A.E. Staley Mfg. Co. and Subsidiaries v. C.I.R., 96-1940

• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)
• Citation: 119 F.3d 482
• Docket Number: No. 96-1940,96-1940
• Parties: -5060, 97-2 USTC P 50,521 A.E. STALEY MANUFACTURING COMPANY AND SUBSIDIARIES, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Decision Date: 02 July 1997

Page 482

119 F.3d 482 80 A.F.T.R.2d 97-5060, 97-2 USTC P 50,521 A.E. STALEY MANUFACTURING COMPANY AND SUBSIDIARIES,
Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. No. 96-1940. United States Court of Appeals,
Seventh Circuit. Argued Oct. 23, 1996.
Decided July 2, 1997.

Page 483

Dan Burt, Henry B. Miller (argued), Burt, Maner & Miller, Washington, DC, for Petitioner-Appellant.

Stuart L. Brown, Internal Revenue Service, Washington, DC, Gary R. Allen, Jonathan S. Cohen, Steven W. Parks (argued), Department of Justice, Tax Division, Appellate Section, Washington, DC, for Respondent-Appellee.

Before HARLINGTON WOOD, JR., RIPPLE and KANNE, Circuit Judges.

RIPPLE, Circuit Judge.

The predecessor of A.E. Staley Manufacturing Company and Subsidiaries ("Staley") paid investment bankers in connection with an unsuccessful effort to defeat a hostile tender offer. On its federal income tax return, the company claimed a deduction for the fees paid to the bankers. The Commissioner of Internal Revenue disallowed the claimed deduction and issued a notice of deficiency. Staley's predecessor then filed a petition in the United States Tax Court challenging the disallowance. The Tax Court agreed with the Commissioner and held that the expenses were capital expenditures which cannot be deducted. Staley now appeals the Tax Court's judgment, and we reverse and remand for further proceedings consistent with this opinion.

I BACKGROUND

A. Facts

Staley, the petitioner in this case, was an affiliated group of corporations, formerly named Staley Continental, Inc. and Subsidiaries ("SCI"). The predecessor of both petitioner and SCI was A.E. Staley Manufacturing Co. ("AES"). From its organization in 1906 until November 1984, AES' primary business consisted of storing, marketing, milling, processing and refining corn and soybeans. AES employed a process called corn wet milling to produce sweeteners, starches, oils and other ingredients for the food and beverage industry. AES' principal product was high fructose corn syrup. By the mid-1980s, high fructose corn syrup had become

Page 484

the leading sweetener in the country's food and beverage market, especially in the soft drink industry.

Because AES believed that the market had matured for its product, in 1984 its board of directors made the long-term strategic decision to enter into the food service business. AES diversified into this area by acquiring other companies, including CFS Continental, Inc., one of the country's leading suppliers in the food service industry. SCI was formed and became the parent company of AES and CFS Continental, Inc. Using the revenues it earned from corn wet milling, SCI began to pursue growth in the food service business.

When an investment banker threatened to acquire SCI in 1986, SCI began to fear the possibility of a hostile takeover. SCI hired a law firm in response, which advised SCI to adopt antitakeover devices. SCI followed this advice and adopted some antitakeover measures. SCI also hired the First Boston Corporation and Merrill Lynch Capital Markets (collectively, "investment bankers") to prepare SCI for, and to advise and assist SCI in the event that another company were to attempt, a hostile takeover. SCI also agreed to hire the investment bankers to represent SCI in the event an offer was made.

In March 1987 Merrill Lynch made presentations to SCI's management and board of directors, in which it recommended that SCI take certain actions to prepare for any unsolicited takeover attempts. SCI implemented many of these proposals and, at the suggestion of Merrill Lynch, set up a defense team of attorneys, investment bankers and SCI executives.

Because Merrill Lynch also suggested that SCI identify friendly "white knight" investors to acquire enough stock in SCI to block any future takeover attempt, SCI sought out Tate & Lyle and discussed the possibility of Tate & Lyle's acquiring a 20% interest in SCI. Some casual conversation occurred about the possibility of merging the two companies. Tate & Lyle began purchasing SCI stock on the open market in April 1987; it soon acquired about 4% of the company. SCI soon feared Tate & Lyle, though, because Tate & Lyle would not sign a "standstill agreement," which would limit the amount of stock that Tate & Lyle would purchase. When Tate & Lyle filed a Hart-Scott-Rodino notification to acquire up to 25% of SCI's stock, SCI feared that this action would put SCI up for sale and decided to resist additional purchases of its stock.

