William E. Cherry v. Reagan Farr, Commissioner of The Department of Revenue For the State of Tennessee

IN THE COURT OF APPEALS OF TENNESSEE
AT NASHVILLE
January 21, 2014 Session
WILLIAM E. CHERRY ET AL. v. REAGAN FARR, COMMISSIONER OF
THE DEPARTMENT OF REVENUE FOR THE STATE OF TENNESSEE
Appeal from the Chancery Court for Williamson County
No. 34048 Robbie T. Beal, Judge
No. M2013-01823-COA-R3-CV - Filed April 15, 2014
Plaintiffs filed suit to recover income taxes paid under protest pursuant to Tennessee’s Hall
Income Tax. At issue is a “Special Dividend” Plaintiffs received that was classified by the
corporation for income tax purposes as a return of “paid-in capital.” Plaintiffs contend the
Special Dividend was exempt because the Hall Income Tax states, in pertinent part, that “no
distribution of capital shall be taxed as income under this chapter, and no distribution of
surplus by way of stock dividend shall be taxable in the year such distribution is made; but
all other distributions out of earned surplus shall be taxed as income when and in whatever
manner made, regardless of when such surplus was earned[.]” Tenn. Code Ann. §
67-2-104(e)(7) (2011). The trial court ruled in favor of Plaintiffs based upon a finding that
“[t]he Special Dividend was not a leveraged dividend and as such the reduction in book value
could have only come through a return of capital distribution.” We have determined the mere
fact the dividend was not a leveraged dividend is not sufficient to prove the dividend was
exempt from the Tennessee Hall Income Tax. To qualify for the exemption, Plaintiffs had
the burden to prove the Special Dividend was paid out of capital. See Tenn. Code Ann. §
67-2-104(e)(7). We, therefore, reverse and remand for entry of judgment in favor of the
Department of Revenue and for other proceedings consistent with this opinion.
Tenn. R. App. P. 3 Appeal as of Right; Judgment of the Chancery Court Reversed
F RANK G. C LEMENT, J R., J., delivered the opinion of the Court, in which A NDY D. B ENNETT,
J., and B EN H. C ANTRELL, S R. J. joined.
Robert E. Cooper, Jr., Attorney General and Reporter, William E. Young, Solicitor General,
and Brad H. Buchanan, Senior Counsel, Nashville, Tennessee, for the appellant, Reagan Farr,
Commissioner of the Department of Revenue for the State of Tennessee.
David J. Callahan, III, Nashville, Tennessee, for the appellees, William E. Cherry and Anne.
W. Cherry.
OPINION
William E. Cherry and Anne W. Cherry (“Plaintiffs”) own common shares in
Capstead Mortgage Corporation (“Capstead”), a real estate investment trust that invests in
real estate-related assets, including residential mortgage-backed securities issued by
government-sponsored agencies. At all times material to this action, the corporation had two
general classes of stock, preferred and common, and the preferred shares of stock had a right
to convert to common shares.
Pursuant to a resolution adopted by its board of directors, Capstead paid a cash
distribution of $7.30 per share to its common shareholders on June 29, 2001, which the
company classified as a “Special Dividend.” The total amount of the dividend to the common
shareholders was $201,236,000; the dividend was debited as “paid-in capital” on Capstead’s
audited financial statements.
In a contemporaneous but independent action, Capstead also effected a two-for-one
reverse-stock split. This resulted in a retirement of all common stock and the re-issuance of
one common share in exchange for each two common shares retired. As a consequence of
the reverse-stock split, the number of common shares issued and outstanding was reduced
by half, with a corresponding increase in the share price times two.1 Because the distribution
of the Special Dividend would significantly reduce the market value of each share, the
purpose of the reverse-stock split, as explained by the board of directors, was to maintain the
market price of its common stock in the mid-teens, at approximately $14 to $15 per share,
and avoid a decline below $10 per share, which the board stated may diminish the
marketability and, thus, the value of Capstead’s stock.
