Bateman v. Commissioner

William H. Bateman and Annabelle P. Bateman, Petitioners, v. Commissioner of Internal Revenue, Respondent

Docket No. 93310

United States Tax Court

40 T.C. 408; 1963 U.S. Tax Ct. LEXIS 114;

May 27, 1963, Filed

*114

Decision will be entered under Rule 50.

Upon the merger of two corporations, petitioner exchanged his common stock in one for common stock and common stock purchase warrants in the surviving corporation. The merger was a tax-free reorganization within the provisions of section 368(a), I.R.C. 1954. Held:

1. The warrants were not stock within the meaning of section 354(a)(1), I.R.C. 1954, and therefore constituted "other property" within the meaning of section 356(a), I.R.C. 1954.

2. The exchange did not have the effect of the distribution of a dividend under the provisions of section 356(a)(2), I.R.C. 1954.

Sydney C. Winton and Sherwin Kamin, for the petitioners.

Alvin C. Martin, for the respondent.

Scott, Judge.

SCOTT

*408 OPINION

Respondent determined a deficiency in petitioners' income tax for the calendar year 1958 in the amount of $ 11,212.36.

The issues for decision are:

(1) Should gain to petitioners be recognized under the provisions of section 356(a)(1) of the Internal Revenue Code of 1954 to the extent of the fair market value of common stock purchase warrants of the Symington Wayne Corp. which were received by William H. Bateman in addition to common stock of that corporation *115 in exchange for common stock of the Wayne Pump Co. upon its merger into Symington Wayne Corp.?

(2) Did the exchange have the effect of the distribution of a dividend within the meaning of section 356(a)(2) of the Internal Revenue Code of 1954?

*409 All of the facts have been stipulated and are found accordingly.

William H. Bateman and Annabelle P. Bateman, husband and wife, residing in Salisbury, Md., filed a joint income tax return on the cash basis of accounting for the calendar year 1958 with the district director of internal revenue, Baltimore, Md. On March 12, 1958, William H. Bateman (hereinafter referred to as petitioner) was the owner of 7,350 shares of common stock of the Wayne Pump Co. which he had acquired more than 6 months prior to that date. The Wayne Pump Co. was a Maryland corporation incorporated in 1928. Its only class of outstanding stock on March 12, 1958, was common stock. On March 12, 1958, the Wayne Pump Co. was merged into the Symington-Gould Corp. Symington-Gould Corp., the surviving corporation upon the merger with its name changed to Symington Wayne Corp., was a Maryland corporation incorporated in 1924. The only class of stock of Symington-Gould Corp. outstanding *116 at the date of the merger was common stock. The merger was a tax-free reorganization within the terms of section 368(a) of the Internal Revenue Code of 1954 to which both the Wayne Pump Co. and Symington Wayne Corp. were parties.

Pursuant to the terms of the merger, each shareholder of the Wayne Pump Co. was entitled to receive 2 1/4 shares of Symington Wayne Corp. common stock and one stock purchase warrant for each share of the Wayne Pump Co. stock surrendered. The warrants were assignable and each warrant entitled the holder, subject to the conditions stated therein, to purchase 1 share of common stock of Symington Wayne Corp. at any time during the 10-year period from June 1, 1958, to May 31, 1968, at $ 10 per share if purchased before June 1, 1963, and at $ 15 per share if purchased thereafter. The corporation was required to reserve from its authorized and unissued common stock a sufficient number of shares to provide for the then outstanding warrants. The provisions of the merger agreement with respect to the warrants were set forth in substance on the face of the stock-purchase warrant certificates and were in part as follows:

Notwithstanding any other provisions hereof, in *117 the event of the liquidation, dissolution or winding up of the affairs of the Corporation (excluding any merger or consolidation), the right to exercise the Warrants shall terminate at the close of business on the fourth full business day before the earliest date fixed for the payment of any distributable amount on the Common Stock of the Corporation. At least 30 days' notice of such payment date shall be given to the registered holders of the Warrants determined as of the date of notice.

