Opinion
Docket Nos. 949-63, 3949-63.
Filed October 19, 1965.
Pacific corporation was engaged in the telephone business in California and other western States. It transferred to Northwest, a newly created subsidiary, the assets used in the telephone business conducted in Oregon, Washington, and Idaho. It thus became the owner of all of the Northwest stock which it subsequently distributed through the medium of short-term rights issued to its stockholders. Held, the transaction was a tax-free spin-off under section 355, I.R.C. 1954, and petitioner-stockholders who obtained Northwest stock by exercising their rights did not thereby realize taxable income at that time. Held, further, amounts realized by a shareholder of Pacific upon a sale of his rights to purchase Northwest stock are taxable as dividend income.
Harry R. Horrow and Stephen J. Martin, for the petitioners.
John W. Holt, for the respondent.
The Commissioner determined deficiencies against petitioners in Federal income taxes for 1961 in the following amounts:
Oscar E. and Evelyn K. Baan ................. $284.44
Irving and Margaret Gordon .................. 895.10
Petitioners Gordon paid this amount subsequent to the filing of the petition in this case.
The principal question presented in these cases is whether petitioners received taxable dividends upon the exercise of rights issued to them by the Pacific Telephone Telegraph Co. enabling petitioners to purchase shares of its wholly owned subsidiary, Pacific Northwest Bell Telephone Co. Also at issue is the tax treatment to be given to the amounts realized by petitioners in docket No. 3949-63 upon the sale of four of the rights received by them.
FINDINGS OF FACT
The stipulation of facts filed by the parties together with the exhibits attached thereto is incorporated herein by this reference.
Petitioners Oscar E. Baan and Evelyn K. Baan, husband and wife, were residents of Sausalito, Calif., during 1961; they filed their joint. Federal income tax return for the calendar year 1961 on the cash basis with the district director of internal revenue in San Francisco, Calif.
Petitioners Irving Gordon and Margaret Gordon, husband and wife, were residents of New York City during 1961; they filed their joint Federal income tax return for the calendar year 1961 on the cash basis with the district director of internal revenue in New York City.
At all times during 1961, the Baans owned 600, and the Gordons owned 1,540, shares of common stock of Pacific Telephone Telegraph Co., which had been purchased by them at various times prior to 1961.
The Pacific Telephone Telegraph Co. (hereinafter referred to as Pacific) is a California corporation which furnishes communications services, mainly local and long-distance (toll) telephone services, in the State of California. Prior to July 1, 1961, it furnished such services also in the States of Oregon, Washington, and a northern portion of Idaho.
Pacific Northwest Bell Telephone Co. (hereinafter referred to as Northwest), a Washington corporation, has commencing on July 1, 1961, furnished such services in the territory previously served by Pacific in Oregon, Washington, and Idaho. Bell Telephone Co. of Nevada (hereinafter referred to as Nevada), a wholly owned subsidiary of Pacific, furnishes such services in Nevada.
Revenues from telephone services constitute approximately 90 percent of the total operating revenues of the three corporations. Other communications services furnished include teletypewriter services, and services and facilities for private-line teletypewriter use, for the transmission of radio and television programs, and for other purposes. Revenues are also received from the sale of advertising space in telephone directories.
In each State in which it operates, each of the three corporations is subject to regulation by a State public utility regulatory authority which has power within its jurisdiction to regulate intrastate rates, services, and other matters, including but not limited to some or all of the following: facilities, security issues, valuations, purchases and sales of property, budgets, the assessment of fees for the expenses of such authorities, and contracts and other relations with affiliated corporations. All three corporations are likewise subject to regulation by the Federal Communications Commission with respect to their method of accounting and to interstate rates, lines and services, valuations, and other matters. The Federal Communications Commission prescribes a Uniform System of Accounts which it requires telephone companies to use in keeping their books.
American Telephone Telegraph Co. (hereinafter referred to as American), a New York corporation, has owned more than 80 percent of the voting stock of Pacific at all times since 1907. Including Pacific, Northwest, and Nevada, there were 21 operating telephone company subsidiaries of American in 1961. Of these operating subsidiaries American owns substantially 100 percent of 15 of them. American owns the following percentages of the outstanding stock of its remaining subsidiaries:
Pacific owns 100 percent of Nevada.
Percent Company owned
Illinois Bell Telephone Co. ................... 99.32 Pacific ...................................... 89.62 Northwest ..................................... 89.13 Mountain States Telephone Telegraph Co. ..... 86.75 New England Telephone Telegraph Co. ......... 69.33
As of June 30, 1961, advances outstanding amounted to $233 million.
American operates a network of cable, wire, and radio circuits and related equipment for intercommunication between and through the territories of its telephone subsidiaries and of other telephone companies and for interconnection (including interconnection by underseas cables and by radio circuits) between telephone systems in the United States and those in many other countries or territories throughout the world.
American's telephone subsidiaries, including Pacific and Northwest, furnish local and toll service in the territories in which they operate and toll service between points within and points outside of such territories, toll service being furnished partly in conjunction with American and other telephone companies. American's subsidiaries operate in the District of Columbia and in every State except Alaska and Hawaii. American estimates that over 90 percent of the toll messages originating in the United States are routed in whole or in part over its lines or those of its subsidiaries.
During all of the year 1961 the capital stock of Pacific consisted of the following:
(a) 820,000 shares of 6 percent cumulative preferred stock authorized with a par value of $100 per share, entitled to 7 votes per share held, of which stock all 820,000 shares were issued and outstanding, with an aggregate par value of $82,000,000; and
(b) 105,000,000 shares of common stock authorized with a par value of $14 2/7 per share, entitled to one vote per share held, of which stock 104,756,943 shares were issued and outstanding, with an aggregate par value of $1,496,527,844.
As of December 31, 1960, Pacific had unappropriated earned surplus in the amount of $192,053,880.76. As of December 31, 1961, Pacific had $178,935,190.15 of unappropriated earned surplus and a capital surplus of $101,326,128.38. There was a sufficient dollar amount of earnings and profits of Pacific in 1961 from which a 1961 dividend could have been paid by Pacific to its stockholders, to cover the dollar amounts which the Commissioner contends were received by the petitioners in these cases and by the other shareholders of Pacific in 1961 with respect to the distribution of Northwest stock. At all times during 1961, Pacific's long-term funded debt was $902 million.
Pacific has from time to time carried out its temporary financing by means of advances from American. These loans are evidenced by demand notes due 1 day after date of issuance, which bear interest at 4 1/2 percent per annum. Normally, Pacific discharges such advances through the use of the proceeds from its issuance and sale of its common stock and long-term debentures. The yearend balance of such advances on Pacific's books and records, in millions of dollars, for the years 1956 through 1963 were as follows:
Year Yearend balance
1956 .......................... $56 1957 .......................... 82 1958 .......................... 11 1959 .......................... 161 1960 .......................... 134 1961 ........................ -0- 1962 .......................... 140 1963 .......................... 49
Before reduction by retroactive depreciation adjustment.
