Opinion
The report of Arthur Black, Special Master, is as follows:
In the course of proceedings to reorganize the debtor companies named above, the United States government has made a tax claim of about $300,000. The debtor companies deny that claim.
This issue has been referred to me for consideration and report.
The facts are as follows:
The Galveston-Houston Electric Company is a holding company. In 1926 it owned all the stock of a group of subsidiary companies, operating electric light and railway plants, an ice business, and a bus line in and about the cities of Galveston and Houston, Tex.
In 1926 this holding or parent company issued and sold, for cash, $3,200,000 of gold notes maturing June 1, 1931.
To secure these notes, the parent company pledged with the Atlantic National Bank of Boston, as trustee, stock and bonds of its subsidiaries of a face value largely in excess of the debt secured.
Early in 1931 it was apparent to the debtor company, to the bankers who had sold the notes, and to the noteholders, that the debtor had no cash, and could obtain no cash, to pay these notes at maturity (which was June, 1931).
The bankers who had sold the notes and who were anxious to protect their customers selected a committee to protect the interests of the noteholders. The committee was formally organized on May 15, 1931. Its members were A. E. Buffum, George S. Mumford, and Augustus P. Loring, Jr. They represented large holdings of these notes. They were each men of intelligence, character, and independence. Their task was to protect, by every legitimate means, the interests of all the noteholders. I find no reason to believe they were influenced by any other interest. In my judgment, they did a first-class job.
The noteholders' committee promptly called for the deposit of notes, and soon had the pledged co-operation of practically all the noteholders. In the meantime, negotiations for the sale of certain property of the subsidiary companies had been started by the debtor company, with the approval of the bankers. The object of the proposed sale was to procure at least part cash for the noteholders. This effort to make a sale had the approval and support of the noteholders' committee.
In August, 1931, terms were agreed upon for the sale of certain properties belonging to the subsidiary companies. This sale involved the surrender by the Atlantic Bank, as trustee, of about half the collateral originally pledged, and provided sufficient funds to pay the noteholders about 60 cents on the dollar in cash. The problem of the committee was to protect its noteholders for the 40 per cent. still due. The company had no more cash, and the value of the collateral still pledged with the trustee was negligible. The only thing for the committee to do was to take the 60 cents in cash and to get a new promise secured by everything which the company could be induced to put behind it.
On September 18, 1931, the noteholders' committee submitted a plan which was designed to bring about this result. This plan was prepared with great care, and contains a mass of detail which may be omitted here. In brief, the plan provided: (1) For the acceptance by the noteholders of 60 per cent. in cash from the proceeds of the sale already described; (2) for the issue of new notes by the company for the balance; (3) for security behind the new notes which should include all the collateral left with the trustee to secure the original notes as well as other substantial assets belonging to the debtor company.
To provide for the security, mentioned in 3 above, the committee undertook to cause a foreclosure of the original collateral still in the hands of the trustee by public auction and to bid in that collateral if it could be bought at a price which the committee opproved. If the committee bought this collateral at the auction, it undertook to convey it to a new corporation formed by the committee.
Through the instrumentality of this new corporation formed by the committee for this purpose, the new notes of the debtor company were to be secured.
The committee distinctly stated its purpose to withdraw the plan if it did not buy in the foreclosed collateral at the auction sale.
The committee's plan was promptly accepted by the debtor company.
The trustee, holding collateral under the original pledge, arranged for a public auction, in accordance with all the terms of the indenture of trust. That auction was widely advertised. It was conducted by Wise, Hobbs & Arnold, who are well-known auctioneers of such property, and bid in by the committee at $112,000, without competition.
Thereafter the committee and the company proceeded to execute the plan. This involved a mass of technical corporate proceedings, carried through with the most careful and intelligent consideration of all questions involved. The net result was to give the noteholders 60 cents in cash and a new promise backed by practically everything the debtor had.
The parent company and its subsidiaries were left free to serve the public that was dependent upon them and to look forward to a return of such economic conditions as would permit the payment of their obligations and a fair return to their stockholders.
In due time a tax return was made for the period covering the transaction which I have briefly described.
It is conceded that the parent company and its subsidiaries constituted an 'affiliated group,' within the meaning of the Revenue Act of 1928, § 141(d), 26 U.S.CA. § 141 note, and as such was entitled to file a consolidated tax return in which the losses of any of the affiliated companies might be set off against the gains of the others, leaving only the balance of net income of the group subject to tax.
