author: Leech: Disney,

text:
    N. O. Nelson Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 104228.
    Promulgated December 9, 1941.

      Stanley S. Waite, Esq., for the petitioner.

      Carroll S. Walher, Esq., for the respondent.
   OPINION.

Leech:

The respondent determined deficiencies in income tax for the years 1936 and 1937 in the amounts of $4,434.30 and $27,624.21, respectively.

The only issue is whether, in computing its surtax on undistributed profits for 1936 and 1937, under section 14 of the Revenue Act of 1936,. petitioner is entitled to a credit under section 26 (c) (1) or 26 (c) (2) of that act. Other adjustments made by respondent and assigned as errors were conceded by petitioner.

We find the facts as submitted by stipulation and exhibits.. Petitioner, a corporation incorporated under the laws of Missouri on June 28,1934, was organized by the N. O. Nelson Manufacturing Co., a Missouri corporation, hereinafter called Manufacturing Co., for the purpose of continuing the business of the latter company in accordance with the terms of an agreement dated December 3, 1934, between the petitioner, the Manufacturing Co., and sundry creditors of the latter. It filed its income tax returns for 1936 and 1937 with the collector of internal revenue for the first collection district of Missouri.

Under the above mentioned agreement, the Manufacturing Co., which had executed a first mortgage deed of trust dated May 5, 1933, for the benefit of creditors, transferred certain of its assets, having a book value of $791,808.54, to petitioner in consideration of its entire authorized capital stock and the assumption by the petitioner of certain liabilities. The transaction became effective December 31, 1934, and the petitioner commenced operations January 1, 1935, with a capital stock of $100,000, divided into 1,000 shares of a par value of $100 each, and a capital surplus of $691,808.54.

In accordance with the agreement, Spang, Chalfant & Co. and the American Radiator & Standard Saniteay Corporation advanced petitioner cash and sold merchandise to it on credit amounting to $120,000 each by March 31,1936. It was agreed that this indebtedness was to be evidenced by notes of petitioner and endorsed by the Manufacturing Co. It was further agreed that 50 percent of petitioner’s capital stock was to be deposited with Spang, Chalfant & Co. and the other 50 percent with the American Radiator & Standard Sanitary Corporation as collateral to secure payment of merchandise purchased by petitioner on credit. The agreement also contained the following statement:

* * * All dividends, if any, upon said stock so deposited as collateral shall be paid only out of current earnings to tlie respective pledgees thereof to he applied on account of any indebtedness owing to them at the time of such payment. * * *

In order to secure additional time for the payment of this indebtedness, and for other purposes, an agreement dated January 21, 1936, was entered into between petitioner, the Manufacturing Co., the American Radiator & Standard Sanitary Corporation, Spang, Chal-fant & Co., and the Mercantile-Commerce Bank & Trust Co., the latter acting for the creditors for whose benefit the mortgage deed of trust dated May 5, 1933, was executed. In accordance with the terms of this agreement, petitioner, on April 1, 1936, executed promissory notes in the amount of $120,000 each in favor of Spang, Chalfant & Co. and the Aunerican Radiator & Standard Sanitary Corporation, to evidence petitioner’s indebtedness to those companies. Also, it provided that payments on the principal of the notes would not be enforced prior (o April 1, 1941. No payments were made thereon in 1936, but in 1937 $30,000 was paid on each note. This agreement further provided as follows:

6. (e) That all surplus funds not required for carrying on the business of N. O. Nelson Co. will be paid ratably to the American Radiator and Standard Sanitary Corporation and Spang, Chalfant and Co., Inc. and to the Mercantile-Commerce Bank and Trust Company, of St. Louis, on the notes of the N. O. Nelson Co., payable to the N. O. Nelson Manufacturing Company and pledged with the Trustee as additional security for the Mortgage Deed of Trust * * *.
9. The said agreement of December 3, 1934, * * * shall continue in full force and effect until April 1,1941, and be in nowise altered, modified or impaired hereby, except to the extent that the same is hereby expressly modified.

As a result of cash loaned petitioner by the Manufacturing Co., beginning on or about January 1,1935, by March 31, 1936, the former was indebted to the latter in the amount of $110,000. This indebtedness was evidenced by a promissory note of petitioner dated April 1, 1936, which was made payable to the Manufacturing Co., endorsed by it, and deposited with the Mercantile-Commerce Bank & Trust Co. as additional security under the mortgage deed of trust of May 5, 1933. No payments were made on this note in 1936, but $27,500 was paid to the Mercantile-Commerce Bank & Trust Co. in 1937.

For the calendar year 1935 petitioner sustained a loss of $61,156.14, and for the calendar years 1936 and 1937 realized net income in the respective amounts of $21,796.48 and $156,997.98, before provision for Federal and state income taxes. The capital surplus and earned surplus of petitioner on December 31, 1935, 1936, and 1937, were as follows:

Petitioner neither declared nor paid any dividends in 1936 and 1937.

Petitioner contends it is entitled to a credit under section 26 (c) (1) of the Revenue Act of 1936 of its entire “adjusted net income” for each of the years in question, in computing its undistributed profits tax for those respective years since, it argues, none of that net income could have been distributed in either of those years “as dividends without violating a provision of a written contract executed by the corporation prior to May 1,1936, which provision expressly deals with the payment of dividends.” Its alternative position is that, in any event, in computing such tax for 1937, it is entitled to a credit for $87,500 which the petitioner actually paid Spang, Chalfant & Co., the American Radiator & Standard Sanitary Corporation, and the Mercantile-Commerce Bank & Trust Co. during that year on account of its obligations to them, under the provisions of section 26 (c) (2) of the Revenue Act of 1936.

The original contract of December 3,1934, provided that “All dividends, if any, upon said stock so deposited as collateral shall be paid only out of current earnings to the respective pledgees thereof to be applied on account of any indebtedness owing to them at the time of such payment.” The amendment to this contract of January 21, 1936, continued the original agreement “in full force and effect * * * except to the extent that the same is hereby expressly modified” and provided “(e) That all surplus funds not required for carrying on the business of N. O. Nelson Co. [petitioner] will be paid ratably to [petitioner’s creditors] * * If the provision in the original contract expressly referring to the payment of dividends survived at all in the quoted modification in the amendment of January 21,1936, then as we understand petitioner’s argument, “all the surplus funds of the petitioner,” which necessarily included current earnings of each of the taxable years, would have had to go to its creditors by way of dividend distribution. Petitioner then says such distributions would not have constituted taxable dividends and that, since all other dividend distributions were by the same provision precluded, no taxable dividends could have been declared or paid out of the current earnings of either of the taxable years without violating such express provision of the contract. We disagree with petitioner.

The amended contract, which is controlling, eliminated the provision expressly referring to the payment of dividends in the original contract and required that “all surplus funds not required for carrying on [its] business” which, of course, included current earnings, were to be paid to petitioner’s creditors, not as dividends assigned to those creditors by petitioner’s sole shareholder, the Manufacturing Co., but as direct payments to them on account of petitioner’s obligations. Petitioner argues that by so expressly limiting the use of current earnings to the payment of debts which undoubtedly existed during both of the taxable years, the use of those funds for any other purpose, one of which could have been the distribution of taxable dividends, was expressly precluded. The argument is not sound. It may well be that such limiting provision, thus construed, would preclude the distribution of taxable dividends. But that mandate would be a consequence, only, of the limitation expressed in the contract. That is to say, such a mandate would be implied from and not expressed in the contract. See Wood v. United States, 16 Peters, 342. Therefore such construction would not satisfy section 26 (c) (1). Helvering v. Moloney Electric Co., 120 Fed. (2d) 617, reversing 42 B. T. A. 78; Sandura Co., 45 B. T. A. 493.

