Commissioner of Internal Revenue v. Gordon

PETITIONER:Commissioner of Internal Revenue
RESPONDENT:Gordon
LOCATION:United States District Court of Maryland

DOCKET NO.: 760
DECIDED BY: Warren Court (1967-1969)
LOWER COURT: United States Court of Appeals for the Second Circuit

CITATION: 391 US 83 (1968)
ARGUED: Apr 04, 1968
DECIDED: May 20, 1968

Facts of the case

Question

Audio Transcription for Oral Argument – April 04, 1968 in Commissioner of Internal Revenue v. Gordon

Earl Warren:

Number 760, Commissioner of Internal Revenue, petitioner versus Irving Gordon et al. and number 781 Oscar E. Bann, et al. petitioners versus Commissioner of Internal Revenue.

Mr. Solicitor General.

Erwin N. Griswold:

May it please the Court.

This is a technical tax case, about as technical as they come and I think I ought to make a confession.

I used it as an examination question two years ago and thus had the benefit of reading the reactions to 200 young minds and I don’t think I learned a great deal.

Abe Fortas:

Who won, Mr. Solicitor General?

Erwin N. Griswold:

It was a tie.

William J. Brennan, Jr.:

How badly did they divide —

Erwin N. Griswold:

How —

William J. Brennan, Jr.:

How badly did they divide — on the result.

Erwin N. Griswold:

That, I do not (Voice Overlap) [Laughter]

I did not review the record.

The case involves the construction of Section 355 of the Internal Revenue Code.

This is a provision which deals with what are called divisive reorganizations.

Some reorganizations put corporations together and Section 355 deals with situations where they’re taken apart.

In the jargon of the trade, Section 355 includes such things as split-ups, split-offs, and spin-offs.

And the transaction involved here is or may be or maybe is not a spin-off.

Now the question is whether it comes within the terms of the statute which provides that there is no income on the receipt of stock or securities on a spin-off when the requirements of the statute are met.

A spin-off arises in a situation where a corporation has a subsidiary and distributes the stock or securities in the subsidiary to its shareholders without the shareholders giving up anything.

There is no exchange.

The general theory is that the shareholders have two pieces of paper representing the same interests which they had before.

Now where the terms of the statute are complied with, it is provided that no gain or loss will be recognized on the receipt of securities in a spin-off.

The problem here arises on these facts.

Pacific Telephone and Telegraph Company, which we will call Pacific, for many years has operated telephone service in California, Oregon, Washington and Idaho, and through a subsidiary in Nevada.

Since 1907, more than 80% of the voting stock of Pacific has been held by American Telephone and Telegraph Company.

And in 1961, which is the year and the only year before the Court, AT&T owned about 90% of Pacific’s common stock, about 78% of Pacific’s preferred stock, and had nearly 90% of the voting power in Pacific.

During the late 1950s and in 1960, Pacific in the process of evolving its management of this great enterprise developed a plan to decentralize its operations by separating out its business in Oregon, Washington and Idaho.

It organized a new corporation called Pacific Northwest Bell Telephone Company and which we refer to as Northwest in this case.

In creating a new corporation, it transferred a small amount of cash to Northwest for stock and then it transferred all of its assets in Oregon, Washington and Idaho to Northwest in exchange for the balance of its stock and debentures.

At this point, July 1, 1961, Northwest exists as a complete operating corporation wholly owned by Pacific Telephone and Telegraph Company.

Erwin N. Griswold:

If Pacific had then distributed all of the Northwest stock and securities to its shareholders, there would have been no doubt that this was a spin-off and that no gain or loss would be recognized.

Indeed, the same result would have happened, subject to certain conditions, if Pacific had distributed at least 80% of the Northwest stock to the Pacific shareholders.

This would have been a spin-off and thus within the terms of the statute, making the distribution tax free.

However, Pacific chose not to proceed in this way and that’s why the problem arises here.

Instead of distributing all of the stock or at least 80% of it, Pacific chose to issue warrants or rights to its shareholders in 1961 through which they or persons who purchased their rights could buy not all or 80% but 57% of the Northwest stock.

Under the rights offer, it took six rights and $16 to acquire a share of Northwest stock and $16 was less than the market value of the Northwest stock so that the rights had value.

At the time when these rights were issued, Pacific had what it denominated a plan in which it was stated that Pacific expected to dispose of the rest of the stock through further issues of rights, the time and prices to be determined later.

However, Pacific was under no obligation to make such a disposition.

It did in fact issue further rights in 1963, 21 months later.

As a result, all of the Northwest stock was eventually disposed of either to the Pacific shareholders at the two separated points of time or to the persons to whom such shareholders sold their rights.

In the first of the cases before the Court, the Gordon case number 760, the shareholder received rights in 1962 and exercised them.

The question is whether he had income from this transaction.

In the other case before the Court, the Bann case, number 781, the shareholder exercised all of his rights but four.

As I’ve said, it took six rights plus $16 to subscribe to a share of Northwest stock.

Mr. Bann exercised all of his rights that he could to get full shares, but he had four leftover, and he sold those four.

The question in the Bann case with respect to the receipt and the exercise of the rights is the same as that in the Gordon case.

In the Bann case however, there is the additional question as to the tax liability arising with respect to the four rights which were not exercised but were sold.

At the time the transaction was under consideration, counsel for Pacific submitted the question to the Internal Revenue Service for a ruling and that ruling is set out in full at page 146 of the record dated June 28, 1961 just before the transfer occurred.

The service rule that the transaction did not fall within Section 355 and that the shareholders would be taxable.

Of course that ruling isn’t binding on the Court.

I mention it however to show the position of those charged with administering the tax laws and to show further that Pacific and its shareholders were not taken by surprise and that there would be nothing unfair if it should eventually be concluded that the treasury’s contemporaneous ruling was correct.

After the transaction was carried out and returns for 1961 had been filed, the Commissioner of Internal Revenue determined deficiencies against the two taxpayers now before the Court, who, as I have indicated, had received and exercised rights, but had not included anything in their tax returns with respect to the transaction.

The taxpayers filed petition for review with the Tax Court.

In a careful opinion by Judge Raum, the taxpayers prevailed there.

Judge Raum held that since a distribution of the Northwest shares to the Pacific shareholders without payment would have been tax-free.

It could not be supposed that Congress intended a tax liability to result from a lesser distribution, that is an offer to dispose of the shares at a price through rights as the transaction was actually carried out.

From the decision of the Tax Court, two separate appeals were taken; one to the Court of Appeals for the Second Circuit in the Gordon case and the other to the Court of Appeals for the Ninth Circuit in the Bann case.

The Second Circuit decided in favor of the taxpayer in a two-to-one decision with Judge Friendly dissenting.

The Ninth Circuit decided in favor of the Commissioner.

Thus, there was a square conflict of decisions.

Erwin N. Griswold:

Both sides filed petitions for certiorari and these are the cases.

Both arise on the same record which are now before the Court.

Before going further, I would like to point out that this case arises in the same basic area as was involved in the famous Gregory case in 293 U.S. decided in 1935, I suppose all tax lawyers would agree one of the great landmarks in the tax law.

The Gregory case involved a spin-off.

At that time, this was an area which had come to be used very widely for rather blatant tax avoidance which was the situation in the Gregory case itself.

As a result, not only was the Gregory decision announced from this Court, but Congress repealed the provisions which had been included in the earlier revenue laws granting tax-free status to spin-offs.

And there was no provision for tax-free status of spin-offs between 1934 and 1951, a period of 17 years.

Now, let me make it plain that in this case, there’s no doubt that there was a substantial and legitimate business purpose and for the steps which Pacific took with respect to its Northwest operations.

The reference to the Gregory case however does seem to me to be relevant because it shows that Congress knew that this was a delicate area with substantial tax avoidance potential.

As a result, when Congress first restored a tax-free status to some spin-offs in 1951, it included careful restrictions.

These restrictions were extended and amplified in the 1954 Code, Section 355 which is now before the Court.

In the light of the background of the spin-off provisions and the language which Congress actually used, it is our position that Congress contemplated that the language of the statute would be carefully read, that its requirements would have to be met, and that it could not be given a broad and sweeping construction.

The statutory provision involved here is the same sort of provision as that relating to collapsible corporations, which was involved in Braunstein against the Commissioner in 374 U.S. where the Court referred to the statute there as setting up “a carefully and elaborately defined category of transactions”.

We have such a provision here.

Let us turn then to the statute itself.

As I’ve said at the opening of the argument, this is a technical tax case.

Much of the technicality is developed in the main briefs and the reply briefs which have been filed by both of the parties.

I’m going to try to keep my argument relatively simple focusing attention on three provisions of the statute.

