Opposition Brief — Commissioner v. Clark

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87-1168

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e ke EP

No. 87-1167 + | FEB 19488

In The cree —

Supreme Court of the United States

October Term, 1987

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COMMISSIONER OF INTERNAL REVENUE,

Petitioner,

DONALD E. CLARK AND PEGGY S. CLARK,

Respondents.

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Vv

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

,———

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BRIEF FOR THE RESPONDENTS IN OPPOSITION

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*Watter B. SLocomBE

Dante. B. Ros—enpaum

Capuin & Dryspa.e, Chartered

One Thomas Circle, N.W.

Washington, D.C. 20005

(202) 862-5000

February 1988

*Counsel of Record

COCKLE LAW BRIEF PRINTING CO.. (800) 225-6964

or call collect (402) 342-2831

a

QUESTION PRESENTED

When respondent’s company was acquired, by a pub-

licly held company, in a tax-free reorganization, respon-

dent received 300,000 shares of common stock and chose

to receive cash instead of 125,000 additional shares of the

acquiring company’s stock. The question presented is

whether, under section 356(a)(2) of the Internal Revenue

Code, the cash he received in lieu of additional stock

should have been taxed as a capital gain or as a dividend.

ill

TABLE OF CONTENTS

Page

Ns esseememsneeennem 1

a (a ae ees 2

Nee ceecereemeetrrssneenenin 2

Neen seeeseeeesemeerernens 5

EEE 5

Discussion .......... = en IS 6

1. The decision below is clearly correct. 00000... 6

a. The court below correctly looked to Sec-

eens rer g@meence,. CT

b. The court below properly treated the

transaction as an integrated whole, con-

sidering the effect of receiving cash on

the tarpayer’s interest in the continuing

Te TTT Te ee, OS

¢ The Bxecutive Branch has already agreed

to accept legislation codifying the an-

alysis of the court below. occ 15

2. There is no conflict requiring this Court’s at-

ac cncenceecarenceecnrecmnsertncaneeereeemreprene 16

3. This Court should not attempt to resolve the

issue presented here before it is resolved

within petitioner’s own ranks, 0000000. 22

EEE EE

lv

TABLE OF AUTHORITIES

Page

Cases:

Commissioner of Internal Revenue v. Bedford’s

Estate, 325 U.S. 288 (1945) 10

General Housewares Corp, v. United States, 615

ee ee Cee RINE, TE weticietoens a ee ee

Ilawkinson v. Commissioner of Internal Revenue.

—&,10,18

239 F.2d 747 (2d Cir. 1956) |

King Enterprises, Ine. v. United States, 189 Ct.

Cl. 466, 418 F.2d 511 (1969)

Lewis v. Commissioner of Internal Revenue, 176

F.2d 646 (1st Cir. 1949) ow... 7

Lorillard v. Pons, 484 U.S. 575 (1978) _.

8, 10, 17

Minnesota Tea Co. v. Helvering, 802 U.S. 609 (1928) 12

173 F.

Ross v. United States, 146 Ct. Cl. 223,

(1959) |

Supp. 793, cert. denied, 361 U.S. 875

Shimberg v. United States, 577 F.2d 283 (Sth Cir

1978), cert. denied, 489 U.S. 1115 (1979)

United States v. Davis, 397 U.S. 301 (1970)

Wright v. United States, 482 F.2d 600 (Sth Cir.

1973) aes

Zenz v. Quinlivan, 218 F.2d 914 (6th Cir, 1954)

STATUTES:

Internal Revenue Code of 1954 (26 U.S.C.) :

RN NII cccsesehssconisarneee

Sec. 302(b) (1)

See. 302(b)(2) —..

See. 302(b) (3)

passim

a oe

passim

ee 12

passim

x

‘,

7,12

8

te

TABLE OF AUTHORITIES—Continued

Page

ERR Age enon are AM nate ented 9

a lO ee 7, 8,9

hs TEED iirc aitsecncethcttepeniccnielatctateniensitdaananasssncaiion 4,7

i i ee passim

eg he 5 aan eee ORO Rea ON 3

nn i ee 3

Reuies anp Recuations:

Priv. Ltr. Rul. 8640064 (July 8, 1986) . 21

Priv. Ltr. Rul. 8728087 (April 13, 1987) 10

Priv. Ltr. Rul. 8748038 (September 1, 1987) 10

Rev. Rul. 75-83, 1975-1 C.B. 112 ................10, 17, 18, 21, 22, 23

Rev. Rul. 76-385, 1976-2 C.B. 92 oc csssssecesnseennenennee 7

Treas. Reg. § 1.368-1( 1) nc .cecccccccsnseenee nt saiipspaie alliage 11

Treas. Reg. § 1.6661-3 SE. A or oan 21

LEGISLATIVE MATERIALS:

Reform of Corporate Taxation: Hearing Before

the Committee on Finance United States Sen-

ate, 98th Cong., Ist Sess. (1983) ..... 16

H.R. Conf. Rep. No. 98-861, 98th Cong., 2d Sess.,

1 Fee SI Serdocktrtadacaesananrdnceasnmencnn 9

H.R. Conf. Rep. No. 100-495, 100th Cong., 1st

Sess., Part LIT (1987) . 20

vi

TABLE OF AUTIHORITIES—Continued

Page

Staff of The Committee on Finance United States

Senate, Mth Cong., Ist Sess., The Reform and

Simplification of the Income Taxation of Cor-

porations (S. Prt. 98-95 1983) oo. eee. ae

Staff of The Committee on Finance United States

Senate, 99th Cong., Ist Sess., The Subchapter

C Revision Act of 1985 (S. Prt. 99-47 1985) 14, 16

Joint Committee on Taxation, 99th Cong., 2d Sess.,

Tax Reform Proposals in Connection with Com-

mittee on Finance Markup (JCS 8-86), March

18, 1986 z 14, 19

MISCELLANEOUS:

ABA Legislative Recommendation 1983-8 (ap-

proved by ABA House of Delegates at 1984

Midyear Meeting) = iaiaalaniicpile: aa

Fleming, ‘‘Reforming the Tax Treatment of Re-

organization Boot,’* 10 J. Corp. Tax 99 (1983) 14

Golub, ** ‘Boot’ in Reorganizations—The Dividend

Equivalency Test of Section 356(1)(2),7° 58 Taxes

$04 (1980) | 14

Levin, Adess, & MeGaffey, ‘* Boot Distributions in

Corporate Reorganizations—Determination of

Dividend Equivalency,’? 30 Tax Lawyer 287 (1977) 14

‘Tax Court Decision Could Ruin Risk Arb Biz,’’

Investment Dealers’ Digest (february 17, 1986), p.20 20

No. 87-1167

“y

Vv

In The

Supreme Court of the United States

October Term, 1987

———$— ~-Q-——- — ——

COMMISSIONER OF INTERNAL REVENUE,

Petitioner,

DONALD E. CLARK AND PEGGY S. CLARK,

Respondents.

ray

Vv

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

—O—

BRIEF FOR THE RESPONDENTS IN OPPOSITION

o—-

OPINIONS BELOW

The opinion of the Court of Appeals (Pet. App. la-l4a)

is reported at 828 F.2d 221. The opinion of the Tax Court

(Pet. App. 15a-39a) is reported at 86 T.C. 138.

JURISDICTION

The judgment of the Court of Appeals (Pet. App. 40a)

was entered on September 4, 1987.) The petition was (tak-

ing account of extensions of time) timely filed on Janu-

ary 11, 1988 and received by respondent on Jannary 14,

1988. The jurisdiction of this Court is invoked under 2s

U.S.C. 1254(1).

°

STATEMENT

Donald Clark, the respondent,’ was the sole share-

holder of Basin Surveys, Inec., a West Virginia corpora-

tion engaged in the business of providing technical ser-

vices to the petroleum industry. In 1978, N.L. Industries

(NL), a publicly held company listed on the New York

Stock Exchange, initiated negotiations with Clark over

the possible acquisition of Basin. In the final negotiating

session, NL offered Clark two alternatives as the price

NL was willing to pay for the stock of Basin: Clark had

a choice of receiving (1) 425,000 shares of NL common

stock, or (2) 300,000 shares of NL common stock and, in-

stead of the additional 125,000 shares, $3.25 million in

eash. After considering the alternative proposals, Clark

decided to accept the offer which provided him with cash

' Mr. Clark’s wife, Peggy S. Clark, is a party solely because

she filed a joint return with her husband for the year in question.

in lieu of the additional shares of stock? In April 1979,

the acquisition was consummated on that basis.

As a result of Clark’s acceptance of the eombined

stock and cash offer, the total number of NIL common

shares outstanding inereased to approximately 32,833,000

shares, and Clark’s stoeckholdings represented approxi-

mately 0.92 pereent of that total. If Clark had aecepted

the all-stoek offer of 425,000 shares, the total number of

NL common shares outstanding would have inereased to

approximately 32,958,000 shares, and Clark’s stockholdines

would have represented approximately 1.3 pereent of that

total. (Pet. App. 16a.) Clark’s 800,000 share ownership of

NL after the transaction was 70.6 pereent of the 425,000

shares he would have owned had he taken the all-stoek

offer.

The transaction qualified as a ‘*reorganization’’ un-

der Section 368(a)(1)(.A) and (a)(2)(D) of the Internal

: In the Tax Court, Clark’s attorney testified (and it was

agreed that, if called, Clark would testify to the same effect) that

Clark originally sought NL stock as the sole consideration for

his Basin stock (C.A. App. 49-50). Also at trial, the official who

represented NL in the negotiations testified that NL was pre-

pared to go forward with the transaction on the basis of either

alternative; that it did not know which offer Clark would ac-

cept; that its preference was to pay Clark a portion of the con-

sideration in cash as a means of reducing the number of shares

of NL stock that would be outstanding after the acquisition;

and that the amount of cash offered to Clark was based on

NL’s determination of the value of the additional 125,000 shares

that it would have had to issue to Clark in the all-stock pro-

posal. (C.A. App. 36-37).

’ The acquisition was structured as a merger of Basin into

a wholly owned subsidiary of NL.

4

Revenue Code of 1954.4 (Pet. App. 16a-17a.) Under See-

tion 356(a)(1), Clark was required to pay tax on the $3.25

million cash or ‘‘boot’’ payment to the extent of his gain

on the transaction with NL. Since Clark’s gain (after

taking into account the cash and market value of the NL

stock received by Clark in exchange for his Basin stock)

exceeded the amount of cash received, Clark reported the

entire cash payment as gain, taxable at long term capital

gain rates under Section 356(a)(2). On audit, the IRS

determined that the eash received by Clark had ‘‘the effeet

of a distribution of a dividend’* under Section 356(a) (2)

aud was, therefore, taxable as a dividend.® Because, in

1979, dividends were taxable at ordinary income rates,

while capital gains were taxed at only 40 percent of ordi-

nary rates, this determination resulted in an asserted de-

ficiency of $972,504.74 in federal income taxes for 1979.

Clark petitioned the Tax Court for review of the IRS

determination. A trial was held in the Tax Court at which

Clark, the NL official who represented NL in the acquisi-

tion, and Clark’s attorney provided testimony on the nego-

tiations between the parties. The Tax Court, in a re-

viewed decision with no dissents among the fifteen par-

ticipating judges, held in favor of the respondent. (Pet.

‘ All statutory references are to the Internal Revenue Code

of 1954, as in effect for the year 1979, unless otherwise specified.