American at all times during 1961 owned 90.25 percent of the outstanding common stock and 78.17 percent of the outstanding preferred stock of Pacific, representing in the aggregate 89.62 percent of the total voting power of Pacific.
The minority common and preferred shares of Pacific are publicly held. At the time of Pacific's annual shareholders meeting in 1961 it had over 38,000 shareholders. For several years prior to 1961, during all of 1961, and at all times since 1961 the common shares and preferred shares of Pacific have been listed for trading on the New York Stock Exchange and the Pacific Coast Stock Exchange.
Commencing with the year 1907, Pacific has employed the calendar year as its accounting year and has kept its books of account to the extent permitted by law on the basis of the accrual method of accounting. Commencing with the year 1914, Pacific has filed its Federal income tax returns on the basis of the calendar year and to the extent permitted by law on the basis of the accrual method of accounting. Since January 1, 1913, Pacific has maintained its accounts in accordance with the Uniform System of Accounts for telephone companies prescribed originally by the Interstate Commerce Commission and since July 1934 by the Federal Communications Commission. For the taxable years 1924 through 1931, Pacific filed, as the parent corporation, consolidated Federal income tax returns with its own subsidiaries. For the taxable years 1932 through 1953, Pacific filed separate corporate Federal income tax returns. For the taxable years 1954 through 1962, Pacific was included as an affiliated subsidiary in the consolidated Federal income tax return of American. Commencing with the taxable year 1961, this consolidated Federal income tax return, with American as the parent corporation, included and was filed in behalf of Northwest as well as the other affiliated corporations. In none of the consolidated Federal income tax returns of American and its affiliates for the taxable years 1954 through 1962 did the members of the affiliated group elect, as permitted under section 1.1502-31(b)(1) of the Income Tax Regulations, to take into account in the computation of consolidated taxable income the gains and losses reflected in certain intercompany transactions.
The parties have stipulated that "for more than five years prior to June 30, 1961, the operations of Pacific in the States of Oregon, Washington and a northern portion of Idaho, constituted one or more telephone communications businesses operated by Pacific which were separable from the telephone communications business operated by Pacific in the State of California." At all times after June 30, 1961, Pacific has continued in the operation of the telephone communications business in California, and Northwest has engaged in the operation of that business in Oregon, Washington, and part of Idaho.
Between the end of World War II and January 1, 1961, there was a substantial increase in the demand for telephone service in the area served by Pacific. The number of telephones increased almost threefold from 2.7 million to about 8 million. The investment in telephone plant (without deducting the depreciation reserve) increased more than fivefold from $662 million to $3,402 million; and annual operating revenues increased more than fourfold from $243 million to $1,120 million. The operations of Pacific in the single State of California in 1960, in terms of plant investment and operating revenues, exceeded those of the entire company in California, Oregon, Washington, and Idaho in 1957, and the operations of Pacific in Oregon, Washington, and Idaho in 1960 almost equaled those for the entire company at the end of World War II. Growth in all the Pacific Coast States was continuing in 1961 at a rapid pace. Recent studies had predicted the population of California would increase from about 16.1 million at the end of 1960 to more than 20 million in 1970. Large population increases were also expected in the other States in which Pacific did business.
In terms of total capital, Pacific at the end of 1960 was the largest subsidiary corporation in the Bell System and the eighth largest non-financial company in the Nation. On the same basis Northwest, as of July 1, 1961, was larger than 8 and smaller than 12 of the other Bell System subsidiaries. It was the largest public service company in the Pacific Northwest area.
John O. Einerman, formerly an officer of American, has been vice president and comptroller of Pacific since March 1958. Shortly after he joined Pacific Einerman was asked by the president of the company to undertake studies looking toward the division of Pacific into two or three separate companies. The basic problem which brought forth the need for such studies was understood by Einerman to be the tremendous growth of the telephone system on the Pacific coast and the fact that the territory covered by Pacific encompassed about one-seventh of the continental United States. He worked with a small group of people within the company and the company's lawyers considering various plans which were developed within this group. That group analyzed the financial impact of the various procedures that they considered. Einerman concluded that the studies showed that it would be extremely desirable from an operating point of view to divide Pacific into two separate corporations. As a result of the studies Pacific was divided into two separate divisions in 1960 and was then divided into two separate corporations in 1961.
In a meeting on January 27, 1961, the board of directors of Pacific resolved to submit to the shareholders of Pacific a plan entitled "Plan For Reorganization of The Pacific Telephone and Telegraph Company" (hereinafter referred to as the plan) for consideration at the annual meeting of the shareholders on March 24, 1961. At the request of the chairman, Einerman addressed Pacific's board of directors and explained the need for and purposes of the plan, prior to the vote on the pertinent resolutions.
The reasons given for dividing the operations of Pacific were the size of the area served by the company (about one-seventh of the area of the mainland States); the rapid growth of the population of the area since World War II with increases in the number of telephones, and the amount of plant investment and operating revenues; and the expected continued growth of the population of the area with a continuing increase in the amount of telephone service required.
The advantages of having a separate division which had been set up in 1960 to run the operations of Pacific in Oregon, Washington, and Idaho were considered by management to be as follows:
1. Top authority closer to communities served.
2. Better recognition of service needs of each community.
3. More flexibility in dealing with customers.
4. Closer relations with employees.
5. Better understanding by public and authorities.
6. More efficient operations.
In addition, the following advantages were expected to be gained by the establishment of the Northwest Division as a separate corporation:
1. Financing problems, as well as operating problems, would be assumed by Pacific-Northwest management.
2. A board of directors with final authority, drawn from the territory served, would replace the then-existing advisory boards.
3. The Pacific Co. management would be able to concentrate full attention to the needs of California and Nevada.
Under the terms of the plan, the board of directors of Pacific was to cause a "New Company" to be incorporated under the laws of the State of Washington. The plan further provided that —
3. The Pacific Company shall transfer to the New Company all of the business and properties of the Pacific Company located in the States of Oregon, Washington and Idaho, including all property, whether real or personal, tangible or intangible, franchises, easements, rights-of-way, licenses, leases and all rights of any nature, whether existing or contingent at the time of transfer, arising out of or in connection with its business in the States of Oregon, Washington and Idaho, all of the foregoing being transferred in consideration for (i) the assumption by the New Company of all liabilities, whether existing or contingent at the time of transfer, of the Pacific Company relating to the business of the Pacific Company in such states, except liabilities with respect to any dividends declared on stock, income taxes for which liability reserves have been established and principal of and interest on the debentures and short term debt of the Pacific Company, and (ii) capital stock and debt obligations of the New Company in a total amount which will bear substantially the same relationship to the net book cost of the assets transferred and liabilities assumed as the total of the par value of the stock (common and preferred) and the aggregate principal amount of the debt obligations of the Pacific Company bears to the net book cost of all its assets less liabilities prior to said transfer, the par value of capital stock, debt obligations and surplus of the New Company to be in substantially the same proportions as the par value of stock (common and preferred), debt obligations and surplus of the Pacific Company prior to said transfer.
