Koehring Co. v. U.S., 77-2016

• Citation: 583 F.2d 313
• Decision Date: 04 August 1978
• Docket Number: No. 77-2016,77-2016
• Parties: 78-2 USTC P 9621 KOEHRING COMPANY, a Wisconsin Corporation, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 313

583 F.2d 313

78-2 USTC P 9621

KOEHRING COMPANY, a Wisconsin Corporation, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 77-2016.

United States Court of Appeals,

Seventh Circuit.

Argued March 3, 1978.

Decided Aug. 4, 1978.

Edward C. Rustigan, Chicago, Ill., for plaintiff-appellant.

Anthony Ilardi, Jr., Atty., Tax Div., Dept. of Justice, Washington, D. C., for defendant-appellee.

Before PELL and WOOD, Circuit Judges, and FLAUM, District Judge. ^*

HARLINGTON WOOD, Jr., Circuit Judge.

The question presented in this appeal is whether the district court erred in finding that a foreign corporation partially owned by the Koehring Company was a "controlled foreign corporation" within the meaning of Section 957 of the Internal Revenue Code. We affirm.

The facts as found by the district court in its unreported opinion are as follows: Koehring Company (taxpayer) is a Wisconsin corporation engaged in the manufacture of heavy construction equipment. In 1959 Koehring acquired a Panamanian corporation which it renamed Koehring Overseas Corporation (KOS). KOS was thereafter operated as a wholly-owned subsidiary responsible for the overseas marketing of Koehring products in the western hemisphere. Under the provisions of the Internal Revenue Code (IRC or Code) prevailing at that time, KOS's profits were not taxed to Koehring until remitted to the parent corporation in the form of a dividend. However, in 1962 Congress debated adding provisions to the IRC which would have taxed the undistributed income of certain controlled foreign corporations. This change was a matter of concern to Koehring officials, who made their views known to members of Congress. Nevertheless, in October of 1962 Congress added the provisions of Subpart F to the Code which would have required Koehring to pay taxes on KOS's undistributed earnings.

In 1963 Koehring entered into an arrangement designed to take KOS out of the ambit of Subpart F by transferring voting control of KOS to Newton Chambers, an English corporation, also engaged in the manufacture of construction machinery. On or about September 3, 1963, Newton Chambers acquired 44,000 shares of newly issued 8% Cumulative voting preferred stock with a par value of $10 per share. This represented 55% Of the outstanding KOS stock entitled to a vote. Koehring retained 36,000 voting shares of $10 par value common stock, representing the remaining 45% Of the voting shares.

At the time of the sale, Newton Chambers and Koehring enjoyed a long standing business relationship, which began shortly after World War II. At that time Koehring gave Newton Chambers a license to manufacture certain equipment designed by Koehring and to market the products in an exclusive territory encompassing much of the eastern hemisphere. In subsequent years Newton Chambers was gradually relieved of portions of its exclusive territory, largely because of its alleged lack of diligence in promoting sales of the Koehring products. This and related problems were the subject of ongoing discussions between the two companies beginning in 1958. Both corporations wanted to improve the international marketing of their products. One of the ideas discussed was the concept of a jointly-owned international marketing subsidiary.

In 1962 Koehring acquired an interest in a French company which it renamed Koehring-Brissonneau. Since Koehring-Brissonneau was engaged in marketing Koehring products in continental Europe, Newton Chambers' chairman, Sir Peter Roberts, protested that the licensing agreement between Koehring and Newton Chambers was being violated and renewed his suggestion of a joint marketing subsidiary. More specifically, his letter suggested that Newton Chambers acquire an equity interest in KOS and that KOS should be the means of coordinating the "international impact of Koehring."

In the spring and summer of 1963, Koehring and Newton Chambers discussed various cross-investment plans. On July 5, 1963, Newton Chambers applied for exchange control approval for the acquisition of the $400,000 worth of KOS preferred stock. Newton Chambers was to acquire the KOS stock on September 1, 1963, but with a right to force redemption of the shares at a premium after June 30, 1968. In December of 1963 Koehring-Waterous, Koehring's Canadian subsidiary, was to invest $400,000 in an issue of 5% Redeemable, non-voting preferred stock to be issued by Ransomes & Rapier, Ltd., a Newton Chambers subsidiary. However, in August of 1963, Koehring discovered that under Panamanian law KOS preferred could not be issued at less than par value, which meant that Newton Chambers would have to invest $440,000 rather than $400,000. At the same time, the amount that Koehring was to invest in Ransomes & Rapier was increased by $40,000. In the end, by February of 1964 Koehring-Waterous had purchased 143,000 shares of Newton Chambers preferred stock for $440,000 (instead of the Ransomes & Rapier preferred) and Koehring itself had purchased 325,000 shares of Ransomes & Rapier common stock for approximately $2,400,000 and 100,000 shares of Ransomes & Rapier preferred for 63,272 pounds. Newton Chambers purchased the 44,000 shares of KOS preferred which the district court found to be subject to an agreement that Newton Chambers would be allowed to withdraw its investment on one year's notice.

