Western Pac. R. Corporation v. Western Pac. R. Co., 26508.

• Citation: 85 F. Supp. 868
• Decision Date: 06 September 1949
• Docket Number: No. 26508.,26508.
• Parties: WESTERN PAC. R. CORPORATION v. WESTERN PAC. R. CO. et al.
• Court: U.S. District Court — Northern District of California

85 F. Supp. 868

WESTERN PAC. R. CORPORATION v. WESTERN PAC. R. CO. et al.

No. 26508.

United States District Court, N. D. California, S. D.

September 6, 1949.

Herman Phleger, Maurice E. Harrison, Moses Lasky, Brobeck, Phleger & Harrison, San Francisco, California, Frank C. Nicodemus, Jr., New York City, A. Perry Osborn, New York City, Norris Darrell, New York City, Mahlon Dickerson, New York City, Leroy R. Goodrich, Oakland, California, for plaintiff.

Rogers & Clark, Webster V. Clark, San Francisco, California, David Freidenrich, San Francisco, California, Julius Levy, New York City, for Russell M. Van Kirk, Henry Offerman and J. S. Farlee & Co., Inc., a corporation, plaintiffs in intervention, Pomerantz, Levy, Schreiber & Haudek, Abraham L. Pomerantz, New York City, of counsel.

Allan P. Matthew, James D. Adams, Robert L. Lipman, Burnham Enersen, Walker Lowry, McCutchen, Thomas, Matthew, Griffiths & Greene, San Francisco, California, for Western Pac. R. Co. et al., defendants.

Everett A. Mathews, Pillsbury, Madison & Sutro, San Francisco, Calif., A. Donald MacKinnon, Milbank, Tweed, Hope & Hadley, New York City, Forbes D. Shaw, Whitman, Ransom, Coulson & Goetz, New York City, for Western Realty Co., defendant.

GOODMAN, District Judge.

Plaintiff, a former holding company, whose interest in its subsidiary had been finally declared valueless in the subsidiary's reorganization proceeding under § 77 of the Bankruptcy Act, 11 U.S.C.A. § 205, has tendered the novel claim that it should be awarded, in equity, a part, if not all, of the subsidiary's income tax saving while in reorganization, resulting from the filing of consolidated corporate income tax returns.

A somewhat detailed history must be set down in order to properly appraise the unique demand of plaintiff.

Plaintiff is The Western Pacific Railroad Corporation; its subsidiary was Western Pacific Railroad Company, an operating railroad company, herein referred to as the "debtor;" defendant, the reorganized subsidiary, is The Western Pacific Railroad Company.

Statement of Facts.

Plaintiff corporation, a so-called holding company, from 1916 to April 30, 1944, owned all the outstanding capital stock of the debtor. For some years prior to 1935, the financial condition of the debtor had been steadily worsening. In 1935 it filed a petition under Section 77 of the Bankruptcy Act, 11 U.S.C.A. § 205, and this Court in that year placed its affairs in the hands of trustees. Thereafter a plan of reorganization was proposed and in 1939 it was approved by the Interstate Commerce Commission. 233 I.C.C. 409. Inter alia, it was determined in the plan that the capital stock of the debtor owned by the plaintiff was without equity or value and that plaintiff and its stockholders therefore were not entitled to participate in the plan. In 1940 this Court approved the plan of reorganization, including approval of the findings of the Interstate Commerce Commission as to the worthlessness of the plaintiff's equity. The Circuit Court of Appeals (now Court of Appeals) of the Ninth Circuit reversed in 1941, 124 F.2d 136. In 1943 the Supreme Court reversed the Circuit Court and affirmed the order of the District Court. Ecker v. Western Pac. R. R. Corp., 318 U.S. 448, 63 S.Ct. 692, 87 L.Ed. 892. It there considered and rejected the contention of the plaintiff that it should have the right to participate in the plan because of recent increased earnings of the debtor. 318 U.S. at pages 508, 509, 63 S.Ct. at pages 723, 724.¹ Thereafter, the plan of reorganization was, in accordance with the statutory provisions, 11 U.S. C.A. § 205 (e) submitted to the creditors, and, after their approval, the plan was confirmed on October 11, 1943 by this Court. The reorganization committee designated in the plan of reorganization, instead of forming a new corporation, determined to use the corporate structure or shell of the old company (debtor) and to execute the plan of reorganization by revesting its former properties in the reorganized company, i. e. the defendant. On November 22, 1943, an agreement was made between the plaintiff, its secured creditors and the reorganization committee wherein a modus of revesting was set up. Among other things, the plaintiff agreed therein to transfer all of its stock in the debtor to the reorganization committee. This agreement was approved by this Court, in December 1943. The transfer of the stock was not actually made until April 1944 because of an unsuccessful litigative² attempt to prevent the same. During the period of years in which the plaintiff was the owner of all the outstanding stock of the debtor, plaintiff had followed the practice of filing consolidated or affiliated income tax returns, in which it had reported the earnings of the debtor as well as other affiliated companies, which the plaintiff wholly or partly owned. The amount of taxes paid by the plaintiff pursuant to such returns was allocated among the various subsidiary companies having taxable income in proportion to the amount of such taxable income. The practice of filing the consolidated returns continued throughout the reorganization period. The returns, during the reorganization period, were prepared by the employees of the debtor and signed by the president of the plaintiff corporation, although they were never submitted to its board of directors for approval or consideration.

