author: Keen:

text:
    Washington Railway & Electric Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 92435.
    Promulgated December 22, 1939.

      Nelson T. Hartson, Esq., for the petitioner.

      Hartford Allen, Esq., and E. G. Moñson, Esq., for the respondent.
   OPINION.

Keen:

The narrow question here raised is whether, petitioner having received an award on January 13, 1930, from the Government in excess of the cost of its land and improvements used in supplying electric power to its street railway line and street lighting system and to individual patrons, including the Government itself, and having expended a total sum in replacement in excess of the award, is entitled to treat that part of the total replacement cost spent before the award was made as replacement cost within the meaning of section 112 (f) of the Eevenue Act of 1928. The Government freely concedes petitioner’s right to do so with moneys spent after the award. Article 579 of Treasury Regulations 74, which is pertinent here, is set out in the margin.

Respondent apparently raises no question of petitioner’s expenditures having been made to replace property about to be taken over by the Government, of the conversion being involuntary, of the similar character and service of the property replaced, or of the threat or imminence of the condemnation at the time the replacements were made. If any such question were raised, it could easily be answered by reference to our findings, which show beyond doubt that in all these respects petitioner fell within the provision of the statute, nor can there be any doubt on the facts that the maintenance by petitioner of its public utility service to the Government and to its other customers made a sudden and abrupt change in the place of operation of its substation impossible. The shift had to be brought about so as to prevent interruption of its functions as a public utility and had to be done gradually, since the technical difficulties were substantial. New land had to be acquired, new buildings constructed, and in some instances new machinery built according to special designs in order to reduce to a minimum the inevitable noise of operation in a residential part of the city. New mains and trunk lines had to be built for the new power substation while the load of the old was gradually distributed among existing substations near the condemned one so that service would continue without interruption. All these tilings were done after it became apparent, through the enactment of the Act of Congress providing for condemnation of the land under its power of eminent domain should it prove necessary, that the petitioner could no longer hold it or continue to use it. Some of the replacement was done before the payment was made on the so-called “sale”— for with the exercise impending of a power eminent over all private rights, the sale was one in form only and not a bargain freely arrived at between a willing buyer and a willing seller — and some of the replacement after the receipt of such payment. The respondent concedes the statutory propriety of the latter but challenges the former solely on the ground that money used to acquire new and similar property for a similar use in anticipation of an involuntary conversion of the taxpayer’s existing property into cash is beyond the statute, whereas money received as part of such an award and thereafter expended in replacement is within it.

We think that so narrow a construction loses sight of the ameliorative intent of the provision. A relief provision should be construed liberally to effect its purpose. Helvering v. Bliss, 293 U. S. 144; United States v. Pleasants, 305 U. S. 357, 363. Nor does the statute in literal terms require that the award shall be paid and then, and not until then, used for replacement. It says that “if property (as a result of * * * 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”, no gain shall be recognized. (Italics ours.) Applying this language to the present situation, we must conclude that if petitioner had exchanged its substation, office building, laboratories, garages, etc., for other like buildings, there would have been no gain, for it would have been immaterial that condemnation had not taken place and the award had not then been made. Davis Regulator Co., 36 B. T. A. 437, 443. So, also, it is clear that if the buildings had been converted “into money which is forthwith in good faith * * * expended” in like property, there would have been no gain; and it is such a conversion by the payment of the award and its immediate reinvestment by petitioner which respondent has recognized here.

But respondent insists that money still unpaid can not be forthwith reinvested nor property still in petitioner’s ownership converted into other property, although the old property was at the time con-cededly subject to an imminent compulsion. We think otherwise. As we intimated, but did not decide, in Francis V. duPont et al., Executors, 31 B. T. A. 278, 280:

It might be that an expenditure in anticipation of involuntary conversion, where such conversion is imminent, might be found to be closely enough related thereto to come within the nonrecognition provisions.