4. The Pacific Company shall offer to its shareholders as set forth below the right to purchase all of the shares of capital stock of the New Company acquired pursuant to this Plan. The number of shares to be offered to the shareholders of the Pacific Company in any one offering, the number of offerings to be made, and the price at which said shares shall be offered to the shareholders of the Pacific Company shall be determined by the Board of Directors of the Pacific Company in its sole discretion, provided, however, that each offering shall be made to the shareholders of the Pacific Company on the following basis:
a. The holders of record, on such date as may be specified by the Board of Directors of the Pacific Company, of the common shares of the Pacific Company will receive rights to purchase stock of the New Company on the basis of a prorate offering entirely to such holders, subject to the following provisions. The holders of record, on such date, of the preferred shares of the Pacific Company other than American Telephone and Telegraph Company will receive rights to purchase such stock on the basis that each such holder of preferred shares, for each preferred share held, will receive seven times the number of rights to purchase stock of the New Company that holders of common shares will receive for each common share held. The rights to participate received by such holders of preferred shares will come from rights which American Telephone and Telegraph Company would otherwise receive with respect to its common shares.
b. In connection with the final offering of the shares of stock of the New Company, shares not sold upon the exercise of rights may be sold by the Pacific Company to American Telephone and Telegraph Company.
The sale of the Northwest stock through the issuance of rights to the shareholders of Pacific pursuant to the plan was intended to serve the purpose of providing Pacific with additional capital funds required by Pacific for future operations in California. In each of the seven 12-month periods ended June 30, 1960, Pacific issued additional common stock and/or long-term debentures. The proceeds from the sale of those securities, net of expenses and premiums, were $1,313,750,000, or an average for each of the 7 years 1954-60 of $187,678,600. In the 36-month period from July 1, 1960, through June 30, 1963, Pacific did not issue any additional common stock or debentures.
Before adopting the plan, the management of Pacific considered various alternative proposals concerning the distribution of the Northwest shares. One such proposal was the distribution of the Northwest shares to the shareholders of Pacific without the payment by them of any consideration. This was dropped because Pacific's management was advised by its attorneys that it would be required to charge such a distribution to earned surplus, and it had insufficient surplus for this purpose. Pacific's management was advised that it could create a reduction surplus out of capital against which a distribution of the shares of Northwest could be charged, but such a reduction surplus would be required under California law to be used first to redeem all of the preferred shares of Pacific. Pacific's management was advised and believed, although possibly erroneously, that under California law Pacific's preferred shares were not subject to redemption. In addition, the desire of Pacific to raise new capital from the distribution of the Northwest shares would not have been fulfilled by such a method.
On March 24, 1961, a meeting of the shareholders of Pacific was held at which the plan was approved and adopted, subject to consent and approval by the Federal Communications Commission and the public utility regulatory authorities in each of the States of Oregon, Washington, and Idaho. At that meeting, Einerman addressed the shareholders regarding the plan, setting forth substantially the same material that he had presented at the directors meeting.
Pursuant to the plan, Northwest was organized under the laws of the State of Washington on March 27, 1961, with an authorized capital stock consisting of 50 million shares of one class common stock with a par value per share of $11. On March 28, 1961, 10,000 shares of such stock were issued by Northwest to Pacific upon the payment by Pacific of $110,000 in cash.
On March 31, 1961, Pacific and Northwest submitted to the public utilities commissioner of Oregon a joint application for an order authorizing Pacific to sell and Northwest to purchase the business and properties of Pacific in the State of Oregon and for certain related orders. On the same date, Pacific and Northwest submitted to the Washington Public Service Commission a joint application for an order authorizing Pacific to sell and Northwest to purchase the business and properties of Pacific in the State of Washington and authorizing the issuance of common stock and debt obligations of Northwest and the acquisition thereof by Pacific. On the same date, Pacific and Northwest submitted to the Idaho Public Utilities Commission a joint application of Pacific to withdraw its tariffs from Idaho and of Northwest to file tariffs with the commission for Idaho. On April 3, 1961, Pacific and Northwest filed with the Federal Communications Commission a joint application for a certificate to the effect that the present and future public convenience and necessity required the acquisition and operation by Northwest of the interstate toll lines of Pacific located in the States of Oregon, Washington, and Idaho, and for a certificate to the effect that neither the present nor future public convenience and necessity would be adversely affected by the discontinuance of interstate telephone and telegraph services by Pacific over the lines to be acquired by Northwest.
On May 15, 1961, the Idaho Public Utilities Commission issued its approval order; on June 5, 1961, the Washington Public Service Commission issued its order granting its approval; on June 12, 1961, the public utilities commissioner of Oregon issued his order granting his approval; and, on June 15, 1961, the Federal Communications Commission issued its approval order and certificate.
At a meeting of the board of directors of Pacific on June 30, 1961, the transfer of assets from Pacific to Northwest as contemplated by the plan was approved. As of 11:59 p.m. on June 30, 1961, all of the business and properties of Pacific in the States of Oregon, Washington, and Idaho were transferred to Northwest in consideration for —
(a) the assumption by Northwest of outstanding liabilities relating to the operations of Pacific in such states, with the exception of liabilities with respect to dividends declared on stock, income taxes for which liability reserves had been established and principal of and interest on debentures and short-term debt of Pacific;
(b) the issuance to Pacific by Northwest of a promissory note payable on demand in the principal amount of $200,000,000 bearing interest at the rate of 4 1/2 per cent per annum; and
(c) the issuance to Pacific by Northwest of an additional 30,450,000 shares of its $11 par value common stock, having an aggregate par value of $334,950,000.
As contemplated by the plan, as of the close of business on June 30, 1961, Pacific ceased operation of the business in the States of Oregon, Washington, and Idaho, and as of July 1, 1961, Northwest commenced operation of the business received from Pacific in the States of Oregon, Washington, and Idaho.
The par value of stock, aggregate debt (including advances from American evidenced by promissory notes due 1 day after issue), surplus per books, and net book cost of assets less liabilities (a) of Pacific immediately prior to the above-mentioned transfer and (b) of Northwest as of commencement of business on July 1, 1961, were as follows:
In two of these companies a small number of directors' qualifying shares are privately held.
Before reduction by retroactive depreciation adjustment and by capital stock expense.
Equal to net book cost of assets less liabilities.
On the 1961 consolidated income tax return filed by American and its subsidiaries the transfer of assets from Pacific to Northwest was treated as a transaction coming under section 351. It was reported that Pacific received from Northwest 30,450,000 shares of Northwest common stock; no securities of Northwest; no money; and other property in the form of a $200 million demand note of Northwest. Since both Pacific and Northwest were included in a consolidated return in the year of the transfer, no gain or loss was reported on the transaction.
