348 F. 2d 278 - United States v. Georgia Railroad and Banking Company

This appeal presents for our consideration two novel questions of federal income tax law. First, we must decide whether a lessor under a 99-year 'lease' of corporate securities is entitled to the dividends-received deduction which 243 of the Internal Revenue Code of 1954, 26 U.S.C.A. 243, affords to corporate shareholders.1 Second, we must answer the question whether the taxpayer-lessor, having distributed the reversion in certain of the leased shares to its own stockholders as a dividend in kind, may amortize over the remainder of the lease term its retained interest in the distributed shares, including its right to receive income under the lease.2 The district court allowed the taxpayer both the deductions it sought. We disagree and reverse on both issues.

The rather unusual transaction which gave rise to this suit had its genesis in the days prior to the Sixteenth Amendment and the advent of the now ubiquitous federal tax collector. On May 7, 1881, the Georgia Railroad & Banking Company entered into a 'lease agreement' with William M. Wadley for a term of 99 years from April 1, 1881. The agreement covered all of the railroad properties owned by the taxpayer, including assets and securities of the Western Railway of Alabama and the Atlanta and West Point Railroad.3 The lessee covenanted to make an annual payment of $600,000 for the use of the properties covered by the agreement, payable in two semi-annual installments. In addition, the lessee agreed to return the properties unimpaired in value and as well adapted to the business of transportation as they were in 1881.4 The lessor had the right under the terms of the agreement to repossess the property upon breach of any of the covenants.5

Wadley's interest in the lease was eventually assigned to the Louisville & Nashville Railroad Company. The L & N in turn assigned one-half of its interest in the agreement to the Atlantic Coast Line Railroad, and the stock has been and is presently registered in the name of the L & N as trustee for itself and the Coast Line. After these assignments, the lease was amended by various supplemental agreements between 1899 and 1910.6

As of March 1, 1913, 9,361 shares of the Atlanta & West Point and 15,000 shares of the Western of Alabama were subject to the lease and the supplemental agreements. The number of leased shares and the proportionate ownership which those shares represent have remained constant since that date. Pursuant to 1053 of the Internal Revenue Code of 1954, 26 U.S.C.A. 1053, the property subject to the lease acquired a tax basis equal to its fair market value on March 1, 1913. Applying that standard, the district court found that the tax basis for a share of Atlanta and West Point was $150 and that of a share of Western of Alabama was $120.

On July 7, 1954, for business reasons relating to the regulatory policies of the Interstate Commerce Commission, the taxpayer in effect distributed its reversionary interest in 7,000 of the 9,361 shares of the Atlanta and West Point and 12,180 of the 15,000 shares of the Western of Alabama to its own shareholders as a dividend in kind. This distribution was accomplished by giving each stockholder Certificates of Participation which entitled him to receive a certain number of shares of each railroad or its equivalent after the expiration of the lease on April 1, 1980, or its earlier termination.7 The taxpayer, however, retained all present interest in the shares whose reversion had been distributed, including all rights to receive the entire $600,000 annual payments pursuant to the terms of the 1881 lease agreement. No gain or loss was recognized to the taxpayer on this transaction, but the taxpayer did write off of its books that part of the basis which was attributable to the 1913 fair market value of the distributed reversionary interest.8 The Internal Revenue Service ruled that the 1954 fair market value of the reversion was taxable to the recipient shareholders as dividend income in the year of receipt, and the taxpayer so advised the distributees of the certificates.9 At that time the reversion in a share of Atlanta and West Point had a fair market value of $3.25 and a share of Western of Alabama had a fair market value of $6.24.

