Before LUMBARD, Chief Judge, and SMITH and HAYS, Circuit Judges.
Petitioner seeks review of a decision of the Tax Court which upheld the Commissioner's determination that petitioner was liable for personal holding company surtax for the year 1952. We reverse.
We shall first briefly summarize the circumstances which were held to have made petitioner liable to taxation as a personal holding company.
Until July 1952 Frelbro Corporation owned all the stock in Brown-Longyear Motors, Inc. In July 1952 John Longyear exercised an option which he had had for some time to purchase 51% of the Brown-Longyear stock. In connection with this stock purchase it was agreed that the balance owing from Brown-Longyear to Frelbro at the beginning of 1952, including an amount credited to dividends, should be paid, together with dividends declared during 1952.However, because Longyear did not want to take over ownership with depleted cash reserves, Frelbro agreed to donate to Brown-Longyear's surplus the amount of $52,213.91.*fn1 This agreement was executed by an exchange of checks, Brown-Longyear delivering to Frelbro its checks to the total of $61,598.56 and Frelbro simultaneously delivering to Brown-Longyear a check in the amount of $52,213.91. At the time of this transfer of checks neither Brown-Longyear nor Frelbro had in its bank account enough to cover its liability on its checks but for the amount received by reason of the transfer.
The Tax Court held that $45,685.83 of the amount paid by Brown-Longyear to Frelbro was on account of dividends. Adding this amount to certain items of income from other sources the Tax Court determined that since the total of this "personal holding company income" was greater than 80% of Frelbro's gross income (and since Frelbro met the "stock ownership requirement" by having "not more than five" stockholders), Frelbro was liable for personal holding company surtax under Internal Revenue Code of 1939 §§ 500-502.*fn2
Petitioner disputes this result on two grounds. First, it maintains that the Brown-Longyear Corporation, which was the product of the consolidation of two pre-existing corporations, was entitled for tax purposes to carry over the deficit of its predecessor corporations, with the result that post reorganization earnings were absorbed by the deficit, and the payment to Frelbro, except for that part representing 1952 earnings, was therefore not a dividend within the meaning of § 115 of the Code. Second, petitioner argues that the practical content of the transaction involving the exchange of checks, whatever its formal aspects, resulted in a dividend to Frelbro amounting only to the difference ($9,384.65) between the amounts exchanged. If the latter view is accepted Frelbro's "personal holding company income" was less than the requisite 80% of gross income.
We find it unnecessary to consider the first of petitioner's contentions, since we are persuaded that for purposes of determining whether petitioner was a personal holding company within the meaning of the statute, only the net amount actually received by petitioner ($9,384.65) is properly to be taken into account as a "dividend."
We do not believe that we are obliged, as the government urges upon us, to regard only the form of the transaction and to disregard its substance, which the petitioner characterizes as "a very awkward and ill-advised method of transferring earnings of Brown-Longyear to its surplus account." In the absence of any suggestion that tax-avoidance motivated the transaction, we believe that this is a case for application of the basic principle that "the incidence of taxation depends upon the substance, not the form, of the transaction." Commissioner v. Hansen, 360 U.S. 446, 461, 79 S. Ct. 1270, 3 L. Ed. 2d 1360 (1959). The principle is not to be applied only when it benefits the government. Cf. Schinebro, Inc. v. Commissioner, 131 F.2d 504 (2d Cir. 1942); Steel Improvement and Forge Co. v. Commissioner, 314 F.2d 96 (6th Cir. 1963).
The only reason for characterizing the payment to petitioner as a payment of dividends is because the parties ill-advisedly called it that. Actually, except for the amount of $9,384.65, nothing was paid and nothing was received. Brown-Longyear did not even have enough in its bank account to cover the so-called payment. At no moment did Frelbro have any right to the control or disposition of the amount received from Brown-Logyear since not only was Frelbro, as an agreed part of the same transaction, under a duty to return the money immediately upon its receipt, but the checks were simultaneously exchanged. Frelbro did not receive the payment from Brown-Longyear under any "claim of right" within the meaning of the cases which have given effect to that concept.*fn3
The "claim of right" cases involve an independent duty to return a payment at some later date and usually concern themselves with whether a payment is taxable in the year when made although the taxpayer may be able to deduct the amount when he repays it in a subsequent year.
"The rule is founded upon the necessity of giving finality to the annual accounting period and upon recognition of the impracticability of compelling the treasury to determine when a taxpayer's claim is without legal warrant. United States v. Lewis, supra, 340 U.S. at page 592, 71 S. Ct. at page 523; Rutkin v. United States, 343 U.S. 130, 137, 72 S. Ct. 571, 96 L. Ed. 833. Pecuniary gain received under a claim of right must be reported for the year in which it has been received. If the taxpayer is subsequently adjudged liable to return the funds, he is allowed a deduction for the year in which they are repaid." United States v. Lesoine, 203 F.2d 123, 126 (9th Cir. 1953).
In United States v. Merrill, 211 F.2d 297 (9th Cir. 1954), the court found the "claim of right" doctrine inapplicable, saying:
"[The] mistake was discovered in the same year as the sum was received (1940) and appropriate adjustments were made in [the taxpayer's] own books and those of his wife's estate in that year in recognition of the mistake. We think the $7500 receipt in 1940 was thereby placed outside the operation of the 'claim of right' rule. That rule is founded upon the proposition that, when funds are received by a taxpayer under claim of right, he must be held taxable thereon, for the Treasury cannot be compelled to determine whether the claim is without legal warrant, and repayment of the funds in a later year cannot, consistently with the annual accounting concept, justify a refund of the taxes paid. United States v. Lesoine, supra, 203 F.2d at page 126, and cases there cited. The usual case for application of the rule involves a taxpayer who [has] received funds during a taxable year, who maintains his claim of right thereto during that year, and who subsequently, in a later year, is compelled to restore the sum when his claim proves invalid. We are not aware that the rule has ever been applied where, as here, in the same year that the funds are mistakenly received, the taxpayer discovers and admits the mistake, renounces his claim to the funds, and recognizes his obligation to repay them.Cf. Carey Van Fleet, 2 B.T.A. 825; Curran Realty Co. v. Commissioner, ...