If more detail is wanted, it will be found in ample amounts in the briefs which have been prepared for the Court.

The full text of Section 355 appears at several places in the papers before the Court.

The place to which I shall refer is in the appendix to the government’s main brief, the usual gray-covered brief, beginning at page 53 of that brief.

Section 355 is a part of subchapter (c) in the Internal Revenue Code relating to corporate distributions and reorganizations.

It follows Section 351 which deals with transfers to a controlled corporation and Section 354 which deals with exchanges in connection with a reorganization.

Section 355 is itself entitled distribution of stock and securities of a controlled corporation.

As you will see, it’s a long provision occupying nearly all of four pages in the brief.

Generally speaking though, we need be concerned only with that portion of the statute which appears on page 53 and the top of page 54, that is a total of one and a half out of the entire four pages.

The rest of the provision is important as a part of the setting of the statute since it illustrates the care with which Congress drew the provision and its apparent concern that its term should be specific and carefully safeguarded.

Let us then look at paragraph (a) (1) of Section 355 as it begins on page 53 of the government’s brief.

It starts off with one important condition imposing word ‘if.

It says, “If a corporation referred to in this section as the distributing corporation; (i) it distributes to a shareholder with respect to its stock”, distributes to a shareholder with respect to its stock, or, and then we can skip (ii) as it has no application here, what does the corporation distribute?

Erwin N. Griswold:

The section then continues, “Solely stock or securities of a corporation”, referred to in this section as controlled corporation, which it controls immediately before the distribution.

Now, I would suggest that the important words there are in (i) distributes to a shareholder with respect to its stock, and then the words immediately following (ii) solely stock or securities of a corporation.

Now, in examining this statute, we can skip the provisions of paragraphs (B) and (C) at the bottom of page 53 and go over to the next page, page 54 of the government’s brief.

We there find (D) as part of the distribution.

The distributing corporation distributes; (i) all of the stock and securities in the controlled corporation held by it immediately before the distribution, or, and then, there’s a longer (ii) and which makes it applicable if they do distribute 80% and certain other conditions are complied with.

Then, no gain or loss shall be recognized to and no amount shall be includable in the income of such shareholder or security holder on the receipt of such stock or securities, which is a consummation devotedly to be wished by any taxpayer.

The question before the Court is whether what was actually done by Pacific’s management here meets the terms of the provisions of Section 355 to which I referred.

Byron R. White:

Mr. Solicitor General, could I ask you about what are the provisions of the — on page 54 and 55 that says paragraph (1) shall not apply, if, then go to (B), securities in the controlled corporation are received and no securities are surrendered in connection with such distribution.

Erwin N. Griswold:

That relates to debt securities, Mr. Justice.

If they had distributed for example debentures, paragraph (3) says that paragraph (1) should not apply —

Byron R. White:

So security — so the security does not apply to stock?

Erwin N. Griswold:

Security does not apply to stock —

Byron R. White:

That’s just wholly inapplicable to this case because securities weren’t involved?

Erwin N. Griswold:

And that is only inapplicable because securities are not involved.

I think we can perhaps have some discussion as to whether rights, not being stocked, are securities, but that isn’t directly involved here.

Before looking at these specific provisions in greater detail, I may observe that counsel for the taxpayer, if I may so, prefer to ignore the precise language of the statute.

They advance Section 355 as a beneficent provision designed to be applicable to bona fide spin-offs of all sorts.

They prefer not to look at the exact text of the — detailed statutory provisions which Congress actually wrote and wrote with care in the light of its experience with earlier spin-off provisions in the Gregory case.

Indeed, in the first 51 pages of the taxpayer’s brief in this Court, they speak of Section 355 only in general terms and make no reference to the precise language which the Congress wrote.

Hugo L. Black:

Mr. Solicitor General, do you mind telling me where the name spin-off came from?

Erwin N. Griswold:

Frankly, I don’t know.

There are — there are split-offs which occur when a portion of the business is taken out and given to shareholders in exchange for some of their stock, a split-off involves an exchange.

There are split-ups where for example, the business is divided into two corporations and the shares in those two corporations are then distributed to the shareholders in exchange for their stock.

Both a split-off and a split-up involved an exchange.

But a spin-off is applied to a situation where there is no exchange.

Where there is a corporation and for a good and sufficient reason, a portion of it is separated out and that stock is then distributed to the shareholders of the original corporation.

And I suppose it has a certain picture appeal, that as long as I can remember has been called a spin-off.

Certainly that was the reference that was made in the Gregory case which goes back 35 years now.

Earl Warren:

This is a spin-off?

This is —

Erwin N. Griswold:

This — this case would have been a spin-off if they had distributed the stock in Pacific.

Whether or not it is a spin-off, we will learn when this Court has decided the case, I suppose.[Laughter]

Earl Warren:

And if it is — if it is not a spin-off, well, what is it?

Erwin N. Griswold:

Well, I referred to it in my opening statement as a kind of a spin-off [Attempt to Laughter] and if it’s not a spin-off, it’s a sale of the Pacific stock through the issuance of rights.

And as a sale of the Pacific stock through the issuance of rights, it should be treated as a sale as it was by Pacific in this case.

Pacific made a gain on the shares which it sold to its shareholders and reported that gain for tax purposes and the question as to the treatment of the shareholders, if Section 355 does not apply because it was not a distribution of solely stock or securities, then turn simply on the other general provisions of the statute and it would be a distribution of property which since Pacific had adequate earnings and profits would be a dividend to the shareholders.

Earl Warren:

Then, it is a spin-off or is this a sale, not any of these other two —

Erwin N. Griswold:

No, it is not — I’m sorry, I referred to split-up and split-off, but Section 355 does relate to them as well as to distributions without the giving up of any other property.

Now, it’s recognized of course that sometimes statutes are read rather broadly and it clearly seen objective becomes the touchstone to interpretation.

In other situations, and I submit that this is one, the statutes are written in a highly articulated manner and are clearly designed to be read specifically and not in general terms.

Broadly speaking, I think that this is the line on which this case will be determined.

If one looks only at the general situation as the taxpayers’ counsels do as far as they can, reasons may be found which will lead to a conclusion their way.

On the other hand, if one looks at the statute and gives a fair construction to the language actually used by Congress, it will be found I submit that the conditions of the statute were not met and that the tax-free status sought by the taxpayers was not achieved.

So let’s look at the terms of the statute with the facts of the case in mind.

In doing this, I would recall that the issue arises because Pacific chose to use warrants or rights rather than distributing the Northwest stock to its shareholders outright.

If Pacific had done the latter here, there would be no problem.

Why should the result be different, simply because they did something less?

The answer is I think that the one would have complied with the terms of the statute while what was actually done did not, and the difference is not entirely formal for a distribution of all of the Northwest stock to the Pacific shareholders would have been a true spin-off, a division of the same enterprise into two, with each shareholder of Pacific now owning two pieces of paper to represent exactly what he owned before.

But what was actually done was quite different and not within the spirit of the statute, as well as not within its terms.

What was actually done was a refinancing of Pacific, a sale of a part of its Northwest stock in 1961 for a very large sum of money which reviews for the expansion of Pacific’s operations in California, as well as to pay off part of its indebtedness to AT&T.

Pacific shareholders did not simply receive the Northwest stock as Section 355 contemplates.

They had to buy it and to put large sums of new money into Pacific in order to get their shares in Northwest, or else to sell or lose their rights.

Now, how does this fit in into the actual terms of the statute?

Let’s look again at the beginning of Section 355 (a) (1) (A).

If a corporation distributes to a shareholder with respect to its stock, did Pacific distribute Northwest stock to its shareholders with respect to its stock?

I suggest that it did not.

In actual fact, Pacific made two distributions or dispositions in 1961.

This is illustrated by the fact that there were two separate mailings of distinct items.

First on September 29, 1961, it distributed rights to its shareholders.

That was certainly a distribution but was it a distributed stock in Northwest, no, rights to the shareholders.

Erwin N. Griswold:

This was a distribution to its shareholders with respect to its stock, but it was clearly a distribution of rights, not of Northwest stock.

No shareholder received Northwest stock at that time and no shareholder would receive Northwest stock at a later time unless he took affirmative steps which he was under no obligation to do.

At a somewhat later time, Pacific did sell Northwest stock, but not to its shareholders.

The sales were made to the then holders of warrants or rights who might or might not have been shareholders of Pacific.

Indeed, the record shows that about a third of the minority shareholders of Pacific did not exercise their rights and did not receive Northwest stock.

Are those rights were traded in or exchanged —

Erwin N. Griswold:

There were some 80,000 rights that expired, but several hundred thousand which must have been sold.

There — these were traded on the exchange.

