Opinion
Docket Nos. 5980-67 — 5982-67.
Filed August 26, 1969.
Petitioner-corporations received 6-percent cumulative preferred stock in partial consideration for assets transferred to the issuing corporation. Held, the payments made to petitioners with respect to this stock were dividends in reality as well as in form, and consequently, petitioners are entitled to the 85-percent dividends-received deduction under sec. 243, I.R.C. 1954.
Dick L. Lansden and William Waller, for the petitioners.
Charles G. Barnett, for the respondent.
The Commissioner determined deficiencies in income taxes in these consolidated cases in the following amounts: fn2
The parties have agreed that these petitioners are transferees of the assets of Dixie Investment Co. and will be subject to transferee liability for any deficiency found herein attributable to the Dixie Investment Co., Inc.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulations and exhibits attached thereto are incorporated herein by this reference.
Petitioner, Ragland Investment Co. (hereinafter sometimes referred to as Ragland Investment), is a corporation organized under the laws of the State of Tennessee, with its principal place of business in Nashville, Tenn. Ragland Investment timely filed its corporate income tax returns for the taxable years ended December 31, 1964 and 1965, with the district director of internal revenue, Nashville, Tenn. Its legal corporate name had formerly been Ragland-Potter Co. (hereinafter sometimes referred to as Ragland-Potter), but on May 20, 1964, the name was changed to its present denomination of Ragland Investment.
Dixie Investment Co., Inc. (hereinafter sometimes referred to as Dixie), was a corporation existing under the laws of the State of Tennessee prior to its liquidation on or about January 31, 1966. Dixie's principal place of business had been Nashville, Tenn. Dixie timely filed its income tax returns for the taxable year ended April 30, 1965, and for the taxable period ended January 31, 1966, with the district director of internal revenue, Nashville, Tenn. Previously, its legal corporate name had been Cooper Martin, Inc., but on May 20, 1964, the corporate name was changed to Dixie Investment Co., Inc.
Petitioners H. H. Ragland and Elizabeth L. Ragland (hereinafter sometimes referred to as Ragland and Elizabeth, respectively) are husband and wife who at all times pertinent hereto resided in Nashville, Tenn. All of the capital stock of Dixie, at the time of its liquidation (Jan. 31, 1966), was owned by Ragland and Elizabeth, and at the time of its dissolution, all of the assets of Dixie were distributed to the two stockholders.
Malone Hyde, Inc. (hereinafter sometimes referred to as Malone Hyde), is a large, integrated wholesale grocery company with headquarters in Memphis, Tenn. In the fall of 1963, negotiations began which resulted in the purchase by Malone Hyde of the assets of Ragland-Potter Co. and six other corporations — Cooper Martin, Inc.; Cooper Martin, Inc., No. 6; Cooper Martin, Inc., No. 7; Cooper Martin, Inc., No. 8; Cooper Martin, Inc., No. 10; and Cooper Martin, Inc., No. 12. During these negotiations, the sellers were represented principally by Ragland as he and his family were the controlling shareholders of the selling corporations (hereinafter sometimes referred to collectively as the Ragland corporations). Sam J. Moore, Jr., and Thomas W. Goodloe, both of Equitable Securities Corp., negotiated the purchase of the assets by Malone Hyde.
On April 16, 1964, Malone Hyde entered into two contracts, one with Ragland-Potter and one with the Cooper Martin companies, under which Malone Hyde agreed to purchase the net assets of the Ragland corporations. Under the agreements, the consideration required from Malone Hyde for the assets of Ragland-Potter, was $4 million in 6-percent cumulative preferred stock, $100 par value, of Malone Hyde, with the balance of the purchase price paid by certified or official bank check or checks.
The consideration required of Malone Hyde under the agreement with Cooper Martin companies was to be paid in part by Malone Hyde issuing $1 million in 6-percent cumulative preferred stock, $100 par value, with the balance of the purchase price to be paid by certified or official bank check or checks.
