National Starch and Chemical Corp. v. C.I.R., 89-1923

CourtUnited States Courts of Appeals. United States Court of Appeals (3rd Circuit)
Citation918 F.2d 426
Docket NumberNo. 89-1923,89-1923
Decision Date28 November 1990

Richard J. Hiegel (argued), Rory O. Millson, Lewis R. Steinberg, Cravath, Swaine & Moore, Richard H. Walker, Geoffrey R.S. Brown, Cadwalader, Wickersham & Taft, New York City, for appellant.

Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, Gilbert S. Rothenberg, Bruce R. Ellisen (argued), Tax Div., Dept. of Justice, Washington, D.C., for appellee.

Before: SLOVITER, BECKER, and STAPLETON, Circuit Judges.


SLOVITER, Circuit Judge.

This is an appeal by National Starch and Chemical Corporation (National Starch) from a decision of the Tax Court affirming the disallowance by the Internal Revenue Service (IRS) of the investment banking fee, legal fees and related expenses incurred by National Starch's Board of Directors in deciding whether to acquiesce in a takeover by Unilever United States, Inc. National Starch contends that these were ordinary and necessary business expenses deductible under section 162(a) of the Internal Revenue Code. The Tax Court agreed with the Commissioner of Internal Revenue that all of the fees were nondeductible capital expenditures. This appeal presents, as far as we can tell, an issue of first impression.

I. Facts and Procedural History

The facts are largely undisputed and are in the record as a result of a stipulation between the parties.

In 1977, Unilever approached National Starch, one of Unilever's suppliers, to gauge its interest in being the target of a friendly takeover. All of the stock of Unilever United States, Inc. is owned by Unilever N.V. (jointly referred to as Unilever) a publicly held Netherlands Corporation. 1 Unilever was interested in increasing its United States revenues relative to its overall revenues.

Unilever expressed its interest in National Starch to, inter alia, Frank Greenwall, a member of National Starch's Board of Directors, who along with his wife was the largest stockholder, holding approximately 14 1/2 percent of the stock. The Greenwalls decided to sell their shares to Unilever if the transaction could be arranged to be tax-free to them so that they could defer capital gains for estate planning purposes. Unilever, which was interested only in a friendly takeover, would proceed only if the Greenwalls were willing to sell their shares.

To satisfy the Greenwalls, the merger was arranged as a "reverse subsidiary cash merger" under which Unilever created a subsidiary, National Starch and Chemical Holding Company (Holding), 2 which offered to either purchase the shares of National Starch's shareholders with money contributed by Unilever or exchange them for preferred stock of Holding. Subsequently, this arrangement received the desired ruling from the Internal Revenue Service that shareholders who exchanged National Starch stock for Holding stock could do so without adverse tax consequences.

When the plan was presented to National Starch's Board of Directors for consideration, the corporation's legal counsel advised the directors that they had a duty to ensure that the transaction "would be fair to the shareholders and that that would involve valuations of the company." App. at 91. Counsel suggested "as a practical matter that it would be extremely useful for the board to have a firm of outside independent investment bankers ... to assist in the valuations of the company to ensure fairness of any transaction," id., and that it was also wise from a legal standpoint in carrying out the Board's fiduciary duties. App. at 92. When it appeared likely that a favorable ruling would be forthcoming from the IRS, National Starch engaged Morgan Stanley & Co. (Morgan Stanley) to do a preliminary analysis, review National Starch's alternatives, make a valuation judgment after studying National Starch, render a fairness opinion, and coordinate the technical details of the merger.

Morgan Stanley prepared and delivered a report to the Board on the fairness of the offer. Unilever had originally proposed a price of $65 to $70 for each share of National Starch, which Morgan Stanley concluded was fair. Unilever thereafter offered $70 a share. National Starch's management suggested a price of $80 a share, which Morgan Stanley relayed to Unilever on the Board's behalf. Morgan Stanley thereafter reported back a Unilever offer of $73.50 a share, the price ultimately agreed upon.

After the sale of the stock, National Starch retained its former management, and it did not materially increase the sale of its products to Unilever. The management at National Starch viewed the transaction as "swapping approximately 3500 shareholders for one." App. at 141. As a matter of administrative convenience, it changed its charter to eliminate its authorized and unissued preferred stock and decreased its authorized common stock to 1,000 shares.