There was a – a before issuance market and a market during all the time that they were outstanding.

This is what, in the Bann case, the problem we had with respect to the four rights.

In that case, they sold the four rights and the question arises as to the taxability of the proceeds.

The important matter in the application of the statute is that Northwest stock was not distributed to the Pacific shareholders.

It was in fact distributed to whatever person’s owned and presented the rights, together with $16 for each share of Northwest stock to be acquired.

This is not what the statute says and the refinancing, which was carried out is not what was contemplated when the statute was formulated.

One element in that picture, which I think is relevant is that the spin-off statute, it seems to me quite plainly contemplates that the size of the distributing corporation will be reduced after the distribution.

Now, you have a corporation which has a subsidiary.

It distributes the subsidiary and the old corporation is left with reduced assets.

In this case, as far as the book value is concerned, the result was an actual increase of the size of Pacific after the distribution because the book value to Pacific of the Northwest shares was less than the $16 a share which it received on the distribution of each share.

That is what gives rise to the capital gain, which Pacific recognized and returned.

There’s one element in this picture, which makes me a little nervous.

It was suggested for the first time in the Second Circuit’s opinion when the Second Circuit said that well, really, this was a distribution of Northwest stock to the shareholders.

And what the shareholders did then was to make a contribution to the capital of Pacific.

They treated the $16 as a — or they said it could be treated as a contribution to the capital of Pacific rather than as a payment of the purchase price.

Well now, if it’s a contribution to the capital of Pacific, it would not be taxable income to Pacific, and I see lurking in the background here a claim for refund by Pacific on the ground that this was a contribution to capital.

It seems to me that that is extremely far-fetched.

The transaction was referred to in the plan as an offer to sell the shares.

It was understood by all as an offer to sell the shares and it seems to me that it should be treated as a sale, both in this case and with respect to Pacific.

Hugo L. Black:

Did I understand you to say sometime ago that they all would sell the stock for less than its value?

Erwin N. Griswold:

Yes, Mr. Justice.

The — it took six rights and $16 to buy one share of Northwest and the market value of the Northwest stock at this time was — of the order of $26 a share.

Hugo L. Black:

Now, you say that that was not adding to the stock value of the company?

Erwin N. Griswold:

That that was —

Hugo L. Black:

That would not add to the — that general assets of the company —

Erwin N. Griswold:

I said — I referred, Mr. Justice, and perhaps it was misleading, to the book value of the assets.

It is true that it reduced the actual value of the assets by the amount of the spread.

But the book value of the Northwest shares, which was based upon the amount of money which Pacific had invested in the three states was of the order of $14 or $15 a share, so that the $16 which they received resulted in a book gain, which for tax purposes would have to be recognized.

Hugo L. Black:

A book gain, but an actual loss?

Erwin N. Griswold:

A book gain but an actual loss, that is true, an actual loss of the difference between the value of the Northwest shares and the $16 a share —

Byron R. White:

But it was — it was over what they paid for it, $16 is more than they paid for it.

Erwin N. Griswold:

$16 was more than their —

Byron R. White:

More than their basis?

Erwin N. Griswold:

More than their base is.

What they paid for — well, their bases is somewhat complicated because it involved the amount that they had invested in assets in those three states, which they then distributed to Pacific in exchange for Pacific’s stock.

Now, the argument that I’ve just made with respect to 355 (a) (1) (A) (i) applies too to the following portion of the statute which requires that there be a distribution of solely stock or securities of a corporation.

And I would point out that that word ‘solely’ was added in 1954 when Congress enacted the Internal Revenue Code of 1954, the corresponding provision which was put in 1951 did not have the ‘solely’ there.

Now, the taxpayers can’t have it both ways, it seems to me.

Either there was a distribution of rights, in which case, it was to a shareholder with respect to his stock but was not a distribution of solely stock or securities. Or there was a distribution of Northwest stock, although it was more accurately a sale, in which case, it was made to the right holders and thus was not a distribution to a shareholder with respect to its stock.

It’s not enough to say that the two parts were some sort of a step transaction and that they are to be read together.

Even that will not bring them within the statute as written, nor will it mean that Pacific distributed solely stock or securities in Northwest.

As this Court said in the Southwest Securities Corporation case, 315 U.S., “Solely’ leaves no leeway”.

What Pacific distributed here was rights representing an obligation against Pacific.

Such rights are not solely stock in Northwest.

Finally, there’s another provision of the statute which was not met here.

This is on the next page, page 54, Section 355 (a) (1) (D) at the top of page 54.

It provides that the distributing corporation.

Here, Pacific, must distribute; (i) all of the stock and securities in the controlled corporation held by it immediately before the distribution, while the following paragraph (ii) qualifies this, if at least 80% of the stock is distributed.

In this case, even if the issuance of rights in the sale of Northwest stock in 1961, is treated as a distribution of stock, it was only 57%.

The required aggregate of at least 80% can be reached only if the 1961 distribution is added into the — in with the sale of the remaining 43% of the Northwest stock which did not occur until 1963, more than 21 months later.

And the important thing about this is that it was not obligating in any way in 1961.

This can best be seen by examining the plan for reorganization which is set out in full beginning at page 102 of the record, and I would call your attention particularly to the relevant portions of the plan on page 109.

Erwin N. Griswold:

This was carefully drawn so as not to subject Pacific to any obligation as to future distributions.

Note the first line on page 109, “It is expected that within about three years,” and then further down the page, in the second paragraph, the third line, it’s provided that the offering price will be determined by the Board of Directors of the company at the time of each offering and then, the next sentence begins it’s expected that, and so on.

Now plainly, we suggest that this does not square with the language of the statute.

The words in Section 355 (a) (1) (D) (i) held by it immediately before the distribution connote some sort at least of a limited time within which the distribution of all of the stock must be made.

Am I right in thinking that the commissioner did not urge that to the Tax Court?

Erwin N. Griswold:

To some extent, Mr. Justice, you’re right.

On the other hand, the consolidated stipulation of facts, which begins on page 33, contains references to this matter in the safeguarding of the position.

It certainly was not squarely raised and presented in the —

Well, what I was thinking about, is there a [Inaudible] in that question in minding the fact?

Erwin N. Griswold:

I do not think so, Mr. Justice, and that we have made a brief reference to and we put forth in our brief that there was here an elaborate stipulation of facts which set forth the full text of all of the documents including a good many internal documents.

The papers, for example, which were presented to the Board of Directors of the company and the argument that we made arises on the face of those documents and I do not see how the evidence could have been presented which would change the effect of those documents.

After all, I just referred to the text of the plan for reorganization and bringing in a witness who would say, “Well, we didn’t really mean that.

What we had in mind was that we were bound to do it”.

It seems to me would not affect the situation.

Now, in referring to the reference to immediately before the distribution in Section 355 (a) (1) (D) (i), we don’t suggest that everything has to be done in an instant or even on the same day.

Obviously, time for the mechanics of the transaction must be allowed, but there must be some sort of a limited time within which the distribution should be made.

If it’s to be done in two stages, they must be at least reasonably close together and what’s more important, committed from the beginning.

Otherwise, it’s impossible to know whether the first distribution complies with the statute.

At the close of 1961 and at the close of 1962, it would have been impossible to determine the tax liability of these taxpayers for the year 1961 as Judge Friendly pointed out in the Second Circuit below.

That’s not only —

Potter Stewart:

Do you think the point is that the entire distribution has to be in the same taxable year?

Would that be the test?

Erwin N. Griswold:

I wouldn’t even be sure of that.

I could imagine that you could have a situation where there is a distribution in December, a distribution in February, all planned and committed, and I would suppose that that could come within the statute.

Certainly, it makes it easier if it’s all within the same taxable year.

Our only position is that when they are widely separated and quite non-committed, that Section 355, in the light of this language, cannot fairly be regarded as applying.

Leaving the thing in limbo for 21 months is not only contrary to the basic approach, always followed by Congress’ annual accounting periods, but it is inconsistent with the language of the statute itself.

And thus, as is discussed in more detail in our briefs, we contend that the disposition or sale made here did not meet the requirements of Section 355 because only 57% of the stock of Northwest was sold in 1961, and there was no commitment to dispose off the rest of the stock.

Now, there’s a remaining issue in the Bann case, number 781.

The taxpayer there sold four of his rights and the majority of the Court of Appeals held that he was taxable on the proceeds at capital gain rates.

Erwin N. Griswold:

We’ve discussed this point at the conclusion of our main brief.

It’s our contention that the decision below on this is wrong because the distribution of rights did not come within Section 355 as it was obviously not a distribution of solely stock or securities in Northwest.

Indeed, this point highlights our argument on the main point in the case.