Contemporaneously with the execution of the sales agreements between Malone Hyde and the Ragland corporations, the majority stockholders of Malone Hyde executed two letter agreements, one addressed to Ragland as president of Ragland-Potter and one addressed to Robert J. Cooper, president of Cooper Martin, Inc. Both letter agreements had been requested by Ragland in connection with the sale, and were substantially identical. In each letter, the majority stockholders of Malone Hyde agreed that so long as any of the 6 percent cumulative preferred stock of Malone Hyde was outstanding, they would submit to the sellers, or to their successors, detailed annual audit reports showing the net worth of Malone Hyde, and quarterly unaudited financial statements. In addition, not later than 4 years from the closing date of the contracted sale the majority shareholders agreed to take all actions within their power and authority to cause Malone Hyde to redeem all of the 6-percent cumulative preferred stock at par value plus accrued dividends. The shareholders also agreed that they would do everything within their power and authority to prevent Malone Hyde from incurring or assuming any obligations which would have the effect of reducing the consolidated surplus of Malone Hyde and its subsidiaries below $5,500,000 and prevent Malone Hyde from taking any other course of action that might prevent or tend to prevent it from redeeming the 6-percent cumulative preferred stock. The letter agreements further provided that if at any time during the 4-year period the consolidated surplus of Malone Hyde and its subsidiaries should be reduced to an amount below $5,500,000, the sellers could demand in writing that the preferred stock, in whole or in part be redeemed, and that the majority stockholders signing the letter agreements would take all actions within their power and authority to cause said preferred stock to be redeemed at par value plus accrued dividends within 30 days from the date of such demand. In addition, if any transactions involving any of the majority stockholders or any proposed corporate action of Malone Hyde would, upon the consummation thereof, reduce the aggregate ownership of the signatory majority stockholders to less than a majority, written notice would have to be given to the sellers and the sellers would have the right to demand in writing that all or part of the preferred stock be redeemed at par value plus accrued dividends. Also, Ragland was given the power to name two members to the board of directors of Malone Hyde, or to any wholly owned subsidiaries of Malone Hyde to which might be transferred the assets of Ragland-Potter or the Cooper Martin companies, as long as Ragland or any of his corporations owned any of the 6-percent cumulative preferred stock.
At the time the agreements were made, the corporate charter of Malone Hyde did not provide for cumulative voting, so that the holders of more than 50 percent of the shares voting for the election of directors could elect all of the directors if they so chose.
On April 30, 1964, the corporate charter of Malone Hyde, Inc., was amended, among other things, to authorize issuance of $5 million of 6-percent cumulative preferred stock consisting of 50,000 shares with a par value of $100 per share. Further, the charter amendment provided as follows:
(a) 6% Cumulative Preferred Stock. Such 6% Cumulative Preferred Stock (hereinafter called the Preferred Stock) shall be entitled to receive dividends at the rate of 6% per annum, cumulative, payable quarterly out of the earnings of the corporation, and in preference to any dividends upon the Common Stock, and no cash dividends shall be paid upon the Common Stock if the payment of dividends on the Preferred Stock shall be in arrears. Such Preferred Stock shall have no voting rights except as may be provided for in the statutes of Tennessee. In case of the liquidation or dissolution of the corporation, the holders of such Preferred Stock shall be entitled to be paid in full, both the par value of such shares and any dividends accrued but unpaid, before any amount shall be paid to the owners of the Common Stock or Class A Common Stock, both of such latter classes of stock being designated junior to the Preferred Stock. The shares of Preferred Stock shall not be subject to conversion into any other securities of the corporation. The shares of Preferred Stock are subject to call at any time, in whole or in part, upon the payment of the par value thereof and accrued dividends, but no less than 25% of the outstanding issue of such Preferred Stock at the time of such call shall be called and redeemed. Commencing at the beginning of the fifth year after date of issuance, the shareholders of such Preferred Stock shall be entitled to demand of the corporation the creation of an adequate Sinking Fund sufficient to retire 5% of the issue of Preferred Stock in said fifth year, and a like amount in each year thereafter. While such Preferred Stock is outstanding, the corporation will issue no other capital stock prior to or on a parity with such Preferred Stock as to earnings or assets, nor any securities convertible into such stock. While such Preferred Stock is outstanding, no cash dividends will be paid by the corporation on any stock ranking junior to said Preferred Stock as to earnings and assets, nor will any of such stock ranking junior be purchased, redeemed, or retired by the corporation, if the aggregate of such dividends and such other payments would exceed the consolidated net income of the corporation accrued after December 14, 1963, plus the net proceeds of the sale of any such stock ranking junior to said Preferred Stock. None of the foregoing provisions relating to the Preferred Stock may be modified or waived without the consent of the holders of 75% of the outstanding Preferred Stock.