On the alternative issue, is petitioner entitled to a credit for $87,500, (be total of the amounts paid to creditors during 1937, under section 26 (c) (2) of the Bevenue Act of 1936? We think it is.

The written contract, as amended on January 21, 1936, provided that “all surplus funds not required for carrying on [its] business” were to be paid ratably to the named creditors. This is categorical as to those funds. They can be appropriated or used for no other purpose. They must be so used or set aside for that use currently when they arise. Petitioner did both. It set them aside by actual payment. The expression “all surplus funds” certainly includes earnings and profits. G. B. R. Oil Corporation, 40 B. T. A. 738, and Michigan Silica Co., 41 B. T. A. 511 (on appeal, C. C. A., 6th Cir.).

Under the limitation that only such funds as are “not required for carrying on [petitioner’s] business” are to be so paid may give petitioner some latitude in determining the amount to be thus used. But petitioner, in making payment, has in fact fixed that amount and it has been paid as “required” by the contract. Surely the payment of that amount, at least, was “required.” We reverse the respondent and allow the contested credit of $87,500 under section 26 (c) (2) of the Bevenue Act of 1936, supra.

Beviewed by the Board.

Decision will be entered vmder Rule SO.

Vast Fossak dissents.

Disney,

dissenting: I must disagree with the conclusion to which majority come, in allowing the petitioner credit for the amount actually paid its creditors during 1937 from earnings and profits. I find in the contract relied upon no provision which in my opinion satisfies section 26 (c) (2) of the Bevenue Act of 1936. The contractual provision upon which the majority opinion in this respect is based is that “all surplus funds not required for carrying on the business of N. O. Nelson Co. [petitioner] will be paid ratably to [petitioner’s creditors] * * The statutory requisite is that a written contract expressly dealing with disposition of earnings and profits of the taxable year shall require earnings and profits to be paid in discharge of, or irrevocably set aside for the discharge of, a debt. In my opinion the above quoted language contains no such requirement. It seems to me plain that the petitioner was, by the above quoted contractual provision, in no wise required either to pay or to set aside for payment any earnings and profits; but that on the contrary it was allowed to use all of such earnings and profits and other funds to carry on its business. Only above the amount required for business purposes is there any provision as to payment. This leaves the matter discretionary with the petitioner. It may or may not pay upon its debt, for the amount it may use for carrying on business is not limited. I do not think that it is within the intendment of section 26 (c) (2) that such discretion be left in the applicant for credit. My conception of that section is that the taxpayer must either distribute the earnings and profits, rendering them taxable to its stockholders, or retain them and pay the tax, or show that it is prevented by a contract from paying out such funds — in other words, that its creditors, and not the -corporation, control the situation. Otherwise no reason appears for granting the credit. The mere fact that debts are paid, out of earnings and profits, does not give credit under section 26 (c) (2). Congress limited the credit to debts paid under the sanction of a contract, and a contract executed prior to a certain date. Only the impact of the contract, taking from the taxpayer its control over the earnings and profits, is sufficient foundation for the credit. Here the taxpayer was completely in control, for it could use all of its funds in carrying on its business. It will not do, I think, to say that only some reasonable amount might be used to carry on business and that the remainder was so subject to the demand of creditors as to be within the purview of section 26 .(c) (2). In the first place, the contract does not so limit the matter, does not say “reasonably required for carrying on the business”; and in the second place, in the absence of a contractual provision limiting the amount used to carry on business, to a reasonable amount of earnings and profits, I can not subscribe to any theory that a court at the behest of creditors would so far interfere with the internal affairs of a corporation as to limit the amount of business it might carry on. Courts both hesitate to interfere in internal corporate affairs, and refuse to make contracts for those who do not see fit to make them for themselves. To say that the petitioner could be prevented by the creditors from spending-more than some reasonable amount in carrying on business would be to say to a large degree that its business must remain static and could not be expanded because of the indefinite contractual provision above quoted, which, does not even contain the words “reasonably required.” By what criterion shall we say (or could a court say in a suit by the creditors) that the petitioner’s business activities shall be limited so that the surplus above its expenses, in such activities is subject to section 26 (c) (2) ? Surely it could not be said that the petitioner could do no further business than it did the year before. New circumstances, new opportunities to make money might so open up that the corporate officials would be derelict in their duty to the stockholders if they did not devote all of the earnings and profits and other funds to the carrying on and expense of business. Current history in many industries serves amply to demonstrate the thought. I find it impossible to believe that the creditors could prevail upon any court to limit the activities of the corporation and its use of its earnings and profits, under the above quoted contractual provision, in the face of a contention by the corporation that it was actually using the funds in business, within the judgment and discretion of the corporate officers. Yet control by the creditors seems to me to be the test.

The majority opinion seems to hold that the contract, within the purview of section 26 (c) (2), does control and “require” the payment because the corporation made a determination, by paying the amount of $87,500, that that amount was “surplus funds.” This seems to me <o beg the question. The contract did not require the corporate officers to make any such determination, but left the matter as above discussed within their discretion. Thus we discern that it was not the contract and its impelling force which caused the payment of the $87,500 and any determination latent therein that .that amount was “surplus funds”, but that such result merely arises from the discretion and control left in the corporation. That control as I see it must be outside of the corporation and lodged in'the creditors. Otherwise we have a situation where the corporation can at its will control the matter of the credit it shall receive under section 26 (c) (2). This I conceive to be directly inimical to the intendment of that section. As above discussed, the mere fact of payment of the debt by no means entitles the corporation to credit under section 26 (c) (2); yet the majority conclusion is in effect merely that payment, voluntary and discretionary, satisfies the statute. The contract did not require it and, in my opinion, the credit is therefore not properly allowed. In Dr. Pepper Bottling Co. of Memphis, Inc. 45 B. T. A. 540, we said in a matter in principle analogous to this:

* * * Thus it appears that it is not the contract, hut the manner in which the petitioner transacted the matter of its discharge hy the use of income, that prevents the distribution of dividends to the extent of the §29,924.38 here involved only because it was in fact paid from the petitioner’s only income. * * *

I regard it as contrary to the objectives of section 26 (c) (2) to allow the discretion of the .corporate officers as to payment of its earnings and profits to control as to whether credit shall be .obtained in the taxable year. I therefore respectfully dissent.

Murdock and Hill agree with this dissent.

       SEC. 26. CREDITS OF CORPORATIONS.
      In the case oí a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax.—
      * * * * * * *
      (c) Contracts Restricting Payment op Dividends.—
      (2) Disposition op propits op taxable year. — An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. For the purposes of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word “debt” does not include a debt incurred after April 30, 1936.


source: Caselaw Access Project

author: Black : Mellott, Van Fossan,

license: Public Domain

text:
    Boston Elevated Railway Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 83489, 97991, 100480, 102555.
    Promulgated December 9, 1941.

      Charles W. Muleahy, Esq., and Ward Loveless, Esq., for the petitioner.

      James T. Haslam, Esq., for the respondent.
   OPINION.

Black :

In our preliminary statement of this report it was pointed out that the Commissioner rested his determination of the deficiencies upon the ground that the taxable net income of petitioner should be determined upon the so-called “leased road” basis, that is to say, upon the basis that the taxable net income of petitioner for each of said years consisted of the dividends paid during the respective years to the stockholders of petitioner under the provisions of the Public Control Act, plus the Federal income tax payable thereon. This being upon the theory that the Commonwealth of Massachusetts was operating petitioner’s properties as lessee and was paying to petitioner as rentals therefor enough to cover dividends to stockholders and taxes.

