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July 10, 1981


The opinion of the court was delivered by: Leighton, District Judge.



This is a suit by a corporate taxpayer to recover $2,026,277, plus interest, in income taxes assessed and paid for the years 1969, 1970 and 1971. The controversy between the parties involves the tax treatment of money received and payments made in connection with two aspects of an issue of debentures by a subsidiary of the corporate taxpayer and sale to foreign investors. A term of the debentures allowed a holder to convert his interest into common stock of the plaintiff corporation. All of the subsidiary's obligations under the debentures were guaranteed by the plaintiff taxpayer.

During the period 1969 through 1971, some of the debentures were exchanged for plaintiff's common stock at a time when the fair cash market value of the shares exceeded the price which had been agreed to for the exchange. Thus, this case presents issues concerning the proper tax treatment of the amount of money paid to plaintiff's subsidiary by foreign investors for the conversion feature of the debentures, and of the amount represented by the fair cash market value of plaintiff's common stock over the face value of the debentures at the time of the conversion. The parties have submitted the case on an agreed statement of the facts, oral arguments, and written briefs. This court has jurisdiction pursuant to 28 U.S.C. § 1346(a)(1).


Plaintiff National Can Corporation was organized in the State of Delaware and has its principal place of business in Chicago, Illinois. It is on a calendar year for federal income tax purposes, keeps its records and files its tax returns for itself and subsidiaries on the accrual basis of accounting. It is an operating company engaged in business both directly and through the ownership of stock in subsidiary corporations. Its business is primarily the manufacture and sale of metal and glass containers, and related products.

On September 1, 1967, National created a subsidiary, the National Can Overseas Corporation, hereafter referred to as NCOC. This subsidiary, like National, is on a calendar year for tax purposes, keeps its records and files its federal income tax returns on the accrual basis of accounting. During the years 1969 through 1971, NCOC filed consolidated federal income tax returns as an affiliate of National. At the end of that period, December 31, 1971, there were 6,082,876 shares of National's common stock issued and outstanding. Each share had one vote on corporate matters, was not liable to call or assessment, and had no preemptive or subscription rights. National's stock was listed and actively traded on the New York and Midwest stock exchanges.

In early 1967, National's corporate development department recommended that if the corporation was to keep pace and be competitive in the container industry, it would have to expand into foreign markets; that creation of new foreign subsidiaries was not feasible because of existing competition, and costs of entering new markets; and that interests in existing overseas can manufacturers should be acquired instead. The department recommended that National's first foreign acquisition be Clover Industries, Ltd., a United Kingdom corporation primarily engaged in the business of manufacturing and selling metal containers in Great Britain. These recommendations were adopted. In order to maximize the amount of debt financing to comply with the balance of payments objectives declared by the President of the United States, National decided that overseas acquisitions would be financed by borrowing United States dollars in the hands of foreign holders, that is "Eurodollars".

In connection with its financial arrangements, National was advised by investment and legal counselors that because of United States tax laws and regulations, it could not borrow Eurodollars without subjecting foreign lenders to United States withholding tax on interests paid; and that the Eurodollars should instead be borrowed by a separate corporate subsidiary of National which would earn less than 20% of its income from United States sources. National was also advised that because of European tax and regulatory laws, the subsidiary it was going to organize should be a domestic rather than a foreign corporation. As a consequence, National incorporated NCOC with an authorized capital stock of 2,000 common shares without par value. On September 20, 1967, National's board of directors authorized the purchase of all NCOC stock for $1,400,000 in cash. At all times, NCOC has functioned as a separate corporate subsidiary of National.

In late 1967, NCOC formed an English subsidiary which acquired over 90% of the common stock of Clover. Interim financing for this acquisition was provided by short term loans of Eurodollars to NCOC's English subsidiary by three American banks. These loans were to be repaid through the proceeds of a 20-year Eurodollar issue to be sold by NCOC to foreign investors in the form of proposed debentures. The interim loans were guaranteed by National. As to all of these contemplated financial ventures, National requested a ruling by the Internal Revenue Service as to the tax consequences of the proposed NCOC debentures. The ruling was given in a letter which referred to the tax consequences of the financial proposals. Then on December 6, 1967, NCOC's board of directors authorized the issuance of $7 million of NCOC debentures which were to be issued and sold in 1967, exclusively to foreign investors through underwriters. The debentures were sold to the underwriters at their face amount of $1,000 each, less a commission of 2 1/2%. This totaled $175,000 paid to the underwriters, NCOC realizing $6,825,000 from the sale of the debentures. National guaranteed the payment of interest and principal of the debentures; NCOC agreed to issue them, and the subscribers agreed to subscribe to them. The debentures are referred to in the subscription agreement and labeled on their face "Bonds", in accordance with British usage, even though they were unsecured. They were listed and traded on the Luxembourg Stock Exchange. Their proceeds were applied by NCOC principally to repay the bank loans used to acquire Clover, to provide working capitol for Clover, and to acquire other foreign can manufacturing operations.

