Frankford-Quaker has also expanded its capital base. All of these benefits should continue for an indefinite period.
The plaintiff has argued that the legal fees were incurred for services leading up to the rejection of the merger and, as such, confer no benefit on future periods (thereby making them a current expense). Legal fees for the rejection of a merger do not require capitalization ( Sibley, Lindsay & Curr Co., 15 T.C. 106 (1950) Cf. Arcade Co. v. United States, D.C., 97 F. Supp. 942, aff'd, 203 F.2d 230 (6th Cir. 1953) cert. denied, 346 U.S. 828, 74 S. Ct. 48, 98 L. Ed. 352 (1953)). However, the plaintiff has also argued that the fees were paid partly for financial advice for the addition of new members. Since the plaintiff cannot identify the amount expended to investigate and reject the statutory merger, and the amount to investigate the ultimate business combination, there can be no current deduction ( Peaslee-Gaulbert Co., 14 B.T.A. 769 (1928)). There must be some basis upon which an allocation can be made F. W. Drybrough, 45 T.C. 424, aff'd., 384 F.2d 715 (6th Cir. 1967).
The $7,000.00 attorney fees are therefore capital expenditures and the plaintiff is not entitled to a deduction under § 162.
During the fiscal year ending June 30, 1962, Frankford-Quaker paid $25,685.50 to former employees of Penn Mutual. These payments were ostensibly made to obtain a covenant not to compete which was signed by each employee. Some of these covenants were executed by clerical employees without skills which are unique to the grocery industry. Other employees who executed these covenants had spent most of their working lives in the grocery industry. The plaintiff knew that the latter group would obtain employment in the grocery industry, but made no attempt to determine whether the covenant was being honored. Accordingly, we find that no business purpose was served by the execution of these covenants.
The payments were made in accordance with the February 15, 1962 modification of the agreement to combine the businesses. Payment by Frankford was conditioned upon Penn Mutual grocers continuing to purchase at a rate equal to 90% of their purchases from Penn Mutual. The purpose of these payments was to lessen the impact of the termination of operations on Penn Mutual employees who were not being retained. Penn Mutual was not obligated to make these payments. Obviously, Frankford was not obligated to make any payment to Penn Mutual employees until they agreed to do so in the February 15, 1962 agreement.
The questions presented are: 1. what asset or like advantage was acquired as a result of the payment? and 2. what period will benefit from the expenditure?
If any asset or like advantage was acquired by Frankford, it was employee goodwill; a belief by the Penn Mutual employees who were joining Frankford-Quaker that the new company had some paternalistic instincts. Such goodwill would seem to benefit an indefinite future period lasting as long as the employees remained employed by Frankford. We see no difference between payments made for customer goodwill and employee goodwill when it comes to determining the tax treatment of such payments. Both of them are made to obtain a competitive advantage; customer goodwill to obtain future patronage of customers, employee goodwill to obtain future efficiency from less apprehensive employees. Payments made as part of a business combination for customer goodwill have long been recognized as capital expenditures. The Pevely Dairy Co., 1 B.T.A. 385 (1924); Anchor Cleaning Service, Inc., 22 T.C. 1029 (1954); Skilken v. C.I.R., 420 F.2d 266 (6th Cir. 1969). We believe that the same sort of benefit is acquired from payments made as part of a business combination for employee goodwill.
The plaintiff seeks to distinguish these payments from payments for goodwill since they were made directly to terminated employees. It points out goodwill payments are usually made to the acquired corporation. The structure of the transaction, however, makes no difference in determining what asset or like advantage was acquired and what period was benefited. Whether this payment was made by Frankford to Penn Mutual which then distributed it to the employees or whether the payments were made by Frankford directly to the Penn Mutual employees makes no difference in determining what advantage Frankford gained from the payments. The tax law has long recognized substance takes precedence over form. Comm. v. Tower, 327 U.S. 280, 66 S. Ct. 532, 90 L. Ed. 670 (1946).
The plaintiff is therefore not entitled to a deduction under § 162(a) of the $25,685.50 paid to Penn Mutual employees.
On June 29, 1963, the plaintiff paid Quaker $85,000.00 to reimburse Quaker for its loss of income resulting from Frankford beginning to supply 35 to 50 of Quaker's largest customers from its warehouse instead of Quaker's.