There are expressions in respondent’s brief, especially the first few pages thereof, which apparently are still arguing for the “leased road” basis of determining petitioner’s net income. But be that as it may, under issue (1) of our report in Boston Elevated Railway Co., supra, we rejected the “leased road” basis and held that the commonwealth was operating petitioner’s properties for petitioner’s account. We have been cited to no authorities which would cause us to reverse our decision in that respect. Accordingly we reaffirm it. We do not deem it necessary to repeat the reasons which we gave in that report for reaching our conclusions on that particular point. We refer to them as there given without repeating them here.

The next question which we have to decide, and the only one which we understand the pleadings and stipulation really submit to us for decision, is whether the páyments made to petitioner by the commonwealth in each of the taxable years to cover deficits in its operating expenses as defined in the Public Control Act, should be taken into petitioner’s gross income for purposes of taxation.

We held in our former report, Boston Elevated Railway Co., supra, that petitioner should be taxed as any other corporation. Cf. Cleveland Railway Co., 10 B.T.A. 310; affirmed on this point, 36 Fed. (2d) 347; certiorari denied, 281 U. S. 743. This holding we reaffirm. It is certainly the general rule that when a public utility corporation, under private ownership, receives payments from the state to reimburse it for deficits incurred in operation or as a guaranty of a fair return, the corporation must return such payments as a part of its gross income for taxation. Gulf, Mobile & Northern Railroad Co., 22 B.T.A. 233; affd., 71 Fed. (2d) 953; affirmed on other issues, 293 U. S. 295; Texas & Pacific Railway Co. v. United States, 286 U. S. 285; Helvering v. Claiborne-Annapolis Ferry Co., 93 Fed. (2d) 875.

The petitioner concedes that the above decisions would be applicable and would cause the income in question to be taxable to petitioner except for one fact, and that fact petitioner alleges, is that the payments in question were loans to petitioner by the commonwealth and that, although petitioner’s obligations to repay such advances were only contingent, nevertheless such advances must be treated as loans for purposes of taxation and when so treated they do not go into petitioner’s gross income for taxation.

We think a careful study of all the facts of these transactions does not support petitioner’s contentions that the advances made to it in the taxable years which we have before us should be treated as loans. In the first place, petitioner’s books of account did not treat them as loans. The last paragraph of the stipulation of facts which has been filed with us reads:

The monies received by the petitioner from the Commonwealth of Massachusetts, as set forth in paragraph IV hereof has [sic] been credited in every year to the account designated Profit and Loss.

It is, of course, true that bookkeeping entries are not conclusive. They are merely evidentiary. If the other facts in the record show that such advances were in fact loans to petitioner, then they should be so treated and the fact that petitioner credited them to its profit and loss account in each of the taxable years would not make them taxable income to petitioner. But an examination of these facts does not, in our opinion, demonstrate that these payments by the commonwealth to reimburse petitioner for its operating deficits, including dividends and taxes, were loans.

Petitioner in its argument lays much stress on the fact that prior to December 31, 1931, the petitioner had repaid to the commonwealth amounts equal to the sum of all payments theretofore made to the petitioner by the commonwealth for deficiencies, as defined in said Public Control Act as amended. It is true that these repayments were made, as petitioner says, but they were made in substantial amounts from capital reserves hitherto set up by petitioner and from a trust fund known as the “West End Special Trust Fund.” Subsequent to 1931 there was no longer any “West End Special Trust Fund”, and also there were no funds in petitioner’s reserve. It should be noted that section 5 of the Public Control Act required petitioner to set up a reserve of $1,000,000 out of a sale of $3,000,000 of its preferred stock.

Section 8 of the Public Control Act provided how this reserve fund and any additions thereto should be used. It reads as follows:

Section 8. The reserve fund shall be used only for the purpose of mating good any deficiency in income as provided in section nine or for reimbursing the commonwealth as provided in sections eleven and thirteen, and until such use, may be invested in income-producing securities in the discretion of the trustees, and all income or interest received thereon shall be treated as part of the general income of the company.

This reserve which petitioner had established under the provisions of sections 5 and 9 of the Public Control Act was exhausted in 1931 and has not been restored in any amount. In fact there is no requirement that petitioner shall renew it by any further capital contributions. The only additions which might be made to petitioner’s reserve fund would be from excess earnings which it might have in any particular year as provided in section 9 of the Public Control Act. During the taxable years which we have before us, petitioner had no excess earnings. Even if petitioner should have any excess earnings in the future, these earnings, as we understand the Public Control Act, would first go into petitioner’s reserve to replenish the original reserve which was exhausted in 1931 before any of such reserves would be paid over to the Commonwealth of Massachusetts in repayment of its advancements. This we understand to be the meaning of the following language in section 11 of the Public Control Act (as amended by Special Acts of 1919, ch. 244). That part of section 11 as amended reads:

* * * if, as 0f the jasf. ,jay 0f any jmie thereafter during the period of public, operation, the reserve fund shall exceed the amount origin ally established, the trustees shall apply the excess, so far as necessary, to reimbursing the commonwealth for any amounts which it may have paid to the company under the provisions hereof, and the commonwealth shall thereupon distribute the amount so received among the cities and towns in which the company operates, in proportion to the amounts which they have respectively been assessed as provided in section fourteen. [Italics ours.]

No provision is made that at the end of the period of public control, when petitioner’s property is to be turned back to its own management and control, petitioner shall reimburse the commonwealth for funds which it may have paid over to petitioner during the period of public control in making good its operating deficits. In fact, section 13 of the Public Control Act provides that if at the end of the period of public control the reserve originally established is .less than it was when established, the commonwealth shall pay to petitioner sufficient funds to restore it to the original amount. Thus it will be seen that petitioner, having once established a reserve out of capital as it did in pursuance to section 5 of the Public Control Act, to be used in making repayments to the commonwealth, is under no obligation to make further payments into the reserve out of capital. Any additions to the reserve in the future must be made from excess earnings as provided in section 9 of the Public Control Act, and we do not think such an arrangement converts what otherwise would clearly be income payments, under the authorities which we have cited, into loans which would not be taxable.

We think that the requirement of the Public Control Act, that petitioner in years in which it has excess income shall pay such excess into a reserve fund to be used to repay the commonwealth, is somewhat similar to the provisions of section 209 of the Transportation Act of 1920 which required a railroad which had excess income during the guaranty period to pay such excess into the Treasury of the United States. Section 209 (d) of the Transportation Act of 1920 provided in part as follows:

Guaranty in excess of minimum operating income. — If for the guaranty period as a whole the railway operating income of any carrier entitled to a guaranty under paragraph (1), (2), or (4) of subdivision (c) of this section is in excess of the minimum railway operating income guaranteed in such paragraph, such carrier shall forthwith pay the amount of such excess into the Treasury of the United States. * * * The amounts so paid into the Treasury of the United States shall be added to the funds made available under section 72 for the purposes indicated in such section. * * *

The Supreme Court, in Texas & Pacific Railway Co. v. United States, supra, in speaking of the provisions of section 209 of the Transportation Act of 1920, including the above quoted provision, among other things, said:

* * * If the fruits of the employment of a road’s capital and labor should fall below a fixed minimum, then the government agreed to make up the deficiency, and, if the income were to exceed that minimum, the carrier bound itself to pay the excess into the federal treasury. In the latter event, the carrier unquestionably would have been obligated to pay income tax measured by actual earnings; in the former, it ought not to be in a better position than if it had earned the specified minimum. Clearly, then, the amount paid to bring the yield from operation up to the required minimum was as much income from operation as were the railroad’s receipts from fares and charges.

Whether petitioner, in a year when it has excess earnings and pays some of these excess earnings into a reserve to be used under certain conditions in making repayment ol advances made by the commonwealth, would be entitled to a deduction therefor on its income tax return, we do not now decide. We have no such payments in any of the taxable years which are before us. The petitioner, in support of its contention that the payments in question from the commonwealth were loans and should not be taken into petitioner’s gross income, relies upon the Board’s decision in Boston Elevated Railway Co., supra.

