Pursuant to a merger plan whereby Commerce Savings and Loan
Association, a state-chartered stock savings and loan association,
was merged in 1976 into Citizens Federal Savings and Loan
Association, a federally chartered mutual savings and loan
association, petitioners, husband and wife, exchanged their
"guaranty stock" in Commerce for passbook savings accounts and time
certificates of deposit in Citizens representing share interests in
Citizens. Relying on §§ 354(a)(1) and 368(a)(1)(A) of the
Internal Revenue Code, which provide an exception to recognizing a
gain on the sale or exchange of property for corporate
reorganizations, petitioners did not report on their 1976 income
tax return the gain they realized on the exchange, because they
considered the merger to be a tax-free reorganization. The
Commissioner of Internal Revenue, however, issued a notice of
deficiency and found petitioners liable for tax on the entire gain.
Petitioners then sought redetermination of the deficiency in the
Tax Court, which rendered a decision in petitioners' favor. The
court reasoned that the savings accounts and certificates of
deposit were the only forms of equity in Citizens, and held that
the requisite continuity of interest existed under the rule that,
even though the literal terms of the reorganization provisions of
the statute are satisfied, the statute also requires that the
taxpayer's ownership interest in the prior organization must
continue in a meaningful fashion in the reorganized enterprise, and
the retained interest must represent a substantial part of the
value of the thing transferred,
Helvering v. Minnesota Tea
Co., 296 U. S. 378. The
Court of Appeals reversed, holding that, despite certain equity
characteristics, the Citizens savings accounts and certificates of
deposit were indistinguishable from ordinary savings accounts and
were essentially the equivalent of cash.
Held: Petitioners were not entitled to treat the
Commerce-Citizens merger as a tax-free reorganization under
§§ 354(a)(1) and 368(a)(1)(A), and thus are taxable on
the gain they realized on the exchange in question. Pp.
469 U. S.
137-143.
(a) Petitioners' Citizens passbook accounts and certificates of
deposit were cash equivalents. The debt characteristics of
Citizens' shares (the passbook accounts and certificates of deposit
are not subordinated to
Page 469 U. S. 132
creditors' claims, the deposits are not considered permanent
contributions to capital, the shareholders have a right to withdraw
the face amount of their deposits in cash, and in practice Citizens
pays a fixed, preannounced rate on all accounts) greatly outweigh
their equity characteristics (the shares are the only ownership
instruments in the association, the shareholders have the right to
vote, and they receive dividends rather than interest on their
accounts and
pro rata distribution of assets in the event
of a solvent dissolution). Pp.
469 U. S.
137-140.
(b) Petitioners have failed to satisfy the continuity of
interest required to qualify the merger as a tax-free
reorganization. The debt value of the Citizens shares was the same
as the face value; because no one would pay more than this for the
shares, the incremental value attributable to the equity features
was, practically, zero. Thus, this retained equity interest in the
reorganized enterprise was not a "substantial" part of the value of
the Commerce stock that was given up. Pp.
469 U. S.
140-142.
(c) To characterize petitioners' Citizen shares as debt does not
conflict with
Tcherepnin v. Knight, 389 U.
S. 332. P.
469 U. S.
143.
716 F.2d 563, affirmed.
REHNQUIST, J., delivered the opinion of the Court, in which
BRENNAN, WHITE, MARSHALL, BLACKMUN, and STEVENS, JJ., joined.
O'CONNOR, J., filed a dissenting opinion, in which BURGER, C.J.,
joined,
post, 469 U. S. 144.
POWELL, J., took no part in the decision of the case.
JUSTICE REHNQUIST delivered the opinion of the Court.
Commerce Savings and Loan Association of Tacoma, Wash., merged
into Citizens Federal Savings and Loan Association of Seattle in
July 1976. Petitioners Harold and Marie Paulsen sought to treat
their exchange of stock in Commerce for an interest in Citizens as
a tax-free reorganization under 26 U.S.C. §§ 354(a)(1)
and 368(a)(1)(A). The Court of Appeals for the Ninth Circuit,
disagreeing with the Court of
Page 469 U. S. 133
Claims and other Courts of Appeals,
* reversed a
decision of the Tax Court in favor of petitioners. 716 F.2d 563
(1983). We granted certiorari, 465 U.S. 1021 (1984), to resolve
these conflicting interpretations of an important provision of the
Internal Revenue Code.
At the time of the merger, petitioner Harold T. Paulsen was
president and a director of Commerce. He and his wife, petitioner
Marie B. Paulsen, held as community property 17,459 shares of
"guaranty stock" in Commerce. In exchange for this stock
petitioners received passbook savings accounts and time
certificates of deposit in Citizens. Relying on 26 U.S.C.
§§ 354(a)(1) and 368(a)(1)(A), they did not report the
gain they realized on their 1976 federal income tax return because
they considered the merger to be a tax-free reorganization.
