THE INTERNAL REVENUE CODE OF 1954 FRIDAY, APRIL 16, 1954 UNITED STATES SENATE, The committee met, pursuant to recess, in room 312, Senate Office Building, at 10:10 a. m., Senator Eugene D. Millikin (chairman) presiding. Present: Senator Millikin, Flanders, Carlson, Frear, and Long. The CHAIRMAN. Mr. Herrmann, will you identify yourself for the record, please? STATEMENT OF DAVID W. HERRMANN, PRESIDENT, NATIONAL ASSOCIATION OF SHOE CHAIN STORES, ACCOMPANIED BY EDWARD ATKINS, EXECUTIVE VICE PRESIDENT Mr. HERRMANN. Mr. Chairman, Senators of the committee, my name is David W. Herrmann. I am vice president of the Melville Shoe Corp. of New York, which operates 794 stores throughout the United States and 12 factories in New Hampshire and Massachusetts. The CHAIRMAN. How many stores? Mr. HERRMANN. 794. The CHAIRMAN. You make your shoes where? Mr. HERRMANN. Primarily in factories located in New Hampshire and Massachusetts. New England. I am president of the National Association of Shoe Chain Stores, and am appearing in behalf of that association, and the American Retail Federation, representing their position on section 359 and related sections of the Internal Revenue Code of 1954, designated as H. R. 8300. Descriptions of both of the aforementioned retail groups and their memberships are appended to this statement. Those responsible for H. R. 8300 are to be complimented on the magnitude of the task they assumed, and the general results of this gigantic effort, in effecting a major revision of the existing code. H. R. 8300 is to be more commended than criticized, but it is inevitable that in drafting volumes of tax legislation, a number of flagrant inequities will appear. Although sections 351 to 373, under the title of "Corporation Organizations, Acquisitions, and Separations," contain a number of clarifications helpful to taxpayers, our opposition is directed to the provisions of section 359 and related sections, dealing with mergers, consolidations, and corporate acquisitions. I will hereafter use these terms interchangeably. As a result of these provisions, relatively large corporations can no longer acquire the assets, or the stock, of relatively smaller corporations in a tax-free statutory merger or consolidation. Two publicly held corporations may merge or consolidate in a tax-free transaction. However, even in this instance, many corporations whose securities are traded on the major stock exchanges would not fall within the definition of a "publicly held corporation," which states: A corporation will be deemed to be publicly held unless 10 or fewer shareholders own more than 50 percent either of the total combined voting power or of the total value of all classes of stock of the corporation. A publicly held corporation could not consolidate tax-free with a closely held corporation unless the stockholders of the transferor corporation received at least 20 percent of the participating stock—after consolidation of the acquiring corporation. This imposes an almost impossible, if not purely academic, requirement which virtually outlaws consolidations or mergers between publicly held corporations and closely held corporations. The CHAIRMAN. Give me some idea of the stock structure of your association. Who owns your stock? Mr. HERRMANN. The association is made up primarily of chainstore organizations, operating in the shoe business. The CHAIRMAN. Is it a true association, or do you have stock? The CHAIRMAN. Very well, go ahead. Mr. HERRMANN. It is incorporated and tax-exempt under the code, sir. I am not an attorney, but as a businessman, will address myself primarily to the equities and economics involved in those provisions of section 359 relating to consolidations and mergers. Most statutory consolidations or mergers take the form of acquisition by a corporation of the stock, or assets, of another in exchange for part of its voting stock. Under the provisions of section 359, few mergers, involving closely held or privately owned corporations, would ever have been effected. In only exceptional and isolated instances would the greatest portion of these mergers have qualified for tax-free status. The tax impact would have precluded most of them. In a majority of instances, a closely held corporation is consolidated or merged with a publicly held corporation. It is this typical transaction most adversely affected by the restrictions imposed in section 359. Consolidations or mergers are undertaken for a number of reasons recognized by law, and recognized as sound, economically. Considerations accruing to the advantage of the stockholders of a closely held corporation include the following: 1. Additional financial resources. 2. Acquiring capital for business needs and expansion. 3. Increased efficiency through an exchange of personnel, methods, and research, which a small corporation might not be able to afford. 