In the event that:

(a) The shares of Common Stock at any time outstanding shall be subdivided, by reclassification, recapitalization or otherwise, into a greater number of shares without the actual receipt by the Corporation of any consideration for the additional number of shares so issued, or the Corporation shall declare a dividend on Common Stock payable in Common Stock, or the number of shares *410 of Common Stock at any time outstanding shall be reduced, by reclassification, recapitalization, reduction of capital stock or otherwise; or

(b) The outstanding shares of Common Stock shall be reclassified or changed other than in a manner referred to in clause (a) of this paragraph; or

(c) The Corporation*118 shall merge or consolidate with or into another corporation or shall sell its property as an entirety or substantially as an entirety, the number of shares issuable upon the exercise of Warrants shall be adjusted, to the nearest one-hundredth shares of Common Stock, so that each holder of Warrants then outstanding shall have the right thereafter, so long as the right to exercise same shall exist, to purchase the kind and amount of securities or property, if any, which the holder would have received had the Warrants been exercised in the same manner and to the same extent immediately prior to any such event. In the event that any adjustment results in the inclusion of a fraction of a share, no fractions of shares of Common Stock shall be issued upon the exercise of Warrants, but in lieu thereof the Corporation shall pay cash based on current market values as determined by resolution of the Board of Directors of the Corporation or by the Treasurer of the Corporation pursuant to such resolution (which determination shall be conclusive). Upon each such adjustment pursuant to this paragraph, a computation and summary thereof shall be filed by an officer of the Corporation at the office *119 of the Warrant Agent.

In the event that the Corporation shall offer any shares of Common Stock, or securities convertible into Common Stock to the holders of the Common Stock as a class for subscription, each registered holder of Warrants then outstanding shall have the same right to subscribe for the same number of shares of Common Stock or amount of such securities, within the same period of time, and at the same price, as he would have been entitled to subscribe for had the Warrants been exercised immediately prior to any such event. The date for the determination of registered holders of Warrants entitled to such subscription rights shall be the same as the record date for the determination of the holders of Common Stock entitled thereto.

Until the valid exercise of the Warrants represented hereby the holder hereof as such shall not be entitled to any rights of a stockholder of the Corporation.

Pursuant to the terms of the merger, petitioner on March 12, 1958, received 16,537 shares of common stock of Symington Wayne Corp. and 7,350 stock purchase warrants in exchange for his 7,350 shares of common stock of the Wayne Pump Co.

On March 12, 1958, the fair market value of each of the *120 7,350 warrants received by petitioner in the exchange was $ 2.875 making a total fair market value of $ 21,131. Since March 13, 1958, the stock purchase warrants have been traded on the American Stock Exchange.

On March 12, 1958, the fair market value of each of the 16,537 shares of common stock of Symington Wayne Corp. received by petitioner in the exchange was $ 8.375 making a total fair market value of $ 138,497.38. Prior to the merger the stock of both the Symington-Gould Corp. and the Wayne Pump Co. was traded on the New York Stock Exchange and since the merger the stock of Symington Wayne Corp. has continued to be traded on the New York Stock Exchange.

*411 The cost and basis of the 7,350 shares of the Wayne Pump Co. common stock in the hands of petitioner was $ 82,400.

For the purpose of section 356(a)(2) of the Internal Revenue Code of 1954, ^1*121 petitioner's ratable share, at the time of the merger, of the undistributed earnings and profits of the Wayne Pump Co. accumulated after February 28, 1913, was in excess of $ 21,131, the fair market value on March 12, 1958, of the warrants received by petitioner.

On March 12, 1958, the earned surplus and undivided profits of the Wayne Pump Co. accumulated after February 28, 1913, was $ 6,654,386.

Petitioner sold 4,000 of his 7,350 warrants during the period from September 22 to October 9, 1958, for a total of $ 28,437.50.

Petitioner attached to his income tax return for the calendar year 1958 an "Appendix A," which he entitled "Statement Required By Income Tax Reg. 1.368-3(b)," in which he set forth the fact of his exchange of his stock in the Wayne Pump Co. for stock and stock purchase warrants in Symington Wayne Corp. Petitioner reported no gain from this exchange. On his return petitioner reported a long-term capital gain in the amount of $ 21,894 from the sale of 4,000 warrants of Symington Wayne Corp. which amount was the difference between a sales price of $ 28,438 and basis of $ 5,937.

Respondent in his notice of deficiency increased petitioner's ordinary income as reported by $ 21,131, denominated as dividend income, with the following explanation:

It is held that on the exchange of 7,350 shares of Wayne Pump Company stock for 16,537 shares of Symington Wayne Corporation stock and 7,350 warrants to purchase additional shares *122 of Symington Wayne Corporation stock gain is recognized to the extent of the fair market value of the warrants received. It is further held that the gain recognized is taxable as a dividend. Since the fair market value of the warrants received by you was $ 2.875 each, your taxable income is increased in the amount of $ 21,131.00 (7,350 X $ 2.875).

