Philip Morris Inc. & Consol. Subsidiaries v. Comm'r of Internal Revenue

• Decision Date: 11 April 1991
• Docket Number: 38953-84.1,33778-83,Docket Nos. 28604-82
• Citation: 96 T.C. No. 23,96 T.C. 606
• Parties: PHILIP MORRIS INCORPORATED AND CONSOLIDATED SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

96 T.C. 606

96 T.C. No. 23

PHILIP MORRIS INCORPORATED AND CONSOLIDATED SUBSIDIARIES, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 28604-82

33778-83

38953-84.1

United States Tax Court

Filed April 11, 1991.

PM is the common parent of an affiliated group of corporations that filed consolidated returns for the years in issue.

On June 1, 1978, PM, through NS, its acquisition subsidiary, acquired all the outstanding stock of S, a publicly traded corporation, in a hostile takeover. W-J was a subsidiary of S.

On June 16, 1978, NS caused W-J to merge with and into S in a transaction that qualified as a liquidation under secs. 332 and 334(b)(1), I.R.C., as amended. On June 19, 1978, NS caused S to merge with and into it pursuant to a liquidation under secs. 332 and 334(b)(2).

In allocating NS's refined adjusted basis in the stock of S to the various assets it received upon the liquidation of S, PM determined that NS paid a control premium which should be allocated among the tangible and intangible assets of S. In determining the value of S's intangible assets, PM used the capitalization or excess earnings method. R determined that the intangible assets of S should be valued using the residual method.

HELD, PM correctly valued S's intangible assets pursuant to sec. 334(b)(2) and the regulations thereunder. HELD FURTHER, the refined upward adjustment made to the adjusted basis of the S stock pursuant to sec. 1.334-1(c)(4)(v), Income Tax Regs., is correct. Jerome B. Libin, William S. Corey, Padric K.J. O'Brien, and Richard A. Burton, for the petitioner.

Lewis R. Mandel, Diane R. Mirabito, and Steven M. Diamond, for the respondent.

JACOBS, JUDGE:

Respondent determined deficiencies in petitioner's Federal income tax as follows:

+----------------------+
                ¦TYE     ¦Deficiency   ¦
                +--------+-------------¦
                ¦12/31/78¦$52,056,108  ¦
                +--------+-------------¦
                ¦12/31/79¦44,316,979   ¦
                +--------+-------------¦
                ¦12/31/80¦59,024,150   ¦
                +----------------------+
                

Following concessions, the primary issue for decision is the fair market value of the Seven-Up Company's (Seven-Up) intangible assets as of June 19, 1978, the date such company was liquidated into the New Seven-Up Company (New Seven-Up) pursuant to sections 332 ² and 334(b)(2), following the unsolicited acquisition (on June 1, 1978) of all of its stock by New Seven-Up.

We must also decide the propriety of three upward refinements to the adjusted basis of the Seven-Up stock pursuant to section 1.334- 1(c)(4)(v), Income Tax Regs. These refinements involve: (1) An increase for Federal income taxes on interim earnings and profits (i.e., earnings and profits of Seven-Up between June 1, 1978 through June 19, 1978); (2) an increase for recapture income items attributable to the period prior to acquisition of Seven-Up's stock by New Seven-Up (i.e., prior to June 1, 1978) which are recognizable on June 19, 1978; and (3) an increase for interim earnings of lower- tier domestic subsidiaries.

Resolution of the value of Seven-Up's intangible assets as of June 9, 1978, and the propriety of the three upward refinements to the adjusted basis of Seven-Up's stock is necessary in order to allocate New Seven-Up's adjusted basis in the Seven-Up stock among the various assets it received upon the liquidation of Seven-Up.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and accompanying exhibits are incorporated by this reference.

Philip Morris Incorporated, a corporation organized and existing under the laws of the Commonwealth of Virginia, had its principal office in New York, New York, when the petitions were filed. Its stock is publicly traded on various stock exchanges.

During the years in issue, Philip Morris Incorporated was the common parent of the group of affiliated corporations which constitute the petitioner in this case. Hereinafter, Philip Morris Incorporated will be referred to as petitioner and Philip Morris and Consolidated Subsidiaries will be referred to as petitioner and its consolidated subsidiaries.

Petitioner and its consolidated subsidiaries timely filed consolidated Federal income tax returns for 1978, 1979, and 1980. They report their income on a calendar-year basis, employing the accrual method of accounting for both financial and tax purposes.