In 1954 and all prior years, the taxpayer had reported the full $600,000 annual payment as rental income. In 1954, the taxpayer amended its return, claiming that a portion of the $600,000 payment represented constructive dividends against which it could offset the 85 per cent dividends-received deduction afforded by 243. The dividends paid to the lessee on the leased stock during the fiscal period January 1, 1954, through October 6, 1954, totaled $84,361. Hence, the district court allowed the taxpayer a dividends-received deduction of $71,706.85.10

In addition, the taxpayer sought to depreciate under 167 that portion of its 1913 basis in the stock whose reversion had been distributed which represented the 1913 fair market value of the right to receive income for the remaining 25 3/4 years of the lease on the theory that the rights the taxpayer retained upon distribution of the reversion constituted property held for the production of income which would be fully exhausted by April 1, 1980. The taxpayer and the district court imputed 63.57% Of the 1913 basis of the stock to the interests retained by the taxpayer in the distributed shares, and the district court allowed a depreciation deduction of $15,501.21 for the period from July 7, 1954, to October 6, 1954.11

The Government appeals from both holdings of the district court. We shall discuss each issue separately below.

* The taxpayer urges that it, rather than its lessees, is entitled to the dividends-received deduction since it is the beneficial owner of the shares of the two railroads.12 The argument runs substantially as follows: The transaction in question is a long-term lease, an arrangement which is generally held not to vest beneficial ownership of the leased property in the lessee. Taxpayer also concurs in the district court's conclusion that the lessees are mere conduits for the payment of dividends, since the dividends actually received by the lessees are paid over to taxpayer pro tanto as a part of the $600,000 annual payment for the use of the property subject to the lease. In this connection, the taxpayer notes that the portion of the $600,000 payment which is property allocable to the use of the stocks approximates that proportion of the average earnings (and thus the dividends) of the two railroads which related to the leased stock during the five-year period immediately preceding the consummation of the 1881 agreement.13 Moreover, in the taxable year in question the amount paid for the use of the shares greatly exceeded the dividends paid out to the lessees. The lessor made the initial capital investment in the two railroads and, therefore, is the real shareholder in the two corporations.14 The lessees, on the other hand, have contributed no capital to the two enterprises. This argument taxpayer urges, comports with the purpose of 243 to minimize the double taxation which would otherwise occur when one corporation invests in another. In substance, the transaction amounts to an anticipatory assignment of income for 99 years without the concomitant transfer of the underlying income-producing property. Under established principles, the assignor is properly taxable on such income and, of course, entitled to the benefit of any deductions which are directly related to the income so assigned.

We think the taxpayer's argument is unpersuasive in several respects. The purpose of 243 is to eliminate the multiple taxation of corporate earnings which would otherwise occur whenever one corporation holds shares of stock in another corporation. Thus, the deduction seems to be directed more to the preservation of income from the stock than to the protection of the investment in the underlying company. This Circuit and other courts have recognized that, where ownership of shares of corporate stock is fleeting or uncertain, the dividends-received deduction is available only to the beneficial owner of the shares. See, e.g., Rupe Investment Corp. v. Commissioner of Internal Revenue (5 Cir. 1959), 266 F.2d 624; Joseph L. O'Brien Corp. v. Commissioner of Internal Revenue (3 Cir.), 301 F.2d 813, cert. denied,371 U.S. 820, 83 S.Ct. 37, 9 L.Ed.2d 61 (1962). And, of course, the question of beneficial ownership must be measured according to the substance of the transaction as a matter of federal income tax law rather than according to technical forms and concepts of state property law. Thus, the question is not whether the transaction should be characterized as an assignment for a term or a lease, but rather whether the taxpayer had so little control over the stock during the 99-year period that he cannot be said to have retained beneficial ownership of the shares.15