In our decision in that case, we upheld petitioner’s contention that a payment of $1,775,388.80 which it received from the commonwealth, July 15, 1932, similar to the payments which' petitioner received from the commonwealth in each of the taxable years now before us, was a loan and therefore should not be taken into petitioner’s gross income. Our decision in that case was largely based upon the court’s opinion in Island Petroleum Co. v. Commissioner, 57 Fed. (2d) 992; certiorari denied, 287 U. S. 646, affirming 17 B. T. A. 1.

A further study of the law and facts connected with the payments by the commonwealth to petitioner, which, as we have already pointed out, petitioner credited in each year to its profit and loss account, convinces us that these payments should not be characterized as loans, Therefore, our reliance in our former opinion on the Island Petroleum Co. case, and the other cases cited, was in error. We think that under authority of Gulf, Mobile & Northern Railroad Co., supra; Texas & Pacific Railway Co. v. United States, supra; and Helvering v. Claiborne-Annapolis Ferry Co., supra, we must hold that the payments which petitioner received in each of the taxable years to make good petitioner’s operating deficits as that term was defined in the Public Control Act were taxable income in the year received. Cf. Lykes Bros. Steamship Co., 42 B. T. A. 1395.

Another reason which leads us to this conclusion is that the $1,193,970 dividends which petitioner paid to its stockholders in each of the taxable years would not be taxable income to the recipient stockholders if paid out of capital, except to the extent that such payments might exceed the cost basis of the stock. It seems plain, however, that it was not the intention of petitioner to pay dividends out of borrowed capital, but out of earnings which were made up in part from its regular receipts from fares and charges to passengers and in part from receipts from the commonwealth. To the extent that our decision in Boston Elevated Railway Co., supra, is in conflict with our holding herein, it will no longer be followed.

Petitioner makes an alternative contention which we think must be sustained. Petitioner says in its brief:

* * * It is further submitted that, even if the Board should overrule its lirinr decision and hold that Hie amounts received from 11m Commonwealth are taxable, the respondent’s determinations as set forth in his deficiency letters should not be sustained, but, in such case, the net income of petitioner should be computed in accordance with the terms of Paragraph 3 of the stipulation of the parties.

Paragraph III of the stipulation has been incorporated in its entirety in our findings of fact. Notwithstanding this paragraph, the respondent attempts to support his determination as to the amount of net income by contending that we should disregard entirely the actual amounts paid to petitioner by the commonwealth in the respective taxable years and substitute in their place so-called accrued amounts as of the close of each calendar year equal to (1) the “deductions in excess of gross income” set forth in paragraph III of the stipulation, (2) the annual dividends paid of $1,193,970, and (3) the Federal income tax on the annual dividends. Clearly there is no basis for such a contention. The amounts paid to petitioner in each of the taxable years by the commonwealth could not be accrued by reason of section 11 of the Public Control Act, as amended, until the last day of June for the years 1933 and 1934 or the last day of March for all years subsequent to the year 1934. Spring City Foundry Co. v. Commissioner, 292 U. S. 182. These accruals correspond with the actual amounts paid to petitioner in each of the taxable years by the commonwealth. These amounts should be used in a computation under Pule 50.

Reviewed by the Board.

Decision will be entered under Rule 50.

Mellott,

concurring: While I concur in the holding of the majority that the amounts received from the commonwealth during the taxable years can not be characterized as loans,.. I am of the opinion that the discussion of the “leased road” theory, upon which the Commissioner relied in making his determination, is inadequate. His contention, with which I find myself in agreement, is that the various acts of the legislature created two separate and distinct entities— Boston Elevated Railway Co. (lessor) and Boston Elevated Railway Co. Public Trustees (lessee). If that be so then the amounts paid for the use of the property, albeit paid in the form of dividends to petitioner’s stockholders, constituted income to petitioner.

Van Fossan,

dissenting: I dissent from the holding that the payments by the commonwealth constituted income to the petitioner.


author: Turner :

text:
    The Thew Shovel Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 102007.
    Promulgated December 9, 1941.

      David L. Johnson, Jr., Esq., for the petitioner.

      Thomas F. Qallahan, Esq., for the respondent.
   OPINION.

Turner :

The respondent determined a deficiency in income tax for the year 1936 in the amount of $49,529.66. Petitioner claims an overpayment of income tax in the amount of $1,518.67. The question presented is whether, in computing the surtax on undistributed profits imposed under section 14 of the Revenue Act of 1936, petitioner is entitled, under section 26 (c) (1) of the Revenue Act of 1936, on account of a contract restricting the payment of dividends, to a credit against its adjusted net income. The parties have filed a written stipulation of facts with certain exhibits attached thereto, and the Board adopts such stipulation as its findings of fact. We shall recite only the facts deemed necessary to discussion of the issue presented.

Petitioner is an Ohio corporation, with offices at Lorain, Ohio, and is engaged in the manufacture and sale of power shovels and related- machinery. It filed its income tax return for 1936 with the collector of the eighteenth district at Cleveland, Ohio.

As of July 1, 1933, an indenture agreement between petitioner and the National City Bank of Cleveland, the latter acting as trustee, was executed, which agreement provided for an issue of 847,500 principal amount of 6% percent refunding notes. As of September 30, 1935, petitioner had outstanding $491,274 principal amount of the said notes and they matured in installments on January 1, April 1, and July 1, 1936. The said indenture contained a covenant that, so long as the refunding notes remained unpaid, petitioner would not pay any dividends on its common stock and not more than 5 cents per share per year on its preferred.

Prior to October 11,1935, the National City Bank of Cleveland had made no loans to petitioner, but the president of the latter had conferred with the president and vice president of the bank concerning the possibility of obtaining a line of credit for a portion of the amount necessary to enable petitioner to redeem, before maturity, the aforesaid outstanding refund notes. On October 11, 1935, the executive committee of the bank took the following action, as stated in its minutes:

Subject to further checking to the satisfaction of the officers, a line of credit for The Thew Shovel Company in the amount of $250,000.00 was approved subject to the usual conditions as to continued satisfactory financial condition and the maintenance of supporting deposit balances ; also on condition that dividends shall not be paid except to the extent of two-thirds of the amount of earnings over and above $100,000.00 per year, and not to exceed $100,000.00 per year; and that the direct borrowings from banks shall not exceed $500,000.00 and commercial paper discounted shall not exceed $250,000.00.

On October 29,1935, the board of directors of the petitioner adopted the following resolution:

Now, Thbeefoee, Be It Resolved that the President of this Company be and he is hereby authorized to borrow on behalf of this Company from a bank or banks an amount or amounts of money not to exceed $500,000 in addition to any and all amounts heretofore authorized, and that the proper officers of this Company be and they hereby are authorized to execute on behalf of this Company the Company’s note or notes evidencing the amount so borrowed, the rate of interest to be such as the President may in his discretion determine to be the best rate available, and all other terms to be such as the President may in his discretion determine.
Further Resolved that the proper officers of this Company be and they hereby are authorized, in the event that the funds necessary therefor can be ob-iained, to take all steps and do all things necessary or proper to anticipate on January 1, 1936, the installments due April 1, 1936 and July 1,1936, on the Company’s 6%% Refunding Notes dated as of July 1, 1933.

