Steehett, Judge:
The respondent in his statutory notices determined deficiencies in the Federal income taxes of the petitioners in amounts and for taxable years as follows:
Docket No. 1960 1961 1962
2376-68. 2377-68-2378-68. 2379-68. 2380-68. 2381-68. 164,786.16 $13,968.68 $1,078,428.30 164,328.41 . 63,471.28 164,329.32. 63,472.17 164,329.32. 63,472.17 164,328.41 . 66,130.64 164,329.32. 63,472.17
At trial the respondent sought leave of the Court to amend his answers in order to conform the pleadings to the proof with respect to the deficiencies in issue. Said amendment was necessitated by the stipulation of the parties concerning the value of certain preferred stock. The petitioners raised no objection to the requested amendments, hence, leave was granted. Therefore the deficiencies in issue for 1962 are as follows:
Docket No. Deficiency
2376-68 $1, 472, 755. SO
2377-68 88, 047. 78
2378-6S 88, 048. 67
Docket No. Deficiency
2379-68 $88, 048. 67
2380-68 90, 707.04
2381-68 88, 048. 67
Due to concessions of the parties these cases present for our determination the following five questions: (1) whether, as the respondent contends, the fair market value of certain business assets transferred by a corporation, whoily owned by the petitioners, was in excess of the consideration received therefor; (2) if such excess did exist, whether the disproportion in value constituted a constructive dividend to the petitioners; (3) whether, as the respondent contends, there was a constructive dividend to the petitioners by reason of their use of the assets of a corporation owned by them in order to aid in the purported sale of said corporation’s stock, and if so, whether the petitioners were the owners of certain preferred stock held as an asset of said corporation on the date said stock was redeemed; (4) should question (3) be decided for the petitioners the respondent raises the alternative contention, that aforementioned stock was section 306 2 stock which upon sale resulted in ordinary income; and (5) whether John D. and Elizabeth N. Gray understated their gross income for the taxable year 1960 by more than 25 percent so that the 6-year statute of limitations of section 6501 (e) is applicable.
BINDINGS OP PACT
Some of the facts were stipulated. The stipulations and the exhibits attached thereto are incorporated herein by this reference.
Petitioners John D. Gray and Elizabeth N. Gray, husband and wife, resided in Portland, Oreg., at the time their petition was filed herein. They filed joint Federal income tax returns for the taxable years 1960, 1961, and 1962 with the district director of internal revenue at Portland, Oreg.
Petitioners John E. Gray, Joan E. Gray, Janet L. Gray, Laurie J. Gray, and Anne L. Gray are the children of petitioners John D. and Elizabeth N. Gray and resided with their parents in Portland, Oreg., at the time their petitions were filed herein. These petitioners, all minors at the time, filed individual Federal income tax returns for 1962 with the district director of internal revenue at Portland, Oreg. They did not file Federal income tax returns for 1960, the only other year involved in their cases.
Petitioners John D. and Elizabeth N. Gray filed their joint Federal income tax return for 1960 on or before April 15,1961. The amount of gross income stated on said return was $546,794.50. Petitioners and respondent on October 31, 1966, and November 2, 1966, respectively, executed a waiver agreement pursuant to section 6501(c) (4), extending the period for assessment to December 31, 1967. On December 14, 1967, petitioners and respondent executed a further agreement extending the period to February 29,1968. The statutory notice for the taxable year 1960 was mailed to the petitioners on February 27, 1968.
In 1947, after having spent 5y2 years in the U.S. Army, John D. Gray (hereinafter referred to as Gray) received a master of business administration degree with distinction from Harvard University. In 1947 Gray was employed by the Pointer-Willamette Co., Portland, Oreg., as assistant to its president. He occupied this position until 1948, at which time he was employed by Oregon Saw Chain Mfg. Corp., Portland, Oreg., as assistant general manager. The stock of Oregon Saw Chain Mfg. Corp. was owned by Spencer Hinsdale and Joseph B. Cox (hereinafter referred to as Cox), both of Portland, Oreg. Oregon Saw Chain Mfg. Corp. was engaged in manufacturing and selling saw chain and related products used in harvesting timber. In September 1950 Spencer Hinsdale’s stock in Oregon Saw drain Mfg. Corp. was purchased by Cox. Thereafter, the name of Oregon Saw Chain Mfg. Corp. was changed to Oregon Saw Chain Corp. In September 1950 Gray became Oregon Saw Chain Corp.’s assistant general manager and served in that position until 1953.
When Oregon Saw Chain Mfg. Corp. began operations in 1947, its manufacturing facilities were located in the basement of the Portland home of Cox. When Gray became employed by Oregon Saw Chain Mfg. Corp. in 1948, its manufacturing facilities had been moved to a garage in Portland, Oreg. In 1950 its manufacturing facilities were' removed to a new plant in Portland, Oreg. While Oregon Saw Chain Corp.’s operations were small when Gray first became employed by it, he soon recognized that the corporation had great potential for future expansion and development.
