Court Opinion

ID: 4483210
Source: CourtListenerOpinion
Date Created: 2020-01-16 21:15:57.78084+00
Date Added: 2024-06-11T14:41:49.176073
License: Public Domain

Scott, J., dissenting: I respectfully disagree with the conclusion of the majority that where funds of a subsidiary corporation are used to acquire stock of its parent from its parent’s stockholder the transaction is to be treated under section 304(a)(2) and (b)(2)(B) as a purchase of an asset by the subsidiary for all purposes except determining the amount, if any, of the dividend received by the stockholder of the parent corporation. In my view this holding ignores the intent of Congress in enacting the predecessor of section 304(a)(2) and (b)(2)(B) to close the "loophole” created by the decision in Rodman Wanamaker Trust, 11 T.C. 365 (1948), affd. per curiam 178 F.2d 10 (3d Cir. 1949). The holding of the majority also ignores the economic realities of the relationship between a parent and subsidiary where the stock of both is closely held and invites tax avoidance by a closely held parent corporation through use of its subsidiary’s earnings for the benefit of the stockholder of the parent. The Wanamaker case involved a "purchase” by a wholly owned subsidiary of its parent’s stock from the sole stockholder of the parent. The case held that since the stock was neither canceled nor redeemed the subsidiary had merely made a purchase and acquired an asset. If, in economic reality, the subsidiary had acquired an asset, no loophole would have been created by our decision in the Wanamaker case. The loophole was created because the use of earnings of a subsidiary to make a so-called "purchase” of its parent’s stock did not result in the subsidiary acquiring an asset but rather in the depletion of the subsidiary’s earnings. This is the loophole that Congress was attempting to close. The intent of Congress is shown in the legislative history of the enactment of the statutes which are now section 304(a)(2) and (b)(2)(B) of the 1954 Code. The majority concentrates on a narrow interpretation of the Wanamaker case because of the limited issue involved in that case rather than on the remedy intended by Congress. The "loophole” was explained in the report of the House Ways and Means Committee as follows: If the stockholders of a corporation which owns all the stock of a subsidiary corporation obtain cash from that subsidiary, in effect they have received a dividend to the same extent as would be the case if the cash had been paid by the subsidiary to the parent corporation and had then been distributed by the parent to the stockholders. And where such stockholders "sell” part of their stock in the parent corporation to the subsidiary they nevertheless retain ownership and control of both corporations, since the "sold” stock is one of the assets which the parent corporation owns by virtue of its possession of all the stock of the subsidiary. * * * [Emphasis added.] H. Rept. No. 2319, to accompany H. R. 8920 (Pub. L. No. 814), 81st Cong., 2d Sess. (1950), 1950-2 C.B. 380,420. In my view it is clear that Congress recognized that a susidiary in substance acquired no asset but in fact distributed its earnings when it purchased the stock of its parent corporation. As more fully discussed in Union Bankers Insurance Co., 64 T.C. 807, 815 (1975), section 304(a)(2) had its origin in section 115(g) of the 1939 Code. S. Rept. No. 2375, to accompany H. R. 8920 (Pub. L. No. 814), 81st Cong., 2d Sess. 82 (1950), specifically spells out the intent of the provisions as follows: Under the amendment, where stock of a parent corporation is acquired by a subsidiary, the amount paid for the stock is treated, for the purposes of section 115(g)(1) as' though such amount had been distributed by the subsidiary to the parent and had then been applied by the parent in redemption of its stock. * * * [Emphasis added.] The bill, H. R. 8300 (which when enacted became the Internal Revenue Code of 1954), as passed by the House of Representatives proposed to have section 304, which incorporated the substance of section 115(g)(2) of the 1939 Code, provide that purchases of its parent’s stock by a subsidiary be treated as if the purchasing company had redeemed its own stock directly from its shareholders. See H. Rept. No. 1337, to accompany H. R. 8300, 83d Cong., 2d Sess. A79 (1954). However, the Senate refused to accept such a provision and proposed changes which were ultimately enacted as section 304(a)(2). The Senate Finance Committee Report (S. Rept. No. 1622, to accompany H. R. 8300 (Pub. L. No. 591), 83d Cong., 2d Sess. 239 (1954)), explained section 304(a)(2) as changed by the Senate as follows: The general rule of present law, preserved in the parent-subsidiary