From March 28, 1961, until September 29, 1961, Pacific was the sole shareholder of Northwest. Pursuant to the plan, on September 29, 1961, Pacific issued to its shareholders rights, evidenced by assignable warrants, to purchase 17,459,490 shares of the common stock of Northwest, constituting approximately 57.3 percent of the total outstanding common shares of Northwest.
In conformance with the provisions of paragraph 4(a) of the plan, each minority common shareholder of Pacific of record at the close of business on September 20, 1961, was issued one right for each common share of Pacific so held. The number of common shares of Pacific so held by minority shareholders was 10,214,804. At the close of business on September 20, 1961, American held 94,542,139 shares of common stock and 640,957 shares of preferred stock of Pacific. Under the plan, 1,253,301 rights were received by the minority preferred shareholders of Pacific on the basis of 7 rights for each preferred share of Pacific held by them. These 1,253,301 rights came from rights which American would otherwise have received with respect to its common shares of Pacific, on the basis of 1 right for each common share of Pacific which American held. Consequently, American received on September 29, 1961, 93,288,838 rights with respect to its 94,542,139 common shares of Pacific. American received no rights with respect to its preferred shares of Pacific.
Under the terms of the offering, six rights and the payment of $16 were required for the purchase of each share of common stock of Northwest. The rights were required to be exercised no later than October 20, 1961.
The common stock of Northwest was listed on the American Stock Exchange and on the Pacific Coast Stock Exchange, and trading with respect to the shares of such stock commenced on September 14, 1961, on a when-issued basis. The rights issued by Pacific on September 29, 1961, were admitted to trading on the American Stock Exchange and on the Pacific Coast Stock Exchange and trading with respect to said rights commenced on September 14, 1961, on a when-issued basis.
Petitioners Baan exercised all of the 600 rights issued to them which entitled them to acquire 100 shares of common stock of Northwest and paid to Pacific $1,600 in cash ($16 per share) on October 11, 1961. Petitioners Gordon exercised 1,536 of the 1,540 rights issued to them which entitled them to acquire 256 shares of common stock of Northwest and paid to Pacific $4,096 in cash ($16 per share) on October 5, 1961. On October 5, 1961, petitioners Gordon sold the four rights to purchase Northwest stock which they had received from Pacific but did not exercise. The net proceeds from the sale of the four rights were $6.36.
The fair market values on selected dates of Pacific common and preferred stocks, as shown by the average of the high and low quotations on the New York Stock Exchange (the principal market in which such stocks were traded), and Northwest common stock, and the rights issued by Pacific to purchase Northwest common stock as shown by the average of the high and low quotations on the American Stock Exchange (the principal market in which such stock and rights were traded) were as follows: 1961
Date Pacific Pacific Northwest Rights common preferred common Jan. 27 ............ 35.1250 149.0625 _______ ________ June 30 ............ 37.6875 155.0000 _______ ________ Aug. 25 ............ 43.5000 169.0000 _______ ________ Sept. 14 ........... 42.2500 164.9375 29.8125 2.234375 Sept. 29 ........... 38.6250 142.5000 26.8125 1.765625 Oct. 5 ............. 39.4375 146.0000 26.0000 1.65625 Oct. 20 ............ 38.0000 150.5000 27.8125 1.953125 As a result of the offering, the minority common and preferred shareholders of Pacific or their assignees acquired by exercising rights 1,897,891 shares of common stock of Northwest and American (after purchasing 2 additional rights privately) on September 29, 1961, acquired all of the 15,548,140 shares of such stock for which it had received rights. The 17,446,031 shares of Northwest thus acquired by the shareholders of Pacific or their assignees by exercising rights had an aggregate fair market value of $468,852,920 at the various dates of exercise of the rights. Pacific received by reason of such acquisitions, cash in the amount of $279,136,496, of which amount $248,770,240 was received from American by its check dated September 29, 1961.In the consolidated income tax return filed by American and its affiliated companies for 1961, gain was reported by Pacific on the sale of the 1,897,891 shares of Northwest common stock by Pacific to its minority common and preferred shareholders in the amount of $8,739,362.07. Since both American and Pacific were included in a consolidated return for 1961 no gain was reported on the sale of 15,548,140 shares of Northwest common stock by Pacific to American.
The offering price of $16 per share to Pacific shareholders of the portion of the common stock of Northwest offered to them in 1961 was determined by Pacific at a meeting of its board of directors on August 25, 1961. At such meeting Einerman, at the request of the president of Pacific, outlined to the board of directors the reasons therefor.
In addressing the board Einerman stated that there were two basic decisions to make in connection with the first offering of Northwest shares: (1) The price to be set for each share; and (2) if the price set was in excess of par value, whether a change should be made in Pacific's dividend to compensate the shareholders for the additional capital invested in Pacific. He then discussed the time schedule that had been established for the offering, all of the dates of which fell in 1961. The necessary registration statement was to be filed with the Securities and Exchange Commission on August 25; its effective date was scheduled for September 13. When-issued trading in the Northwest stock and rights would commence on September 14, and the stock would go ex rights on September 15. The appropriate stockholders of record of Pacific on September 20 would receive such rights which would be mailed to them in the form of stock warrants together with a prospectus on September 29. Such warrants would expire if not exercised by October 20.
Seven factors were presented for consideration in setting the offering price for the Northwest stock to be sold through rights in 1961. There were questions raised during this presentation with regard to these seven factors but none of the questions raised nor any of the discussion that followed uncovered any additional factors over and above the seven, and equal importance was given to each. Those factors listed on a chart which was used to present them to the board as "factors to be considered" were as follows:
1. Tax status of rights to be issued.
2. Market value of shares to be sold.
3. Rights values received in the past.
4. Rights values at various offering prices.
5. Company's requirements for new capital.
6. Proceeds at various offering prices and shareholder's investment above par.
7. Taxes to be paid at various offering prices.
Some of these factors argued for a high offering price whereas the others tended to support a low offering price.
In behalf of Pacific's management Einerman recommended to the board, after giving appropriate weight to all seven factors, that the offering price for the Northwest shares to be sold through rights be set at $16 plus six rights. All of management's recommendations as made to the board by Einerman on August 25, 1961, were approved, and the rights were issued as set forth hereinbefore.
In order to insure the success of a distribution of stock through an issue of rights, the difference between the fair market value of the stock and the option price, referred to as the underpricing, must be sufficiently large in two respects. First, the underpricing in terms of dollar amount must be large enough to make it worthwhile for shareholders to sell their rights if they do not choose to exercise them. Normally a cash value of $0.20 for each right would be adequate. Secondly, the percentage of underpricing must be large enough to make the purchase of the stock a good investment, and insure that the rights will be exercised. Taking into account that the issuance of Northwest stock by Pacific was not underwritten, the maximum underpricing necessary to insure the success of the issue would have been 10 percent.