On December 22, 1952, Cox purchased the assets of Planerchain Saws Ltd., a Canadian corporation engaged in manufacturing and selling saw chain and related products used in harvesting timber in Guelph, Ontario, Canada. On February 17, 1953, Cox organized Oregon Saw Chain Ltd. under the laws of the Dominion of Canada, transferring $300 to the' corporation for 3 shares of its common stock with a par value of $100 per share. On March 4, 1953, Cox sold the assets previously purchased from Planerchain Saws Ltd. to Oregon Saw Chain Ltd. for a total purchase price of $39,463.94. The purchase price paid by Oregon Saw Chain Ltd. consists in part of the issuance to Cox of the remaining 47 Shares of its common stock.
On November 17,1953, Cox sold his 50 shares of Oregon Saw Chain Ltd. to Gray for a purchase price of $5,000. On the same day Gray was elected president of the corporation.
On November 20,1953, Oregon Saw Chain Corp., Oregon Saw Chain Ltd., and Gray entered into an agreement whereby Oregon Saw Chain Corp. sold and assigned to Oregon Saw Chain Ltd. certain Canadian patents and patents applications (described infra) concerning saw chains, file holders, and related maintenance and service tools for a royalty equal to (a) 5 percent of Oregon Saw Chain Ltd.’s gross sales for a 10-year period commencing December 1, 1953, and ending November 30, 1963, plus (b) 5 percent of any royalties received during said period by Oregon Saw Chain Ltd. from its own sublicensing.
On November 18, 1953, Gray organized Oregon Chain Corp. under the laws of the State of Oregon, transferring $10,000 in cash to the corporation in return for all of its capital stock, which consisted of 100 shares of common. On the same day Gray was elected president and chairman, of the board of Oregon Chain Corp. On November 23,1953, Oregon Chain Corp., Oregon Saw Chain Corp., Gray, David S. Pat-tullo, and Paul A. Lewis (the latter two individuals being owners of one share of stock each of Oregon Chain Corp. as nominees for Gray) entered into an agreement whereby Oregon Saw Chain Corp. sold and assigned to Oregon Chain Corp. all of its operating assets (with certain enumerated assets excepted including the November 20,1953, sales agreement) including its tangible and intangible assets, for a purchase price composed of (a) the assumption by Oregon Chain Corp. of Oregon Saw Chain Corp.’s liabilities; (b) a cash payment equal to the excess of the book value of Oregon Saw Chain Corp.’s assets (exclusive of the retained assets) over its liabilities; (c) a cash payment of $65,000 for goodwill; and (d) a royalty equal to 15 percent of Oregon Chain Corp.’s gjross sales and income from sublicensing for the period from December 1, 1953, through November 30, 1958, and a royalty equal to 10 percent of its gross sales and income from sub-licensing for the period from December 1,1958, through November 30, 1963.
On December 2, 1953, Cox caused Oregon Saw Chain Corp. to be liquidated and dissolved under the laws of the State of Oregon. Among other assets received, Cox received the two agreements dated November 20, 1953, and November 23, 1953, in the liquidation of Oregon Saw Chain Corp., thus succeeding to the latter corporation’s rights to the payments due under those contracts.
Gray utilized separate, directly owned United States and Canadian corporations to operate the Cox businesses, continuing the same direct form of ownership that had been utilized by Cox. The paid-in capital of Oregon Chain Corp. was $10,000 and it had a substantial and continuing royalty obligation to Cox.
On December 14, 1953, Oregon Chain Corp. changed its name to Oregon Saw Chain Corp., which on July 2,1957, changed its name to Omark Industries, Inc., its present name. On July 2, 1959, Oregon Saw Chain Ltd. changed its name to Omark Industries (1959) Ltd. Omark Industries, Inc., and Omark Industries (1959) Ltd. and their respective predecessors will hereinafter be referred to as Omark and Omark 1959, respectively.
In January 1954 Gray transferred by gift 5 shares of his Omark stock to each of his three children, Anne L. Gray, Joan E. Gray, and Janet L. Gray, and 10 shares to his wife, Elizabeth N. Gray. Furthermore, Gray transferred 5 shares to each of two other children, John E. Gray and Laurie J. Gray, in January 1955 and April 1957, respectively. After all of these transfers, the stock of Omark was owned as fallows:
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In January 1951 Gray transferred by gift 3 shares of his Omark 1959 stock to each of his three children, Anne L. Gray, Joan E. Gray, and Janet L. Gray, and 5 shares to his wife, Elizabeth N. Gray. Furthermore, Gray transferred 3 shares to each of two other children, John E. Gray and Laurie J. Gray, in January 1955 and April 1957, respectively. After all of these transfers, the stock of Omark 1959 was owned as follows:
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Immediately after its formation, Omark adopted a June 30 fiscal year. At the time its stock was acquired by Gray, Omark 1959 was on a fiscal year ending at the end of February. At a board of directors meeting held on October 25, 1954, Omark 1959 changed its fiscal year Jo a June 30 fiscal year, beginning with the fiscal year ending June 30, 1955, in order to have its fiscal year coincide with Omark’s fiscal year.
The type of saw chain manufactured by Omark and Omark 1959 was generally referred to as “chipper type” saw chain and was manufactured under a combination of certain basic United States and Canadian patents issued to Max Merz (hereinafter referred to as Merz) and Cox, the inventors. A patent grant is a negative right in that it gives the owner thereof the right to exclude others from manufacturing the subject matter of the patent.