area, is set forth in paragraph (2). Under this rule, supplemented by subsection (b)(2)(B), if a subsidiary corporation purchases outstanding stock of its parent, the proceeds of such sale shall be considered to be first a distribution by the subsidiary to the parent and then immediately thereafter a distribution by the parent corporation in redemption of its own stock. [Emphasis added.] The legislative history of section 304(a)(2) shows an intent by Congress to have the transaction treated as a use by the parent of the subsidiary’s funds for redemption by the parent of the parent’s stock. Section 304(a)(2)1 does not limit the purposes for which the distribution "shall be treated as a distribution in redemption of the stock of the issuing corporation” except that this treatment shall be of "Certain Stock Purchases” for "purposes of sections 302 and 303.” The instant case involves an application of section 303, which provides that a "distribution of property to a shareholder by a corporation,” the stock of which is included in a decedent’s estate and which meets other standards, "shall be treated as a distribution in full payment in exchange for the stock so redeemed.” Property can be distributed "to a shareholder” only by a corporation in which the distributee holds shares. Rodman Wanamaker Trust, supra. Therefore, only the issuing corporation can make a distribution under section 303 to its shareholder. Only becaúse of the provisions of section 304(a)(2) is the parent treated as having made such a distribution to the shareholder when the subsidiary purchases the stock of its parent from its parent’s shareholders. Since the parent is treated as having made the distribution, it follows that the parent has used the subsidiary’s funds for the distribution and has in substance and by law received a distribution from its subsidiary. Therefore, to the extent of the subsidiary’s earnings and profits, the parent has received a dividend from its subsidiary. This is the holding of Union Bankers Insurance Co., supra, and Broadview Lumber Co. v. United States, an unreported case (N.D. Ind. 1975, 36 AFTR 2d 75-6367, 75-2 USTC par. 9832). In concluding that there is no constructive dividend, the majority states: No obligation undertaken by Webb Co. was discharged by Kinchafoonee, * ■* *, and no transfer of assets was made by Kinchafoonee for the benefit of Webb Co. or anyone else for an amount less than full consideration, * * * This statement presupposes that section 304(a)(2) does not treat the purchase as a redemption by Webb Co. Since, under Wanamaker, only Webb Co. could redeem its own stock, section 304(a)(2) was enacted to cause a purchase by Webb’s subsidiary to be treated as such a redemption. Therefore, under section 304(a)(2) a statutory obligation was placed on Webb Co. to redeem its stock if, in fact, it used a subsidiary’s funds for the purchase of its stock. It was this statutory obligation of Webb Co. to redeem that was discharged by Kinchafoonee, thus in substance resulting in a distribution by Kinchafoonee to Webb Co. See George R. Tollefsen, 52 T.C. 671 (1969), affd. 431 F.2d 511 (2d Cir. 1970). The cases cited by the majority in reaching its conclusion that Webb Co. received no "constructive” dividend are either distinguishable or upon close analysis support an opposite conclusion. The ramifications of not treating section 304(a)(2) in accordance with the interpretation given it in the committee reports and in Union Bankers are serious.2  Under the holding of the majority, if one person owned all of the stock of a parent corporation which had a deficit in earnings and profits and that parent corporation owned all of the stock of a subsidiary which had earnings and profits, the stockholder of the parent could draw out all the earnings of the subsidiary over a period of time, resulting in no dividend to the stockholder of the parent or to the parent corporation itself. This result may be illustrated as follows. A owns all the stock of P which has a deficit in earnings and profits of $200,000. P has no income and therefore no current earnings and profits. S is an operating company with $1 million of accumulated earnings and profits which are increased yearly by current year’s earnings. A has S redeem $200,000 of his stock of P. This redemption results in no dividend to A since, under section 304(b)(2)(B), for the purpose of determining the amount constituting a dividend to the stockholder of the parent company as apparently the majority recognizes, the determination is made as if the subsidiary distributed $200,000 to the parent corporation and immediately thereafter the parent distributed $200,000 to its stockholders. Since the $200,000 distribution which