Com'r of Internal Revenue v. Capento Securities Corp.

• Decision Date: 31 January 1944
• Docket Number: No. 3897.,3897.
• Citation: 140 F.2d 382
• Parties: COMMISSIONER OF INTERNAL REVENUE v. CAPENTO SECURITIES CORPORATION et al.
• Court: U.S. Court of Appeals — First Circuit

140 F.2d 382 (1944)

COMMISSIONER OF INTERNAL REVENUE v. CAPENTO SECURITIES CORPORATION et al.

No. 3897.

Circuit Court of Appeals, First Circuit.

January 31, 1944.

Bernard Chertcoff, Sp. Asst. to Atty. Gen. (Samuel O. Clark, Jr., Asst. Atty. Gen., Sewall Key and Samuel H. Levy, Sp. Assts. to Atty. Gen., J. P. Wenchel, Chief Counsel, Bureau of Internal Revenue, and John M. Morawski, Sp. Atty., Bureau of Internal Revenue, all of Washington, D. C., of counsel), for petitioner for review.

Edward C. Thayer, of Boston, Mass., for Capento Securities Corporation et al.

Before MAGRUDER, MAHONEY, and WOODBURY, Circuit Judges.

MAGRUDER, Circuit Judge.

This case involves the income and excess profits tax liability of the Capento Securities Corporation and of the Raytheon Production Corporation for the fiscal year ending May 31, 1936. The Commissioner ruled that Capento Securities Corporation had derived a taxable gain of $34,840 from an exchange of bonds for stock during the taxable year, and that Raytheon Production Corporation had derived a taxable gain of $450,000 from the same exchange, and accordingly determined the deficiencies in controversy. The Board of Tax Appeals disagreed with the Commissioner and decided that there was no deficiency in the case of either corporation. In each case the Commissioner filed a petition for review in this court and by our order the cases were consolidated for docketing, argument and decision.

At the outset of the taxable year the two respondent corporations were wholly-owned subsidiaries of the Raytheon Manufacturing Company.

Respondent Raytheon Production Corporation in 1929 issued secured gold bonds of $500,000 face value maturing serially in each of the years 1940 to 1944, inclusive. Presumably the bonds were issued for cash at par. The company's capital stock consisted of 1,000 shares of common with a par value of $100 per share, all owned by the Raytheon Manufacturing Company.

In 1933 respondent Capento Securities Corporation was organized, with a capital stock represented by 10 shares of common, par value $100 per share, all owned by Raytheon Manufacturing Company. Capento proceeded to purchase, at a cost of $15,160, the whole of the aforesaid issue of $500,000 of bonds of the Raytheon Production Corporation. These bonds were Capento's only asset, and so far as appears, Capento was organized for the sole purpose of acquiring them. If Raytheon Production Corporation had directly bought in its own bonds at a cost less than their face value it would have made a taxable gain in 1933 under the doctrine of United States v. Kirby Lumber Co., 1931, 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131.¹

In 1934 Raytheon Production Corporation

applied to the First National Bank of Boston for a loan of $200,000 for the purpose of obtaining additional working capital. The loan was made upon the condition that the $500,000 of bonds held by Capento should be subordinated to the loan, and they were so subordinated under an agreement in usual form, to which Capento was a party, executed September 21, 1934.

Raytheon Production Corporation in the spring of 1935 applied to the First National Bank of Boston and to the Federal Reserve Bank of Boston for an additional loan of $100,000. At the outset of the negotiations, it was apparently the understanding of the parties that the $500,000 of bonds would also be subordinated to this second loan. However, on May 27, 1935, the First National Bank wrote to the Raytheon Production Corporation, in part, as follows:

"It has occurred to us that it would be far simpler and more desirable from the standpoint of the holder of the company's notes that these bonds be replaced by an additional stock interest which would be clearly subordinate to our position. We do not know as this would make any vital difference so far as you are concerned, but I think we would feel somewhat more comfortable with this form of obligation.

"I shall appreciate it if you will consider this matter and develop a plan in accordance with the above suggestion if possible."

