APPEAL FROM THE UNITED STATES TAX COURT T.C. Docket No. 6952-71
Aldisert, Gibbons and Rosenn, Circuit Judges.
H. and G. Industries, Inc., the taxpayer-appellant in this case, redeemed an issue of its preferred stock at a premium in order to relieve itself of the allegedly onerous stock purchase agreement pursuant to which the preferred was issued. The sole question on this appeal is whether the taxpayer is entitled to deduct the premium paid by it on this redemption as an ordinary and necessary business expenses under § 162(a) of the Internal Revenue Code of 1954 (the Code). The taxpayer deducted the item on its income tax return for the fiscal year ending August 31, 1968. The Tax Court denied the deduction, 60 T.C. 163, and denied reconsideration in a memorandum opinion dated June 13, 1973. This appeal followed, and we affirm.
The facts of this case are not in dispute. The taxpayer*fn1 is a New York corporation, with its principal place of business in New Jersey, engaged in the manufacture of paint brushes and rollers. It concluded in 1963 that it needed approximately $450,000 to liquidate an existing loan account with a Newark bank and to establish and maintain adequate working capital. It borrowed $250,000 from another New Jersey bank and it obtained the balance of $200,000 from the First Small Business Investment Corporation of New Jersey (SBIC)*fn2 under a Stock Purchase Agreement. Pursuant to the agreement, SBIC purchased 2,000 shares of "8% Convertible Participating Preferred Stock" of the taxpayer, having a par value of $100 per share, for $200,000. The taxpayer agreed to pay an 8% cumulative preferred dividend, as well as 12 1/2% of annual consolidated net profits which remained after taxes and after the 8% dividend. The profit participation amount was limited to a maximum of $14,000 annually no matter how great profits were in a given year. The taxpayer retained the option to call all (but not part) of the preferred stock at any time, at $120 per share. The agreement contained various other restrictions on the taxpayer, involving such matters as the permissible levels of current assets and net worth, mergers, compensation of officers, and dividends on common stock. The agreement would terminate when the taxpayer called the preferred, or when SBIC converted its stock to common stock or else offered any of its preferred stock to the taxpayer pursuant to the taxpayer's right of first refusal.
From the issuance of this preferred stock in 1963 until the redemption of the stock in 1967, the taxpayer carried the stock on its balance sheets in the capital account. Both the 8% dividend and the 12 1/2% annual participation amounts were treated as dividend distributions on the taxpayer's tax returns for those years.
A company officer testified that the payments on the preferred stock were burdensome*fn3 because it "reduced our working capital and in essence strangled our corporation as far as growth was concerned." The taxpayer therefore retired the shares in 1967 at the contract price of $120 per share, or $240,000. To replace the capital, the taxpayer thereupon negotiated a conventional mortgage loan at 7 per cent and secured a seasonal line of credit at a quarter per cent above prime.
We should first note what is not involved in this case. The taxpayer concedes that preferred stock was in reality equity rather than debt, and thus it does not contend that the redemption premium is deductible as interest under § 163 of the Code. We can therefore set aside the numerous cases which examine the characteristics of an obligation to determine whether it is in reality equity or debt.
The taxpayer contends, however, that even if the obligation is equity, the $40,000 premium, which it always considered to be a "pre-payment penalty," should be deductible as an ordinary and necessary business expense under § 162(a) of the Code.*fn4 In support of this contention it relies on those cases which permit a deduction for payments made by a corporation to buy out of a burdensome contract obligation with another party,*fn5 or which permit a deduction for the payments made by a corporation to purchase the stock of a different corporation in order to be relieved of a contract it made with the latter corporation.*fn6 It argues that the deduction should also be allowed when a company purchases its own stock to disengage itself from a burdensome contract which is an adjunct to the stock issue.
The Government responds by relying first upon our decision in John Wanamaker Philadelphia v. Commissioner of Internal Revenue, 139 F.2d 644 (3d Cir. 1943). In that case the corporate taxpayer had issued obligations which were denominated preferred stock. The first question presented in the case was whether preferred stock dividends accrued by the taxpayer on its books were deductible as interest, on the taxpayer's theory that the obligation was in reality debt rather than equity. The court rejected the taxpayer's contention, finding that the taxpayer had failed to establish the existence of a creditor-debtor relationship. The second question presented in the case was whether the taxpayer could deduct the redemption premium it had paid in redeeming the obligations. This court held:
In view of our conclusion that the preferred stock did not represent indebtedness it follows that the premiums paid by the taxpayer . . . in connection with the redemption of its preferred stock were liquidating distributions upon stock and may not be deducted from gross income for those years as items of expense.
139 F.2d at 647-48. The Government contends that this language indicates that a premium paid on the redemption of preferred stock is not deductible as an expense under any theory.
As the Tax Court noted in its memorandum opinion in the instant case, Wanamaker was decided under Treas. Reg. § 1.61-12(c) (1), which at the time provided that if a corporation repurchased bonds at a price in excess of the issuing price or face value, "the excess of the purchase price over the issuing price or face value is a deductible expense for the taxable year." See Roberts & Porter, Inc. v. Commissioner of Internal Revenue, 307 ...