the subsidiary is treated as having made merely brings the parent’s deficit in earnings and profits to zero, no dividend results to A, the parent’s stockholder. Under the view of the majority no distribution is considered to have been made to P by S except for determining whether A received a dividend. Therefore P continues to have a $200,000 deficit in earnings and profits. The procedure of having S purchase $200,000 of A’s stock in P could be repeated indefinitely by A under the holding of the majority with no dividend resulting to either A or P. Under a proper interpretation of section 304(a)(2) the first $200,000 distribution by S to its parent, P, would bring P’s earnings and profits to zero.3  While the majority in discussing the Union Bankers Insurance Co. case points to the factual differences in that case and the instant case and refers to the "meshing” of section 304 and section 815, the opinion does state that the reasoning of Union Bankers and Broadview Lumber Co. v. United States, supra, will no longer be followed insofar as they hold that, in a situation described in section 304(a)(2) and (b)(2)(B), the "parent corporation realizes a taxable dividend.”4 The statement of the majority in fact completely overrules the first issue decided in the Union Bankers case and this should be clearly recognized and specifically stated. Section 815 provides that a distribution by an insurance company corporation to that corporation’s shareholders shall be treated as made first from the shareholders surplus account, to the extent thereof, and then from the policyholders surplus account to the extent thereof. The policyholders surplus account is composed of the portions of the current and accumulated earnings and profits of an insurance company which have never been subjected to income tax since these profits are considered as being a reserve for the benefit of the policyholders. Section 815 makes it clear, with exceptions not here relevant, that unless an insurance company corporation distributes to its shareholders an amount in excess of its shareholders surplus account, the amount in the policyholders surplus account is not subject to income tax. It is only where an amount distributed to an insurance company corporation’s shareholders is treated as being out of the policyholders surplus account that the portion so distributed is subjected to Federal income tax referred to as a phase III tax. Where a subsidiary insurance company purchases stock of its parent insurance company from that parent’s stockholders, the subsidiary has made no distribution to its shareholders unless section 304(a)(2) is interpreted as it was in Union Bankers. Only by treating the amount paid by the subsidiary to its parent’s stockholders as a distribution to the parent under section 304(a)(2) has a distribution been made by the subsidiary to its shareholders. Therefore, under the holding of the majority in this case the shareholder of a parent insurance company corporation could deplete completely the untaxed policyholders surplus account of that parent’s subsidiary with no income tax being paid by the subsidiary or by the parent on this previously untaxed amount. The tax avoidance which might result in the case of an insurance company from a failure to treat the acquisition of a parent’s stock by its subsidiary as a distribution to the parent for purposes other than determining whether the parent’s stockholder has received a dividend is obvious. However, the avoidance in cases of other corporations though less obvious is just as real. A simple adverse result of the holding of the majority is the milking of a subsidiary’s earnings without any tax at the parent level. This may be illustrated by the following example: A parent corporation has four stockholders and wholly owns a subsidiary that has earnings and profits. Periodically the stockholders of the parent wish to receive the earnings of the subsidiary without tax consequences to the parent, as limited by section 243. Under the majority opinion, each stockholder may sell a pro rata portion of his stock to the corporation, and in this manner have the benefit of two corporate entities without any corporate tax to the parent resulting from the receipt by the parent’s stockholders of the subsidiary’s earnings. Furthermore, if the earnings and profits of the subsidiary are not reduced (and apparently the majority considers they should not be) the subsidiary holds pieces of paper which are not in reality assets in its hands but carries on its books fictitious earnings and profits.5  The majority opinion, at page 306, states: "As a result of Kinchafoonee’s stock purchase, Webb Co.’s balance sheet was unchanged. Webb Co. retained the same assets, liabilities, and