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Does Alumax bar "bankruptcy-proofing" and special voting rights?

Whenever a corporation seeks to borrow funds with respect to a specific asset or business, the lender commonly requests that the asset or business be placed in a "bankruptcy-remote" subsidiary, which is often referred to as a "special-purpose entity" (or an SPE). The lender will also frequently request various special rights, including the ability to accelerate the loan upon a bankruptcy filing by the SPE and, in many instances, a tiny ownership interest in the SPE in order to permit the lender to "veto" a voluntary bankruptcy filing by the SPE.

Another common situation involves co-investment, in which one person (Investor) will acquire a small (less than 20-percent) ownership interest in a corporation (Target). If Target is a member of an affiliated group that files a consolidated return (Group), the interest obtained by Investor cannot have more than 20 percent of the vote or 20 percent of the value of Target in order for Target to continue to file consolidated returns with the Group. The Investor may be given one seat on the board of directors of Target, but this seat will have less than 20 percent of the voting power in Target. The Investor may want, however, to have more input into certain major decisions, such as a sale of substantially all of the assets of Target or a merger of Target into another corporation. Again, it is customary in such situations for the articles of incorporation or bylaws of Target to require unanimous approval of certain actions by the board of directors or the shareholders in order to protect the interest of the Investor.

In its recent decision in Alumax Inc. U. Commissioner, 109 T.C. 133 (1997), the Tax Court held that special voting and other rights given to a shareholder resulted in deconsolidation. At first blush, Alumax raises the question whether special voting rights can be given to protect the interests of a major creditor or a minority shareholder. On closer inspection, however, Alumax should probably be viewed as involving a unique factual situation, thereby limiting the decision's effect on the types of rights commonly given to lenders or minority shareholders.

Background

Section 1501 of the Internal Revenue Code grants an affiliated group of corporations the privilege of filing a consolidated return.(1) Under section 1504(a)(1), an affiliated group is generally defined as one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation, but only if the common parent directly owns stock in at least one other includible corporation and stock meeting the requirements of section 1504(a)(2) is owned directly by one or more of the other includible corporations. The requirements of section 1504(a)(2) are satisfied if the stock owned by one or more includible corporations (1) possesses at least 80 percent of the total voting power of the stock of such corporation, and (2) has a value equal to at least 80 percent of the total value of the stock of such corporation.

The determination of the "voting power" attributed to the stock in a corporation has long focused on the shareholders' ability to elect directors on the corporation board. In several rulings, the Internal Revenue Service has treated the right to elect directors as indicative of the voting power of stock. The leading ruling in this regard is Rev. Rul. 69-126, 1969-1 C.B. 218. That ruling involved a corporation owning 100 percent of the common stock and 50 percent of the preferred stock of a subsidiary. The subsidiary's board of directors was composed of eight directors, five of whom were elected by the common shareholders and three of whom were elected by the preferred shareholders. The only voting right given to the preferred shareholders was the right to vote for directors.

Because the preferred stock holders were able to participate in the election of directors, the IRS concluded that the preferred stock was voting stock for purposes of section 1504(a). A mathematical formula was used to determine voting power of the parent corporation. By applying the formula (5/8 x 100% + 3/8 x 50%), the IRS determined that the parent corporation participated in the management of the subsidiary corporation since the 80-percent voting requirement of section 1504 was satisfied.

In I.T. 3896, 1948-1 C.B. 72, the parent corporation owned 100 percent of the common stock and 55.5 percent of the preferred stock of one of the parent's subsidiaries. There were seven directors on the subsidiary's board. The common stock holders were able to elect six of the seven directors and the preferred stock holders were able to elect one of the seven directors. The preferred stock holders' approval was additionally needed for (1) any change in the certificate of incorporation except an increase in common stock; (2) the disposition of the company's property by sale, merger, etc.; (3) the creation of a mortgage or lien (not including the acquisition of property subject to a lien or renewal of an existing mortgage); (4) the issuance of bonds in excess of a certain amount; and (5) the authorization or issuance of any stock outranking the preferred stock or of any security convertible into such stock. According to the ruling, it was proper to treat the preferred stock as voting stock: "any stock which participates in the action of the directors is voting stock."

