Summary
recognizing a "close scrutiny" standard, but finding it "unwarranted to apply legalistic and mechanical tests, in the area of parent-subsidiary relationships, without regard to the realities of the business world and the manner in which transactions are handled in the normal and ordinary course of doing business"
Summary of this case from Pepsico P.R., Inc. v. CommissionerOpinion
Docket No. 5969-65.
1968-02-29
MALONE & HYDE, INC., OF MISSOURI, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
W. Stuart McCloy, for the petitioner. Charles G. Barnett, for the respondent.
W. Stuart McCloy, for the petitioner. Charles G. Barnett, for the respondent.
Petitioner was organized as a wholly owned subsidiary to take over an area of existing business of its parent. The parent furnished capital to cover a large portion of petitioner's fixed assets and advanced funds on open account initially without, but in the years involved herein with, interest to cover petitioner's inventory requirements. Petitioner's operations were highly successful. Held, under all the circumstances, the advances represented bona fide indebtedness and the interest paid was a proper deduction.
TANNENWALD, Judge:
Respondent determined the following deficiencies in petitioner's income tax:
+--------------------------------+ ¦Fiscal year ended ¦Deficiency ¦ +-------------------+------------¦ ¦June 24, 1961 ¦$3,380.00 ¦ +-------------------+------------¦ ¦June 30, 1962 ¦2,255.98 ¦ +-------------------+------------¦ ¦June 29, 1963 ¦13,884.00 ¦ +--------------------------------+
The only issue for decision is whether certain advances to petitioner by its parent corporation constituted a bona fide debt or a contribution to capital.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Petitioner, Malone & Hyde, Inc., of Missouri, had its principal place of business in Sikeston, Mo., at the time of the filing of the petition herein. It filed its corporate income tax returns for the fiscal years ended June 24, 1961, t rough June 29, 1963, with the district director of internal revenue, St. Louis, Mo.
All of petitioner's issued and outstanding stock is and, since its incorporation in 1955, has been owned by Malone & Hyde, Inc., which has its principal place of business in Memphis, Tenn.
Both petitioner and its parent are engaged in the wholesale distribution of foods and related products to independent retail grocers. Their sales are for the most part carried out on the basis of cash payment at the time ordered are placed by their customers. A variety of other services (i.e., financing, planning of store construction and operation, and aid in setting up advertising programs) is also furnished to customers. The operations of the parent and petitioner have been highly successful.
Prior to 1955, the parent carried on a business of approximately $3 million in sales annually, with a substantial number of customers in Missouri, which it serviced and supplied directly from Memphis. Because of the distance of this area from the Memphis warehouse, it decided that operations would be more efficient if a warehouse were established in an appropriate location in Missouri. Accordingly, in 1955, the parent organized petitioner to operate a warehouse in Sikeston and to supply and service customers in the Missouri area. Petitioner commenced business in January 1956. Except for its Memphis operation, the parent customarily carried on warehousing and sales to independent grocers through subsidiaries.
The warehouse, which was subsequently enlarged, was leased from an unrelated third party. Petitioner itself initially acquired and owned $89,698
of various leasehold improvements, warehouse equipment, automobiles, trucks, and office furniture and equipment. Its beginning inventory was approximately $400,000.
This is the original cost reflected on the petitioner's balance sheet as of June 23, 1956. The record does not disclose the portion of this figure which represents acquisitions between January and June.
The parent paid $50,000 for all of petitioner's issued and outstanding stock. It is also advanced approximately $400,000 in the form of cash and inventory in kind. The parent's decision to allocate $50,000 to petitioner's capital and the balance to advances was made after careful consideration of all factors anticipated in petitioner's operations. The management of the parent was experienced and regarded as highly competent. The parent continued to make advances needed, either in cash or in sales of inventory on credit. During the period from January 1956 to June 1957, the parent made additional advances and petitioner made some payments. The net amount of advances was $471,048 as of June 23, 1956, and $345,000 as of June 29, 1957.
During the fiscal year ended June 28, 1958, the advances were divided into two accounts on the books of the parent and petitioner, one representing long-term advances and the other representing short-term credit on current sales of merchandise by the parent to petitioner. Petitioner would pay off the charges to the latter account as accounts payable in the normal course of business. As of the end of the 1958 fiscal year, the long-term advances totaled $345,000.
During the fiscal year ended June 27, 1959, the parent advanced an additional $100,000 on a long-term basis. The parent made no additional long-term advances and petitioner made no repayments of such advances until the fiscal year ended June 27, 1964, when petitioner repaid $300,000 to the parent. In the fiscal year ended June 26, 1965, the parent again advanced an additional $100,000. The long-term advances amounted to $445,000 as of the close of the 1959 through 1963 fiscal years, $145,000 as of June 27, 1964, and $245,000 as of June 26, 1965.
During the fiscal year ended June 24, 1961, the parent contributed $100,000 in order to have petitioner's capital more in keeping with the size of its business.
The parent financed petitioner in the same way as it financed its other subsidiaries. None of the subsidiaries could borrow on its own initiative, all financing being provided, or arranged for, by the parent.
All advances were carried on open account on the books and records of both the parent and petitioner. No notes or other formal evidence of indebtedness were given, nor were the advances secured in any fashion. No maturity date or rate of interest was specified. The advances were not subordinated to the claims of other creditors. The parent and petitioner at all times expected that the advances would be repaid.
