HMW Industries, Inc. v. Wheatley

Decision Date25 September 1974
Docket NumberNo. 74-1092,74-1092
Citation504 F.2d 146
Parties74-2 USTC P 9726 HMW INDUSTRIES, INC., Petitioner-Appellee, v. Rueben B. WHEATLEY, Commissioner of Finance, Government of the Virgin Islands, Respondent-Appellant.
CourtU.S. Court of Appeals — Third Circuit

Joseph L. Costello, Bryant, Costello & Burke, Christiansted, St. Croix, V. I., James R. Wiener, David H. Brockway, Donovan, Leisure, Newton & Irvine, New York City, for petitioner-appellee.

Verne A. Hodge, Atty. Gen., Gordon S. Gilman, Asst. Atty. Gen., Charlotte Amalie, St. Thomas, V. I., for respondent-appellant.

Before ALDISERT, ADAMS and GARTH, Circuit Judges.

OPINION OF THE COURT

GARTH, Circuit Judge.

This appeal 1 involves the proper income tax treatment of non-taxable subsidies granted under Act 224 of the Virgin Islands Sessions Laws (1957). The question presented is whether such subsidies (non-taxable when paid) reduce the basis of property acquired with the subsidy payment, os that upon liquidation and distribution of that property (from subsidiary to parent), the reduced property basis results in increased income and hence additional taxes to the parent. The answer to this question depends upon whether the non-taxable subsidies are to be considered as 'non-shareholder contributions to capital' subject to the provisions of 362(c)(2) 2 of the Internal Revenue Code, or whether they retain their non-taxable character despite liquidation and distribution. The district court held 3 that the subsidy payments made to Standard Time Corporation ('STC') did not constitute non-shareholder contributions to capital such as to require a reduction in asset basis. We agree.

The facts are undisputed. HMW, the taxpayer-petitioner, is a Pennsylvania corporation, formerly known as Hamilton Watch Co. Prior to August 4, 1969, all of the outstanding stock of STC, a Virgin Islands corporation engaged in the watch manufacturing business in St. Croix, was owned by petitioner. On August 4, 1969, STC was liquidated and its assets distributed to petitioner 4 in a transaction qualifying under 332 of the Internal Revenue Code for non-recognition of gain or loss. Under 334(b)(1) of the Code, petitioner's tax basis in the assets received from STC was the same as STC's tax basis in those assets prior to the liquidation. HMW filed a Virgin Islands income tax return for the period August 5, 1969 through January 31, 1970, using STC's ending (or liquidation) inventory tax basis as its beginning inventory tax basis. Thereafter, respondent asserted a deficiency of $181,548.80 in petitioner's income taxes for fiscal 1970. The theory upon which the deficiency was assessed appears in the 'Explanation of Items' section of the assessment as follows:

Included in the cost of goods sold section was beginning inventory of $346,778.11. This was the same amount as the ending inventory on the subsidiary's (STC) return before liquidation. The question was raised as to whether the amount was correctly includable in cost of goods sold. Subsidy received or accrued during the period ending 8/4/69 was deemed to be in excess of $395,600.00. This is broken down into the following categories:

Income Tax 243,335.34

Examination revealed that during a time period before liquidation, the only property acquired by Standard Time was inventory. Since the subsidy exceeded the inventory at the time of liquidation, the basis of the inventory in the hands of the subsidiary was zero. When the inventory was transferred to the division (HMW), the same basis should have been used, which had a zero basis. This adjustment resulted in a substantial increase in income. 5

The asserted deficiency is the result of the Commissioner's contention that the subsidies received by STC reduced STC's basis in its inventory, and consequently reduced HMW's carry-over inventory basis. This reduction in the basis of HMW's opening inventory had the effect of decreasing HMW's cost of goods sold, thereby increasing its taxable income for the fiscal year ended January 31, 1970. Thus, HMW is liable for the deficiency assessed only if the subsidies paid to STC are found to be non-shareholder contributions to capital.

I.

Whether the subsidies paid here are non-shareholder contributions to capital as the Commissioner contends or a reduction in taxes without more, as is contended by the taxpayer, requires an examination of the history and purpose of the relevant tax laws. By the Naval Appropriation Act of July 12, 1921,

The income-tax laws in force in the United States of America and those which may hereafter be enacted shall be held to be likewise in force in the Virgin Islands of the United States, except that the proceeds of such taxes shall be paid into the treasuries of said islands. 6

This provision was incorporated into the Virgin Islands Code and is the basis of the Virgin Islands income tax law. Thus, 33 V.I.C. 1931(15) provides:

'Virgin Islands income tax law' means so much of the United States Internal Revenue Code as was made applicable in the Virgin Islands by the Act of Congress entitled 'An Act making appropriations for the naval service for the fiscal year ending June 30, 1922, and for other purposes,' approved July 12, 1921 (48 U.S.C. 1397).

