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

• Author: Lipton, Richard M.
• Position: Tax Court decision

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...