In an additional action that was contemporaneous with and contractually required by
the reverse-stock split, Capstead adjusted the conversion ratio applicable to its preferred
shareholders. As stated by the board of directors, Capstead was contractually required to
adjust the conversion ratio whenever a distribution to common stockholders was made in
excess of current earnings in order to protect the conversion rights of the preferred
shareholders and their proportionate share of corporate equity.
1
As both parties acknowledge, due to the reverse-stock split, the Special Dividend can be valued at
a pre-split price of $7.30 per common share or a post-split price of $14.60 per common share.
-2-
Plaintiffs received $671,593.28 from the 2001 Special Dividend. At the end of the
2001 tax year, Plaintiffs received a 2001 investment report from Capstead that, inter alia,
characterized the Special Dividend as “nontaxable distributions for federal purposes.”
Plaintiffs timely filed their 2001 Tennessee Individual Income Tax Return on which they
listed the Special Dividend from Capstead as “nontaxable dividends.”
Following an audit by the Tennessee Department of Revenue in 2005, Plaintiffs
received an Income Tax Audit Report advising that the Special Dividend had been included
in Plaintiffs’ 2001 tax base. The notice explained that dividends on stock are taxable pursuant
to the Tennessee Hall Income Tax, codified at Tenn. Code Ann. § 67-2-102 (2011), which
provides:
An income tax in the amount of six percent (6%) per annum shall be levied
and collected on incomes derived by way of dividends from stocks or by way
of interest on bonds of each person, partnership, association, trust and
corporation in the state of Tennessee who received, or to whom accrued, or to
whom was credited during any year income from the sources enumerated in
this section, except as otherwise provided in this chapter.
Plaintiffs paid the tax and interest specified in the notice under protest on December
28, 2006. On May 11, 2007, Plaintiffs filed a claim for a refund, asserting that the Special
Dividend was subject to the distribution-of-capital exemption, which provides as follows:
[N]o distribution of capital shall be taxed as income under this chapter, and no
distribution of surplus by way of stock dividend shall be taxable in the year
such distribution is made; but all other distributions out of earned surplus shall
be taxed as income when and in whatever manner made, regardless of when
such surplus was earned[.]
Tenn. Code Ann. § 67-2-104(e)(7) (2011).
After the Commissioner denied the claim, Plaintiffs timely filed this action to
challenge the imposition of the Hall income tax on $644,676 of the Special Dividend. The
amount of the refund at issue is $56,434.33. The Commissioner filed an answer.
After conducting discovery, the parties agreed that no material facts were in dispute;
thus, both parties filed cross-motions for summary judgment. The Chancellor granted
Plaintiffs’ motion for summary judgment and the Commissioner appeals.
-3-
A NALYSIS
The parties concede that no factual disputes exist and the sole issue presented is
whether the Special Dividend falls within an exemption, specifically, the
distribution-of-capital exemption under the Tennessee Hall Income Tax in Tennessee Code
Annotated § 67-2-104(e)(7).2
“Exemptions in tax statutes are strictly construed against the taxpayer and the burden
is on the taxpayer to establish his exemption.” United Canners, Inc. v. King, 696 S.W.2d 525,
527 (Tenn. 1985); Fidelity-Bankers Trust Co. v. McCanless, 181 S.W.2d 747, 750 (Tenn.
1944). Furthermore, “[e]very presumption is against the exemption and a well-founded doubt
is fatal to the claim.” United Canners, Inc., 696 S.W.2d at 527; Fidelity-Bankers Trust Co.,
181 S.W.2d at 750. Thus, when a taxpayer files suit claiming an exemption, “the Tennessee
Income Tax Law will be given a strict construction in favor of the State and th[e] burden is
on complainant to prove its right to the exemption.” Fidelity-Bankers Trust Co., 181 S.W.2d
at 750. In this case, it is undisputed that Plaintiffs bear the burden of demonstrating the
Special Dividend was exempt; in order to show this exemption, the taxpayers must prove that
the Special Dividend was paid out of capital.
