McDonald's Restaurants of Illinois, Inc. v. C. I. R.

• Decision Date: 14 September 1982
• Docket Number: No. 81-2933,81-2933
• Citation: 688 F.2d 520
• Parties: 82-2 USTC P 9581 McDONALD'S RESTAURANTS OF ILLINOIS, INC., et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 520

688 F.2d 520

82-2 USTC P 9581

McDONALD'S RESTAURANTS OF ILLINOIS, INC., et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 81-2933.

United States Court of Appeals, Seventh Circuit.

Argued June 3, 1982.

Decided Sept. 14, 1982.

Sheldon I. Fink, Chicago, Ill., for petitioners-appellants.

Ernest J. Brown, Tax Div., Dept. of Justice, Washington, D. C., for respondent-appellee.

Before CUMMINGS, Chief Judge, BAUER, Circuit Judge, and GRANT, Senior District Judge. ^*

CUMMINGS, Chief Judge.

This income tax case is an appeal by taxpayers from 27 decisions of the Tax Court determining deficiencies in their federal income tax totaling $566,403. The Tax Court disposed of the various deficiencies in one opinion reported in 76 T.C. 972 (1981).

The pertinent facts as found by the Tax Court and supplemented by the record are not in dispute. In June 1977, when they filed their petitions in the Tax Court to review the deficiency assessments, taxpayers were 27 wholly-owned subsidiaries of McDonald's Corporation (McDonald's), the Delaware corporation that franchises and operates fast-food restaurants. ¹ The taxpayers all had their principal places of business in Oak Brook, Illinois. They maintained their books and records on the accrual method and filed their tax returns on a calendar-year basis.

On the opposite end of the transaction at issue here were Melvin Garb, Harold Stern and Lewis Imerman (known collectively as the Garb-Stern group). The group had begun with a single McDonald's franchise in Saginaw, Michigan, in the late 1950's and expanded its holdings to include McDonald's restaurants elsewhere in Michigan and in Oklahoma, Wisconsin, Nevada and California. After 1968 relations between the Garb-Stern group and McDonald's deteriorated. In 1971 McDonald's considered buying some of the group's restaurants in Oklahoma, but abandoned the idea when it became clear that the acquisition could not be treated as a "pooling of interests" for accounting purposes ² unless all of the Garb-Stern group's restaurants were acquired simultaneously. In November 1972, however, negotiations resumed, McDonald's having decided that total acquisition was necessary to eliminate the Garb-Stern group's friction.

The sticking point in the negotiations was that the Garb-Stern group wanted cash for its operations, while McDonald's wanted to acquire the Garb-Stern group's holdings for stock, consistent with its earlier expressed preference for treating the transaction as a "pooling of interests" for accounting purposes. McDonald's proposed a plan to satisfy both sides: it would acquire the Garb-Stern companies for McDonald's common stock, but it would include the common stock in a planned June 1973 registration so that the Garb-Stern group could sell it promptly. ³

Final agreement was not reached until March 1973. Negotiations then were hectic; for a variety of accounting and securities-law reasons, the acquisition had to be consummated not before and not after April 1, 1973. The final deal was substantially what had been proposed earlier. The Garb-Stern companies would be merged in stages into McDonald's, ⁴ which would in turn transfer the restaurant assets to the 27 subsidiaries that are the taxpayers here. In return the Garb-Stern group would receive 361,235 shares of unregistered common stock. The agreement provided that the Garb-Stern group could participate in McDonald's planned June 1973 registration and underwriting or in any other registration and underwriting McDonald's might undertake within six years (Art. 7.4); the group also had a one-time right to demand registration in the event that McDonald's did not seek registration within the first year (Art. 7.5). ⁵ The Garb-Stern group was not obligated by contract to sell its McDonald's stock but fully intended to do so.

After the April 1 closing, both parties proceeded on the assumption that the Garb-Stern group's shares would be included in the June 1973 "piggyback" registration. In mid-June a widely publicized negative report about McDonald's stock caused the price to drop from $60 to $52 a share in two weeks, and McDonald's therefore decided to postpone the registration and sale of additional stock. The Garb-Stern group acquiesced, although it had made no effort to withdraw from the registration before McDonald's decided to cancel it.

Through the rest of the summer, the price of McDonald's stock staged a recovery. In late August McDonald's decided to proceed with the registration, and the Garb-Stern group asked to have its shares included. The registration was announced on September 17 and completed on October 3, 1973. The Garb-Stern group thereupon sold virtually all of the stock it had acquired in the transaction at a price of more than $71 per share.

