Lawrence v. MacFarland

• Decision Date: 08 February 1962
• Citation: Lawrence v. MacFarland, 209 Tenn. 376, 354 S.W.2d 78, 13 McCanless 376 (Tenn. 1962)
• Parties: , 209 Tenn. 376 Joseph P. LAWRENCE et ux. v. Alfred T. MacFARLAND, etc.
• Court: Tennessee Supreme Court

Page 78

354 S.W.2d 78

13 McCanless 376, 209 Tenn. 376

Joseph P. LAWRENCE et ux. v. Alfred T. MacFARLAND, etc.

Supreme Court of Tennessee.

Feb. 8, 1962.

Phillips, Gullett & Steele, Dearborn, Berry & Warner, Nashville, for appellants.

George F. McCanless, Atty. Gen., Milton P. Rice and David M. Pack, Assts. Atty. Gen., for appellees.

BURNETT, Justice.

As a result of a holding of this Court in Evans v. McCabe, 164 Tenn. 672, 52 S.W.2d 159, 617, that a general income tax statute was unconstitutional by reason of the provisions contained in Section 28 of Article 2 of our Constitution that 'The Legislature shall have power to levy a tax upon incomes derived from stocks and bonds that are not taxed ad valorem', the Legislature enacted what is known as the Hall Income Tax Law. This statute is a limited income tax statute and taxes incomes derived by way of dividends from stocks or by way of interest upon bonds. Section 67-2601 et seq., T.C.A.

This case, for the first time, presents the question of whether or not the amounts received by owners of shares in the Massachusetts Investors Trust specifically in this case or from regulated investment companies, which amounts to pro rata distributions of gains realized by said concern upon disposition of securities held in its portfolio (under the Federal Income regulations, commonly called capital gains) are subject to income taxation under the Hall Income Tax Law.

During the year 1959 the appellants, who were the owners of certain shares of stock in the Massachusetts Investors Trust, received from that Trust in excess of $3,000.00 representing a pro rata distribution of amounts realized by the Trust as dividends and interest upon the shares of stock and bond holdings in its portfolio. No question is raised as to the tax which was voluntarily paid on this sum. In the same year the complainants received from this Trust 78 additional shares thereof, plus a cash balance of $17.52, which represented a pro rata distribution of gains realized by the Trust upon the sale of securities held in its portfolio. The tax on this last item, which was slightly in excess of $63.00, was paid under protest and this suit was brought for the purpose of recovering this tax. The record shows the appellants elected, as they had a right to do, to take their pro rata share of gains in additional shares of the Trust rather than in cash.

The Massachusetts Investors Trust is regulated in its operation by the Investment Company Act of 1940, 15 U.S.C.A. § 80a-1 et seq. It engages in no business other than buying, selling and holding securities of other companies and government obligations. It maintains two accounts, which it denominates as an 'income account' and a 'principal account'. The 'income account' contains amounts realized by the Trust from dividends and interest upon its holdings, while the 'principal account' contains amounts realized from the sale of securities. Out of the 'income account' are paid to the shareholders what are denominated as 'dividend distributions', while out of the 'principal account' are paid what are called 'capital gain distributions'.

'The per share net asset value' of the value of the Trust's holdings are arrived at by taking the aggegate value of all the Trust's holdings and dividing them by the number of shares outstanding. This value, that is the 'per share net asset value' fluctuates with the market value of the Trust's security holdings. This figure, that is the 'per share net asset value', plus commission to a salesman represents the price of a share in the Trust to the purchaser. These shares after being purchased in this Trust may be disposed of only to the Trust. Of course, this may be done through an intermediary.

No question of the tax is involved with reference to the dividends and interest, which was recognized as paid out as income. The argument here is that the additional 78 shares of stock and small amount of money were paid by reason of gains on the sale of securities, which were regarded by M.I.T. as the 'principal item' rather than an 'income item'. According to this record this stock came from what is denominated by a witness herein as 'capital gains distribution' rather than from any dividend or interest on the stocks that they had but was derived from the sale of certain capital assets wherein the sale produced in excess of what the cost of the asset was in the beginning. This company had carried this in an account which is known as the 'principal account' and then they made the distribution therefrom. This brings us to what is necessary under the tax statute of this State for a proper determination.