During the year 1942, the debtor made substantial net earnings. Neither plaintiff, nor any of its other subsidiary companies, had any earnings during 1942. A consolidated return was filed for the year 1942 in which the tax liability, due to the earnings of the debtor, was $4,144,828. Later in 1943, after the filing of the 1942 return and payment of the tax, the tax attorneys for defendant "discovered" Section 123 of the Revenue Act of 1942. 26 U.S.C.A. § 23(g) (4).³ They proposed what they denoted a "paradoxical" theory, by which the worthlessness of the plaintiff's stock (which had cost the plaintiff some $75,000,000) in the operating railroad company (debtor) might be availed of as an offset to the operating income of the debtor and thus result in a net loss and no tax obligation. Further, their theory was that part of this $75,000,000 loss in 1943, could be "carried back" to 1942, § 122(b) (1) of the Internal Revenue Code, 26 U.S.C.A. § 122(b) (1), and part could be "carried over" to 1944. Section 122 (b) (2) of the Internal Revenue Code, 26 U.S.C.A. § 122(b) (2). Thereupon a claim for refund of the amount of tax paid for 1942 was filed in the name of the plaintiff. Operations of the debtor during 1943 and up to April 30, 1944 were increasingly profitable and, except for the offset of the capital stock loss of the plaintiff itself, would have called for the payment of some $17,000,000 in income taxes. So the tax attorneys caused the filing of consolidated tax returns for 1943 and for the forepart of 1944 in the name of plaintiff, in which sufficient portions of the $75,000,000 stock loss were used as offsets against the operating accounts for these years, so as to show no net income. The validity of the offsets was questioned by the Commissioner of Internal Revenue and conferences were had between the tax counsel for the defendant and the Commissioner. As a result, a tax settlement was made with the Commissioner whereby, in consideration of the withdrawal of the claim for refund, the Commissioner accepted and approved the returns. The nature and basis of this compromise settlement will be hereafter, more fully discussed.

Subsequent to the filing of the claim for refund of the 1942 tax paid, and the filing of the consolidated tax returns for 1943 and part of 1944, and after negotiations for the settlement of the entire tax issue with the Commissioner of Internal Revenue had started, the plaintiff, on October 10, 1946 filed its bill of complaint in equity herein. In substance the bill of complaint recited the filing of the claim for refund, the commencement of the negotiations for the approval of the consolidated returns and prayed that the Court settle the proprietary rights of the plaintiff and the defendant in the tax saving involved. It was further prayed that funds equivalent to the tax savings be placed in the custody of the court for proper and equitable distribution.⁴

On April 7, 1947, the Court permitted the filing of a complaint in intervention on behalf of certain stockholders of the plaintiff who wished to join in the demand of the plaintiff and in its prayer for relief against the defendant. The settlement and agreement with the Commissioner, by which the claim for refund was withdrawn and the consolidated returns for the years 1942, 1943 and part of 1944 were accepted and approved, was consummated on August 14, 1947.

On December 17, 1947, plaintiff filed a supplementary bill of complaint, wherein the consummation of the settlement and compromise was set forth. It was there further alleged that the defendant through its officers and attorneys had controlled the board of directors of the plaintiff corporation and that by reason of such control plaintiff was caused to file the consolidated returns for the benefit of the defendant. Throughout the proceedings and in the trial, this has been referred to as "duality of control."

In the supplementary complaint, the plaintiff prayed that the Court, in equity, enter a decree allocating and directing the payment of the abated taxes, amounting to some $17,000,000, to the plaintiff by way of mitigation of its losses in its subsidiary.

After many preliminary motions were made and disposed of, and after the filing of answers by the defendants and after pretrial conference, the cause finally came on for trial.

The trial itself consumed 13 days; the proceedings are set forth in 1,700 pages of transcript; 14 witnesses testified and 164 exhibits, with various subdivisions, were introduced in evidence.

A number of special defenses were pleaded and...