At the time of the trial, Ragland was ill and could not attend. The parties, however, have stipulated that had he been in attendance and testified, his testimony in part would have been as follows:
During the Fall of 1963, negotiations began between * * * [myself] and Thomas W. Goodloe, of Equitable Securities Corporation, and Sam Moore, also of Equitable Securities Corporation, acting for Malone Hyde, Inc., a Tennessee corporation engaged in both wholesale and retail grocery business, with principal office in Memphis. Mr. Goodloe and Mr. Moore were endeavoring to arrive at an agreement under the terms of which Malone Hyde, Inc., would acquire Ragland-Potter Company and the various Cooper Martin companies or their assets. These negotiations culminated in a contract dated April 16, 1964, under the terms of which Malone Hyde, Inc., agreed to and did purchase the assets of Ragland-Potter Company and the Cooper Martin companies.
When the negotiations began, I consulted Mr. J. Marshall Ewing, a tax consultant with offices in the American Trust Building in Nashville, Tennessee, and sought his advice as to the form the transaction should take in the event an agreement was reached, and the mechanics of handling the transaction, with a view of minimizing the tax impact of the sale insofar as I legally could do so. As a result of Mr. Ewing's advice it was decided to sell assets so that I would retain the corporations and so that these corporations could thereafter be operated as personal holding companies. In this way the corporations as a result of the transaction would owe a tax on the gain resulting from the sale of the assets but the stockholders would owe no personal income tax until the liquidation or subsequent sale of the corporate stock. This resulted in the postponing of a substantial amount of capital gains taxes.
Mr. Ewing also advised me that if Malone Hyde, Inc., was not in a position to pay the entire sales price in cash that it would be to the advantage of the selling corporations to take preferred stock rather than a note. As I understand it, this was because of the dividend credit which the corporation would be entitled to in the case of the receipt of dividends on preferred stock, whereas there would be no such credit upon the receipt of interest. During the course of the negotiations the representatives of Malone Hyde suggested that the selling corporations accept a note in part payment of the sale of the assets. This was refused because of tax reasons. Subsequently, when the agreement was finally reached, $1 million of the purchase price of the assets of the Cooper Martin stores [later Dixie] took the form of 6% preferred stock of Malone Hyde and $4 million of the purchase price of the assets of Ragland-Potter was represented by 6% preferred stock of Malone Hyde.
Neither Ragland-Potter Company nor Cooper Martin would have entered into the transaction on the basis of the contracts of April 16, 1964, except for the fact that they would receive preferred stock in part payment of the purchase price and not a note. The sellers would have insisted on a full payment of cash for the purchase rather than accept a note in partial payment.
With regard to these transactions, Ragland's intention was to receive the full purchase price for the assets of his corporations at the earliest possible date that was consistent with favorable tax consequences.
The effective date of the purchase contemplated under the agreements between Malone Hyde and the corporations controlled by Ragland was May 4, 1964. The final consideration received by Ragland-Potter for the sale of its assets to Malone Hyde consisted of 40,000 shares of 6-percent cumulative preferred stock, $100 par value; cash of $3,820,713.86; and liabilities assumed by Malone Hyde of $1,833,181.23. Ragland, as president of Ragland-Potter and also in his individual shareholder capacity, executed a letter representing that the preferred stock was being acquired for investment. Ragland-Potter obtained the written opinion of counsel for Malone Hyde that the preferred stock was validly issued, and that registration thereof was not required under the Securities Act of 1933.