A good deal of reference is made in the opinions below and in the briefs to this Court’s decision in Palmer against Commissioner back in 302 U.S. Where in an opinion by Justice Stone, it was held that the issuance of rights did not constitute a distribution by a corporation.

The premise on which that opinion was based however was that in that particular case, the rights were issued at the fair market value of the distributed stock as of the time the rights were determined on.

There is a language in the Palmer case which it seems to me Justice Stone probably would be reexamining himself if he were here to do it.

But I would point out that regardless of the Palmer case and its status now, the Congress substantially amended the statute by the Internal Revenue Code of 1954, adding a whole new subchapter (C) spelling out in much greater detail the provisions with respect to distributions.

And we would contend that the Palmer case is no longer applicable, whether it was rightly or wrongly decided, and that Section 301 and other sections of the code squarely call for the treatment of the rights on receipt as being taxable income.

Now, it is convenient with respect to rights which are usually short-lived to withhold taxability until the rights have been disposed of and to treat the proceeds of the rights as being the dividend or distribution.

And ordinarily, this makes no difference, although we suggest that the better analysis is to say that the rights are income at their fair market value when they are received.

And that there is then a capital gain or loss, ordinarily a short-term gain or loss, on the sale of the rights depending upon whether they were sold for a little more or a little less than they were worth when they were received.

In this case, such a gain or loss would have been a short-term gain or loss all in the same taxable year so that the result of the amount — the result of taxing the amount received on sale is a convenient and wholly accurate way to treat the transaction, but we suggest that it should be treated as a dividend distribution and not in any sense as a capital gain or loss.

Abe Fortas:

How do you get that — how do you get that — I beg your pardon.

How do you get the treatment of it as a dividend?

You mean that it should treat as dividend, the difference between $16 or six — whatever works out to?

Erwin N. Griswold:

Well, roughly here, it would be one-sixth of the difference between $26 and $16 or about a $1.66 is a right.

It would actually we suggest not be so mechanically determined in this case since there was a market, an active market for these shares.

It would be determined by what was the market value of the rights on the date of receipt and there was — it did run out, as I recall it, between $1.60 and $1.85, one or two days a little higher and a little lower per right.

Abe Fortas:

I thought you were suggesting that the difference between the price at which the right was sold and the amount paid by the stockholder to Pacific should all be treated as dividend, did I misunderstand you?

Erwin N. Griswold:

No.

I’m only — only contending that the fair market value of the right, when received, should be treated as a dividend.

Abe Fortas:

Yes.

Erwin N. Griswold:

That then if the right is sold some days later, there is technically a short-term capital gain or loss on the right.

It usually isn’t very much and being short-term, it’s treated in full anyway so that it’s easier and simpler, and it’s the practice usually followed and as a consequence of the continuing wait of the Palmer case, then what you do is look and see what did he sell the right for and then treat that as a dividend.

I’m only suggesting that though that’s convenient and is acceptable to us that perhaps from an excessively pedantic point of view, the analysis would be that the distribution of the right is a dividend, that it is viewed as whole property.

It can go up or down in value and if it goes up or down in value, the difference between what you get for it and its value when you received it would be a short-term capital gain or loss.

Abe Fortas:

Thank you.

Hugo L. Black:

I started to ask you this question.

You make one argument under Section (A) of 355 and one under Section (B).

Do you argue those, so to speak, conjunctively or alternately?

Hugo L. Black:

Either one of them (Voice Overlap)

Erwin N. Griswold:

Mr. Justice, we make — we make two arguments under 355 (a) (1) (A); one with respect to distributes to a shareholder with respect to its stock, and the other with respect to solely stock or securities of a corporation.

And then, we make an argument under (D), D for Detroit, we make no argument under (B) or (C) and —

Hugo L. Black:

Those two?

Erwin N. Griswold:

Those are the two provisions of the statute upon which we specifically relied.

Hugo L. Black:

But you have to — one have to agree with you on both, but —

Erwin N. Griswold:

No, Mr. Justice.

If we are right on either one, then the taxpayer does not comply with the terms of the statute.

Under the basis of Judge Friendly opinion [Inaudible]?

Erwin N. Griswold:

Well, I thought he made it referenced to both, but he did refer to D particularly.

Abe Fortas:

Mr. Solicitor General, is your — is it your position that in any case where warrants are distributed even without the payment of money that that destroys the tax-free aspects of the transaction?

Erwin N. Griswold:

Yes, Mr. Justice because it is not solely stock or securities.

Abe Fortas:

Well, I suppose it happened that the mathematics of it, the arithmetic of the transaction worked out so that the stock right was distributed together with warrants.

Erwin N. Griswold:

There again, that — that would be exactly what was involved in Southwest Consolidated.

The Court there held that warrants were not stock and therefore, it was not a distribution of solely stock or securities.

We would take the same position here.

Abe Fortas:

I see.

Erwin N. Griswold:

For the reasons indicated, we submit that the decision of the Ninth Circuit Court of Appeals in the Gordon case number 760 should be affirmed and that the decision of the Second Circuit Court of Appeals in the Bann case number 781 should be reversed on both questions raised.

Earl Warren:

Mr. Horrow.

Harry R. Horrow:

May it please the Court.

There are two issues here.

One issue arises with respect to the exercise of the Northwest rights.

The other issue relates to the sale of the Northwest rights.

The Solicitor General misspoke in referring to the sale issue as arising in the Bann case.

Actually, it arose in the Gordon case and the Bann case involves only the exercise of rights issue, the same issue that is involved in the Gordon case.

Addressing myself first to the exercise issue, I should like to review briefly the facts giving rise to the reorganization that is in question here.

Pacific operated the telephone business in the four western states, California, Washington, Oregon and Idaho prior to July 1, 1961.

This territory experienced enormous growth in the post-war period, so much so that it was apparent that extreme administrative difficulties were being generated by the expansion which was taking place.

The company therefore undertook a study to determine whether or not it was desirable to divide Pacific into two or more corporations and this study took place over a period of about two years, which begun in 1958.

The result of the study was that it was desirable to divide the business of Pacific into two corporations, one which would have all of the business and assets in the three Northwest states, and the other the remaining operations in California.

Harry R. Horrow:

The reasons for the division were to have a management and a board drawn from the area served so that there would be a better understanding of the service needs, so that there would be better relations with customers, employees, and government officials.

The plan to divide the Pacific company had nothing whatever to do with devising a means of raising capital.

Based on this study, it was determined to proceed with the division of the Pacific company.

The most obvious way of affecting this division would be by transferring all of the assets and business in the three Northwest states to a new corporation, and then simply distributing the stock of that corporation pro rata to the Pacific shareholders.

Such a distribution would have taken the form of a dividend and would have had to be charged to the earned surplus of Pacific.

Pacific did not have sufficient surplus for this purpose.

Accordingly, counsel for the company advised Pacific management that under the California law, it could not create Northwest and distribute the Northwest stock directly to the Pacific shareholders without the payment of any consideration.

The plan then devised in conformity with the California law was to affect a distribution of a Northwest stock by rights offerings.

The Northwest assets represented about 20% of Pacific’s business and when Northwest was created, it had a net worth of approximately $575 million.

In order to induce the Pacific shareholders to retain their proportionate interest in Pacific in the form of Northwest stock, the price at which the stock was offered was fixed at approximately 40% below the fair market value of the Northwest stock.

These rights represented in effect, part of the equity of Pacific shareholders since 20% of the company had been transferred to Northwest, and the rights were the means in conformity with the State Law whereby Pacific distributed the Northwest stock to the Pacific shareholders so that they could retain their equity in the Pacific company.

Abe Fortas:

But that isn’t quite so.

Isn’t your company, Pacific distributed the stock less $16 per share, in effect that’s totally shortly enough, either that the $16 was either — either has to be subtracted as a practical matter from the value of Northwest or you have treat it as a capital contribution — I’m just talking about the net effect of the transaction.

Harry R. Horrow:

The net effect is to increase the capital of Pacific, but it need not to be considered, as the Second Circuit considered it from a tax standpoint, as a contribution to capital.

It can be considered as I will develop later in my argument as simply a sale of the Northwest stock to the Pacific shareholders because of a sale under the Palmer case decided 30 years ago and which has been followed by the Commissioner ever since a sale is a distribution.

Abe Fortas:

And that’s the way it was set up actually in the plan, wasn’t it, as announced to the shareholders.

It was set up as a sale.

Harry R. Horrow:

Yes, Your Honor, so that the rights or the means whereby the Northwest stock was distributed to the Pacific shareholders.

Now, the opposing views of the Commissioner and the taxpayers are not simply that the transaction involving the receipt of Northwest stock is tax-free under Section 355.