The significant feature of the Merz saw chain is that the cutter on the sideplate of each link of chain had a curved portion, whereas prior cutters were L-shaped. The Cox saw chain modified the Merz design by flattening the top thus producing a curved portion and a flat toe. This improved cutting characteristics and permitted sharpening in the field. The Merz patents gave the owner thereof the right to exclude others from making a saw chain with a cutter on a sideplate having a curved portion. The Cox patents gave the owner thereof the right to exclude others from manufacturing a saw chain with a cutter on a sideplate having a curved portion and a flat toe.
Both the Merz and the Cox patents were valid. The later Cox patent was valid because it contained a needed improvement over the Merz patent. It was necessary for a manufacturer to have licenses under both the Merz and the Cox patents in order to make Cox chipper chain. That is, the Cox patent could not be used without infringing upon the Merz patent.
In 1960 Omark was the sole owner of the basic Cox United States saw chain patent and corresponding patents in all foreign countries except Canada. In 1960 Omark 1959 was the sole owner of the basic Cox Canadian saw chain patent. In 1960 Draper Corp. was the owner of the Merz United States and Canadian patents.
By agreement entered into on November 14, 1956, Draper Corp. (hereinafter referred to as Draper) owner/assignee of the United States and foreign Merz patents granted to Oregon Saw Chain Corp. (Omark) an irrevocable, royalty-free, nonexclusive license with respect to the United States, Canadian, and other foreign Merz patents. The agreement further provided that the Merz Canadian patents “may be sublicensed or assigned” by Oregon Saw Chain Corp. (Omark) to Oregon Saw Chain Ltd. (Omark 1959). In exchange Omark granted Draper an irrevocable, royalty-free, nonexclusive license with respect to the Cox United States patents and Omark 1959 granted Draper an irrevocable, royalty-free, nonexclusive license with respect to the Cox Canadian patents.
At the end of 1960 Omark 1959 did not have in its own right a license under any of the Merz patents, United States or Canadian. Although the agreement of November 14,1956, gave Omark the right to sublicense Omark 1959 with respect to the Merz Canadian patents Omark did not do so. Omark 1959 was able to manufacture Cox chipper chain only at the sufferance of Omark; it had no independent right to use the Merz patents which were essential to the manufacture of saw chain under the Cox patents.
Apart from Omark only McCullock Motors Corp., Borg-Warner Corp., Mall Tool Co., and Pioneer Saws Ltd. had licenses under the Merz Canadian patents. However, none of these licensees had the right to sublicense as of 1960. For this reason any prospective purchaser of Omark 1959 (other than Omark) would of necessity have to negotiate directly with. Draper, the owner of the Canadian Merz patent, for a license. From October 4, 1956, when Engineering Research, Inc., assigned the Merz patents to Draper until 1963 when Omark acquired the Draper saw chain business, Draper issued licenses under the Merz patents only in exchange for a needed cross-license of the Cox patents from Omark and to rep] ace commitments which existed prior to the acquisition of the Merz patents by Draper.
The Cox chipper chain was commercially successful; comprising approximately 95 percent of the total commercial chain sold. The Cox chipper chain eliminated all other types of saw chain from the market and was responsible in large part for the success of the Omark companies. Omark and Omark 1959 marketed Cox chipper chain under the trademark “Oregon.” By the end of 1960 Oregon chain was considered the best available in the United States, Canada, as well as 50 to 60 other countries where saw chain was sold. On June 15, 1955, Omark granted Omark 1959 a license to use the “Oregon” trademark but retained the right to terminate upon 30 days’ written notice.
During the period after their acquisition by Gray, Omark and Omark 1959 substantially increased their export sales of saw chain to foreign markets. Omark’s and Omark 1959’s export sales of saw chain for their taxable years ended June 30, 1956, through June 30, 1960, were as follows:
Saw chain export sales in feet
Taxable year ended, June SO— Omark Omark 19S9
1956_ minor 9,400
1957_ minor 12,600
1958_ 66, 081 30, 800
1959_ 67, 428 58, 300
1960_ 127, 006 328, 500
By October 28, 1959, a potential conflict had arisen between Gray and Cox as a result of the expanding foreign sales activities of Omark and Omark 1959. This potential conflict had its origin in the different royalty rates provided in the sale agreements entered into with Oregon Saw Chain Corp., Cox’s corporation, on November 20, 1953, both of which were distributed to Cox when Oregon Saw Chain Corp. was liquidated on December 2, 1953. Because of this rate differential, it was in Gray’s best interest to have as high a percentage of export sales as possible made by Omark 1959, since this would have resulted in the payment of royalties at the lower 5-percent rate provided in the contract between Omark 1959 and Cox, as successor to Oregon Saw Chain Corp. Conversely, it was in Cox’s best interest to have export sales made by Omark, since this would have resulted in the payment of royalties at the higher 10-percent or 15-percent rate provided in the contract between Omark and Cox, as succesor to Oregon Saw Chain Corp.
In order to resolve this conflict, Gray and Cox reached an agreement, not reduced to writing, to modify the agreement between Omark and Cox and to cancel the agreement between Omark 1959 and Cox, the latter hi return for a lump-sum payment to Cox. Thereafter, on September 1 and October 1,1959, Cox sold all of his right, title, and interest under the sale agreements with Omark and Omark 1959, respectively, to Pacific Plywood Co. (hereinafter referred to as Pacific), an Oregon corporation unrelated either to Cox, Gray, Omark, or Omark 1959.