outstanding stock.” It further states that Kinchafoonee’s balance sheet was changed only in that its "cash was reduced by $288,904 and the Webb Co. stock was added to its other assets,” and that "Had Kinchafoonee immediately sold the Webb Co. stock for $288,904 in a separate transaction, Kinchafoonee’s balance sheet would have been the same as before it acquired that stock.” These statements are inaccurate and misleading. Under section 312(a) and (e) there should be changes in Webb Co.’s accounts to reflect the proper charges to capital and to earnings and profits resulting from the redemption. Also, it is not at all clear, given the nature of Webb Co., that its stock could be sold to outside interests or that it would be worth $288,904. In the case of a wholly owned subsidiary, where the parent’s only asset is the subsidiary’s stock, there is no real asset in the subsidiary’s hands after the purchase of its parent’s stock. The subsidiary now has an equity interest in a corporation the only asset of which is the subsidiary’s stock. In this situation, it is clear that there has been a reduction in the worth of the subsidiary with no offsetting asset.6  The example given by the majority of the limitation of the dividend where the redemption by the parent of the stock would result in a dividend again misconstrues the provisions of the statute. A dividend to the shareholder will not necessarily result if either corporation has earnings but only if, after considering the subsidiary to have distributed its earnings to its parent, the parent has sufficient net earnings and profits to support the dividend.7 Furthermore, where the parent’s earnings and profits are reduced by taxes paid by it there has been no tax avoidance, and neither section 304(a)(2) nor (b)(2)(B) forces or should force a dividend to that extent. In conclusion, it is noted that the majority opinion refers to the series of. "fictions” which are to be applied to close the loophole "revealed by the Wanamaker opinion.” However, the majority refuses to carry the "fiction” to its logical and in my view necessary conclusion. Compare the discussion in United States v. Davis, 397 U.S. 301, 311 (1970), of application of the attribution rules of section 318 to section 302(b)(1), although there is no specific reference to the attribution rules in that subsection. Whether the situation here should result in a personal holding company tax to Webb Co. or merely a normal tax on 15 percent of the distribution from Kinchafoonee, I have not considered. It may be that a distribution by Kinchafoone to Webb Co. should not result in a personal holding company tax. However, under section 304(a)(2) there has been a use by Webb Co. of Kinchafoonee’s funds which should result in the same tax, if any, to Webb Co. as would result if Kinchafoonee had distributed the $288,904 directly to Webb Co. and Webb Co. had redeemed the stock of Cecil’s estate with the funds distributed to it by Kinchafoonee.   Sec. 304(a)(2) provides: (2) Acquisition by subsidiary. — For purposes of sections 302 and 303, if— (A) in return for property, one corporation acquires from a shareholder of another corporation stock in such other corporation, and (B) the issuing corporation controls the acquiring corporation, then such property shall be treated as a distribution in redemption of the stock of the issuing corporation. [Emphasis added.]    While the ramifications are more apparent in the wholly owned subsidiary context, the difference is only a matter of degree. With real adverse interests in the ownership of a subsidiary, it is unlikely that minority stockholders would permit the use of the earnings of a subsidiary to be distributed other than pro rata. In the instant case the minority shareholders of Kinchafoonee were all members of Cecil’s (the decedent) family and, as the record shows, were the beneficiaries under his will. Therefore, there was no more adverse interest here than in the case of a wholly owned subsidiary. It is also worthy of note that Webb Co. during its entire 8-year existence never reported any taxable income and none of its subsidiaries ever declared a formal dividend, even though it is clear that at least Kinchafoonee had earnings and profits. Furthermore, in the final windup of Webb Co., the Webb Co. stock held by three of the Webb Co. subsidiaries was "redeemed” for stock that Webb Co. received in a reorganization in which the three heirs of Cecil received cash and stock of a Nebraska corporation for all their interest in Webb Co. and all its subsidiaries. In this manner the remaining earnings of the Webb Co. subsidiaries were received by the Webb Co. stockholders with no tax consequences or only capital gain consequences. In fact, the record shows that Kinchafoonee had over $1,500,000 of accumulated earnings and profits at the time it acquired the stock of Cecil’s estate.    