Litton Bus. Sys., Inc. v. Comm'r of Internal Revenue

• Decision Date: 26 December 1973
• Docket Number: Docket No. 1085-68.
• Citation: 61 T.C. 367
• Parties: LITTON BUSINESS SYSTEMS, INC., PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

61 T.C. 367

LITTON BUSINESS SYSTEMS, INC., PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 1085-68.

United States Tax Court

Filed December 26, 1973.

Deane E. McCormick, Jr., for the petitioner.

Sheldon M. Sisson, for the respondent.

P corporation entered into an agreement with unrelated T corporation (an established financially successful business), where P, or a wholly owned subsidiary, would acquire all of the assets of T in exchange for voting common stock of P, pursuant to sec. 368(a)(1)(C), I.R.C. 1954. In order to effect the reorganization agreement, P incorporated a wholly owned subsidiary, S corporation. P stock; valued at $23,542,802.50, was then made available by P to S pursuant to a contribution to capital by P to S of $9,227,385.19 of P stock and by a sale of the remaining $19,315,417.31 of P stock by P to S resulting in a purported debt obligation advance account owing from S to P. S then transferred, or caused to be transferred, to T the $28,542,802.50 of P stock owned by S in exchange for all of the assets of T. Held, under these circumstances the advance account represented a bona fide indebtedness, and S is entitled to deductions for interest expense thereon.

DAWSON, Judge:¹

In his statutory notice of deficiency respondent determined the following deficiencies in the Federal income taxes of Eureka-carlisle Co. (formerly Eureka Specialty Printing Co.), which was later acquired by petitioner pursuant to a statutory merger:

+-----------------------------+
                ¦TYE July 31—   ¦Amount     ¦
                +-----------------+-----------¦
                ¦1962             ¦$429,625.36¦
                +-----------------+-----------¦
                ¦1963             ¦307,903.49 ¦
                +-----------------+-----------¦
                ¦1964             ¦273,412.54 ¦
                +-----------------------------+
                

Certain concessions have been made by the parties. The only issue remaining for our decision is whether part of a transfer by a parent corporation of its stock to a wholly owned subsidiary, for the purpose of having the subsidiary participate in a reorganization under section 368(a)(1)(C)^1a with a third-party corporation with the use of such stock, was in fact a sale of the stock to the subsidiary creating a bona fide indebtedness from the subsidiary to the parent, so that the subsidiary is entitled to interest expense deductions on amounts paid as interest on such purported obligation.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulations of facts and exhibits attached thereto are incorporated herein by this reference.

Litton Business Systems, Inc., the petitioner herein, is the successor to Eureka-Carlisle Co. pursuant to a statutory merger under the laws of the State of New York on August 3, 1969. Eureka-Carlisle Co., to whom respondent issued the statutory notice of deficiency and who initially filed the petition herein, operated under the name of Eureka Specialty Printing Co. (a Delaware corporation) prior to May 31, 1965, and during the years at issue.

Eureka Specialty Printing Co. (a Delaware corporation) (herein referred to as New Eureka) was incorporated on November 20, 1961, under the laws of the State of Delaware, and at that time its principal office was in Scranton, Pa. New Eureka reported its income on the accrual basis and filed its Federal corporate income tax returns on a fiscal year ending July 31. Its return for the period December 1, 1961, to July 31, 1962, was timely filed with the district director of internal revenue at Scranton, Pa., and its returns for the taxable years ended July 31, 1963, and July 31, 1964, were filed with district director of internal revenue at Philadelphia, Pa. During the years at issue New Eureka did not file consolidated returns with a parent corporation.

At the time the petition was filed herein under the name of Eureka-Carlisle Co., the principal office of such corporation was located at San Francisco, Calif.

In 1961, Litton Industries, Inc. (herein referred to as Litton), was interested in acquiring Eureka Speciality Printing Co. (a Pennsylvania corporation) (herein referred to as Old Eureka). Old Eureka was a highly profitable specialty printing company with its principal office located at Scranton, Pa. It had been formed in the late 1890's or early 1900's and had developed an excellent reputation and expertise in high-speed printing, perforating, and coating equipment.