On October 28, 1959, Omark and Gray entered into an agreement with Pacific amending the royalty provisions of the original sale contract between Omark (then Oregon Chain Corp.) and Oregon Saw Chain Corp. to provide for the payment thereunder of specified dollar royalty amounts on export sales by Omark (excluding export sales to Omark 1959) for each of the remaining years under, the original sale contract if the percentage royalties due thereunder did not equal or exceed those specified amounts. Omark 1959 and Gray entered into an agreement with Pacific whereby Omark 1959 agreed to pay to Pacific a lump-sum of $245,000 to cancel and terminate the sale agreement of November 20, 1953. In addition, said agreement restricted Omark 1959’s ability to sell its products in the United States through November 30, 1963, by requiring Omark 1959 to pay Pacific a royalty equal to 10 percent of such sales (exclusive of sales to Omark) through that date.
Following their acquisition by Gray, Omark and Omark 1959 grew and prospered under Gray’s leadership and supervision. Omark built and moved into a new plant in Portland, Oreg., in 1955, and Omark 1959 built and moved into a new plant in Guelph, Ontario, Canada, in the same year.
Omark’s assets, net worth, net sales, and after-tax profits for its taxable years ended June 30,1954, through June 30,1960, were as follows:
Tear ended Juno 30— Assets Net worth Not sales After-tax profits
1954 1. $1,735,654 $285,610 $2,228,875 $275,610
1955. 3,162,242 996,979 5,810,902 697,703
1956. 4,798,033 1,989,866 7,691,001 992,888
1957. 7,540,942 2,879,383 10,146,659 889,516
1958. 6,366,438 2,956,833 8,610,742 196,187
1959. 7,114,255 3,845,477 8,709,565 887,585
19602. 7,635,030 4,518,552 10,574,518 719,110
Omark 1959’s assets, net worth, net sales, after-tax profits, and accumulated earnings for its taxable year ended February 28, 1955, were $391,552,3 $191,517, $792,933, $148,901, and $186,517 (Canadian dollars) , respectively. The corresponding figures for Omark 1959’s taxable years ended June 30,1955, through June 30,1963, all on an unconsolidated basis and all stated in Canadian dollars, were as follows:
Alter-tax Accumu-Year ended Juno 30— Assets Net worth Net sales profits lated earnings
1956 1. $397,458 $238,237 $217,466 $45,876 $233,237
1956. 816,964 626,988 1,428,903 283,677 620,988
1957. 1,335,373 929,499 1,913,627 403,416 924,499
1058. 1,253,150 1,070,689 1,372,377 139,076 1,065,689
1959. 1,787,678 1,267,239 1,622,427 2198,937 1,262,239
1960 3. 2,470,431 1,628,869 2,704,411 361,630 1,623,869
1961. 1,745,104 1,745,104 1,777,172 198,456 1,740,104
1962.. 1,744,885 1,744,423 none (681) 1,739,423
1963. 1,761,397 1,756,397 none 16,974 1,756,397
On December 31, 1960, the earned surplus of Omark 1959 was $1,822,325 (Canadian dollars).
During the period after acquisition by Gray and continuing through 1960, both Omark and Omark 1959 began to manufacture and sell products other than saw chain and related accessories. For example, in September 1956, Omark purchased from Cox all of the tangible and intangible assets used by Cox in the business of manufacturing and selling powder-actuated tools and related fasteners. Cox had acquired these assets in October of 1955 from Powder-Power Tool Corp. In October of 1959 Omark began manufacturing and selling welding products with the acquisition of the assets of the Graham Manufacturing Co. Omark 1959 acquired from Cox in September of 1956 all of the stock of Omark Industries Ltd., a Canadian corporation, which also was engaged in the business of manufacturing and selling powder-actuated tools and related fasteners in Canada. Omark Industries Ltd. was liquidated into Omark 1959 at the beginning of Omark 1959’s fiscal year ended June 30, 1960. Omark 1959 acquired a minority stock interest in 1958, in Sporting Arms Ltd., Clovelly Park, South Australia, which was engaged in the business of manufacturing and selling firearms and powder-actuated tools and accessories. Additionally, Omark 1959 acquired all of the stock of Canadian Fastening Systems Ltd. (hereinafter referred to as Canadian Fastening) in October 1959, and all of the stock of Montreal Motor Boat Co. Ltd. (hereinafter referred to as Montreal Motor Boat) in February 1960, both of which companies were at the time of acquisition, and had been for some time, major distributors of saw chain for Omark 1959 in Canada. Canadian Fastening was also engaged in the business of selling pins for powder-actuated tools; and Montreal Motor Boat was also engaged in the business of selling marine and boating products. They were not engaged in the manufacture of saw chain. At the time of their acquisition both companies had losses relating to activities other than chain sales. They were acquired by Omark 1959 to protect important sources of distribution and to provide diversification.
After their acquisition by Omark 1959, both Canadian Fastening and Montreal Motor Boat continued to serve as saw chain distributors for Omark 1959 in Canada and, therefore, were treated by Omark 1959 as sales branches.