When construing the taxability of corporate distributions, the court is to consider the
substantial and practical effect upon the corporation rather than the form in which the
company handled the matter. Lawrence v. MacFarland, 354 S.W.2d 78, 81 (Tenn. 1962).
Whether the distribution is made from capital or profits is determined from the standpoint
of the corporation and not the stockholder. Id. “The resolution of the board of directors of
the corporation declaring the dividend is prima facie evidence of the nature of the dividend
as it is evidence of the intention of the corporation so declaring it.” Fidelity-Bankers Trust
Co. v. McCanless, 181 S.W.2d 747, 750 (Tenn. 1944). However, “[t]he nature of the
2
Whether the Special Dividend is considered a return of capital for federal income tax purposes and
exempt from federal taxable income is neither relevant nor determinative of whether it is exempt under
Tennessee’s Hall Income Tax. Dobson v. Huddleston, 863 S.W.2d 392, 398-99 (Tenn. 1993). As the court
explained in Dobson:
[t]he taxpayer would have the Court rely upon federal tax law principles for the
interpretation of the state income tax. Such reliance would be inappropriate, first, because
the issue is controlled by the plain meaning of the statutes and prior decisions of this Court
and, also, because the state’s statutory scheme of taxation is radically different from that of
the federal government, and reliance upon federal principles would defeat the intent and
purposes of the state statutes.
Id.
-4-
dividend is a question of fact to be determined by proof of the actual condition of the
corporation’s assets and liabilities.” Id.
Plaintiffs contend they have presented prima facie evidence, in accordance with
Fidelity-Bankers Trust Co., in support of their position that the nature of the dividend was
a return of capital. In April 2001, the board of directors held their annual meeting and
decided to distribute “excess under-utilized capital” in the form of a Special Dividend from
$200 million in cash the company had on hand as of that date. This distribution was
identified as a “Special Dividend” on Capstead’s audited financial statements and debited
as “paid-in capital.” In addition, Plaintiffs assert that they have demonstrated the substantial
and material impact that the Special Dividend had on Capstead; specifically, it reduced
Capstead’s asset holdings. Plaintiffs rely on the financial records of Capstead as audited by
Ernst & Young to show that during 2001, Capstead’s assets, which included mortgage
securities and other investments, decreased from approximately $5.4 billion to approximately
$3.5 billion caused, in part, by a significant increase in mortgage prepayments. Thus, the
asset holdings of Capstead decreased by approximately $1.9 billion in 2001, the year in
which the Special Dividend was made. Moreover, Capstead began 2001 with an accumulated
deficit, but subsequently made a net income of approximately $100 million which the
company distributed to its common and preferred shareholders as ordinary dividends in
addition to the Special Dividend. Further, the financial statements show that Capstead’s
liabilities decreased by over $2.5 billion from the end of 2000 to the end of 2001. Based on
the foregoing, Plaintiffs assert they demonstrated the Special Dividend could only have been
paid out of capital.
Conversely, the Commissioner argues that the Special Dividend fits within the
Tennessee Supreme Court’s definition of a dividend; therefore, it is taxable under the Hall
Income Tax. Specifically, the Commissioner asserts that Plaintiffs received the Special
Dividend as a consequence of their ownership of common stock in Capstead, that each
stockholder received the same cash amount per share, and that Plaintiffs’ income from the
Special Dividend was in proportion to their fractional ownership of the share of the common
stock of Capstead. The Commissioner also states that, before and after the payment of the
Special Dividend, Plaintiffs were in a position to enjoy future, recurrent returns upon their
Capstead stock, the Special Dividend did not reduce the number of shares held by existing
shareholders, and Capstead remained a going concern after the payment of the Special
Dividend. Therefore, the Commissioner contends, the Special Dividend distribution fits
squarely within the definition of a taxable dividend as articulated by the Tennessee Supreme
Court. We agree.