On April 22, 1963, pursuant to the plan, Pacific's board of directors resolved to offer the remaining 13,013,969 shares of common stock of Northwest held by it to the shareholders of Pacific of record on June 4, 1963. On June 12, 1963, Pacific issued to its shareholders rights evidenced by assignable warrants to purchase all such shares at a price of $16 per share, exercisable at any time before the close of business on July 3, 1963. Rights were received by the minority common shareholders, minority preferred shareholders, and American, the common parent corporation of Pacific, on the same basis as the 1961 offering of Northwest shares, except that American relinquished rights to purchase 8,829 shares of Northwest which it would otherwise have received under the plan with respect to its common shares of Pacific, so that the minority common and minority preferred shareholders of Pacific could be offered shares of Northwest on a 1-for-8 basis. The exercise of eight rights was required for the purchase of each share of Northwest.
As a result of the 1963 offering, the minority common and preferred shareholders of Pacific or their assignees acquired by exercise of their rights 1,416,552 shares of Northwest, and American acquired the balance at $16 per share, including the 11,580,456 shares for which it had received rights which it exercised, and 16,961 shares also acquired by American, as provided in the plan, constituting the shares offered to the minority common and preferred shareholders of Pacific for which shares the rights were allowed to lapse by such shareholders, or a total for American of 11,597,417 shares. In the two offerings, in 1961 and 1963, American thus acquired a total of 27,145,557 shares of Northwest, or about 89.1 percent of its single class of common stock.
The offering price of $16 per share to Pacific shareholders for the portion of the common stock of Northwest held by Pacific in 1963 and offered to the shareholders through rights in 1963 was determined by Pacific at a meeting of its board of directors on May 24, 1963. That determination was based upon the same factors which were presented to the board in regard to the setting of the offering price on the 1961 offering of Northwest stock by Pacific.
In response to requests by Pacific, the Commissioner issued a ruling letter on June 28, 1961, regarding the tax consequences of the planned division of Pacific and distribution of Northwest stock to the shareholders of Pacific through an issue of rights. In regard to the issuance of the rights and the distribution of the Northwest stock the Commissioner ruled as follows:
(6) The receipt by the shareholders of the Pacific Company of rights to purchase shares of stock of the Northwest Company will not result in taxable income to the shareholders.
(7) No taxable income will result to the shareholders of the Pacific Company by reason of holding the above-described rights to purchase shares of stock of the Northwest Company until the date of expiration of the rights, without having exercised, sold or exchanged them.
(8) The full amount realized by the shareholders of the Pacific Company upon the sale or exchange of the above-described rights to purchase shares of stock of the Northwest Company will constitute ordinary income to the shareholders so selling or exchanging the rights.
(9) The receipt by the shareholders of the Pacific Company of stock of the Northwest Company upon the exercise of the above-described rights, in case of each shareholder which is not a corporation, will result in a distribution of property under section 301 of the Code in an amount equal to the excess, if any, of the fair market value of the stock of the Northwest Company at the time of the exercise of the rights over the amount paid for the stock; and, in the case of each shareholder which is a corporation, will result in a distribution of property under section 301 in an amount equal to the excess, if any, of the basis of the stock of the Northwest Company in the hands of the Pacific Company at the time of the exercise of the rights over the amount paid for the stock, assuming the basis of such stock is less than its fair market value.
On November 15, 1962, the Commissioner issued another ruling letter to Pacific which reaffirmed the positions taken in the ruling of June 28, 1961, as set forth above.
OPINION
American Telephone Telegraph Co. (American), a New York corporation, owned all of the stock or at least a controlling interest in the stock of some 21 corporations engaged in the business of furnishing telephone and other communications services within the United States. In the aggregate, American and its various subsidiaries comprise what is sometimes referred to as the Bell System. Its stock ownership in its west coast subsidiary, Pacific Telephone Telegraph Co. (Pacific), represented some 89 percent of the latter's voting control. The minority shares in Pacific were publicly held by over 38,000 stockholders, including petitioners.
Pacific operated within the States of California, Oregon, Washington, and a part of Idaho. Between the end of World War II and the beginning of 1961, Pacific's telephone business experienced enormous growth and was expected to continue to expand at a rapid rate. Due to this growth and the size of the area served by Pacific, many of its activities were controlled locally within the various States in which it operated. Eventually a separate division was set up to operate almost autonomously in the States of Oregon, Washington, and Idaho. It was then concluded that it would be preferable to disassociate completely the activities of that division from the operations of Pacific in California by a transfer of the entire business conducted in the three northern States to a new corporation to be followed by a distribution to the shareholders of Pacific of the stock of the new corporation. To accomplish this objective Pacific Northwest Bell Telephone Co. (Northwest) was organized as a Washington corporation on March 27, 1961, and as of July 1, 1961, Pacific transferred to it all of the assets pertaining to operations in the area to be served by the new corporation. In return for the assets received, Northwest assumed some of the liabilities to which such assets were subject, issued to Pacific a promissory note payable on demand in the principal amount of $200 million, and issued to Pacific 30,450,000 shares of its $11 par value common stock having an aggregate par value of $334,950,000.
Pacific had previously purchased for $110,000 in cash 10,000 shares of Northwest common stock at par, which the Government agrees was an integral part of the later transfer.
Since Pacific was then in need of additional capital to finance its own operations in California, the plan to distribute the Northwest shares to Pacific's stockholders was devised in such manner that it would provide Pacific with such needed capital at the same time. This was accomplished by Pacific's issuing transferable short-term rights to its shareholders to buy the Northwest stock. In order to receive a share of Northwest it was necessary to surrender six rights and to pay $16 in cash. Such Northwest stock was expected to have and did in fact have a fair market value substantially in excess of the $16 subscription price. The petitioners in both cases before us exercised their rights, thus obtaining shares of Northwest having a fair market value considerably greater than the cash paid therefor; also, petitioners Gordon had four remaining rights which they sold for $6.36. Two principal problems are thus presented for solution: (1) Whether petitioners in both cases realized dividend income to the extent that the Northwest stock had a fair market value in excess of the subscription price; and (2) what is the proper tax treatment of the cash received by the Gordons upon the sale of their remaining rights?
Pacific thus disposed of some 57.3 percent of its Northwest stock in 1961 and the remainder in 1963. There is no dispute between the parties that the two offerings were component parts of a single plan and that they must be regarded together as resulting in the disposition of 100 percent of the Northwest stock in a single transaction.
The amount of stock (57.3 percent) covered by the first offering was determined in such manner that direct control of the new corporation (over 50-percent stock ownership) would pass immediately from Pacific to American.