On April 8, 1988, Tate & Lyle made a public tender offer directly to SCI's stockholders to purchase shares for $32 per share. On that same day, Tate & Lyle also sued SCI to enjoin the use of SCI's antitakeover devices and the application of various states' antitakeover statutes. Tate & Lyle's chairman of the board of directors and chief executive officer, Neil M. Shaw, wrote Donald E. Nordlund, who held the same positions at SCI, stating that if Tate & Lyle were successful in its bid to acquire SCI, it would cancel SCI's diversification policy by selling CFS Continental, Inc. and would return SCI back to its core business, corn syrup. The management, board of directors and investment bankers of SCI considered Tate & Lyle's tender offer to be hostile because it was made without their consent or knowledge. On April 9 the defense team of SCI held an emergency meeting at which it decided that the tender offer was not in the best interests of the company or its shareholders because Tate & Lyle had no capital, marketing or research and development to offer. However, because the board recognized that it had a duty to evaluate the merits of the tender offer, it hired First Boston and Merrill Lynch on April 12 to advise and assist it with respect to the offer. The agreements provided that the investment bankers' fees for their services would be (1) $500,000 in cash; (2) an additional fee of 0.40% of the value of the transaction if Tate & Lyle or another company acquired at least 50% of SCI's stock; (3) an additional fee of 0.40% of the recapitalization if SCI effected a recapitalization; and (4) additional quarterly fees of $500,000 for four quarters if no fees were paid under (2) or (3). SCI and the investment bankers then began to consider alternatives to the tender offer, including a recapitalization, a leveraged buy-out and a sale to a white knight.

Page 485

On April 18 the investment bankers indicated to SCI that their evaluation had revealed that $32 per share was below the true value of SCI's stock. They also discussed the different alternatives to the tender offer that were available to SCI: the sale of SCI in its entirety, the sale of a division, a recapitalization, a leveraged buy-out, a placement of blocks of stock, a spin-off, a public offering and the commencement of an offer to acquire Tate & Lyle ("pac-man" defense). On April 20 SCI's board voted unanimously to reject Tate & Lyle's tender offer. The investment bankers then discussed with other corporations the possibilities of a friendly purchase of SCI and of a loan for a recapitalization. To assist in this regard, the investment bankers prepared a selling book for prospective buyers that contained information about SCI.

On April 29 Tate & Lyle raised its offering price to $35 per share. On May 2 SCI's board determined that the offer was still inadequate and should be rejected. Again the board resolved, and the investment bankers continued, to investigate alternatives. Once again SCI urged its shareholders to reject the tender offer. On May 10 the investment bankers informed SCI that they had been unable to find an alternative to Tate & Lyle's offer that would persuade SCI's shareholders not to sell. In response, SCI's board instructed its attorneys to negotiate with Tate & Lyle while the investment bankers continued to look for alternatives. On May 13 Tate & Lyle increased its tender offer to $36.50 per share; the investment bankers informed SCI that this was a fair offer and that no alternatives had been found. SCI's board then determined that the price was fair and recommended that its stockholders should accept it. After the sale, Tate & Lyle replaced SCI's management, terminated 104 executives, closed the company's headquarters, fired the clerical staff and moved the executive offices. SCI's entire board of directors resigned. Tate & Lyle then sold CFS Continental, Inc. and changed SCI's name to A.E. Staley Manufacturing Company.

SCI paid $6,238,109 to First Boston and $6,272,593 to Merrill Lynch (and $165,318 to Charles P. Young for printing) for services in connection with SCI's response to Tate & Lyle's tender offers. It deducted these costs as business expenses on its tax return. The Commissioner disallowed all of the fees paid to First Boston and Merrill Lynch and $50,000 of the printing costs. ¹

B. Tax Court Proceedings

The full Tax Court held, with five judges dissenting, that neither the investment bankers' fees nor the printing costs were deductible. See A.E. Staley Mfg. Co. v. Commissioner, 105 T.C. 166, 1995 WL 535269 (1995). Judge Halpern, writing for the majority, relied upon the Supreme Court's recent decision, INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 112 S.Ct. 1039, 117 L.Ed.2d 226 (1992), in which the Court held that costs incurred to facilitate a friendly acquisition are capital expenditures and are therefore not immediately deductible. The Tax Court began with the proposition that the taxpayer's subjective reasons for making an expenditure are irrelevant to the deductibility determination. Rather, under the "origin of the claim" test, see Woodward v. Commissioner, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970), the nature of the transaction out of which the expenditures arose governs whether an item is a deductible expense or a capital expenditure. The Tax Court took the view that the transaction giving rise to the investment bankers' fees was...