The courts have addressed similar issues. In Erie Lighting Co. v. Commissioner, 93 F.2d 883 (1st Cir.), revg 35 B.T.A. 906 (1937), the court of appeals addressed whether the preferred stock issued by Erie Lighting Company (ELC) was voting stock or nonvoting stock for purposes of the applicable consolidation provisions. In that case, the holders of the preferred stock of ELC had the right to vote on many matters that were usually reserved to the stockholders(2) but the holders of the preferred stock did not have the right to vote in the election of ELC's board of directors unless dividends with respect to the preferred stock remained unpaid for two quarters, a condition that had not arisen for many years. The court noted that the matters on which the preferred stockholders could vote did not restrict ELC's board of directors with respect to that board's management of ELC's business and affairs. Accordingly, the preferred stock was not treated as voting stock for purposes of the applicable consolidation rules.

In Rudolph Wurlitzer Co. v. Commissioner, 81 F.2d 971 (6th Cir. 1936), affg 29 B.T.A. 443 (1937), the corporate taxpayer issued preferred stock that was nonvoting stock under the taxpayer's corporate charter. State law, however, caused all shareholders to be entitled to vote in elections for directors. In a situation in which state law and a corporate charter conflicted regarding voting rights, the court in Wurlitzer determined that state law prevailed. Therefore, the preferred stock was treated as voting stock for consolidation purposes.

Faces in Alumax

Although the taxable years at issue in Alumax were in the 1980s, it is necessary to go back to the early 1970s to understand the nature of the stock issued by Alumax. Alumax was formed in late 1973 by Amax, a corporation that had been a worldwide supplier of metals and energy for many decades. Prior to the formation of Alumax, Amax's principal businesses were in aluminum, coal, gold, and molybdenum. Amax had conducted an aluminum business since 1962.

In December 1973, Amax caused three of its wholly owned subsidiaries that were engaged in the aluminum business to transfer to Alumax substantially all of their assets. In consideration, these subsidiaries were issued 180 shares of stock of Alumax. The remaining 320 shares of stock of Alumax were transferred to Amax in exchange for the transfer by Amax of the stock of its other subsidiaries engaged in the aluminum business.(3)

Stock Sale to Mitsui

In 1974, Alumax was recapitalized as part of a transaction in which Mitsui & Co. Ltd. (Mitsui Japan) became a shareholder of Alumax. Specifically, Alumax was authorized to issue both class A and class B common stock. The stock held by Amax's subsidiaries was changed into class A stock, as were 70 of the shares held by Amax; the remaining 250 shares previously held by Amax were converted into class B common stock and sold by Amax to Mitsui Japan for $125 million in cash. Subsequently, Mitsui sold some of the class B common stock to Nippon Steel Corporation (NSC) and transferred other shares to its wholly owned subsidiary, Mitsui & Co. (U.S.A.), Inc. (Mitsui USA).(4)

After the 1974 reorganization, each share of each class of Alumax common stock had one vote, and any action of the Alumax stockholders required an affirmative vote of a majority of the outstanding shares of each class. The stockholders agreement that was entered into in 1974 between Mitsui and the Amax Group provided that Alumax was to pay dividends on or with respect to its stock at such times as its board of directors determined appropriate in light of its earnings, cash flow, and capital requirements. Each share of each class of stock of Alumax participated equally in all dividends and other distributions from Alumax.

The Alumax board consisted in 1974 of 10 voting and 2 nonvoting members, with 5 of the directors being elected by the Amax Group and 5 of the directors being elected by Mitsui; the board was subsequently changed to 12 voting members, with half being elected by the holders of each class of stock. Any action of the Alumax board, which exercised all corporate powers, required an affirmative vote of a majority of the directors elected by the holders of the class A common stock and an affirmative vote of a majority of the directors elected by the holders of the class B common stock.

This historical perspective concerning the ownership and voting rights of the Amax Group on the one hand and Mitsui on the other hand is an important backdrop to the events occurring the following decade. From 1974 through the 1984 restructuring, the Amax Group and Mitsui shared control of Alumax, and all dividends were distributed equally to the two groups of shareholders. It is against this historical situation that the effect of the 1984 restructuring must be measured.

The 1984 Restructuring

In 1984, the certificate of incorporation of Alumax was restated and the shareholders agreement and bylaws were revised. Under the restated certificate, Alumax was authorized to issue (1) 250 shares of class A common stock, (2) 250 shares of class B common stock, and (3) 250 shares of class C common stock; all three classes had a par value of $100 per share. No share of Alumax class A common stock, however, could be issued and outstanding at any time that any share of the Alumax class C common stock was issued and outstanding, and vice versa. As part of the restructuring, the Amax Group converted its stock in Alumax into 250 shares of class C common stock; Mitsui and NSC (collectively, the Mitsui Group) continued to hold 250 shares of class B common stock.

