July 28, 1930
COMMISSIONER OF INTERNAL REVENUE
Appeal from the United States Board of Tax Appeals.
Before L. HAND, CHASE, and MACK, Circuit Judges.
MACK, Circuit Judge.
This appeal from an order of redetermination of the Board of Tax Appeals involves assessments of income and profits taxes for the years 1917, 1918, and 1919, the validity of which depends upon whether or not respondent and the Board have correctly determined the "invested capital" of a large business enterprise which prior to those years had gone through a series of mutations in its corporate and financial structure.
The present petitioner, Auto Sales Corporation, was organized November 5, 1917, and immediately took over all the assets of the Autosales Gum & Chocolate Company in consideration of the issue of its stock of the par value of some $6,500,000. The chocolate company theretofore, and petitioner thereafter, operated public weighing and vending machines in railroad terminals and other public places, on annual, automatically renewable franchises. The chocolate company, however, was not a simple corporate unit; upon its organization in 1911, it had acquired the properties and/or stock of some thirty companies, among which was the entire capital stock of the Weighing & Sales Company, hereinafter called the company. This latter company was in itself an affiliated group through stock ownership of five preexisting companies; it was engaged in the manufacture of vending machines which it caused to be operated under similar yearly franchi detailed analysis of the financial structure of the weighing company is deferred; it suffices here to state that, because of an outstanding mortgage trust deed, its corporate existence was continued after its entire capital stock had been acquired by the chocolate company. That company took over the contracts a assumed the obligations of the weighing company. It included the latter's property among its own assets, and, on its books, carried all of the weighing company stock at $1.
Section 208 of the Revenue Act of 1917 (40 Stat. 306) and section 331 of the Revenue Act of 1918 (40 Stat. 1095) both provide that if, on a reorganization or change of ownership after March 3, 1917, the control of the business remains in the hands of the same parties, partnerships, or companies, the invested capital of the new company, as to the assets transferred (with certain exceptions here immaterial), shall be computed as though in effect such reorganization or change in ownership had not been effected. Both petitioner and respondent concede the applicability of these two sections; we therefore proceed with the consideration of the case as though petitioner had never been organized and the stock of the weighing company were still owned by petitioner's predecessor, the chocolate company.
In computing its invested capital for the y petitioner included the sum of $1,348,557.50 as the value of the weighing company stock held by it. This sum was disallowed by respondent, who treated the companies as affiliated, refused to include the value of the alleged intangible a of the weighing company, and allowed, as an addition to the invested capital of the affiliated group, on account of the weighing company, $160,661.67, which was the admitted value of the weighing company's machines. On appeal to the board, petitioner contended that it was entitled to have included in its invested capital, as tangible property, the cash value of the shares of stock of the weighing company. The board, however, affirmed respondent's determination on the theory that the companies were affiliated and that therefore the value of the stock could not as such be included; further that, from the evidence before it, it was impossible to determine the invested capital actually contributed by the weighing company to the affiliated group. The applicable sections of the Revenue Acts of 1917 and 1918 are set forth in a footnote,*fn1 and the many Treasury Regulations involved will be duly considered.
Petitioner now contends: (1) That the chocolate company and the weighing company we not affiliated corporations, because the latter company was not actively engage in business, all of its machines and franchises being then operated by the chocolate company; (2) that therefore petitioner is entitled to have included in its invested capital the weighing company stock valued as tangible property; (3) that the value of such stock is to be determined by the value of the assets of the company; and (4) that, even if the companies be considered as affiliated, the share contributed by the weighing company to the consolidated invested capital m be determined from the present record to be at least $1,409,300. Respondent contends: (1) That the companies were affiliated corporations during the taxable years in question; (2) that therefore the invested capital is the consolidated invested capital of the affiliated group to be computed by ascertaining the invested capital of the constituent corporations and deducting any duplications or intercompany items, including stock held inter sese; and (3) that, since there is nothing in the record from which a determination of the invested capital of the weighing company may be made, respondent's determination must be accepted.
1. The primary question of affiliation may be readily decided. The sole basis for arguing against a statutory affiliation is that the weighing company, all of whose stock was owned and all of whose property and franchises controlled and/or operated by the chocolate company, was not active. The logical basis for, and the legislative history of, the requirement of consolidated returns by "affiliated corporations," has only recently been quite fully examined in United States v. Cleveland, Painesville & Eastern R.R., 42 F.2d 413 (C.C.A. 6th) it is clear from that opinion that within section 240(a) of the Revenue Act of 1918 and section 1331 of the Revenue Act of 1921 (retroactively made a part of the act of 1917), any subsidiary corporation, substantially all of whose stock is owned by another corporation, must be deemed to be affiliated with the latter. That the subsidiary is wholly inactive and but a bookkeeping department of the parent company is immaterial, even under the act of 1917, which alone specifies that the corporations must be "engaged in the same or as is the very situation in which the economic unity of the two corporate entities is most apparent and the arbitrary apportionment of income, against which the statute is directed, most easily effectuated. See United States v. Cleveland, etc., R.R., supra. Nor does the fact that legal continuance of the inactive subs was dictated by the requirements of an outstanding security obligation take the enterprise out of the statutory definition. See Lavenstein Corp. v. Commissioner, 25 F.2d 375 (C.C.A. 4th); Utica Knitting Co. v. United States, Ct. Cl., decided May 6, 1929. We are entirely clear that within the taxable years in the chocolate company and the weighing company were affiliated corporations; a consolidated return was required, and the invested capital of the affiliated group must be determined therefrom.
