Waterman Steamship Corporation v. Commissioner of Internal Revenue
430 F.2d 1185 (1970)
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Rule of Law:
A pre-sale distribution from a subsidiary to its parent corporation, which is labeled a dividend, will be treated as part of the taxable capital gain from the sale of the subsidiary's stock when it is an integral part of a pre-arranged plan and the funds for the distribution are sourced from the buyer.
Facts:
- Waterman Steamship Corporation (Waterman) was the sole owner of two subsidiary corporations, Pan-Atlantic Steamship Corporation (Pan-Atlantic) and Gulf Florida Terminal Company.
- Malcolm P. McLean sought to acquire Pan-Atlantic and Gulf Florida but faced regulatory hurdles with the Interstate Commerce Commission (ICC) if he purchased their assets directly.
- On December 20, 1954, McLean offered to purchase all of the capital stock of the two subsidiaries from Waterman for $3,500,000 cash.
- To avoid a large capital gains tax on the sale, Waterman rejected the offer and counter-proposed to sell the stock for $700,180 (its tax basis) after Pan-Atlantic declared a dividend to Waterman of approximately $2,800,000.
- On January 21, 1955, Pan-Atlantic's board declared a dividend of $2,799,820 to Waterman. Lacking cash, Pan-Atlantic issued a promissory note to Waterman for that amount.
- On the same day, immediately after the dividend declaration, Waterman's board approved the sale of the subsidiaries' stock to McLean's newly formed entity, McLean Securities Corporation (Securities), for $700,180.
- Within minutes of the sale closing, the new board of Pan-Atlantic, presided over by McLean, authorized Pan-Atlantic to borrow $2,500,000 from McLean and $299,820 from Securities.
- Pan-Atlantic then immediately used these borrowed funds to issue a check to Waterman for $2,799,820, satisfying the promissory note.
Procedural Posture:
- On its consolidated income tax return, Waterman Steamship Corporation eliminated the $2,799,820 received from Pan-Atlantic as a tax-free intercompany dividend.
- The Commissioner of Internal Revenue determined that the payment was part of the purchase price, resulting in a long-term capital gain, and asserted a tax deficiency against Waterman.
- Waterman petitioned the U.S. Tax Court for a redetermination of the deficiency.
- The Tax Court, with four judges dissenting, held in favor of Waterman, finding that the payment was a legitimate dividend because it was declared and paid while Waterman was the legal owner of the stock.
- The Commissioner of Internal Revenue (appellant) appealed the Tax Court's decision to the United States Court of Appeals for the Fifth Circuit, with Waterman Steamship Corporation as the appellee.
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Issue:
Does a payment declared as a dividend from a subsidiary to its parent, made via a promissory note immediately before the parent sells the subsidiary's stock, constitute a tax-free intercompany dividend when the buyer provides the funds to satisfy the note as part of an integrated transaction?
Opinions:
Majority - Wisdom, Circuit Judge
No, the payment does not constitute a tax-free intercompany dividend but is instead part of the purchase price. The court held that tax consequences must be governed by the substance of a transaction, not its form. Viewing the events as a single, integrated transaction, the court found that the purported dividend was inextricably tied to the sale of the stock. The funds used to pay the 'dividend' did not come from Pan-Atlantic's own earnings but were supplied by the buyer, McLean. Pan-Atlantic merely acted as a conduit for the payment of the purchase price to Waterman. The entire two-step process had no business purpose other than to avoid taxes on what was substantively a $3,500,000 sale.
Analysis:
This case is a landmark application of the substance-over-form and step-transaction doctrines in tax law. It establishes that courts will collapse a series of formally distinct steps into a single transaction if they are interdependent components of a pre-arranged plan designed to achieve a tax-advantaged result. The decision significantly limits the ability of parent corporations to bail out subsidiary earnings and profits tax-free immediately prior to a stock sale, thereby converting what would be capital gains into tax-free intercompany dividends. This precedent forces taxpayers and courts to analyze whether a pre-sale distribution is genuinely a return on investment or merely a disguised portion of the purchase price funded by the buyer.
