Superheater Co. v. Commissioner

THE SUPERHEATER CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Superheater Co. v. Commissioner

Docket No. 8383.

United States Board of Tax Appeals

12 B.T.A. 5 ; 1928 BTA LEXIS 3618 ;

May 18, 1928 , Promulgated

*3618 George E. Holmes, Esq., for the petitioner.

Thomas M. Dudley, Jr., Esq., for the respondent.

PHILLIPS

*5 Petitioner appeals from the determination of a deficiency of $37,911.67 in income and profits tax for 1920. It alleges that the Commissioner erred in refusing to permit the deduction of $100,000 paid in settlement of a claim for damages, and in determining that it realized income by reason of the receipt in that year of 15,000 shares of the capital stock of a certain British company.

FINDINGS OF FACT.

The petitioner is a New York corporation with its principal office in New York City. It was formerly known as the Locomotive Superheater Co.

The Locomotive Superheater Co. was incorporated in 1912 under the laws of Delaware, with a capital stock of $2,500,000. The capital stock was divided into 25,000 shares of the par value of $100 each, of which 24,875 shares had been issued and were outstanding on January 1, 1914, and January 1, 1917.

In September, 1914, the Schmidtsche Heissdampf Gesellschaft mit beschrankter Haftung, a German corporation hereinafter referred to as the German Company, held 13,525 shares of the stock of the Locomotive *3619 Superheater Co. represented by several certificates registered in its name, certificate No. 134 being for 13,490 shares. In September, 1914, certificate No. 134 was on deposit with a German bank at London, England, having been seized by the British Government.

By action of the board of directors of the Locomotive Superheater Co. at its October 2, 1914, meeting, upon the request of the German Company, certificate No. 134 for 13,490 shares standing *6 in the name of the German Company was canceled on the Company's books and a new certificate, No. 288, for 2,500 shares was issued to Briesen & Knauth, a firm of New York attorneys, and another certificate, No. 289, for 10,990 shares was issued in the name of the German Company. Certificates Nos. 288 and 289, together with an assignment in blank, were, pursuant to an agreement, placed on deposit with the Commercial Trust Co. of Jersey City, N.J.

By action of the board of directors of the Locomotive Superheater Co. at its February 21, 1916, meeting, upon the request of the German Company, certificates Nos. 288 and 289 were withdrawn from the Commercial Trust Co. and canceled, new certificates being issued in place thereof, *3620 one certificate, No. 352, in the name of the German Company for 6,740 shares, and two certificates in the name of Briesen & Schrenk (successors of the dissolved firm of Briesen & Knauth), one of such certificates being No. 351 and being for 4,250 shares, and one certificate being No. 353 and being for 2,500 shares. Certificates Nos. 351, 352, and 353, together with an assignment in blank, were, pursuant to agreement, placed on deposit with the Commercial Trust Co. of Jersey City, N.J.

By action of the board of directors of the Locomotive Superheater Co. at its December 29, 1916, meeting, upon the request of the German Company, certificate No. 352, for 6,740 shares, was withdrawn from the Commercial Trust Co. and canceled, two new certificates being issued in lieu thereof, one, certificate No. 389, being issued to Briesen & Schrenk for 6,025 shares and one, certificate No. 390, being issued in the name of the German Company for 715 shares. Certificates Nos. 389 and 390, together with an assignment in blank were pursuant to agreement placed on deposit with the Commercial Trust Co. of Jersey City, N.J.

The net result of the three successive transfers made at the request of the *3621 German Company was that the original certificate No. 134 for 13,490 shares was canceled of record and the shares covered thereby were represented by certificates No. 353 for 2,500 shares, No. 351 for 4,250 shares, and No. 389 for 8,025 shares, making a total of 12,775 shares, all registered in the name of Briesen & Schrenk, and by certificate No. 390 for 715 shares in the name of the German Company.

The Locomotive Superheater Co. was advised on December 28, 1916, that the German Company had sold on November 16, 1916, 12,825 shares of the Company's stock to Jacob Robert Sigg-Fehr, Gottfried Rudolph Baumann-Kienast, and Edmund Cams, all of Zurich, who were stated to be Swiss citizens. These individuals are hereinafter referred to as the Swiss claimants. By the terms of the sale Briesen & Schrenk were designated trustees of the 12,825 shares sold.

*11 On January 1, 1917, there stood on the books of the Locomotive Superheater Co. 715 shares in the name of the German Company and 12,775 shares in the name of Briesen & Schrenk. On April 6, 1917, a state of war was declared between the United States and the German Empire. The Trading with the Enemy Act was passed by Congress *3622 as of October 6, 1917, and provided for an alien property custodian.