Even after the new direct and indirect product-line acquisitions by Omark and Omark 1959, their major products continued to be saw chain. For example, for their fiscal years ended June 30,1960, the consolidated sales, stated in Canadian dollars, of Omark, Omark 1959, and their respective sales subsidiaries were broken down by product-lines as follows:
Product Omark and subsidiarios Omark 1959 and subsidiaries Total Percentage to total
Saw chain.. Saw chain bars.. . Saw chain accessories..... Powder-actuated tools and accessories.. Welding products.. Marine equipment... Other products... 1 $6,230,000 $2,105,000 $8,335,000 618,000 515,000 2,024,000 978,000 380,000 220,000 91,000 412,000 25,000 265,000 27,000 838,000 606,000 2,436,000 1,003,000 265,000 407,000 60.00 6.03 4.35 17.54 7.22 1.91 2.93
Totals..... 10,745,000 3,145,000 13,890,000 99.98
'Canadian Fastening and Montreal Motor Boat produced the following operating results, stated in Canadian dollars, for their respective 1956 through 1960 calendar years:
Calendar year Canadian Fattening after-tax profit (loss) Montreal Motor Boat after-tax profit (loss)
1956___ ($19, 450) $18, 217
1957_ (25, 640) 17, 756
1958_ (22, 750) (40, 689)
1959_ (19, 075) (156, 683)
1960__ (20, 013) (156, 611)
Omark Industries Ltd. produced the following operating results, stated in Canadian dollars, for its fiscal years of operation prior to its liquidation into Omark 1959:
Fiscal year ended Profit {loss)
Mar. 31, 1957_ ($21,198)
Mar. 31,1958_ 28, 911
June 30,19581_ 4,512
June 30, 1959_ 14, 886
If the after-tax profits or losses of Canadian Fastening, Montreal Motor Boat, and Omark Industries Ltd., are combined with Omark 1959’s after-tax profits for its taxable years ended June 30, 1956, through June 30, 1960, and if the certain, nonrecurring items of income set forth above are eliminated from Omark 1959’s after-tax profits for its taxable years ended June 30, 1959, through June 30, I960,4 Omark 1959’s after-tax profits, expressed in Canadian dollars, were as follows:
OmarJc 1959 taxable year ended June SO— Adjusted after-tax profits
1956 _ _$282,344
1957_ _ 374,334
1958 _ _ 109,089
1959 _ _ (10,594)
1960 _ _ 97,917
The combined after-tax profit of Omark 1959, Canadian Fastening, and Montreal Motor Boat for the 6-montli period ended December 31, 1960, was $114,276 (Canadian dollars).
The manufacturing equipment of Omark 1959 was modern and up-to-date in 1960. The plant was 5 or 6 years old at the time and already needed expansion, but the physical facilities were in good condition ■and the building and equipment on the inside were good. The machinery and equipment utilized in the manufacturing process were modern and well maintained. All parts for machinery in Guelph and in Portland were interchangeable.
Omark 1959 employed approximately 200 trained people in Canada. It had its own sales organization in Canada and its own shipping-department. Omark 1959 employed some industrial engineers in Guelph who worked on systems and industrial procedure. In addition, Omark 1959 had some managerial personnel at its Guelph plant.
However during the period following their acquisition by Gray and continuing throughout 1960, Omark 1959 was dependent on Omark from the standpoint of corporate organization and administrative structure, product research and development, development of production methods and machinery, patent licensing and prosecution, advertising and sales promotion, staff training, personnel management and planning, quality control, selection of outside professional representation (e.g., auditors), and accounting systems and procedures. In February of 1961 Omark bad approximately 400 employees. Omark 1959 bad no corporate policymaking employees of its own in Canada. At this time Omark was the owner of many major and minor patents, trademarks, and applications therefor in addition to the Merz and Cox patents. Omark 1959 owned only the Cox Canadian patent.
By the end of 1960 Omark and its branches in the United States occupied approximately 175,300 square feet of manufacturing, warehousing, and selling space. Omark 1959 and its selling subsidiary had approximately 53,500 square feet of comparable space. Omark was the “home office” of the companies as a whole and was the place where all major decisions were made and where the major expertise in all areas of company operations was located. Gray regarded Omark 1959 as a “branch” operation of Omark. Gray possessed ultimate responsibility for the overall supervision, management, and policymaking for both corporations; and he devoted his full-time efforts to the discharge of these responsibilities. While many of the minor or routine day-to-day decisions of both corporations necessarily were made by personnel other than Gray, all final decisions on important organizational, operational, policy, and personnel matters were made by Gray himself. Gray’s skills as a corporate executive and his permeating influence in the major decisions and activities of Omark and Omark 1959 were major factors in their profitability.
Aside from the terminable license granted by Omark to Omark 1959 to use the “Oregon” trademark there were no contracts between the two corporations requiring a continuing relationship. There were no employment contracts, management contracts, or purchasing agreements.
All export sales made by Omark 1959 through the end of 1960 were solicited and obtained by Omark through the efforts of Omark’s own export staff and sales personnel in the United States and abroad. The export policies of both Omark and Omark 1959 were determined by an export policy committee created by Gray and comprised entirely of Omark employees in Portland. Omark 1959 had no export department or export sales staff of its own and engaged in no export selling efforts at any time through the end of 1960. Omark merely channeled export sales obtained by it during this period through Omark 1959. Omark 1959’s profitability was dependent on a high volume of saw chain sales, its export sales, amounted to approximately one-third of its total saw chain sales in its year ended June 30,1960.