1. Exercise of Rights. — There is no serious question that, apart from certain specific provisions of the 1954 Code, the exercise of rights by Pacific's stockholders in the circumstances of this case would result in their receiving taxable dividends equal to the excess of the value of the Northwest stock over the subscription price. So much is clear from such decisions as Palmer v. Commissioner, 302 U.S. 63, and Choate v. Commissioner, 129 F.2d 684 (C.A. 2). However, petitioners contend that there are provisions in the 1954 Code which preclude the treatment of the foregoing amounts as taxable dividends. They argue that the transaction was completely tax free under section 355, dealing with the distribution of stock and securities of a controlled corporation (so-called spin-off or divisive reorganization), or alternatively under section 354, involving exchanges of stock and securities in certain reorganizations. As a further alternative, they take the position that if sections 355 and 354 are inapplicable, then the distribution resulting from the receipt of Northwest stock by petitioners was a distribution in partial liquidation of Pacific under section 346(b), resulting in the realization of capital gains as provided therein. Since we have reached the conclusion that section 355 is applicable, we do not pass upon the alternative contentions.
The Palmer case has generally been regarded as based upon the theory that there may be a taxable dividend where the optioned stock is worth more than the subscription price at the time of the offering, and since the Northwest stock had a value substantially in excess of the subscription price at the time of issuance of the rights, there is not present here the condition for nontaxability that existed in the Palmer case itself. The scope of Palmer was considered at length in Choate, and, since the value of the Northwest stock on the dates of exercise of the rights herein was not in excess of its value on the date of issuance of the rights the problem which proved so troublesome in Choate is not before us. The Commissioner has charged petitioners with having received dividends only to the extent that the Northwest stock had a value on the date of exercise of the rights in excess of the subscription price, and such excess in turn was less than the corresponding excess as of the time of the offering.
Section 355 is captioned "DISTRIBUTION OF STOCK AND SECURITIES OF A CONTROLLED CORPORATION." Subject to various conditions and limitations spelled out therein, it was intended to provide for nonrecognition of gain or loss in a so-called spin-off or divisive reorganization, whereby a corporation divests itself of one of its business enterprises through the medium of distributing to its stockholders the stock of a subsidiary in which such business is being carried on at the time of distribution. See S. Rept. No. 1622, 83d Cong., 2d Sess., pp. 266-268. It is undisputed that the telephone and communications operations conducted in Oregon, Washington, and Idaho constituted a separate business; and it is also undisputed that if Pacific had transferred that business to Northwest solely for stock of the latter (here Pacific received a $200 million note in addition to stock), and if Pacific had then distributed the Northwest stock without consideration to its own stockholders (rather than through the medium of stock rights), the distribution would have qualified as a nonrecognizable spin-off. Such distribution would have been what petitioners properly characterize as a classic case of a tax-free divisive reorganization. And we hold that neither the use of stock rights nor the presence of the note requires a different result under section 355.
SEC. 355. DISTRIBUTION OF STOCK AND SECURITIES OF A CONTROLLED CORPORATION.
(a) EFFECT ON DISTRIBUTEES. —
(1) GENERAL RULE. — If —
(A) a corporation (referred to in this section as the "distributing corporation") —
(i) distributes to a shareholder, with respect to its stock, or
(ii) distributes to a security holder, in exchange for its securities, solely stock or securities of a corporation (referred to in this section as "controlled corporation") which it controls immediately before the distribution,
(B) the transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both (but the mere fact that subsequent to the distribution stock or securities in one or more of such corporations are sold or exchanged by all or some of the distributees (other than pursuant to an arrangement negotiated or agreed upon prior to such distribution) shall not be construed to mean that the transaction was used principally as such a device),
(C) the requirements of subsection (b) (relating to active businesses) are satisfied, and
(D) as part of the distribution, the distributing corporation distributes —
(i) all of the stock and securities in the controlled corporation held by it immediately before the distribution, or
(ii) an amount of stock in the controlled corporation constituting control within the meaning of section 368(c), and it is established to the satisfaction of the Secretary or his delegate that the retention by the distributing corporation of stock (or stock and securities) in the controlled corporation was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax,
then no gain or loss shall be recognized to (and no amount shall be includible in the income of) such shareholder or security holder on the receipt of such stock or securities.
* * * * * * *
(3) LIMITATION. — Paragraph (1) shall not apply if —
(A) the principal amount of the securities in the controlled corporation which are received exceeds the principal amount of the securities which are surrendered in connection with such distribution, or
(B) securities in the controlled corporation are received and no securities are surrendered in connection with such distribution.
For purposes of this section (other than paragraph (1)(D) of this subsection) and so much of section 356 as relates to this section, stock of a controlled corporation acquired by the distributing corporation by reason of any transaction which occurs within 5 years of the distribution of such stock and in which gain or loss was recognized in whole or in part, shall not be treated as stock of such controlled corporation, but as other property.
* * * * * * *
(b) REQUIREMENTS AS TO ACTIVE BUSINESS. —
(1) IN GENERAL. — Subsection (a) shall apply only if either —
(A) the distributing corporation, and the controlled corporation (or, if stock of more than one controlled corporation is distributed, each of such corporations), is engaged immediately after the distribution in the active conduct of a trade or business, or
(B) immediately before the distribution, the distributing corporation had no assets other than stock or securities in the controlled corporations and each of the controlled corporations is engaged immediately after the distribution in the active conduct of a trade or business.
(2) DEFINITION. — For purposes of paragraph (1), a corporation shall be treated as engaged in the active conduct of a trade or business if and only if —
(A) it is engaged in the active conduct of a trade or business, or substantially all of its assets consist of stock and securities of a corporation controlled by it (immediately after the distribution) which is so engaged,
(B) such trade or business has been actively conducted throughout the 5-year period ending on the date of the distribution,
(C) such trade or business was not acquired within the period described in subparagraph (B) in a transaction in which gain or loss was recognized in whole or in part, and
(D) control of a corporation which (at the time of acquisition of control) was conducting such trade or business —
(i) was not acquired directly (or through one or more corporations) by another corporation within the period described in subparagraph (B), or
(ii) was so acquired by another corporation within such period, but such control was so acquired only by reason of transactions in which gain or loss was not recognized in whole or in part, or only by reason of such transactions combined with acquisitions before the beginning of such period.
Subject to the conditions spelled out in the four subparagraphs (A) through (D), section 355(a)(1) provides in substance that where a corporation (the "distributing corporation") distributes to its shareholders stock of a corporation controlled by it no gain or loss shall be recognized by the distributees. Cf. W. E. Gabriel Fabrication Co., 42 T.C. 545, 551. The principal controversy herein relates to subparagraphs (A) and (C). Subparagraph (B) is not involved at all since there is no contention that the transaction was used as a "device for the distribution of the earnings and profits" of either Pacific or Northwest. And subparagraph (D) is involved herein only in a manner closely related to subparagraph (A).