After several conferences between special counsel for the Locomotive Superheater Co. and the office of the Alien Property Custodian the Company on July 18, 1918, upon advice of its counsel, canceled certificates Nos. 351, 353, and 389 and reinstated certificate No. 134. Pursuant to the demand of A. Mitchell Palmer, properly in office at the time as Alien Property Custodian, made as of August 21, 1918, upon the ground that there existed on deposit in a London bank a certificate (No. 134) for 13,490 shares in the name of the German Company and the resultant conclusion that the property was enemy-owned, the Company transferred on its books to the Alien Property Custodian 13,775 shares of stock. The balance of the shares making up the total of 13,490 shares covered by certificate No. 134 represented the 715 shares never transferred by the German Company to Briesen & Schrenk, said shares having been transferred on the books of the Company to the Alien Property Custodian some time previous.

Dividends declared as of June 21, 1918, and July 19, 1918, in the total amount of $128,250, were withheld by the Locomotive *3623 Superheater Co. and subsequently paid to the Alien Property Custodian on November 12, 1918. Dividends declared by the Locomotive Superheater Co. as of October 18, 1918, and January 29, 1919, in the total amount of $128,250, were paid to the Alien Property Custodian on October 29, 1918, and February 10, 1919, in equal amounts of $64,125.

On February 5, 1919, the Alien Property Custodian having obtained possession of certificate No. 134 surrendered it with other certificates to the Locomotive Superheater Co. for cancellation and secured certificate No. 482 for 13,525 shares, certificate No. 483 for 3 shares, certificate No. 484 for 550 shares, and certificate No. 485 for 100 shares, the total number of shares covered by said certificates totaling 14,178.

On or about January 23, 1919, Francis P. Garvin, as the duly appointed and qualified Alien Property Custodian, sold to Walker D. Hines, Director General of Railroads for the United States, 14,178 shares of the Locomotive Superheater Co. at the price of $200 per share, among which shares so sold were the 12,775 shares sold by the German Company to the Swiss claimants and claimed by them. Thereafter on February 18, 1919, the Locomotive *3624 Superheater Co. *8 issued a stock certificate, No. 487, to "Walker D. Hines, Director General of Railroads for the United States," covering 14,178 shares, among which 14,178 shares were the said 12,775 shares. Certificates previously issued to cover such shares, referred to in the paragraph immediately preceding this paragraph, were canceled.

On the 12,825 shares of the 14,178 shares sold by the Alien Property Custodian to the Director General of Railroads, dividends were paid to the Director General of Railroads in office at the times indicated, by the Locomotive Superheater Co. in the amount of $448,875. Such dividends were paid between April 28, 1918, and December 28, 1920, inclusive.

In the latter part of the year 1920, after continued negotiations between attorneys for the Swiss claimants and the attorneys for the Company looking towards the avoidance of litigation on the part of the Swiss claimants for the acts of the Locomotive Superheater Co. in connection with the seizure of the stock by the Alien Property Custodian, it was agreed between the parties that the Company would be released from liability for any of its acts in consideration of the payment of a fixed *3625 sum. Pursuant to this agreement the Company paid the Swiss claimants the sum of $100,000.

On January 10, 1921, John Barton Payne, Director General of Railroads, successor to Walker D. Hines, in said office, sold the said 14,178 shares, including the said 12,775 shares, to the Locomotive Superheater Co. at the price of $248 per share.

On the 8th day of December, 1921, the Swiss claimants brought suit against Frank White individually and as Treasurer of the United States, and others, in the Supreme Court of the District of Columbia. By such suit the Swiss claimants sought an injunction against Frank White as Treasurer of the United States, and James C. Davis as Director General of Railroads, and Thomas W. Miller as Alien Property Custodian, restraining them from transferring, assigning, delivering, paying out, or in any way disposing of certain funds, including the sum of $3,180,800, being the proceeds of the sale of the stock by the Director General of Railroads to the Locomotive Superheater Co., together with additional sums received by any of the defendants, or of any predecessor in office of said defendants, by way of dividends, or otherwise, upon the said 12,825 shares of *3626 stock or in any way in respect thereto. The Swiss claimants appealed to the Court of Appeals of the District of Columbia from the order of the Supreme Court of the District of Columbia discharging the rule to show cause and denying a temporary injunction. Frank White, individually and as Treasurer of the United States, and James C. Davis, individually and as Director General of Railroads, were named as appellees. The decision of the Court of Appeals of the *9 District of Columbia in the above action is reported as .