In pursuance of this suggestion a plan of reorganization was adopted by the three affiliated corporations on May 28, 1935. The plan provided that, by appropriate charter amendment, the capital stock of Raytheon Production Corporation should be increased by 5,000 shares of 6% non-cumulative preferred stock, par value $100 per share, such preferred shares to have full voting power with the common shares, share for share. Capento was to transfer the $500,000 of bonds to the Raytheon Production Corporation for cancellation and retirement solely in exchange for the whole of the new issue of 5,000 shares of the latter's preferred stock. The existing liability of Raytheon Production Corporation with respect to said bonds was to be transferred to capital stock account in payment of said preferred stock. This plan of recapitalization was carried into execution, and on October 24, 1935, the two banks made the additional loan of $100,000 to Raytheon Production Corporation, the parent company guaranteeing the loan.

The Board found as a fact, and this is not disputed, that the preferred stock which Capento received during the taxable year in exchange for the bonds was actually worth $50,000 at date of acquisition. Since Capento had acquired these bonds in 1933 at a cost of $15,160, Capento admittedly made a gain during the taxable year of $34,840 as a result of the exchange.

Capento contended, however, and the Board so ruled, that the substitution by Raytheon Production Corporation of preferred shares for bonds was a recapitalization, which, under § 112(g) (1) (D) of the Revenue Act of 1934, 48 Stat. 680, 26 U.S. C.A. Int.Rev.Acts, page 695, was a "reorganization", as defined, and that since Capento exchanged the bonds of Raytheon Production Corporation, a party to the reorganization, solely for preferred stock in the same corporation, the resulting gain may not be recognized, as provided in § 112(b) (3).²

We agree with this conclusion of the Board. There is no doubt that the exchange falls literally within § 112(b) (3). The Commissioner, however, invokes the authority of Gregory v. Helvering, 1935, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596, 97 A.L.R. 1355. There the purported "reorganization", though following the literal language of the statutory definition, was an operation having no business or corporate purpose. The plan was not to reorganize the business or any part of the business but to accomplish the transfer of certain corporate assets to the stockholders, a transfer which, if done directly, would have rendered the distribution taxable to the stockholders as dividends. The evanescent new corporation did no business except to serve as the roundabout channel for this distribution and was immediately thereafter dissolved. In substance, of the original corporation were distributed to its shareholders and the corporation's surplus was correspondingly reduced. Under these special circumstances the court regarded the reorganization as a mere sham and held that the distribution was taxable to the stockholders as a dividend. In the case at bar the reorganization was not resorted to in order to evade an impending tax liability. Capento could have held onto the bonds indefinitely without being subjected to a tax. The reorganization was an ordinary business transaction, entered into at the suggestion of the banks, who were unwilling otherwise to make the proposed loan to Raytheon Production Corporation. The bonds were hopelessly in default, and Capento as the owner of all the bonds was, in the equity sense, the owner of Raytheon Production Corporation. There resulted a permanent revision of the capital structure of Raytheon Production Corporation pursuant to a plan of recapitalization — a normal business procedure dictated by the necessity of raising new capital. In such circumstances it is the purpose of the non-recognition provisions of the Act to save the taxpayer from an immediate recognition of a gain, where, in a popular and economic sense, there has been a mere change in the form of ownership and the taxpayer has not really "cashed in" on the theoretical gain, though a gain may have accrued in a constitutional sense. As the Board pointed out 47 B.T.A. 694, Capento, having become a preferred shareholder, "has subjected its investment to the risks of the business instead of having, as a bondholder, a fixed obligation." We are clear that the doctrine of the Gregory case is inapplicable to the situation here presented. See Helvering v. Minnesota Tea Co., 1935, 296 U.S. 378, 385, 56 S.Ct. 269, 80 L.Ed. 284; Bass v. Commissioner, 1 Cir., 1942, 129 F.2d 300, 309; Mertens, Law of Federal Income Taxation (1939 Supp.) § 17.48.

We...