Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 76 C 4050 -- George N. Leighton, Judge.
Cummings, Chief Judge, Gibson, Senior Circuit Judge,*fn* and Cudahy, Circuit Judge.
This case is about the tax treatment due a corporation that issues its own stock in order to satisfy the conversion option of its subsidiary's convertible debentures. The parent corporation claims it should be allowed to amortize over the remaining life of the converted debentures the difference between the fair market value of the stock issued and the face value of the debentures, or else be allowed an immediate deduction for the same amount. The district court in a well-written opinion disallowed these deductions. 520 F. Supp. 567 (N.D. Ill. 1981). We affirm.
The parties stipulated to the facts. National Can Corporation (Can) is a Delaware corporation with its principal place of business in Chicago, Illinois. Can is primarily a manufacturer of metal and glass containers and related products. Can uses the calendar year and the accrual method of accounting for federal income tax purposes and files a consolidated federal income tax return for itself and its subsidiaries. During the years 1967 through 1971, its common stock was listed and actively traded on the New York and Midwest Stock Exchanges.
In early 1967, Can decided to expand its manufacturing overseas by acquiring Clover Industries, Limited (Clover), a British can manufacturer. In order to maximize its debt financing and to comply with the United States Government's voluntary program of limiting the exodus of United States dollars, Can elected to borrow dollars held by Europeans, the so-called eurodollars. However, if Can borrowed the eurodollars itself, the foreign lenders would be subject to United States withholding tax on the interest paid as well as other possible tax burdens that would make borrowing more difficult. The remedy was to form a subsidiary. By forming a subsidiary to do the borrowing, Can could avoid the adverse tax consequences provided the subsidiary received less than 20 percent of its income from United States sources and was adequately capitalized so that its eurodollar borrowing did not exceed five times its share capital. Many such companies were formed to raise foreign capital, and they came to be known generically as "80/20 corporations" or "International Finance Subsidiaries."*fn1 In this instance, European tax and regulatory laws made preferable Can's creation of a domestic rather than a foreign subsidiary.
Thus on September 1, 1967, Can organized the National Can Overseas Corporation (Overseas) as a Delaware corporation with authorized capital stock of 2,000 common shares without par value. Later in September 1967, Can purchased all of Overseas' stock for $1,400,000 in cash. Overseas then formed an English subsidiary, which acquired over 90 percent of the common stock of Clover. United States banks provided interim financing to Overseas' English subsidiary for Clover's acquisition. The interim loans were guaranteed by Can and structured to be repaid from the proceeds of a 20-year issue of debentures to be sold by Overseas to foreign holders of eurodollars.
On October 26, 1967, pursuant to a request by Can, the Internal Revenue Service ruled that the proposed issue of debentures by Overseas would be a bona fide indebtedness of Overseas provided they were not held by Can or its affiliates. The I.R.S. also ruled that no withholding of tax would be required from the interest paid by Overseas on the debentures to non-resident aliens or foreign corporations, nor would withholding be required upon their conversion of the debentures into stock, provided Overseas had no gross income or less than 20 percent of its gross income was derived from sources within the United States. This favorable ruling, however, was limited to tax treatment that would be accorded purchasers of the debentures other than Can or Overseas. The I.R.S. did not waive any arguments regarding the tax treatment due Can or Overseas.
In December 1967, as the final step in its acquisition of Clover, Overseas used underwriters to issue to foreign investors $7,000,000 principal amount of 5 3/8 percent convertible debentures payable twenty years from December 1, 1967. Overseas sold the debentures at their face value of $1,000 per debenture, and after paying a 2 1/2 percent commission of $175,000 to the underwriters, realized $6,825,000. Overseas then used the proceeds to repay the interim bank loans which had been used to acquire Clover, to provide working capital for Clover, and to acquire other foreign can-manufacturing operations.
The debentures were redeemable by Overseas between five and twenty years from the date of issuance at a premium starting at 105 1/4 percent and ratably decreasing to 100 percent. After June 1, 1969, the debentures were convertible into common stock of Can, based upon an exchange rate subject to adjustment to prevent dilution. The initial exchange rate for conversion was $38.50 worth of debentures for each share of Can's common stock, which was approximately 110 percent of the price at which the stock was trading on the New York Stock Exchange on the date the debentures were issued. As a result of a two-for-one stock split, the exchange price became $19.25 debentures per share effective June 3, 1970. The debentures were not subordinated, and those converted into Can common stock were not further convertible, could not be transferred except between Can and Overseas, were not redeemable unless all outstanding debentures were redeemed at the same time, and might be cancelled at the direction of the holder (either Can or Overseas).
Can guaranteed Overseas' punctual payments of principal and interest on the debentures and also guaranteed Overseas' obligation to convert the debentures into Can common stock. In support of the conversion guarantee, Can agreed that beginning June 1, 1969, it would have sufficient authorized but unissued or reacquired shares of its stock available and properly registered to satisfy all unexercised conversion rights. Can thus reserved initially 181,818 shares of its authorized common stock for possible issuance upon conversion of the Overseas debentures and listed the shares on the New York and Midwest Stock Exchanges effective upon notice of issuance. Can also filed a statement with the Securities and Exchange Commission registering the shares for possible issuance, which it kept effective during the relevant years.
From 1969 through 1971, many of the holders of the Overseas debentures exercised their right to exchange the debentures for Can common stock. As might be expected, on the dates that most such rights were exercised the fair market value of the stock exceeded the conversion price. Overseas did not hold any stock of Can, so that upon presentation of the debentures for conversion, Can issued its common stock and cash in lieu of fractional shares for the debentures. The excess of the fair market value of the Can common stock issued for Overseas debentures at the time of the exchange (plus cash paid by Can for fractional shares) over the face amount of the Overseas debentures acquired by Can in the exchange is set forth below for each year at issue in this case:
Value of Cash Fair Market