On November 9, 1935, the petitioner’s president wrote the bank as follows:

This will confirm our understanding that the National City Bank has approved a line of credit for The Thew Shovel Co. up to $250,000. This with the similar line of credit granted by the Central United National Bank, will enable ns to carry out our expressed desire to prepay on January 1st the remaining installments of our refunding notes and also retire the limited amount of debentures outstanding which have not been exchanged for the refunding notes.
Under the terms of our indenture it will be necessary to deposit the funds required for the purpose with the National City Bank, Trustee, December 2nd, 1935 whereupon the Trustee will notify all registered note holders that we are taking advantage of the stipulation which permits us to make prepayment in full January 1st.
We shall therefore wish to make use of the entire line of credit so as to have the funds available either November 30th or December 2nd. Mr. R.. B. Miller, oiir Treasurer, will contact Mr, Shannon with reference to the preparation of the note or notes and will also ascertain if you desire any action by our Board of Directors beyond that taken under advice of counsel at a recent directors meeting authorizing the retirement of the notes and the borrowing of funds necessary for the purpose.
It is further understood that we will at about the same time establish a working account with the National City Bank and carry balances which at the outset will not be less than 10% of the loan and which we shall hope to increase materially thereafter.
It will he the policy of The Thew Shovel Co. to take no action with reference to the resumption of dividends on either preferred or common stock without fully discussing the situation with both banks and ascertaining that any action proposed is not considered unjustifiable.
* * * * * * *

On November 13,1935, the president of the bank replied as follows:

I have your letter of the ninth, concerning the loan arrangements which we discussed the other day when you were in. As I told you, we established a line of credit for The Thew Shovel Company in the amount of $250,000, subject to the continued satisfactory financial condition of the company and the maintenance of supporting balance.
It is our understanding that the borrowings of The Thew Shovel Company and The Universal Crane Company will not exceed $750,000., and that not more than $250,000., of this amount will be in the form of customers’ paper discounted.
I believe that it is our understanding that if you have occasion to increase your borrowings beyond the figure stated above, you will talk to us about it at that time. I also note what you say about dividend action and your assurances in this respect are entirely satisfactory.
* * * * * ‡ *

On November 29, 1935, the petitioner executed and delivered to the bank its ninety-day note for $250,000 and the funds in that amount were made available to petitioner on November 30, 1935. Thereafter, during the remainder of 1935 and the entire year of 1936, the petitioner remained obligated to the bank iir the full amount of $250,000, successively renewing its note on February 27, May 27, .August 25, and November 23, 1936. The entire amount was still owing to the bank on January 1, 1937.

On or about December 1, 1935, the petitioner also borrowed an additional amount of $250,000 from the Central United National Bank, and with the funds borrowed from the two banks it called the aforesaid refunding notes for redemption before January 1, 1936. During the year 1936 petitioner paid off $100,000 of the amount borrowed from the Central United National Bank and during that year it made no written request for the bank’s consent to declare or pay dividends.

During the year 1935 and prior to October 27, 1936, the petitioner did not declare or pay any dividends on its preferred or common stock. On October 27, 1936, petitioner wrote to the National City' Bank as follows:

You have received our financial statement of Sept. 30, 1930 and the statement of earnings for the first nine months of the year. These earnings seem to justify a dividend distribution before the end of the year and such action is the more desirable by reason of the existing surtax upon undistributed profits. Our directors should take definite action to that end before Dec. 1st.
We recognize, however, that a contractual arrangement exists in connection with our $250,000. loan from your bank as expressed in our letter of November 9, 1935 and your reply of Nov. 13, 1985 whereby we are bound to secure your approval of and consent to any dividend distribution tha^t may be made. We therefore request that you advise us as to your attitude regarding the payment of dividends by us in so far as such payment relates to the loan in question. An early reply will be appreciated.

On October 30, 1936, the executive committee of the bank, acting upon the request of the petitioner, took the following action, as stated in its minutes:

In addition to present commitments of $250,000. for direct loans, and $150,000. to cover customers paper discounted, on motion duly made, seconded and unanimously carried it was agreed to discount for The Thew Shovel Company up to a total of $150,000. of customers paper on condition that a similar commitment will be secured from other banks.
The Chairman explained to the Committee that pursuant to an agreement entered into when the direct loan of $250,000. was made to The Thew Shovel Company in October of 1935, that company has asked our permission to pay all arrearages of dividends on the preferred stock of The Thew Shovel Company; 12% % of the arrearages of dividends of the preferred stock of the Universal Crane Company, and dividends of 50 cents per share on the common stock of The Thow 'Shovel Company, requiring the payment of a total amount of approximately $332,400.00. After a full discussion, on motion duly made, seconded and unanimously carried it was decided that permission be given to pay such dividends.

On the same day, October 30, 1936, the vice, president of the bank wrote the petitioner as follows;

We have your letter of October 27, 1936 with reference to the payment of dividends prior to the end of the current year.
In November, 1935 after most careful investigation we offered to loan The Thew Shovel. Company $250,000., provided that the Company could secure an additional loan of equal amount, for the purpose of retiring in advance of their due dates your outstanding refunding notes approximating $500,000 in amount.
It was represented to us that the loan could and would be repaid out or prospective future earnings of the Company and this representation seemed to be substantiated by our investigations. The refunding notes which were to be retired carried a provision restricting the payment of dividends by the Company and it seemed proper to us that restrictions of a similar nature should apply to our loan.
The records of our Executive Committee show that they authorized the loan upon the condition that no dividends should be paid from the first $100,000. of earnings and not to exceed two thirds of the earnings in excess of $100,000. with a further limitation that dividends in excess of $100,000, should not he declared.
Tour letter of November 9, 1935, while not setting forth the above arrangement in detail, stated that no dividends would be paid without our approval, thereby enabling us to enforce the conditions upon which our loan was made. We therefore stated in our reply of November 13, 1935 that your assurances in this respect were satisfactory and thereafter made the loan to you pursuant to this contractural agreement.
In view of your unexpectedly large earnings we are willing to waive the limitation that dividends shall not be paid in excess of $100,000. but we do insist that you retain the first $100,000. of your 1936 earnings and one-third of earnings in excess of $100,000., and that such portion of earnings shall not be distributed as dividends, but shall be retained in the working capital of the Company.
We trust that this clearly answers the question raised in your recent communications. We believe that the position we have taken is for the best interest of your Company as well as for the proper protection of this bank.

On November 9, 1936, the petitioner’s president wrote a letter to the bank, replying to the above letter, saying that:

This will acknowledge your letter of October 30th which states very clearly the attitude of the National City Bank with reference to the proposed distribution of dividends by The Thew Shovel Co. We recognize the justice of your conclusions and shall be governed in our actions by the limitations originally established by your executive committee when the loan was made to us in November, 1935.

On November 10, 1936, the board of directors of the petitioner declared a dividend of $33.25 per share on its preferred stock, representing all dividends accruing up to December 15, 1936, and a dividend of 50 cents per share on its common stock, amounting to a total of $316,530.75.

At December 31,1936, the petitioner was indebted to the two banks on its notes in the amount of $400,000. It was also contingently liable in the amount of $589,796.03 on customers’ notes discounted.

The petitioner furnished the National City Bank with quarterly financial and earnings statements and the annual reports of its independent auditors. Those statements showed that the net earnings of the petitioner, before provision for Federal income taxes, were $173,332.92 for the year 1935, $512,997.42 for the first nine months of 1936, and $741,939.90 for the full year 1936. The statement dated September 30, 1936, shows “Estimated normal tax” for the first nine months in the amount of $75,789.61. The balance sheets of the petitioner show capital surplus of $854,122.10 and earned surplus of $571,068.26 as of December 31, 1935, and capital surplus of $866,-939.60 and earned surplus of $831,127.41 as of December 31, 1936. The corrected net income for income tax purposes, as computed by the respondent, before provision for Federal income taxes, was $150,-296.13 for’ 1935 and $771,673.60 for 1936. The Federal income tax paid by petitioner for 1935 was $20,665.72.

The petitioner’s “adjusted net income” for the taxable year ended December 31, 1936, was $667,536.92, and its normal income tax for that year was $104,136.68. Income tax already paid by petitioner for 1936 amounts to $108,464.58.