The Hall Income Tax statute in pertinent part states that a tax shall be levied on
“incomes derived by way of dividends from stocks.” Tenn. Code Ann. § 67-2-102 (2011)
-5-
(emphasis added). The statute does not define the term dividend; however, there are several
Tennessee cases that specifically define “dividend” as that term is used in the Hall Income
Tax statute. Our Supreme Court defined the term dividend, for purposes of determining
whether a corporation’s distribution constituted a return of capital, in Gallagher v. Butler,
378 S.W.2d 161 (Tenn. 1964) and Dobson v. Huddleston, 863 S.W.2d 392 (Tenn. 1993). The
court stated that “[d]ividends, as ordinarily used, refers to the recurrent return upon stock
paid to stockholders by a going corporation in the ordinary course of business which does not
reduce their stock holdings and leaves them in a position to enjoy future returns upon the
same stock.” Gallagher, 378 S.W.2d at 167; Dobson, 863 S.W.2d at 396.
In line with the Supreme Court’s definition of dividend, Capstead continued to be a
“going concern” after the Special Dividend was distributed, Plaintiffs’ proportionate share
of common stocks was not reduced, and they remained in the same position as before to
enjoy future returns upon their stock. These facts are confirmed by Christopher Sieber, the
senior vice president of Capstead, who admitted in his deposition that the Special Dividend
did not reduce the number of shares held by existing shareholders; he also testified that no
assets were returned to the common stockholders other than the cash payments constituting
the Special Dividend itself.
Plaintiffs also insist it is relevant and material that their percentage of stock ownership
decreased due to the Special Dividend; they rely on evidence of the reverse-stock split and
the mandatory conversion of the preferred shares to show a reduction in their stock
percentage. We, however, are not persuaded by this argument. Plaintiffs acknowledged the
reverse-stock split was not mandated by the Special Dividend. Furthermore, as Mr. Sieber
admitted, the Special Dividend did not reduce the number of shares held by the existing
shareholders. We acknowledge that the preferred stockholders were entitled to more common
shares following the three events discussed above; nevertheless, this fact does not prove that
“paid-in-capital” was the source of the Special Dividend.
Although Plaintiffs insist they have sufficiently proven that the Special Dividend was
paid from capital, we have concluded that they have not proven that the distribution was a
return of capital as distinguished from being funded by some other source or sources; thus,
Plaintiffs have not carried their burden of proof. See Fidelity-Bankers Trust Co., 181 S.W.2d
at 750. “[T]he Legislature clearly did not intend in the administration of the law that the
administrators thereof have the burden of tracing dividends to the source - the contrary is
true.” Lawrence v. MacFarland, 354 S.W.2d at 81. The burden of demonstrating that the
distribution constitutes a return of capital rests with the taxpayer. Although the audit
conducted by Ernst & Young regarding Capstead’s financial statements are consistent with
Plaintiff’s arguments, there remains doubt concerning the source of the Special Dividend.
As our courts have previously held, a well-founded doubt against the exemption is fatal to
-6-
the taxpayer’s claim, see United Canners, Inc. v. King, 696 S.W.2d at 527; see also
Fidelity-Bankers Trust Co., 181 S.W.2d at 750, and the record here creates a well-founded
doubt as to whether the Special Dividend was a return of capital. This is because the record
does not establish that capital was in fact the source of the funds used to pay the Special
Dividend.3
Because the source of the funds used to pay the Special Dividend is in doubt, and
realizing that the burden is on the taxpayer to establish the exemption, we have concluded
that Plaintiffs failed to demonstrate the Special Dividend qualifies for the
distribution-of-capital exemption. Accordingly, the Special Dividend is subject to the
Tennessee Hall Income Tax.
I N C ONCLUSION
The judgment of the trial court is reversed, and this matter is remanded for further
proceedings consistent with this opinion. Costs of appeal are assessed against Plaintiffs,
William E. Cherry and Anne W. Cherry.
______________________________
FRANK G. CLEMENT, JR., JUDGE
3
Commissioner insists the source of the distribution comes from interest income and debt,
specifically, interest income, mortgage principal payments and short-term borrowings; Plaintiffs, however,
insist the funds came from “excess under-utilized capital,” or more specifically, mortgage prepayments,
which the board of directors decided to return to shareholders rather than reinvest.
-7-