Appeal from the decision of the United States Tax Court which determined a deficiency in appellant's corporate income tax for the taxable year 1965 and imposed a 5% penalty pursuant to 26 U.S.C. § 6653(a) (1954). Reversed.
Before Feinberg, Chief Judge, Oakes, Circuit Judge, and Conner, District Judge.*fn*
This is an appeal pursuant to 26 U.S.C. § 7482 from a decision of the United States Tax Court, 73 T.C. 1019, determining a deficiency in the tax return of appellant Gerli & Co., Inc. ("Gerli") for the taxable year 1965 in the amount of $346,448.50 and imposing a 5% penalty in the amount of $17,332.42 pursuant to 26 U.S.C. § 6653(a).
Factual and Procedural Background
Gerli, a Delaware corporation engaged in textile manufacturing, had a wholly owned Canadian subsidiary, La France Textiles, Ltd. ("LFT") which was established in 1927*fn1 and operated profitably for many years. However, in the late 1950's LFT suffered several consecutive years of heavy losses and in 1959 sold its plants, equipment and inventories and substantially ceased business activity. After five years of searching for a suitable business venture for LFT, Gerli concluded in 1964 that LFT should be fully liquidated.
On October 26, 1964, Gerli applied to the Internal Revenue Service ("IRS") for a ruling that the liquidation of LFT would be accorded tax-free treatment pursuant to 26 U.S.C. §§ 332 and 367.
Section 332 provides that complete liquidation of a subsidiary corporation which is at least 80% owned by the taxpayer is a non-taxable event. Section 367, as it stood in 1965, provided that a foreign subsidiary "shall not be considered a corporation" for the purpose of eligibility for the Section 332 exemption unless
it is established to the satisfaction of the Secretary (of the Treasury) or his delegate that such exchange is not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes.
In connection with Gerli's application for an exemption ruling, Gerli's counsel had a number of discussions with IRS representatives, who indicated that such a ruling would not be issued unless Gerli agreed to report all of LFT's accumulated earnings and profits as dividend income to it during the year of liquidation. On December 2, 1964, Gerli accordingly filed an "Addendum to Request for Section 367 Ruling" in the form of a letter from Gerli's president, Francis M. Gerli, stating that Gerli
agrees that in the event it proceeds with the liquidation of LFT, Ltd., pursuant to a ruling of the Commissioner based on the solicitation of October 26, 1964, current and accumulated earnings of LFT, Ltd. at the time of liquidation will be treated by Gerli & Co., Inc., as dividend income in the year of the LFT, Ltd., liquidation, subject to applicable foreign tax credits.
On January 15, 1965, the IRS issued a letter stating that, based upon the information submitted and upon the foregoing representation,
(1) The proposed complete liquidation of L.F.T. is not in pursuance of a plan having as one of its principal purposes the avoidance of federal income taxes within the meaning of section 367 of the Code.
(2) In accordance with section 333(a), no gain or loss will be recognized by Gerli upon the receipt of L.F.T.'s assets provided all the requirements of section 332(b) are met.
It is important that a copy of this letter be attached to the Federal income tax return of Gerli for the taxable year in which the transaction is consummated.
LFT was fully liquidated in 1965, with Gerli receiving cash and assets having a stipulated total value of $1,782,296. In its federal income tax return for that year, Gerli, contrary to its representation to the IRS, did not include as income any of the proceeds of the liquidation, but merely stated:
Approval for a tax free liquidation of LFT, Ltd. was received from the Treasury Department, Washington, D.C. on January 15, 1965.
No copy of the letter ruling of the IRS was attached to the return.
When Gerli's 1965 return was audited, the IRS issued a "30-day letter" which determined a deficiency of $372,826.23, based principally upon Gerli's failure to report as dividend income the accumulated earnings and profits of LFT. The Appellate Division of the IRS remanded the case to the District Director of the IRS, stating:
Our preliminary review of the case indicates that there is substantial doubt as to whether there is any legal authority to require the taxpayer to report dividend income in such a situation absent a binding closing agreement.
The District Director thereafter issued an amended 30-day letter treating as a long-term capital gain the amount of $1,370,013.43 by which the proceeds of the liquidation exceeded Gerli's cost of acquiring LFT's shares, and determining a deficiency of $346,448.50.*fn2
Gerli petitioned the Tax Court for a redetermination of this deficiency. On March 5, 1980, the Tax Court (Samuel B. Sterrett, Judge) ruled (1) that Gerli was not entitled to the benefit of the IRS ruling granting tax exemption for the liquidation of LFT because it had failed to comply with the express condition of that ruling that the proceeds of the liquidation be reported as dividend income on Gerli's federal tax return for ...