Throughout any period during which any Alumax class C common stock was outstanding, each share of the class B common stock (held by the Mitsui Group) had one vote, and each share of the class C common stock (held by the Amax Group) had four votes, on each matter submitted to the Alumax shareholders. Shareholder voting, however, was restricted on various matters (shareholder restricted matters, discussed below) and any action on any nonrestricted matter was not to take effect for 14 calendar days if it was taken over the express objection of the Mitsui Group. Furthermore, if the Mitsui Group objected to any matter, the Mitsui Group had the right to purchase the class C common stock held by the Amax Group unless Amax elected to exchange the class C common stock for class A common stock, which did not have the special voting rights ascribed to the class C common stock. In other words, if the Mitsui Group objected to any proposed action by the Amax Group, the Mitsui Group could effectively force Amax to convert its class C common stock into class A common stock, which would eliminate the voting advantage which Amax otherwise had. Thus, the "extra votes" given to the class C common stock only mattered if there was no dispute!

The shareholder restricted matters required the consent of each class of stock outstanding, voting by class and not in the aggregate. These matters were:

* To amend the certificate of incorporation;

* To amend the bylaws;

* A merger of Alumax;

* An acquisition or a disposition of any material asset, which was defined as an asset with a net book value of at least five percent of Alumax's net worth;(5)

* Partial or complete liquidation or dissolution;

* Capital appropriation or an asset disposition of $30 million or more (which was approximately 1.8 percent of Alumax's total assets);

* Election or dismissal of the CEO;

* Any transaction involving Alumax and any affiliate.

Furthermore, during any period during which the class C common stock was outstanding, the Alumax board of directors was required to declare and pay dividends equal to 35 percent of Alumax's net income to the extent permitted by law (the Base Dividends). These dividends were paid 80 percent to the holders of the class B common stock and 20 percent to the holders of the class C common stock; any dividends in excess of the Base Dividend were paid equally to the two classes of stock. In other words, in exchange for accepting diluted voting power, the Mitsui Group was entitled to additional, guaranteed dividends.

These special provisions concerning the rights of shareholders were mirrored in provisions affecting the rights of Alumax's directors. The Alumax board consisted of six voting members and two nonvoting members throughout any period during which any share of the class C common stock was outstanding. The holders of the class B common stock elected two of the voting members (the class B directors); the remaining four voting members of the board were elected by the holders of the class C common stock (the class C directors). The class B directors had only one vote each on matters submitted to the board, whereas the class C directors had two votes each, giving the class C directors 80 percent of the board vote.

Although the class C directors nominally had 80 percent of the vote on board matters, class voting was required on the same matters (director restricted matters) on which separate shareholder class approval was required. Furthermore, on all other matters submitted to the directors (director nonrestricted matters), any board action on any director nonrestricted matter was not to take effect for 14 calendar days if it was taken over the objection of a class B director, and any such board action was not to take effect at all if as a result of such objection, the Mitsui Group purchased the class C common stock from Amax or the class C common stock was converted by Amax into class A common stock. Thus, the extra votes given to the class C directors mattered only if there was no dispute between the various classes of directors; if a serious dispute arose, the additional voting power given to the class C directors could be countered by the Mitsui Group threatening to purchase the class C common stock, which would require Amax to convert such shares into class A common stock. Because the special voting rights of the class C directors terminated if the class C common stock was converted, as a practical matter these additional voting rights were in place only so long as there were no corporate decision disputed by the class B directors. Thus, even though Amax nominally controlled 80 percent of the voting power in Alumax, in reality the Mitsui Group could block anything. Thus, the reality of the voting rights of the parties was the same 50-50 arrangement that existed prior to the 1984 restructuring.(6)

In fact, the Alumax board often voted by class on various matters, although other matters were determined using the weighted voting structure. The matters on which class votes were required during 1984 through 1986 included (1) the election of officers; (2) capital appropriations totalling approximately $268 million, (3) the 5-year budget plan; (4) the 5-year capital expenditure plan; (5) the declaration of dividends; (6) employee compensation matters; (7) the election of the CEO and the president of Alumax; (8) a loan by Alumax to the Mitsui Group; and (9) amendments to the certificate of incorporation and bylaws. In contrast, the director nonrestricted matters addressed by the Alumax board during the same period using the weighted voting procedures included (1) the election of officers other than the CEO; (2) capital appropriations totalling approximately $100 million; (3) the authorization of certain bank and credit agreements; (4) amendments to the Alumax thrift and retirement plans; (5) a $50 million contribution to a subsidiary of Alumax; and (6) the appointment of independent auditors.

