Ludwig v. Comm'r of Internal Revenue

• Decision Date: 29 September 1977
• Docket Number: Docket No. 5764—75.
• Citation: 68 T.C. 979
• Parties: DANIEL K. LUDWIG AND GERTRUDE V. LUDWIG, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

68 T.C. 979

DANIEL K. LUDWIG AND GERTRUDE V. LUDWIG, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 5764—75.

United States Tax Court

Filed September 29, 1977.

Petitioner, a United States citizen, was the sole stockholder of Oceanic, a controlled foreign corporation. Petitioner borrowed $100,538,775 from a group of banks and pledged his stock in Oceanic as part of the collateral for the loan. Held, Oceanic was not a ‘guarantor’ of petitioner's loan within the meaning of sec. 956(c), I.R.C. 1954, and, thus, petitioner did not realize taxable income from Oceanic under sec. 951 as a result of the loan transaction. Richard G. Cohen, Gary I. Fritzhand, and R. Palmer Baker, Jr., for the petitioners.

Larry Kars, for the respondent.

FEATHERSTON, Judge:

Respondent determined a deficiency in petitioners' Federal income tax for 1963 in the amount of $4,438,086.75. After various concessions by the parties, the sole issue remaining for decision is whether a controlled foreign corporation wholly owned by petitioner Daniel K. Ludwig was a guarantor, within the meaning of section 956(c),¹ of petitioner's obligations to a group of lending banks, with the result that income was realized by petitioner under section 951.

FINDINGS OF FACT

Petitioners Daniel K. Ludwig (hereinafter petitioner) and Gertrude V. Ludwig, husband and wife, are citizens of the United States, residing in New York, N.Y. They filed a joint Federal income tax return for 1963 with the Internal Revenue Service, New York, N.Y. Gertrude V. Ludwig is a party hereto solely by reason of having filed a joint return.

In June 1963, petitioner entered into an agreement with Phillips Petroleum Co. (hereinafter Phillips), providing for the purchase by petitioner from Phillips of 1,340,517 shares of stock of Union Oil Co. (hereinafter Union Oil). These shares represented Phillips' entire holding in Union Oil, and amounted to approximately 15 percent of Union Oil's total outstanding stock. The purchase price was $75 per share, or a total of $100,538,775.

Pursuant to the purchase agreement, the parties were required to obtain, and they eventually did obtain, (a) the consent of the Antitrust Division of the U.S. Department of Justice of the sale by Phillips of its Union Oil stock to petitioner and (b) the consent to the sale by Phillips of its Union Oil stock to petitioner, pursuant to a preliminary injunction of January 1961, of the United States District Court for the Southern District of California in the matter of United States v. Phillips Petroleum Co.

In order to pay for the 1,340,517 shares of Union Oil, petitioner arranged to borrow the entire amount of the purchase price from three banks—Chase Manhattan Bank (Chase Manhattan), Chemical Bank New York Trust Co. (Chemical Bank), and Bank of America National Trust & Savings Association (Bank of America). Chase Manhattan served as agent for the lending banks in negotiating the loan agreement with petitioner. All negotiations as to the terms and conditions of the loan agreement (other than those concerning the amount of participation of each of the lending banks) were conducted by Chase Manhattan as agent for the lending banks.

Part of the negotiation of the agreement involved the collateral to be used to secure the loan. Under Regulation U, Federal Reserve Board, 12 C.F.R., Part 221 (1963) (hereinafter Regulation U), a loan of this type (for the purchase of a security listed on a national securities exchange) was required to be secured by collateral having a value of at least twice the amount of the loan. Petitioner offered and the banks accepted as collateral the 1,340,517 shares of Union Oil stock to be acquired by petitioner with the loan proceeds, plus 1,000 shares of Oceanic Tankships, S.A. (Oceanic).

Oceanic was a Panamanian corporation which, during 1963, had 1,000 shares of stock outstanding, all of which were owned by petitioner. During the taxable year 1963, Oceanic's assets consisted primarily of all of the outstanding stock of Universe Tankships, Inc. (Universe), a Liberian corporation engaged principally in the business of owning and operating oceangoing vessels. As of December 31, 1963, Oceanic had accumulated earnings and profits of $5,092,318. At the time Chase Manhattan agreed to accept the stock of Oceanic as collateral for petitioner's loan, it determined that such stock had a value at least equal to its book value of approximately $200 million. Thus, the total collateral for the loan (the Union Oil stock plus the Oceanic stock) was valued by the lending banks at approximately $300 million.