Before it ceased to exist, Commerce was a state-chartered
savings and loan association incorporated and operated under
Washington State law. It was authorized to issue "guaranty stock,"
to offer various classes of savings accounts, and to make loans.
Each stockholder, savings account holder, and borrower was a member
of the association. Each share of stock and every $100, or fraction
thereof, on deposit in a savings account carried with it one vote.
Each borrower also had one vote.
The "guaranty stock" had all of the characteristics normally
associated with common stock issued by a corporation. Under the
bylaws, a certain amount of guaranty stock was required to be
maintained as the fixed and nonwithdrawable capital of Commerce. In
accordance with Wash.Rev.Code Ann. § 33.48.080 (Supp.1981),
holders of guaranty stock, but no other members, had a
proportionate proprietary interest in its assets and net earnings,
subordinate to the claims of
Page 469 U. S. 134
creditors. Dividends could not be declared or paid on the
guaranty stock unless certain reserves had been accumulated and
dividends had been declared and paid on withdrawable savings
accounts.
Citizens is a federally chartered mutual savings and loan
association under the jurisdiction of the Federal Home Loan Bank
Board. 12 U.S.C. § 1461
et seq. It offers savings
accounts and makes loans, but has no capital stock. Its members are
its depositors and borrowers. Each savings account holder has one
vote for each $100, or fraction thereof, of the withdrawal value of
his savings account up to a maximum of 400 votes. Each borrower has
one vote.
Citizens is owned by its depositors. Twice each year its net
earnings and any surplus are to be distributed to its savings
account holders
pro rata to the amounts on deposit. Its
net assets would similarly be distributed if liquidation or
dissolution should occur. It is obligated to pay written withdrawal
requests within 30 days, and may redeem any of its accounts at any
time by paying the holder the withdrawal value.
The merger was effected pursuant to a "Plan of Merger," under
which Commerce's stockholders exchanged all their stock for
passbook savings accounts and certificates of deposit in Citizens.
The plan was designed to conform to the requirements of
Wash.Rev.Code § 33.40.010 (1983), which provides for mergers
between business entities, and to qualify as a tax-free
reorganization under the terms of §§ 354(a)(1) and
368(a)(1)(A). Under the plan, Commerce stockholders received for
each share a $12 deposit in a Citizens passbook savings account,
subject only to the restriction that such deposits could not be
withdrawn for one year. They also had the alterative of receiving
time certificates of deposit in Citizens with maturities ranging
from 1 to 10 years at the same $12-per-share exchange rate. The
plan further provided that former Commerce stockholders could
borrow against their deposits resulting from the exchange at
1.5%
Page 469 U. S. 135
above the passbook rate as opposed to a 2% differential for
other depositors. Following the exchange, the merged entity
continued to operate under the Citizens name.
Petitioners had a cost basis in their Commerce stock of $56,802;
in the exchange they received passbook accounts and certificates of
deposit worth $209,508. In 1976, 26 U.S.C. § 1002 (1970 ed.)
required that "on the sale or exchange of property the entire
amount of the gain or loss . . . shall be recognized." Accordingly,
petitioners were required to declare as income on their 1976 return
the $152,706 profit unless one of the exceptions incorporated by
reference in § 1002 applied.
Included among the exceptions to § 1002 were the corporate
reorganization provisions set out in §§ 354 to 368. As
already noted, petitioners have attempted to rely on §
354(a)(1), which provides:
"No gain or loss shall be recognized if stock or securities in a
corporation a party to a reorganization are, in pursuance of the
plan of reorganization, exchanged solely for stock or securities in
such corporation or in another corporation a party to the
reorganization."
Section 368(a)(1)(A) defines a "reorganization" to include "a
statutory merger or consolidation," and §§ 7701(a)(3),
7701(a)(7), and 7701(a)(8) further define the terms "corporation"
to include "associations," "stock" to include "shares in an
association," and "shareholder" to include a "member in an
association." There is no dispute that at the time of the merger
Commerce and Citizens qualified as associations, petitioners
qualified as shareholders, Commerce's guaranty stock and Citizens'
passbook accounts and certificates of deposit qualified as stock,
and the merger qualified as a statutory merger within these
provisions of the Code. Accordingly, under the literal terms of the
Code the transaction would qualify as a tax-free "reorganization"
exchange rather
Page 469 U. S. 136
than a sale or exchange on which gain must be recognized and
taxes paid.
Satisfying the literal terms of the reorganization provisions,
however, is not sufficient to qualify for nonrecognition of gain or
loss. The purpose of these provisions is
""to free from the imposition of an income tax purely
paper
profits or losses' wherein there is no realization of gain or loss
in the business sense but merely the recasting of the same
interests in a different form.""
Southwest Natural Gas Co. v. Commissioner, 189 F.2d
332, 334 (CA5),
cert. denied, 342 U.S. 860 (1951)
(
quoting Commissioner v. Gilmore's Estate, 130 F.2d 791,
794 (CA3 1942)).