Section 67-2602, T.C.A., levies an income tax of six (6%) percent per annum 'on incomes derived by way of dividends from stocks * * * of each person, * * * who received, or to whom accrued, or to whom was credited during any year income from the sources above enumerated except as hereafter provided.'

The preceding Section of the Code, § 67-2601, T.C.A., is a section defining the terms in this Act. Under this Section the term 'stocks' for the purpose of the statute is defined 'to mean shares of stock issued by corporations chartered and organized under the laws of the state of Tennessee, or of any other state, or of the United States, or of any foreign government, and all interests in partnerships, associations or trusts represented by transferable evidence of such interest.'

The factual situation in the instant case was testified to by an expert in this language: 'and it is out of that principal account that the shareholders are paid the residual left over at the end of the accounting period, at the end of the year, because the realized gains offset whatever realized losses they may have and it is purely discretionary with the shareholder as to whether he accepts cash or whether he re-invests, so to speak, by maintaining his position in that fund to the ownership of additional shares.' This expert then concludes that the fund in the instant case is not a dividend and does not come from earned surplus but is a part of the capital. He in making this explanation says there is 'a difference in the philosophy' on this question.

An exception which was referred to in § 67-2602, the levying statue above quoted from, is contained in § 67-2609, thus:

'No distribution of capital by stock dividend, or liquidation or otherwise, shall be taxed as income; but earned surplus shall not be considered as capital, and shall be taxed as income when and in whatever manner it may be distributed, irrespective of when it was earned.'

The Chancellor concluded that these 78 shares received by the shareholder came from earned surplus and did not constitute a distribution of capital stock and thus that it was taxable. The Chancellor likewise concluded after having reached this conclusion that it was unnecessary for him to rule on the constitutional question hereinafter to be discussed.

Certain principles with regard to this interpretation and application of the Hall Income Tax and statutes hereinabove referred to have been before this Court on one or two occasions, and specifically in First National Bank of Memphis v. McCanless, 186 Tenn. 1, 207 S.W.2d, 1007, to the effect and holding that the tax statute was intended to provide for an assessment and collection of taxes on property upon which there was no ad valorem tax paid. In other words Section 67-2607, T.C.A., expressly excludes the tax as fixed by the Act here on property which pays ad valorem tax. It is also held in this same case that it was the intention of the Legislature in enacting this law, the Hall Income Tax Law, to tax the total amount of revenue produced by stocks and bonds and that in passing the law the Legislature clearly did not intend in the administration of the law that the administrators thereof have the burden of tracing dividends to the source--the contrary is true.

We, of course, must keep in mind that in our interpretation of the Act we shall look at the transactions with respect to their substantial and practical effect rather than to the form in which the M.I.T. handled the matter. In doing so, we must give the word 'dividends' its ordinary meaning unless the specific terms of the statute applicable to the tax specify otherwise. Whether or not the distribution made by dividends is from capital or profits is determined, of course, from the standpoint of the corporation making the distribution rather than from the standpoint of the stockholder receiving the same. The profits, of course, that the stockholder receives only become income of the stockholders when they are distributed as dividends.

This Court in Fidelity-Bankers Trust Co. v. McCanless, 181 Tenn. 476, 181 S.W.2d 747, reached the very obvious and correct conclusion, we think, that a distribution from a depletion or depreciation reserve does not constitute a taxable dividend where it is a distribution of capital, but that in determining whether or not the dividend as paid out of a depreciation or depletion reserve is paid out of capital is a fact question to be determined under the facts of the case. It is also determined in this case that the bookkeeping methods of corporations are immaterial and whether or not the fund as paid out was from capital depended upon the proof of the actual condition of the corporation's assets and liabilities.

It is noted that under the statute (§ 67-2601, T.C.A.) the definition of stocks, which we referred to above and quoted, doesn't say that they have to be stocks of any kind of corporation but it is any stocks as long as the stock certificates, in this case called 'certificates of beneficial interest', were alienable. It is true that they were not freely alienable and cannot be traded on the Stock Exchange or over the board but the requirement of transferability is satisfied by the fact that the interest evidenced thereby may be sold through an intermediary to the issuing...