By the end of 1960 the percentage of outstanding stock of Omark owned by Gray, his wife and children had decreased from 100 percent to 90.4 percent as a result of the sale by Gray of a portion of his Omark stock to various key officers and employees of Omark and other persons not connected with Gray or Omark.
In January of 1960 the Omark stock was split 2,000 for 1. A total of 5 percent of Gray’s stock or 10,000 shares was sold by Gray to certain key officers and employees for a total of $241,100; the sales being made subject to repurchase by Gray in the event of the termination of the purchaser’s employment. The remaining 4.6 percent or 9,148 shares were sold during the period from June 24,1959, through September 10, 1960, to unrelated persons for $824,651.52. However, Gray, his wife, and children continued to own 100 percent of the outstanding stock of Omark 1959 throughout 1960. Gray expected to continue the policy of reducing his family’s percentage ownership in Omark in succeeding years, culminating in a public sale of a portion of their Omark stock not later than the end of 1964, at which time Omark’s royalty obligation to Pacific would be ended. The eventual public sale of some of his and his family’s Omark stock had been contemplated by Gray in earnest as early as June 1959. In fact, such public sale was consummated in 1964. Since that time Omark stock has been listed on the New York Stock Exchange. Presently the Gray family owns 87.4 percent of the outstanding stock of Omark, the other 62.6 percent being owned by approximately 7,000 other stockholders.
By the end of 1960 certain problems had arisen as a result of the operation of Omark and Omark 1959-as brother-sister corporations. First, because of the fact that Gray and his family owned 100 percent of the stock of Omark 1959 but only 90.4 percent of the stock of Omark, it was hi the best interests of Gray and his family to have export sales made by Omark 1959. Conversely, th'e interests of the minority stockholders of Omark were best served by having Omark make these export sales. Controversies arose out of these potential competing interests at various times prior to the end of 1960. Gray felt an obligation to provide fair treatment to the minority stockholders of Omark, and, therefore, it was his desire to avoid any semblance of favoritism for Omark 1959 over Omark. Second, the above competing interests also led to dissatisfaction among the employees of Omark and Omark 1959, since contributions to profit-sharing plans established by the two corporations were directly dependent upon the profitability of each corporation, which in turn, was dependent upon the volume of export sales. Third, the brother-sister corporate relationship produced certain conflicts between the managements of the two corporations, since in certain areas (e.g., future international growth and expansion) their objectives were not always the same. Fourth, since Omark 1959 was dependent upon Omark, questions arose as to the amount of costs being incurred by Omark for services performed by it for Omark 1959. Fifth, since Gray intended to have Omark engage in additional corporate acquisitions, he wanted to avoid problems involved in assimilating the acquired companies into the existing brother-sister structure.
In addition to the above reasons for realigning the operations of the two corporations, a separate and equally important reason for such realignment was to prepare Omark for the eventual public sale of its stock by 1964 by Gray and his family and other stockholders. Gray was advised by underwriters that the stock of Omark would be unattractive for a public offering until the conflicting interests between Omark and Omark 1959 had been eliminated. In determining what course of action to follow Gray considered income tax aspects, both United States and Canadian; for this purpose he employed certain advisers, expert in matters of taxation.
The 'decision to realign the operations of Omark and Omark 1959 was earned into effect in December 1960. As the first step in this realignment, on December 22, 1960, Omark organized a new wholly owned Canadian subsidiary, Omark Industries (1960) Ltd. (hereinafter referred to as Omark 1960), transferring $200,000 (Canadian dollars) to Omark 1960 in return for all of its authorized common stock, 20,000 shares of no-par value. Omark 1960’s authorized capital also included 18,000 shares of preferred stock of $100 (Canadian dollars) par value which, pursuant to its certificate of incorporation, (a) were entitled to noncumulative dividends in the discretion of Omark 1960’s board of directors at the annual rate of 5 percent prior to any dividends on the common stock; (b) were redeemable at any time in the discretion of Omark 1960 at par value plus any declared but unpaid dividends; (c) enjoyed a preference in the distribution of assets upon liquidation; and (d) were entitled to one vote per share upon Omark 1960’s failure to pay dividends thereon for 2 consecutive years and retained such voting rights until dividends aggregating 5 percent per year had been paid on the preferred shares for 2 consecutive years.
On December 27,1960, Omark 1959 entered into an agreement with Omark 1960 whereby Omark 1959 sold all of its assets to Omark 1960, including the stock of Canadian Fastening, Montreal Motor Boat, and Omark International Ltd.,5 excluding an $80,000 (Canadian dollars) note payable from Gray to Omark 1959. In consideration for these assets, Omark 1960 agreed to assume all of Omark 1959’s liabilities and to pay Omark 1959 (a) 18,000 shares of Omark 1960 preferred stock, (b) $10,000 (Canadian dollars) cash, and (c) a promissory note bearing interest at 5 percent per year for the balance of the purchase price. The total purchase price was equal to the book value of the assets of Omark 1959 as of December 31,1960.