Accordingly, a consolidated return was filed for the period in question. A profit of about $2,000,000 was reported for the subsidiary companies, resulting from the sale of properties in August as already described. A loss of about $2,940,000 was reported for the parent company, resulting from the foreclosure sale of its securities pledged to secure the $3,200,000 note issue, already described. The loss of the parent company was set off against the gains of the subsidiaries, showing a net loss of about $900,000 and no tax.
The government refuses to allow the loss claimed by the parent company, and assesses a tax on the profits shown before that deduction. There is no difficulty over the figures. These can be agreed upon without delay. The sole question is whether the parent company suffered a deductible loss.
The government argues that this whole complicated procedure was a subterfuge, conceived and executed by the debtor company for the sole purpose of evading a just tax.
I am unable to accept that conclusion.
The first thought in the minds of everybody was to pay off, or refinance, the notes which fell due June 1, 1931. The bankers anticipated trouble as early as February. The debtor company admitted its condition, and offered to assist. The noteholders' committee was organized in May. There was no tax problem in February and none in May. In the meantime, the bankers, the committee, and the company were busy on the single problem of paying these notes. No tax question arose until August, when the sale of subsidiary properties showed a profit. In my judgment, the tax question which then arose was still incidental to the main objective. It is not denied that after the August sale the possibility of a tax was carefully considered by the company and by the committee. The company hoped to continue operations, and the committee expected to be the company's creditor for some time to come. Any proper reduction in taxes would benefit each of them. I have no doubt that the committee and the company then and there determined to employ any legal means by which taxes could be reduced or avoided, so long as the means employed was consistent with complete protection for the noteholders.
The government argues that the committee was nominated by the company. Such a claim is unjustified. The committee was intelligent and independent. It was friendly without being subservient. The committee knew what it wanted and knew to what extent the company could respond. The company realized that, and its representatives made every possible effort to satisfy the committee. There was no occasion for any show of feeling. A quiet, determined man generally gets more than his boisterous neighbor. This committee got for its noteholders the maximum cash and security obtainable.
The government argues that the sale of the pledged securities, which is the basis of the loss claimed, was unfairly conducted, as a part of the general conspiracy to evade a tax.
The fact is that the sale was conducted in strict compliance with the terms of the indenture. It was advertised in leading papers in Boston, Chicago, and New York, on four different dates. The terms were clear and reasonable. The auction was conducted by a recognized auctioneer in a perfectly normal and fair manner. There was no other bidder than the committee. The reason is obvious, the securities sold were defaulted second mortgages, junior to first mortgages then selling in the open market at about 30 cents on the dollar. These securities had no value, except for trouble-making purposes. The price paid by the committee was $112,000, which under the circumstances was fair. As a matter of fact, had the committee paid a million dollars more, there would still have been a sufficient loss to the company to offset the profits.
The government contends that the company has sustained no loss which can be computed from some closed transaction or identifiable event.
On this issue I find that the company did suffer a clear loss subject to exact computation as a result of the foreclosure sale by the noteholders' committee. This sale, as I have already stated, was conducted in good faith and was entirely beyond the company's control.
Finally, the government argues that this transaction was a reorganization within the terms of the Revenue Act of 1928, § 112, and its subdivisions (26 U.S.C.A. § 112 and note), and, this being such a reorganization, no gains or losses can be recognized. Particular emphasis is laid on section 112(i)(1)(B), 26 U.S.C.A. § 112 note, which defines a reorganization as 'a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred.'
A careful examination has been made of each of the subdivisions of section 112 cited. I find none of them applicable to the facts in this case.
It is perfectly obvious that clause (B), above quoted, has no application, for the company did not transfer the pledged securities to another corporation. They were sold at a public auction to the noteholders' committee.
The company was powerless to control that sale. The sale was a foreclosure sale by the company's creditors, to which it had to submit. The committee properly purchased these securities at the sale, and thereby obtained complete title and control. That sale became a completed transaction, by which the company's loss was definitely determined.
The later transfer of these securities to the new corporation formed by the committee to provide security for the new notes was a distinct and separate transaction.
Conclusion.
This entire transaction was conceived and carried through in the best of faith and with an earnest and intelligent effort to comply with all the terms of the existing tax law. In my judgment, this compliance was complete. There is no just claim for tax against any of the debtor companies. I recommend that all claims be denied. Burton E. Eames and George M. Naylor, Jr., both of Boston, Mass., and Claude M . Houchins, of Washington, D.C. (Tyler, Eames, Wright & Reynolds, of Boston, Mass., of counsel), for Galveston-Houston Electric Co.