The total consideration paid by Malone Hyde, Inc., for the assets of the Cooper Martin companies consisted of 10,000 shares of 6-percent cumulative preferred stock, $100 par value; cash of $934,756.75; and liabilities assumed by Malone Hyde in the amount of $509,330.90. The Cooper Martin companies, and Ragland and Cooper in their individual capacities as shareholders, executed a letter representing that the preferred stock was being acquired for investment. After the assets of the Cooper Martin companies were sold to Malone Hyde, Dixie Investment acquired all of the securities received by the sellers in that transaction. Dixie Investment obtained the written opinion of counsel for Malone Hyde that the preferred stock was validly issued, and that registration thereof was not required under the Securities Act of 1933.
The board of directors of Malone Hyde periodically passed resolutions authorizing payment of the 6-percent dividends to the holders of the preferred stock. In a letter from the secretary-treasurer of Malone Hyde to the executive vice president of Ragland-Potter, the dividend payments enclosed therein are referred to as "Preferred Stock Dividend Checks." All of the amounts paid as dividends on the preferred stock were charged to surplus, rather than to operations, on the books of Malone Hyde. In addition, Malone Hyde filed Form 1099 information returns with the Internal Revenue Service reporting the amounts paid to the preferred shareholders under the heading of "Dividends and other distributions," instead of the heading entitled "Interest."
During the taxable years ended December 31, 1964 and 1965, Ragland Investment received from Malone Hyde payments totaling $120,000 and $242,666.67 (respectively), and reported them as dividends on its tax returns. Ragland Investment also took deductions for dividends received in the amounts of $102,000 and $206,266.67 for the taxable years 1964 and 1965.
During the taxable year ended April 30, 1965, and the taxable period May 1, 1965, to January 31, 1966, Dixie Investment received payments totaling $45,000 and $45,666.67 (respectively) from Malone Hyde. On its income tax returns, Dixie reported the receipts as dividend income and from these receipts deducted $38,250 and $38,816.67 (respectively), as amounts that represented the dividends received deduction under section 243, I.R.C. 1954.
In Malone Hyde's Federal corporation income tax returns for the taxable years ended June 27, 1964, and June 26, 1965, Malone Hyde did not claim a Federal income tax deduction for interest paid or accrued in regard to the payments made as dividends on the 6-percent cumulative preferred stock.
In Malone Hyde's financial statements and in reports made to shareholders in addition to those filed with the Securities and Exchange Commission, Washington, D.C., the 6-percent cumulative preferred stock issued by Malone Hyde was reported as part of that corporation's equity capital. In substance, the following represents the explanations that were attached to these reports:
All of the 6% Preferred Stock (a total of $5,000,000) was issued in connection with the acquisition of the operating assets of Ragland-Potter Company. No cash dividends may be paid on any stock that ranks junior to this Preferred Stock that will have the effect of reducing the Consolidated Retained Earnings of the Corporation below the sum of $3,991,720, which amount represented the Consolidated Retained Earnings of the Company at December 14, 1963.
The Company is obligated to redeem in its entirety the Preferred Stock at par plus accrued dividends on or before May 4, 1968. Should the aggregate of the Consolidated Retained Earnings and Consolidated Paid-In Surplus fall below $5,500,000, the holder of the Preferred Stock can require the Company to redeem it on thirty days notice. The company has the right to redeem the stock, in whole or in part, at any time at par plus accrued dividends, provided, however, that no partial redemption shall be less than the 25% of the total Preferred Stock outstanding at the time of such redemption.
In November of 1965, Malone Hyde redeemed the 40,000 shares of 6-percent cumulative preferred stock issued to Ragland Investment and at the same time redeemed the 10,000 shares of stock issued to Dixie Investment. In the redemptions, Malone Hyde purchased the stock at the par value ($100 per share) together with accrued dividends computed at the rate of 6 percent per annum to the date of actual redemption.