Respondent in his notice of deficiency decreased the long-term capital gain as reported by petitioner by $ 2,781 as a result of using as a basis for the 4,000 warrants sold by petitioner the far market value of those warrants on the date of issue plus the expense of sale instead of the basis claimed by petitioner. Respondent computed petitioner's dividends-received credit by including in dividends received to which the 4-percent credit was applied, the $ 21,131 representing the fair market value of the warrants on March 12, 1958.

Petitioner contends that the stock purchase warrants he received constitute "stock or securities" within the meaning of section *412 354(a)(1). ² Petitioner argues that the warrants are stock within the meaning of that section, but that if these warrants are held to be securities, the limitations in section 354(a)(2)*123 2 do not apply because securities within the meaning of section 354(a)(2) are principal-amount securities. The warrants petitioner received have no principal amount. Petitioner contends, in the alternative, that even if the warrants constitute other property within the meaning of section 356, the distribution of the warrants does not have the effect of a dividend, and that the gain to be recognized is capital gain.

Respondent contends the stock purchase warrants are neither stock nor securities within the meaning of section 354(a)(1), but rather constitute *124 other property within the meaning of section 356. Respondent asserts the distribution of the warrants has the effect of a dividend within the meaning of section 356(a)(2) and that the amount of the fair market value of the warrants on March 12, 1958, should be taxed to petitioner as a dividend. Alternatively, respondent argues that should the warrants be held to be securities within the meaning of section 354(a)(1), nevertheless, due to the limitations in section 354(a)(2), they would constitute other property under section 356.

Section 354(a)(1) where applicable permits a taxpayer to exchange stock or securities of a corporation a party to a reorganization solely for stock or securities in such corporation or in another corporation a party to the reorganization without the recognition of gain or loss. In construing the provisions of the Revenue Act of 1928 comparable to the provisions of sections 354(a)(1) and 356 of the Internal Revenue Code of 1954, ³ the Supreme Court, in Groman v. Commissioner, 302 U.S. 82, 84, stated the purpose of these provisions as follows:

where, pursuant to a plan, the interest of the stockholders of a corporation continues to be definitely represented in *125 substantial measure in a new or different *413 one, then to the extent, but only to the extent, of that continuity of interest, the exchange is to be treated as one not giving rise to present gain or loss. If cash or "other property," that is, property other than stock or securities of the reorganized corporations, is received, present gain or loss must be recognized. * * *

If section 112(b)(3) of the Internal Revenue Code of 1939 applied to the exchange here involved, a holding that the stock purchase warrants were securities would dispose of this case favorable to petitioner. Certainly, the purpose of the statute requiring that the taxpayer have a continuing interest in the surviving corporation *126 is met under the facts here present. However, section 354(a)(2), a new provision of the 1954 Code, places a limitation on the applicability of the nonrecognition provisions of section 354(a)(1) making those provisions inapplicable under certain circumstances where a taxpayer received securities (other than stock) of a corporation a party to the reorganization in an exchange otherwise within the provisions of section 354(a)(1). Therefore, under the provisions of section 354, unless the warrants are considered to be stock, the question still remains whether section 354(a)(1) is not made inapplicable by the provisions of section 354(a)(2)(B) since petitioner exchanged no warrants for the warrants he received. Section 354(a)(1) is made inapplicable by section 354(a)(2)(B) if "any such securities are received and no such securities are surrendered."

Respondent, in his regulations, ^{4*128 *129} construes this provision to mean that section 354(a)(1) applies only where stock is surrendered for stock, securities are surrendered for securities, or securities are surrendered for stock and securities. This same interpretation was placed upon this section in a footnote in Carlberg v. United States, 281 F. 2d 507, 509*127 (C.A. 8, 1960), which stated as follows:

n3 The meaning of the term "securities" in section 354(a) and the qualification of the Certificates as "securities", if they are not "stock", are not factors in the case. This is because the Maryland and Missouri stockholders surrendered only stock and thus, in contrast to section 112(b)(3) of the 1939 Code, 26 U.S.C.A. (I.R.C. 1939) section 112(b)(3), the limitation of section 354(a)(2)(B) applies.