Old Eureka was the largest producer of trading stamps in the United States, printing stamps for most of the approximately 60 companies using trading stamps, such as Sperry & Hutchinson (S & H), blue Chip, and McDonald. Old Eureka's business constituted about 80 percent of the national trading stamp printing market, and Old Eureka had been able to generate and maintain its large share of the market with only three salesmen covering the United States.

Prior to October 1, 1961, Old Eureka had received a trial order from the Atlantic & Pacific grocery store chain (A & P) for stamps for two or three of the A & P stores, and this was expected to eventually expand throughout the A & P chain nationally.

Old Eureka also produced a variety of other printed items, such as outsert advertising attached to the exterior of a product, special types of stationery, Christmas tags, cutouts, decorative booklets, catalogues, books, periodicals, fund-raising and commercial seals, and addressing labels.

Old Eureka operated very efficient high-speed machinery for processing its specialized printing work. The company's machinery had been recently modernized and was essentially new equipment. In this respect the capacity of the plant was such that a considerable increase in production volume could have been obtained from existing plant and equipment, with no further replacement or additional machinery.

Old Eureka's position in the market was enhanced by its extensive security system which included safety watermarked paper, serial numbered stamps, inventory controls, bonded warehouses, closed-circuit television, and security guards. In addition, Old Eureka had developed an automatic stamp-coiling process which facilitated the dispensing of stamps at supermarkets by merely dialing the price of the goods purchased on the stamp dispenser device.

Litton expected Old Eureka's excellent reputation and position in the market to assure its particular progress along with the anticipated growth of the trading stamp market in general. Litton also considered the other printing operations of Old Eureka capable of expansion with the addition of sales personnel and development of a promotional organization. Further, given the modern equipment in operation, with its existing capacity for additional production, Litton expected that additional capital investments would not be necessary to accommodate anticipated growth.

Taxable income reported by Old Eureka in 1959, 1960, and 1961 was approximately $1,800,000 in each year.

On October 9, 1961, Litton entered into an Agreement and Plan of Reorganization with Old Eureka. Under the agreement, either Litton or a wholly owned subsidiary of Litton would acquire substantially all of the assets of Old Eureka in exchange for voting common stock of Litton. Litton agreed that it would deliver or cause to be delivered to Old Eureka 3 shares of Litton stock per each share of class A common stock of Old Eureka issued and outstanding at the date of closing and 3 shares of Litton stock per each share of class B common stock of Old Eureka issued and outstanding at the date of closing. Litton also gave an understanding whereby Litton or its wholly owned subsidiary would assume and agree to pay or discharge certain of Old Eureka's liabilities and obligations.

Litton is a large, diversified corporation, and, from an operational and management viewpoint, its operations are divided into groups. Each group is composed of certain subsidiaries under the general supervision of a group executive, who is an officer of the parent corporation, Litton. The group executive's function, in working with a particular subsidiary, is similar to that of a board of directors in providing long-range goals and strategic planning rather than day-to-day supervision.

The current operations of the subsidiary are directed by its own particular manager. It is Litton's philosophy that in order to encourage a proprietary attitude on the part of the manager, each subsidiary should be viewed as a separate entity whose operating executives are fully responsible for the subsidiary's performance as though they were running a company founded by themselves.

The subsidiary is furnished with a minimum amount of permanent capital judged necessary to conduct the business as if it were an autonomous entity. Any additional machinery, services or nonpermanent capital financing are provided on an arm's-length basis through loans or other forms of payment. This allows the subsidiary's performance to be measured subject to the normal financial constraints of an independent corporation. As independent corporations will often go beyond their stockholders for additional operating and capital funds, such constraints would include having the subsidiary required to provide for the servicing of debt obligations in measuring its comparative performance.

In November of 1961, New Eureka was incorporated as a wholly owned subsidiary of Litton for the purpose of acquiring the assets of Old Eureka pursuant to the plan of reorganization. Litton subscribed to and paid $1,000 for 1 share of common stock of New Eureka as the initial capitalization.

New Eureka's board of directors included a senior vice president of Litton, a vice president of another Litton subsidiary, and the president of New Eureka who had also been president of Old Eureka.

The first meeting of the board of directors of New Eureka was held on November 24, 1961. The minutes of that meeting included the following resolution:

RESOLVED, that the officers of this corporation be and they hereby are authorized to do all acts...