The Mitsui Group also had the right to purchase the class C stock held by Amax upon the occurrence of certain other events, such as (1) a downgrading of the credit rating of certain securities of Amax or Alumax; (2) acceleration of the indebtedness of Amax or Alumax; (3) bankruptcy or insolvency of certain significant subsidiaries of Amax; (4) changes in the ownership of Amax or certain subsidiaries; (5) a breach of the stockholders agreement; or (6) a change in generally accepted accounting principles that would prohibit the Mitsui Group from recording the net income of Alumax in its financial statements. The final provision indicates that the ownership structure of Alumax was intended to afford favorable tax consequences to Amax without adversely affecting the financial (book) treatment of the Mitsui Group.

On the tax front, Amax and Alumax entered into a tax-sharing agreement under which (1) Alumax was required to pay Amax 90 percent of the tax liability of Alumax and its subsidiaries; (2) Amax was required to compensate Alumax if Alumax was adversely affected by inclusion in the Amax consolidated group; and (3) Alumax was required to compensate Amax if Alumax derived any tax savings from its inclusion in the Amax return. This determination was made through a comparison of the actual tax returns with pro forma returns treating Alumax as the parent of its own consolidated group. A pledge and indemnity agreement was entered into, in which the Amax Group pledged their class C stock (and, if converted, their class A stock) to the Mitsui Group as collateral for an indemnity against certain and other costs that might arise out of the 1984 restructuring. In this regard, Amax was given control over any challenges by the IRS to the inclusion of Alumax in Amax's consolidated return.

The 1986 Restructuring

In 1986, Alumax was restructured again. Under its restated certificate of incorporation, Alumax was authorized to issue 750 shares of voting common stock, and 10 million shares of preferred stock (Alumax preferred) with a par value of $25 per share. Four million shares of the Alumax preferred were designated by the Alumax board as series A nonvoting preferred stock and were exchangeable for the common stock of Alumax.

Simultaneously, pursuant to a recapitalization and stock purchase agreement, (1) Mitsui exchanged 57 shares of the class B common stock that it held for 4 million shares of Alumax series A nonvoting preferred stock, (2) Mitsui sold to Amax for $291.5 million the remaining 168 shares of class B common stock that it held, and (3) NSC sold to Amax for $43.5 million the 25 shares of class B common stock that it held. The class B common stock and class C common stock, all of which was held by the Amax Group, was then converted into a single class of common stock that was held solely by the Amax Group.

As a result of the 1986 restructuring, the Mitsui Group ceased to own any common stock of Alumax; all remaining ownership in Alumax was represented by the nonvoting preferred stock. During the following two years, Mitsui exchanged the preferred stock of Alumax for shares of common stock of Amax, which were subsequently sold by Mitsui. Seven years later, Amax distributed all of the Alumax stock to its shareholders (presumably tax-free under section 355) and Amax was merged into Cyprus Minerals Company in a Morris Trust-type transaction.

The Parties' Arguments

The issue presented to the Tax Court in Alumax was whether consolidation of Alumax and Amax was permitted under then-applicable law. Prior to January 1, 1985, section 1504(a) permitted consolidation only if stock possessing at least 80 percent of the voting power of all classes entitled to vote and at least 80 percent of each class of nonvoting stock was owned by one or more includible corporations (the "80-percent voting power test"); effective for taxable years beginning after December 31, 1984, consolidation required ownership of stock that possesses at least 80 percent of the total voting power of all classes of stock of the corporation and has a value equal to at least 80 percent of the total value of the stock of such corporation (the "80-percent vote and value test"). A special transition rule permitted corporations which satisfied the 80-percent voting power test on June 22, 1984, to maintain qualification as a member of a consolidated group through 1987. The parties in Alumax both assumed that this special transition rule was applicable, so that the only issue was whether Alumax could be treated as part of the Amax consolidated group under the 80-percent voting power test.(7)

The Taxpayers' Arguments

The taxpayers argued that the determination of voting power of stock was to be made according to a "mechanical test" that looked to the voting power of the directors the stock elects. According to the taxpayers, the cases and rulings had not taken into account the shareholders' voting rights with respect to matters other than the right to vote in the election of directors, no matter how extensive such rights might be, and had never measured voting power other than by reference to the voting power of directors. Because the class C stock held by Amax elected four directors who could cast 8 out of the 10 votes cast on matters by the board of directors of Alumax, Amax controlled 80 percent of the voting power of Alumax.