In order to protect the value of the Oceanic stock held as collateral, the banks required of petitioner certain negative covenants restricting his absolute control over the assets and liabilities of Oceanic and Universe during the term of the loan. These restrictions were set forth in the loan agreement and included, in part, the borrower's covenants not to cause Oceanic or Universe to do any of the following without the consent of the lenders:

(1) Borrow money, except in connection with shipping operations;

(2) Pledge assets as collateral, except as to borrowings in connection with shipping operations;

(3) Guarantee, assume, or become liable on the obligation of another, or invest in or lend funds to another, except to the extent of $40 million total;

(4) Merge or consolidate with any other corporation;

(5) Sell or lease (other than in the ordinary course of business) or otherwise dispose of any substantial part of its assets;

(6) Transfer any shares of any controlled subsidiary;

(7) Pay or secure any amount owing by Oceanic or Universe to petitioner; (8) Pay any dividends, except in such amounts as may be required to make interest or principal payments on petitioner's loan from the lending banks.

The principal purpose of these negative covenants was to protect the lenders against possible actions by petitioner, as the controlling stockholder of Oceanic and (through Oceanic) Universe, which could diminish the value of the Oceanic stock held as collateral. This kind of protection was critical in satisfaction of Regulation U requirements concerning the value of collateral. With the protection of the negative covenants the lending banks could look to the value of the Oceanic stock as their source of recovery in the event of default in repayment by petitioner. In the event of such default the banks expected to be able to sell the pledged Union Oil and/or Oceanic stock to satisfy their claims.

In July 1963, the loan agreement was concluded and petitioner issued personal promissory notes to the lending banks as follows:

+-------------------------------+
                ¦Chase Manhattan ¦$50,269,387.50¦
                +----------------+--------------¦
                ¦Chemical Bank   ¦40,000,000.00 ¦
                +----------------+--------------¦
                ¦Bank of America ¦10,269,387.50 ¦
                +----------------+--------------¦
                ¦Total           ¦100,538,775.00¦
                +-------------------------------+
                

In that same month, petitioner completed his purchase of the Union Oil stock.

During 1963 through 1965, the board of directors of Oceanic held meetings and kept minutes of these meetings. Such minutes do not reflect any discussion of or reference to petitioner's purchase of Union Oil stock or the loan agreement pursuant to which his Oceanic stock was pledged as collateral.

Subsequent to the execution of the loan agreement, the agreement was amended twice to extend the maturity date of the first installment repayment. The second such amendment extended the maturity date to July 19, 1965. On or about July 20, 1964, petitioner paid from his personal account $2,484,627.26 in interest on the loan. On or about December 23, 1964, petitioner paid from his personal account an additional $2,075,672.63 in interest.

On or about February 17, 1965, petitioner sold all the Union Oil stock purchased on July 19, 1963, to Union Oil for $35.50 per share ($106.50 per share if the price is adjusted for a 3-for-1 stock split which took place in 1964). This resulted in a gain of $45,152,943.87. From the proceeds of this sale, on February 17, 1965, petitioner repaid to the lending banks the loan principal and all remaining interest to date. The gain on the sale was duly reported on petitioners' joint Federal income tax return for 1965. That return showed a tax liability of $11,471,413.78, which was paid.

ULTIMATE FINDING OF FACT

Oceanic was not a guarantor of petitioner's obligations to the lending banks.

OPINION

Under section 951(a)(1)(B), a United States shareholder of a controlled foreign corporation is required to include in gross income his pro rata share of such corporation's increase in earnings invested in United States property during the taxable year. Section 956(a)(1)² provides that the amount of the earnings of a controlled foreign corporation invested in United States property for the taxable year is the aggregate amount of such property held, directly or indirectly, at the close of the taxable year but only to the extent that the amount thereof would have constituted a dividend if such amount had been distributed during the year. See sec. 1.956—1(a), Income Tax Regs.

Section 956(b)(1)(C)³ provides that the term ‘United States property’ includes an obligation of a ‘United States person.’ Thus, if a controlled foreign corporation makes a loan to its shareholder, a United States person, the obligation to repay the loan is United States property and the shareholder thereby realizes income under section 951. Section 956(c) goes further and provides that a controlled foreign corporation shall be considered as holding an obligation of a United States person if such corporation is, under regulations issued by the Secretary of the Treasury, a ‘guarantor’ of such obligation.

In the instant case, petitioner was a United States shareholder of a controlled foreign corporation, Oceanic. As of December 31, 1963, that corporation had accumulated earnings and profits of $5,029,318...