’ Because of a computational error, the amount of gain

actually reported on the return was $3,195,294. In his later

computation for entry of decision by the Tax Court, Clark stip-

ulated that the amount of gain recognized and reported should

have been $3,250,000.

. Pursuant to sec. 356(a)(2), the amount claimed to be tax-

able as a dividend was $2,319,611, the accumulated earnings

and profits of Basin on the acquisition date.

5)

App. 15a-39a.) The Fourth Circuit affirmed, with vo dis-

sents. (Pet. App. la-14a.)

The Fourth Cirenit and the Tax Court considered the

two cirenit court cases which had previously addressed

the issue presented here—Wright v. United States, 482

F.2d 600 (Sth Cir. 1973) and Shimberg v. United States,

O77 F.2d 283 (Sth Cir. 1978), cert. denied, 439 U.S. 1115

(1979). Both courts agreed with the approach adopted

by the Eighth Cireuit in Wright, which produced capital

vain treatment, and both rejected Shimberg, which would

have yielded dividend treatment, as a case in which the

hitth Cireuit had reached the contrary result beeause it

(and the district court whose decision it reversed) had

misunderstood the court’s holding in Wright. (Pet. App.

13a, 27a-29a.)

ARGUMENT

Summary

The decisions of the Court of Appeals and the Tax

Court are correct. They are in accord with basic tax prin-

ciples applicable in the dividend equivalency and reorgani-

zation areas, the decisions of this Court and other federal

courts, the views of numerous tax commentators and the

American Bar Association, and the legislative reecommen-

dations of the staff of the Senate Finance Committee. In-

deed, the Treasury Department has agreed to a proposed

legislative amendment that would codify the approach

adopted below; and the Commissioner himself, has a long-

standing, published position which is at odds with the

position advanced on his behalf in the Court of Appeals

and in the petition.

Petitioner overstates the administrative importance of

the alleged conflict between this case (and Wright) on the

one hand and Shimberg on the other. Beeause of the

elimination of favorable capital gains rates, in the case of

individual shareholders no practical consequence normally

attaches any longer as to whether boot is treated as a

dividend or as capital gain. It is true that corporate

shareholders generally pay lower taxes if, contrary to the

opinion below and in Wright, boot is treated as a dividend

(because of the 80 or 70 percent dividends received de-

duction). However. uf, as suggested in the petition, the

Commissioner were to adopt the approach of the courts

below, it is unlikely that such corporate taxpayers would

rely on the opinion in Shimberg, which is widely regarded

as a ‘‘sport,’’ to classify boot such as existed here as divi-

dends. In any event, it is premature for petitioner to ask

this Court to resolve the alleged conflict, when no such

effort to use Shimberg to reduce future revenues has

arisen and when the issue presented apparently has not

been resolved within the Government’s own ranks.

Discussion

l. The decision below is clearly correct. The law at

issue here is easily summarized: In a corporate acquisi-

tion which qualifies as a ‘‘tax-free’’ reorganization under

Section 368, if a sharehoider of the acquired corporation

receives (in addition to stock in the acquiring company)

cash or other property (‘‘boot’’), he or she must recognize

gain on the transaction up to the amount of the boot re-

ceived (Section 356(a)(1)). That gain is a capital gain

unless the receipt of boot ‘‘has the effect of the distribu-

tion of a dividend,’’ in whieh case the shareholder must

treat it as a dividend (taxed at higher rates in the year

at issue) up to his or her ratable share of aceumulated

earnings and profits of the corporation. Section 856(a)

(2). The sole issue here is, therefore, whether the eash

payment to Mr. Clark had ‘‘the effect of a dividend’’

within the meaning of Section 356, so that, under the rate

structure then in effect, it should have been taxed as ordi-

nary income rather than as the capital gain he reported.

a. The court below correctly looked to Section 302 for

guidance. The initial question considered below is the

seurce of guidance by which to identify a dividend. See-

tion 356 does not contain any guidelines by which to discern

the ‘‘effeet of a dividend.’’ However, Section 302 contains

general principles for determining when a distribution of

cash by a continuing corporation is equivalent to a divi-

dend and when it results in the distributee shareholder’s

parting with a sufficiently large interest in the corporation

to qualify for sale or exchange treatment.’ Virtually al!

Under Section 302, the distribution qualifies for capital

gain treatment if it satisfies one of the following three tests:

(1) The distribution is “not essentially equivalent to a div-

idend.” Section 302(b)(1). This has been interpreted to mean

that the distribution effects a “meaningful reduction’ in the

shareholder’s percentage interest. United States v. Davis, 397

U.S. 301, 313 (1970). In the case of a minority shareholder, vir-

tually any reduction in his percentage interest is considered

“meaningful.” See, e.g., Rev. Rul. 76-385, 1976-2 C.B. 92 (re-

duction from 0.0001118 percent to 0.0001081 percent).

(2) The distribution effects a ‘substantially disproportion-

ate’ redemption of stock. Under Section 302(b)(2), this means

(Continued on following page)

of the courts which have considered the question, including

the courts below, have held that the principles of Section

302 should be applied in determining dividend equivalency

under Section 356(a)(2). See, Wright v. United States,

supra, at 605; Aing Enterprises, Inc. v. United States,

418 F.2d 511, 520-21 (Ct. Cl. 1969); Ross v. United States,

146 Ct. Cl. 223, 173 F. Supp. 798, 797, cert. denied, 361 U.S.

875 (1959); Hawkinson v. Commissioner, 235 F.2d 747,

751 (2d Cir. 1956). See also Shimberg v. United States,

supra, at 287 n. 15 (stating that Section 302 applies in

‘‘appropriate cases’’).

As noted by the Fourth Cireuit, ‘‘there are several

persuasive reasons why § 302 should be used in deter.

mining whether boot should be taxed as ordinary income."