See Treas.Reg. § 1.368-1(b), 26 CFR
§ 1.368-1(b) (1984). In order to exclude sales structured to
satisfy the literal terms of the reorganization provisions but not
their purpose, this Court has construed the statute to also require
that the taxpayer's ownership interest in the prior organization
must continue in a meaningful fashion in the reorganized
enterprise.
Pinellas Ice & Cold Storage Co. v.
Commissioner, 287 U. S. 462,
287 U. S.
468-470 (1933). In that case we held that
"the seller must acquire an interest in the affairs of the
purchasing company more definite than that incident to ownership of
its short-term purchase-money notes."
Id. at
287 U. S. 470. We
soon added the requirement that "this interest must be definite and
material; it must represent a substantial part of the value of the
thing transferred."
Helvering v. Minnesota Tea Co.,
296 U. S. 378,
296 U. S. 385
(1935).
Compare LeTulle v. Scofield, 308 U.
S. 415,
308 U. S.
420-421 (1940) (no retained property interest where
transferor received transferee's bonds),
with John A. Nelson
Co. v. Helvering, 296 U. S. 374,
296 U. S. 377
(1935) (continuity of interest satisfied where nonvoting preferred
stock received). Known as the "continuity-of-interest" doctrine,
this requirement has been codified in Treas. Regs. §§
1.368-1(b), 1.368-2(a).
The present case turns on whether petitioners' exchange of their
guaranty stock in Commerce for their passbook savings
Page 469 U. S. 137
accounts and certificates of deposit in Citizens satisfies this
continuity-of-interest requirement. More generally, we must decide
whether a merger of a stock savings and loan association into a
mutual savings and loan association qualifies as a tax-free
reorganization. Following his ruling in Rev.Rul. 69-6, 1969-1
Cum.Bull. 104, which itself apparently was at odds with his earlier
policy expressed in Rev.Rul. 54-624, 1954-2 Cum.Bull. 16, the
Commissioner rejected petitioners' treatment of the
Commerce-Citizens merger as a tax-free reorganization under
§§ 354(a)(1) and 368(a)(1)(A) and issued a statutory
notice of deficiency finding petitioners liable for tax on their
entire $152,706 gain.
Petitioners sought redetermination of the deficiency in the Tax
Court, which found that the Commissioner's position had been
uniformly rejected by the courts. Following
Capital Savings and
Loan Assn. v. United States, 221 Ct.Cl. 557, 607 F.2d 970
(1979);
West Side Federal Savings and Loan Assn. v. United
States, 494 F.2d 404 (CA6 1974);
Everett v. United
States, 448 F.2d 357 (CA10 1971), the Tax Court reasoned that
the savings accounts and certificates of deposit were the only
forms of equity in Citizens, and it held that the requisite
continuity of interest existed. 78 T.C. 291 (1982).
The Commissioner appealed to the Court of Appeals for the Ninth
Circuit, which declined to follow the cases cited by the Tax Court
and reversed. 716 F.2d 563 (1983). It reasoned that "despite
certain formal equity characteristics" the passbook savings
accounts and time certificates of deposit "are in reality
indistinguishable from ordinary savings accounts and are
essentially the equivalent of cash."
Id. at 569. For the
reasons that follow we affirm the decision of the Court of
Appeals.
Citizens is organized pursuant to Charter K (Rev.), 12 CFR
§ 544. 1(b) (as of July 1, 1976), which provides for raising
capital "by accepting payments on savings accounts representing
share interests in the association." These shares are
Page 469 U. S. 138
the association's only means of raising capital. Here they are
divided into passbook accounts and certificates of deposit. In
reality, these shares are hybrid instruments having both equity and
debt characteristics. They combine in one instrument the separate
characteristics of the guaranty stock and the savings accounts of
stock associations like Commerce.
The Citizens shares have several equity characteristics. The
most important is the fact that they are the only ownership
instrument of the association. Each share carries in addition to
its deposit value a part ownership interest in the bricks and
mortar, the goodwill, and all the other assets of Citizens. Another
equity characteristic is the right to vote on matters for which the
association's management must obtain shareholder approval. The
shareholders also receive dividends rather than interest on their
accounts; the dividends are paid out of net earnings, and the
shareholders have no legal right to have a dividend declared or to
have a fixed return on their investment. The shareholders further
have a right to a
pro rata distribution of any remaining
assets after a solvent dissolution.
These equity characteristics, however, are not as substantial as
they appear on the surface. Unlike a stock association where the
ownership of the assets is concentrated in the stockholders, the
ownership interests here are spread over all of the depositors. The
equity interest of each shareholder in relation to the total value
of the share, therefore, is that much smaller than in a stock
association. The right to vote is also not very significant. A
shareholder is limited to 400 votes; thus any funds deposited in
excess of $40,000 do not confer any additional votes. The vote is
also diluted each time a loan is made, as each borrower is entitled
to one vote. In addition the Commissioner asserts, and petitioners
do not contest, that in practice, when depositors open their
accounts, they usually sign proxies giving management their
votes.