On its Federal corporation income tax return for the taxable year ended June 25, 1966, Malone Hyde claimed a deduction for interest paid for the payments made in the form of dividends on the 6-percent cumulative preferred stock. In addition, Malone Hyde filed claims for refund for the taxable years 1964 and 1965 based upon the assertion that the amounts paid in those years in the form of dividends in respect of the 6-percent cumulative preferred stock were in fact interest.
At the time of the trial herein, the question involving Malone Hyde's right to an interest deduction for the payments in question for the taxable year 1965 was in a suspended status. For the taxable year 1964, Malone Hyde executed a Form 870-AD in which Malone Hyde reserved the right to file suit in the U.S. District Court for refund of taxes that Malone Hyde claims were overpaid as the result of the corporation's failure to claim an interest deduction for the liability it incurred during that taxable year in regard to the dividends on the 6-percent cumulative preferred stock.
At the time the 6-percent cumulative preferred stock was issued to the Ragland corporations, the officials of Malone Hyde knew that within 4 years its majority shareholders were bound to use their best efforts to have the stock redeemed by Malone Hyde, and so they did not consider the stock in question to be a permanent part of the equity capital of the corporation. The 6-percent cumulative preferred stock did not give the holders thereof any right to convert their stock into any other form of the equity capital of Malone Hyde.
The Commissioner determined deficiencies against petitioners herein based in part on the disallowance of the dividends-received deduction taken by Ragland Investment and Dixie. The Commissioner explained in the deficiency notices that the amounts received "represented interest income * * * rather than dividends, and the dividends received deduction[s] claimed by you * * * [are] not allowable."
ULTIMATE FINDINGS
The 6-percent cumulative preferred stock of Malone Hyde, Inc., represented an equity investment in Malone Hyde and the payments made with respect to it were in fact dividends.
OPINION
This case offers for our determination the familiar issue of whether ostensible dividend payments on preferred stock are, in reality, interest on indebtedness. We are, however, presented with a slightly different twist to the usual factual pattern in that the petitioners here are contending for an equity rather than a debt classification in order to qualify for the 85-percent dividends-received deduction prescribed in section 243(a)(1), I.R.C. 1954. Of course this twist in no way alters the applicable legal principles.
SEC. 243. DIVIDENDS RECEIVED BY CORPORATIONS.
(a) GENERAL RULE. — In the case of a corporation, there shall be allowed as a deduction an amount equal to the following percentages of the amount received as dividends from a domestic corporation which is subject to taxation under this chapter:
(1) 85 percent, * * *
All statutory references are to the Internal Revenue Code of 1954 unless otherwise specified.
Accordingly, we note ab initio that the dividends received deduction, just as other tax deductions bestowed by Congress, exists solely as a matter of legislative grace. It is therefore incumbent upon the petitioners herein to show that the payments in issue are dividends in substance as well as in form. Wetterau Grocer Co. v. Commissioner, 179 F.2d 158, 160 (C.A. 8, 1950), affirming a Memorandum Opinion of this Court; John Wanamaker Philadelphia v. Commissioner, 139 F.2d 644, 646 (C.A. 3, 1943), affirming 1 T.C. 937 (1943).
Although the terms "dividends" and "interest," "stocks" and "bonds" are often used and once had readily discernible boundaries, the provisions of modern security instruments have blurred the traditional benchmarks that once served to distinguish equity capital from indebtedness. In addition, preferred stock by its very nature evidences some of the protective features customarily associated with a debt instrument. Commissioner v. Meridian Thirteenth R. Co., 132 F.2d 182, 186 (C.A. 7, 1942), reversing 44 B.T.A. 865 (1941); Charles L. Huisking Co., 4 T.C. 595, 599 (1945).
In charting these murky waters, the courts have mapped out numerous criteria of distinction to guide them in steering a true course. Such criteria are no more than helpful landmarks along the way. As the Supreme Court has said in considering this problem, "There is no one characteristic * * * which can be said to be decisive in the determination of whether the obligations are risk investments in the corporations or debts." John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946).