In September 1963, a new KOS Board of Directors was constituted; three directors being elected by Newton Chambers and two by Koehring. In January 1964, Sir Peter Roberts became Chairman. The district court found that between October 25, 1963, and November 1967 there were ten board meetings and two stockholders meetings. Of the two stockholders meetings, one was adjourned for lack of a quorum and no Newton Chambers representatives attended the other. Of the ten board meetings, no Newton Chambers directors participated in six, one of which had to be adjourned for lack of a quorum. One of the four directors meetings attended by Newton Chambers directors was that at which Sir Peter Roberts was elected Chairman. At each of the others the primary actions were found by the district court to be of a passive nature more consistent with the theory that KOS was an instrumentality of Koehring than that it was a joint international sales subsidiary actively dominated by Newton Chambers. The court also made the following finding:

The actions of the Newton-Chambers directors was such as would be expected of sham directors whose real interest lay in protecting the Newton-Chambers stake in KOS. On April 1, 1965, Sir Peter Roberts urged that KOS keep $440,000 in the bank to protect the preferred shareholder's investment. On September 16, 1966, Sir Peter Roberts acquiesced in surrendering to Koehring-Brissonneau the European territory and former non-British African colony territory. In November 1967, the Newton-Chambers directors successfully opposed declaring a dividend on the common stock.

After Newton Chambers acquired majority control of KOS there were remarkably few changes in KOS operations. Newton Chambers did not attempt to replace existing management, which was closely identified with Koehring, with executives more loyal to Newton Chambers. KOS continued to sell only Koehring products until 1967, when it began selling a few Newton Chambers products on a trial basis at the suggestion of Koehring's president. No Newton Chambers directors were authorized to draw checks on behalf of KOS, even though at least two Koehring directors who were not officers of KOS were so authorized. Moreover, Newton Chambers referred to its control over KOS as being "nominal" in the minutes of the Board of Directors meeting on September 11, 1963 (Exhibit G), and stated that its investment in KOS was "nominal" in its 1963 annual report. ¹

On the basis of the above facts, the Internal Revenue Service claimed that for the tax year ending November 30, 1964, KOS was a "controlled foreign corporation" of Koehring as defined by Section 957 of the Code and that its "Subpart F" income was therefore taxable to Koehring under Section 951 even though not yet distributed as a dividend to Koehring. After exhausting intra-agency appeals procedures, Koehring paid the claimed deficiency and filed a claim for a refund in the amount of $412,840.47. After the IRS denied the claim, the present action was commenced on July 30, 1971, seeking refund of the taxes paid plus statutory interest. A trial was held in May of 1975 and on June 3, 1977, the district court issued an order dismissing the Koehring suit. ² Appeal has been taken to this court pursuant to 28 U.S.C. § 1291.

I.

Subpart F of the IRC was enacted in order to deter United States taxpayers from using related foreign base companies located in tax haven countries to accumulate earnings that could have been accumulated just as easily in the United States. By requiring the United States taxpayer to include in his current taxable income his share of the current foreign base company income of foreign corporations controlled by him, Subpart F removes the tax deferral benefits of such off-shore earnings accumulations. For the purposes of this subpart, Section 957(a) of the Code defines a "controlled foreign corporation" (hereinafter CFC) as "any foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned . . . by United States shareholders . . .." Not surprisingly, the Treasury Regulations relating to Section 957 require that in certain circumstances the nominal distribution of voting power will be ignored when it is not consistent with the reality of control. ³ Of particular relevance to the case at bar are the two parts of Regulation § 1.957-1(b)(2). The first part of that regulation provides:

(2) Shifting of formal voting power. Any arrangement to shift formal voting power away from United States shareholders of a foreign corporation will not be given effect...