Furthermore, the taxpayers argued that this determination should be made only with respect to the director nonrestricted matters on which class voting was not required. The matters on which class voting was required were treated by the taxpayers as a narrow set of actions, such as mergers, material acquisitions, and dispositions and transactions with affiliates, that frequently are the subject to mechanisms, such as class voting, intended to protect minority interests. They were viewed by the taxpayers as far short of the unlimited list of matters on which the preferred stockholders could have voted in Erie Lighting or would have been prevented from voting on in Wurlitzer. The taxpayers further argued that the mandatory dividend provisions that were imposed on Alumax, as well as the objectionable action provisions giving rights to the Mitsui Group if they did not agree with any nonrestricted action by the board of directors, should not be taken into account.(8)

The IRS's Arguments

The IRS agreed that the vast majority of cases applying the voting power test under section 1504(a) should be measured by reference to the election of directors. The IRS contended, however, that in an "aggressively structured" transaction like Alumax, election of directors is not an appropriate measure of voting power. In such situations, the IRS argued that it was necessary to look beyond the election of directors to determine voting power.

According to the IRS, all the judicial and administrative authorities that have construed the meaning of the terms "voting stock" or "voting power" for purposes of section 1504(a) disavow the mechanical test urged by the taxpayers. Although recognizing the importance of the voting power of the class C directors, the IRS argued that the voting powers of such directors had to be weighed on all board matters, and not just those which were not subject to class voting. The IRS further contended that the potential effect of class voting requirements, at both the director and shareholder levels, had to be weighed in determining control.

In addition, the IRS urged the Tax Court to take into account both the mandatory dividend provision and the objectionable action provision in determining voting power. According to the IRS, these provisions placed substantial restrictions on the power of the Alumax board to act on certain board matters and, consequently, on the voting power of the class C directors. According to the IRS, the cumulative effect of all these provisions -- the director class voting requirement, the stockholder class voting requirements, the mandatory dividend provision, and the objectionable action provision -- was to reduce the voting power of the class C common stock to well below 80 percent.

The Tax Court's Analysis

The Tax Court's decision in Alumax was based upon a rejection of the taxpayers' regal contentions, followed by a point-by-point analysis of each of the various rights given to the stockholders. The Tax Court never expressly examined the overall relationship of the shareholders of Alumax, though that relationship certainly must have affected the court's analysis.

The threshold issue was whether the taxpayers were right in contending that a purely mechanical test should be applied to determine voting power. This contention was squarely rejected by the Tax Court. According to the court the taxpayers were incorrectly interpreting the prior cases -- Erie Lighting and Wurlitzer -- that only addressed whether the stock in question was voting or nonvoting stock. These cases do not even address how to measure the voting power possessed by different classes of voting stock. Likewise, the questions presented in prior rulings, including particularly Rev. Rul. 69-126 and I.T. 3896, were whether the stock in question was voting stock or nonvoting stock for purposes of the applicable consolidation provisions and how to measure the voting power possessed by different classes of voting stock for purposes of those provision. According to the court, none of these decisions or rulings involved facts similar to the instant case. Likewise, none adopted the mechanical test argued by the taxpayers.

Instead, the court concluded that Erie Lighting supports the conclusion that the determination of voting rights must be based on all the facts and circumstances. In Erie Lighting, the court looked at the facts before it, including the nature of the matters on which the holders of the preferred stock issued by ELC could vote, in determining whether the preferred stock should be treated as "voting stock." The court found that the preferred stock had the right to vote on many matters that it determined were of the type that are usually reserved to shareholders (shareholder matters)(9) but that it did not have the right to vote in the election of directors unless dividends were in arrears. The court in Erie Lighting did not indicate that any of the shareholder matters on which the preferred stockholders had the right to vote restricted the ELC directors with respect to the management of its business. Nor were any management matters taken away from the ELC directors.(10) To the contrary, under state law and ELC's bylaws, the directors of ELC were entrusted with the management of the corporation's business and affairs. Accordingly, the preferred stock was not voting stock because it did not participate in the election of ELC's directors, who were entrusted with the management of ELC's business.