In its return for 1936 the petitioner, relying on section 26 (c) (1) of the Bevenue Act of 1936, claimed a credit against adjusted net income in the amount of $315,683.69 and the respondent, in determining the deficiency herein, disallowed the credit so claimed. The credit provided by section 26 (c) (1) is “an amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends.”

It is the contention of the petitioner that its letter of November 9, 1935, and the bank’s letter of November 13, 1935, constituted such contract, that it could not have distributed during the taxable year as dividends any amount in excess of $356,662.66 without violating the provisions thereof, and that it is therefore entitled to a credit equal to the excess of its adjusted net income over that amount.

The respondent’s argument in effect is that even though a written contract did exist it did not operate as a legal restriction on or prohibition of the payment of dividends within the meaning of the statute.

In its reply brief petitioner specifically disavows any claim that the resolution adopted by the executive committee of the bank on October 11, 1935, preliminary to the commitment by the bank to make the loan, was part of the contract by implication Or otherwise. It does claim, however, that by its letter of November 9, 1935, it was obligated to pay no dividends without the consent of the bank and upon acceptance of the proposal by the bank in its letter of November 13, 1935, a contract within the meaning of section 26 (c) (1), supra, came into existence. Cf. Kilby Steel Co., 41 B. T. A. 1237, and Chess & Wymond v. Glenn, 40 Fed. Supp. 666 (U. S. Dist. Ct., W. Dist. Ky., Sept. 6, 1941). See also Atlantic Co., 45 B. T. A. 657, wherein the bank had “the right at its option to declare any note of the company [the taxpayer] held by it at once due and payable,” but had no right to prevent the payment of dividends. The provisions of the above letters dealing with the payment of dividends appear as the fifth paragraph of petitioner’s letter and as the second sentence of the third paragraph of the bank’s letter. In the petitioner’s letter it was stated that “It will be the policy of The Thew Shovel Co. to take no action with reference to the resumption of dividends on either preferred or common stock without fully discussing the situation with both- banks and ascertaining that any action proposed is not considered unjustifiable.” The bank’s reply was signed by its president and the pertinent statement was, “I also note what you say about dividend action and your assurances in this respect are entirely satisfactory.”

These letters certainly meet two tests of the statute. They were in writing, executed prior to May 1, 1936, and they did “expressly” deal with the payment of dividends. Treating the petitioner’s letter as an agreement not to pay dividends without the consent of the bank and assuming that such an agreement to the extent consent is not given is a contract within the meaning of the statute here under consideration, it still does not appear from the facts of record that the petitioner is entitled to the credit claimed or any part thereof.

The petitioner under date of October 27,1936, requested the consent of the bank to the declaration of dividends and on October 30, 1936, the bank gave its reply. The petitioner in its letter stated that it felt its earnings record would justify the resumption of dividends and in that connection called attention to its financial statement of September 30, 1936, and its statement of earnings for the first nine months of the year, both of which had been furnished the bank. In its reply the bank, after referring to the resolution of its executive committee originally authorizing the officers of the bank to make the loan to petitioner, consented to the payment of dividends in the following language:

In view of your unexpectedly large earnings we are willing to waive the limitation that dividends shall not be paid in excess of $100,000 but we do insist that you retain the first $100,000 of your 1936 earnings and one-third of earnings in excess of $100,000, and that such portion of earnings shall not be distributed as dividends but shall be retained in the working capital of the company.

The substance of the petitioner’s argument appears to be that the consent of the bank to the distribution of dividends extended only to two-thirds of the excess of the 1936 earnings over $100,000, after making allowance for 1936 Federal income tax, and that the two-thirds .of such excess amounted to $356,662.66, while as to the remainder of its earnings the restrictions of the contract still applied and distribution of any portion of such remainder would have been in violation thereof. Such an interpretation can, in our opinion, result only from a misreading of the bank’s letter of consent. That consent was expressed not in terms of the earnings that might be distributed but in terms of the earnings which the bank insisted the petitioner must retain, thereby indicating its consent to the distribution of all other earnings. Specifically, the bank said that it was willing to waive the limitation it had originally determined upon as to the maximum amount of dividends that might be distributed in any one year, but said that it did insist that the petitioner retain the first $100,000 of its 1936 earnings and “one-third of earnings in excess of $100,000.” Accordingly, the petitioner was required to retain from its total earnings the first $100,000 of its 1936 earnings and one-third of earnings in excess of $100,000, leaving it free to distribute as dividends all other earnings.

With respect to earnings which could be distributed as dividends by the petitioner unless restricted by the contract between it and the bank, the parties have stipulated that net earnings for the full twelve months of 1936, before provision for Federal income tax, were $741,-939.90 and that the normal income tax for 1936 was $104,136.68. A comparative balance sheet attached to and made a part of the stipulation shows that earned surplus at December 31, 1935, was $571,-068.26. It is accordingly apparent that earned surplus at the beginning of the year 1936 plus net earnings during that year, after provision for normal income tax, was slightly in excess of $1,200,000. By the terms of the bank’s consent the petitioner was required to withhold from distribution the first $100,000 of 1936 earnings and “one-third of earnings in excess of $100,000.” Applying that consent to the earnings which could be distributed as dividends on or prior to December 31, 1936, it appears that the petitioner could have distributed during the year 1936 a sum in excess of $700,000. The parties have stipulated that adjusted net income for the taxable year ended December 31, 1936, was $667,536.92. Accordingly adjusted net income did not exceed the amounts which could have been “distributed within the taxable year as dividends without violating provisions of a written contract” and there is no amount which may be credited against adjusted net income under section 26 (c) (1) in computing the surtax on undistributed profits. Cf. Central West Coal Co., 44 B. T. A. 661; Trianon Hotel Co., 44 B. T. A. 1073; and Maumee Malleable Castings Co., 44 B. T. A. 263. It might, of course, be argued that a proper interpretation of the bank’s consent- would require the. retention of only one-third of the 1936 earnings in excess of and in addition to the first $100,000 from 1936 earnings, but if that interpretation should be made, the result would be to lessen the amount of the earnings still subject to the restriction of the contract and to increase the amount which could be distributed without violation of its provisions, because in such case there would be no restriction whatever in the terms of the bank’s consent to the distribution of accumulated earnings on hand at the beginning of the year.

Decision will he entered wider Bule 50.

       SEC. 26. CREDITS OE CORPORATIONS.
      In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax—
      *»»***•
      (c) Contracts Restricting Payment of Dividends.—
      (1) Prohibition on payment of dividends. — An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can he distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. * * *


author: Black:

text:
    Williams Furniture Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 104191.
    Promulgated December 9, 1941.

      H. A. Mihills, G. P. A., for the petitioner.

      P. L. Yam, Saaften, Esq., for the respondent.
   OPINION.

Black:

The principal issue in this proceeding is whether, under section 112 (f) of the Revenue Acts of 1934 and 1936, no gain or loss should be recognized in connection with the proceeds of $120,000 received by petitioner as use and occupancy insurance as the result of the fire which destroyed the greater part of petitioner’s plant on March 31, 1936, which proceeds, together with straight fire insurance proceeds, were credited to a replacement fund account on its books and all used in. the acquisition of other property similar or related in service or use to the property destroyed by the fire. As an alternative petitioner contends that, if gain is to be recognized, it all accrued during the fiscal year ended May 31,1936, and none of it is taxable for the fiscal year ended May 31, 1937. Section 112 (f) of both acts is identical and is printed in the margin.