During 1919 George L. Bourne, who was president and director of the Locomotive Superheater Co., proceeded to England in behalf of the company to discuss with the directors of the Schmidt Superheating Co., Ltd., a British corporation, plans for the acquisition by the Locomotive Superheater Co. of a controlling interest in the British corporation. Previous to this time both Bourne and the Locomotive Superheater Co. were large stockholders in the British company but such stock had been seized by the British Public Trustee, who had refused to release same or to permit the purchase of same by other than British *3627 citizens. The negotiations with the Schmidt Superheating Co., Ltd., took place during 1919 and 1920. Bourne originally proposed to purchase a majority of the stock, 61,000 shares of the par value of Pound 1 each, for Pound 25,000. The original negotiations were dropped on account of regulations prohibiting the acquisition of stock by aliens. The by-laws of the British company also prohibited the issuance of stock at less than par, except that the British company was authorized to allow a commission of 25 per cent of par. Bourne, on behalf of the petitioner, realizing that it was impossible to carry out the original plans, thereafter, in 1919, opened up new negotiations to obtain a substantial holding in the British company.

In July, 1919, Bourne offered to acquire a certain number of unissued shares in the Schmidt Superheating Co., Ltd., and to arrange for the company to be licensed under patents held by the petitioner in respect of the manufacture and export to various countries of forged return bends. At that time the British company was in financial stress. Owing to post-war conditions it was impossible to conclude the negotiations at this period. Bourne finally proposed *3628 to purchase 25,000 shares of stock at par less a commission of 25 per cent and also to issue a license agreement to the British company for 15,000 shares. This represented 50 per cent interest in the ordinary stock of the British company. Such proposal was eventually carried through.

In April, 1919, the name Schmidt Superheating Co., Ltd., was changed to Marine and Locomotive Superheater Co., Ltd. By resolution passed March 26, 1920, and confirmed April 12, 1920, new articles of association were adopted by the Marine and Locomotive Superheater Co., Ltd., which contained among other provisions, the following:

The directors shall not without the consent of the Board of Trade allot any shares or register any transfer of shares, the allottment or registration of which would cause more than 50% of the total of the issued par capital, or *10 more than 50% of the voting power for the time being, of the company to be held by foreigners and/or foreign corporations or corporations under foreign control * * *.

Subject to any contract for the time being subsisting with respect to the disposal of the shares in the company for the time being unissued and subject to the provisions *3629 of these articles, the shares shall be at the disposal of the Directors and they may allot, or otherwise dispose of them, to such persons, at such times and either at par or premium, and generally on such terms and conditions as they think proper and with full power to give to any person with any, or without, consideration the call of, or option to take, any shares either at par or at a premium and for such time and on such conditions as the Directors think fit. * * *

Permission for the acquisition of the 50 per cent interest in the British company by petitioner was obtained from the Board of Trade in 1919. The authorization for the issuance of the 25,000 shares was made at the board of directors' meeting of the Schmidt Superheating Co., Ltd., held July 25, 1919. The 25,000 shares consisted of 21,000 "A" ordinary and 4,000 "B" ordinary shares, each of the par value of Pound 1. There was no substantial difference between "A" ordinary and "B" ordinary shares. Payments on the 25,000 shares were made partly in 1919 and partly in 1920, as calls were issued. The first payment was made on July 30, 1919, and the payments completed March 21, 1920.

A memorandum was prepared and executed *3630 in 1919 which set forth the principal provisions of the license agreement upon which the parties had agreed. Under this memorandum the license agreement was to provide for the issuance of 15,000 shares of stock to petitioner and for certain royalties to be paid to it, a minimum annual payment thereunder being guaranteed by the British company. In 1919 and 1920, the attorneys for petitioner and the British company were engaged in preparing and drafting the formal patent license agreement. Two or three drafts were subsequently drawn up and exchanged between petitioner and the British company before the final agreement was executed.

Under date of April 30, 1920, the directors of the Marine and Locomotive Superheaters, Ltd., adopted a resolution to enter into the license agreement with petitioner which had been negotiated by its officers, as set out above. The license agreement in its final form was signed and sealed September 10, 1920. On that date the directors of the British company adopted the following resolution:

As part consideration under the license agreement with the Locomotive Superheater Company the Directors resolved to allot to F. R. Fitzpatrick and M. T. McKee, *3631 as nominees for the Locomotive Superheater Company, 15,000 "B" ordinary shares, such shares to be issued as fully paid.

Such certificates were issued on September 17, 1920.

*11 Machinery for the production of forged return bends was shipped by the petitioner to the British company in the latter part of 1919 or the early part of 1920. Bourne wrote to the British company on December 5, 1919, setting out generally the terms upon which that company could for the time being export forged return bends until such time as a formal license agreement could be executed. One McKee, a mechanical engineer employed by the petitioner, was sent over to England in the latter part of March, 1920, to assist in setting up the machinery for operations. The British company began to operate the machinery in the manufacture of forged return bends in July or August, 1920.