After Erie Lighting, other rulings have considered the ability of stock to participate in the management of a corporation through the election of one or more directors in determining the existence of voting stock or the extent of voting power for purposes of the consolidation provisions. Rev. Rul. 69-126; I.T. 3896. The Tax Court concluded, however, that the facts in those rulings were not similar to the facts in Alumax. Furthermore, none of those rulings suggested that the power of the boards of directors was restricted or limited, such as by completely taking away from those boards the power to vote on certain matters relating to the management or corporate business and affairs that were entrusted to those boards under applicable state law.

Accordingly, the Tax Court determined that it should examine the effect of the director and stockholder class voting requirements, the mandatory dividend provision, and the objectionable action provision on the power of the class C common stock. Thus, all the facts and circumstances concerning the special voting powers given to the Mitsui Group as holders of the class B stock, and the directors elected by the Mitsui Group, needed to be weighed in determining whether Amax held 80 percent of the voting power in Alumax. This required the Tax Court to weigh the importance of these provisions.(11)

The determination that all the facts and circumstances had to be taken into account was probably fatal in and of itself to the taxpayers' argument in light of the feet that the class C directors held a bare 80 percent of the vote on the Alumax board; any diminution of Amax's power would have voided consolidation. Nonetheless, the Tax Court went through a painstaking analysis of each of the special voting arrangements in reaching its conclusion.

First, the Tax Court looked to the stockholder restricted and director restricted matters on which a class vote was required. The Tax Court emphasized that these were matters on which under Delaware law the Alumax board of directors was required to vote, but on which the vote or approval of the Alumax stockholders was not required under Delaware law. The Tax Court emphasized that these matters were not similar to the matters on which the preferred stockholders had the right to vote in Erie Lighting; the preferred stockholders in Erie Lighting could not control management of the business enterprise, which was reserved to the board of directors under Delaware law.

Another argument raised by the taxpayers was that these matters should be ignored because they were "extraordinary" or "highly unusual" matters and not part of the "day to day" matters on which the board of Alumax could, and did, vote. Thus, the taxpayers contended that these special voting rights should not be taken into account.

The Tax Court addressed this argument in several fashions. First, the court noted that to the extent that the taxpayers based their argument upon the actual exercise of these class voting rights, it is not the exercise of a power but its existence that determines voting control. Second, even if the restricted matters were extraordinary or highly unusual, they were nonetheless board management matters under Delaware law, so that shareholder approval was not required. Third, that these were generally major matters did not aid the taxpayers; indeed, the importance of these matters showed how much power the Mitsui Group had on Alumax's board.

Second, the Tax Court considered the importance of the mandatory dividend provision. The IRS contended that the determination whether to declare and pay dividends was one of the board management matters on which the Alumax board would have had the power to vote were it not for the mandatory dividend rule, which required annual dividends equal to 35 percent of Alumax's net income. The taxpayers contended that this provision should be disregarded on the grounds that it was similar to (and as innocuous as) the restrictions placed on boards of directors by debt instruments or preferred stock.

The Tax Court rejected the taxpayers' arguments because contractual restrictions on paying dividends, such as arise under a debt instrument or preferred stock, are a logical extension of the management matters entrusted to a board of directors, whereas the power to declare dividends is a management right itself. The alienation of this right of the board of directors to determine whether to declare and pay dividends was viewed by the Tax Court as different from the contractual limitations on the amount of dividends that could be declared as a result of debt covenants or preferred stock.(12)

Third, the Tax Court weighed the importance of the "objectional action" provision, under which the Mitsui Group had a virtual veto over any matter approved by the board of directors that had a material and adverse effect on the Mitsui Group. The taxpayers contended that this provision should be ignored because it created only a contingent right to acquire additional voting power, which is comparable to the contingent voting rights held by the preferred stockholders in Erie Lighting.(13)

The Tax Court rejected this argument, too, concluding that there were significant distinctions between the rights held by the Mitsui Group under the director objectionable action provision and the rights held by the holders of contingent rights in the authorities on which the taxpayers relied. Contrary to the taxpayers' claims, the objectionable action provision did not give the Mitsui Group merely additional contingent voting rights; the provision gave the Mitsui Group the legally enforceable right to negate the exercise of the power of the Alumax board on any director nonrestricted matter which the Mitsui Group believed could materially and adversely affect the value of its investment in Alumax. As a practical matter, this provision prevented the Alumax board, and the class C directors, from having effective power to take action on any director nonrestricted matter.