The fact that dividends rather than interest are paid is by no
means controlling. Petitioners have not disputed the
Page 469 U. S. 139
Commissioner's assertion that in practice Citizens pays a fixed,
preannounced rate on all accounts. As the Court of Appeals
observed, Citizens would not be able to compete with stock savings
and loan associations and commercial banks if it did not follow
this practice. Potential depositors are motivated only by the rate
of return on their accounts and the security of their deposits. In
this latter respect, the Citizens accounts are insured by the
Federal Savings and Loan Insurance Corporation (FSLIC), up to
$40,000 in 1976 and now up to $100,000. 12 U.S.C. § 1728(a).
The Code treats these dividends just like interest on bank accounts
rather than like dividends on stock in a corporation. The dividends
are deductible to Citizens, 26 U.S.C. § 591, and they do not
qualify for dividend exclusion by the Citizens shareholders under
§ 116.
The right to participate in the net proceeds of a solvent
liquidation is also not a significant part of the value of the
shares. Referring to the possibility of a solvent liquidation of a
mutual savings association, this Court observed:
"It stretches the imagination very far to attribute any real
value to such a remote contingency, and when coupled with the fact
that it represents nothing which the depositor can readily
transfer, any theoretical value reduces almost to the vanishing
point."
Society for Savings v. Bowers, 349 U.
S. 143,
349 U. S. 150
(1955).
In contrast, there are substantial debt characteristics to the
Citizens shares that predominate. Petitioners' passbook accounts
and certificates of deposit are not subordinated to the claims of
creditors, and their deposits are not considered permanent
contributions to capital. Shareholders have a right on 30 days'
notice to withdraw their deposits, which right Citizens is
obligated to respect. While petitioners were unable to withdraw
their funds for one year following the merger, this restriction can
be viewed as akin to a delayed payment rather than a material
alteration in the nature of the instruments received as payment. In
this case petitioners were immediately able to borrow against
their
Page 469 U. S. 140
deposits at a more favorable rate than Citizens' depositors
generally. As noted above, petitioners were also in effect
guaranteed a fixed, preannounced rate of return on their deposits
competitive with stock savings and loan associations and commercial
banks.
In our view, the debt characteristics of Citizens' shares
greatly outweigh the equity characteristics. The face value of
petitioners' passbook accounts and certificates of deposit was
$210,000. Petitioners have stipulated that they had a right to
withdraw the face amount of the deposits in cash, on demand after
one year or at stated intervals thereafter. Their investment was
virtually risk free and the dividends received were equivalent to
prevailing interest rates for savings accounts in other types of
savings institutions. The debt value of the shares was the same as
the face value, $210,000; because no one would pay more than this
for the shares, the incremental value attributable to the equity
features was, practically, zero. Accordingly, we hold that
petitioners' passbook accounts and certificates of deposit were
cash equivalents.
Petitioners have failed to satisfy the continuity-of-interest
requirement to qualify for a tax-free reorganization. In exchange
for their guaranty stock in Commerce, they received essentially
cash with an insubstantial equity interest. Under
Minnesota Tea
Co., their equity interest in Citizens would have to be "a
substantial part of the value of the thing transferred." 296 U.S.
at
296 U. S. 385.
Assuming an arm's-length transaction in which what petitioners gave
up and what they received were of equivalent worth, their Commerce
stock was worth $210,000 in withdrawable deposits and an
unquantifiably small incremental equity interest. This retained
equity interest in the reorganized enterprise, therefore, is not a
"substantial" part of the value of the Commerce stock which was
given up. We agree with the Commissioner that the equity interests
attached to the Citizens shares are too insubstantial to satisfy
Minnesota Tea Co. The Citizens shares are not
significantly different from the notes that this
Page 469 U. S. 141
Court found to be the mere "equivalent of cash" in
Pinellas
& Cold Storage Ice Co., 287 U.S. at
287 U. S.
468-469. The ownership interest of the Citizens
shareholders is closer to that of the secured bondholders in
LeTulle v. Scofield, 308 U.S. at
308 U. S.
420-421, than to that of the preferred stockholders in
John A. Nelson Co. v. Helvering, 296 U.S. at
296 U. S. 377.
The latter case involved a classic ownership instrument --
preferred stock carrying voting rights only in the event of a
dividend default -- which we held to represent "a definite and
substantial interest in the affairs of the purchasing corporation."
Ibid.
Petitioners argue that the decision below erroneously turned on
the relative change in the nature and extent of the equity
interest, contrary to the holding in
Minnesota Tea Co.
that "the relationship of the taxpayer to the assets conveyed
[could] substantially chang[e]," and only a "material part of the
value of the transferred assets" need be retained as an equity
interest. 296 U.S. at
296 U. S. 386.
In that case, taxpayers received voting trust certificates
representing $540,000 of common stock and $425,000 cash; 56% of the
value of the assets given up was retained as an equity interest in
the transferee. In
John A. Nelson Co., supra, the taxpayer
received consideration consisting of 38% preferred stock and 62%
cash. Here, in contrast, the retained equity interest had almost no
value. It did not amount to a "material part" of the value of the
Commerce stock formerly held by petitioners.
