Rev. Rul. 61-18

Advice has been requested whether amounts received by a corporation, under the circumstances described below, from the sale of its Class B stock to another corporation for the purpose of qualifying the latter corporation as a related corporation under the `trade-out-and-build' program of the United States Maritime Administration, constitute taxable income and, if so, the character of such income.

On November 8, 1956, the United States Maritime Administration announced its so-called `trade-out-and-build' program, effective November 5, 1956, providing for the transfer of certain United States owned flag vessels to foreign ownership and registry under certain conditions. See 21 F.R. 8588, Title 46, chapter II, subchapter B, Part 221, Appendix, entitled `Transfer of U.S. Privately Owned Vessels to Foreign Ownership and/or Registry.' This program, having as its primary objective the expansion of the United States tanker fleet, allowed shipowners who committed themselves to construction of new vessels in American yards for United States flag documentation and operation permission to transfer an off-setting amount of tonnage to foreign registry and ownership. Under the requirements of the program, as far as here pertinent, a corporation which applies for transfer of United States flag vessels to foreign ownership and registry in conjunction with the `trade-out-and-build' program, and which commits itself to construct a new vessel, is required to be the owner, or parent, or United States subsidiary or related company of the owner of a United States flag vessel.

To obtain the benefits available under the program, a corporation, M , was organized, in 1956, with a capitalization of three classes of stock, common, Class A , and Class B . Its common stock was issued to three individuals for 100 x dollars and its Class A stock was sold to an affiliated shipping and trading corporation for 1,450 x dollars. To obtain the major portion of the capital (aside from loans) necessary to undertake the construction of new vessels, M corporation arranged in 1957 to sell all of its Class B stock for 100 x dollars a share to a shipowning corporation, P , which desired to transfer a certain vessel which it owned to foreign registry and ownership. In consideration of the agreements by P corporation to purchase the specified amount of Class B stock, M corporation agreed that it would obtain a `transfer order' from the Maritime Administration, to which it became entitled by virtue of its commitment to the Maritime Administration to build a replacement vessel, authorizing the transfer to foreign registry of the vessel owned by P corporation.

The Class B stock was non-transferable and non-assignable. Its holders were entitled to noncumulative dividends of one cent per share before dividends could be paid upon the other two classes of stock. The stock was subject to redemption at the discretion of the board of directors for ten cents per share, and in the event of liquidation or dissolution the shareholders were entitled to payment of ten cents per share.

It has long been a principle of Federal tax administration that the substance of a transaction, rather than the form, is considered to control its Federal income tax consequences. This rule is one that is well established and has found support in numerous decisions of the Supreme Court of the United States and lower courts. The rule of substance versus form has been stated by the Supreme Court in varying language. In every case where the problem was present, the questions of taxation were determined by viewing what was actually done, rather than the declared purpose of the participants. See Weiss v. Louis Stearn , 265 U.S. 242, T.D. 3609, C.B. III-2, (1924); George W. Griffiths v. Helvering , 308 U.S. 355, Ct. D. 1431, C.B. 1940-1, 136; Commissioner v. Court Holding Company , 324 U.S. 331, Ct. D. 1636, C.B. 1945, 58; and Higgins v. John Thomas Smith , 308 U.S. 561, Ct. D. 1434, C.B. 1940-1, 127.

In the instant case, P corporation, in actuality, owned a vessel which it was desirous of transferring to foreign registry. However, under Maritime Administration regulations it could not transfer the vessel until it had undertaken to build a replacement vessel. P corporation, in its own capacity, had neither the facilities nor financial capability to qualify for this construction. Therefore, P corporation, by its purchase of stock in M corporation, became a related company and thus qualified under the requirement of the Maritime Administration. On the other hand, M corporation, by its sale of stock to P , obtained the necessary funds which enabled it to qualify for a loan from the Maritime Administration. Stripped of its formalities, the transaction merely constituted a mutual agreement whereby P corporation was provided with a transfer right and M corporation with the necessary minimum working capital to proceed with construction of a new replacement vessel.

P corporation, shortly after it obtained such right, sold the purchased stock at its redemption value of ten cents a share to a corporation affiliated with M and, in its tax return for the year under consideration, treated the loss on the sale of its stock as an addition to the cost of its vessel transferred. Thus, P corporation considered that it was actually buying not the stock of M corporation, but the right to transfer its vessel to foreign registry.

Revenue Ruling 58-40, C.B. 1958-1, 275, and cases cited therein, hold, in effect, that securities purchased from a corporation, in order to enable the purchaser to obtain certain property (including rights) are not considered to be capital assets. It would logically follow that the proceeds from such sales should not be treated by the seller as payment for the stock issued.

Under these circumstances, it is the position of the Internal Revenue Service that of the total amount received by M from P , only ten cents per share was actually paid for the stock and, to that extent, no gain or loss is recognized to the M corporation. See section 1032 of the Internal Revenue Code of 1954. The remainder of the amount received by M corporation from the sale of its Class B stock constitutes a payment for the privilege or right under which the purchaser of the stock, because of its ownership thereof, was entitled to transfer American ships to foreign registry. See Rev. Rul. 58-40, supra . Hence, such remainder constitutes gross income to the recipient under section 61 of the Code.

The question then resolves itself as to whether such income constitutes gain upon the sale of a capital asset and, thus, capital gain, or gain upon the sale of property other than a capital asset and, thus, ordinary income.

Revenue Ruling 58-296, C.B. 1958-1, 276, holds, in part, that payments received for agreements to retain ships under American registry, procured for the purpose of enabling the payors to meet the requirements of the Maritime Administration under an earlier program, effected in the year 1954, so as to be able to transfer like ships to foreign registry, constitute ordinary income and not capital gain. Such an agreement does not constitute a sale or exchange of property. The privilege passing under the agreement is a privilege created and suspended by administrative action of a governmental agency and does not constitute property within the purview of section 1221 of the Code. While not so stated in Revenue Ruling 58-296, the transfer rights were not considered to constitute `capital assets' or `property used in the trade or business' within the meaning of sections 1221 and 1231 of the Code. The same holding is equally applicable in the instant case.

Furthermore, a taxpayer who is eligible, under the `trade-out-and-build' program of the Maritime Administration, to transfer American ships to foreign registry has become so entitled because of his agreement to perform acts desired by the Maritime Administration, namely, construction of a vessel in United States yards for United States registry. This transfer right is granted in recognition of the fact that the vessel so constructed will be built at a higher cost and, because of the requirement that American Flag ships employ American seamen, and other restrictions, will be more expensive to operate than would be true if it were registered under the flag of another country. Therefore, the transfer right could also be considered as a form of compensation or indemnification for higher profits foregone by the owner of an American Flag ship. Such profits to be realized in the future would constitute ordinary income. See Commissioner v. P. G. Lake, Inc., et al. , 356 U.S. 260, Ct. D. 1823, C.B. 1958-1, 516, and Commissioner v. Gillette Motor Transport, Inc. , 364 U.S. 130, Ct. D. 1853, C.B. 1960-2, 466. Thus, it follows that any proceeds received from the sale of such right would retain the character of ordinary income.

Accordingly, it is held in this case that (1) the portion of the proceeds from the sale of the Class B stock of the M corporation which is in excess of the nominal redemption value of the stock represents gross income to M corporation; and (2) such income constitutes ordinary income from the transfer of a privilege or right which does not qualify as a capital asset.