Much of the argument made by the Solicitor General is addressed to the proposition that the receipt of the Northwest stock, through the rights offerings, is not governed by Section 355, but the Solicitor General has not stated what it is and what the Commissioner has contended resulted to the receipt of the stock.

And it might be pertinent to look at the question, which was so properly asked by the Second Circuit Judge Moore — which is set forth in the appendix at 275 and turning to the top of page 277, pointing to the fact that when the taxpayers exercise their rights, they simply receive the same and retain the same equity that they have before, only they have two pieces of paper, certificates in Pacific and Northwest instead of simply certificates in Pacific representing their ownership in the Pacific Corporation.

Abe Fortas:

They did that less $16 though?

Harry R. Horrow:

That is true, but the payment of cash into the corporation should not be a vice to a tax and I will advert to that Your Honor if I may in pointing to the question raised by the — by Judge Moore and which properly was raised.

As I have stated, he pointed to the fact that when Pacific decided to have his assets held by two corporations instead of one, the taxpayer simply had two pieces of paper instead of certificates in one corporation.

And the question is asked, “How this corporate change of asset ownership, brought income, and if so, where is it?”

Here, the taxpayer wound up with the same equity, they paid $16 a share in the Pacific and the Commissioner asserts that somehow or other, they received a dividend.

Now what is the subject of the dividend?

What form does it take?

The Commissioner now suggests that it takes the form of the rights which were received although I shall deal with that in the course of my argument, the Commissioner had ruled that the subject of the income, the distribution, was not the rights but was a stock and yet the stock represented to retain ownership in Pacific.

These rights had a three-week duration, by their terms they expire, they are worthless after three weeks.

Harry R. Horrow:

They require the payment of cash into Pacific in order for the shareholders of Pacific to retain their same equity.

The effect of the Commissioner’s determination in finding that this transaction resulted in income is to hold that where the taxpayer simply paid money into the corporation to retain their same equity that somehow or other, they received the income.

And as an added element of harshness, the Commissioner asserts that the retention of this equity not only resulted in income, but resulted in ordinary income, a dividend income.

Hugo L. Black:

May I ask you when the shareholder received what he gets, did he receive in stock, plus rights, something of greater value than he had in the original company?

Harry R. Horrow:

No Your Honor.

Hugo L. Black:

Why he didn’t, if the rights worth more than when they were assessed and as valued?

Harry R. Horrow:

When the rights were issued, there was no reduction in the aggregated net worth of Pacific.

There was no distribution of property.

The aggregate property and net worth of Pacific and Northwest was exactly the same as it was before Northwest was created.

The payment of cash by the Pacific shareholders into Pacific surely should not result in income.

They were out of pocket far from receiving anything from the corporation.

They were financially out of pocket.

There is nothing here that presents an occasion for the imposition of the tax and it would be a very strange thing for Congress to provide that this transaction should give rise to income.

On the contrary, our position is that Section 355 properly construed, accords the receipt of the Northwest stock nonrecognition.

Earl Warren:

Suppose instead of — suppose instead of it being a loss to the right holder or the stockholder, it was a profit.

Would your argument be different then?

Harry R. Horrow:

There would have to be a profit in some tangible form as the Court asked, “Where is it?

Where is the profit?”

Earl Warren:

You say there cannot be —

Harry R. Horrow:

There cannot be a profit here because the taxpayers receive nothing more than what they have before.

They own part of Pacific to the extent that they exercise their rights.

They have the same equity, only they have the equity in two corporations instead of one and this is precisely what Section 355 was intended to accomplish.

The legislative history of Section 355 shows clearly that Congress intended to facilitate and promote the breakup of large corporations, of any corporations, so that they could be reduced to smaller business units under altered corporate structures although owned essentially by the same shareholders.

And this is precisely what happened here.

Hugo L. Black:

— it’s more specific in the same condition it had been, when the stock was issued?

Harry R. Horrow:

Yes, Your Honor.

The purpose — the only purpose of this reorganization was to divide the Pacific company into two corporations which essentially the same ownership.

Hugo L. Black:

But, it wasn’t — this went to different shareholders, isn’t it?

Harry R. Horrow:

No, Your Honor.

Hugo L. Black:

I mean to the same shareholders but with a different company.

Harry R. Horrow:

The Northwest stock represented the investment of the shareholders through Pacific, and the assets in business in the three Northwest states.

Hugo L. Black:

But why if, I’ll just say if — why if the stock was worth more, I mean the right was worth more than it was assessed there, when it passed out to the Pacific’s holding, was not then a distribution of dividend so far as Pacific was concerned?

Harry R. Horrow:

Well, I will deal with that Your Honor. I think the answer to that question is found in the Palmer case and this case was cited and discussed in our brief and in the government’s briefs, the Palmer case dealt with the nature of stock rights.

Hugo L. Black:

Under the same statute?

Harry R. Horrow:

The Palmer case dealt with the question of whether the issuance of stock rights gave rise to a dividend.

Hugo L. Black:

Under the same statute or different?

Harry R. Horrow:

Under a different statute, but essentially the same language.

The Palmer case arose under the 1928 Act and the language, despite the assertions by the government to the contrary, the language of the Dividend Distribution Section in the 1928 Act is the same for all practical purposes as the language in 301, Section 301, which is the dividend distribution section relied on by the Commissioner in the 1954 Code.

Now in the Palmer case, there are rights issued to shareholders.

These rights had a value at the time they’re issued, they were traded, and the question was whether the receipt of those rights constituted income.

The Commissioner contended before this Court that rights were property and therefore, when the corporation issued the rights, there was a distribution of property, and therefore, a dividend.

The Supreme Court held this, “Rights are simply offers.

There is no distribution of property when rights are created”.

Hugo L. Black:

But why wouldn’t that be if the rights were created in a way, it gave the man something more valuable than what that which he hadn’t before?

Harry R. Horrow:

There is no reduction in the corporate property or net worth.

And a dividend involves three elements.

It involves a distribution of property, out of earnings and profits.

The mere fact that the —

Hugo L. Black:

Property is something of value?

Harry R. Horrow:

Property maybe something of value.

When the corporation declares a dividend, the right to that dividend is property.

The taxpayer does not receive a dividend until the dividend is paid.

There is no dividend in the sense of taxable income until property is distributed.

And in the Palmer case, the Supreme Court said that when the rights are issued at that point, there is no distribution because there is no transfer of corporate property, not until the offer is accepted by exercising the rights.

Is there a transfer?

Hugo L. Black:

But isn’t it accepted, when it’s accepted as a stock in the new corporation?

Harry R. Horrow:

That is so.

And that is our position here, Your Honor, that when the Northwest rights were issued, there was no distribution, not until the rights were exercised was there a distribution and the distribution then took the form of the Northwest stock, because in the exercise of rights, the rights are extinguished and the property transferred.

The property distributed is the stock which is subject to the rights.

In this case, the Northwest stock and therefore in our view contrary to the Commissioner’s position, there was a distribution solely of stock.

Abe Fortas:

The Solicitor General suggests that if you pursue that line of argument, you would find yourself impaled on the other horn of the dilemma that he presents, because in that event, there haven’t been some trading in the warrants of the stock that was not distributed to the stockholders of Pacific, but it was distributed in part of the stockholders and in part to others and in any event, there is no assurance that it was distributed as a statute seems to contemplate pro rata (Voice Overlap) Pacific.

Harry R. Horrow:

Your Honor, I think that is one of the questions involved in the interpretation of 355 (a) (1) (A) that can be most easily disposed of because the statute does not say distribute it to all of the shareholders of Pacific and the rights were issued to the Pacific shareholders as shareholders.

As shareholders, they exercise (Voice Overlap).

Abe Fortas:

No, but in your colloquy with Justice Black, you said that the distribution did not take place until the stock of Northwest was distributed.

And if that so, and there was trading in the rights in the intervening time, then the distribution did not take place to stockholders of Pacific, but only in part to stockholders of Pacific and in part to strangers and that’s what I understand the Solicitor General argues.

Harry R. Horrow:

That is correct.

The statute does not require that 100% of the stock be distributed to 100% of the shareholders.

The statute does not say all of the shareholders and that provision simply is a provision designed to ensure continuity of interest and continuity of interest as the court’s below held is surely taken care of by having more than 95% of the rights exercised by the Pacific shareholders to whom the rights were issued.

Earl Warren:

Do I understand Mr. Horrow that, under your argument, it makes no difference what the value of these rights on the market was?

Harry R. Horrow:

In our view, it could make a difference, but not under the facts of this case or these cases, simply this.

The rights were a mechanism designed to affect a distribution of the Northwest stock.

The testimony showed that a rights offering would be successful if only a 10% under pricing were used if the rights — if the offering price was only 10% less than the expected fair market value of the stock subject to the rights.

