Kraft Foods Company v. Commissioner of Internal Rev., 7

• Citation: 232 F.2d 118
• Decision Date: 02 April 1956
• Docket Number: 23225.,No. 7,Docket No. 23224,8,7
• Parties: KRAFT FOODS COMPANY, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent (two cases).
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

232 F.2d 118 (1956)

KRAFT FOODS COMPANY, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent (two cases).

Nos. 7, 8, Docket Nos. 23224, 23225.

United States Court of Appeals Second Circuit.

Argued December 16, 1955.

Decided April 2, 1956.

COPYRIGHT MATERIAL OMITTED

Norris Darrell, John F. Dooling, Jr., Dean D. Ramstad, New York City (Erwin N. Griswold, Cambridge, Mass., Sullivan & Cromwell, New York City, of counsel), for petitioner.

H. Brian Holland, Asst. Atty. Gen., Hilbert Zarky, Ellis N. Slack, Lee A. Jackson, Harry Baum, Spec. Assts. to the Atty. Gen., for respondent.

Before CLARK, Chief Judge, and MEDINA and WATERMAN, Circuit Judges.

WATERMAN, Circuit Judge.

The sole issue raised by this appeal from a decision of the Tax Court, 1954, 21 T.C. 513, is whether so-called debenture interest payments made by the taxpayer corporation, Kraft Foods Company, to its parent corporation and sole stockholder, National Dairy Products Corporation, during the years 1934 to 1938, inclusive, constituted deductible "interest * * * on indebtedness" within the meaning of Section 23(b) of the Revenue Acts of 1934, 1936, and 1938, 26 U.S.C.A. (I.R.C.1939) § 23(b). Jurisdiction is conferred on this Court by Section 1141(a) of the Internal Revenue Code of 1939, as amended, 26 U.S. C.A. (I.R.C.1939) § 1141(a).

The material facts, which were stipulated by the parties, may be summarized as follows, insofar as here pertinent.

In May, 1930, National Dairy purchased all the assets of Kraft-Phenix Cheese Corporation for a total consideration of over $81,000,000, and issued $33,264,500 of its own 5¼% debentures to the sellers in part payment. National Dairy then transferred to taxpayer, a Delaware corporation organized in May, 1930, about $72,000,000 worth of these Kraft assets in exchange for all 20,000 shares of taxpayer's par $100 capital stock. Taxpayer opened its books with a stated capital of $2,000,000 and a surplus of $32,381,748 (reflecting the worth of the assets as carried on the books of the seller).

From May, 1930, through the end of 1933, taxpayer earned $11,908,000 and paid dividends of $11,250,000 to its parent, National Dairy. During this period National Dairy and its subsidiaries regularly filed consolidated federal tax returns. On these consolidated returns the earnings of the subsidiaries of National Dairy, including taxpayer, were offset by substantial net losses of National Dairy. These losses were primarily due to the interest charges on National Dairy's large long-term indebtedness — an indebtedness incurred in acquiring the assets subsequently transferred to National Dairy's operating subsidiaries, including taxpayer.

In 1934, when Congress abolished consolidated federal tax returns, taxpayer's board of directors declared a dividend of $30,000,000 "out of the surplus" payable in 6% debentures due February 1, 1948. A concurrent write-up of intangibles increased the total book values of taxpayer's assets from over $34,000,000 to about $47,500,000. It would have been necessary to liquidate a large part of taxpayer's business in order to pay such a substantial dividend in cash, and it is apparent from the circumstances that there was no desire to liquidate any part of the enterprise. Indeed, the corporate resolutions indicate that the dividend was to be paid in debentures in order to preserve the taxpayer's cash position. As required by the resolutions, 30 debentures of $1,000,000 each were issued and delivered to National Dairy. The debentures were simple in form and contained an unconditional promise to pay the principal amount to National Dairy or order on February 1, 1948, with interest from June 30, 1934 at the rate of 6% per annum payable on the first day of each month until maturity. In addition they contained the usual provisions for acceleration of the maturity date in case of insolvency or default in payment of interest. There were no provisions for retirement or amortization of principal.

During the five years (1934-1938) involved in this litigation, petitioner's operations continued to be highly profitable. Although a small portion of petitioner's substantial earnings were retained as surplus, nearly all of taxpayer's earnings found their way to the parent corporation, National Dairy, in the form of interest on the debentures or dividends. The amounts paid as interest on the debentures were $900,000 in 1934 (second half), and $1,800,000 for each of the years 1935 through 1938, a total of $8,100,000. Dividends paid from 1934 through 1938 totaled $17,133,000.

