Opinion

JUSTICE O'CONNOR, with whom THE CHIEF JUSTICE joins, dissenting.

Today the Court holds that the merger of a stock savings and loan association into a mutual savings and loan association does not qualify as a tax-deferred reorganization under § 368(a)(1)(A) of the Internal Revenue Code. Although the merger meets all the statutory requirements, and although all courts that considered similar transactions before this case found they qualified as tax-deferred reorganizations, see ante at 469 U. S. 132 -133, and n., the Court nevertheless concludes that such a merger fails to qualify under a refined interpretation of the judicially imposed "continuity-of-interest" doctrine. This holding introduces an unfortunate and unnecessary element of uncertainty into an area of our income tax laws where clear and consistent precedent is particularly helpful to both taxpayers and tax collectors. Because I find the Court's holding unwise as a matter of policy and unwarranted as a matter of law, I respectfully dissent.

The Court concedes that the merger of Commerce Savings and Loan Association of Tacoma, Wash. (Commerce), into Citizens Federal Savings and Loan Association of Seattle (Citizens) met the literal terms of the Internal Revenue Code to qualify the merger for treatment as a tax-deferred reorganization. Ante at 469 U. S. 135. Indeed, the merger between Commerce and Citizens satisfies the statutory definition of a reorganization in § 368(a)(1)(A), and the Citizens mutual share accounts meet the statutory definition of stock in § 7701(a)(7). Nevertheless, the Court refuses to accord the merger the benefits of § 368(a)(1)(A) because of the "continuity-of-interest" requirement as currently codified in Treas. Regs. §§ 1.368-1(b) and 1.368-2(a), 26 CFR §§ 1.368-1(b) and 1.368-2(a) (1984). Ante at 469 U. S. 136. The Treasury Regulations, codifying the requirements of this Court's decisions in Gregory v. Helvering, 293 U. S. 465 (1935), and Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U. S. 462 (1933), provide tax-deferred status for the acquiring corporation when it continues the business of the acquired corporation or utilizes a substantial part of its assets. Treas. Regs. §§ 1.368-1(b) and (d)(2), 26 CFR §§ 1.368-1(b) and (d)(2) (1984). Similarly, the shareholders of the acquired corporation need not immediately recognize any gain from the transaction as long as they retain a continuing proprietary interest in the surviving corporation. Ibid.

Here, all concede that Citizens continued the business of Commerce after the merger. The sole issue is whether the Commerce stockholders retained a continuing proprietary interest when they received mutual share accounts in Citizens in exchange for their Commerce guaranty stock. The Court concludes that they did not.

The continuity-of-proprietary-interest doctrine "was born of a judicial effort to confine the reorganization provisions to their proper function." B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders 14.11 (4th ed.1979). The cases establish that the owners of an acquired corporation must immediately recognize any gain from a merger unless they receive an equity interest in the surviving business that represents a substantial part of the value of the property transferred. Pinellas Ice & Cold Storage Co. v. Commissioner, supra, the first relevant authority of this Court, established that receipt of short-term promissory notes were not securities for purposes of a reorganization. The Court stated that

the seller must acquire an interest in the affairs of the purchasing company more definite than that incident to ownership of its short-term purchase-money notes

to qualify as a reorganization. Id. at 287 U. S. 470. Three Terms later, in Helvering v. Minnesota Tea Co., 296 U. S. 378 (1935), the Court upheld as a reorganization the transfer of the corporate assets in exchange for voting trust certificates representing common stock plus almost an equal amount of cash. The Court there said:

[The] interest must be definite and material; it must represent a substantial part of the value of the thing transferred.... * * * * The transaction here was no sale, but partook of the nature of a reorganization in that the seller acquired a definite and substantial interest in the purchaser. True it is that the relationship of the taxpayer to the assets conveyed was substantially changed, but this is not inhibited by the statute. Also, a large part of the consideration was cash. This, we think, is permissible so long as the taxpayer received an interest in the affairs of the transferee which represented a material part of the value of the transferred assets.

Id. at 296 U. S. 385 -386.

Shareholders maintained a sufficient continuity of proprietary interest when corporate assets were exchanged for 38 percent nonvoting and redeemable preferred stock and 62 percent cash. John A. Nelson Co. v. Helvering, 296 U. S. 374 (1935). But consideration consisting wholly of the transferee's bonds was held to make the bondholders merely creditors rather than proprietary owners of the business. LeTulle v. Scofield, 308 U. S. 415 (1940).