In this case, in order to ensure that the Pacific shareholders would retain their same proportionate interest in Pacific insofar as possible, consistent with the necessity of not dipping into Pacific’s surplus so that Pacific could conform to the California law.

The price at which the Northwest stock was offered was 40% less and the fact that the under pricing was successful is established by the great majority of the shareholders who exercised their rights.

Now the statement was made that approximately one-third of the minority shareholders did not exercise their rights.

The record shows that not less than two-thirds exercise their rights and a large number of rights were exercised through brokers and it is common knowledge that stockholders will use brokers as a matter of convenience in the exercise of rights.

So a great many of the rights that were exercised through brokerage firms, we believe, were exercised by Pacific shareholders, but in response to your question as to whether the difference between the value of the stock subject to the rights offer and the offering price makes a difference, conceivably it could, but not under the facts of this case because the record overwhelmingly establishes that the rights mechanism used here was for the primary purpose of getting the stock, the Northwest stock, in the hands of the Pacific shareholders.

Hugo L. Black:

I understood you to say or assert that these sections which requires the distribution, immediately before the stock and securities in the controlled corporation, immediately withhold the distribution, then referred all of it, but it says all of the stock and the securities and you say that they did not get it actually until rights had been exercised and cover it within the form.

Harry R. Horrow:

Well, Your Honor, the —

Hugo L. Black:

It says all of the stock?

Harry R. Horrow:

Yes Your Honor.

That portion of the statute to which you have referred to is in Section 355 (a) (1) (D).

Hugo L. Black:

(D) (1)?

Harry R. Horrow:

And D (1), yes, and the inquiry of Mr. Justice Fortas as I understood was directed at 355 (a) (1) (A) and that was the language —

Hugo L. Black:

I thought (Voice Overlap) been mistaken.

I thought he was talking about this alternative of the Solicitor General?

Harry R. Horrow:

No, I believe that he was addressing his remarks to —

Hugo L. Black:

Well, whether he was or not, what do you say about that?

Harry R. Horrow:

355 (a) (1) (D) requires a distribution of either all of the stock of the controlled corporation or at least 80% —

Hugo L. Black:

It says all of the stock and securities in the controlled corporation?

Harry R. Horrow:

The statute, Your Honor, permits retention of some shares as long as these shares are not retained for the purpose of avoidance of federal income tax, but in any event, it is our position that all of the shares of Northwest were distributed.

Now the point with respect to 355 (a) (1) (D) —

Hugo L. Black:

But the rights were not distributed, I understood you to say —

Harry R. Horrow:

Rights were not distributed.

Hugo L. Black:

— until they were cashed in?

Harry R. Horrow:

The rights were not the subject to the distribution, but rather the stock, but all of the stock was offered to the Pacific shareholders and all of the stock was thereby distributed.

Hugo L. Black:

Plus the rights —

Harry R. Horrow:

Well Your Honor —

Hugo L. Black:

— wasn’t it?

Harry R. Horrow:

— the rights were the means whereby the stock was distributed.

The rights —

Hugo L. Black:

Whatever it was, they didn’t get the stock, did they until they cashed in those rights.

Harry R. Horrow:

They exercised their rights and thereby received the stock.

Hugo L. Black:

Tell me, that was how many years?

Harry R. Horrow:

There was a period of 21 months between —

Hugo L. Black:

After the distribution?

Harry R. Horrow:

There was a period of 21 months before Pacific completed the distribution of all of the Northwest stock.

Now with respect to that point, in the Tax Court, no contention was made by the Commissioner.

Hugo L. Black:

Suppose it wasn’t?

Harry R. Horrow:

The Commissioner then —

Hugo L. Black:

(Voice Overlap) would he overlook at the grades here?

Harry R. Horrow:

There are two elements involved in this contention.

One is the factual issue as to whether these two distributions were part of the same transaction and the other is a legal issue as to whether the statute permits more than one distribution.

Now the Commissioner apparently has abandoned any theory which was contended, and I think properly so, that the statute is not restricted to one distribution.

There is nothing in the language of 355 (a) (1) (D) that requires that there be only one distribution of all the stock in order to qualify under 355.

Now, if that so, then the mere fact that there were two distributions is not a violation of that subsection.

Turning then to the facts as just Mr. Justice Harlan pointed out, this is a matter that falls within the province of the Tax Court and the Tax Court so found.

[Inaudible]

Harry R. Horrow:

Oh!

I think your inquiry suggest the answer, Your Honor, and the answer I think is clear that this is a matter of fact finding for the Tax Court and the Tax Court made a finding.

Harry R. Horrow:

The Tax Court found that the 1961 and the 1963 distributions were part of the same transaction.

Abe Fortas:

Well, could you have stop — could the company have stopped short of the 1963 transaction without a breach of its representations in the agreement?

Harry R. Horrow:

No, Your Honor.

Abe Fortas:

— (Voice Overlap) as if it could have, doesn’t it?

Harry R. Horrow:

No.

Abe Fortas:

Would you show me the language on which you rely on?

Harry R. Horrow:

I would like to point to the language that is referred to in the taxpayers’ reply brief on page 8.

And there, it is stated in the plan, the Pacific company shall offer to its shareholders as set forth below the right to purchase all of the shares of capital stock of the new company acquired pursuant to this plan.

Abe Fortas:

Where does that appear in the plan?

Have you got a reference to it?

Because I’m looking at the 108 of the record and 108 of the record says that promptly after acquiring —

Harry R. Horrow:

Page 103, Your Honor, in the Appendix.

Abe Fortas:

That’s not the plan, is it?

Harry R. Horrow:

Yes.

The plan for reorganization which was submitted to the shareholders begins on page 102 of the Appendix.

Abe Fortas:

Alright the language to which I refer and which the Solicitor General referred appears on 108 and 109 of the record, is that right?

Harry R. Horrow:

That is correct.

Abe Fortas:

And first, it says that promptly after acquiring the securities of the new company, the company will offer for sale approximately 56% of the stock.

And then on page 109, it says it’s expected that within about three years, the company will offer for sale the balance of the stock.

Are you saying that there’s something in the plan that countered — that’s contrary to that?

Harry R. Horrow:

It’s not contrary to it.

The statement on page 109 relates solely to the maximum period of time during which it was anticipated that all of the stock would be distributed.

Abe Fortas:

So, could you tell me where in here, there is a provision saying that the company will distribute all of the stock to the stockholder?

It may be here, but I haven’t seen it.

Harry R. Horrow:

Your Honor, at the bottom of 103 and the top of 104, after referring to the fact that the first offering would be approximately 56%, the statement is made and I quote the bottom page 103, “At a time or times related to its need for a new capital, the company will offer the remainder of the shares of the new company for sale in a similar manner to shareholders of the company”.

And similar representations were made in the registration statement, there is no question that the Tax Court so found that all of the shares would be offered, and the company was required to offer all the shares to the Pacific shareholders.

Abe Fortas:

Well, it’s not all that clear just by the text?

Earl Warren:

I understood you just say Mr. Horrow that this was — the transaction was not a part of any refinancing deal and wouldn’t that indicate that if they needed refinancing, it would be offered to the stockholders, otherwise not?

Harry R. Horrow:

Your Honor, because of the fact that Pacific was not in the position to charge surplus in the distribution of the Northwest stock, the stock had to be offered to the Pacific shareholders at more than its book value.

The book value was around $13 a share, necessarily.

Hugo L. Black:

What was its actual value?

Harry R. Horrow:

The actual value based on market quotations, Your Honor, was in excess of $26 a share, ranged prices but —

Hugo L. Black:

Now, that’s what we’d have to consider, isn’t it?

Harry R. Horrow:

That is a relevant fact Your Honor and it reinforces the point I made that the market value of the Northwest stock was 40% greater than the offering price.

And the reason for that was to affect the distribution of the Northwest shares to the Pacific shareholders to provide the maximum inducement to them to retain their equity in Pacific.

Now, as I have said —

Hugo L. Black:

What if I just give them a dividend with that much money, would that made any difference?

Harry R. Horrow:

If they had received cash, surely, that would have been a taxable dividend.

Hugo L. Black:

The stock was the same as cash, wasn’t it?

Harry R. Horrow:

The stock represented the retention of their equity and under Section 355, Congress expressly permitted, provided for the breaking up of the corporation into several corporations so that the shareholders could receive the stock of the new corporations tax free and this is —

Hugo L. Black:

If you complied with the terms of the statute –-

Harry R. Horrow:

I beg your pardon.

Hugo L. Black:

If you complied with the terms of the statute?

