Tribune Pub. Co. v. U.S.

• Decision Date: 06 January 1988
• Docket Number: Nos. 86-3734,86-3987 and 86-3988,s. 86-3734
• Citation: 836 F.2d 1176
• Parties: -428, 88-1 USTC P 9125 TRIBUNE PUBLISHING COMPANY, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1176

836 F.2d 1176

61 A.F.T.R.2d 88-428, 88-1 USTC P 9125

TRIBUNE PUBLISHING COMPANY, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

Nos. 86-3734, 86-3987 and 86-3988.

United States Court of Appeals Ninth Circuit.

Argued and Submitted May 7, 1987.

Decided Jan. 6, 1988.

Joseph H. Trethewey, Trethewey, Brink, Todd & Clayton, Seattle, Wash., for plaintiff-appellee.

Gary D. Gray, Asst. U.S. Atty., Tax Div., for defendant-appellant.

Appeal from the United States District Court for the Western District of Washington.

Before FLETCHER and NORRIS, Circuit Judges, and LYNCH, ^* District Judge.

NORRIS, Circuit Judge:

This case involves the tax treatment of settlement proceeds of securities fraud litigation arising out of an I.R.C. Sec. 368 tax-free reorganization. ¹

I

In 1969, Tribune Publishing Co. (Tribune), the taxpayer, owned 6,109 shares, or 7.1 percent, of the outstanding stock of West Tacoma Newsprint Co. (Newsprint), a producer of newsprint. Tribune's basis in the stock was $619,462. That year, Newsprint was acquired by Boise Cascade Corp. (Boise Cascade) in a tax-free reorganization--specifically, a merger within the scope of I.R.C. Sec. 368(a)(1)(A). Tribune received 41,476 shares of Boise Cascade stock in the merger in return for its Newsprint shares. At the time, Boise Cascade stock had a market price of $74.50 per share, making the market value of the stock Tribune received in exchange for its Newsprint stock approximately $3.1 million.

After the merger, the market price of Boise Cascade stock fell precipitously following reports that Boise Cascade had failed to disclose material facts about its financial condition. As a result, Tribune and others sued Boise Cascade for securities fraud. In 1977, as part of a settlement of the litigation, Tribune received from Boise Cascade $451,000 in cash plus promised discounts on newsprint purchased by Tribune over an eight-year period. In 1978 and 1979, Tribune received newsprint discounts of $107,000 and $127,000 respectively.

In 1977, Tribune reported $121,500 of the $451,000 cash portion of the settlement as a dividend under I.R.C. Sec. 356(a)(2) and the balance of the cash as a non-taxable return of basis. In 1978 and 1979, Tribune further reduced its basis by the amount of the discounts it received on newsprint purchased.

The government, disagreeing with Tribune's tax treatment of both the cash and discount portions of the settlement, imposed deficiency assessments. Tribune paid the assessments in full and brought this action for a refund. The district court held in Tribune's favor in all respects. ² The government timely appeals. We affirm in part and reverse in part. We hold that (1) because the proceeds of the settlement are properly characterized as "boot" of the original tax-free reorganization, Tribune is entitled to treat a portion of the proceeds as a dividend under I.R.C. Sec. 356(a)(2); (2) Tribune is not entitled to treat the balance of the proceeds as a non-taxable return of basis; and (3) the IRS is entitled to impute a part of the settlement proceeds as interest under I.R.C. Sec. 483.

II

A

The parties agree that whether a claim is resolved through litigation or settlement, the nature of the underlying action determines the tax consequences of the resolution of the claim. See Brief for the Appellant at 8; Opening Brief for the Appellee at 10; Spangler v. Commissioner, 323 F.2d 913, 916 (9th Cir.1963) ("In determining whether receipts are taxable as ordinary income or return of capital it is immaterial whether taxpayer effected collection amicably or by resolving a dispute through compromise or litigation. It is the nature of the underlying claim that controls and not the manner of collection."). It is not disputed that Tribune's underlying claim in the securities fraud litigation was that the market value of the Boise Cascade stock that Tribune received in 1969 pursuant to the tax-free reorganization was inflated because of Boise Cascade's failure to disclose material facts. Nor is there any dispute that the purpose of Tribune's fraud action was to recoup the difference between the actual value of the Boise Cascade stock it received and the price Tribune effectively paid for the stock, measured in this case by its market value at the time of the merger. At this point in the analysis, however, Tribune and the government part company.