*414 We think that respondent's regulations correctly interpret section 354(a)(2)(B) as making section 354(a)(1) inapplicable if only stock is surrendered and stock and securities are received. There is nothing in section 354(a)(2)(B) which limits its application to principal amount securities as petitioner contends. Since petitioner in the instant case surrendered only stock, if the warrants he received are considered not to be stock but to be securities, section 354(a)(1) is inapplicable to the exchange except to the extent provided in section 356(a). ^5*130 We will therefore confine our consideration to whether the warrants constitute stock within the meaning of section 354(a)(1). ⁶

In Helvering v. Southwest Corp., 315 U.S. 194 (1942), warrants to purchase voting stock were held not to be voting stock. In E. P. Raymond, 37 B.T.A. 423 (1938), we held stock purchase warrants to be securities and in so doing apparently accepted as a fact that these securities were not stock. The Court of Claims in Goodhue v. United States, 17 F. Supp. 86 (1936), held stock rights not to constitute stock but to represent a contractual right to purchase stock. In Carlberg v. United States, supra, in holding certain certificates of contingent interest to represent stock, the court considered *131 the rights connected with such certificates to differ from the "contractual" rights of the warrants involved in Helvering v. Southwest Corp., supra.One of the major differences which the taxpayer had urged and the court apparently approved was that the warrants in the Southwest case gave no rights in the stock to the holder until a payment for the stock was made, *415 whereas in the Carlberg case the holder of certificates of contingent interests needed to take no positive action or provide any additional consideration to become entitled to the reserved stock. Cf. Miles v. Safe Deposit Co., 259 U.S. 247 (1922). Also in the Carlberg case the holder of the certificates of contingent interest was entitled to the accumulated dividends on the stock when and if the contingency was removed and the stock certificates issued to her. Cf. Phillip W. McAbee, 5 T.C. 1130, 1149-1150 (1943). In the instant case a payment was required before the warrant holder would be entitled to receive stock and the warrants did not entitle the holder to any dividends or other rights of stockholders until exercised with the required payments to receive the stock. The provisions of the warrants here involved are *132 not distinguishable in any material respect from those involved in Helvering v. Southwest Corp., supra.We, therefore, hold that the stock purchase warrants did not constitute stock. If they were securities, section 354(a)(1) is made inapplicable to this exchange by the provisions of section 354(a)(2)(B) and the fair market value of the warrants is recognized as gain to the extent provided in section 356 just as it would be if the warrants were not securities but were "other property."

Neither party takes the position that these warrants were not property at all. Both apparently recognize that the warrants are "property." It is also agreed that at the date of their issue the warrants had a fair market value even though the payment required to be made per share to receive Symington Wayne Corp. stock for them was in excess of the value per share of Symington Wayne Corp. stock at the date of their issue. Cf. Palmer v. Commissioner, 302 U.S. 63 (1937).

The remaining issue in the case is whether the distribution of the stock purchase warrants to petitioner had the effect of the distribution of a dividend within the meaning of section 356(a)(2). The parties are agreed that both petitioner's *133 gain realized on the exchange of his shares and the earnings and profits of the Wayne Pump Co. exceed the fair market value of the stock purchase warrants received.

The question here is not the constitutional question considered in Miles v. Safe Deposit Co., supra, since here, unlike in that case, the warrants were not issued to stockholders of the issuing corporation but were issued in exchange for stock of another corporation. The exchange constitutes a taxable event except to the extent that the Internal Revenue Code provides for nonrecognition of the gain resulting from the exchange. However, in considering whether the exchange "has the effect of a dividend" within the provisions of section 356(a)(2) some of the principles set forth in the Safe Deposit Co. case and in Palmer v. Commissioner, supra, involving the issuances to stockholders of rights to acquire stock of another corporation owned by the issuing corporation, are helpful. In the instant case as in *416 Palmer v. Commissioner, supra, nothing has been "distributed" out of either the Wayne Pump Co. or Symington Wayne Corp. to the stockholders of the Wayne Pump Co. All the assets of the Wayne Pump Co. were merged with those *134 of Symington Wayne Corp. The warrants did not, as would notes or bonds, give the holders any rights to any money or other assets of either corporation on a creditor basis. In fact, the only right these warrants gave was to receive an additional equitable common stock interest in Symington Wayne Corp. by payment into that corporation of an amount in excess of the current fair market value of a similar equitable common stock interest at the date the warrants were issued. For these reasons, even though the warrants had a fair market value at the date of their issue, they had none of the characteristics of a "distribution of a dividend." We feel that unless such warrants are specifically made a "dividend" by statutory provisions, they should not be so considered.