Since under sec. 243 there might be a tax paid by P on the distribution it received from S, there might, after the first distribution, still remain a small deficit in P’s earnings and profits.    It is of course immaterial whether the distribution from the subsidiary to the parent is taxable. The taxability of a distribution is governed by the facts of the particular case. The basic holding in Union Bankers was that there was a distribution by the subsidiary to its parent when the subsidiary purchased its parent’s stock.    The citation by the majority of Rev. Rui. 70-305, 1970-1 C.B. 169, as modified by Rev. Rui. 74-503, 1974-2 C.B. 117, which deals with the acquisition by a subsidiary corporation of its parent company’s stock on the open market, highlights its misconception of the purpose of sec. 304(a)(2) and (b)(2)(B). If a subsidiary of a corporation, the stock of which is widely held, buys its parent’s stock on the open market or in fact if the parent itself buys its stock on the open market, only in the most technical sense can it be said that a redemption of the stock has occurred. When the stockholder of the parent tells his broker to sell his stock, he never knows who the purchaser is when the sale is made. The corporation buying the stock does not know whose stock it purchased. Even in this situation the stock of the parent in the hands of the subsidiary is an asset only in the sense that the subsidiary can resell the stock on the open market at the will of its parent, thus replacing the funds used to acquire the stock. However, in the case of a closely held corporation resale, if possible, would cause a shift in the corporate ownership generally unacceptable to the controlling shareholders. Prior to enactment of sec. 1032, gain or loss was recognized where a corporation dealt in open market acquisitions of its own stock. See Pittsburgh Laundry, Inc., 47 B.T.A. 230 (1942); Cardinal Corp., 52 T.C. 119, 126 (1969). Rev. Rul. 70-305, to which the majority refers, merely refused to extend the provisions of sec. 1032 to open market acquisitions of stock of a parent by a subsidiary. Rev. Rul. 74-503 made it clear that no corporation could have a basis other than zero in its own stock and modified Rev. Rui. 70-305 to make it clear that stock of its parent acquired by a subsidiary from its parent’s stockholders did not retain a basis other than zero if later acquired by the parent. If the parent did in fact have the subsidiary resell the stock rather than cancel it, gain or loss to the subsidiary is recognized. Nothing in these rulings may properly be read as intimating that stock of a closely held parent corporation in the hands of its wholly owned subsidiary is realistically a salable "asset” of the subsidiary.    The report of the majority speaks of the "value” of the stock of Webb Co. in the hands of Kinchafoonee. However, it is obvious that any "value” to Webb Co. stock in Kinchafoonee’s hands is only to the extent of some percentage of the value of stock of other subsidiaries held by Webb Co. Therefore, when the subsidiary is not wholly owned, there may be some value to the parent’s stock held by the subsidiary, but certainly the total value of the parent and subsidiary has been reduced by the amount of the subsidiary’s funds paid out for its parent’s stock. H.Rept. No. 2319, to accompany H.R. 8920 (Pub.L. No. 814), 81st Cong., 2d Sess. (1950), 1950-2 C.B. 380, 420, in effect recognizes the lack of asset value of a parent’s stock in the hands of a subsidiary with the statement, "and where such stockholders [of the parent corporation] 'sell’ part of their stock in the parent corporation to the subsidiary they nevertheless retain ownership arid control of both corporations, since the 'sold’ stock is one of the assets which the parent corporation owns by virtue of its possession of all the stock of the subsidiary.”    Footnote 11 of the majority again misconstrues the statute in this respect with the statement "If sec. 304(a)(2) imposes a tax on the parent corporation, sec. 304(b)(2)(B) is superfluous because a dividend to the parent would automatically give the parent earnings and profits equal to the sales price.” This is obviously incorrect since the parent might have a deficit in earnings and profits to offset against the dividend. As pointed out in Union Bankers, sec. 304(b)(2)(B) makes it clear that the distribution from the subsidiary to the parent is the first distribution made so that such an offset is required. After that distribution, the parent is treated as making a distribution to its shareholder.