In its financial statements McDonald's treated the transaction as a "pooling of interests". In its tax returns for 1973, however, it treated it as a purchase. ⁶ Consistent with that characterization, McDonald's gave itself a stepped-up basis in the assets acquired from the Garb-Stern group to reflect their cost ($29,029,000, representing the value of the common stock transferred and a $1-2 million "nuisance premium" paid to eliminate the Garb-Stern group from the McDonald's organization). It allocated that basis among various Garb-Stern assets, then dropped the restaurant assets to the 27 taxpayer subsidiaries pursuant to Section 351 of the Internal Revenue Code governing transfers to corporations controlled by the transferor. The subsidiaries used the stepped-up basis allocable to them to compute depreciation and amortization deductions in their own 1973 tax returns.

It is those deductions by the subsidiary taxpayers that the Commissioner reduced. He ruled that the transfer of the Garb-Stern group's assets to McDonald's was not a taxable acquisition but a statutory merger or consolidation under Section 368(a)(1)(A) of the Code, ⁷ and that under Section 362(b) ⁸ McDonald's was required to assume the Garb-Stern group's basis in the assets acquired. In turn, the subsidiaries were required to compute depreciation and amortization deductions on this lower, carryover basis. With properly computed deductions, the subsidiary taxpayers owed an additional $566,403 in 1973 income taxes. The Tax Court upheld the Commissioner's deficiency assessments, and this appeal is the result. ⁹

The Code distinguishes between taxable acquisitions and nontaxable (or more accurately tax-deferrable) acquisitive reorganizations under Sections 368(a)(1) (A)-(C) and 354(a)(1) ¹⁰ for the following common-sense reason: If acquired shareholders exchange stock in the acquired company for stock in the acquiring company, they have simply readjusted the form of their equity holdings. They have continued an investment rather than liquidating one, and the response of the tax system is to adjust their basis to reflect the transaction but postpone tax liability until they have more tangible gain or loss.

To ensure that the tax treatment of acquisitive reorganizations corresponds to the rationale that justifies it, the courts have engrafted a "continuity of interest" requirement onto the Code's provisions. See, e.g., Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179, 62 S.Ct. 540, 86 L.Ed. 775; LeTulle v. Scofield, 308 U.S. 415, 60 S.Ct. 313, 84 L.Ed. 355. That test examines the acquired shareholders' proprietary interest before and after the reorganization to see if "the acquired shareholders' investment remains sufficiently 'at risk' after the merger to justify the nonrecognition tax treatment," 76 T.C. at 997.

The taxpayers, the Commissioner, and the Tax Court all agree that the Garb-Stern group holdings were acquired by statutory merger. They also all agree that the "continuity of interest" test is determinative of the tax treatment of the transaction of which the statutory merger was a part. But the taxpayers on the one hand, and the Commissioner and the Tax Court on the other, part company over how the test is to be applied, and what result it should have produced. In affirming the Commissioner, the Tax Court recognized that the Garb-Stern group had a settled and firm determination to sell their McDonald's shares at the first possible opportunity rather than continue as investors, 76 T.C. at 989. It nonetheless concluded that because the Garb-Stern group was not contractually bound to sell, the merger and the sale could be treated as entirely separate transactions and the continuity-of-interest test applied in the narrow time-frame of the April transaction only. Thus tested, the transaction was in Judge Hall's view a nontaxable reorganization, and the taxpayer subsidiaries were therefore saddled with the Garb-Stern group's basis in taking depreciation and amortization deductions. The taxpayers by contrast argue that the step-transaction doctrine should have been applied to treat the April merger and stock transfer and the October sale as one taxable transaction. They also argue that the Tax Court's extremely narrow view of both the step-transaction doctrine and the continuity-of-interest test in this case is not consonant with appellate court case law, the Tax Court's own precedents, or the Service's practices hitherto. We agree with the taxpayers.

The Step-Transaction Doctrine

The step-transaction doctrine is a particular manifestation of the more general tax law principle that purely formal distinctions cannot obscure the substance of a transaction. See e.g., Redding v. Commissioner, 630 F.2d 1169, 1175 (7th Cir. 1980), certiorari denied, 450 U.S. 913, 101 S.Ct. 1353, 67 L.Ed.2d 338. As our Court there noted:

The commentators have attempted to synthesize from judicial decisions several tests to determine whether the step transaction doctrine is applicable to a particular set of circumstances * * *. Unfortunately, these tests are notably abstruse-even for such an abstruse field as tax law.

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