We do not interpret the statutory provisions as requiring a holding that the issuance of the warrants here involved had the effect of a distribution of a dividend within the provisions of section 356(a)(2).

Section 316 defines a dividend in part as follows:

For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders --

Section 317 defines property as follows:

For *135 purposes of this part, the term "property" means money, securities, and any other property; except that such term does not include stock in the corporation making the distribution (or rights to acquire such stock).

It is clear from these statutory provisions that the exchange can be considered to "have the effect of a dividend" only if the transaction is viewed as a distribution by the Wayne Pump Co. to petitioner since by definition a distribution to petitioner by Symington Wayne Corp. of rights to acquire its stock is not property within the definition of dividend. However, even though the stock and warrants of Symington Wayne Corp. were actually issued to petitioner by that corporation upon surrender of his stock in the Wayne Pump Co., since this was done upon a merger of the two corporations, the effect is the same as if Symington Wayne Corp. had issued the stock and warrants to the Wayne Pump Co. for its assets and the Wayne Pump Co. had distributed them to petitioner. Cf. David T. Grubbs, 39 T.C. 42 (1962).

Since this reorganization was a merger of the two corporations, we feel that in determining whether the exchange had "the effect of the distribution of a dividend" the distribution *136 to petitioner of the Symington Wayne Corp. stock-purchase warrants should be viewed no differently than would the distribution to him of similar warrants of the Wayne Pump Co.

Respondent argues that because the definition of "property" in section 317 is expressly limited to part I of subchapter C of the Code *417 (secs. 301 through 318) it does not apply when the term "dividend" as defined in section 316 is taken out of part I of subchapter C and put into section 356 which is in part III of subchapter C.

We cannot agree with respondent. Section 316 defines "dividend" for purposes of the whole subtitle which includes sections 1 through 1552. Although the definition of "property" contained in section 317 may be limited to part I of subchapter C, the definition of "dividend" in section 316 is not so limited, and it is the definition of "dividend" that must be applied to section 356. It would lead to confusion should the meaning of the word "dividend" vary depending on where in the Code the word is located.

Respondent argues that his interpretation of the word "dividend" as applied to section 356(a)(2) was adopted by the Supreme Court in Commissioner v. Estate of Bedford, 325 U.S. 283 (1945).

In *137 the Bedford case, there was a recapitalization under section 112(g)(1)(E) of the Revenue Act of 1936 wherein preferred stock was surrendered in return for new preferred, common, and cash. The taxpayer argued that the distribution more nearly had the effect of a partial liquidation than of a dividend. The Court in rejecting this argument stated (p. 287):

Respondent [taxpayer], however, claims that this distribution more nearly has the effect of a "partial liquidation" as defined in § 115(i). n5 But the classifications of § 115, which governs "Distribution by Corporations" apart from reorganizations, were adopted for another purpose. They do not apply to a situation arising within § 112. The definition of a "partial liquidation" in § 115(i) is specifically limited to use in § 115. To attempt to carry it over to § 112 would distort its purpose. [Footnote omitted.]

We construe this holding to mean that in characterizing transactions where there is a reorganization, the partial liquidation rules in section 115 of the 1939 Code do not apply and the amounts received by the shareholder are considered distributions to which section 112(c)(1) and (2) of the 1939 Code is applicable.

It does *138 not follow that the term "dividend," other than as the term is limited by the concept of partial or total liquidations, changes meaning when used in section 112(c)(2) of the 1939 Code or section 356(a)(2). In fact, the Court in Commissioner v. Estate of Bedford, supra, indicated the opposite view when it continued from the above:

That limitation [limitation in sec. 115(i)] is not true of § 115(a) which defines "dividend" for the purpose of the whole title. Accordingly, this definition is infused into § 112(c)(2). Under § 115(a) a distribution out of accumulated earnings and profits is a "dividend", thus confirming the conclusion that a distribution of earnings and profits has the "effect of the distribution of a taxable dividend" under section 112(c)(2).

There was no question in the Bedford case whether the cash received by the shareholder did constitute property. Our attention has not *418 been called to, nor have we found, any case holding the receipt of stock-purchase warrants as having the effect of a dividend under section 356(a)(2).

Respondent contends that the proper reading of section 356

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