In January, 1941, taxpayer's president, pointing out that National Dairy by refundings had substantially reduced the interest rate on its own outstanding debentures, asked National Dairy to consent to a reduction of the interest rate on taxpayer's debentures from 6% to 4%. The requested interest reduction was authorized and the debentures were amended accordingly. No payments were made on principal during the stated life of the debentures or at their maturity. When the debentures matured in 1948 they were replaced by a new issue of debentures, still outstanding, bearing interest at 4%.

In its returns for the taxable years 1934 through 1938, taxpayer claimed as deductions under Section 23 (b) of the applicable Revenue Acts the portions of its earnings paid to National Dairy as interest on the debentures. The Commissioner disallowed the deductions, and the Tax Court, two judges dissenting, sustained the Commissioner's determination. The Tax Court concluded that there was no intent to create a genuine debtor-creditor relationship between taxpayer and its parent, and that the so-called interest payments in reality constituted non-deductible dividend distributions. We think this conclusion of ultimate fact is erroneous, and that where, as here, the evidence consisted of stipulated facts, this Court is entitled to draw its own inferences of ultimate fact from the record.¹

Taxpayer is a Delaware corporation. Under Delaware law taxpayer was empowered to pay dividends in money or in property to the extent of assets exceeding capital. Laws of Delaware 1929, Ch. 135, § 16, 8 Del.C. §§ 170-172. At the time the dividend was declared, taxpayer's capital was $2,000,000 and its assets had a value, based upon the arm's-length sale less than four years before, of about $72,000,000. Although its book surplus at this time was artificially stated at only about $31,000,000, assets of the magnitude of $70,000,000 supported the dividend. The abundant earning power of taxpayer, already demonstrated in prior years, assured the debt service. Indeed, the Tax Court stated that taxpayer had ample surplus to supply the consideration for the $30,000,000 debenture dividend and had ample substance to support those debentures when issued.

The declaration of a dividend creates a debtor-creditor relationship between a corporation and its stockholders.² In this case taxpayer by regular corporate action properly declared a dividend; it then issued debentures in payment of this dividend. The debentures were of a simple and common form, and contained an unconditional obligation to pay the interest and principal. They contained all the necessary features of instruments of indebtedness and none of the features ordinarily associated with equity interests. We think it clear that under the applicable law of Delaware these corporate acts merely by their occurrence created legal relations of an enforceable character.

This conclusion is supported by the Tax Court's finding that the purpose of the transaction was to obtain for taxpayer a tax benefit from the interest deductions which only a valid indebtedness would give rise to. In other words, taxpayer intended to become indebted because the desired deductions could be secured only if it created genuine indebtedness. The parties were competent to contract a debt; if it was their "purpose" or "intent" to do so, then they succeeded because they performed consciously and purposefully the legal acts that establish a debt.

We have thus far been concerned only with whether the parties intended and created an indebtedness enforceable under state law. We think the parties did all they could have done to establish a debt, and that the Tax Court erred in concluding that the parties had not intended to do what their acts of record clearly indicated they were attempting to accomplish with every means within their power. We now reach the crucial question raised by these appeals: what were the tax consequences, if any, of the events here involved?

Section 23(b) of the applicable Revenue Acts provides that in computing net income "there shall be allowed" as a deduction "all interest * * * indebtedness" (with exceptions not pertinent here). The crucial word, of course, is "indebtedness." In general, "The words `interest on indebtedness' should be accorded their usual, ordinary and every day meaning." Preston v. Commissioner, 2 Cir., 1940, 132 F.2d 763, 765. If they were always accorded that meaning, however, the determination that a particular instrument had created an "indebtedness" enforceable under corporate law would settle conclusively the treatment for federal tax purposes of any payments made pursuant to the instrument. It is now a commonplace that words have many meanings, each dependent upon their context. Thus, "indebtedness" as used in a federal taxation statute may not carry the same meaning as the same word used in the context of corporate finance. As the Supreme Court has said, "although an indebtedness is an obligation, an obligation is not necessarily an `indebtedness' within the meaning of § 23(b)." Deputy v. DuPont, 1940, 308 U.S. 488, 497, 60 S.Ct. 363, 368, 84 L.Ed. 416. Our present problem is whether there is some paramount policy of federal tax law which requires in this case that taxpayer's payments pursuant to its debentures be considered, for tax purposes, as "dividends" rather than "interest * * * on...