The intent of the parties in creating the relationship with the corporation is a highly significant factor in deciding these questions. Gooding Amusement Co. v. Commissioner, 236 F.2d 159, 166 (C.A. 6, 1956), affirming 23 T.C. 408 (1954), certiorari denied 352 U.S. 1031 (1957); United States v. Title Guarantee Trust Co., 133 F.2d 990, 993 (C.A. 6, 1943), and Commissioner v. Meridian Thirteenth R. Co., supra at 186. Lacking sorcery powers to divine the parties' subjective intent, courts must always rely on the overt manifestations thereof, i.e., the parties' acts. Verifine Dairy Products Corporation of Sheboygan, 3 T.C. 269, 276 (1944).
The facts herein reveal that Malone Hyde amended its corporate charter to authorize the issuance of the preferred stock and pursuant thereto issued preferred stock certificates to Ragland Investment and Dixie Investment. The latter two companies demanded and obtained the written opinion of counsel for Malone Hyde that the preferred stock was validly issued. On their own behalf the two companies executed investment intent letters stating that the preferred stock was being acquired by them for investment purposes. The preferred stock dividend payments were periodically authorized by action of Malone Hyde's board of directors, were charged to surplus on its books, and were reported under the heading of "Dividends and other distributions" on Form 1099 information returns filed by Malone Hyde with the Internal Revenue Service.
During the years in issue, the parties consistently, and without exception, referred in a multiplicity of documents, such as the sales agreements, letter agreements, corporate charter amendment, stock certificates, annual reports to shareholders, and various other documents filed with the Securities and Exchange Commission, to the certificates involved as "preferred stock" and the payments with respect thereto as "dividends." Throughout the period commencing with the issuance of the preferred stock and terminating with its redemption, all parties consistently treated the payments in issue as dividends on their tax returns. It was only after the preferred stock was redeemed that Malone Hyde decided to claim a deduction for interest and to file the requisite refund claims. While the foregoing factors showing consistent treatment by the parties may not be determinative of the issue, they do, taken together, constitute highly significant evidence of an intention to create preferred stock. John Wanamaker Philadelphia v. Commissioner, supra at 646-647; Zilkha Sons, Inc., 52 T.C. 607 (1969).
A second important indicium of preferred stock is the provision in the charter amendment that dividends on the preferred stock are "payable quarterly out of the earnings of the corporation" (emphasis supplied). Crawford Drug Stores v. United States, 220 F.2d 292, 296 (C.A. 10, 1955); Commissioner v. Meridian Thirteenth R. Co., supra at 187; and Kingsmill Corporation, 28 T.C. 330, 336-337 (1957). A requirement that corporate distributions be made only out of earnings is a traditional requirement for dividend payments. In contrast, a bondholder or other creditor normally has a legally enforceable right to the payment of interest irrespective of the availability of current or accumulated earnings.
Thirdly, the charter amendment provides that in the event of the liquidation or dissolution of Malone Hyde, the preferred shareholders take priority only over the holders of the common stock, and it follows that they are not entitled to share in the assets on a parity with secured and general creditors. This element is an indispensable feature of stock under Tennessee law. Furthermore, this feature is clearly characteristic of a stockholder relationship rather than the more secure position of a creditor. John Wanamaker Philadelphia v. Commissioner, supra at 647; First Mortgage Corp. v. Commissioner, 135 F.2d 121, 125 (C.A. 3, 1943); Affiliated Research, Inc. v. United States, 351 F.2d 646, 649 (Ct.Cl. 1965).
Tenn. Code Ann. see. 48-203. Equality of no par shares — redemption provisions — preference in dividends and liquidation. — * * * any class or classes of stock may be preferred as to its or their distributive share or shares of the assets of the corporation upon dissolution; but, in case of insolvency, the debts and other liabilities of the corporation shall be paid before any payment or distribution is made to the holders of any class of stock. * * *
In John Wanamaker Philadelphia v. Commissioner, for example, the court said at p. 647 "the most significant characteristic of a creditor-debtor relationship — [is] the right to share with general creditors in the assets in the event of dissolution or liquidation."
