literal language of the above definition of the term ‘reorganization.‘ However, the parties are in agreement on the established principle that such literal compliance alone is not sufficient, and both cite Roebling v. Commissioner, 143 Fed.(2d)810; certiorari denied, 323 U.S. 773, as authority that, in addition thereto and to constitute through merger a ‘reorganization‘ within the meaning of the Federal income tax statutes, the transaction must meet the test of the ‘continuity of interest‘ doctrine enunciated in numerous decisions of the Supreme Court of the United States to distinguish a transaction which, though taking the form of a reorganization, constitutes a taxable sale or exchange from a transaction which in fact as well as in form constitutes a tax-free reorganization within the intendment of the Federal statute. The parties differ only with regard to whether the ‘continuity of interest‘ test has been met under the facts of this case.
In the Roebling case, supra, two corporations complied with state law providing for mergers, but, since the stockholders of the merged corporation received in exchange therefor only long term bonds of the continuing corporation, the court held that they thereby surrendered their former proprietary interest in certain property and simply became creditors of the continuing corporation, and that the transaction was not a ‘reorganization‘ within the meaning of section 112(g)(1)(A) of the Revenue Act of 1938, which provided, ‘(1) The term 'reorganization’ means (A) a statutory merger or consolidation.‘ In reaching its conclusion the court relied upon the ‘continuity of interest‘ doctrine first introduced in Supreme Court decisions in Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462, and as applied in Le Tulle v. Scofield, 308 U.S. 415, and other cited cases.
In the instant case and under the agreement of merger, all of Peoples' assets were acquired by petitioner in exchange for certain amounts of stock, bonds, cash, and the assumption of debts. As to the stock involved, the owners of 59.2 per cent of Peoples' common shares received 16.4 per cent of petitioner's outstanding common stock, representing their continuing proprietary interest in the enterprise after the merger. The question here is thus narrowed to one of whether such retained proprietary interest was sufficient to satisfy the test of the ‘continuity of interest‘ doctrine enunciated by court decisions.
An examination of numerous Supreme Court decisions involving application of the ‘continuity of interest‘ test leads to the conclusion that there is no precise formula for that test, but, instead, different language has been used to express a meaning of the phrase ‘continuity of interest‘ as applied to the facts involved in each particular case. In cases involving an exchange in a merger or consolidation alleged to constitute a ‘reorganization‘ as defined by the tax statutes, it has been held, in Pinellas Ice & Cold Storage Co. v. Commissioner, supra (1933), that an exchange for cash and promissory notes constituted a sale because such notes were the equivalent of cash and the transferor did not acquire a sufficiently definite ‘interest in the affairs of the purchasing company‘; in Helvering v. Minnesota Tea Co., 296 U.S. 378 Dec. 16, 1935), that an exchange for $426,842.52 in cash and 18,000 shares of common stock valued at $540,000 constituted a merger ‘reorganization‘ because the statute does not inhibit a substantial change in the relationship of the transferor to the assets conveyed and the transferor acquired a ‘definite and material‘ interest in the affairs of the transferred‘; in Nelson Co. v. Helvering, 296 U.S. 374 (Dec. 16, 1935), that an exchange for $2,000,000 cash and the entire authorized issue of 12,500 shares of nonvoting preferred stock constituted a merger ‘reorganization‘ because the transferor acquired ‘a definite and substantial interest in the affairs of the purchasing corporation,‘ represented by ownership of the preferred stock, although denied voting rights, since neither participation in the management of nor a controlling stock interest in the transferee is requisite; and in Le Tulle v. Scofield, supra (1940), that an exchange for cash and bonds constituted a sale because the transferor became solely a creditor of the transferee and did not retain ‘any proprietary interest in the enterprise‘; and, further, that the statute is ‘not satisfied unless the transferor retained a substantial stake in the enterprise,‘ as for instance, such a stake as was thought to be retained in the Minnesota Tea and Nelson Co. cases, supra.