See Southwest
Natural Gas Co. v. Commissioner, 189 F.2d at 335 (insufficient
continuity of interest where stock received represented less than
l% of the consideration).
Petitioners' real complaint seems to be our willingness to
consider the equity and debt aspects of their shares separately.
Clearly, if these interests were represented by separate pieces of
paper -- savings accounts on the one hand and equity instruments of
some kind on the other -- the value of the latter would be so small
that we would not find a continuity of proprietary interest. In
order not "to exalt artifice above reality and to deprive the
statutory provision
Page 469 U. S. 142
in question of all serious purpose,"
Gregory v.
Helvering, 293 U. S. 465,
293 U. S.
469-470 (1935), it is necessary in the present case to
consider the debt and equity aspects of a single instrument
separately.
See Rev.Rul. 69-265, 1969-1 Cum.Bull. 109,
109-110, which treats the conversion rights incorporated in
convertible preferred stock as "property other than voting stock"
for purposes of § 368(a)(1)(C).
Petitioners also complain that the result reached by the court
below is inconsistent with the Commissioner's position that a
merger of one mutual savings and loan institution into another
mutual association or into a stock association would still qualify
as a tax-free reorganization.
See Rev.Rul. 69-3, 1969-1
Cum.Bull. 103. If the continuity-of-interest test turns on the
nature of the thing received, and not on the relative change in
proprietary interest, argue petitioners, the interest received in
the merger of two mutual associations is no different from the
interest received in the instant case.
As already indicated, shares in a mutual association have a
predominant cash-equivalent component and an insubstantial equity
component. When two mutual associations merge, the shares received
are essentially identical to the shares given up. As long as the
cash value of the shares on each side of the exchange is the same,
the equity interest represented by the shares received -- though
small -- is equivalent to the equity interest represented by the
shares given up. Therefore, to the extent that a mutual association
share reflects an equity interest, the continuity-of-interest
requirement, as defined in
Minnesota Tea Co., is satisfied
in an exchange of this kind. The fact that identical cash deposits
are also exchanged does not affect the equity aspect of the
exchange. In the case of a merger of a mutual association into a
stock association, the continuity-of-interest requirement is even
more clearly satisfied because the equity position of the
exchanging shareholders is not only equivalent before and after the
exchange, but it is enhanced.
Page 469 U. S. 143
Finally, petitioners argue that the characterization of their
mutual association shares as debt conflicts with this Court's
decision in
Tcherepnin v. Knight, 389 U.
S. 332 (1967), holding that a withdrawable mutual
association share indistinguishable from Citizens' shares was a
"security" within the meaning of § 3(a)(10) of the Securities
Exchange Act of 1934.
Cf. Marine Bank v. Weaver,
455 U. S. 551,
455 U. S. 557
(1982) (distinguishing
Tcherepnin because the withdrawable
capital shares there did not pay a fixed rate of return and "were
much more like ordinary shares of stock and
the ordinary
concept of a security' . . . than a certificate of deposit" [in a
bank]); Wisconsin Bankers Assn. v. Robertson, 111
U.S.App.D.C. 85, 294 F.2d 714, 717 (Burger, J., concurring),
cert. denied, 368 U.S. 938 (1961). The purpose of the
Securities Acts is different from the purpose of the Tax Code. The
focus in Tcherepnin was on the investment character of the
shares, specifically whether they satisfied the test in SEC v.
W. J. Howey Co., 328 U. S. 293,
328 U. S. 301
(1946), for an investment contract, namely the "investment of money
in a common enterprise with profits to come solely from the efforts
of others." Unlike the instant case, there is no requirement that
the investors have a substantial proprietary interest in the
enterprise. Moreover, in Howey as in this case, we
disregarded the formal terms of the instruments in question and
looked to their economic substance. Any remaining tension between
the instant decision and Tcherepnin and Weaver
can be explained by the fact that this Court has in cases such as
Tcherepnin liberally construed the definition of
"security" in the Securities Acts, while such liberality is not
warranted in construing the scope of the reorganization
provisions.
The judgment of the Court of Appeals is
Affirmed.
Page 469 U. S. 144
JUSTICE POWELL took no part in the decision of the case.
*
Capital Savings and Loan Assn. v. United States, 221
Ct.Cl. 557, 607 F.2d 970 (1979);
West Side Federal Savings and
Loan Assn. v. United States, 494 F.2d 404 (CA6 1974);
Everett v. United States, 448 F.2d 357 (CA10 1971).
JUSTICE O'CONNOR, with whom THE CHIEF JUSTICE joins,
dissenting.