No interest was paid on the advances prior to the fiscal year ended June 27, 1959, when the parent, for the first time, imposed a charge on the advances at a flat rate of $500 per 4-week period. Because this charge was not commenced at the beginning of the fiscal year, only $4,500 was paid during that year. In each of the fiscal years ended June 25, 1960, June 24, 1961, and June 30, 1962, petitioner paid its parent $6,500 representing these charges. In the fiscal year ended June 29, 1963, the method of computing the payments were changed at the suggestion of a new accountant hired by petitioner's parent. In that year, petitioner paid the parent $26,700 representing ‘interest’ of 6 percent of the outstanding long-term advances.
One reason for the change was that the parent was borrowing funds necessary for advances to its subsidiaries and it was felt that ‘interest’ should be charged to petitioner and used to offset the interest charges of the parent.
Petitioner's business grew beyond all expectations, its net sales increasing from $5,199,604 during the fiscal year ended June 29, 1957, to $15,521,008 during the fiscal year ended June 29, 1963. Its inventory increased from $431,355 to *889,625 and its inventory-turnover ratio from 11.65 to 18.28 during the same period. At all times, its current assets exceeded its total liabilities, including the amount of the advances owed to the parent, except for a minor deficit in this respect during the first fiscal year.
Retained earnings of the petitioner increased from $3,444 at the close of its 1956 fiscal year to $364,898 at the close of its 1963 fiscal year.
In fiscal 1956, current assets were $495,107 and the aggregate of liabilities and advances by the parent was $525,071.
ULTIMATE FINDING OF FACT
The advances by the parent to petitioner represented bona fide indebtedness and not equity capital and the payments involved herein constitute deductible interest.
OPINION
The sole issue for our consideration is whether certain advances to petitioner by its parent corporation and sole stockholder constituted debt or equity capital. If the advances were equity, the interest deductions claimed herein are not allowable.
We see no need to attempt to match the facts in this case to the detailed and varied criteria utilized by the decided cases in determining whether an advance is debt or equity; in the final analysis, the issue is one of fact and the burden of proof is on petitioner. E. G., John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946); Gooding Amusement Co. v. Commissioner, 236 F.2d 159 (C.A. 6, 1956), affirming 23 T.C. 408 (1954); Cohen v. Commissioner, 148 F.2d 336 (C.A. 2, 1945). Instead, we will simply outline the particular elements herein which lead us to conclude that the advances in question constituted bona fide indebtedness.
We start from the premise that arrangements between a parent corporation and its wholly owned subsidiary ‘invite close scrutiny.’ See Kraft Foods Co. v. Commissioner, 232 F.2d 118, 123 (C.A. 2, 1956). At the same time, we think it unwarranted to apply legalistic and mechanical tests, in the area of parent-subsidiary relationships, without regard to the realities of the business world and the manner in which transactions are handled in the normal and ordinary course of doing business. See Byerlite Corporation v. Williams, 286 F.2d 285, 294 (C.A. 6, 1960).
The parent corporation was engaged in the wholesale grocery business. It organized petitioner to take over an existing nucleus of that business. Petitioner's task was to consolidate and expand that nucleus rather than to venture into an unexplored market. The business risk was minimal.
The parent, after careful consideration, estimated that petitioner would need $50,000 in capital to acquire fixed assets. As it turned out, this was short of the $90,000 which petitioner actually invested in such assets in the early months of its existence, but we are not impelled to penalize petitioner on this account alone, particularly since, by the first taxable year before us, the parent had increased its capital investment in petitioner to $150,000. The great bulk of the parent's advances were for current assets, i.e., petitioner's inventory requirements. Given the high turnover rate, the inventory was extremely liquid and reflected full market value. Except for a minor variation in petitioner's first fiscal year, its current assets at all times exceed the combined total of the parent's advances and its liabilities to other parties. Under such circumstances, there is not doubt that the indebtedness to the parent could have been readily paid off in full at any time. That it was not so liquidated is simply the result of petitioner's fast-growing sales operations which required a constantly increasing inventory.
Both petitioner and the parent always considered the advances as indebtedness and their books and records clearly reflected this intention. The parent and the petitioner at all times expected the advances to be repaid and this expectation was clearly reasonable under the circumstances. Respondent argues that lack of formal evidence of the indebtedness, absence of interest in the early years, lack of security, and the fact that unrelated person would be unlikely to loan money on the same basis,
require a holding that the advances were in the nature of equity. We think that respondent's assertions in this regard are misdirected in the context of this case.
Obviously, such a loan would have required the payment of interest. The executive vice president of the First National Bank of Memphis testified that the bank would have charged interest at one-half point above the prime rate. He also testified that the bank would have loaned the same amount either on a revolving credit or 2-year term unsecured, unsubordinated basis, and would not have required a guarantee from the parent or the maintenance of cash accounts with the bank. He indicated that ‘perhaps' the bank would have asked the parent to execute a repurchase agreement on the inventory, but that such an agreement would not be too important because of the ready convertibility of petitioner's inventory into cash. Such a repurchase agreement clearly would have been a meaningless and unnecessary requirement for the parent to have imposed.
Under all the circumstances, we are not disposed to second guess the parties as to how the advances, by means of which the parent bankrolled the petitioner's inventory, should be treated. On the basis of the entire record before us, we think respondent improperly characterized the advances as equity and that the interest deductions should have been allowed. Byerlite Corporation v. Williams, supra; Jack Daniel Distillery v. United States, 379 F.2d 569 (Ct. Cl. 1967); Waterman Steamship Corporation v. United States, 203 F. Supp. 915 (S.D. Ala. 1962), reversed on other issues 330 F.2d 128 (C.A. 5, 1964), affd. 381 U.S. 252 (1965); Edward Katzinger Co., 44 B.T.A. 533 (1941), affd. 129 F.2d 74 (C.A. 7, 1942).
To reflect the concessions of the parties on other issues,
Decision will entered under Rule 50.