An examination of the factors which indicate the situs of beneficial ownership of the shares of stock which are subject to the lease agreement leads us to the conclusion that if beneficial ownership lies anywhere during the lease term it lies with the lessees, not the taxpayer. Virtually all the indicia of present ownership are vested in the lessees. We start with the proposition that the 1881 lease, together with the supplemental agreements, undoubtedly were conceived in a bona fide, arm's length business transaction in which the Georgia Railroad and Banking Company substituted a fixed annual income on its shareholdings for the normal risks of a business venture to which mere ownership of the shares would subject it. This business purpose is borne out by the fact that there is no attempt in either the 1881 agreement or its subsequent modifications to gear the rent allocable to use of the shares of the two railroads to the dividends actually paid to the lessee.16 By the terms of the lease, the full $600,000 remains due each year whether the two railroads pay no dividends at all in that year or pay dividends equalling twice the amount of the 'rent.' We think the duration of the lease is also economically significant. A 99-year lease has afforded the lessees a substantial opportunity to manage and develop the two railroad companies. The lessees have virtually unfettered authority to vote the shares as they see fit and to participate in the selection of the directors of both corporations. The lessee really bears the operating risks of the two enterprises; as a practical matter, all present rights in the leased stock have been transferred to the lessees for the terms of the agreement. They also have physical possession of the stock certificates. The fact that the leased shares are recorded in the name of the L & N as trustee for itself and the Coast Line simply serves to bolster the conclusion that the parties have treated the lessees as beneficial owners of the shares, although this factor alone can, of course, never be controlling. It is not without significance that the lessor, prior to 1954, treated the full $600,000 payment on its tax returns as rental income rather than partially as dividends constructively received from the lessees. Perhaps most telling of all is the provision in the 1904 and 1905 assignments that the lessees could collect for themselves and use the dividends on the leased stock during the term of the agreement. This statement clearly suggests to us that both lessor and lessee contemplated full and free use by the lessees of whatever dividends were paid.17 In addition, the taxpayer's claim to beneficial ownership is undermined to some degree by the fact that the reversionary interest in most of the leased stock has now been distributed to its own shareholders.

Of course, the taxpayer still holds whatever rights it has as lessor under the lease. This includes only the right to enforce the covenants of the lease and, upon default, to obtain an earlier distribution of the actual shares to the taxpayer's shareholders and repossess the shares not distributed. The restrictions on the lessees, on he the other hand, are relatively minor. They cannot, for example, encumber the property subject to the lease or vote the shares for that purpose, and they must return the leased property in as good condition as when it was leased and 'unimpaired in value.'18 Therefore, we conclude that, in the circumstances of this case, the lessor-taxpayer has, in substance, divested himself of beneficial ownership of the shares and is not entitled to deduct 85% Of the dividends paid on those shares against the $600,000 annual payment made by the lessees for the use of the shares.

The Taxpayer contends that the logic of this court's decision in Rupe Investment Corp. v. Commissioner, supra, requires a conclusion that it is the beneficial owner of the shares. In that case we held that an investment company which had temporary record title of stock which it was purchasing as agent for another was not entitled to the dividends-received deduction on dividends actually paid to it during the period of its record ownership. In reaching that conclusion we approached the problem in much the same fashion that we have here, analyzing the substance of the transaction for the purpose of pinpointing the location of beneficial ownership. Factually, the case is clearly distinguishable from the instant one, but the court adhered, as we do, to the basic principle that 'taxation is not so concerned with nice refinements of title as it is with actual command over property.' 266 F.2d at 630; see Harrison v. Schaffner, 312 U.S. 579, 851, 61 S.Ct. 759, 85 L.Ed. 1055, 1057 (1941). Taxpayers here, like the taxpayers in Rupe, did not have such command.