4. Acquisition of more readily marketable stock. 5. Continuity of the business in the event one or more key executives die, and heirs are incompetent to run the business. 6. Insuring the ability to meet estate taxes, without sacrificing the business through forced sale. Advantages to the acquiring corporation include: 1. Diversification. 2. Acquisition of capable management. 3. Expansion which might otherwise require many years to effect. 4. Economies resulting from combined operations, resulting in increased net profits. 5. The elimination of losses usually incurred in launching a new enterprise. All of these considerations are vital to the business involved, and generally result in higher taxable corporate income for the Govern ment. In the report of the Committee on Ways and Means, the sole justification for section 359 is contained in the following statement: Publicly held corporations usually have a corporate existence separate from that of their shareholders and, as a rule, do not merge or consolidate with a view to the tax advantages which may result therefrom at the shareholder level. There is ample evidence, however, that closely held corporations may undertake these transactions solely in the hope of distributing earnings to shareholders at capital gains rates. It appears from the aforementioned statement, that Government is requesting legislation to kill dozens, maybe hundreds, of legitimate transactions, when it already possesses more direct means to deal with the situation which section 359 attempts to reach by indirection. Section 102 may be invoked in cases of unnecessary accumulation of surplus, which may be taxed as provided in the act. If surplus is necessary in the conduct of a business, it will not be paid out, in any event, and no tax will arise at the stockholder level. The CHAIRMAN. Give us an example of your operations. Mr. HERRMANN. The operation of the corporation that I— The CHAIRMAN (interposing). Your National Association of Shoe Chain Stores. Mr. HERRMANN. Our National Association of Shoe Chain Stores represents practically all of the accredited shoe chains in the United States. We endeavor to implement a program of research for the benefit of the association members. We endeavor to interpret legislation for the benefit of the association's members. We run a style show each year for the purpose of creating general style uniformity in the industry, and giving the association's members the benefit of research by expert stylists who are hired to do a job which some members could not afford to pay for. The CHAIRMAN. What is the financial relationship between your association and the Foot Comfort Shoe Store of Keokuk, Iowa? Mr. HERRMANN. The financial relationship of the association to the average shoe store is on a basis of dues, very low dues, which are predicated on covering the expenses of the association. It is a nonprofit association, and it is an association that is run entirely for the benefit of its membership. The CHAIRMAN. Do you direct their operations? Mr. HERRMANN. We have an executive secretary, Mr. Edward Atkins, who actively directs the operation. We elect new officers, every 2 years, who are representatives of the association's member companies. The CHAIRMAN. What is the obligation of the shoe store toward the association? Mr. HERRMANN. The obligation of a shoe store toward the association is voluntary. The stores, or the chains, pay dues up to approximately $2,000 for the larger chains, based on the size of the company and starting with $100, which is a nominal membership. The CHAIRMAN. You don't own any of the stock! Do you have any ownership interests, stock or otherwise, in any of the companies that you serve? Mr. ATKINS. Mr. Senator, may I interrupt? The CHAIRMAN. Yes. Mr. ATKINS. I am Edward Atkins, executive vice president of the association. I think I sense the direction of your question. May I say this: No officers of the association, neither paid or unpaid, own stock in other members of the association, except the companies which they happen to be affiliated with. The association, itself, controls no stock in any member company. Is that your question? The CHAIRMAN. I believe so. I am still somewhat confused. Mr. ATKINS. We are just a typical trade association like several thousand others. The association, itself, has no financial control over any of its members. The CHAIRMAN. Proceed, please. Mr. HERRMANN. Thank you. Up to the present time, it has been regarded economically and legally sound to put one's estate in good order, to create maximum liquidity, so that the heirs and, incidentally, the Government's interest in estate taxes, are adequately protected. If section 359 becomes law, two lamentable results are inevitable. A business, which might otherwise be merged with another, will not be, because of the tremendous tax impact