DITTER, D. J.
The question in this case is whether certain debentures which purported to evidence corporate indebtedness were, for federal income tax purposes, in reality shares of stock. Contending payments to debenture holders were interest, the corporation took deductions which were disallowed by Internal Revenue. The tax difference was then paid and this suit brought for its recovery. A jury having found against the taxpayer, appropriate motions for post trial relief are now before the court. I conclude that judgment for plaintiff, notwithstanding the verdict, must be awarded.
Fischer Machine Company is a Pennsylvania corporation that builds and sells machines and parts. In 1946 it created a wholly owned subsidiary, Sicorp, to market patented addressing machines under the name "Scriptomatic."
Sicorp entered into an agreement with Resources and Facilities Corporation (REFAC) in 1959 to market these addressing machines overseas. The founder and president of REFAC is Eugene M. Lang. In 1960, he and Sicorp organized a Switzerland corporation, Scriptomatic S.A., to market Scriptomatic products in Europe. Lang held 25 per cent and Sicorp 75 per cent of the new company.
By 1962 Herbert W. Leonard was president of Sicorp. He had been employed by the company since 1951 and was principally responsible for the growth of its business. George Kooch was also employed by Sicorp in the middle 1950's and by 1962 was responsible for the production side of its operations.
In the late 1950's and early 1960's, Sicorp's business flourished. By 1962, however, it became apparent that computers would soon wrest away the market served by the large-sized Scriptomatic machines and that Sicorp would have to develop another market to survive. As a result, Leonard and Kooch produced two new machines that could be sold to small companies needing addressing service but which could not afford an expensive computer system. At the end of 1962, about a dozen of the smaller, less expensive machines had been sold, and Sicorp's executives felt it was in a favorable position to gain a good share of the addressing machine business. This was estimated to be somewhere between $125,000,000. and $200,000,000. a year. Lang testified that the overseas addressing market was as large as that of the United States and prospects for a significant share were good since the competition would be less severe.
In discussing a transition from large to small machines, Leonard discovered that Fischer's owner was reluctant to invest the additional capital required and was considering the sale of Sicorp. He then requested and received an option to purchase the company. Leonard contacted Lang and with him agreed to form a group of investors for the acquisition of Sicorp.
Lang in turn went to Walter Mann, an individual with great entrepreneurial and financial experience, who had assisted Lang in forming another successful company some years before. Given the leadership of this enterprise, Mann quickly got in touch with various individuals and institutional investors. After a series of negotiations, Leonard, Kooch, Lang, and Mann concluded that the demands of prospective institutional investors were unacceptable and so they decided to go ahead and exercise the option, obtaining the money necessary to purchase the corporation from their own resources and those of their friends.
As a result, Fischer and Mann, who acted as agent for the group of investors, entered into an agreement. By its terms, the investors purchased the whole business of Sicorp including assets, goodwill, and trademarks. Fischer's inventory of addressing machine parts was to be paid for by a series of notes, retirable over a two year period, and payments for Fischer's patents were in accordance with a royalty arrangement. Thus, a new corporation, Scriptomatic, Inc., came into existence.
Originally it was planned that Leonard, Kooch, Lang and Mann were to get 33 1/3 percent of the common stock while other investors were to get 66 2/3 percent. This division was based on the fact that Leonard and Kooch not only contributed the option to purchase Sicorp but their managerial abilities which were essential to the future success of Scriptomatic. Lang and Mann, on the other hand, received their shares for promoting the successful financing of the company. However, the investors decided that Leonard and Kooch should be provided with an incentive. Therefore, approximately five per cent of the shares were placed in escrow on the understanding that Leonard and Kooch would receive them contingent upon Scriptomatic's achieving $100,000. of net retained earnings by 1966. This was readily accomplished in a much shorter time so that the actual capitalization of Scriptomatic, as modified by the escrow agreement, was as follows:
Number of Shares Percentage
Herbert Leonard &
George Kooch 2,205 28%
Eugene Lang 551.25 7%
Walter Mann 262.50 3 1/3%
Other Investors 4,856.25 61 2/3%
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