Defendant argues this payment "had its origin in the merger" which makes it a capital transaction. It has been recognized that all payments made pursuant to the acquisition of a business are not necessarily acquisition costs. Southern Massachusetts Oil Corp., 1966 T.C. Memo 115, 25 C.C.H. Tax Ct. Mem. 614 (1966). The appropriate analysis to determine whether or not a payment was a capital expenditure is to determine what asset or like advantage was acquired, then determine the period which benefited from that expenditure. The first problem is to determine what asset or like advantage was acquired for the payment. No tangible property was received in exchange for the payment. Nor was the payment made to obtain the customer list of Quaker. Customer lists have long been considered capital assets. Union National Bank, 18 B.T.A. 468 (1929); Manhattan Co. of Virginia, Inc., 50 T.C. 78 (1968); Richard M. Boe, 35 T.C. 720 (1961), aff'd., 307 F.2d 339 (9th Cir. 1962). The members of Quaker had become members of Frankford with their acceptance of the agreement; therefore, Frankford already had access to Quaker's customers before they agreed to make this payment. The payment was made to reimburse Quaker for its loss of marginal income occasioned by the transfer of customers. Both Frankford and Quaker recognized that Quaker's fixed expenses (taxes, administrative salaries, etc.) would continue after Frankford began to service these customers. Without the revenues provided by these customers, Quaker's income would be reduced thereby increasing its operating loss. Similarly, Frankford's fixed expenses would remain the same; it would increase its profits for the current year to the extent its charges to Quaker customers exceeded its incremental costs for such things as packaging and delivering. The advantage that Frankford obtained from this transaction was a $90,364.00 increase in profit for the period. In exchange for that advantage, they paid Quaker $85,000.00, which approximated Quaker's loss of marginal income of $84,199.00.
In Interstate Transit Lines v. C.I.R., 319 U.S. 590, 63 S. Ct. 1279, 87 L. Ed. 1607 (1943), rehearing denied, 320 U.S. 809, 64 S. Ct. 26, 88 L. Ed. 489 (1943), the United States Supreme Court refused to permit a corporation to deduct the reimbursement of a subsidiary's operating loss as an ordinary and necessary expense. After acceptance of the February 5, 1962 agreement, Quaker could be considered a subsidiary of Frankford. Shareholders of 80% of Quaker's stock executed assignments to Frankford. Further, paragraph 3(e) of the agreement provided, "Quaker shall be operated as a subsidiary of Frankford". The existence of the parent subsidiary relationship, however, was not controlling in Interstate. While the court acknowledged that the profit earned by the subsidiary would increase Interstate's profits, it pointed out, "The assumption of the deficit was not dependent upon a corresponding service or benefit rendered to the petitioner." The tax court has permitted the parent to reimburse his subsidiary for operating losses where it served as an adjustment to the price of goods furnished by the subsidiary to the parent, ( Fishing Tackle Products Co., 27 T.C. 638 (1957)), and where the subsidiary performed services exclusively for the parent ( Texas and Pacific R.R., 1 C.C.H. Tax Ct. Mem. 863, (1943)).
In the case sub judice like Interstate, no goods were sold nor services rendered by Quaker to Frankford. The court recognized in Deputy v. Du Pont, 308 U.S. 488, 493, 60 S. Ct. 363, 366, 84 L. Ed. 416 (1939), the deductions did not turn upon equitable considerations, but depend upon legislative grace requiring "a clear provision therefor" if they are to be allowed. "[The] taxpayer who sustained the loss is the one to whom the deduction shall be allowed. Had there been a purpose to depart from the general policy in that regard, and to make the right to the deduction transferrable or available to others than the taxpayer who sustained the loss, it is but reasonable to believe that purpose would have been clearly expressed." New Colonial Ice Co. v. Helvering, 292 U.S. 435, at 440, 441, 54 S. Ct. 788, at 791, 78 L. Ed. 1348 (1934). Further, the fact that payments were made pursuant to a binding legal obligation does not control their tax treatment. White v. Fitzpatrick, 193 F.2d 398 (2d Cir. 1951).
Quaker sold no goods nor rendered any services to Frankford which would permit it to reimburse the operating loss under the court's adjustment of price theory. In exchange for the agreement to reimburse the loss, Frankford did receive the right to service Quaker's largest customers for one year without having to serve its smaller ones. The record shows that this right did benefit Frankford in that profits increased by some $90,000.00. At first glance, it appears that this right is a nullity. The terms of the February 5th agreement provide:
"3(c) Active Quaker retail grocers who accept the exchange shall become members of Frankford-Quaker Grocers Association.
(e) Quaker shall be operated as a subsidiary of Frankford and active Quaker Retail Grocers shall be serviced by Quaker in distribution of food and merchandise so long as the Board of Directors of Frankford shall determine.