2. The consolidated taxable net income of affiliated corporations may be ascertained without great difficulty; the gross incomes are pooled, the various items classified for deduction purposes, p from intercompany transactions eliminated, and various inventory adjustments, simple in theory but intricate in application, are made. See Staub, Consolidated Returns, in Haig, The Federal Income Tax, pp. 188, 195, 200. The determination of consolidated invested capital, even in the simple case of a single parent co and wholly owned subsidiary, is, however, replete with difficulties both in theory and practical operation. Broadly speaking, such consolidated invested capital represents the aggregate of the invested capital of each of the affiliated companies; in practice, however, the determination of this aggregate raises thorny questions as to the treatment of inadmissible assets (cf. Reg. 45, arts. 815-817; Revenue Act of 1918, § 325), the allocation of the undistributed surplus of each company, and, as in the instant case, the valuation of the stock of the subsidiary owned by the parent n its book value, in exchange for tangible and/or intangible property, obligations and/or stock of the parent company. We need in this opinion deal only with the last of these questions.
If company Ahe two companies are not affiliated within the statutory definition, such stock or bonds may be included as tangible property in the invested capital of company A.*fn2 If, however, there is affiliation, the par as well as the market value o the stock of the subsidiary so owned is immaterial; the invested capital of the parent is separately computed and the amount to be added thereto in respect of the subsidiary is determined in accordance with the Regulations. See Reg. 45, art. 864.*fn3 If the subsidiary's stock was acquired by the parent company for c the cash so paid is to be the basis in determining, for the purpose of computing the consolidated invested capital, the value of the property acquired. Reg. 45, art. 867. If, however, such stock was acquired in exchange for the stock of the parent company, the amount to be included in the consolidated invested capital*fn4 is to be computed as though the net tangible and intangible assets of the subsidiary had been acquired instead of its stock. Reg. 45, art. 868. The value of the net rather than the gross tangible and intangible assets is taken because the real value of the business entity, acquired in exchange for stock, is represented by the difference between its assets and liabilities. Beyond this, the Regulations fail to shed light except for the inference that the other rules relating to the determination of the invested capital of a single corporation are generally applicable to affiliated companies.
3. The detailed facts of the case at bar reveal the difficulties engendered by these omissions: The entire stock of the weighing company, the affiliated subsidiary, was acquired by the chocolate company, not for cash alone or for stock of the parent alone, but for a mixed aggregate of cash, chocolate company stock and bonds, and the assumption company's obligations. The latter had outstanding $406,800 worth of bonds secured by a mortgage of all its present and future property to the Empire Trust Company, under which there were to be made annual sinking fund payments of $20,000. The chocolate company deposited with the trustee $375,000 in cash, $475,000 of its bonds, and $225,000 par value chocolate company stock, and received in re entire capital stock of the weighing company. Shortly thereafter the weighing company leased and/or assigned, subject to the mortgage, all of its machines, contracts, and other assets to the chocolate company which agreed to discharge the obligations under the trust deed. The problem presented therefore is how to allocate these items in order to determine the contribution in respect of the weiated invested capital of the affiliated group.
It is apparent from the record t and bonds thus paid for the weighing company stock were intended in the first p of the latter's outstanding bonds and the satisfaction of the mortgage. The cash therefore should, or in any event could, properly be deemed to be allocated, first, to the payment of these bonds; the requirements of the annual sinking fund payments would exhaust it within the twenty years that the bonds had to run. This left for the purchase of the weighing company's stock the $475,000 of chocolate company bonds and the $225,000 of its stock. In our judgment, such an acquisition of the subsidiary's stock for the bonds and stock of the purchasing parent is to be assimilated to the case of acquisition for the purchaser's stock alone (article 868) rather than to the case of a purchase entirely for cash (article 867). Accordingly there may be added to the consolidated invested capital, in respect of the weighing company, the value of its net tangible and intangible assets, except that as to the latter the statutory limitation must be applied to the aggregate intangibles of both parent and subsidiary paid in for the parent's stock. See note 4, supra.