Accordingly, the Tax Court concluded on the basis of the facts in Alumax that all of the rights which were given to the Mitsui Group -- the director and stockholder class voting rights, the mandatory dividend provision, and the director objectionable action provision -- reduced the voting power of the class C stockholders in the Amax Group. As a result, the taxpayers had failed to establish that the class C common stock gave Amax at least 80 percent of the voting power in Alumax.(14) Therefore, consolidation was not permitted.

Analysis

The Tax Court appears to have reached the right conclusion in Alumax when it determined that Amax did not control Alumax. The special voting arrangements afforded to the Mitsui Group, through a combination of class voting and "objectionable action provisions," effectively gave the Mitsui Group a veto over any action that the board of directors wanted to undertake. It was not difficult for the Tax Court to conclude that the directors elected by the class C stockholders did not really control Alumax.

Another important, albeit unstated, factor in Alumax could have been the corporation's history. Prior to 1984, the Mitsui Group owned half of the stock of Alumax and, as a result, had half of the value of Alumax as well as an effective veto over any corporate actions. The 1984 restructuring maintained the 50/50 split as far as value went, but it allegedly gave Amax 80 percent of the voting power in Alumax. All the restrictions placed on the board of directors in the 1984 restructuring, however, effectively returned to the Mitsui Group most of the powers it had prior to 1984. It was not difficult for the Tax Court to conclude that the 1984 restructuring had not, in substance, changed the shared control over Alumax.

These considerations were important to the Tax Court in applying the facts-and-circumstances test that it established for voting power in Alumax. Put simply, the arrangement that Amax and the Mitsui Group conjured up for Alumax was almost "too cute" and, as a result, was not respected.

The problem with the Tax Court's decision in Alumax is that it contains broad language that could affect everyday situations that are not as troublesome as the one presented in Alumax. The Tax Court stated that any approval right given to a group of shareholders to restrict the rights of a board of directors under local law could be viewed as a "voting right" that has to be taken into account in determining voting power. If this language were broadly applied, it could have an adverse effect on numerous, non-abusive transactions.

Two scenarios readily come to mind. Lenders are always concerned that a borrower will declare bankruptcy. To prevent a bankruptcy filing, lenders often take numerous steps in documenting a loan.(15) First, of course, the maturity of the loan will be accelerated upon a bankruptcy filing. Second, the borrower is often asked to covenant against a voluntary bankruptcy filing. Third, the lender often asks for the creation of a special class of preferred stock that will be entitled to a "class vote" prior to the occurrence of a bankruptcy filing.

Another common scenario involves minority shareholders. The minority shareholders of a corporation frequently ask for "super-majority" voting provisions with respect to certain corporate matters, such as a sale of the assets of the corporation or the approval of contracts between the corporation and persons related to the controlling shareholder. The effect of these "super majority" provisions is usually to give the minority shareholder an effective veto over any such actions.

If a minority shareholder owns 20 percent of the stock of a corporation that is a member of a consolidated group, the IRS could conceivably argue on the basis of Alumax that these "extra" voting rights afforded to the minority shareholder reduce the voting power of the majority shareholder below the required 80-percent level. Likewise, if a corporate lender has a veto right with respect to a bankruptcy filing by an 80 percent-owned corporate subsidiary, arguably the majority shareholder possesses less than 80 percent of the voting power if all matters are considered.

The broad language used by the Tax Court in Alumax should not affect these "normal" situations. Indeed, the IRS itself acknowledged in Alumax that the voting power of directors was, in most situations, the most important consideration in determining voting power. The rights given to lenders and shareholders may technically circumscribe the powers of the corporation's board of directors, but the non-tax reasons for these rights have to be taken into account.

Indeed, the best way to distinguish Alumax from these situations is to look at the origin of the special voting provisions. Alumax presented an unusual situation in that the Mitsui Group was attempting in substance to retain the 50-percent voting power it previously had while nominally giving 80 percent of the voting power over Alumax to Amax so that Alumax and Amax could be consolidated for tax purposes. In contrast, in situations in which a lender or a minority shareholder insists upon a veto right with respect to certain corporate actions, there rarely is a tax motivation for the requested veto right. It would be ironic if the tax laws somehow prevented the protection of lenders and minority shareholders by barring the usage of special voting rights that in some fashion dilute the power of the corporation's board.