(Pet. App. 5a.) Most importantly, Section 302 and Section

396 address the same issue—whether a particular corpor-

ate distribution should be treated as a dividend or as a sale

or exchange of a portion of the shareholder’s interest in

the corporation. The two sections also contain similar

language.’ Finally, this interrelationship between the two

sections has been expressly recognized by Congress. In

(Continued from previous page)

that immediately after the distribution, the percentage interest

of the distributee shareholder in the voting stock of the cor-

poration must be (i) less than 50 percent, and (ii) less than 80

percent of what it was immediately prior to the distribution.

(3) The distribution effects a complete termination of the

distributee shareholder's equity interest in the corporation. Sec-

tion 302(b)(3).

° Section 302(b)(1) provides for ordinary income treatment

if the distribution is “essentially equivalent to a dividend,”

while Section 356(a)(2) treats boot as ordinary income if it

“has the effect of a distribution of a dividend.”

the Conference Committee Report for the Deficit Redue-

tion Act of 1984, which made changes in the reorganization

provisions, it is stated unequivocally that ‘‘{t|he principles

of section 302 are applicable in testing for dividend equiv-

alency under section 356.’’ H.R. Conf. Rep. No. 98-861,

98th Cong. 2d Sess. 1, 845 (1984-3 C.B. (Vol. 2) 1, 99).°

Qn appeal to the Fourth Cireuit, the Commissioner

challenged this proposition and argued that the principles

of Section 302 are not applicable in the reorganization con-

text, and that, under special standards to be developed for

Section °56(a)(2) only (presumably on a_ case-by-case

basis), a distribution such as the one here should be treated

, This Court has recognized that such express Congressional

recognition of the judical and administrative interpretation of

a statute should be given great weight in determining the mean-

ing of the relevant provisions. Cf. Lorillard v. Pons, 434 U.S.

575, 580 (1978). Apart from the statement in the Conference

Committee Report, the 1984 amendment, itself, requires the

conclusion that the principles of Section 302 apply in deter-

mining dividend equivalency under Section 356(a)(2). The

amendment adds language to Section 356(a)(2) to make it clear

that the question of whether a distribution has the effect of a

dividend is to be “determined with the application of [the at-

tribution rules of] section 318(a)."" This amendment would have

little, if any, meaning unless it were assumed that the tests for

determining dividend equivalency contained in Section 302 are

applicable. Thus, the tests contained in Section 302 require a

determination of the shareholder's percentage interest in the

corporation before and after the distribution. For purposes of

this determination, stock owned by individuals and entities

which are related to the shareholder, within the meaning of

Section 318, are deemed to be owned directly by the share-

holder. Unless the Section 302 test of a change in ownership

interest were to be applied for Section 356(a)(2) purposes, there

would be no need for an attribution rule to compute such own-

ership interests.

10

as a dividend.’ The Fourth Circuit was troubled by the

Commissioner’s new approach: ‘‘[I|n return for abandon-

ing the § 302 analysis, the Commissioner offers no realistic

alternative, except perhaps a return to the abandoned rule

that any pro rata distribution in a reorganization must

automatically be treated as a dividend.’ (Pet. App. 6a.)

The Fourth Cireuit squarely rejected the petitioner’s gen-

eral argument and instead ‘‘joinfed] the long line of

courts that have applied § 302 in the reorganization con-

text.’’ (Pet. App. 6a.) Petitioner does not, in this Court,

mount a general attack on the use of Section 302, only on

its application, but once Section 302 is applied, the holding

below necessarily follows.

- It should be noted that, although petitioner's litigating po-

sition before this Court is now one of agnosticism as to wheth-

er Section 302 applies, the official position of the Internal Rev-

enue Service is that the principles of Section 302 do indeed

apply in determining dividend equivalency under Section 356

(a)(2). See, Rev. Rul. 75-83, 1975-1 C.B. 112; Priv. Ltr. Rul.

8728037 (April 13, 1987); Priv. Ltr. Rul. 8748038 (September 1,

1987).

ue As a result of dicta in Commissioner v. Bedford's Estate,

325 U.S. 283, 292 (1945), for many years it was assumed that

cash or property other than qualifying stock or securities re-

ceived in a corporate reorganization would always have the

effect of a taxable dividend to the extent of the corporation’s

accumulated earnings and profits. This “automatic dividend”

rule came under increasing criticism, however, as being “dif-

ficult to reconcile’ with the language of Section 356(a)(2),

which implies that certain distributions might have the effect

of a dividend while others might not. See e.g., Hawkinson v.

Commissioner, 235 F.2d 747, 750-51 (2d Cir. 1956). As a result,

the courts and the Internal Revenue Service have now retreated

from the automatic dividend rule. See e.g., Wright v. United

States, supra, at 605; Shimberg v. United States, supra, at 287;

King Enterprises, Inc. v. United States, 418 F.2d 511, 520 (Ct.Cl.

1969).

L1

b. The court below properly treated the transaction

as an integrated whole, considering the effect of receiving

cash on the taxpayer’s interest in the continuing business.

This Court has established that the basic characteristic of

a dividend is a distribution to shareholders ‘‘without a

change in the relative economic interests or rights of the

shareholders.’’ United Slates v Davis, 397 U.S. 301, 313

(1970). Seetion 302, in accord with that principle,

measures whether exchange, rather than dividend, treat-

ment is appropriate by considering whether the share-

holder has experienced a significant reduction in his own-

ership interest as a result of the cash payment, so that the

transaction is treated as a sale or exchange, of a portion

of that ownership interest for cash. In a tax-free reorgan-

ization, such as occurred here, measuring the effect of the

cash requires measuring the effect of the distribution on

the taxpayer’s interest in the combined corporation that

emerged from the transaction—here NL. This follows

because the ‘‘essence of [a tax-free reorganization] is a

continuance of the proprietary interests in the continuing

enterprise under modified corporate form.’? Lewis v.