As noted above, the taxpayer relies heavily on the anticipatory-assignment-of-income cases, notably Lucas v. Earl, 281 U.S. 111, 50 S.Ct. 241, 74 L.Ed. 731 (1930); Helvering v. Horst, 311 U.S. 112, 61 S.Ct. 144, 85 L.Ed. 75, 131 A.L.R. 655 (1940); and Harrison v. Schaffner, 312 U.S. 579, 61 S.Ct. 759, 85 L.Ed. 1055 (1941). We do not think the principle of those cases is applicable here. Their rationale is that income from personal services or income-producing property cannot be 'attributed to a different tree from that on which (it) grew,' Lucas v. Earl, supra, 281 U.S. at 115, 50 S.Ct. at 241, 74 L.Ed. at 733, in advance of its realization in order to escape a tax on that income. The assignments in all of those cases were gratuitous and the underlying asset which produced the income remained with the taxpayer-donor. And in United States v. Joliet & Chicago R.R., 315 U.S. 44, 62 S.Ct. 442, 86 L.Ed. 658 (1942), there was a constructive receipt by the taxpayer of income payments made directly to its shareholders in discharge of its obligation to them. Any other result would have permitted the corporation to separate the income itself from the income-producing entity, thereby avoiding the double tax imposed on corporate earnings. In the instant case, as we have noted above, the taxpayer has not gratuitously assigned the dividends from the shares of the two railroads; rather, it has substituted a fixed income for 99 years in lieu of the dividend income in an arm's-length bargain. There is therefore no question of attempting to shift the incidence of ordinary income taxation.19 Additionally, as we have pointed out above, more than the right to receive the income from the stock was transferred to the lessees during the lease term. Virtually all the incidents of present ownership passed to the L & N and the Coast Line for the 99-year period. In this respect, the instant case is comparable to Blair v. Commissioner of Internal Revenue, 300 U.S. 5, 57 S.Ct. 330, 81 L.Ed. 465 (1939), where the life beneficiary of a testamentary trust gratuitously assigned a certain portion of the trust income to his daughter for the remainder of his life. It was held that the incidence of taxation shifted to the daughter because she became beneficial owner of that portion of the life interest.

The taxpayer also warns of possible tax-avoidance implications if the lessee is entitled to a dividends-received deduction. The district court also pointed out that a holding which would enable the lessee of corporate stock to take the dividends-received deduction would encourage trafficking in the deduction. For example, an owner of corporate stock could lease the shares to his wholly owned subsidiary for a stipulated rental. Under such a holding, it is argued, the corporation would be taxed on only 15% Of the dividends and could obtain a full deduction for the 'rent' paid over to the real owner of the shares. We are confident that the Commissioner and the courts will guard against any tax-avoidance scheme which has no business purpose other than to take advantage of the double deduction referred to above just as consistently as they have in the past.20 Cases of this nature must, to a degree, be taken on their particular facts. Suffice if to say that the spectre of tax avoidance is totally absent from the instant case. We have before us a bona fide bargain consummated almost 32 years before the income tax law became effective, and both lessor and lessee have derived material business benefits from the transaction.21

In summary, we think the taxpayer divested himself of beneficial ownership of the shares in question and thus may not take advantage of the benefits of 243. What the taxpayer in substance is receiving under the 1881 agreement is rental income, taxable as such.

The taxpayer contends that, having distributed the reversion in certain of the leased shares to its own stockholders as a dividend in kind, it may now take annual depreciation deductions to recover the capital investment in what remains.22 It is argued that taxpayer has retained all present rights in the distributed shares, the most significant aspect of which is the right to receive the $600,000 annual payment for the remainder of the lease term. The present interest in those shares constitutes property held for the production of income, and its productive capacity is diminishing each year. By 1980, the productivity of the retained property will be totally exhausted. Section 312(a)(3) requires the taxpayer to charge off that portion of its adjusted basis which represents the reversionary interest distributed to its shareholders as a dividend, and the $1,596,624 remaining on its books constitutes the 1913 value of the present ownership rights in the leased shares from 1954 to 1980. This figure may be amortized over the remaining years of the lease, taxpayer reasons, since it forms the 'cost basis' of the retained interest in the stocks.

We accept the taxpayer's and the district court's interpretation of 312 for the purpose of this decision, and we do not question the accuracy of the taxpayer's computation of the adjusted basis of the retained interest. Nevertheless, we cannot agree that 167 permits a deduction in circumstances such as these. Although the taxpayer's argument may have a certain theoretical appeal, it does not make tax sense.