Since the types of exchanges in different mergers or consolidations of necessity vary considerably one from the other in order to meet the widely varying circumstances as to capital structure, etc., involved in different transactions of that character, and in the light of the pronouncements in the above cited cases, we conclude that the basic test is whether, under all the facts and circumstances involved in a particular merger or consolidation, it can be said that the transferor corporation or its stockholders retained a proprietary stake in the enterprise represented by a definite and material interest in the affairs of the transferee company and, as was said in the Minnesota Tea case, supra, that such retained interest represents ‘a substantial part of the value of the thing transferred,‘ so that the transaction genuinely partakes of the true nature of a merger or consolidation and, further, that, other than being ‘substantial,‘ there is no precise measure of the extent of such proprietary stake requisite to satisfy the ‘continuity of interest‘ test laid down by court decisions. Each case must rest upon its own facts in the light of prior decisions.
In the instant case that part of the consideration consisting of bonds did not represent a proprietary interest in the assets transferred, Le Tulle v. Scofield, supra, and for the purposes of this opinion may be considered as being in the same category as the cash consideration, thus in effect treating the transfer as one for cash and stock, as was true in the Minnesota Tea case, supra. Accordingly, the principle enunciated and as applied in deciding the last cited case is determinative of the instant case.
In the Minnesota Tea case, supra, the assets of one corporation were transferred to another corporation and, as more particularly shown in the Circuit Court's opinion in 76 Fed.(2d) 797, for a total consideration of $966,842.52, consisting of $426,842.52 cash and 18,000 shares of the transferee corporation's stock, which stock had a value of $540,000. In deciding that there was a reorganization, the Supreme Court enunciated the principle that the retained definite and substantial interest represented by stock in a transferee corporation ‘must represent a substantial part of the value of the thing (assets) transferred. * * * in order that the result accomplished may genuinely partake of the nature of merger or consolidation,‘ and it concluded that the corporation's assets represented by the value of the stock of the transferee corporation satisfied the requirement of the principle enunciated.
In the instant case, as in the Minnesota Tea case, supra, the record discloses no value of the assets transferred other than as evidenced by the consideration paid therefor. Here, the total consideration paid amounted to $663,393.01, consisting of cash and its equivalent amounting to $657,800.51 and common stock of petitioner having a market value of $5,592.50. Such a small fractional portion of the total value of the assets transferred as is represented by the value of the common stock can not in our opinion be said to represent a substantial part of the value of the assets transferred, as is required under the principle enunciated in the Minnesota Tea case, supra, and we hold that the transaction here involved did not constitute a statutory merger within the provisions of section 112(g)(1)(A), supra, and, therefore, was not a reorganization. On this issue the respondent is sustained.
The petitioner points to the various facts as to continuity of the business enterprise, directors, officers, employees, etc., and particularly to the fact that after the exchange those persons who had owned 59.2 per cent of Peoples' common stock owned 16.4 per cent of petitioner's outstanding common stock, as representing their continuing proprietary interest. Petitioner contends that such continuing proprietary interest in the transferee corporation measured by the 16.4 per cent of its common stock should be regarded as substantial enough to meet the continuity of interest test. We think it should not be so regarded, if for no other reason, that that such method gives no consideration to the value of petitioner's outstanding preferred stock, which is not shown and which, as well as did the common stock, represented an interest in the value of all of petitioner's assets, including those transferred by Peoples, after the consummation of the transaction involved; and it would be necessary to know the value of this outstanding preferred stock in order to arrive at the proper proportion of the interest of the holders of the 16.4 per cent of common stock in the assets transferred by Peoples. And in this connection it may be noted that, while the value of the outstanding preferred stock is not shown, it is obvious that it represented a vastly more valuable interest in petitioner and its assets than did the entire outstanding common stock, since after the transaction was completed petitioner's outstanding 678,000 shares of common stock had a market value of only 5 cents per share or a total of $33,900, while petitioner's outstanding 9,590 shares of preferred stock of $10 par value per share bore an annual dividend rate of $6 per share, or the equivalent of 6 per cent on a $100 per share valuation, and, as shown by an exhibit to the stipulation, was entitled to receive in preference to the common stock, upon any distribution of assets other than dividends from surplus or profits, $100 per share plus any accumulated and unpaid dividends thereon.
Reviewed by the Court.
Decision will be entered under Rule 50.