Commissioner, 176 F.2d 646, 648 (Ist Cir. 1949): see also,

Treas. Reg. § 1.368-1(b).

Consistent with these principles, the courts below held

that the relevant inquiry was to compare the economic

interest that Clark had in the continuing enterprise, NL,

as a result of receiving the boot distribution with what

that interest would have been had no boot been received.”

= (Pet. App. 14a, 34a-35a.) It is a measure of the degree to

which the result below turns on the particular facts of this case

that the Fourth Circuit, like the Tax Court, stressed that, on

(Continued on following page)

Specifically, applying Section 302, the Fourth Circuit con-

cluded that the transaction should be examined as an

integrated whole, in which ‘‘the tax consequences .

should reflect the reality of Clark’s choice to forego

125,000 shares of N.L. stock,’’ not, as petitioner argues, as

if the receipt of the cash were a transaction entirely

separate from the simultaneous and related transfer of the

company to NL. The Fourth Cireuit found, ‘*by taking

the eash, Clark surrendered his potential interest in N.L.

to the extent of almost 30%.’’ Accordingly, he was en-

titled, under Section 302, to treat the income as capital

gain.

The integrated approach adopted by the courts below

is also in accord with the established principle of tax law

known as the ‘‘step transaction’? doctrine. Under this

doctrine, rather than giving separate consideration to each

of the various steps which comprise an integrated trans-

action, the steps are viewed together in light of the overall

transaction to determine their tax effect. See e.g. Mimne-

sota Tea Co. v. Helvering, 302 U.S. 609, 613 (19388); Zenz

v. Quinlivan, 213 F.2d 914 (6th Cir. 1954). The courts

below approached the facets of this case from an ‘‘inte-

grated perspective.’’ (Pet. App. 18a.) They focused on

(Continued from previous page)

this record, there was direct and unchallenged evidence of what

the taxpayer's interests in NL would have been had he not re-

ceived the boot, because he was offered a direct choice of the

cash or 125,000 more shares of NL stock.

a3 Here, as the Tax Court pointed out, because Clark ex-

perienced more than a 20 percent reduction in his potential

ownership interest in NL, the transaction qualified for sale or

exchange treatment under the ‘safe harbor’ of Section 302(b)

(2). (Pet. App. 34a-35a.)

13

the overall transaction and, in aceordance with both his-

torical fact and economic reality, treated the eash boot as

a payment in consideration for Clark’s acceptance of a

lesser interest in the continuing enterprise which emerged

from the reorganization.

and that

of Shimberg—is to ignore the overall effect of the trans-

In contrast, the Commissioner’s approach

action and treat the cash payment in isolation, as having

been made ‘*pro rata’’ to Clark as a stockholder of Basin,

while that company was still in existence and Clark was

still its sole shareholder.'* The Commissioner, following

Shimberg, would measure the effeet of the distribution

as though it had occurred as an independent transaction,

and he would ignore its effeet on Clark’s ownership in-

terest in NL, the continuing enterprise in the reorganiza-

tion.'®

- Petitioner assiduously tries to avoid acknowledging that

his position is one which requires a fragmented view of the

distribution. However, as the Fourth Circuit observed (Pet. App.

7a-8a), the Government's ‘“‘pro rata’ approach is necessarily

based on the view that Clark received the $3,250,000 from Basin

before that company was merged into NL. For the distribution

in issue here can be viewed as pro rata only if it is viewed as

having been made to Clark while Basin was still in existence and

he was still its sole shareholder. In contrast, the distribution

clearly would not be pro rata if it were viewed as having been

made by NL to Clark simultaneously with his becoming a stock-

holder of NL in exchange for shares in that company, since only

he and not the other shareholders of NL received cash.

ts Again, the facts of this case underlie the analysis of the

courts below and highlight the unrealism of the Commission-

ers position. Thus, as the Tax Court pointed out, the facts

make it especially difficult to view this case as involving a pre-

reorganization distribution by Clark’s company, since that com-

pany had nowhere near enough money to have paid the cash

(Continued on following page)

14

The more realistic, integrated method of analysis

used by the courts below had previously been adopted by

the Eighth Cireuit in Wright v. United States. 482 F.2d

600 (8th Cir. 1973). It has been endorsed by numerous

commentators and by the American Gar Association.'® and

recommended for statutory codification by the Staff and

the Chairman of the Senate Finance Committee.!? Shim-

berg—with its contrary, artificial analysis of the receipt

of the cash boot as unrelated to the simultaneous receipt

of stock—is regarded as an aberration. resulting from a

(Continued from previous page)

itself. Accordingly, here there was no issue of a pre-reorgani-

zation distribution of a cash accumulation. Pet. App. 37a. In-

deed, the amount of cash received by Clark was much greater :

than the amount of Basin’s liquid assets or the book value of its

net equity—illustrating the contrived nature of the Govern-

ment’s notional “dividend” of the cash by Basin just before an

unrelated stock-for-stock exchange with NL. In short, contrary

to the Government's assertion, there is no economic basis for

treating the cash received from NL as a bail-out of Basin’s earn-

ings, rather than a payment by NL in lieu of additional NL stock.