As we recognized in Dudley v. Commissioner of Internal Revenue, 258 F.2d 182 (3d Cir. 1958), the purpose behind the enactment of the Naval Appropriation Act was to impose 'upon the inhabitants of the Virgin Islands . . . a territorial income tax, payable directly into the Virgin Islands treasury, to assist the Islands in becoming self-supporting.' 258 F.2d at 185. Thus, the effect of the above quoted provisions was to create a separate taxing structure for the Virgin Islands 'mirroring' the provisions of the federal tax code except as to those provisions which are incompatitible with such a separate tax structure. Dudley, supra; cf. Chicago Bridge and Iron Co. v, Wheatley, 430 F.2d 973 (3d Cir. 1970) cert. denied, 401 U.S. 910, 91 S.Ct. 873, 27 L.Ed.2d 809 (1971).

In 1957, Act No. 224, Virgin Islands Sessions Laws was enacted to encourage new business enterprises in the Virgin Islands. Its preamble stated:

Whereas it is deemed of great benefit to the people of the Virgin Islands, as well as to the economy of the Virgin Islands, to establish as many self-sustaining enterprises in the Virgin Islands as is practical-- to attract additional investment capital-- to promote tourism-- to promote the building of hotels, guest houses, and housing projects-- to the end that the economic life of the Virgin Islands may be as diverse and stable as possible, and the people of the Virgin Islands trained and employed in investments, in finance, in modern techniques of production, mechanical skills, services and trades; and

Whereas it is deemed to be in the public interest to extend such inducements and render such aid as will encourage persons, firms and corporations to establish and develop new business enterprises; to make additional investment capital available to new and existing business; to promote tourism and the building of hotels, guests houses and housing projects.

Act No. 224's 'Declaration of Policy' provided among other things:

(d) To achieve this objective, exemptions from payment of certain taxes or fees and the granting of special subsidies shall be allowed to new business enterprises and to such other persons and corporations as hereinafter provided, and

(e) In order that the encouragement tendered by this Act in the form of subsidies for the promotion of the business and industrial development of the Islands may be an incentive, having a real and unmistakably sure basis, the Government of the Virgin Islands hereby declares that it considers all orders granting subsidies and tax exemptions made available under the provisions of this Act as being in the nature of a contract or agreement between the Government of the Virgin Islands and the persons or corporations receiving the benefit of the subsidies or tax exemptions, and that it will not adopt any legislation which may impair or limit such subsidies or tax exemptions granted hereunder or which may defeat the purpose of this Act.

To achieve the stated objectives and policy aims, the Act 6(b) among other things provided that each qualifying corporation 'shall also be entitled to receive a nontaxable subsidy in an amount equal to Seventy Five (75%) Per Cent of the Income Tax paid into the Treasury of the Virgin Islands . . ..'

In 1960, Congress amended Title 26 to include Section 934. 7 It is apparent that Congress was concerned with the attempt by the Virgin Islands legislature to reduce the income tax liability of certain taxpayers 'with respect to the tax attributable both to income from sources within the Virgin Islands and from sources within the United States.' Both the Senate and House Reports indicate that Congress felt that Act No. 224 had achieved 'substantially the same effect' as a 'rebate' of income taxes but that the Act failed to limit the 'rebate' or reduction in tax to just Virgin Islands income. It, thus, enacted section 934(a) which provides that:

Tax liability incurred to the Virgin Islands pursuant to this subtitle . . . shall not be reduced or remitted in any way, directly or indirectly, whether by grant, subsidy, or other similar payment . . ..

However, recognizing that the purpose of Act No. 224 was the economic development of the virgin Islands, it did not find objectionable a properly limited reduction in income tax liability as an incentive for new businesses to locate there. Therefore, a number of exceptions to the general rule stated in section 934(a) were provided.

One of these exceptions is section 934(b) which provides:

(b) Exception for certain domestic and Virgin Islands corporations.-- In the case of a domestic corporation or a Virgin Islands corporation, subsection (a) shall not apply (if the information required by subsection (d) is supp...

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