The conditions of subparagraph (A) appear in section 355(a)(1) as follows:
SEC. 355. DISTRIBUTION OF STOCK AND SECURITIES OF A CONTROLLED CORPORATION.
(a) EFFECT ON DISTRIBUTEES. —
(1) GENERAL RULE. — If —
(A) a corporation (referred to in this section as the "distributing corporation") —
(i) distributes to a shareholder, with respect to its stock * * *
* * * * * * *
solely stock or securities of a corporation (referred to in this section as "controlled corporation") which it controls immediately before the distribution,
* * * * * * *
then no gain or loss shall be recognized to (and no amount shall be includible in the income of) such shareholder or security holder on the receipt of such stock or securities.
As we understand the Government's position, it is that the conditions of (A) have not been satisfied since Pacific did not distribute the stock of Northwest but rather distributed rights to purchase the Northwest shares, and that the stock of Northwest was in any event not distributed "with respect to its [Pacific's] stock." We think that these contentions are unsound.
It argues further at this point that such rights did not constitute "stock or securities" within sec. 355(a)(1)(A). In view of our conclusion that the shares of Northwest rather than the rights were the subject of the distribution within the meaning of (a) (1) (A) it becomes unnecessary to resolve the controversy as to whether the rights themselves would qualify as "stock or securities."
The Government's position is based upon a highly technical and inhospitable reading of the statute that fails to give effect to the basic objective that Congress sought to achieve. This case concededly involves a spin-off. Pacific plainly divested itself of the business which it had conducted in the three northwest States. Had it distributed the Northwest stock directly to its stockholders without consideration there would clearly have been the type of divisive reorganization contemplated by the statute, at least as far as subparagraph (A) is concerned. And, in our view, the situation is not changed merely because that distribution was conditioned upon payment of $16 a share by the distributees. It was nonetheless a distribution of Northwest stock to these petitioners, stockholders in Pacific, made "with respect to" their ownership of stock in Pacific. If Congress had intended that a distribution of the Northwest stock be treated as tax free when made without consideration, it is inconceivable that it could have intended the transaction to result in taxable income to the distributees where they paid out money in connection with receiving such stock. The stock of Northwest was literally "distributed" to petitioners, albeit for a consideration, and we hold that the statute should not be construed so as to depart from such literal meaning, where to do so would frustrate the legislative purpose.
The Government's argument revolves largely around the notion that the rights to subscribe were the subject of the distribution rather than the Northwest stock itself, and that the stock was obtained only as a result of exercising those rights. However, Palmer v. Commissioner, 302 U.S. 63, makes it clear that issuance of the rights, even though they may be valuable, may not be considered as a distribution of corporate earnings and profits. If any income is to be charged to petitioners it must be regarded as stemming from the exercise of the rights, by obtaining the Northwest stock for a consideration less than its fair market value. But section 355 was intended to permit the receipt of such stock without tax even where the recipient, paid nothing therefor, and we think it would be a distortion of congressional purpose to impute an intention to impose the tax where the recipient was required in effect to contribute to the capital of the distributing corporation as a condition to receiving the distributed stock. We conclude that the transaction before us was within the terms of section 355(a)(1)(A), and we next consider whether the conditions of (a) (1) (C) have been met.
There is no merit to the Government's contention that Palmer is no longer good law in this respect. There is no indication in the 1954 Code that Congress intended to disapprove any part of that decision, and It has been applied by the courts in cases arising thereunder. See William H. Bateman, 40 T.C. 408. The employee stock option cases, Commissioner v. LoBue, 351 U.S. 243, and Commissioner v. Smith, 324 U.S. 177, relied on by the Commissioner as authority overruling Palmer, do not discuss this aspect of that case at all, but rather cite Palmer with approval in other respects.
Subparagraph (C) is not self-contained, but incorporates other provisions by reference; it spells out as one of the conditions for non-recognition in section 355(a)(1) that "(C) the requirements of subsection (b) (relating to active businesses) are satisfied." Thus, subparagraph (C) is really nothing more than the means whereby the provisions of subsection (b) are brought into play at this point.
Subsection (b) provides in part as follows:
(b) REQUIREMENTS AS TO ACTIVE BUSINESS. —
(1) IN GENERAL. — Subsection (a) shall apply only if either —
(A) the distributing corporation, and the controlled corporation * * * is engaged immediately after the distribution in the active conduct of a trade or business, or
* * * * * * *
(2) DEFINITION. — For purposes of paragraph (1), a corporation shall be treated as engaged in the active conduct of a trade or business if and only if —
(A) it is engaged in the active conduct of a trade or business, or substantially all of its assets consist of stock and securities of a corporation controlled by it (immediately after the distribution) which is so engaged,
(B) such trade or business has been actively conducted throughout the 5-year period ending on the date of the distribution,
(C) such trade or business was not acquired within the period described in subparagraph (B) in a transaction in which gain or loss was recognized in whole or in part, and
There is no dispute that Pacific and Northwest were each engaged in the active conduct of a trade or business within (b) (1) (A), or that the requirements of (b) (2) (A) and (b) (2) (B) have been met. However, the Government argues that there has been a failure in respect of Northwest to comply with (b) (2) (C), in that the transaction whereby Northwest acquired its business from Pacific was one "in which gain or loss was recognized in whole or in part." Petitioners vigorously deny that any gain or loss was recognized.
The purpose of these provisions was to prevent a tax-free distribution of a corporation's earnings and profits through the medium of a temporary purchase of a going business with liquid assets and then in effect distributing those assets to its stockholders. See Cohen, Silverman, Surrey, Tarleau, and Warren, "The Internal Revenue Code of 1954: Corporate Distributions, Organizations, and Reorganizations," 68 Harv. L. Rev. 393, 430. Plainly, no such circumstances were present here, since this case involves a bona fide separation of a business conducted for many years by Pacific. We turn then to the particular contentions urged by petitioners in support of their position that the gain on the transfer of assets by Pacific to Northwest was nonrecognizable. They rely upon two alternative grounds: (1) That as a result of the consolidated return filed in behalf of Pacific and the affiliated group, no gain or loss was in fact recognized; and (2) that in any event the transfer of the business by Pacific to Northwest was nonrecognizable under section 351.
SEC. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.
(a) GENERAL RULE. — No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. * * *
It is in connection with this second ground that the matter of the $200 million note becomes pertinent, since the Government contends that Pacific's transfer to Northwest was not "solely in exchange for stock or securities" of Northwest, in view of the note as part of the consideration for the transfer. Petitioners, on the other hand, argue that the note is a security within the meaning of section 351. We need not resolve this controversy, because, in our view, there was no recognizable gain or loss by reason of the consolidated return, and it therefore becomes unnecessary to consider the alternative ground.