The NCOC debentures were bearer instruments with interest coupons attached, calling for payment of 5 3/8% per annum, payable semiannually, on June 1 and December 1 of each year. They were in denominations of $1,000 and payable at par in 20 years on December 1, 1987, if not previously redeemed. They were redeemable by NCOC between five and twenty years from the date of issuance at a premium starting at 105 1/4% and ratably decreasing to 100%. All debentures redeemed had to be cancelled. They were convertible for the common stock of National any time after June 1, 1969, based on a price subject to adjustment to prevent dilution. The initial price at which they could be converted was $38.50 per share of National's common stock, a price approximately 110% of that at which the stock was being traded on the New York Stock Exchange on the date that NCOC debentures were issued. As a result of a two for one stock split, this price became $19.25 per share effective June 3, 1970.

The debentures were not subordinated; and those which have been converted into National common stock are not further convertible, could not be transferred except between National and the NCOC, are not redeemable unless all outstanding debentures are redeemed at the same time, and may be cancelled at the direction of the holder, being either National or NCOC. They contained on their face an agreement into which National entered with each holder guaranteeing unconditionally the due and punctual payment of principal and interest on the debentures if these were not paid by NCOC. National unconditionally guaranteed it would advance to NCOC such funds as would be necessary to enable payment of all principal and interest when due. The guarantee also provided that if NCOC failed to perform its obligation to convert the debentures into National common stock, National would "perform such obligation when and as such performance by [NCOC] is required, as if such obligation were being performed by" NCOC. In the guarantee, National agreed at all times after June 1, 1969, to have sufficient authorized but unissued or reacquired shares of its common stock available and properly registered to satisfy all unexercised conversion rights in full. In compliance with this guarantee, National reserved 181,818 shares of its authorized but unissued common stock for possible issuance in exchange for NCOC debentures and listed such shares on the New York and Midwest stock exchanges effective on official notice of issuance. National filed with the Securities and Exchange Commission, and caused to become effective on April 1, 1969, a registration statement with respect to such shares. Pursuant to this guarantee, National kept such registration effective during all the years relevant to this controversy.

It has been determined by the Internal Revenue Service that the debentures would have had to have been priced to yield to maturity 6.9% if they had been sold in the Eurodollar market without being convertible for National's common stock. In order to yield this return, the debentures had to have been sold for 83.6% of face resulting in a discount of $1,148,720. The parties agree that the discount at which the debentures would have sold if they had not been exchangeable for National's common stock is $1,148,720. In other words, if the debentures had been issued without the privilege to convert them for National's common stock, but had contained all the other terms under which they were sold, they would have obtained a price of $5,851,280 rather than $7 million.

During the period 1969 through 1971, certain holders of the debentures exercised their right to exchange them for National common stock. On the dates most of such rights were exercised, the fair market value of National's common stock was in excess of the conversion price. During such years, NCOC did not own any National common stock; therefore, it was not able to meet its conversion obligation according to the terms of the debentures. On presentation of debentures by their holders, National, pursuant to its guarantee, exchanged its common stock and cash in lieu of fraction of shares. The excess of the fair market value of National's common stock issued at the time of the conversion (plus cash paid by National for fraction of shares) over the face amount acquired by National, for each year in issue in this case, was as follows:

           Fair Market
           Value of
           National                                                             Excess of
           Common Stock                                                         Fair Market
           Issued on         Cash in          Total           Face Amount       Value of
           Conversion        Lieu of          Value           of Debentures     Stock Over
           for               Fractional       Given For       Acquired by       Face Amount
  Year     Debentures        Shares           Debentures      National          of Debentures
  1969     $7,398,117        $11,504          $7,399,621      $4,232,000        $3,167,621
  1970      1,406,135            653           1,406,788         887,000           519,788
  1971        349,821            314             350,135         244,000           106,135

The NCOC debentures received by National in the above conversion exchanges have been retained by it and have not been cancelled or called. NCOC has paid National interest on these debentures each year pursuant to their terms. Subsequent to December 31, 1971, five NCOC debentures were acquired by National for conversion to its common stock, pursuant to the guarantee. In addition, on June 8, 1977, National purchased NCOC debentures having a face amount of $58,000 on the open market for $48,285 in cash. As of December 31, 1978, National owned 5,426 NCOC debentures, 5,368 of which were acquired on conversion for its common stock pursuant to the guarantee and 58 of which were purchased for cash in the open market.

National filed timely consolidated federal income tax returns for the calendar years 1969 through 1971 for itself and its subsidiaries, including NCOC, and paid the taxes due. National treated the excess of the fair market value of its common stock (plus cash paid for fractional shares) issued for the debentures over their face amount received on the conversion as a premium paid for their acquisition and amortized such amount over their remaining life. The Internal Revenue Service disallowed deductions of $83,662, $181,489, and $200,242, respectively, for such amortization and assessed additional taxes against National as a result. Subsequently, National paid all the deficiencies assessed with respect to these years. On March 10, 1976, National filed with the Internal Revenue Service a timely claim for refunds in the following amounts for the calendar years 1969 through 1971:

Year             Refund Claimed
      1969               $1,672,504
      1970                  255,735
      1971    ...

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