Redding v. C. I. R.

• Citation: 630 F.2d 1169
• Decision Date: 25 August 1980
• Docket Number: Nos. 79-1775,79-1776,s. 79-1775
• Parties: 80-2 USTC P 9637 Gerald R. REDDING and Dorothy M. Redding and Thomas W. Moses and Anne M. Moses, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 1169

630 F.2d 1169

80-2 USTC P 9637

Gerald R. REDDING and Dorothy M. Redding and Thomas W. Moses and Anne M. Moses, Petitioners-Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant.

Nos. 79-1775, 79-1776.

United States Court of Appeals Seventh Circuit.

Argued Feb. 14, 1980.

Decided Aug. 25, 1980.

Daniel F. Ross, Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellant.

Robert N. Davies, Indianapolis, Ind., for petitioners-appellees.

Before BAUER, WOOD and CUDAHY, Circuit Judges.

CUDAHY, Circuit Judge.

This is an appeal by the Commissioner of Internal Revenue from determinations of the United States Tax Court that Gerald R. and Dorothy M. Redding and Thomas W. and Anne M. Moses ("taxpayers") do not owe any income tax on account of the receipt or exercise of stock warrants. ¹ These warrants were distributed as part of a series of transactions involving distribution by the Indianapolis Water Company (the "Water Company") to its stockholders of all the stock of its wholly-owned subsidiary, Shorewood Corporation ("Shorewood"). The distribution of warrants was made preliminarily to the distribution of stock, which was distributed upon the exercise of the warrants. The Tax Court treated the two distributions as being part of a single transaction, sheltered from taxation under section 355 of the Internal Revenue Code of 1954, ² granting nonrecognition to a corporation's distribution to its stockholders of stock or securities in a controlled corporation. We hold that the distribution of stock warrants to the taxpayers constituted a dividend to them and that section 355 is not available to render the transaction nontaxable. We, therefore, reverse.

I.

The Water Company, which is a public utility, owned all of the stock of Shorewood, which in turn owned most of the waterfront property surrounding the reservoirs used by the Water Company. Shorewood wished to develop its waterfront realty, but the Indiana Public Service Commission determined that real estate development was not an appropriate activity for a public utility and suggested that Shorewood be separated from the Water Company.

To achieve this end, Shorewood's capital structure was altered. In 1970, Shorewood's authorized common stock was increased from 1,000 and 2,500,000 shares. On the same day, Shorewood issued to the Water Company 481,291 shares of common stock in exchange for Shorewood's 1,000 shares then outstanding and held by the Water Company. On January 6, 1971, the Water Company agreed to purchase an additional 855,630 shares of common stock from Shorewood for a total ownership of 1,336,921 shares. The board of directors of the Water Company decided to distribute to its shareholders of record on January 6, 1971, stock rights or warrants to purchase Shorewood stock on the basis of one warrant for each share of the Water Company common stock outstanding. The warrants gave the holder the right to receive one share of Shorewood stock upon surrender of two warrants and the payment of $5.00 to the Water Company and further right to subscribe to any remaining Shorewood shares by allotment. The warrants were transferable.

The total offering of Shorewood shares by the Water Company thus amounted to 1,069,537 shares, which comprised slightly more than 80% of the total outstanding amount of Shorewood stock. Of these shares to be offered, 50,000 shares were reserved for the underwriters, and 1,019,537 shares were available for distribution to warrant holders. Any shares not sold to warrant holders were to be bought by the underwriters, on a "firm commitment" basis, at a slightly discounted price. The Water Company thus retained slightly less than 20% of the outstanding Shorewood stock. Immediately after the distribution, the shareholders of the Water Company held substantially more than 50% of the outstanding shares of Shorewood.

The warrants were issued on January 7, 1971, and expired and became valueless if not exercised by 3:30 p. m. on January 22, 1971. During this subscription period, shareholders or their transferees or assignees subscribed to all 1,069,537 Shorewood shares offered, except for 50,000 shares acquired by the underwriters. Hence, 1,019,537 shares of Shorewood stock were actually distributed to the warrant holders and 50,000 shares conveyed to the underwriters on February 2, 1971. As contemplated by the Water Company, an over-the-counter market in warrants developed during the subscription period, with the price ranging from $0.39 to $1.05 per warrant. There is no dispute that both at the time of issuance and at the time of exercise of the warrants the subscription price of $5.00 was less than the fair market value of Shorewood stock. That is to say that at all relevant times there was a "spread" between the subscription price and the fair market value of Shorewood stock.