on stockholders. It will face the possibility of sale subsequent to the death of one or more key stockholders, in order to meet estate taxes. It may be sacrificed under pressure, a lower estate valuation will result, and the Government will incur a loss in revenue. Or, the business may be merged with a publicly held corporation; the profit to the stockholders of the transferor corporation will be taxed at capital gains rates based on the market value of the stock exchanged, and more often than not, a large block of the stock received will be sold within the fiscal year to satisfy the tax liability accruing. This might easily depress the market, affecting thousands of innocent stockholders. As a result, stockholders of many companies, aware of these consequences, will become reluctant to approve mergers, regardless of corporate advantage. In the case of highly desirable acquisitions, purchase prices would have to be stepped up to meet the tax liability resulting from the exchange. It is quite conceivable that in the cases of many closely held corporations whose stocks carry a characteristically low base, the purchase price would have to be advanced as much as 33 percent. This would tend to make many worthwhile mergers impossible to complete. Many closely held corporations, especially the type most likely to be involved in mergers, are relatively large, with their shares actively traded on the exchanges, or over the counter, and with their stock widely distributed and held by thousands of stockholders, and I am at this point citing an example with which I am very familiar. The following example is by no means unusual in the case histories of consolidations or mergers. Corporation X, a closely held corporation, according to the definition in section 359, was merged, in 1952, with corporation Y, a publicly held corporation, in a statutory consolidation. Corporation X had approximately 475,000 common and preferred shares outstanding, a net worth over $7 million, and a list of about 2,000 stockholders. Corporation Y had 2,400,000 common shares outstanding, a net worth of $23 million, and over 15,000 stockholders. There were a number of advantages for both organizations inherent in the merger: Diversification, a new medium of expansion, and the ecquisition of management with a fine record of achievement, evidently motivated the larger corporation. Increased efficiency, the backing of larger resources for an expansion program, and greater marketability for the stock evidently motivated the smaller corporation. If section 359 were then law, the merger would not have occurred. Stockholders of the smaller corporation would not have assumed the tax burden. Stockholders of the larger corporation would have been reluctant to create a situation whereby large blocks of stock would have to be thrown on the market to meet the tax obligation. sands of stockholders would have been penalized. Thou The real loser, however, would have been the United States Govern ment. The annual dividends on the common shares of stock of the X corporation have been increased from $1.45 per share annually to $1.80 per shade. The value of the common shares of the X corporation has risen from $17 to $29, with an obvious comparable increase in potential estate taxes. There is no greater justification for taxing stockholders because they changed certificates pursuant to a statutory consolidation, or merger, under section 112 (g) than there is to tax a stock dividend. No real profit can accrue in either instance until the stock is sold. The stated purpose of section 359 is to prevent the distribution of earnings at capital gains rates. But despite this statement in the report, the section then proceeds to impose a tax on the exchange at those very capital gains rates, not only on accumulated earnings, but on the entire amount of stock received in the exchange, to the extent that the value of such stock represents an accretion in value over its original base. Actually, this section imposes a tax on capital. The surplus, and even that part of the capital stock which might have resulted from a transfer of surplus to capital, was taxed at normal and surtax rates in the years in which the earnings occurred. It is now in danger of being doubly taxed at capital gains rates before a share of stock is sold, or a dollar of real or liquidated profit is realized. The proposed section is invidious in its implications. It differentiates between small business and big business. It forbids, or penalizes, the stockholders of a closely held corporation from realizing greater marketability for their stock holdings through consolidation, or merger, and in the same section, gives a green light to publicly held corporations. We should not labor under any illusion about publicly held corporations. They merge for the same justifiable business reasons; but |