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Colt's Manufacturing Co. v. Commissioner of Internal Revenue

decided: August 20, 1962.


Author: Moore

Before CLARK, WATERMAN and MOORE, Circuit Judges.

LEONARD P. MOORE, Circuit Judge.

Colt's Manufacturing Company (Colt's) appeals from a judgment of the Tax Court (35 T.C. No. 78), three judges dissenting, determining a statutory deficiency in excess profits tax for 1952 in the amount of $42,523.93.

The dispute between the taxpayer and the Commissioner is whether certain treasury stock acquired by Colt's from its stockholder should be considered as "invested capital" and within the definition of "equity capital" as defined in the Excess Profits Tax Act of 1950, Section 437, 26 U.S.C. (1952 ed.) ยง 437. The facts relating to the acquisition of the treasury stock are determinative of its status as an "asset" and whether it was being held "in good faith for the purposes of the business."

Colt's a Connecticut corporation in the small firearms business, prospered during World War II. After the war it found itself with surplus cash and other liquid assets in excess of $7,500,000. Unsuccessful in finding any profitable use for this large surplus and pressed by a group of stockholders for a distribution, Colt's directors adopted a plan for the solicitation of tenders of stock at a price not to exceed $53 a share. A notice of a special meeting of stockholders (March 6, 1950) to act upon the plan was given which contained the statement:

"In view of the Company's strong capital position the Board of Directors during the past year has explored merger and expansion possibilities with diligence. It has become evident, however, that this capital position is not a dominant factor in effecting an acceptable consolidation and no satisfactory expansion program has been developed. Consequently the Board has concluded that the purchase by the Company of outstanding shares of its capital stock to an extent which would not interfere with the carrying on of its normal operations would be in the best interests of the Company and would accord to stockholders an opportunity either to sell their shares to the Company for cash or, by not selling, to increase their proportionate equity in the Company.

"In purchasing shares tendered, the Company in no event will expend in excess of $7,000,000 and in no event in excess of a sum which would reduce the operating capital of the Company below an amount adequate for its normal operations."

The plan was adopted by the stockholders on March 29, 1950. Thereunder 124,827 of the 195,900 shares outstanding were tendered and redeemed at a cost to the company of $6,524,167.82. Colt's authorized capital stock consisted of 400,000 shares of which 200,000 shares had been issued. After the acquisition of the 124,827 shares and an additional block of 4,100 shares (originally intended for employee participation purposes) at an aggregate cost for both blocks of $6,653,174, there remained outstanding as of December 31, 1950, as shown in Colt's statement for 1950, 71,073 shares with a "Stockholders Ownership" value of $7,165,776. Of the 128,927 shares of treasury stock, 8,927 were used on July 18, 1951, to acquire the assets of Walter P. Jacobs Industries, Inc. and the remaining 120,000 shares were retired on December 18, 1952.

At all times Colt's in its books recorded the reacquired stock as "treasury stock" and did not regard it as an asset or a liability. These shares were not voted and no dividends were paid thereon.

In computing Colt's "excess profits credit" for 1952, Colt's selected the method "Based on Invested Capital" (Sec. 436) which defines the credit in substance as the invested capital credit as computed under section 437 reduced by the amount computed under section 440 (b) relating to inadmissible assets. Excluding the treasury stock from both assets and inadmissible assets and using the table set forth in section 437, Colt's arrived at a "Net Excess Profit Credit" of $1,187,086.64. The Commissioner included the treasury stock under assets and inadmissible assets with a resulting figure of $1,040,671.31.*fn1

Section 437 in an effort to define "Invested Capital" defines it as "adjusted invested capital determined under paragraph (2)." That paragraph in turn defines "adjusted invested capital" as the sum of "equity capital" plus other items not here involved. The search for a definition finally ends with the disclosure in paragraph (c) that "The equity capital of the taxpayer as of any time shall be the total of its assets held at such time in good faith for the purposes of the business, reduced by the total of its liabilities at such time."

The first question to be resolved is: Is the treasury stock an asset? If so, the second question arises: Was it held "in good faith for the purposes of the business"?

Counsel for the Commissioner conceded "that accounting-wise this stock we have reference to is not an asset." An accountant whose qualifiations as an expert were acknowledged by the Commissioner's counsel testified that proper accounting treatment of reacquired shares set up as treasury stock was "to take that item off the equity side"; that it should be deducted from the capital stock or surplus; and that it "should not be carried as an asset on the asset side of the balance sheet." The Securities and Exchange Commission in its regulations forbids corporations from treating reacquired shares as assets. Regulation S-X, Rule 3-16, provides:

"Reacquired shares shall be shown separately as a deduction from capital shares, or from the total of capital shares and surplus, or from surplus, at either par or ...

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