Today the Court holds that the merger of a stock savings and
loan association into a mutual savings and loan association does
not qualify as a tax-deferred reorganization under §
368(a)(1)(A) of the Internal Revenue Code. Although the merger
meets all the statutory requirements, and although all courts that
considered similar transactions before this case found they
qualified as tax-deferred reorganizations,
see ante at
469 U. S.
132-133, and n., the Court nevertheless concludes that
such a merger fails to qualify under a refined interpretation of
the judicially imposed "continuity-of-interest" doctrine. This
holding introduces an unfortunate and unnecessary element of
uncertainty into an area of our income tax laws where clear and
consistent precedent is particularly helpful to both taxpayers and
tax collectors. Because I find the Court's holding unwise as a
matter of policy and unwarranted as a matter of law, I respectfully
dissent.
The Court concedes that the merger of Commerce Savings and Loan
Association of Tacoma, Wash. (Commerce), into Citizens Federal
Savings and Loan Association of Seattle (Citizens) met the literal
terms of the Internal Revenue Code to qualify the merger for
treatment as a tax-deferred reorganization.
Ante at
469 U. S. 135.
Indeed, the merger between Commerce and Citizens satisfies the
statutory definition of a reorganization in § 368(a)(1)(A),
and the Citizens mutual share accounts meet the statutory
definition of stock in § 7701(a)(7). Nevertheless, the Court
refuses to accord the merger the benefits of § 368(a)(1)(A)
because of the "continuity-of-interest" requirement as currently
codified in Treas. Regs. §§ 1.368-1(b) and 1.368-2(a), 26
CFR §§ 1.368-1(b) and 1.368-2(a) (1984).
Ante at
469 U. S. 136.
The Treasury Regulations, codifying the requirements of this
Court's decisions in
Gregory v. Helvering, 293 U.
S. 465 (1935), and
Pinellas Ice & Cold Storage
Co. v. Commissioner, 287 U. S. 462
(1933), provide tax-deferred status for the acquiring corporation
when it continues the business of
Page 469 U. S. 145
the acquired corporation or utilizes a substantial part of its
assets. Treas. Regs. §§ 1.368-1(b) and (d)(2), 26 CFR
§§ 1.368-1(b) and (d)(2) (1984). Similarly, the
shareholders of the acquired corporation need not immediately
recognize any gain from the transaction as long as they retain a
continuing proprietary interest in the surviving corporation.
Ibid.
Here, all concede that Citizens continued the business of
Commerce after the merger. The sole issue is whether the Commerce
stockholders retained a continuing proprietary interest when they
received mutual share accounts in Citizens in exchange for their
Commerce guaranty stock. The Court concludes that they did not.
The continuity-of-proprietary-interest doctrine "was born of a
judicial effort to confine the reorganization provisions to their
proper function." B. Bittker & J. Eustice, Federal Income
Taxation of Corporations and Shareholders �14.11 (4th
ed.1979). The cases establish that the owners of an acquired
corporation must immediately recognize any gain from a merger
unless they receive an equity interest in the surviving business
that represents a substantial part of the value of the property
transferred.
Pinellas Ice & Cold Storage Co. v.
Commissioner, supra, the first relevant authority of this
Court, established that receipt of short-term promissory notes were
not securities for purposes of a reorganization. The Court stated
that
"the seller must acquire an interest in the affairs of the
purchasing company more definite than that incident to ownership of
its short-term purchase-money notes"
to qualify as a reorganization.
Id. at
287 U. S. 470.
Three Terms later, in
Helvering v. Minnesota Tea Co.,
296 U. S. 378
(1935), the Court upheld as a reorganization the transfer of the
corporate assets in exchange for voting trust certificates
representing common stock plus almost an equal amount of cash. The
Court there said:
"[The] interest must be definite and material; it must represent
a substantial part of the value of the thing transferred. . .
."
"
* * * *
Page 469 U. S.
146
"
"The transaction here was no sale, but partook of the nature of
a reorganization in that the seller acquired a definite and
substantial interest in the purchaser."
"True it is that the relationship of the taxpayer to the assets
conveyed was substantially changed, but this is not inhibited by
the statute. Also, a large part of the consideration was cash.
This, we think, is permissible so long as the taxpayer received an
interest in the affairs of the transferee which represented a
material part of the value of the transferred assets."
Id. at
296 U. S.
385-386.
Shareholders maintained a sufficient continuity of proprietary
interest when corporate assets were exchanged for 38 percent
nonvoting and redeemable preferred stock and 62 percent cash.
John A. Nelson Co. v. Helvering, 296 U.
S. 374 (1935). But consideration consisting wholly of
the transferee's bonds was held to make the bondholders merely
creditors rather than proprietary owners of the business.
LeTulle v. Scofield, 308 U. S. 415
(1940).
Against this background, the Court concludes that the equity
interest represented in the share accounts of a mutual savings and
loan is so insubstantial that shareholders who receive such
accounts do not retain a sufficient proprietary interest in the
enterprise. The basis of the Court's holding is a characterization
of the mutual share accounts as "hybrid instruments" having both
equity and debt characteristics,
ante at
469 U. S. 138.
The Court finds that the debt characteristics outweigh the equity
characteristics,
ante at
469 U. S. 140,
and concludes that the equity interest received does not represent
"a substantial part of the value of the thing transferred."