Taxpayers were stockholders of the Water Company. Gerald and Dorothy Redding owned 7,000 Water Company shares, and Thomas and Anne Moses owned 35,543 shares. They received a corresponding number of warrants and exercised all of them. The Moseses also exercised an additional subscription privilege to obtain an additional 6,228 shares of Shorewood stock.

Taxpayers contended that both the receipt and the exercise of the warrants were tax-free to them under the provisions of section 355. ³ It was stipulated that the transaction was not a "device" for the distribution of earnings and profits pursuant to section 355(a)(1)(B); ⁴ that the separately conducted "active business" requirements of section 355(a)(1)(C) were met; that the 1,069,537 shares of Shorewood distributed in the offering amounted to 80% control; and that the shares retained by the Water Company were not held for tax avoidance purposes within the meaning of section 355(a)(1)(D) (ii).

II.

The Tax Court ⁵ agreed with taxpayers that the transactions involved in these cases met the requirements for a corporate division, in this case a "spin-off," contained in section 355 and were, accordingly, tax-free. A spin-off occurs when the stock of a subsidiary corporation is distributed to the shareholders of the parent without the surrender by them of stock in the parent. ⁶ "(T)he general purpose of Congress in sanctioning, in proper cases, tax-free spin-offs was to permit the real owners of enterprises to rearrange their units and evidences of ownership to suit their own ideas of how best to carry on their businesses." Commissioner v. Wilson, 353 F.2d 184, 186 (9th Cir.1965). See H.Rep.No. 1337, 83d Cong., 2d Sess., reprinted in (1954) U.S.Code Cong. & Admin.News pp. 4017, 4059. Accord S.Rep.No. 1622, 83d Cong., 2d Sess., reprinted in (1954) U.S.Code Cong. & Admin.News, pp. 4621, 4672.

In reversing the Tax Court, we find taxpayers have failed to meet their burden of showing that the several transactions here meet the tests of section 355 so as to qualify for nonrecognition of the gain otherwise subject to tax. As the parties and the Tax Court acknowledged to be the case were we to find section 355 inapplicable, we conclude the distribution of the warrants by the Water Company is taxable as a dividend. It is not controlling that taxpayers sold none of their rights, exercised all of them, and received stock for them (for which taxpayers also paid the additional consideration of $5.00 per Shorewood share). The tax treatment of taxpayers must depend upon an analysis of the transaction as a whole rather than only of the specific facts applicable to these taxpayers. This is true because the nonrecognition of gain afforded by section 355 requires adherence to requirements governing the transaction as a whole. ⁷

The Tax Court, in determining whether the issuance of the warrants and their exercise by warrant holders should be immunized from tax by section 355, purported to rely heavily on its prior ruling granting tax-free status to warrants used in somewhat similar transaction in Baan v. Commissioner, 45 T.C. 71 (1965), ⁸ rev'd, 382 F.2d 485 (9th Cir. 1967), aff'd sub nom. Commissioner v. Gordon, 382 F.2d 499 (2d Cir.1967), 9th Cir. aff'd sub nom. Commissioner v. Gordon, 2d Cir. rev'd, 391 U.S. 83, 88 S.Ct. 1517, 20 L.Ed.2d 448 (1968). ⁹ In Baan, the Tax Court apparently felt that it could ignore the issuance of warrants as a taxable event under the dictum of Palmer v. Commissioner, 302 U.S. 63, 58 S.Ct. 67, 82 L.Ed. 50 (1937), that an issuance of stock rights is not a dividend, ¹⁰ and that it could proceed to consideration of the warrant exercise and stock issuance only. ¹¹ In the instant case, on the other hand, the Tax Court expressly declined to state a view on the current vitality of the Palmer dictum. ¹² Instead, it applied the "step transaction doctrine" to reach its conclusion that the two transactions which took place should be viewed as "steps" in a single transaction meeting the requirements of section 355 and that, hence, neither the receipt nor the exercise of the warrants results in tax. We shall, therefore, address first the applicability of the step transaction doctrine, which we think is significantly related to the current status of the Palmer dictum, to be discussed later. As to the application of the step transaction doctrine, we believe the Tax Court erred.

III.

The attempted application of the step transaction doctrine in this case to shift the focus from the issuance of the stock rights or warrants to the subsequent distribution of stock is important, because, to qualify under section 355, a distribution must consist solely of stock or securities, which do not include stock rights such as these. See Treas.Reg. § 1.355-1(a) (1979). See also S.Rep.No. 1622, 83d Cong., 2d Sess. 266, reprinted in (1954) U.S.Code Cong. & Admin.News, pp. 4621, 4902. As the Court of Appeals for the Ninth Circuit said in Commissioner v. Baan,

(Section 355(a)(1)(A)) relates "solely" to the distribution of "stock or securities" of the controlled corporation. Further, in view of ...