
    ANDERSON, CLAYTON & CO. v. THE UNITED STATES
    [No. 343-55.
    Decided December 4, 1957]
    
      
      Mr. John O. White for the plaintiff. Messrs. Fulbright, Grooker, Freeman, Bates <& White, were on the briefs.
    
      Mr. John A. Bees, with whom was Mr. Assistant Attorney General Charles K. Rice, for the defendant. Mr. James P. Garland was on the brief.
   Littleton, Judge,

delivered the opinion of the court:

Plaintiff sues to recover $39,507.93, representing an alleged overpayment of excess profits taxes and interest for the fiscal years ending July 31, 1950 and July 31, 1951, together with interest thereon as provided by law from the date of payment, March 9, 1955. Timely claims for refund were rejected by the Commissioner of Internal Eevenue on August 23, 1955.

Plaintiff, a Delaware corporation with its principal place of business in Houston, Texas, is engaged in the merchandising and ginning of cotton, the crushing of cottonseed, the refining of cottonseed oil, and other related activities. During its fiscal year ended July 31, 1951, and for many years prior thereto, plaintiff owned all the capital stock of Western Cottonoil Company, a Delaware corporation engaged in the ginning of cotton, crushing of cottonseed, refining of cottonseed oil, and other related activities in the states of Texas, Oklahoma, New Mexico, Arizona and California.

In order to centralize working capital, the plaintiff followed a general policy of financing its subsidiaries, including Western Cottonoil Company, by capitalizing them in an amount equal to their fixed investments and furnishing to them working capital in the form of loans on notes and current advances on open account. Because its cotton collateral was quick and marketable, plaintiff, a cotton merchandising firm, could borrow money at rates of from 2 to 214 percent below those available to its subsidiary cottonoil companies whose assets were less available as collateral.

By reason of the expansion of cotton growing in new irrigated areas, new gins were required, and because of the adoption of a new and more efficient solvent process for extracting cottonseed oil, large new fixed asset investments were made by plaintiff’s subsidiary, Western. By the spring of 1951 Western’s fixed assets account had increased to approximately $30,000,000, whereas its outstanding capital stock was only about $1,693,000. It was thus apparent to the plaintiff, the parent corporation, that its subsidiary was seriously undercapitalized.

After exploring and abandoning as impracticable, an attempt to have the subsidiary raise capital through the issuance of bonds or through direct bank borrowings, the management of the plaintiff corporation decided to propose to its board of directors that the subsidiary be dissolved and its operations conducted as a division of the parent company. At that time the subsidiary was indebted to the plaintiff in the sum of $51,062,500.16, evidenced by promissory notes, and an indebtedness on advances on open account in the sum of $1,689,028.47.

In studying this matter the plaintiff corporation concluded that prior to the adoption of any plan of liquidation of the subsidiary, the total indebtedness of $52,751,528.63 of the subsidiary to the parent company should be eliminated either by repayment to the parent, or by the cancellation thereof as a contribution by plaintiff to capital of the subsidiary. In this connection plaintiff had in mind the avoidance of recognition of taxable gain to either company upon the liquidation of the subsidiary.

Following an unsuccessful attempt by the subsidiary to borrow a sufficient amount from banks to pay off the above indebtedness to the parent company, the management of the plaintiff company decided to recommend to the board of directors of plaintiff that it cancel the entire indebtedness as a contribution to the capital of the subsidiary. At a meeting of the parent’s board on July 2, 1951, the parent company was duly authorized to make a contribution of the indebtedness to the capital of the subsidiary, and on July 10, 1951, the parent company canceled and returned to the subsidiary its notes and also canceled the above mentioned indebtedness on open account. The total amount of $52,751,-528.63 was thereupon entered on the books of both companies as a contribution to the capital of the subsidiary. In determining to contribute this amount to the capital of the subsidiary, no consideration was given to the effect of such capital contribution upon excess profits credit of the subsidiary, and it was not a factor in the decision.

On July 31,1951, the subsidiary, Western Cottonoil Company was merged into plaintiff, and thereafter the business operation and activities of the subsidiary were carried on and substantially expanded by plaintiff, - the parent corporation.

