Before BIGGS, MARIS and GOODRICH, Circuit Judges.
This is a petition for review of a decision by the Tax Court. The Commissioner, respondent here, has determined certain deficiencies in income and excess profits taxes for 1936 and 1937 against Okonite, petitioner here. The Tax Court found in favor of the Commissioner, following full finding of facts and an opinion thereon. 4 T.C. 618. Only such facts will be stated here as are necessary to show the legal points presented by the taxpayer to this Court.
In 1927, Okonite issued and sold $2,000,000 face amount of 15-year 5 1/2 percent debentures and $1,000,000 par value of 7 percent cumulative preferred stock. The terms under which debentures and stock were issued required Okonite to pay into a sinking fund sums sufficient to retire annually at least 3 1/2% ($70,000) of the bonds and at least $40,000 of preferred stock.*fn1
In 1934, Okonite was, in the words of the Tax Court, "feeling the effects of the depression." It had operated at a loss for three years and was being drained of cash by the sinking fund requirements. It therefore proposed a plan to modify the sinking fund provision for the bonds. Acceptance of the plan was optional with the holders. In that year 77.2% of the debentures were deposited to evidence acceptance, enough to render the plan operative.The new bonds carried a rate of 6%. For those who did not assent, and there were some, the terms of the old 5 1/2% bonds remained in effect. The provisions of the plan are set out by the Tax Court. In essence the 1934 arrangement eased the requirements of the 1927 sinking fund provisions for bonds.
In 1936, the first of the tax years in question, Okonite, seeking to comply with sinking fund requirements, purchased $99,500 face value of the 6% bonds and $5000 face value of the 5 1/2% bonds. The next year, for the same purpose, it bought $93,000 face amount of 6% bonds and $3,500 of 5 1/2% bonds. So far as the 6% bonds of 1934 were concerned there was no deficiency in either 1936 or 1937. With respect to the 5 1/2% bonds of 1927, however, while there was no deficiency at the end of 1937, the Tax Court found, "there remained a deficiency of $14,000 in the sinking fund at the end of 1936."
So much for the relevant history of Okonite bonds. The other set of legally significant facts has to do with its preferred stock.
In the spring of 1936, dividends on the preferred stock were unpaid and in arrears by $31.50 per share. Furthermore, the Tax Court found that "The company was also in arrears on the sinking fund requirements on the preferred stock and was short of cash." It will be recalled that the preferred stock issued in 1927 carried a minimum sinking fund provision of $40,000 annually. This preferred stock had a 7% cumulative dividend rate*fn2 and a call provision at $115 per share, "plus all unpaid dividends, whether or not earned or declared, to the date of redemption thereof." On August 17, 1936, a dividend of $1.50 a share was declared on the preferred stock. Within a short time in the same year, Okonite's certificate of incorporation was amended to permit adoption of a plan "whereby the dividends arrears on the preferred stock would be eliminated". The latter fact finding by the Tax Court renders clear the motivation and nature it attributed to the 1936 plan and shows, we think, a statement of corporate purpose. See Bazley v. Commissioner, 3 Cir., 1946, 155 F.2d 237.
Under the 1936 corporate amendment, a new class of 11,000 shares of $100 par value 6% preferred stock, in addition to preferred and common then outstanding, was authorized. Dividends on the new 6% preferred were to be cumulative and prior to common. The new preferred was callable at $105, plus all unpaid dividends. Sinking fund requirements were to be an amount equal to 10% of net income after certain deductions.
Toward the close of 1936 the plan*fn3 became effective since 6,824 shares out of a total of 6,952 outstanding had been turned in to be exchanged, retired and cancelled.The following provision contains the language which is the basis for taxpayer's most heavily pressed argument in this Court: "to each holder of said stock the right to exchange each share of his seven per cent preferred stock of the Company for one share and 15/100ths of a share of the Company's new six per cent preferred stock, plus an extra dividend on each share of his seven per cent stock of one-tenth of a share of the Company's new six per cent preferred stock and in connection with such exchange, to receive in payment of all arrears of dividends up to and including the quarterly dividend period ending September 1, 1936, on each share of the seven per cent preferred stock exchanged as aforesaid, a stock dividend of three-tenths (3-10ths) of a share of new six per cent stock of the Company at par."
The small amount of remaining outstanding 7% stock was retired, part in 1936, the residue in 1937, by payment of the accumulated dividends and calling it at the stipulated price. Dividend and sinking fund requirements for the 6% stock were met by the Company for 1937.
Tax Effect of Preferred Stock Transaction.
The first legal issue with which we are concerned arises from the terms of the 1936 plan. Did that transaction involve a taxable stock dividend which Okonite could take as a dividends paid credit or was it a non-severable recapitalization and therefore included in the type of statutory reorganization for which no credit for dividends paid could be taken by the corporation? Okonite contends for the former view while the Commissioner, with whom the Tax Court agrees, maintains the latter.
Okonite relies upon section 27(e) of the Revenue Act of 1936, 26 U.S.C.A. Int. Rev. Acts, page 837, and maintains that four tenths of each share of new 6% stock was a taxable dividend to the shareholders. The Commissioner relies on section 112(b) (3) and section 27(h), 26 U.S.C.A. Int. Rev. Acts, pages 838, 855, maintaining that 7% stock was exchanged for 6% stock and that the distribution of the new stock was not a taxable transaction to the shareholders. The pertinent portions of the statutes involved are set out in the margin.*fn4 There can be no argument that a recapitalization is within the statutory definition of a reorganization.*fn5 Nor is there dispute that there was a recapitalization at least to the extent of the exchange of 1.15 shares of the new 6% stock for each share of old 7% stock. May the ...