Harry R. Horrow:

That is right —

Hugo L. Black:

(Voice Overlap) back to the questions that you’ve —

Harry R. Horrow:

That is our position that we do comply and the suggestion that we do not so contend is not — it’s not warranted.

We contend that Section 355 is fully complied with.

Our case revolves around the interpretation of Section 355 and the highly technical and inhospitable reading to quote the Tax Court which the Commissioner seeks to give Section 355, engrafted under that Section conditions that are nowhere expressed, results in taxable income when there was none and results in frustration of the purposes of Congress rather than as the Tax Court pointed out, carrying out the purposes of Section 355.

Section 355, and as the Solicitor General conceded, permitted the Northwest stock to be distributed tax-free without the payment of any cash.

It was stated that if that had been done, Section 355 clearly would have been complied with.

The position of the Commissioner is that simply because the taxpayers paid money into Pacific instead of receiving the Northwest stock without any payment that thereby they incurred a tax.

I was — you said at the beginning, but I’m not sure that I grasped it.

If I wasn’t a stockholder — distribute it directly —

Harry R. Horrow:

It was not, Your Honor, because such a distribution would have had to be charged to surplus and Pacific did not have sufficient surplus to permit a distribution in that manner.

That would have been a violation of the California law and Pacific was so advised.

Therefore, when in conformity with the California corporation law, the stock rights method was used in order to avoid charging surplus, the offering price was fixed at an amount in excess of book value.

Now necessarily, that figure involved the payment into Pacific of very, very large sums of money.

The total amount paid in under the rights offerings was approximately $480 million.

Because of the fact that the rights offerings would involve such a large inflow of capital, it was necessary to take cognizance of that and not raise capital as Pacific had customarily by issuing its own securities.

It was — Pacific then was requiring about $250 million a year and prior to 1961, it had been issuing its own securities, its own debentures and its own stock in order to raise capital.

Harry R. Horrow:

But because the distribution of the Northwest stock in conformity with the California law required the payment of capital into Pacific, it was unnecessary for Pacific during this interim period to resort to issuance of its own securities to raise capital.

And necessarily, because Pacific was a public utility, it could not have on hand properly large sums of unused capital.

In the interest of the shareholders and the ratepayers, it would have been improper for Pacific to have a large amount of unused cash, lying in the banks and yielding a low rate of return.

Now, I have dealt with the Palmer case and I think it might be pertinent here to talk about the — whether or not the 1954 Code changed the rule in that case.

As I said, that rule was accepted by the Commissioner.

It’s embodied in a general counsel’s memorandum.

As far as I know, the administrative practice of the Commissioner for 30 years has been to follow the Palmer case, that there is no — that there is no income, no distribution when rights are issued, that when the rights are exercised, that’s when the distribution takes place.

In fact, in the rulings that were issued in this case — in these cases, the Commissioner applied the Palmer doctrine.

The Commissioners rulings sated that there was a distribution of property.

The property was in the form of a Northwest stock and the Commissioner further said that the receipt of rights was not taxable income.

Now, I wish to point out that the Commissioner’s theory here before this Court is not only contrary to his long-established administrative practice, but it’s contrary to the rulings that he expressively made in the — in connection with this reorganization.

Now, as to the 1954 Code, the Commissioner relies on a change in the definition of property, and the contention made is that rights are therefore property and when they’re issued, there is a distribution of a dividend.

Well, as I pointed out, the Palmer case turns not on the concept of property.

It turns on the concept of what is a distribution and there was no change made in the 1954 Code in language of the statute dealing with distributions of property as dividends.

Not only there was a no change in that language, but Congress, in the committee reports stated that Section 301 which embodies this language substantially was the same as the corresponding provisions in the prior law which were involved in the Palmer case.

There is no indication whatever in any of the Committee reports that Congress ever made any change in this important rule, in this backhanded fashion by simply dealing with what I consider was a drafting clarification in the definition of property and we’ve explained that in our brief.

It’s a highly tactical point, but I think that it’s perfectly clear that there is no basis whatever for the assertion that Congress intended to make any change in the 1954 Code with respect to the Palmer rule.

And after Palmer case is applied, there is a distribution because Palmer said that a sale of property to shareholders of a corporation is in a literal sense, a distribution.

There is also a distribution solely of stock because the subject to the distribution is not the rights, but a Northwest stock.

Byron R. White:

Do you think it’s a distribution that you sell stock of stockholders even if it is sold at fair market price?

Harry R. Horrow:

Yes, Your Honor.

It is a distribution but it does not involve any distribution out of earnings and profits.

There are three elements.

There clearly is a distribution in the sense that there is a transfer of corporate property to the shareholders and that’s the sense in which the word — the term distribution is used in Section —

Byron R. White:

Except for Section 355, why it’s unquestioned that the distribution of the stock would have been a taxable dividend?

Harry R. Horrow:

No, Your Honor, that is not I am questioning, because it is our position that if this transaction does not fit under Section 355, it fits under some other reorganization provision or in any event —

Byron R. White:

Well, aside from the reorganizations, if a corporation which has owned stock in another company, in an unrelated company for some time and the stockholder’s — the value of the stockholder’s stock has reflected the value of that corporate holding.

If that stock is simply distributed to stockholders, it’s normally a taxable dividend?

Harry R. Horrow:

It would be a taxable transaction and a taxable distribution, Your Honor, but it maybe either an ordinary dividend or it may be a distribution and partial liquidation.

In our contention, one of our alternative contentions here is that because the Northwest stock represented 20% of the assets of the Pacific company before Northwest was created that if there is any taxable distribution, it is a —

Byron R. White:

Is that issue here before us?

Harry R. Horrow:

No, it is not before this Court.

Byron R. White:

That isn’t in this case, is it?

Harry R. Horrow:

No Your Honor.

It was an alternative contention which was not considered by the Tax Court because the Tax Court found that there was no taxable distribution.

Byron R. White:

But the fact that the — the mere fact that the stockholders’ interest hasn’t changed any — it doesn’t necessarily mean that the distribution is taxable?

Harry R. Horrow:

No Your Honor, but it’s a very compelling factor —

Byron R. White:

That’s an interesting fact.

Harry R. Horrow:

— in finding that the purpose and the fact of the reorganization fits under Section 355 because Section 355 was designed to accomplish just that, to permit one corporation to be divided into two corporations or more with essentially the same ownership and that’s exactly what happened here.

The Pacific shareholders wound up with certificates in two corporations instead of one, there is just simply a change in the corporate structures.

We’ve had some discussion on 355 (a) (1) (D) and I believe that the issue there is controlled by the clear finding of the Tax Court which is clearly supported by the record and this finding is not supported only by the documents, the representations that were made by the shareholders in the filings with the Securities and Exchange Commission which were subject to all the civil and criminal penalties, if there are any material misrepresentations of fact, but it’s also supported by the unequivocal testimony of the controller and the vice president of Pacific.

He testified that the 1963 offering and the 1961 offering of the Northwest stock were interdependent.

Neither step would have been taken without the other and the court found that they were part and parcel of the same transaction looking toward the distribution of all of the Northwest stock by Pacific.

Byron R. White:

Could I ask you if it — the parent company to whom most of the stock was distributed I take it is AT&T?

Harry R. Horrow:

Yes, Your Honor.

Byron R. White:

Now, will they pay tax or will they consolidate a return —

Harry R. Horrow:

The American filed a consolidated return but the absence of a dividend income is predicated on the ruling that the subject of the distribution was the Northwest stock and the Commissioner ruled that if the basis of the Northwest stock was less than the offering price and then in the case of corporate shareholder of Pacific, there would be no dividend and American, like all the other corporate shareholders of Pacific under the Commissioner’s ruling, are deemed not to have received dividend income.

But under the theory, the new theory, that the Commissioner has expounded here, that the rights are taxable income when received, there still is no income for the corporate shareholders because corporate shareholders are treated differently than individual shareholders in respect with dividends —

Byron R. White:

And so the consolidated return has nothing to do with it?

Harry R. Horrow:

The consolidated return has nothing to do with it, Your Honor, on the question of the receipt of income through the exercise of the rights.

I might say this that I was somewhat startled to find in the Commissioner’s brief the espousal of the theory of convenience, the rule of convenience in connection with determining tax liability.

When the Commissioner issued his rulings, he said the taxable event was the exercise of the rights.

Now, the position is that the taxable event is the receipt of the rights.

When he ruled that the exercise event was — gave rise to the tax, the measure of the tax was the difference in the Commissioner’s view between the value of the Northwest stock at the time of exercise and the offering price.

Now the Commissioner asserts that the taxable event is the receipt of the rights and that while analytically speaking, the amount of the income is the value of the rights at the time of receipt, nevertheless as a matter of “convenience,” the taxable income maybe determined by the difference between the value of the Northwest stock and the offering price at the date of exercise.

