Appeal from the entry of summary judgment in favor of appellee in the United States District Court for the Southern District of New York (Whitman Knapp, District Judge ), 496 F. Supp. 1286 (1980), dismissing appellant's action for a refund of corporate income taxes. Reversed and remanded.
Before Kaufman and Timbers, Circuit Judges, and Ward, District Judge.*fn*
This appeal presents the narrow question whether for federal income tax purposes an acquiring corporation may deduct the expenses incident to its acquisition of a corporate subsidiary by a tax-free, stock-for-stock exchange pursuant to I.R.C. §§ 361 and 368, in the later tax years during which the acquiring corporation liquidates the subsidiary and disposes of the line or lines of business acquired in the earlier transaction. Reasoning in this case that these expenses were incurred by appellant acquiring corporation in the creation of a new corporate entity comprising the acquiring corporation merged with two acquired subsidiaries, the district court held that the expenses became part of the capital basis of the acquiring corporation and could only be deducted at the time of the surviving corporation's demise. Because we find that the acquiring corporation may have been entitled to deduct some of these expenses at the time the acquired corporations were liquidated, we reverse and remand for further findings of fact.
Appellant McCrory Corporation ("McCrory") brought this action in district court seeking a refund of $57,278.70, plus interest, on income taxes alleged to have been improperly assessed and collected for the corporation's tax year that ended January 31, 1966. McCrory maintained that the Internal Revenue Service ("IRS") erroneously disallowed deductions totaling $159,107 for expenses incurred incident to the two transactions in issue here. The dispute was presented to the district court for decision by cross-motions for summary judgment, on the basis of facts stipulated to by the parties.
Each of the two transactions giving rise to this appeal presents the same legal question. Both transactions involved the acquisition by one corporation of the stock of another by statutory merger. In the first transaction, completed on October 31, 1958, Olen Company, Inc. ("Olen"), was acquired by and merged into H. L. Green Company ("Green"), McCrory's predecessor.*fn1 On December 22, 1960, in the second transaction, National Shirt Shops of Delaware, Inc. ("National"), was acquired by and merged into McCrory. Olen was engaged in the business of operating a chain of retail stores dealing in general merchandise. National operated a chain of stores selling men's furnishings at retail. The IRS determined that both transactions were tax-free mergers pursuant to I.R.C. § 368(a)(1)(A), and as a result the shareholders of Olen and National who exchanged their stock for shares in Green and McCrory, respectively, sustained no gain or loss for federal income tax purposes.*fn2
At the time it was acquired by Green, Olen was operating its retail business both directly and through the ownership of 123 subsidiary corporations. The subsidiaries acquired by Green from Olen thereafter functioned as Green's Mobile (Alabama) Division. The Mobile Division proved unprofitable, however, and on January 31, 1961, when most of the subsidiaries in the division were insolvent, the Olen subsidiary corporations were liquidated and their assets distributed to Green. By November 1961, each of the subsidiaries had been dissolved and the subsidiaries' corporate charters had been surrendered. McCrory, having succeeded Green in June 1961, then directly operated the retail stores acquired in the Olen merger. The stores were gradually sold off over the course of the next three years. The Olen business was finally discontinued in McCrory's tax year ending January 31, 1965.
Like Olen, National operated its retail outlets both directly and through subsidiary corporations. On January 31, 1964, McCrory sold the operating assets of the National subsidiaries to third parties and in November and December 1964 liquidated the subsidiaries.*fn3 The corporate charters of all of the National subsidiaries were surrendered between June 1965 and January 1966.*fn4
Green initially sought to deduct the $52,843 of expenses incident to its acquisition of Olen in the tax year during which the acquisition was made. The IRS ultimately determined not to allow this deduction on the ground that the expenses were nondeductible capital expenditures that could be deducted only when Green finally abandoned the Olen business. Accordingly, McCrory, as Green's successor, claimed the $52,843 deduction for its tax year ending January 31, 1965, the year in which the Olen business was finally discontinued. Because McCrory had a net operating loss for that tax year, however, it carried this deduction over to the tax year ending January 31, 1966, the year in issue, for which McCrory had a net operating loss carryover.
On its 1960 income tax return, McCrory deducted $146,533 as expenses incident to its merger with National. The IRS allowed $40,269 of this amount to be taken as a current deduction, but required the remaining $106,264 to be capitalized. McCrory then sought to deduct this latter sum in the tax year ending January 31, 1966, during which it had completed divesting itself of the National subsidiaries and their assets. Thus, for the corporation's tax year ending January 31, 1966, McCrory claimed a total deduction of $159,107 for expenses incident to the Green-Olen and McCrory-National transactions. It was the IRS's determination not to allow this deduction that led to this lawsuit.
The precise question before us, we were somewhat surprised to discover, is one of first impression. The parties have pointed us to no case, and we have found none, addressing the issue raised in this case whether capitalized expenses incurred in connection with the acquisition of ongoing lines of business by statutory merger can be deducted in the year when the lines of business are sold or abandoned. Strictly speaking, we are not here concerned with capitalized organization or reorganization expenses, or with expenditures incident to the liquidation of a corporation.
The question presented divides itself into two sequential lines of inquiry. The first is whether the acquisition expenses at issue here should be viewed as expenditures incident to corporate organizations or reorganizations, or be treated as expenditures incident to the purchase of assets. The Government, calling McCrory's expenditures "merger expenses," contends that the expenses should be treated as organization or reorganization expenditures. In our view, McCrory's acquisition expenses are more properly viewed as analogous to expenses incident to the purchase of an asset and should be treated accordingly. Viewing the matter in this way, we conclude that McCrory may have been entitled to the deduction of some of its acquisition expenses at the time it disposed of the Olen and National assets and lines of business. Having reached this conclusion, it is necessary that we then turn to a second line of inquiry and consider whether all or only part of McCrory's acquisition expenses were deductible. We conclude that, because some of the acquisition expenses were incurred, in effect, in the raising of capital, McCrory was not entitled to deduct all of ...