The December 27,1960, agreement was superseded by mutual agreement of both parties by a new sale agreement dated June 5, 1961. The June 5,1961, agreement provided that Omark 1959 sell to Omark 1960 as of December 31, 1960, all of its assets except for notes in the amounts of $80,000 (Canadian dollars) and $35,000 (Canadian dollars) due to Omark 1959 from Gray and Molded Container Corp. (an Oregon corporation 52 percent of the stock of which was owned by Gray), respectively. In consideration for these assets, Omark 1960 agreed to assume all of Omark 1959’s liabilities in the amount of $1,223,623 (Canadian dollars), and to pay Omark 1959 (a) 15,000 shares of Omark 1960 preferred stock of $100 (Canadian dollars) par value per share, having a fair market value of $1 million (Canadian dollars), (b) $10,000 (Canadian dollars) in cash, and (c) the balance ($82,604) (Canadian dollars) on open account. The total purchase price was equal to the book value of the assets as of December 31, I960.6
The assets sold by Omark 1959 to Omark 1960 and their respective book values, stated in Canadian dollars, were as follows:
Asset Boole value
Cash_ $600
Marketable securities_ 98, 000
Accounts receivable, including accounts receivable from subsidiaries_ 801, 229
Accounts receivable from Sporting Arms Ltd. and Svenska Oregon A.B_ 388, 086
Inventories_ 534, 609
Prepaid expenses-21, 536
Investments in subsidiaries_ 209, 798
Investment in Sporting Arms Ltd_ 114, 695
Land _ 49, 333
Buildings, machinery, and equipment_ 558, 829
Patents_ 39, 512
Total-2, 816, 227
On a consolidated basis, the book values, stated in Canadian dollars, of the assets of Omark 1959, Canadian Fastening, Montreal Motor Boat, and Omark International Ltd. sold to Omark 1960 on December 31,1960, were as follows:
Asset Boole value
Cash_ $45, 575
Marketable securities- 98, 000
Accounts receivable, excluding accounts receivable from subsidiaries- 003, 845
Accounts receivable from Sporting Arms Ltd. and Svenska Oregon A.B- 388, 086
Inventories_ 784,159
Deferred accounts receivable- 100, 000
Prepaid expenses_ 24, 561
Investment in Sporting Arms Ltd- 114, 695
Land _ 49, 333
Buildings_ 171, 810
Equipment_ 402, 283
Leasehold improvements- 39, 407
Patents_ 201, 057
Goodwill_ 1, 500
Total _ 3, 024. 311
Tlie total liabilities of Omark 1959, Canadian Fastening, and Montreal Motor Boat on December 31, 1960, were $1,268,663 (Canadian dollars). Omark International Ltd. was inactive and had no liabilities. Thus, the net book value of the assets of Omark 1959, Canadian Fastening, Montreal Motor Boat, and Omark International Ltd., sold to Omark 1960 on December 31, 1960, was $1,755,648 (Canadian dollars) ($3,024,311 less $1,268,663).
On June 13, 1961, the name of Omark 1959 was changed to Yarg Ltd. (hereinafter referred to as Yarg). Yarg had had ceased manufacturing operations on December 31,1960, after the sale of its operating assets to Omark 1960.
Pursuant to Gray’s intention that Yarg be a real estate investing corporation, the company sought investments for its liquid assets. By mid-1962 Yarg had made certain investments in, or loans to, Molded Container Corp. (hereinafter referred to as Molded), Sunset Science Park, Inc., and Northwest Science Investment Corp., all located in Portland, Oreg. As of June 1, 1962, Gray owned 52 percent of the outstanding shares of Molded. From May 15,1960, through October 20, 1961, Gray had loaned Molded $83,723 (Canadian dollars); by December 31, 1961, Molded had repaid $3,723. On October 26, I960,. Yarg made a loan to Gray in the amount of $80,000 (Canadian dollars)'. On June 30, 1961, Gray repaid said amount to Yarg by transferring to Yarg the notes due to him from Molded in the total amount of $80,000. A new note dated June 30, 1961, was executed by Molded to Yarg as evidence of said indebtedness. Said note provided for 6-percent interest per year commencing October 1,1961. During the period from December 31,1960, through October 27,1961, Yarg made five separate loans to Molded in the total amount of $110,000 (Canadian dollars). These loans were evidenced by interest-bearing promissory notes from Molded to Yarg. No repayments were made by Molded to Yarg as of the end of 1961. On June 30, 1961, Yarg purchased from Gray an $80,000 interest-bearing note due to Gray from Molded, thus bringing Yarg’s total investment in Molded by way of loans to $190,000. On February 16, 1962, Yarg converted $18,000 of these loans into 9,375 shares of stock of Molded; and on February 19,1962, Yarg purchased from Molded an additional 8,639 shares of its stock for $17,278 (Canadian dollars). On June 28, 1962, Yarg sold notes of Molded in the face amount of $172,000, representing the remaining balance of its loans to Molded, to Omark for a purchase price equal to their face value. In addition to the transactions with Molded, Yarg by August 1962 had loaned approximately $104,000 (Canadian dollars) to Sunset Science Park, Inc., an Oregon corporation engaged in development of a planned industrial park in Portland, and had invested $15,000 (Canadian dollars) in Northwest Science Investment Corp., an Oregon corporation which was a diversified small business investment corporation, serving small science based industries in the Pacific Northwest.
During the latter part of 1961 and continuing into 1962 Yarg employed various agents for the purpose of discovering and/or investigating possible real estate acquisitions or investments in Portland, Toronto, Vancouver, and Winnipeg. No such acquisitions were made by Yarg.