Now I submit Your Honor that — submit to this Court that tax liability could not be predicated on such flexible rules.

The taxable event is either the exercised dates or it’s the receipt date or no rules of convenience can be permitted simply because in this particular case, there was not much difference in dollar amount between the value of the rights at the date of exercise and the value of the rights at the date of receipt.

There must be one rule of taxation that applies to all taxpayers.

Potter Stewart:

I thought we’re talking about the value of the right at the time of receipt and then value the right at the time of the sale of the right?

Harry R. Horrow:

No Your Honor.

Potter Stewart:

That was the rule of convenience because mathematically, it comes up the same way or analytically it should be the value at the time of the receipt of the right?

Harry R. Horrow:

As I understand it Your Honor, the Commissioner has taken a position that as a matter of computational convenience, the Commissioner could determine properly that the measure of income was the value at the date of exercise.

Earl Warren:

This I believe is the proper thing.

Harry R. Horrow:

The Solicitor General has referred to the rule of construction to be applied here.

The rule of construction which the taxpayers are contending for is not a so called liberal construction.

Our contention is the statute must be applied as it reads Section 355 is in the context of the reorganization provisions.

It is part of subchapter C dealing with all types of reorganizations not merely the device of reorganizations that are embraced within the Section 355.

The legislative history shows clearly that in connection with Section 355, Congress wished to do a way with forms in corporate mechanics in determining whether or not a device of reorganization would be treated as tax free.

It wanted to deal with the substance.

The effect of transactions and the reason for it is because of the history of the spin-off, so called spin-off provisions if I maybe permitted to use the tax jargon here which the Solicitor General referred to which occurred in the Gregory case.

Now this case is the antithesis of the Gregory case.

In the Gregory case, the taxpayer used a form of spin-off in order to affect what was essentially a distribution of earnings and profits.

It was a tax avoidance scheme pure and simple that followed the form of the statute, but the substance was exactly the opposite of what Congress intended.

Therefore, when it became apparent that the spin-off provisions could be abused, in 1934, the Congress did away with a spin-off provision but it retained all of the other device of reorganization, the split-ups and the split-off.

And the reason is clear because the Congress at all times evinced the policy of encouraging the division and the breaking up of corporations, rearrangement of corporate structures with essentially the same ownership.

Therefore, it was impelled to reinstate the spin-off provision in 1951, but it did not reinstate it in the form in which it was put in 1924 when the Gregory case and all of that litigation arose.

There was a qualification in the statute as it stood in 1951 which showed clearly that Congress did not want the spin-off provisions to be abused by using that form of device of reorganization as a means the getting earnings and profits out of the corporation.

Therefore in 1954, when there was a complete overhaul of the code, a reexamination of all of the provisions of the code and in particular the corporate reorganization provisions, Congress placed the emphasis on substance and not form.

And in one Section, Section 355, it dealt with all types of device of reorganizations and it said regardless of the mechanics, the forms, the corporate forms used whether it’s a spin-off or a split-off or a split-up, as long as in substance, there was no distribution of earnings and profits then that change of corporate ownership, change in corporate structure on their audit form would be permitted to take place on a tax-free basis.

The purpose of Congress, I think, in doing that is well set out in the committee report.

The committee report is referred to in the Commissioner’s brief on page 2 of his reply, but unfortunately, he has omitted from the text which is quoted, the entire language which shows clearly that Congress wished to be exceedingly liberal with respect to readjustments and rearrangements of corporate structure but to tighten up on the distribution of earnings and profits so that the substance, the effect of the transactions would control.

The full text of that statement in the committee report which I have referred to appears in the taxpayers’ brief on pages 33 and 34 and I would like to read one statement in that report that I think is pertinent here, “Thus, your committee would liberalize present law with respect to the non-recognition of gain or loss in cases which involved mere rearrangements of the corporate structure while at the same time, providing less liberal rules in other areas in order to ensure that transactions which are in substance, although not in form, dividend distributions by corporations to their shareholders are subject to tax at ordinary income rather than a capital gain rates”.

Now what do we have here?

We have precisely what the committee was dealing with, the rearrangement of corporate structures with essentially the same ownership and this, the statute was designed to permit to be accomplished on a tax-free basis.

The changes that were made in the prior law by the 1954 Code through Section 355 are set out in the brief of the taxpayers, the opening brief on pages 34 and 35, and they show clearly that Congress in dealing away with a necessity for pro rata distributions and making it unnecessary to form a holding company which would take over the stock of a controlled corporation and be the subject of a tax free spin-off.

Congress was concerned with eliminating all of these corporate mechanics, but it wanted to make sure that there would be no use of Section 355 to distribute earnings and profits in the four conditions two of which had been relied on by the Commissioner here.

The four conditions in Section 355 are all designed to implement this overall concern of Congress that there’d be no distribution of earnings and profits.

Now when the taxpayers exercise their rights, when the Pacific shareholders exercise their rights, what happens?

Was there any distribution of earnings and profits?

Assuredly not because all of the property and net worth that had been in Pacific was then in two corporations, Pacific and Northwest and was still available for distribution of dividends to be taxed when as and if distributed, but not until then.

Harry R. Horrow:

Now, turning to the precise language of 355 (a) (1) (A), taking that language as it should be read in its ordinary meaning and in the context in which the Section appears, it is our contention that we meet all of the conditions prescribed.

William J. Brennan, Jr.:

Did you argue both of these cases in the Court?

Harry R. Horrow:

Yes, Your Honor.

In Section 355 (a) (1) (A), a corporation referred to in this Section as a distributing corporation distributes.

Assuredly there was a distribution here under the Palmer case, the transfer of corporate property to a shareholder is a distribution even though it might be called a sale.

As the Palmer case says, a sale literally is a distribution.

And the language is precisely the same in Section 301 which seemingly the Commissioner agrees, includes a so called sale or on pages 6 and 7, the reply brief of the Commissioner, the statement is made and I quote, “There is such a distribution with respect to stock only when the sale is a bargain, the price is less than value”.

In that circumstance which is the present case, the item distributed is the value of the bargain measured by the spread between the price and the value.

It is submitted that what is distributed is not an item of value.

What is distributed is property and the property that was distributed here was the Northwest stock.

With respect to its stock, as our brief shows clearly, means simply the recognition of the shareholders in their capacity as such and nothing more.

We believe that we complied in every way with the terms and conditions of Section 355.

Earl Warren:

Mr. Solicitor General, would you mind giving us your response to the portion of the Committee’s Bill on the 1954 Code that he just mentioned a little while ago.

It’s on page 34 of his brief.

It’s about the purpose of the Congress in changing the language of the 355.

Erwin N. Griswold:

Well, Mr. Chief Justice, the full quotation from the committee report is given accurately in the taxpayers brief in the footnote at the bottom of page 33 and 34 and I have — I agree with it entirely.

The Congress wasn’t trying to remove unwarranted restrictions, unnecessary or desirable business practices but it was also including provisions to ensure that this would not be misused and there’s nothing in that paragraph in the Committee report which even suggest that the language which the Congress actually used in the statute is not to be read as having its meaning and to be applied the way it was written, and that gets us back to our contentions about the three particular paragraphs of the statute where it seems to us that the provisions of the statute were not met by the distribution of rights as distinguished from the distribution of shares.

The counsel has referred to the fact that rights were used here because there were difficulties under California law and they couldn’t have distributed the shares.

I think that’s, perhaps, exaggerated.

Pacific had able counsel here and I don’t think it would have been above or beyond their capacities to have developed a recapitalization which would have produced capital surplus, which would have enabled the distribution to be made if that’s what they’d wanted to do.

The fact was that they wanted very much, they needed desperately, we’re fortunate that we have an excellent management available there.

They need it desperately to have large amounts of new capital to provide for the rapid growth of the business in California and as the Tax Court pointed out on its opinion on page 240 of the record, this was the dominating factor which determined their use of rights rather than the distribution of stock.

Then I would like to point out that rights are property, there’s no doubt about that.

One other problems in this case is that both sides have to try to deal somehow or other with the Palmer case.

I don’t think that the Palmer case is a barrier to the government’s position here nor necessarily a barrier to the taxpayers’ position, but I think it’s perfectly obvious that rights are a property.

All one would have to do would be to consider a theft of the envelope containing the rights or a question of property tax liability with respect to rights.

And there is a very important factor here in that Congress didn’t make changes in 1954 and they were more substantial than my other learned brother has indicated.

I would call a particular attention to Section 317 which is new in the 1954 Code and which defines property in such a way as clearly to include rights to subscribe to shares in another corporation.

We would welcome a reexamination and a clarification of the Palmer case along the lines indicated in our brief.