For the purpose of determining the excess profits credit of the subsidiary, Western Cottonoil Company, for the fiscal year ended July 31, 1951, the Commissioner of Internal Revenue determined that the indebtedness to the parent company of $51,062,500.16, evidenced by notes, was properly included in borrowed capital for the purpose of computing the excess profits credit prior to the cancellation of the notes on July 10, 1951, but that the $52,751,528.63 contribution to the capital of Western made on July 10, 1951, was not a capital contribution for the purpose of calculating the excess profits credit after July 10. Thus, the excess profits credit of Western was reduced for the fiscal year ending July 31, 1951, by the sum of $364,202.34, representing 12 percent of 21/365th of $52,751,528.63. This action also eliminated a carryback from 1951 to 1950, and the Commissioner determined and assessed an additional excess profits tax of $7,939.61 for the fiscal year ending July 31, 1950, of which sum $7,079.79 was attributable to the elimination of such excess profits credit carryback. By reason of the elimination of $364,202.34 from the excess profits credit of Western Cot-tonoil Company for 1951, the Commissioner also assessed an additional excess profits tax of $25,902.03 for 1951. Plaintiff, as successor to Western, paid these assessments with interest thereon of $6,526.11 on March 9,1955.

Section 435 of the Internal Revenue Code (26 U. S. C. [1952 ed] 435) provides that the excess profits credit for any taxable year shall be the sum of (1) 83 percent of the average base period net income, and (2) 12 percent of the net capital addition for tbe capital year, minus 12 percent of the net capital reduction for the taxable year. Section 435 (g) of the Internal Revenue Code, defines net capital addition as follows:

(1) Net Capital Addition.
The net capital addition for the taxable year shall, for the purposes of this section, be the excess, divided by the number of days in the taxable year, of the aggregate of the daily capital addition for each day of the taxable year over the aggregate of the daily capital reduction for each day of the taxable year. * * *
* * if* %
(3) Daily Capital Addition.
The daily capital addition for any day of the taxable year shall, for the purposes of this section, be the sum of the following:
(A) The aggregate of the amounts of money and property paid in for stock, or as paid-in surplus, or as a contribution to capital, after the beginning of the taxable year and prior to such day.
(B) The amount, if any, by which the equity capital (as defined in section 437 (c)) at the beginning of the taxable year exceeds the equity capital at the beginning of the taxpayer’s first taxable year under this sub-chapter.
(C) 75 per centum of the amount, if any, by which the average borrowed capital for the taxable year (as defined in section 439 (a)) exceeds the daily borrowed capital for the first day of the taxpayer’s first taxable year under this subchapter.

Section 441 of the Code contains the rules for determining excess profits credit as follows:

(a) Equity capital.
The term “equity capital” means the equity capital as defined in section 437 (c).
(b) Property paid-in.
For the purpose of determining the amount of property paid in for stock, or as paid-in surplus, or as a contribution to capital, such property shall be included in an amount equal to its basis (unadjusted) for determining gain upon sale or exchange. If the unadjusted basis of the property is a substituted basis, such basis shall be adjusted, with respect to the period before the property was paid in, by an amount equal to' the adjustments proper under section 113 (b) (2).
(c) Money and 'property paid-in.
For the purpose of determining the amount of money and property paid in for stock, or as paid-in surplus, or as a contribution to capital, there shall be included only money and property paid in good faith for the purposes of the taxpayer’s business.
* # * * #
(g) (2) If an indebtedness of the taxpayer is canceled or released in exchange for stock, or as paid-in surplus, or as a contribution to capital, the amount paid in shall be considered equal to the amount of the indebtedness. [Italics supplied.]

The question presented for decision is whether the contribution to the capital of its subsidiary by plaintiff through the cancellation of the subsidiary’s indebtedness (notes and current account), constituted money and property paid in good faith for the purpose of the subsidiary’s business and therefore became a proper basis for computing the subsidiary’s invested capital credit?

The defendant concedes that the loans by the plaintiff to its subsidiary were made in good faith for the purpose of the subsidiary’s business, being part of a plan whereby the parent company could furnish working capital to the subsidiary more cheaply than the subsidiary could obtain funds elsewhere. It is also conceded that if the cancellation of the subsidiary’s indebtedness to the parent had been made to furnish additional working capital, then there would be no defense to plaintiff’s claim.

There is no dispute concerning the good faith of the cancellation of indebtedness here involved. We think it is important to note that in this case the cancellation of the indebtedness and the transfer and conversion of the indebtedness to equity capital did not reduce the working capital of the subsidiary for the remainder of the fiscal year 1951. The funds belonged to Western for that period and were continued in use of the business of the subsidiary from July 11 to July 31, 1951, when the subsidiary was merged with the parent company and its business was thereafter carried on and substantially expanded by the parent company.