For tax practitioners, the lesson to be learned from Alumax is the familiar one that there must be business reasons, and not merely tax motivation, underlying every transaction. The 1984 restructuring of Alumax appears to have been undertaken merely to provide for consolidation with Amax, with the retained powers and control of the Mitsui Group being thinly disguised. If the 1984 restructuring had been "real" and effected for bona fide business purposes, the Tax Court might have reached a different conclusion concerning the tax effect of the voting arrangement. Likewise, tax practitioners who are considering the tax consequences of business transactions, including particularly the granting of special rights to lenders and minority shareholders, should not be over-concerned so long as there is a bona fide business reason for the arrangement.

(1) Except as otherwise indicated, all statutory references are to the Internal Revenue Code of 1986, as amended (the Code).

(2) The matters that the court determined were usually reserved to stockholders included increases or reductions of capital stock of the company, increases in its capital indebtedness, the number of directors serving on ELC's board of directors, the place of its principal office, and the time of its stockholder meetings.

(3) In their capacity as shareholders of Alumax, Amax and its subsidiaries are referred to as the Amax Group.

(4) Mitsui Japan and Mitsui USA are referred to collectively as Mitsui.

(5) Alumax's net worth was over $730 million, so that approval was required for asset acquisitions and dispositions of $36 million or more.

(6) There was a special dispute provision under which Amax could dispute whether a decision by the board of directors could have an adverse effect on the Mitsui Group. If such a challenge were filed, a panel of arbitrators was to decide within 14 calendar days whether any action of the Alumax board could have a material and adverse impact on the Mitsui Group. If the panel were to decide in that time frame in Amax's favor, then the decision went into effect and Mitsui could not purchase the class C shares from Amax (unless Amax converted them into class A shares). On the other hand, if the panel held against Amax, or if the panel did not decide the challenge in Amax's favor within the 14-day period, the proposal would not become effective and Mitsui would have the right to purchase the class C shares from Amax.

(7) Because the Tax Court concluded that the 80-percent voting power test was not satisfied in 1984, the special transition rule did not apply; hence, consolidation for 1985 and 1986 had to be determined under the 80-percent vote and value test.

(8) In the alternative, the taxpayers argued that even if the court were to consider the director and stockholder class voting requirements, the mandatory dividend provisions, and the objectionable action provision, the voting power of the Alumax class C common stock could not be reduced below 80 percent because those requirements and provisions did not "meaningfully impair" the power of the Alumax board.

(9) Shareholder matters included increases or reductions of capital stock, increases in capital indebtedness, the number of directors, the place of a corporation's principal office, and the time of stockholder meetings.

(10) Arguably, the amount of a corporation's debt and the location of its principal office should be viewed as management decisions that do not directly affect shareholders, but this distinction was ignored by the court.

(11) The Tax Court concluded that the evidence provided by two experts in Delaware corporate law, one for the taxpayers and one for the IRS, were not helpful in making this determination.

(12) The Tax Court distinguished the preferential dividend requirement in Erie Lighting on the grounds that the ELC board was not required to pay a dividend; rather, the ELC board was required to pay dividends first to the preferred stock if and when the ELC board determined to pay dividends at all.

(13) The taxpayers also relied on Atlantic City Electric Co. v. Commissioner, 288 U.S. 152 (1933) (redeemable voting preferred stock treated as voting stock unless and until it is redeemed); Vermont Hydro-Electric Corp. v. Commissioner, 29 B.T.A. 1006 (1934) (preferred stock not voting stock even though it was entitled to certain voting rights upon the occurrence of certain events); and Rev. Rul. 64-251, 1964-2 C.B. 338 (unexercised warrants to purchase stock in a corporation do not constitute stock ownership).

(14) The Tax Court also concluded that the taxpayers had not established that the class C common stock gave Amax 80 percent of the value of Alumax during 1985 and 1986, so that consolidation was not permitted in those years under both the "vote" and "value" tests.

(15) Because bankruptcy is a right under the Constitution, the effect of these provisions is not clear.

RICHARD M. LIPTON is a partner in the Chicago law firm of Sonneschein, Nath & Rosenthal. He is a frequent lecturer on corporate tax issues, and has published articles in numerous publications. His article on the investment company rules in the Taxpayer Relief Act of 1997 appeared in the January-February 1998 issue of The Tax Executive.
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Title Annotation:Tax Court decision
Author:Lipton, Richard M.
Publication:Tax Executive
Date:Mar 1, 1998
Words:7360
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