= See ABA Legislative Recommendation 1983-8 (approved

by ABA House of Delegates at 1984 Midyear Meeting); Levin,

Adess, & McGaffey, “Boot Distributions in Corporate Reorgani-

zations—Determination of Dividend Equivalency,” 30 Tax Law-

yer 287, 288 (1977); Golub, “ ‘Boot’ in Reorganizations—The

Dividend Equivalency Test of Section 356(a)(2),"" 58 Taxes 904,

911-13 (1980); Fleming, “Reforming the Tax Treatment of Re-

organization Boot,” 10 J. Corp. Tax 99, 107-110 (1983).

id See Staff of The Committee on Finance United States

Senate, 98th Cong., Ist Sess., The Reform and Simplification oj

the Income Taxation of Corporations, 63 (S. Prt. 98-95, 1983):

Staff of The Committee on Finance United States Senate, 99th

Cong., 1st Sess., The Subchapter C Revision Act of 1985, 6, 217-

18 (S. Prt. 99-47, 1985): Joint Committee on Taxation, 99th

Cong., 2d Sess. Tax Reform Proposals in Connection with Com-

mittee on Finance Markup (JCS 8-86), March 18, 1986.

15

misreading—both by the Fifth Cirenit and by the district

court it reversed—of the Wright approach adopted by the

courts below in this ease.'8

e. The Executive Branch has already agreed to ac-

cept legislation codifying the analysis of the court below.

In fact, the exeentive branch has already decided that the

approach taken by the courts below and challenged by

petitioner here is acceptable as a matter of tax policy. A

major study of revision of ‘*Subchapter C’’ of the Internal

Revenne Cede, that is, of the provisions dealing with taxa-

tion of corporate distributions and reorganizations, nas

heen underway for the past several years. One of the is-

sues considered has been the proper treatment of trans-

actions such as Clark’s sale of his business. Consistent

with the recommendations of the American Bar Associa-

tion’s special committee on the question, the staff of the

Senate Finance Committee recommended in 1983 that the

Wright analysis, adopted by the courts below in this case,

should be expressly codified in the statute and the Shim-

berg approach rejected.”

18 Specifically, it seems clear that the Shimberg conn eer

stood the taxpayer there to be arguing that under be Pov

relevant comparison was between his dominant ownership Pp :

centage in the acquired company and his small minority sow ot

ership in the post-acquisition Company, not y sotang Sect

ownership in that continuing Company would ge ": bee

and without the boot. See Pet. App. 13a, 28a. See also — ~

Housewares Corp. v. United States, 615 F.2d ee ts a

1980) where, as the Tax Court pointed out, [tlhe Fi 7 ay s

misunderstanding of the Wright holding is even more Clearly evi

denced. Pet. App. 28a, n. 8.

19 See nn. 16 and 17.

16

In 1983, the Treasury Department, throngh the Office

of the Assistant Secretary for Tax Policy, the agency

charged with developing tax policy for the executive

branch, presented its formal position on the reeommenda-

tion. Viewing Wright and Shimberg as offering alterna-

tive tax approaches to the same question, and reviewing

the arguments on both sides, the Treasury statement de-

scribed the matter as ‘ta very close eall,’’ and coneluded

that ‘‘on balance, we do not object to the Staff’s recom-

mended approach,’ which it described as measuring

whether boot has the ‘‘effect of a dividend’? by beatif ine’?

to the shareholders’ reduction in interest as measured

after the aequisition.’°° That approach is exactly the

analysis employed by the court below in this case. .

The effect of this statement of the Treasury Depart-

ment’s position is that, in urging this Court to hear this

case and decide it on the basis of Shimberg, petitioner is

in the anomalous position of asking this Court for the

opportunity to persuade it of a position the tax poliey

authorities have already decided is ‘‘on balance”’ incorrect.

On all counts, therefore, the approach adopted by the

court below is, and is widely regarded as, sound and ecor-

rect. Indeed, it has been accepted by the tax policy au-

thorities of the executive branch. ,

2. There is no conflict requiring this Court’s atten-

tion, Petitioner also claims that, apart from alleged de-

20 :

See Reform of Corporate Taxation: Hearing Before the

Committee On Finance United States Senate, 98th C

, ong., Ist

Sess., 24-25 (S. Hrg. 98-556, 1983) (emphasis in pants see

also Staff of The Committee on Finance United States Senate

99th Cong., Ist Sess., The Subchapter C Revisi

6 (S. Prt. 99-47, 1985). pter C Revision Act of 1985,

17

fects on the merits, the conflict of the decision below with

the 1979 Fifth Cirenit decision in Shimberg will create

sienificant problems for the administration of the tax laws

unless this Court «rants review. There are significant

differences between the facts of this ease and those of

Shimberg2' but in any event, the petitione: greatly over-

states the problems that would arise were this Court to

decline to resolve the conflict now.”

a In the present case, the taxpayer was actually offered a

choice between an all-stock deal and a deal with less stock and

cash: no such clear alternative was available to the seller in

Shimberg. Also, here, as contrasted to Shimberg, the acquired

corporation did not have sufficient accumulated earnings and

profits, or net assets, much less cash, to cover the amount of

cash paid to the seller in the reorganization.

Although petitioner finds a “clear conflict’ to be present

here, it should be noted that, in 1978, the Government opposed

the taxpayer's petition for certiorari in Shimberg on the tenuous

factual ground that the holding of that case did not conflict

with the holding in Wright, because in the latter case the ac-

quired and acquiring corporations were controlled by the same

interests. There is not the slightest suggestion in the Wright

opinion that the approach adopted there, and the underlying

rationale for that approach, were based on the faci that the

acquired and acquiring corporations were related entities. More-

over, apart from the Government in its Brief in Opposition in

Shimberg, everyone else who has considered the Wright case

(including the courts, Congress, commentators and even the

Internal Revenue Service—-see Rev. Rul. 75-83, 1975-1 C.B.

112—and the Treasury Department in its comment on Subchap-

ter C revision) has interpreted Wright's holding to be appli-

cable in cases involving unrelated corporations and therefore

in conflict with Shimberg.