At the time petitioner filed its returns for the taxable years in question it reported the occurrence of the fire and the receipt of the proceeds, but contended that no gain or loss should be recognized since it had used all of the proceeds, and more too, in the acquisition of other property similar or related in service or use to the property destroyed. The respondent allowed this contention with respect to the proceeds of straight fire insurance, but rejected'the contention with respect to the proceeds of $120,000 from the use and occupancy insurance, and in his deficiency notice “held that the proceeds from use and occupancy insurance contracts constitute taxable income prorated between the two years, $26,000.00 to the fiscal year ended May 31,1936, and $94,000.00 to the fiscal year ended May 31,1937.” The respondent has not cited any authority for his determination and subsequent to the hearing he notified us that he did not desire to file a brief.

Article 112 (f)-l of Kegulations 86 and 94 contains a paragraph, identical in both regulations, which reads as follows:

The proceeds of a use and occupancy insurance contract, which by its terms insured against actual loss sustained of net profits in the business, are not proceeds of an involuntary conversion but are income in the same manner that the profits for which they are substituted would have been.

Doubtless the Commissioner relied upon this regulation in his determination of the deficiencies. It seems to be well settled that, if under the terms of a use and occupancy insurance contract the taxpayer is insured against actual loss sustained of net profits in the business, then it is true that the proceeds received under such a policy are not proceeds of an involuntary conversion, but are income in the same manner that the profits for which they are substituted would have been. International Boiler Works Co., 3 B. T. A. 283; Miller v. Hocking Glass Co., 80 Fed. (2d) 436; certiorari denied, 298 U. S. 659. If, however, the contract of insurance does not insure against the loss of net profits, but is a contract to pay the insured a flat per diem allowance for the loss of the use and occupancy of the property destroyed by fire, measured from the date of the occurrence of the fire to the time when the destroyed property can, with ordinary diligence, be replaced and operations resumed, then upon receipt of the proceeds under such a policy no gain or loss should be recognized, providing the proceeds are expended in the acquisition of other property similar or related in service or use to the property destroyed. Piedmont-Mt. Airy Guano Co., 3 B. T. A. 1009; Flaxlinum Insulating Co. 5 B. T. A. 676.

In the instant proceeding two of the three policies originally insured petitioner against the loss of net profits, but on December 8, 1935, this form of policy was cancelled and a corrected form adopted providing that if petitioner’s plant were destroyed by fire, petitioner would be paid a straight per diem amount measured by a reasonable time required for reconstruction. The third policy was on the corrected form. The record, therefore, clearly shows that the use and occupancy insurance carried by petitioner was not based upon and had no relation to insurance of profits, but, instead, was based entirely upon a per diem allowance multiplied by the estimated number of days it would take to rebuild petitioner’s plant. No income statements or other financial statements were required or requested of petitioner. The only dispute between petitioner and the insurance companies was over the time it would take to rebuild. Petitioner claimed it would take 9% months. The insurance companies first estimated 6% months. A compromise of 7 months and 5 days was finally agreed upon.

For the purposes of the application of section 112 (f), supra, we know of no valid reason why proceeds from use and occupancy policies of the type here involved should be treated any differently than the proceeds from the straight fire insurance policies. We think the evidence clearly shows that petitioner’s plant (as a result of the fire) was involuntarily converted into money, namely, proceeds from straight fire insurance and proceeds from use and occupancy insurance, and that this money was forthwith in good faith expended in the acquisition of other property similar or related in service or use to the property so converted. All of the money thus received was so expended. We, therefore, hold that under section 112 (f), supra, no gain or loss should be recognized upon the receipt of the proceeds of the use and occupancy insurance in the amount of $120,000. Piedmont-Mt. Airy Guano Co., supra; Flaxlinum Insulating Co., supra.

Relative to the second issue, the respondent disallowed a deduction taken by petitioner on its income tax return for the fiscal year ended May 31, 1936, in the amount of $1,317.06 representing the cost of tank foundations, abandoned as a result of the fire. The reason given in the deficiency notice for the disallowance was that this item was covered by fire insurance. In its brief petitioner contends that the amount it deducted on its return “is an allowable deduction, because not covered by insurance, or in the alternative as a loss of useful value.” The applicable statute is section 23 (f) of the Revenue Act of 1934, which is as follows:

SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* ' * * * * * *
(f) Losses by Cobpobatxons — In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.

The record in this case refutes the respondent’s determination that this item was covered by fire insurance. The evidence shows in the first instance that these foundations were uninsurable, and further shows that their value was eliminated from the insured values when the fire loss was adjusted. Clearly, therefore, the alleged loss was not “compensated for by insurance or otherwise” and accordingly becomes an allowable deduction if the record satisfies the statutory requirements that a loss was actually sustained.

As early as the Revenue Act of 1918 and continuing through all the subsequent revenue acts, the Commissioner in his appropriate regulations has allowed a deduction for “loss of useful value” of capital assets, when through some change in business conditions the usefulness in the business of a capital asset is suddenly terminated so that the taxpayer discards it permanently from use in the business. This was intended as an exception to the rule requiring a sale or other disposition of property in order to establish a loss, and was made applicable to buildings “only when they are permanently abandoned or permanently devoted to a radically different use.” The material provisions of article 23 (e)-3 of Regulations 86 are printed in the margin.

In C. U. Connellee, 4 B. T. A. 359, the. taxpayer in 1919 began the construction of a hotel building. During that year he incurred liabilities of $7,922.17 in putting in the foundation, after which the entire project was abandoned. We allowed the taxpayer in that case to deduct as a loss in that year the amount expended in connection with the hotel venture.

In Kilby Car & Foundry Co., 4 B. T. A. 1294, we held that a corporation which, through a change of business conditions, has no use for a building erected for a particular purpose and abandons the building is entitled to deduct the loss sustained by reason of such abandonment. Substantially to the same effect see Multibestos Co., 6 B. T. A. 1060; Fraser Brick Co., 10 B. T. A. 1252; American Cigar Co., 21 B. T. A. 464, 494 (6th issue); affirmed upon other issues, 66 Fed. (2d) 425; certiorari denied, 290 U. S. 699.

In the instant proceedings, the evidence definitely shows that after the fire petitioner decided to rebuild its new plant elsewhere, and that it had no possible further use for the tank foundations. The usefulness to petitioner of these foundations was as fully destroyed by the fire as was the plant itself, and petitioner thereafter abandoned such foundations permanently from use in its business. The respondent does not claim that the foundations had any .salvage value. Under the authorities above cited, we hold that petitioner is entitled to deduct the cost of the foundations as a loss sustained during the fiscal year ended May 31,1936.

Decision will ~be entered, under Bule SO.

       SEC. 112. RECOGNITION OF GAIN OR LOSS.

      (f) Involuntary Conversions. — If property (as a result of its destruction in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation, or the threat or imminence thereof) is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or into money which is forthwith in good faith, under regulations prescribed by the Commissioner with the approval of the Secretary, expended in the acquisition of other property similar or related in service or use to the property so converted, or in the acquisition of control of a corporation owning such other property, or in the establishment of a replacement fund, no gain or loss shall be recognized. If any part of the money is not so expended, the gain, if any, shall be recognized, but in an amount not in excess of the money which is not so expended.

         Art. 23 (e)-3. Loss of useful value. — When, through some change in business conditions, the usefulness in the business of some or all of the capital assets is suddenly terminated, so that the taxpayer discontinues the business or discards such assets permanently from use in such business, he may claim as a loss for the year in which he takes such action the difference between the basis (adjusted as provided in section 113 (b) and article 113 (a) (14) — 1, 113 (b) — 1, and 113 (b)~2) and the salvage value of the property. This exception to the rule requiring a sale or other disposition of property in order to establish a loss requires proof of some unforeseen cause by reason of which the property has been prematurely discarded, as, for example, where an increase in the cost or change in the manufacture of any product makes it necessary to abandon such manufacture, to which special machinery is exclusively devoted, or where new legislation directly or indirectly makes the continued profitable use of the property impossible. This exception does not extend to a case whore the useful life of property terminates solely as a result of those gradual processes for which depreciation allowances are authorized. It does not apply to inventories or to other than capital assets. The exception applies to buildings only when they are permanently abandoned or permanently devoted to a radically different use, and to machinery only when its use as such is permanently abandoned. * * *


author: Arnold:

text:
    Natural Gas Pipeline Company of America, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 101721.
    Promulgated December 9, 1941.