Eugene O'Dunne, Jr., Sp. Atty., Bureau of Internal Revenue, Francis J. W. Ford, U.S. Atty., and J. Duke Smith and Arthur L. Murray, Sp. Assts. to U.S. Atty., all of Boston, Mass., and J. E. Marshall, of Washington, D.C., for the United States.
BREWSTER, District Judge.
In the matter of the reorganization of the Galveston-Houston Electric Company and affiliated companies, the government has asserted a claim for income taxes for the years 1931 and 1932 which the debtor has disputed.
The disputed claim was referred to a master, who has filed his report setting forth the essential facts with his conclusion that no taxes are due for these years.
The matter comes before the court upon debtor's motion to confirm the master's report, and has been heard upon the report together with a stipulation respecting additional undisputed facts which the government thought material on the questions of law raised. The stipulation contains the details of the plan of refinancing certain issues of secured notes issued by the principal debtor Galveston-Houston Electric Company. What was done pursuant to the plan is set forth in detail by the master and will not be repeated in this memorandum.
It is clear that in the course of the plan to pay off a part of the issue and refund the balance, both gain and loss resulted. The value of certain securities hypothecated as security for the secured notes had unquestionably decreased in value to an extent sufficient to wipe out any gain that may have resulted from the sale of other assets, the proceeds of which were used to retire 60 per cent. of the issue.
There was a sale of these hypothecated securities at public auction conducted by the trustee holding the securities as collateral. It would naturally be supposed that the extent of the loss could best be fixed by such a sale which the master has found was honestly and fairly conducted and widely advertised. It would seem only fair and equitable that the loss so established be deducted. I have no doubt the debtor is entitled to the deduction, unless it must be held as a matter of law, upon the facts submitted, that the transaction comes within some provision of section 112 of the Revenue Act of 1928 (26 U.S.C.A. § 112 and note). Rose v. Trust Co. of Georgia (C.C.A.) 77 F. (2d) 355; Edison Securities Corporation v. Commissioner, 29 B.T.A. 483.
It is the contention of the government that section 112(b)(4) of the act (26 U.S.C.A. § 112 and note) applies. These provisions are that no gain or loss shall be recognized if a party to a reorganization exchanges property in pursuance of a plan of reorganization solely for stock or securities in another corporation, a party to the reorganization. It is urged that the principal debtor and the new corporation were parties to a 'reorganization,' as that term is defined in subdivision (i)(1)(B) of said section 112 (26 U.S.C.A. § 112 note), which provides that the term 'reorganization' means 'a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred.'
Assuming, for the sake of argument, that all the steps taken by the debtor and its affiliates were part of a single plan to pay off indebtedness in part and refund as to the balance, there was in my opinion no reorganization within the meaning of that term, because the transferor was not in control of the corporation to which the hypothecated securities were transferred by the committee for bondholders who purchased them at the foreclosure sale. As part consideration for the transfer, 2,000 shares were issued to the committee, who still hold them. The fact that later the new corporation issued 32,000 shares to the debtor for other assets does not bring the transactions within the definition of reorganization.
Furthermore, if we assume the old and new corporations were parties to a 'reorganization,' the facts do not warrant the conclusion that there was an exchange of property solely for stock or securities in the new corporation.
The master reaches the conclusion that none of the exceptions of section 112 apply, and with this conclusion I agree. See Bus & Transport Securities Corporation v. Helvering, 296 U.S. 391, 56 S.Ct. 277, 80 L.Ed. 292; Pinellas Ice Co. v. Commissioner, 287 U.S. 462, 53 S.Ct. 257, 77 L.Ed. 428; Helvering v. Ward (C.C.A.) 79 F. (2d) 381.
Helvering v. Minnesota Tea Co., 296 U.S. 378, 56 S.Ct. 269, 80 L.Ed. 284, and John A. Nelson Co. v. Helvering, 296 U.S. 374, 56 S.Ct. 273, 80 L.Ed. 281, are distinguishable. These cases dealt with mergers which came within the definition of a reorganization under clause (A) of section 112(i)(1) of the act (26 U.S.C.A. § 112 note).
The master's report is confirmed, and an order may be entered disallowing the claim of the United States for income taxes for the years 1931 and 1932.