Against this background, the Court concludes that the equity interest represented in the share accounts of a mutual savings and loan is so insubstantial that shareholders who receive such accounts do not retain a sufficient proprietary interest in the enterprise. The basis of the Court's holding is a characterization of the mutual share accounts as "hybrid instruments" having both equity and debt characteristics, ante at 469 U. S. 138. The Court finds that the debt characteristics outweigh the equity characteristics, ante at 469 U. S. 140, and concludes that the equity interest received does not represent "a substantial part of the value of the thing transferred." Helvering v. Minnesota Tea Co., supra, at 296 U. S. 385.

I agree that a mutual share account is a hybrid security, and that it has substantial debt characteristics. The opportunity to withdraw from the account after one year cloaks the account holder with some of the attributes of a creditor, and the account with some of the attributes of debt. I nevertheless believe that the equity interest represented in a mutual share account is substantial, and thus satisfies the continuity-of-proprietary-interest requirement.

The taxpayers in this case received mutual share accounts and certificates of deposit from Citizens which gave them the same proprietary features of equity ownership which they previously had as stockholders in Commerce, plus the right after a stated interval to withdraw their cash deposits. As the Court recognizes, the guaranty stockholders of Commerce were the equitable owners of the corporation and had a proportionate proprietary interest in the corporation's assets and net earnings. Ante at 469 U. S. 133 -134. When they exchanged their shares for deposits in Citizens, they became the equitable owners of the mutual association. As equitable owners, the mutual share account holders retained all the relevant rights of corporate stockholders: the right to vote, the right to share in net assets on liquidation, and the right to share in the earnings and profits of the enterprise. Indeed, the proprietary interest obtained by petitioners here is more weighty than that obtained by the nonvoting, preferred shareholders in John A. Nelson Co. v. Helvering, supra: The petitioners possess not only the primary voting interest in the continuing enterprise, but also the only interests in existence with proprietary and equity rights in the mutual association. To the extent there is any equity at all in a mutual association, it is represented by the share accounts obtained by the petitioners.

To find that the equity of a mutual association is insubstantial, the Court today looks to each equitable power or attribute of mutual share account ownership to determine its value and the extent to which it is actually exercised. The Court values the debt characteristics separately from the equity characteristics of the same instrument to determine whether the equity interest is a substantial part of the value of the property transferred. The only support for the Court's action of separately valuing the debt and equity aspects of a single instrument is Rev.Rul. 69-265, 1969-1 Cum.Bull. 109. Apparently no court has ever relied on such a distinction with respect to a single instrument. See B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders 4.02, p. 4-7 (4th ed.1979) ("in litigated cases, classification has been treated as an all-or-nothing question, so that instruments have not been fragmented into part equity and part debt"). Nor does this Court's opinion in Minnesota Tea Co., supra, provide any support for the Court's approach today.

The flaw in this approach is most clearly evident in the majority's attempt to explain why a merger between mutual associations qualifies as a tax-deferred reorganization whereas a merger of a stock savings and loan into a mutual association does not. When a more heavily capitalized mutual association is acquired by a thinly capitalized mutual association, the equity component of the value of share accounts will be reduced. Under the majority's separate valuation approach, at some point that value should be reduced so substantially as to defeat claims that a continuing proprietary interest is maintained. The Court avoids this result by noting that

the equity interest represented by the shares received -though small -is equivalent to the equity interest represented by the shares given up.

Ante at 469 U. S. 142. But the same was true when Commerce merged into Citizens. The equity interest represented by the share accounts in Citizens is the sole and complete equity interest in that association, and it was obtained in exchange for shares in Commerce that represented the equivalent sole equity interest in the stock savings and loan association.

The Court's denigration of each of the equity attributes of a mutual share account is also troubling. The Court notes that the ownership interests in Citizens are "spread over all of the depositors" and that the right to vote "is... diluted each time a loan is made, as each borrower is entitled to one vote." Ante at 469 U. S. 138. But such characteristics are by no means confined to mutual share accounts. Dilution of voting power of shareholder equity in all corporations may and frequently does occur with each new stock issue or new class of stock. Yet the threat of dilution has never divested stock of its status as a substantial equity interest. Nor should the fact that mutual accounts are often voted by proxy affect the result: proxy voting, after all, is a common practice among holders of common stock in large corporations as well. Such factors should have no part in the determination of whether the "continuing proprietary interest" test is met. Indeed, this Court has found ownership of non voting preferred stock to provide a sufficient proprietary interest. John A. Nelson Co. v. Helvering, 296 U.S. at 296 U. S. 377.