The Government argues that whatever interests were retained by the taxpayer in the distributed stock are insufficient to constitute 'property' as that term is used in 167. Nothwithstanding the fact that the taxpayer's retained interest, even if it be a mere contract right, would constitute valuable property in the ordinary sense of the term, see e.g., Commissioner of Internal Revenue v. P. G. Lake, Inc., supra, note 19; Commissioner of Internal Revenue v. Gillette Motor Transport, Inc., 364 U.S. 130, 80 S.Ct. 1497, 4 L.Ed.2d 1617 (1960), it does not automatically follow that such an interest is depreciable. The lessor's rights in a leasehold are derived from the income-producing capacity of the underlying property interest. Ordinarily, it is that underlying property which constitutes the depreciable asset. In the instant case, the income-producing property is corporate stock, which has long been held a non-depreciable asset by its very nature. See Exposition Souvenir Corp. v. Commissioner of Internal Revenue (2 Cir. 1947), 163 F.2d 283, 285; 4 Mertens, Law of Federal Taxation, 23.49. Thus, taxpayer was not entitled to amortize its cost or other basis of the shares themselves. Furthermore, we cannot agree that a leasehold which was created after the acquisition of the underlying property by the taxpayer can itself constitute a depreciable asset except to the extent that the taxpayer incurred additional capital costs in obtaining the leasehold.23 It follows that the taxpayer, in 1913, possessed no depreciable property interest in the leased shares.

In 1913 the shares were assigned a basis equal to their fair market value on March 1 of that year. There is conflicting testimony in the record as to the effect which the outstanding lease might have had on the value of the stocks, but the district court's determination of fair market value apparently did not take the lease into account in fixing those values. There was certainly no clear proof that the lease had reserve rentals which would justify allocation of a portion of the 1913 basis to the value of the leasehold. Indeed, the taxpayer is not contending that any portion of the basis is allocable to the premium value of the leasehold itself.

It is argued, however, that the 1954 distribution of the reversion was an occurrence with peculiar economic and tax significance. We cannot agree. By distributing the reversion in 1954, taxpayer did nothing more than split">split its bundle of property rights into tow parts. We cannot see how this action on its part can result in a depreciable asset where none previously existed, unless it made some additional investment. The rights which the taxpayer retained after the distribution are merely a fragment of the total bundle of nondepreciable property rights which the taxpayer had before the distribution. The taxpayer has obtained no asset which it did not have in 1913. While similar property might constitute a depreciable asset when acquired separately from the reversionary interest in the shares themselves and while a portion of the total tax basis of the shares can reasonably be allocated to the retained interest,24 the mere fact that a basis exists on the taxpayer's books and that the property is exhaustible does not alone confer depreciability. While there need not always be a cost to the taxpayer in order to permit a depreciation deduction, we think in the present circumstances the taxpayer is required to show the acquisition of property in which he has some separate investment before he can claim a depreciation deduction.25 See Detroit Edison Co. v. Commissioner of Internal Revenue, 319 U.S. 98, 63 S.Ct. 902, 87 L.Ed. 1286 (1943). Depreciability cannot be conferred merely by the voluntary, grantuitous division of its nondepreciable property into two segments, one of which becomes, as a result of the separation, wasting solely by reason of lapse of time.26 No tax consequences would have ensued if the taxpayer's entire interest in the shares had been distributed in 1954;27 we cannot see why any different result should obtain because taxpayer divests itself of only a portion of those rights in that same year. To hold otherwise would, we think, be to distort the economic realities of the 1954 distribution.

Nor is it significant that, as a matter of accounting, the taxpayer may have been required by 312 to reduce its earnings and profits by the adjusted basis of the property distributed. The taxpayer contends that, having lost a large portion of its basis without any concomitant transfer of basis to its shareholders, it should be permitted to recover the remainder of the basis still on its books. However, the transaction, from the taxpayer's viewpoint, had the same economic significance as if it had waited until the expiration of the outstanding lease to distribute the shares. In that event, taxpayer would have recovered no portion of its basis through a deduction. In short, we think 312 has no relationship to the tax consequences of the transaction to the taxpayer. The loss of basis in the hands of the taxpayer's shareholders has resulted from the form in which the transaction was cast.28 That form cannot affect the tax consequences of the transaction to the taxpayer.

We conclude that the district court erred in allowing the taxpayer a deduction equivalent to 85% Of the dividends paid on the leased shares and in permitting the taxpayer to amortize the interest it retained in the leased shares whose reversion was distributed. Accordingly, the judgment is reversed with directions to enter judgment for the United States.