As of June 30, 1962, Yarg’s balance sheet, stated in Canadian dollars, indicated the following:
ASSETS
Current assets:
Cash at bank- $161, 996
Capital and place of business taxes refundable_ 736
Total current assets_ 162,732
Investments in and advances to affiliated companies: Investment in Omark Industries (1960) Ltd.: 16,000 preferred shares at cost- $1, 500, 000
Investment in Molded Container Corporation — 18,014 common shares at cost- 35, 278
Investment in Northwest Science Investment Corp.— 15,000 common shares at cost- 15, 000
Advance to Sunset Science Park, Inc- 31, 875
Total investments and advances- 1, 582,153
Total_ 1, 744, 885
In June 1961 Omark 1960 liad paid a dividend to Yarg on the preferred stock held by Yarg in the amount of $37,500 (Canadian dollars) representing one-half year’s dividend (from January 1,1961).
By mid-1962 a new factor had entered the picture to cause Gray to reevaluate the continuing role Yarg was to play. This was the impending enactment of the Revenue Act of 1962, which added, of particular significance, section 1248 to the Internal Revenue Code of 1954. Serious uncertainties were presented to Gray by his attorneys as to the tax problems that could arise with respect to Gray, his wife and children by reason of the various early versions of section 1248 if they retained their ownership in the corporation. A letter addressed to Gray from his attorney, dated April 20, 1962, stated, concerning the proposed legislation, in part, as follows:
Section 18 of the Act eliminates the present estate tax exclusion for foreign real estate. This reduces the incentive for you to build an estate in Canada.
The provision of the Act which concerns me most is Section 18 which states that redemptions or liquidation distributions to U.S. stockholders from a controlled foreign corporation will be taxed as dividend income instead of capital gain. If enacted this would virtually eliminate the possibility of liquidating Yarg, Ltd., in the future. This provision is to be made effective upon enactment of the Act, unlike the other sections I mentioned which will be effective after the end of 1962 or later. I recognize this Section may be modified as to effective date or it may be made to apply only to earnings accumulated after the enactment of the Act but I am reluctant to rely on this.
Because of the uncertainties presented to Gray by his attorneys as to the tax problems that could arise under the early versions of the bill, Gray concluded that it would be best to terminate such ownership; this decision was not made by Gray until the latter part of August 1962. Because of the sense of urgency created by the effective date provision referred to above, Gray concluded that the termination of their Yarg stock ownership should take place at the earliest possible date.
Having decided to terminate the Yarg stock ownership as quickly as possible, the next decision to be made by Gray was the manner in which that ownership would be terminated. Gray again consulted with his attorneys, who advised him that there were two alternative routes which could be followed. First, he was advised that Yarg could be liquidated, which it was stated might result in ordinary income. Second, he was advised that the stock of Yarg could be sold to an unrelated third-party purchaser at capital gains rates. Faced with these alternatives, Gray chose the stock sale route. If Gray had known that there was any substantial possibility that the sale of the Yarg stock would have resulted in ordinary income, the sale would not have taken place, since be would have retained only 10 percent of the sale proceeds after taxes at ordinary rates.
Having decided to sell the Yarg stock, it became necessary to locate an unrelated purchaser for the stock. To this end, Gray asked his attorney, Donald J. Griswold (hereinafter referred to as Griswold) of the law firm of Pattullo, Gleason & Griswold, Portland, Oreg., and two well-known investment banking firms, Dean Witter & Co. of San Francisco, Calif., and Blyth & Co. of New York, N.Y., to assist him in his efforts to find a purchaser. Efforts were then expended by all parties to find a purchaser. Dean Witter & Co. made an offer of the stock to Investors Diversified Services, a large mutual fund in Minneapolis, Minn., discussed the matter with one of the governors of the Investment Bankers Association and made several offers of the stock through its Montreal office. Griswold, working through an attorney of his acquaintance, Hugh Guthrie, of the law firm of Hungerford, Gamble & Guthrie of Guelph, Ontario, Canada, came in contact with another attorney, David Ward (hereinafter referred to as Ward) of the law firm of Macdonald, Davies & Ward of Toronto, Canada. In turn, Ward introduced Griswold to Frank H. Cameron (hereinafter referred to as Cameron), a resident of Vancouver, British Columbia, Canada. Subsequently, in early September 1962, Griswold discussed the matter by telephone with Cameron, who expressed an interest in purchasing the stock of Yarg. Griswold had never known or heard of Cameron prior to being put in touch with him by Ward in September 1962.
On September 11, 1962, Cameron met in Griswold’s law offices in Portland with Griswold and with David S. Pattullo (hereinafter referred to as Pattullo), one of Griswold’s law partners, and Fred IT. Torp (hereinafter referred to as Torp) of the law firm of Davies, Biggs, Strayer, Stoel & Boley of Portland, Oreg., who also represented Gray. Following his meeting with Griswold, Pattullo and Torp, Cameron prepared a letter dated September 11, 1962, addressed to Gris-wold’s law firm which was transcribed by a secretary in Griswold’s office, stating, in part, as follows:
TMs letter will be our undertaking that we will cause a group of investors in Vancouver, B.O. to purchase all of the issued shares of a company known as Yarg Ltd. for cash in an amount equal to the net book value less 4%