Erie Lighting Co. v. Commissioner of Internal Revenue

• Decision Date: 31 December 1937
• Docket Number: No. 3268.,3268.
• Citation: 93 F.2d 883
• Parties: ERIE LIGHTING CO. v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — First Circuit

93 F.2d 883 (1937)

ERIE LIGHTING CO. v. COMMISSIONER OF INTERNAL REVENUE.

No. 3268.

Circuit Court of Appeals, First Circuit.

December 31, 1937.

Bernhard Knollenberg, of New York City (Charles M. Trammell, of Washington, D. C., and Bradford S. Magill and Francis J. Sweeney, both of New York City, on the brief), for petitioner for review.

Joseph M. Jones, of Washington, D. C. (James W. Morris, Asst. Atty. Gen., and Sewall Key and Norman D. Keller, Sp. Assts. to Atty. Gen., on the brief), for the Commissioner.

Before BINGHAM, WILSON, and MORTON, Circuit Judges.

WILSON, Circuit Judge.

This is a petition for review of a decision and order of the Board of Tax Appeals determining deficiencies in the income tax of the petitioner for the year 1927 and the period of the year 1928 from January 1st to October 31st, of $56,266.30 and $37,678.01, respectively.

The sole question in issue in the case is whether, during the taxable periods involved, the petitioner was affiliated with the Pennsylvania Electric Company and its parent, Associated Gas & Electric Company.

During the taxable periods there were outstanding 100,000 shares of the petitioner's preferred stock, of which a large part was in the hands of the public. The pertinent rights and limitations of the preferred stock are as follows:

"The holders of preference shares shall be entitled to receive out of the surplus or net profits of the said corporation, and the said corporation shall be bound to pay, quarterly cumulative dividends at the rate of $2.00 per share per annum, which quarterly dividends shall be paid, or set aside for payment, for each quarter before any dividend shall be declared or paid upon any other stock of said corporation; * * * After all accumulated and accrued dividends on the preference shares have been declared and paid, or set aside for payment, dividends may be declared and paid out of the remaining surplus or net profits to holders of common shares at the rate of $2.00 per share per annum, and all additional distribution of surplus or net profits as dividends shall be made at the same rate per share to holders of stock of both classes." * * *

"The holders of the said preference shares shall have no power to vote the same at any election for directors unless the dividends on the said preference shares for two quarterly periods, whether consecutive or not, shall remain unpaid."

The provisions of the statutes applicable to this case are section 240(d) of the 1926 Revenue Act, 44 Stat. 46, and section 142(c) of the 1928 Revenue Act, 45 Stat. 832. Subdivision (d) of section 240 provides as follows:

"(d) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns at least 95 per centum of the stock of the other or others, or (2) if at least 95 per centum of the stock of two or more corporations is owned by the same interests. As used in this subdivision the term `stock' does not include nonvoting stock which is limited and preferred as to dividends. This subdivision shall be applicable to the determination of affiliation for the taxable year 1926 and each taxable year thereafter."

With the exception of the last sentence, subdivision (c) of section 142 of the Revenue Act of 1928 reads exactly the same.

The decision of this case depends solely on whether the petitioner's outstanding preferred stock during the tax periods involved was "nonvoting stock which is limited and preferred as to dividends," within the meaning of the sections of the revenue acts above referred to.

The first statute authorizing the filing of a consolidated return by two or more affiliated corporations, section 240(b) of Revenue Act of 1918, 40 Stat. 1081, defined affiliated corporations as two or more corporations where one corporation owns or controls substantially all of the stock of its subsidiary or subsidiaries. The Commissioner of Internal Revenue realized that, if the statute were taken literally, although no definite percentage of stock required to be owned or controlled was stated, either great latitude must be permitted in this respect, or the purpose of the statute would be frustrated. If the control of substantially all of both voting and nonvoting stock were required, it could seldom be complied with, as preferred stock is not usually given voting power so long as the preferred dividends are met, and it is generally distributed to the public and seldom found in considerable quantities in the control of an allied corporation.

The Commissioner, to render the statute practical in its operation, by Article 633 of Regulation 45 issued under the act of 1918, provided that the "stock" referred to in section 240(b) must be construed as voting stock.

The same language was used in the Revenue Act of 1921, § 240(c), 42 Stat. 260, and the Commissioner in Article 633 of Regulation 62 under this act again restricted the word "stock" to voting stock, thus excluding preferred or other capital stock, under whatever name, that had no voting power in the control or management of the corporation's business.

In the Revenue Act of 1924, § 240(c), 43 Stat. 288, Congress practically adopted the Regulations of the Department and specifically provided that two corporations would be deemed affiliated if one owned or controlled substantially all the voting stock of the other.

Little advance in clarifying the construction of the law was made by this change in the wording of the statute over the wording of the Regulations under the acts of 1918 and 1921. The Commissioner and the Board and the courts, however, prior to 1926, consistently construed these acts to mean that preferred stock not having the right to vote for directors was not "voting stock." Schlafly v. United States, 8 Cir., 4 F.2d 195, 200.

The purpose of the provisions relating to affiliated companies was to enable corporations under one management to make a consolidated return as though they were a unit in transacting business, and to avoid such a manipulation of intercompany transactions as would prevent the government from correctly ascertaining and collecting the sums as taxes that are justly due it. Schlafly v. United States, supra, 8 Cir., 4 F.2d 195 at page 200; Atlantic City Electric Co. v. Commissioner, 288 U. S. 152, 154, 53 S.Ct. 383, 384, 77 L.Ed. 667.

The Commissioner and the Board, in the construction of the acts prior to 1926, generally, whenever the question was raised, followed this rule, that the stock which must be taken into consideration in determining whether grounds for affiliation exist, was stock having a right to control the management of a corporation, as in the election of directors.

With such an established and recognized construction by the Department, Congress in enacting the 1926 and 1928 acts should be held to mean by "nonvoting stock" stock not having the right to vote for directors who control the management of the corporation. Massachusetts Mutual Life Insurance Co. v. United States, 288 U.S. 269, 273, 53 S.Ct. 337, 339, 77 L.Ed. 739; National Lead Co. v. United States, 252 U.S. 140, 146, 40 S.Ct. 237, 239, 64 L. Ed. 496; Poe, Collector v. Seaborn, 282 U.S. 101, 116, 51 S.Ct. 58, 61, 75 L.Ed. 239; Costanzo v. Tillinghast, 287 U.S. 341, 53 S. Ct. 152, 77 L.Ed. 350.

It is admitted that the conditions have not arisen that give the preferred stock in this corporation a right to participate in the election of directors.

It is generally provided in all legislative acts and corporate charters that the management of the corporate business shall be intrusted to a board of directors. Fletcher's Cyclopedia of the Law of Corporations, vol. 3, § 1726. The statutes of Pennsylvania, the home state of the petitioner, provide that the business of every corporation shall be managed and conducted by a president and board of directors. The by-laws of the petitioner follow the statute.

The Board of Tax Appeals apparently based its conclusions that the preferred stock in this case was not deprived of all powers...