Finally, the preferred shareholders were represented from the outset by two members on Malone Hyde's board of directors. The conferral of a voice in corporate management without an operative act of default with respect to the corporate instrument involved is representative of a stockholder status. Zilkha Sons, Inc., supra; and Ernst Kern Co., 1 T.C. 249, 271 (1942).
If we include the letter agreements between the majority stockholders of Malone Hyde and the sellers as part of the controlling documents, the stock in issue does assume some of the characteristics of a "hybrid" security. These agreements provide that the majority shareholders agree to "take all actions within their power and authority" to cause Malone Hyde to redeem the preferred stock within 4 years from issuance. Respondent urges that this, together with the other protective provisions contained in the letter agreements, amounts to a guarantee of redemption at a fixed maturity date. A fixed maturity date is, of course, a usual provision in a debt instrument.
With respect to the significance in these cases of a power to force redemption, we note the statement in 11 Fletcher, Cyclopedia Corporations, sec. 5310, that "As a rule, the stockholder's right to compel a redemption is subordinate to the rights of creditors," citing, among others, Schneider v. Mingenback, 139 F.2d 86 (C.A. 10, 1943), in support of said statement.
However, we note that redemption of the preferred stock is contingent upon, among other things, the availability of corporate funds for this purpose, the retention of majority control, and continued willingness to redeem on the part of the signing shareholders. The fact that the parties saw fit to include in the charter amendment a provision for the creation of a sinking fund at the beginning of the fifth year after issuance would seem to indicate tacit recognition on their part that some contingency may well prevent redemption within the initial 4-year period.
Moreover, we deem it significant that the corporation, as distinguished from some of its shareholders in their individual capacities, is not obligated to redeem the preferred stock. As was said in Northern Refrigerator Line, Inc., 1 T.C. 824, 829-830 (1943), in a similar situation wherein a third-party corporation guaranteed payment of dividends and ultimate redemption of certain preferred stock:
Apparently its theory is that this contract gives to the preferred stockholders that security of payment at all events, without regard to the existence or extent of a corporate surplus or earnings, which is a feature of the debtor-creditor relationship. But that security of payment springs not from their relationship with petitioner, but from the contract of guaranty executed by another corporation, the holder of the common stock. It is too well settled to require much emphasis here that a contract of guaranty is an undertaking separate and distinct from the principal obligation. The debtor is not a party to the guaranty, and the guarantor is not a party to the principal obligation, and there is no privity between them. * * * The right of the preferred stockholders to demand payment from petitioner upon maturity is still dependent upon petitioner's ability to pay without impairment of its capital. The fact that the stockholders may then look to and enforce payment by another does not affect the character of their relationship with petitioner. [Emphasis added; citations omitted.]
Clearly the failure to redeem here would not result in a cause of action against Malone Hyde. In contrast, the holder of a debt instrument normally has prescribed remedies available to him upon an act of default by the debtor. Parisian, Inc. v. Commissioner, 131 F.2d 394 (C.A. 5, 1942), affirming a Memorandum Opinion of this Court.
In any event, even assuming arguendo the existence of a fixed maturity date, that factor alone, while relevant, is not conclusive. Milwaukee Suburban Transport Corporation v. Commissioner, 283 F.2d 279, 282-283 (C.A. 7, 1960), affirming a Memorandum Opinion of this Court on this point, certiorari denied 368 U.S. 976 (1962); Charles L. Huisking Co., supra at 599.