Despite the above concessions, defendant makes the contention, which in our opinion is untenable, that the cancellation of the indebtedness was not intended to serve any purpose of the subsidiary’s business; that the subsidiary already had the money and property of the parent corporation that had been previously loaned to it for the purposes of its business, and that the sole purpose of the cancellation of the loans and the open account was to avoid the recognition of gain to either company following a later dissolution of the subsidiary corporation. Such a contention finds no support either in the facts of this case or in the applicable law or regulations. Both section 441 (g) (2), quoted above, and Regulations 130, section 437-6 (3), provide that if an indebtedness of the taxpayer is canceled or released as a contribution to capital, the amount paid in shall be considered equal to the amount of the indebtedness.

In view of the obvious undercapitalization of the subsidiary discussed above, and the continued need in the business for the funds represented by the notes and open account of indebtedness to the parent company, the cancellation of the notes and the account balance clearly amounted under the statute to a good faith contribution to capital to be included in computing the daily capital additions on which the excess profits credit for any taxable year is to be computed. The defendant was in error in treating the transaction otherwise.

Plaintiff is entitled to recover $39,507.93 with interest thereon from March 9, 1955, according to law, and judgment will be entered to that effect.

It is so ordered.

Maris, Circuit Judge, sitting by designation; Madden, Judge; Whitaker, Judge; and Jones, Chief Judge, concur.

EINDINGS OE EAOT

The court, having considered the evidence, the report of Commissioner Richard H. Akers, and the briefs and argument of counsel, makes findings of fact as follows:

1. The plaintiff is a Delaware corporation with its principal business office at Houston, Texas. It was organized December 31,1929.

2. The plaintiff is engaged in the merchandising and ginning of cotton, the crushing of cottonseed, the refining of cottonseed oil, and related activities in the United States and elsewhere directly and through subsidiary corporations.

3. During its fiscal year ended July 31, 1951, the plaintiff owned all the capital stock of the Western Cottonoil Co., a Delaware corporation, which was engaged in the ginning of cotton, crushing of cottonseed, refining of cottonseed oil, and other related activities within the States of Texas, Oklahoma, New Mexico, Arizona, and California.

4. In order to centralize working capital, the plaintiff followed a general policy of financing its subsidiaries by capitalizing them in an amount equal to their fixed investments and furnishing to them working capital in the form of current advances. Because its cotton collateral was quick and marketable, the plaintiff, which was a cotton merchandising firm, could borrow money at rates 2 to 2y2 percent below those available to its subsidiary cottonoil companies whose assets were less available as collateral.

5. For some periods prior to the year involved in this proceeding, the business of the Western Cottonoil Co. was fairly seasonal in character and required variable amounts during the season for working capital. However, as a result of the expansion of cotton growing into irrigated areas and the related entry of cottonseed oil firms into crop production loans, the business of the Western Cottonoil Co. in the fiscal year ended July 31, 1951, was no longer seasonal. Operating funds were used to finance production until the crop was harvested and for the remainder of the year to carry the resulting inventory. Crop loans were at their peak in July and inventories at their peak in January. In January 1951, Western Cottonoil Co. had inventories of approximately $51,700,000 compared to $11,800,000 in July 1951, but its crop loans in January were $14,300,000 as compared with $48,300,000 in July. In other words, it had a total of crop loans and inventories on January 31,1951, of approximately $66,000,000 as compared with a total for the same two items on July 31, 1951, of $60,100,000.

6. Both because of the expansion of cotton growing in the new irrigated areas requiring new gins and because of the adoption of a new and more efficient solvent process for extracting cottonseed oil, large new fixed asset investments were made by tbe Western Cottonoil Co., of which some $17,200,-000 was authorized during the fiscal year ended July 31, 1951.

7. By the spring of 1951, it became apparent to the management of the plaintiff that the Western Cottonoil Co. was seriously undercapitalized as a result of its large additional investment in fixed assets and its continued working capital requirements, as shown in the preceding findings. At that time its fixed assets account had increased to approximately $30,000,000 whereas its outstanding capital stock was approximately $1,693,000.

8. After exploring and abandoning as impracticable an attempt to have Western Cottonoil Co. raise capital through the issuance of bonds or direct bank borrowing, the management of the plaintiff decided to propose to its board of directors that the Western Cottonoil Co. be dissolved and its operations conducted as a division. In addition to improving the financial situation, better managerial relations and some savings in corporate expense and state taxes were foreseen.

Counsel was consulted who advised the management officials of the plaintiff that to avoid recognition of gain to either company the indebtedness of the subsidiary, Western Cottonoil Co., to the parent company, the plaintiff, should be eliminated either by repayment or by its cancellation as a contribution to capital before any plan of liquidation was adopted. That indebtedness amounted to $52,751,528.63, of which $51,062,500.16 was evidenced by notes of the Western Cottonoil Co. and the balance of $1,689,028.47 was in an open account. In addition, the commercial banks with which the plaintiff transacted business did not look with favor on advances of that character.