As subsidiaries of American, Pacific and Northwest were included in the group of affiliated corporations for which a consolidated return was filed for 1961. Thus, the gain resulting from the transfer of assets from Pacific to Northwest which might otherwise have been subject to tax was eliminated in that consolidated return pursuant to regulations prescribed by the Commissioner under section 1502. Those regulations provide as follows (Income Tax Regs., sec. 1.1502-31(b)(1)):
(b) Computations. In the case of affiliated corporations which make, or are required to make, a consolidated return, and except as otherwise provided in the regulations under section 1502:
(1) Taxable income. The taxable income of each corporation shall be computed in accordance with the provisions covering the determination of taxable income of separate corporations, except:
(i) There shall be eliminated unrealized profits and losses in transactions between members of the affiliated group and dividend distributions from one member of the group to another member of the group (referred to in the regulations under section 1502 as intercompany transactions);
The Government does not dispute that the gain upon the transfer from Pacific to Northwest was properly relieved of tax in the consolidated return. It argues, however, that the regulations provide for the elimination of gain or loss whereas sections 355(b)(2)(C) and 351 are phrased in terms of nonrecognition of gain or loss. It contends that the gain herein was "recognized" but "eliminated." We think that this distinction is spurious, and that the terms "elimination" and "nonrecognition" are intended to be synonymous in this context. Apart from the absence of any solid basis for the claimed distinction, a careful textual examination of the statute and regulations discloses that the word "eliminated" was used in the sense of "nonrecognition."
Under the regulations "unrealized profits and losses" arising out of intercompany transactions are to be "eliminated." Here, it is undisputed that the gain on the transfer from Pacific to Northwest was properly "eliminated," and therefore must have been an "unrealized" gain within the meaning of these provisions. Yet section 1002 directs that, except as otherwise provided, the entire gain or loss on a sale or exchange of property determined under section 1001 shall be "recognized." And section 1001(a) states that the gain on sale of property "shall be the excess of the amount realized therefrom over the adjusted basis." Thus, if no gain were "realized" within the meaning of the regulations so as to justify "elimination," no such gain was "recognized."
This result is confirmed by examining the consequences that would follow in respect of the basis of the transferred property. Section 1051, dealing with the basis of property acquired in an intercompany transaction, provides as follows:
SEC. 1051. PROPERTY ACQUIRED DURING AFFILIATION.
In the case of property acquired by a corporation, during a period of affiliation, from a corporation with which it was affiliated, the basis of such property, after such period of affiliation, shall be determined, in accordance with regulations prescribed by the Secretary or his delegate, without regard to inter-company transactions in respect of which gain or loss was not recognized. * * *
The basis of the property is thus to be determined "without regard to inter-company transactions in respect of which gain or loss was not recognized." However, if gain were "recognized" in such a transaction, the basis of the property in the hands of the transferee would be "increased in the amount of gain recognized to the transferor." Sec. 362.
Plainly, all of the foregoing provisions contemplate nonrecognition of gain or loss in intercompany transactions, with the result that the transferred property retains its basis in the hands of the transferee. If "elimination" meant something different from "nonrecognition," and if the Commissioner were correct here, then we would have the bizarre situation where the gain were "recognized" even though "eliminated" and the property transferred would acquire a stepped-up basis even though no tax were paid on the gain. We can hardly imagine the Commissioner accepting any such result without a struggle. The real difficulty is due to his unsound position here. We hold that the gain "eliminated" in the consolidated return was not "recognized," with the consequence that the requirements of section 355(b)(2)(C) have been met, thus complying with the condition of section 355(a)(1)(C).
There remains finally for consideration whether the condition of section 355(a)(1)(D) has been met. As already noted, subparagraph (D) is closely related to (A) as it is involved herein. It requires that —
(D) as part of the distribution, the distributing corporation distributes —
(i) all of the stock and securities in the controlled corporation held by it immediately before the distribution, or
(ii) an amount of stock in the controlled corporation constituting control within the meaning of section 368(c) * * *
Certainly, Pacific disposed of every share of Northwest, retaining none whatever, thus satisfying the underlying objective of subparagraph (D). The reasoning behind the Government's highly technical argument that Pacific did not "distribute" all the Northwest stock is basically the same as its position under (A), and rests on the notion that the issuance of the stock rights and the exercise thereof preclude a finding that Pacific had "distributed" all of the Northwest stock. We reject that position here in accordance with the conclusion that we reached in respect of the argument relating to (A).
That objective has been satisfied by Pacific's parting with every share of Northwest. However, if it be thought necessary that such distribution be made to the stockholders of Pacific, the fact that some shares were transferred to purchasers of rights rather than to the stockholders is immaterial here. For, not only did the ultimate transferees take through the stockholders, but in any event the record discloses that the stock rights sold represented only a small percentage of the rights issued, and at least more than 80 percent of the shares, constituting control under sec. 368(c), were in fact distributed to shareholders of Pacific, thus satisfying either part (i) or (ii) of subpar. (D).
2. Sale of Rights. — The remaining issue concerns the taxation of the proceeds received by petitioners Gordon from the sale of four of the rights issued to them. This sale took place on October 5, 1961, and the Gordons received $6.36 for the four rights or $1.59 each. In Gibson v. Commissioner, 133 F.2d 308 (C.A. 2), the court held that a sale of rights results in "ordinary income" at least "to the extent of the spread between the market value of the stock at the time of the issuance of the option and the option price for the stock" (p. 309).
The value of the rights herein on the issuance date, September 29, 1961, was greater than $1.59 per right so that there is not presented here any problem comparable to that considered in Choate v. Commissioner, 129 F.2d 684 (C.A. 2), where the market value of the optioned stock increased after the rights were issued.
In Gibson, the court determined that the petitioner there received an option to obtain a distribution, and through a sale of her rights she anticipated that distribution. The amount realized in anticipation of the distribution was required to be treated in the same manner as the distribution itself. Cf. Helvering v. Horst, 311 U.S. 112.
Petitioners accept this reasoning, but contend that since under section 355 the distribution of stock in the present case is nontaxable and no gain would be recogonized until a sale of the stock, the amounts realized from a sale of the rights should be taxed in the same manner as gains from sales of the stock, i.e., capital gains. This argument fails to take into account the nature of section 355, which is a nonrecognition provision, and can be utilized only by those shareholders who come within its terms. Those shareholders who sold their rights did not come under section 355 in respect of such rights, and without section 355 a distribution of the stock of another corporation would have resulted in the distribution of a dividend to the shareholders of the distributing corporation. The anticipation of such a distribution results in a realization of income which must similarly be treated as a dividend to which the dividends received credit applies. Cf. Tobacco Products Export Corporation, 21 T.C. 625.
The same would be true with respect to any other provisions, such as those in sec. 354, upon which petitioners might rely as a ground for relieving them of the tax upon the exercise of the rights, even if we were to hold such provisions applicable in such circumstances, an issue that we found unnecessary to decide. See pp. 87-88, supra.
Decision will be entered for the petitioners in docket No. 949-63.
Decision will be entered under Rule 50 in docket No. 3949-63.