22 Whatever the merits of petitioner's contention that the

decision below conflicts with Shimberg, there is no merit to his

contention (Pet. 8) that the decision below conflicts with other

circuit court cases. As the Tax Court pointed out, in King FEnier-

prises, Inc. v. United States, 418 F.2d 511 (Ct.Cl. 1969), there was

no dispute that the dividend determination should be made with

(Continued on following page)

1s

Most important, insofar as the decision below aids

taxpayers who want to treat income as capital gain rather

than dividends, the issues treated in this ease, in Wright

and in Shimberg, are of no continuing importance, The

practical impact of the characterization of ‘boot’? as capi-

tal gain rather than ordinary income has been almost en-

tirely eliminated by the abolition, in the 1986 Tax Reform

Act, of the lower tax rate for capital vain income of both

individuals and corporations.2 Petitioner argues (Pet. at

9 n.6) that the elimination of the differential rates may

be *‘something of an experiment.’’ The possibility that

Congress might at some future point reverse a basic tax

policy decision of the 1986 Act is far too speculative to

justify this Court reviewing a decision on the basis of the

significance it would have only if that reversal oceurred.

Moreover, as noted above, the executive branch tax

policy authorities have already agreed to accept a codifi-

cation of the result in this ease as a part of a pending

broad revision of the taxation of corporate reorganiza-

(Continued from previous page)

references to the acquired corporation,” while in Hawkinson v.

Commissioner, 235 F.2d 747 (2d Cir. 1956), the appeals court

“clearly did not confront the issue of choice between the ac-

quired and the acquiring corporation.” (Pet. App. 24a, n. 7.)

23 Petitioner's claim (Pet. at 10-11) that acceptance of the

decisions below and in Wright would require other adjustments,

e.g., to the amount of gain, basis in the acquired stock, and

earnings and profits is simply incorrect. As the Fourth Circuit

pointed out, the issue of the character of the boot income—

governed by Section 356(a)(2) and (even according to the IRS

in Rev. Rul. 75-83) Section 302—is entirely separate from the .

issue of the amount of such gain and the effect of the trans-

action on earnings and profits. These latter issues are provided

for in detail in Section 356(a). (See Pet. App. 6a.)

19

tions. General revision of Subchapter C, including codify-

ing the method of analysis that led to the decision below,

remains on the Congressional agenda.* If it is appro-

priate to consider the prospect of future aetion by Con-

eress in deciding whether this Court should hear tax cases,

it is far more reasonable to assume that Congress will in

the near future enact the pending general Subchapter C

revisions, which are relatively non-controversial, than that

it will restore the capital gain/ordinary income differen-

tial, which would be a major policy change.

Petitioner also suggests that, even without a capital

vain/ordinary income differential, there will be abana

tax administration problems if this Court does not inform

the tax world whether Shimberg on the one hand, or the

decisions below and in Wright, on the other, correctly

states the law. Specifically, petitioner suggests that, while

most taxpayers are now largely indifferent to the character

of boot income, some corporate taxpayers actually poemee

the result in Shimberg, because an expansive scope for

dividend treatment will make boot income subject to the

. * . = , . > ° 25

corporate ‘*dividends-received deduction.

isi “isi including

sad Indeed, provisions to effect such a revision, —

codibina the smaieia used below as previously —_— by

Treasury, was included at one point in the a ~_ ap a

: t to effec -

ly because of the desire not to attemp

prs but essentially technical change amid the — over

the 1986 Act. See joint Committee on Taxation, 991 oy

Id Sess., Tax Reform Proposals in Connection with Senate Fi-

nance Committee Markup, (JCS 8-86), March 18, 1986.

ion 243 included in

s As a result of an amendment to Section 2

the Budget Reconciliation Act of 1987, the yo gpeemesr yer

deduction is currently equal to 80 percent of the amount o

(Continued on following page)

20

Petitioner’s specter of corporate taxpayers relying

on Shimberg to deny the Government revenues by improp-

erly expanded dividends-received deductions is overdrawn

and implausible. Shimberg’s analysis has been heavily

criticized by commentators, and it is viewed by the tax

bar generally as an aberrational decision, occasioned by

misinterpretation of the approach adopted in Wright and

followed in this case. Shimberg’s rejection by the courts

below would be a further deterrent to corporate tax man-

agers relying on its authority.”

In any event, if the Internal Revenue Service wishes

to protect the revenues from unjustified reliance on Shim-

(Continued from previous page)

the dividend in the case of corporate shareholders owning 20

percent or more ot the outstanding stock of the distributing

corporation, and 70 percent of the amount of the dividend

in the case of all other corporate shareholders. See H.R. Conf.

Rep. No. 100-495, 100th Cong., 1st Sess., Part Ill at 425 (1987).

as The decision below has already been described as like-

ly to reduce the possibility for abusive reliance on Shimberg

by Wall Street arbitragers seeking to use dividends-received

deductions in the context of acquisitive reorganizations. Such

arbitragers purchase stock in a corporation before an acquisi-

tion transaction is closed and realize profits on the spread be-

tween the market price and the takeover price. If the acquisi-

tion is structured as a tax-free reorganization including some

cash distribution to shareholders of the acquired corporation,

corporate arbitragers could, embracing Shimberg and the peti-

tioner’s position in this Court, treat the boot (up to the amount

of their gain on the arbitraging transaction) as a dividend, taxed

at a much lower effective rate (after giving effect to the divi-

dends received deduction) than if the boot were treated as

capital gain on the transaction. Accurding to a tax partner at

one of the national accounting firms, “This [Clark] decision

could eliminate many arbs from the takeover game” in which

they have sought to reclassify cash payment of boot as dividends.

See “Tax Court Decision Could Ruin Risk Arb Biz,”’ Investment

Dealers’ Digest (February 17, 1986), p. 2. (A copy of this ar-

ticle is attached to respondent's appellate brief as Appendix 2).

21

berg, it has many resources of its own to bring to bear

before it can justifiably ask this Court to intervene.”’