The advice of counsel in this instance was in accord with a plan followed by the plaintiff in 1943 in connection with the liquidation of a joint stock association into the parent company, and in that instance a final closing agreement was executed for that year.

9. Following an unsuccessful attempt by Western Cotton-oil Co. to borrow a sufficient amount from banks to pay off the indebtedness just referred to, the management of the plaintiff decided to recommend to the board of directors of the plaintiff that it cancel the indebtedness as a contribution to the capital of the Western Cottonoil Co. At a meeting of the plaintiff’s board of directors on July 2,1951, the plaintiff was authorized to make a contribution of the foregoing indebtedness to the capital of the Western Cottonoil Co. Pursuant to that authority, the plaintiff, on July 10, 1951, returned to Western Cottonoil Co. its notes in the sum of $51,062,500.16 and canceled its open account in the sum of $1,689,028.47. The sum of $52,751,528.63 was duly entered on the books of both companies as a contribution to the capital of Western Cottonoil Co. In determining to contribute the sum of $52,751,528.63, including $51,062,500.16 evidenced by notes, no consideration was given to the effect of the capital contribution upon the excess profits credit of Western Cottonoil Co. nor was it a factor in the decision.

10. At a meeting on July 23, 1951, the board of directors of the plaintiff adopted a plan for the liquidation of Western Cottonoil Co. into the plaintiff. At meetings on the same day, the board of directors of Western Cottonoil Co. adopted the plan of liquidation just referred to and the stockholders approved it. On July 27,1951, the board of directors of the plaintiff, pursuant to the foregoing plan of liquidation, adopted a resolution merging Western Cottonoil Co. into the plaintiff effective July 31,1951.

11. Except for the cash necessary to the operation of its business, the funds of Western Cottonoil Co. prior to liquidation were invested in accounts and notes receivable, crop loans, inventories and physical plants, which were assets useful and utilized in operation of its business. After liquidation, the business operation and activities theretofore carried on by Western Cottonoil Co. were carried on and substantially expanded by the plaintiff.

12. The Commissioner of Internal Eevenue excluded the capital contribution in the amount of $52,751,528.63 in the calculation of the excess profits credit of the plaintiff for the fiscal year ended July 31,1951, and such action reduced the excess profits credit of Western Cottonoil Co. by $364,202.34. That amount represents 12 percent of 21/365ths of the amount of $52,751,528.63. No borrowed capital credit for the note indebtedness was allowed by the Commissioner after the cancellation on July 10, the forgiveness being regarded as effective for that purpose. However, the Commissioner determined that the indebtedness represented by the notes was properly included in borrowed capital for the portion of the fiscal year prior to its cancellation.

13. As a result of the $364,202.34 reduction in excess profits credit for the year ended July 31, 1951, the Commissioner determined an additional excess profits tax of the Western Cottonoil Co. of $25,902.03 for that year. This action also eliminated carryback from 1951 to 1950, and the Commissioner determined an additional excess profits tax of the same company of $7,939.61 for the year ended July 31,1950.

14. By assessment notices dated February 28, 1955, the plaintiff, successor to Western Cottonoil Co., was notified of the additional assessment of $7, 939.61 excess profits tax and interest in the amount of $1,882.77 to such date for the fiscal year ended July 31, 1950; and of $25,902.03 excess profits tax and $4,847.23 interest to such date for the fiscal year ended July 31, 1951. March 9, 1955, the plaintiff paid the sum of $40,571.64 covering such additional assessments and interest.

15. On or about March 25, 1955, the plaintiff filed claims for refund in the sum of $32,981.82 with interest on account of the taxes referred to in the preceding finding and has received official notice of rejection of those claims dated August 23, 1955.

16. Plaintiff claims that $7,079.79 of the additional excess profits tax assessment for the fiscal year ended July 31, 1950, amounting to $7,939.61, was attributable to the reduction in the 1951 excess profits credit of $364,202.34, which defendant does not dispute.

The interest allocable to $7,079.79 of the 1950 assessment is $1,678.88, which interest was paid on March 9, 1955. The interest allocable to the $25,902.03 additional assessment of excess profits tax for 1951 due to the reduction in the excess profits credit is $4,847.23, which interest was also paid' on March 9,1955.

CONCLUSION OF LAW

Upon tbe foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that plaintiff is entitled to recover. It is therefore, ordered and adjudged that plaintiff recover of and from the United States the sum of thirty-nine thousand, five hundred and seven dollars and ninety-three cents ($39,507.93), with interest thereon from March 9,1955, according to law.  