National Starch's tax return for the year that ended August 15, 1978 (the date of acquisition) treated the $2,225,586 Morgan Stanley fee as a deduction for an ordinary and necessary business expense under section 162(a) of the Internal Revenue Code. The IRS disallowed the deduction and issued a notice of deficiency in the amount of $1,068,281. National Starch filed a petition in the United States Tax Court contesting the disallowance. It also claimed a refund, asserting that it had overpaid its 1978 taxes in the amount of $706,079 because it had not deducted, and was entitled to deduct, ancillary expenses which included its attorneys' fees, costs associated with the proxies, and the SEC fees it incurred with respect to the merger plan. 3 The Tax Court upheld the disallowance by the IRS. 93 T.C. 67 (1989).

The Tax Court rejected the IRS' contention that the expenditures were nondeductible because they were incurred incident to a recapitalization, merger, or reorganization, concluding essentially that the form and structure of the transaction was selected primarily for administrative convenience. On the other hand, the Tax Court concluded that these were nondeductible capital expenditures because National Starch's directors determined that it would be in National Starch's "long-term interest to shift ownership of the corporate stock to Unilever" and "[t]he expenditures in issue were incurred incident to that shift in ownership...." Id. at 75. Accordingly, it believed those expenditures "lead to a benefit 'which could be expected to produce returns for many years in the future.' " Id. (quoting E.I. du Pont de Nemours and Co. v. United States, 432 F.2d 1052, 1059 (3d Cir.1970)). Such a benefit is "capital in nature" because its purpose has to do with the corporation's betterment for the indefinite future. Id. The court noted that National Starch's 1978 annual report stated that it would benefit from the availability of Unilever's enormous resources, and that Morgan Stanley's report stated that National Starch's affiliation with Unilever would create the opportunity for synergy. Id. at 76.

The Tax Court rejected National Starch's argument that the Supreme Court's decision in Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345, 91 S.Ct. 1893, 29 L.Ed.2d 519 (1971), created a new test to determine deductibility under section 162(a) that looks to whether a separate and distinct additional asset is created, rather than the length of the period of the benefits. 93 T.C. at 77. It also rejected National Starch's contention that the dominant aspect of the transaction was the fiduciary duty the Board of Directors owed to the shareholders and not the transfer of the stock, finding instead that "the dominant aspect was the transfer of petitioner's stock for the benefit of [National Starch] and its shareholders." Id. at 78.

National Starch has appealed from the Tax Court's decision. We have jurisdiction pursuant to 26 U.S.C. Sec. 7482. Our review of the Tax Court's construction of the Code is plenary; we review its factual findings and inferences for clear error. Pleasant Summit Land Corp. v. Commissioner, 863 F.2d 263, 268 (3d Cir.1988).

II. Ordinary and Necessary Business Expenses
A. Effect of Lincoln Savings

The issue before us is whether National Starch's expenditures for investment banking and legal fees can be deducted under section 162(a) of the Internal Revenue Code as ordinary and necessary business expenses or whether they must be capitalized under section 263. Section 162 provides: "[t]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business...." 26 U.S.C. Sec. 162(a) (1988). This provision must be interpreted in tandem with section 263, which prohibits deductions for "[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." 26 U.S.C. Sec. 263(a)(1) (1988).

The Supreme Court has enumerated five separate requirements for deductibility under section 162(a). The item must (1) be paid or incurred during the taxable year (2) for carrying on any trade or business, and (3) be an expense (4) that is "necessary" and (5) "ordinary." Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. at 352, 91 S.Ct. at 1898. Only the "ordinary expense" requirement is in dispute here. The Court has stated, in somewhat circular fashion, that the principal function of the term "ordinary" is to distinguish between expenses currently deductible and capital expenditures which, if deductible at all, must be amortized over the useful life of the asset. See Commissioner v. Tellier, 383 U.S. 687, 689-90, 86 S.Ct. 1118, 1119-20, 16 L.Ed.2d 185 (1966).

Tax deductions are a matter of legislative grace. See Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593, 63...

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