At all relevant times, New Seven-Up (formerly PMI, Inc.) was a corporation organized under Delaware law with its principal office in St. Louis, Missouri; it also employs the accrual method of accounting to report income. New Seven-Up was a wholly owned subsidiary of petitioner formed for the sole purpose of acquiring Seven-Up. The entity which acquired Seven-Up will be referred interchangeably to as either “petitioner” or New Seven-Up.

Background

Prior to the years at issue, petitioner and its subsidiaries were primarily engaged in the manufacture and sale of cigarettes and beer. Petitioner's initial business, the manufacture and sale of cigarettes, was established in 1919.

Between 1958 and 1978, petitioner rose from a near-bottom ranking among the major U.S. cigarette companies to a strong position in the industry. Its cigarette business outside the United States expanded through the export of domestically manufactured goods as well as the acquisition or creation and development of several foreign tobacco companies.

For the period ended December 31, 1977, petitioner's combined operating revenues exceeded $5 billion, with operating revenues and operating income from its tobacco business of approximately $3.5 billion and $615 million, respectively.

Beginning in the 1950's, petitioner and other domestic cigarette manufacturers were confronted with rising public concern regarding the health issues associated with cigarette smoking. In 1964, an Advisory Committee to the Surgeon General of the U.S. Public Health Service released a report which concluded that cigarette smoking was a health hazard. In 1966, Federal legislation was enacted which required publication of a warning statement on cigarette packaging.

PETITIONER'S DIVERSIFICATION HISTORY

Over the years, petitioner implemented a diversification program by acquiring several businesses that were more or less related to its cigarette business. Based on its knowledge of the role packaging plays in consumers' selection of products, petitioner acquired certain specialty paper manufacturers, i.e., in 1957, petitioner acquired Milprint, Inc., the world's largest flexible food packaging manufacturer (which was named Philip Morris Industrial Incorporated during the years at issue), in an exchange of stock valued at approximately $16,557,000; and in 1970, petitioner acquired Plainwell Paper Company, Inc., for approximately $3,965,000.

Petitioner believed that the distribution system it had established throughout the United States for its cigarettes could also be utilized for products traditionally sold alongside cigarettes in retail outlets. Thus, in 1960, petitioner acquired the assets of the American Safety Razor Company in an exchange of stock valued at approximately $22,957,000; in 1963, petitioner acquired Burma Vita Company (which sold Burma Shave products) for approximately $2,000,000 and Clark Gum Company for approximately $3,409,000. These latter acquisitions did not prove as successful as desired; accordingly, they were either abandoned (Burma Vita) or sold (American Safety Razor Company and Clark Gum Company) prior to 1978.

By the late 1960's, petitioner focused on larger acquisitions that could have a significant impact on its earnings. In this regard, petitioner paid particular attention to the beverage industry.

THE BEVERAGE INDUSTRY

Petitioner periodically investigated various segments of the beverage industry (beer, soft drinks, and juices) with a view toward further acquisitions. The beverage industry, like the cigarette industry, involves the manufacture and sale of consumer products that are agriculturally based, widely distributed, and sold on the basis of consumer preferences for taste, packaging, and advertising.

THE BEER INDUSTRY

In 1968, petitioner undertook a study of the beer industry. At the time, the domestic beer industry generally consisted of two groups of companies, most of which were family owned or controlled: brewers that had successfully expanded into the national market and had established a premium-priced beer (such as Anheuser-Busch Inc., Jos. Schlitz Brewing Company, and Miller Brewing Company (Miller)) and regional and local brewers that lacked production capacity and/or the financial resources to compete with the existing national beer companies. Up to this time, the national brewers had increased sales and market share by investing in additional production capacity and new technology in manufacturing and distribution and, with the savings derived from such investments, by increasing marketing and promotional efforts.

During May and June 1969, petitioner unsuccessfully attempted to enter the beverage industry through the acquisition of a major interest in Canadian Breweries Limited, then the largest Canadian beer manufacturer and owner of the seventh-largest U.S. beer company, Carling Brewing Company. At the end of May 1969, upon learning that petitioner's attempt to acquire Canadian Breweries Limited would be unsuccessful, W.R. Grace & Co. (Grace) offered petitioner the opportunity to purchase its 53-percent interest in Miller, then the eighth-largest domestic beer company.

On June 12, 1969, a special meeting of petitioner's board of directors approved the proposed Miller acquisition, based on the recommendation of George Weissman (Weissman) (vice chairman of petitioner's board of directors from 1973 until November 1978 when he became chairman of the board and chief executive officer). Petitioner purchased Grace's interest in Miller, paying approximately $130 million in cash. In 1970, petitioner purchased the remaining 47 percent of Miller from the DeRance...