The fair market value of the ordinary shares of the British company did not exceed 10 shillings per share in 1919.

Prior to July, 1919, the outstanding stock consisted of 10,000 preference shares and 40,000 "A" ordinary shares of the par value of Pound 1 each. The authorized stock consisted of 15,000 preference shares, *3632 61,000 "A" ordinary shares and 39,000 "B" ordinary shares.

The respondent determined that the 25,000 shares were purchased by the petitioner at par and that the petitioner realized a taxable gain upon the receipt of the 15,000 shares for the license agreement, in the amount of $26,025, which was determined by him to be the value of the 15,000 shares at 10 shillings a share.

OPINION.

PHILLIPS: The two errors alleged are stated in the petition to be as follows:

(a) The disallowance of a deduction in the sum of $100,000 taken by the taxpayer in its 1920 return, said amount representing a payment to a certain Swiss partnership and the individuals thereof for the purpose of avoiding litigation in connection with certain acts of the corporation.

(b) The inclusion in income for the year 1920 of $26,025 on the ground that such sum represented a profit to the company resulting from the purchase of shares of stock in a certain British corporation and the execution of an agreement with such British company covering a certain license for the use of patents owned by the Locomotive Superheater Company.

All of the facts with respect to the first issue are admitted by the pleadings. *3633 The petitioner claims that it is entitled to deduct the $100,000 paid to the Swiss claimants as either an ordinary and necessary expense of its business or as a loss sustained. The Commissioner denies that it was either an ordinary and necessary expense or a loss. It is unnecessary to repeat here the facts which gave rise to the claim made on behalf of the Swiss claimants. The substance of their complaint was that petitioner canceled its capital stock owned by them and reinstated other stock in such manner that this stock came into the hands of the Alien Property Custodian by reason of which they *12 were damaged. To avoid litigation on the part of the Swiss claimants for these acts, petitioner agreed to and did pay $100,000 to be released from liability. It would appear that there can be no question of good faith involved, since an agency of the United States owned more than 50 per cent of the capital stock of petitioner and must have given its consent to the payment. We are of the opinion that the Commissioner erred in refusing to permit the deduction of this payment. *3634 , and decisions cited; .

The second issue arises out of the circumstances in which petitioner acquired 40,000 shares of the capital stock of the British company. Fifteen thousand shares of this stock were acquired ostensibly in part payment for a right to use and manufacture certain patented devices, and the respondent has included their value as income to the petitioner. Petitioner contends that we should go back of the form of the transaction to its substance, when we will find that the 15,000 shares in question were not issued for the license but were acquired as a part of the transaction by which petitioner acquired 25,000 shares for Pound 18,750 in cash. It would appear that if we are to reach the conclusion which petitioner urges we must go further than looking through form to substance and look through both the form and substance of the transaction to the thoughts which motivated the actions of the parties.

The transaction took the form of a purchase of 25,000 shares of stock for Pound 25,000 and the granting of a license in consideration of the issue of *3635 15,000 shares of stock and the undertaking to pay royalties. This license agreement was not a worthless thing, availed of as a subterfuge for the issuance of stock, but was a bona fide contract under which the parties intended to and did operate in subsequent years. The substance of the transaction was that petitioner paid Pound 18,750, the British company issued 40,000 shares of its stock, and the parties entered into the license agreement. The evidence justifies the conclusion that petitioner would not have purchased 25,000 shares of the British company stock for Pound 18,750 had not the license agreement been made. But it does not follow that the transaction, in its substance, falls into two transactions; one a purchase of 40,000 shares for Pound 18,750 and the other the grant of a license in consideration of an undertaking to pay royalties. There is no attempt to show the negotiation of two such transactions, each independent of the other, and a final merging of the two to meet some need.

The substance of the situation is that the parties entered into two contracts which were mutually dependent in their inception. It is not possible to rearrange these as petitioner, *3636 in effect, contends we should do, into two contracts having terms other than those fixed by the parties, on the theory that we are looking to the substance *13 of the transaction. The contracts entered into fully expressed the agreement made by the parties and we see no basis on which we may reframe those contracts on the theory that the parties would have made different contracts had the law permitted.

There is a further consideration which might be mentioned. The contracts as made appear to have been legal. If we were to follow petitioner's suggestion we should be construing the agreements of the parties as illegal. As between the two constructions, that which makes the agreements legal is to be preferred. The action of the Commissioner in adding to income the value of 15,000 shares of the capital stock of the British company is approved.

Decision will be entered under Rule 50.