One final consideration influences our decision. Prior to engaging in this transaction, the parties entered into protracted arm's-length bargaining concerning the form the transaction should take with full awareness that a tax advantage to one would result in a concomitant tax disadvantage to the other. Of course, as respondent freely admits, the parties to the transaction were free to minimize their taxes within the framework of the law. Gregory v. Helvering, 293 U.S. 465 (1935), and Kraft Foods Co. v. Commissioner, 232 F.2d 118, 127-128 (C.A. 2, 1956), reversing 21 T.C. 513 (1954). It is our view that, given a transaction where the contract is negotiated between parties with conflicting tax interests and where the resultant document sets forth duties and obligations which conform to the business or economic realities of the situation, this Court should not take upon itself the task of recasting the agreement. Rather, under such circumstances, we are inclined to leave the parties to live up to their own agreement.
Therefore, having carefully weighed the foregoing factors, we conclude that the indicia of the preferred stock clearly predominate. Consequently, we hold that the petitioners are entitled to the 85-percent dividends-received deduction claimed by them for the taxable years in issue.
Reviewed by the Court.
Decisions will be entered for the petitioners.
HOYT, J., dissents.
The majority apparently is willing to accept the labels attached by the parties to the payments in question as determinative of the tax consequences — i.e., the parties to a business transaction can determine between themselves which party the Government shall tax. This is nonsense. Even though every "i" is dotted and every "t" is crossed, this "opens questions as to the proper application of a taxing statute; it does not close them." Bazley v. Commissioner, 331 U.S. 737, 741; 2554-58 Creston Corp., 40 T.C. 932.
Here the Commissioner determined that the so-called preferred dividends were not dividends but interest. Unquestionably the burden is on petitioner to prove otherwise.
Despite the careful terminology used by Malone Hyde and Ragland in the basic contract and the instruments issued ("preferred stock"), was it really "preferred stock"? Certainly the Commissioner is not bound by labels. Even Malone Hyde had doubt about what they had done taxwise. They first treated the questioned payments as dividends, then reversed the field and claimed them as interest. Of course Ragland stuck to its guns — we set the deal up this way deliberately (no question about it) and the Commissioner is stuck with it (anyone is privileged to minimize taxes). But how can parties to a contract bind the Commissioner, who is not a party, especially when one party to the contract is not itself sure as to the tax nature of the creature spawned by the contract?
Ragland wanted to sell its assets. Malone Hyde wanted to buy. A price of $5 million was determined. How was payment to be made? All cash probably could have been raised. Or part cash and a note? No, Ragland's tax advisers said, part cash and preferred stock, more advantageous from a tax standpoint. Well, I want my money shortly, says Ragland. O.K., the controlling stockholders of Malone Hyde say, we will do that, and agree to use our best efforts to have the preferred stock redeemed within four years. (The stock was in fact redeemed in 18 months.) Malone Hyde's tax advice apparently was equivocal as to the effect of the transaction. At any rate, Malone Hyde claimed no deduction as interest for payments made to Ragland with reference to the stock until after Ragland's preferred stock was redeemed and the majority stockholders of Malone Hyde had satisfied their obligation to Ragland. A very short time indeed in which to record a mind change, if the suspicion that a change was not in mind from the beginning.
I would conclude the securities in question were merely a short-term means of financing the purchase of assets and that the characteristics of debt outweigh the characteristics of an investment in the stock of Malone Hyde. The questioned payments were interest on deferred purchase price and not true dividends.
RAUM, DAWSON, and HOYT, JJ., agree with this dissent.
I agree with Judge Tietjens' conclusion, but as the author of the opinion in Zilkha Sons, Inc., 52 T.C. 607 (1969), I wish to add my comments. Based on the facts of this case, I would conclude that the securities acquired by the sellers in substance more resembled a debt than stock. In selling the businesses, the sellers were willing to agree to defer part of the purchase price. However, they wanted to receive earnings on the deferred part of the purchase price, and they wanted to receive full payment within a relatively short time — 4 years. As a result of the agreement made with the shareholders of the purchaser, the sellers were assured that they would receive the desired earnings and the desired repayment. They did not assume the risks of a shareholder. Compare Zilkha Sons, Inc., supra.
TIETJENS, DAWSON, and HOYT, JJ., agree with this dissent.