Helvering v. Minnesota Tea Co., supra, at
296 U. S.
385.
I agree that a mutual share account is a hybrid security, and
that it has substantial debt characteristics. The opportunity to
withdraw from the account after one year cloaks the account holder
with some of the attributes of a creditor, and the account with
some of the attributes of debt. I nevertheless
Page 469 U. S. 147
believe that the equity interest represented in a mutual share
account is substantial, and thus satisfies the
continuity-of-proprietary-interest requirement.
The taxpayers in this case received mutual share accounts and
certificates of deposit from Citizens which gave them the same
proprietary features of equity ownership which they previously had
as stockholders in Commerce, plus the right after a stated interval
to withdraw their cash deposits. As the Court recognizes, the
guaranty stockholders of Commerce were the equitable owners of the
corporation and had a proportionate proprietary interest in the
corporation's assets and net earnings.
Ante at
469 U. S.
133-134. When they exchanged their shares for deposits
in Citizens, they became the equitable owners of the mutual
association. As equitable owners, the mutual share account holders
retained all the relevant rights of corporate stockholders: the
right to vote, the right to share in net assets on liquidation, and
the right to share in the earnings and profits of the enterprise.
Indeed, the proprietary interest obtained by petitioners here is
more weighty than that obtained by the nonvoting, preferred
shareholders in
John A. Nelson Co. v. Helvering, supra:
The petitioners possess not only the primary voting interest in the
continuing enterprise, but also the only interests in existence
with proprietary and equity rights in the mutual association. To
the extent there is any equity at all in a mutual association, it
is represented by the share accounts obtained by the
petitioners.
To find that the equity of a mutual association is
insubstantial, the Court today looks to each equitable power or
attribute of mutual share account ownership to determine its value
and the extent to which it is actually exercised. The Court values
the debt characteristics separately from the equity characteristics
of the same instrument to determine whether the equity interest is
a substantial part of the value of the property transferred. The
only support for the
Page 469 U. S. 148
Court's action of separately valuing the debt and equity aspects
of a single instrument is Rev.Rul. 69-265, 1969-1 Cum.Bull. 109.
Apparently no court has ever relied on such a distinction with
respect to a single instrument.
See B. Bittker & J.
Eustice, Federal Income Taxation of Corporations and Shareholders
�4.02, p. 4-7 (4th ed.1979) ("in litigated cases,
classification has been treated as an all-or-nothing question, so
that instruments have not been fragmented into part equity and part
debt"). Nor does this Court's opinion in
Minnesota Tea Co.,
supra, provide any support for the Court's approach today.
The flaw in this approach is most clearly evident in the
majority's attempt to explain why a merger between mutual
associations qualifies as a tax-deferred reorganization whereas a
merger of a stock savings and loan into a mutual association does
not. When a more heavily capitalized mutual association is acquired
by a thinly capitalized mutual association, the equity component of
the value of share accounts will be reduced. Under the majority's
separate valuation approach, at some point that value should be
reduced so substantially as to defeat claims that a continuing
proprietary interest is maintained. The Court avoids this result by
noting that
"the equity interest represented by the shares received --
though small -- is equivalent to the equity interest represented by
the shares given up."
Ante at
469 U. S. 142.
But the same was true when Commerce merged into Citizens. The
equity interest represented by the share accounts in Citizens is
the sole and complete equity interest in that association, and it
was obtained in exchange for shares in Commerce that represented
the equivalent sole equity interest in the stock savings and loan
association.
The Court's denigration of each of the equity attributes of a
mutual share account is also troubling. The Court notes that the
ownership interests in Citizens are "spread over all of the
depositors" and that the right to vote "is . . . diluted each
Page 469 U. S. 149
time a loan is made, as each borrower is entitled to one vote."
Ante at
469 U. S. 138.
But such characteristics are by no means confined to mutual share
accounts. Dilution of voting power of shareholder equity in all
corporations may and frequently does occur with each new stock
issue or new class of stock. Yet the threat of dilution has never
divested stock of its status as a substantial equity interest. Nor
should the fact that mutual accounts are often voted by proxy
affect the result: proxy voting, after all, is a common practice
among holders of common stock in large corporations as well. Such
factors should have no part in the determination of whether the
"continuing proprietary interest" test is met. Indeed, this Court
has found ownership of
nonvoting preferred stock to
provide a sufficient proprietary interest.
John A. Nelson Co.
v. Helvering, 296 U.S. at
296 U. S.
377.
The Court also finds that the right to share in the profits of
the association, through dividends and ownership of a share of the
assets and undistributed profits of the association, is not
controlling. The majority downplays the shareholders' interest in
the assets and undistributed profits, a right that is solely one of
ownership. It finds that the dividends paid to the shareholders are
analogous to interest paid to bank depositors because the dividends
are paid at a fixed, preannounced rate and are treated as interest
for some other tax purposes.