Petitioner routinely publishes revenue rulings or ‘‘acqui-

escences”’ declaring that it will henceforth follow certain

eases.2 To the degree that petitioner’s concern is being

whipsawed, he could greatly relieve that concern by pub-

lishing an announcement that [Wright and the decision

below and not Shimberg are to be followed in character-

izing boot, for purposes of the dividends-reeeived dedue-

tion as well as otherwise.

In the face of such action by petitioner—and the gen-

eral weakness of Shimberg as a precedent—it would be

a hardy corporate taxpayer indeed that would rely on

Shimberg to expand its dividends-received deduction.”

Those who did so would face a formidable hurdle in gain-

ing judicial acceptance of their position, even in the Fifth

a If, for some reason, petitioner wants corporate taxpayers

to remain able to reduce their taxes by taking advantage of

Shimberg, he need do nothing at all.

a Having issued such an announcement, petitioner would,

of course, abide by it in ruling on reorganizations, thereby deal-

ing with the need for “the IRS to have a uniform rule to apply

in issuing these rulings.” (Pet. at 11). In fact, petitioner has

followed this very procedure in communicating to taxpayers his

position disagreeing with the opinion in whe stn wg args gg

ly applying that position to taxpayers requesting r -

aman pemactons. See Rev. Rul. 75-83, 1975-1 C.B.

112; e.g., Priv. Ltr. Rul. 8640064 (July 9, 1986).

29 Indeed, in the face of a disavowal by the Commissioner

of Shimberg, together with the widely held view (expressed by

the courts below, as well) that Shimberg was wrongly decided,

it is not even clear that Shimberg would constitute “substantial

authority” sufficient to avoid a penalty under section 6661 for

substantial understatement of taxable income, at least in the

case of taxpayers residing outside of the Fifth and Twelfth cir-

cuits. See Treas. Reg. § 1.6661-3.

22

and Twelfth Circuits in which Shimberg is nominally

authority. The chance that the petitioner would be un-

able to persuade those circuits to reconsider Shimberg

seems small, but for present purposes it is sufficient to

observe only if such an effort failed would review by this

Court be appropriate.

3. This Court should not attempt to resolve the issue

presented here before u is resolved within petitioner’s

own ranks. Petitioner has changed his position several

times in this case on the proper analysis of the trans-

action at issue and still fails to present a position con-

sistent either with his rulings in related areas or with

the view of the tax policy authorities. In the Fourth

Circuit, petitioner maintained that Section 302 principles

do not apply at all in the case of a cash payment governed

by Section 356(a)(2). This was contrary to petitioner’s

position in the Tax Court, in Wright, in Rev. Rui. 75-83,

1975-1 C.B. 112 (which is not mentioned in the petition,

even though it is viewed by the IRS as the principal ad-

ministrative pronouncement in this area) and in numer-

ous private rulings (dealing with pro rata and non-pro-

rata distributions in a reorganization) issued by the IRS,

which conceded that Section 302 applied.

Petitioner’s current attack on the Fourth Cireuit

decision before this Court, as outlined in the petition’s

extensive discussion of the merits, differs significantly

from its fundamental argument to that court. There peti-

tioner argued that the general ‘dividend equivalence”’

test of Section 302—under which the standard for being

a dividend is whether the boot had the effeet of substan-

tially or ‘‘meaningfully’’ reducing Clark’s equity inter-

25

est—should not be applied at all in the reorganization

context, where Section 356(a)(2) requires a determina-

tion of whether boot ‘‘has the effect of the distribution

of a dividend.’”” The Fourth Circuit clearly regarded that

general attack on the applicability of Section 502 as the

core of the Government’s case and squarely rejected it.

(Pet. App. 5a-6a.)

Now, having seen that position rejected when pre-

sented to the Fourth Cireuit as the general issue posed

by this case, petitioner takes a different and far less

generalizable tack. Petitioner now declares only that *‘in

the context presented here, there is no tension between

the principles of Section 302 and the principles that should

be applied under Section 356(a)(2).’’ (Pet. at. 19.) This

shift in position, however, reduces the issue to whether

the courts below—each of which explicitly applied the

Section 302 rules to the Section 356(a)(2) problem—

erred in applying the Section 302 rules to these particular

facts, not whether they applied a correct standard.

Moreover, the tax policy authorities have already pro-

nounced acceptable a codification of the analysis used

below. Adoption by this Court of the position advanced

by petitioner at this stage of the proceedings would only

serve to confuse, rather than clarify, the state of the law

in the corporate reorganization area. Even as reformu-

lated, it is at odds with the approach of the Connnissioner

in Rev. Rul. 75-83 and in numerous private rulings. It

24

would be open to abuse and manipulation® and would,

properly, be rejected by the IRS in many other situations

as inconsistent with step transaction principles. And, as

pointed out by the Fourth Cireuit, in place of abandoning

the principles of Section 302, it ‘‘offers no realistic alter-

native, except perhaps a return to the abandoned rule that

any pro rata distribution in a reorganization must auto-

matically be treated as a dividend.’’ (Pet. App. 6a.)

Before this Court considers the issue presented here,

petitioner should reconcile the differences within the

executive branch.

In sum, petitioner is asking this Court to review the

decision below to overturn a generally supported approach

that the executive branch has already accepted in the legis-

lative arena in favor of a position which has changed at

each stage of this litigation. Moreover, it is doing so in

a context of minimal continuing importance and where

the petitioner himself should be able to eliminate any ad-

verse effects on revenues from the conflict it perceives.

_

Ww

od For an example of how the Government's approach might

be manipulated, see the opinion below. (Pet. App. 12a.)

oe

25

| CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted,

*Watrrer B. SLocomBE

Dante B. Rosenpaum

- Capurx & Dryspae, Chartered

One Thomas Circle, N.W.

Washington, D.C. 20005

(202) 862-5000

February 1988

*Counsel of Reeord