What was the value of such net tangibles and in heretofore stated, the weighing company was in itself an affiliation of six companies; but the record does not disclose whether or not, at the time of affiliation with the chocolate company, this original affiliated group had be merged in the weighing company; that is, whether their assets had become part of the assets of the weighing company. The only evidence is a consolidated balance sheet of these companies; but again it is not entirely clear, assuming that there had been no merger, whether or not the separate assets of the weighing company were included in this consolidated balance sheet. Since the burden throughout is on petitioner, we must assume against it either that there had been a m of the weighing company and its five subsidiaries and that the combined assets are shown in this balance sheet, or that, if there had been no merger, the separate assets of the weighing company are included therein.*fn5 The consolidated balance sheet may be summarized as follows:*fn6
Current Assets*fn* 113,000 $523,000
Franchises, etc 1,468,000 1,511,000
Bonded Indebtedness $487,000
Current Liabilities*fn* 93,000 580,000
We begin by reducing the liabilities by $375,000, the cash payment made by the chocolate company to be applied to the bonded indebtedness of the weighing company. This gives us the following:
Intangibles 1,511,000 2,034,000
Bonde d Indebtedness $112,000
Current Liabilities 93,000 205,000
These figures must next be adjusted in accordance with article 835 of Regulations 42, which provides that, where stock or shares and bonds or other obligations have been issued for a mixed aggregate of tangible and intangible property, it will be presumed, in the absence of satisfactory evidence to the contrary, that the bonds were issued for tangible property and that the stock was issued for the balance of the tangible property, if any, and for the intangible property; the theory being that the vendor of tangibles will ordinarily demand the more definite obligation. There is no evidence whatever in the present record as to the intended allocation of the chocolate company stock and bonds given for the net tangibles and intangibles represented by the weighing company stock. Consequently, the item of tangible assets, $523,000, must be further reduced by $475,000, the amount of chocolate company bonds issued therefor. Bonds are "borrowed capital" within the statutory definition, and may not be included in "invested capital." See Revenue Act of 1917, § 207; Revenue Act of 1918, § 325. This leaves, as net assets of the weighing company to be added to the consolidated invested capital, $48,000 worth of tangibles and the alleged $1,511,000, intangibles.
The tangibles may be included at their actual value (see, supra, note 2);*fn7 the intangibles, however, are subject to the limitations of section 207 (a) of the 1917 act and/or section 326(a) (4) and (5) of the 1918 act, which is applied to the aggregate intangibles of the affiliated group paid in for the parent's stock (supra note 4); that is, the weighing company intangibles are to be added to the intangibles of all the corporations in the chocolate company affiliation, whose stock was similarly acquired, and there can be allowed as an addition to the consolidated invested capital only a part proportionate to the amount of intangibles which will be allowed to the entire group. Here again petitioner has failed to furnish the information necessary for a proper computation of invested capital within this limitation; for there is no evidence in the record as to the value of such aggregate intangibles of the entire chocolate company affiliation and consequently we cannot determine which part, if any, of the weighing company's intangibles may be included in the consolidated invested capital. Nor have we been furnished with data showing the actual cash value of those weighing company assets, at the time acquired, or the par value of the total stock of the consolidation outstanding at the beginning of the taxable year. Both of these items are additional bases for the limitations imposed by section 207(a) and section 326 (a) (4) and (5), and, in the absence of information as to them, we could not, even if we knew the value of the aggregate intangibles, compute the amount of weighing company intangibles to be added, because the lowest of the three possible limitations must be taken. Supra, note 4.
Respondent has allowed, in respect of the weighing company's total acquired assets, $160,661.67, apparently for tangibles alone.*fn8 It is not clear, nor need we determine, how this result was reached. While on the present record we should have found at the most $48,000 as the value of the allowable assets to be included in the consolidated "invested capital," it may well be that respondent had additional facts before him. The burden was on petitioner to demonstrate that the assessment and order of redetermination were prejudicial to it as a matter of law. In our judgment, this burden has not been met.
Having determined that the corporations were affiliated, it might well have sufficed to point out, as did the Board of Tax Appeals, that the record was bare of facts to justify reversing respondent's determination. We have gone further in this opinion, and shown the lack of facts revealed when the statutes and regulations are applied, in order to demonstrate the necessity of making an adequate record before the Board, as a basis for its necessary findings of fact, in these complex tax cases. We cannot go beyond the record in this court; the burden is on petitioner both before the Board and here to prove that the determination of respondent and/or the Board is without any substantial support in that record. Mere charges that such determinations were arbitrary, capricious, or erroneous, supported by information found only in the briefs but not in the record, are of no weight. These criticisms, while not wholly true of the instant case, are applicable in whole or part to the increasing number of cases coming from the Board of Tax Appeals.