Ante at
469 U. S.
138-139. These dividends, however, cannot be properly
equated with interest on bank deposits because shareholders have no
enforceable legal right to compel the payment of dividends. That
the amount of the dividend is preannounced at a suggested rate is
not significantly different from preannounced dividends paid by
many large corporations, particularly on preferred stock. Although
the majority notes correctly that dividends on share accounts are
treated like interest on bank accounts for purposes of
deductibility by the association as business expenses for income
tax purposes, I.R.C. § 591, the reason
Page 469 U. S. 150
for this treatment is unrelated to the classification of mutual
shares as equity. Prior to 1951, mutual associations were exempt
from income tax. 26 U.S.C. § 101 (1946 ed.). The Revenue Act
of 1951, 65 Stat. 452, removed the exemption and provided for the
deduction of dividends from the taxable income of the association
to prevent the accumulation of tax-exempt income in the
associations. Note, Reorganization Treatment of Acquisitions of
Stock Savings and Loan Institutions by Mutual Savings and Loan
Associations, 52 Ford.L.Rev. 1282 (1984). Tax treatment of the
dividends to the association is simply irrelevant to the
classification of the instrument received by the shareholder for
purposes of determining his proprietary interest.
Finally, the majority concludes that the right to participate in
the proceeds of a solvent liquidation is "not a significant part of
the value of the shares" because the possibility of a liquidation
is remote.
Ante at
469 U. S. 139.
The task at hand is to classify the nature of the mutual share
account; the market value of the share account on liquidation is a
separate question. The remoteness of the contingency of liquidation
cannot reasonably be dispositive of the equity character of the
right of the shareholders. The likelihood of liquidation will vary
with the particular association and the prevailing economic
climate, but the character and nature of the right will not change.
To the extent that a mutual association has assets in excess of its
liabilities, the share account holders have a right to a
proportionate share of those assets in the event of
liquidation.
Having unpersuasively attempted to argue away the equity
characteristics of the mutual share accounts, the Court then finds
that the debt characteristics outweigh the equity characteristics,
concluding that the equity value is "practically, zero."
Ante at
469 U. S. 140.
The Court's reasoning suggests that, no matter how much capital a
mutual association possesses, the equity value of its shares is
insubstantial because
Page 469 U. S. 151
no one would pay more for the shares than their face value. This
result is preordained by the Court's unsupported determination that
the value of the "nonequity" features is equal to the face value of
the account. By definition, nothing can be left to allocate to the
equity features. A more realistic analysis would acknowledge that
the equity aspects of a hybrid instrument are intertwined with the
debt aspects and cannot be valued in isolation.
The result reached by the Court today is inconsistent with the
tax-deferred treatment accorded mergers between two mutual
associations or between a stock association and a mutual
association when the stock association is the survivor. Compare
Rev.Rul. 69-6, 1969-1 Cum.Bull. 104 (merger of a stock association
into a mutual association is a sale of assets), with Rev. Rul.
69-3, 1969-1 Cum.Bull. 103 (merger of two mutual associations
qualifies as a tax free reorganization), and Rev.Rul. 69-646,
1969-2 Cum.Bull. 54 (merger of mutual association into stock
association qualifies as a tax free reorganization). And because a
transaction that is a sale rather than a tax-deferred exchange at
the shareholder level cannot qualify as a tax-deferred
reorganization at the corporate level,
see I.R.C.
§§ 361 and 381, the result of the Court's holding is to
discourage an entire class of legitimate business transactions
without regard to the desirability of such mergers from an economic
standpoint. This result is directly contrary to the intent of
Congress.
"Congress . . . adopted the policy of exempting from tax the
gain from exchanges made in connection with a reorganization, in
order that ordinary business transactions [would] not be prevented
on account of the provisions of the tax law."
S.Rep. No. 398, 68th Cong., 1st Sess., 14 (1924).
The Court's opinion also has ramifications beyond mutual
associations. This case presents the first opportunity for the
Court to consider the use of hybrid instruments in reorganizations.
Previously, the Court has held that the receipt
Page 469 U. S. 152
of stock, whether common, voting, or nonvoting preferred,
satisfies the continuity-of-interest test. If the Court is to now
examine the actual exercise of the proprietary rights conferred by
ownership of a particular security, it will inevitably reach
conflicting results in similar cases. Predicting the tax
consequences of reorganizations undertaken for a valid business
purpose will become increasingly difficult. I would adhere to
precedent and to a clear test and hold that a hybrid instrument
which has the principal characteristics of equity ownership should
be treated as equity for purposes of the
continuity-of-proprietary-interest requirement. If the value of
that instrument considered as a whole represents a substantial part
of the value of the property transferred, in my view the
continuity-of-interest requirement is satisfied and the transaction
should qualify as a tax-deferred reorganization. I, therefore,
dissent.