      Benjamin EL. Bartholow, Esq., and G. B. Randall, Esq., for the petitioner.

      Franklin F. Korell, Esq., for the respondent.
   OPINION.

Arnold:

The rule is established that, where bonds are issued for less than their face value by a corporation on the accrual basis, the difference between the amount realized and the face value of the issue will be recognized as bond discount. Helvering v. Union Pacific Railroad Co., 293 U. S. 282; Hummel-Ross Fibre Corporation, 31 B. T. A. 451; affd., 79 Fed. (2d) 474. A concise statement of the discount concept is contained in New York, Chicago & St. Louis Railroad Co., 23 B. T. A. 177, 196, which was quoted with approval in Dodge Bros., Inc. v. United States, 118 Fed. (2d) 95. The applicable regulations provide for the amortization of bond discount over the life of the bonds. Art. 22 (a)-18, Regulations 86 and 94, Revenue Acts of 1934 and 1936. Both parties have applied the rule to the transaction of December 30,1931, but with different results. Since the principle of amortizing bond discount over the life of the bonds is recognized by the parties, we need determine only the correct amount to be prorated.

An analysis of the conflicting claims shows that different amounts were determined as bond discount because of the variance in treatment of the consideration for the 1,499,000 shares of stock issued on December 30,1931. Petitioner, in reliance on the offer made by its creditors and accepted by its directors and stockholders, allocated $2,900,000 of the notes with accrued interest to the 1,499,000 shares of no par capital stock issued. Respondent refused to accept the allocation and determined the bond discount to be the difference between the aggregate notes with accrued interest and the par value of the bond issue, i. e., $878,212.28, plus $44,940.33, representing costs of printing the bonds, stamps, fees, etc., or a total bond discount of $923,152.61.

Respondent contends that the amortization of bond discount is only a concept which should not be extended to cover transactions in which the substance of what was done fails to disclose that the bonds were actually issued under circumstances equivalent to a “discount” as the term is used in the regulations. He argues that the notes were exchanged for bonds, and that stock (1,000 shares) was exchanged for new stock (1,500,000 shares) as integral parts of a single or entire transaction, citing Dodge Bros., Inc. v. United States, supra. He insists that if his first contention is rejected, nevertheless, the Board should not find that the stock had a fair market value on December 30,1931, of $3,000,000, or any market value whatsoever, citing Hummel-Ross Fibre Corporation v. Commissioner, 79 Fed. (2d) 474. Finally he points out that the evidence discloses that petitioner had no dividend record at December 30,1931, or for several years thereafter, that the face value of its bonded indebtedness exceeded the capital invested, and that, because of market conditions and the speculative nature of petitioner’s enterprise, no purchaser could have been found for its stock.

We can not agree with respondent’s contentions. In our opinion he properly recognized petitioner’s right to amortize bond discount under the particular facts of this case. As to his second contention, respondent has stipulated that petitioner’s creditors offered to sur-pender all of its -outstanding 8 percent notes with aocrued interest “for cancellation in exchange and consideration for the issuance to .them” of 1,499,000 shares of stock and $60,000,000 par value of bonds. This offer was verbal. It was submitted as the result of an agreement reached after numerous conferences between 15 to 20 representatives of petitioner’s creditors. The unconfcradicted testimony of the witnesses shows that the creditors collectively agreed to -accept as payment for their notes and interest -sufficient shares of petitioner’s common stock which, with stock then outstanding, would equal 1,500,000 shares at $2 per share and $60,000,000 face value of bonds at a discount price of approximately 93%.

This offer was -accepted by petitioner’s directors and stockholders as made. The entries on petitioner’s books of account and the resolutions adopted by its stockholders and directors clearly reflect the .acceptance and the intention of the parties that 1,499,000 shares of .additional stock would be issued to “the holders of the notes * * * in full payment” for $2,900,000 of the notes and interest, so that “after the issuance thereof” the capital of the petitioner “shall be Three Million Dollars ($3,000,000)..” The creditors, therefore, subjected $2,900,000 to the risk of the business. No stock-for-stock exchange (1,500,000 shares for 1,000 shares) was established despite the vigorous cross-examination of petitioner’s witnesses as to the mechanics of the transfer.

Bespondent’s final contention is that petitioner’s stock had no value. Value or the lack of it is of importance in determining whether the allocation of consideration as made by the parties between the stock and the bonds was reasonable. The fact that petitioner was newly organized at December 30,1931, and without any earnings or dividend record does not necessarily prove that the .stock lacked value. Its assets, tangible and intangible, indicate that there was value behind the stock. Petitioner’s tangible assets consisted of the bonds of the Texoma Natural Gas Co., and the pipeline and facilities necessary to transport natural gas from Oklahoma to Illinois. In addition, petitioner had intangible assets at December 30, 1931, which, in our opinion, were very valuable, namely, its contracts for the supply and sale of natural gas. By its supply contracts petitioner assured itself of natural gas of at least 210,000,000 cubic feet daily whieh was the total -capacity of its pipeline. By its sales contract petitioner was assured of an annual profit of $900,000 from approximately 63 percent of its daily capacity. That the remaining 37 percent of its pipeline capacity was sold at a profit is established by petitioner’s stipulated net income for the years 1935 to 1939, inclusive. These contracts must be considered corporate assets. Obviously the contracts were of great value to petitioner and their value must be weighed and considered in determining whether the capital stock had value.

Expert testimony was offered by both parties regarding the value or lack of value of the capital stock on December SO, 1981. Despondent’s expert witness, after testifying to the dismal condition of the security market in December 1931, expressed the opinion that the assets reflected on petitioner’s 1931 return, which was not introduced in evidence, indicated that the stock was without Value. He admitted on cross-examination that he gave no consideration to the contracts held by petitioner.

On the other hand petitioner’s expert, whose qualifications are recognized by respondent, testified that in his opinion the shares could have been sold if placed oh the market on or about December 30,1931. He testified that the purchasers would have been parties seeking to double or treble their investment rather than investors seeking a reasonable return thereon, but he thought the nature of the business, the sponsors and management of the enterprise, the contracts held by petitioner, and the potential earning capacity of the capital stock would have secured purchasers for the stock at two dollars per share. This witness also testified that, had petitioner’s bond issue been sold on the market, the bond discount would have been considerably in excess of $3,778,212.28. He supported his opinion by specific instances of financing by public utilities late in 1931 and early in 1932 in which the percentage realized on -bond issues by operating companies with established earning capacities was much less than that realized by petitioner.

After carefully weighing and considering the stipulated facts and the testimony, it is our opinion that the parties intended to and did fix the value of the petitioner’s stock at $2 per share. We are further of the opinion that the amount so fixed is reasonable and is justified by the facts peculiar to this case. By accepting the offer of its creditors, petitioner reduced its interest rate from 8 percent 'to less than 6y2 percent, since $3,778,212.28 spread over the 15-year life of the bonds is less than % of 1 percent of the face 'amount of the bonds. If petitioner had been able to sell this bond issue oh the market in December 1931, the testimony of the expert witnesses •clearly establishes that the bond discount' would have exceeded the amount of discount that will be paid to petitioner’s creditors under the present facts. We hold, therefore, that the amount of bond discount to be amortized by petitioner over the life of its bonds is $3,778,212.28.

Reviewed by the Board.

Decision will he entered, under Bute 50.