Applying the foregoing principle, Tribune argues that the settlement proceeds should be treated as boot of the original transaction. Thus Tribune insists that the transaction should be viewed as though it received not only 41,476 shares of Boise Cascade stock in exchange for its Newsprint stock, but also $451,000 cash and the newsprint discounts as additional consideration. Because the underlying transaction in this case was a tax-free reorganization under I.R.C. Sec. 368(a)(1)(A), Tribune contends the proceeds should be treated as boot of the original transaction under I.R.C. Sec. 356(a)(2). The government argues in response that I.R.C. Sec. 356(a)(2) cannot govern the tax treatment of settlement proceeds because, under I.R.C. Sec. 354(a)(1), the recognition rules for tax-free reorganizations are not triggered unless the exchange is "in pursuance of the plan of reorganization." The government contends that the settlement proceeds received by Tribune were received pursuant to a settlement agreement, not a merger agreement, and that therefore the settlement proceeds cannot be considered as distributed "in pursuance of the plan of reorganization" under I.R.C. Sec. 354(a)(1).

In our view Tribune clearly has the better of the argument on this issue. The government's position misperceives the nature of our inquiry. There is no question that the cash and newsprint discounts were received pursuant to a settlement. The question before us, however, is how to characterize these settlement proceeds. The test for characterizing proceeds of litigation is stated most simply as " 'In lieu of what were the damages awarded?' " Raytheon Production Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir.) (citations omitted), cert. denied 323 U.S. 779, 65 S.Ct. 192, 89 L.Ed. 622 (1944). ³ The answer to that question in this case is that the settlement proceeds were received by Tribune in lieu of the additional consideration that Tribune would have received had it bargained with knowledge of the true value of Boise Cascade stock rather than the market value which was allegedly inflated by Boise Cascade's failure to disclose material facts. We took just this approach in Spangler v. Commissioner to determine the tax treatment of proceeds received by a plaintiff who claimed that she had been induced by fraud to sell her stock. Applying the principle that the nature of the underlying claim controls the tax treatment of the proceeds of litigation, we held that money received by the plaintiff in lieu of dividends she would have received had she not sold the stock was taxable as dividend income rather than as a return of capital. 323 F.2d at 916-17.

Similarly, in Victor E. Gidwitz Family Trust v. Commissioner, 61 T.C. 664 (1974), the Tax Court, considering the tax treatment of money received in the settlement of an action for damages for failure to deliver options in a merger, stated, "The taxability of the settlement is controlled by the nature of the litigation.... The nature of the litigation is, in turn, controlled by the origin and character of the claim which gave rise to the litigation." 61 T.C. at 673 (citations omitted). The court concluded that because the underlying claim arose out of the purported inadequacy of consideration received in the merger, the settlement proceeds represented additional consideration that the taxpayers would have received in the underlying merger. See also Megargel v. Commissioner, 3 T.C. 238, 243 (1944).

In sum, we engage in the fiction of treating the settlement proceeds received by Tribune as if they had been received as part of the original transaction. As noted above, the underlying transaction was the merger of Boise Cascade and Newsprint, a tax-free reorganization under I.R.C. Sec. 368(a)(1)(A). ⁴ I.R.C. Sec. 354 provides for the nonrecognition of gain or loss from such transactions. ⁵ Consideration other than the stock of a corporate party to the reorganization, such as the cash and discounts at issue in this case, may also be transferred without destroying the nonrecognition of the stock portion of the transaction. However, when separate consideration, known as "boot," is present, gain is recognized under I.R.C. Sec. 356(a)(1) to the extent of the boot. ⁶ I.R.C. Sec. 356(a)(2) provides that if boot has the effect of the distribution of a dividend, then the distributee may treat the boot as a dividend to the extent of its ratable share of the undistributed earnings and profits of the corporation. ⁷ When I.R.C. Sec. 356 is applied to this case, the settlement proceeds should be treated as dividend income to the extent of Tribune's ratable share of Newsprint's retained earnings. Thus, the district court correctly held that Tribune was entitled to treat a portion of the settlement proceeds as dividend income. ⁸

B

The district court further ruled that Tribune would be permitted to treat the remainder of the settlement proceeds, consisting of the remaining cash and the newsprint discounts, as a non-taxable return of basis until its basis in the Newsprint stock was exhausted. ⁹ The government contends that this treatment is incorrect because I.R.C. Sec. 356(a)(1) provides that gain in a reorganization, other than gain attributable to dividends under I.R.C. Sec. 356(a)(2), must be recognized to the extent of boot received. ¹⁰ Tribune responds that treating the remaining boot as a return of basis is correct under Burnet v. Logan, 283 U.S. 404, 51 S.Ct. 550, 75 L.Ed. 1143 (1931), because the total amount of Tribune's settlement recovery was uncertain. According to...