The Court also finds that the right to share in the profits of the association, through dividends and ownership of a share of the assets and undistributed profits of the association, is not controlling. The majority downplays the shareholders' interest in the assets and undistributed profits, a right that is solely one of ownership. It finds that the dividends paid to the shareholders are analogous to interest paid to bank depositors because the dividends are paid at a fixed, preannounced rate and are treated as interest for some other tax purposes. Ante at 469 U. S. 138 -139. These dividends, however, cannot be properly equated with interest on bank deposits because shareholders have no enforceable legal right to compel the payment of dividends. That the amount of the dividend is preannounced at a suggested rate is not significantly different from preannounced dividends paid by many large corporations, particularly on preferred stock. Although the majority notes correctly that dividends on share accounts are treated like interest on bank accounts for purposes of deductibility by the association as business expenses for income tax purposes, I.R.C. § 591, the reason for this treatment is unrelated to the classification of mutual shares as equity. Prior to 1951, mutual associations were exempt from income tax. 26 U.S.C. § 101 (1946 ed.). The Revenue Act of 1951, 65 Stat. 452, removed the exemption and provided for the deduction of dividends from the taxable income of the association to prevent the accumulation of tax-exempt income in the associations. Note, Reorganization Treatment of Acquisitions of Stock Savings and Loan Institutions by Mutual Savings and Loan Associations, 52 Ford.L.Rev. 1282 (1984). Tax treatment of the dividends to the association is simply irrelevant to the classification of the instrument received by the shareholder for purposes of determining his proprietary interest.

Finally, the majority concludes that the right to participate in the proceeds of a solvent liquidation is "not a significant part of the value of the shares" because the possibility of a liquidation is remote. Ante at 469 U. S. 139. The task at hand is to classify the nature of the mutual share account; the market value of the share account on liquidation is a separate question. The remoteness of the contingency of liquidation cannot reasonably be dispositive of the equity character of the right of the shareholders. The likelihood of liquidation will vary with the particular association and the prevailing economic climate, but the character and nature of the right will not change. To the extent that a mutual association has assets in excess of its liabilities, the share account holders have a right to a proportionate share of those assets in the event of liquidation.

Having unpersuasively attempted to argue away the equity characteristics of the mutual share accounts, the Court then finds that the debt characteristics outweigh the equity characteristics, concluding that the equity value is "practically, zero." Ante at 469 U. S. 140. The Court's reasoning suggests that, no matter how much capital a mutual association possesses, the equity value of its shares is insubstantial because no one would pay more for the shares than their face value. This result is preordained by the Court's unsupported determination that the value of the "nonequity" features is equal to the face value of the account. By definition, nothing can be left to allocate to the equity features. A more realistic analysis would acknowledge that the equity aspects of a hybrid instrument are intertwined with the debt aspects and cannot be valued in isolation.

The result reached by the Court today is inconsistent with the tax-deferred treatment accorded mergers between two mutual associations or between a stock association and a mutual association when the stock association is the survivor. Compare Rev.Rul. 69-6, 1969-1 Cum.Bull. 104 (merger of a stock association into a mutual association is a sale of assets), with Rev. Rul. 69-3, 1969-1 Cum.Bull. 103 (merger of two mutual associations qualifies as a tax free reorganization), and Rev.Rul. 69-646, 1969-2 Cum.Bull. 54 (merger of mutual association into stock association qualifies as a tax free reorganization). And because a transaction that is a sale rather than a tax-deferred exchange at the shareholder level cannot qualify as a tax-deferred reorganization at the corporate level, see I.R.C. §§ 361 and 381, the result of the Court's holding is to discourage an entire class of legitimate business transactions without regard to the desirability of such mergers from an economic standpoint. This result is directly contrary to the intent of Congress.

Congress... adopted the policy of exempting from tax the gain from exchanges made in connection with a reorganization, in order that ordinary business transactions [would] not be prevented on account of the provisions of the tax law.

S.Rep. No. 398, 68th Cong., 1st Sess., 14 (1924).

The Court's opinion also has ramifications beyond mutual associations. This case presents the first opportunity for the Court to consider the use of hybrid instruments in reorganizations. Previously, the Court has held that the receipt of stock, whether common, voting, or nonvoting preferred, satisfies the continuity-of-interest test. If the Court is to now examine the actual exercise of the proprietary rights conferred by ownership of a particular security, it will inevitably reach conflicting results in similar cases. Predicting the tax consequences of reorganizations undertaken for a valid business purpose will become increasingly difficult. I would adhere to precedent and to a clear test and hold that a hybrid instrument which has the principal characteristics of equity ownership should be treated as equity for purposes of the continuity-of-proprietary-interest requirement. If the value of that instrument considered as a whole represents a substantial part of the value of the property transferred, in my view the continuity-of-interest requirement is satisfied and the transaction should qualify as a tax-deferred reorganization. I, therefore, dissent.