We think that the situation here justifies the application of this principle. The petitioner’s property in the old power substation and other buildings in the doomed area was, in our opinion, as much “converted” by and at the time of the purchase of new buildings intended for the same use as though they had been then exchanged for the new buildings; and this “conversion” having taken place after the threat of the exercise of the sovereign’s power became imminent, for the authorizing Act of Congress spoke of condemnation or otherwise “at an early date,” and the Treasury officials left no doubt in the minds of petitioner’s officers that delay would not be tolerated, the fact that the petitioner retained until the so-called “sale” to the Government a bare legal title to the old buildings and land can not obscure the fact that the involuntary conversion was already, for all practical purposes, complete and that practical public considerations alone made necessary the postponement for a brief spell of the surrender of petitioner’s title. The case is a close one, but any other conclusion would defeat the remedial intendment of the provisions in circumstances which we think were obviously intended to be embraced within it.

Even though we consider the situation here covered by that part of the statute having to do with the conversion of the property into money which is forthwith expended in the acquisition of similar property, we can see no reason compelling us to make so illiberal a construction of the statute as to conclude that the relief provided by it and intended by Congress is not available to petitioner. To do so it would be necessary to construe the word “forthwith” as meaning “afterwards”, that is, after the actual conversion and the receipt of the award. The dictionary defines “forthwith” as follows:

Immediately; without delay; directly; hence, within a reasonable time under the circumstances of the case; promptly and with reasonable dispatch.

According to this definition it seems apparent that Congress, by the use of the word “forthwith”, meant to provide that the expenditure of money resulting from the involuntary conversion of property in the acquisition of similar property must be made with some immediate chronological relationship to the conversion, thereby guarding against such a long delay after the conversion as to raise a doubt whether the purchase of similar property was actually and in good faith a replacement, or was an additional investment. If there is that immediate chronological relationship between the expenditure for replacement and the condemnation or threat thereof, it is immaterial that the expenditure for replacement immediately preceded the payment of the compensation or immediately followed it. Upon this general subject see August Buckhardt, 32 B. T. A. 1272; M. J. Caldbeck Corporation., 36 B. T. A. 452.

Respondent leans heavily on two decisions of the Court of Appeals for the Second Circuit as supporting an opposite view. There are peculiar circumstances in the first of these cases which, notwithstanding a certain generality in the court’s language, distinguish it in principle from the instant case.

The statute in the section considered speaks of the requirement of “good faith,” but even if this were absent, it would follow necessarily that a taxpayer seeking to avail himself of a relief provision, which is a matter of grace and not of right, may not abuse it. And by the same token, a relief provision although liberally construed so as to effect its alleviatory purpose should not be so loosely construed as to make easy its abuse by taxpayers acting mala fide. Probably all men would agree on the difference between these extremes, but when the line between approaches the mean, the question of where it should be drawn is a question of degree, and as to that reasonable men may differ. Cf. Holmes, J., in Klein v. Board of Tax Supervisors, 282 U. S. 19, at page 22. We think, however, that the principal case relied on by respondent, Bandes v. Commissioner, 69 Fed. (2d) 812 (C. C. A., 2d Cir.), affirming 28 B. T. A. 99, when compared with the situation in the instant case, well illustrates where the distinction lies between liberal interpretation of a relief provision and loose construction which lends itself to abuse. In that case the petitioner, his brother, and another acquired in 1926 certain land in New York City which they intended to convey to a wholly owned corporation which should build an apartment house on it. Before construction was begun, however, the city condemned the land for a school site, proceedings starting in January 1927 and title passing in February, but the award not being confirmed until June 1928. The award was paid in July and each brother realized a gain recognizable if section 112 (f) did not apply. The brothers, after learning that condemnation was imminent, looked for other property on which to build an apartment house. The best they could do was to buy two separate parcels of about the same total area, and by March 1927 they had contracted to buy both and had taken title to them by May of that year. Construction was begun on one in June and on the other in the fall of the same year. The brothers made advances to the apartment house corporation for the work, and when the award was paid them they deposited it in their joint bank account to offset these prior advances. The Circuit Court held that this application of the award did not satisfy the statute, saying (at page 813):

Replacement by the taxpayer must refer to Ms use of the money paid for the property, because, if replacement by the taxpayer out of any of his funds were considered a conversion in kind, there would be no conversion into money, for the two alternatives are mutually exclusive. In the case at bar there was clearly a conversion of the condemned property into the money paid for it by the city, and the inquiry must be whether the petitioner expended the money in the manner required by the statute as a condition precedent to nonrecognition of gain or loss.
It is tempting to say that, if a taxpayer buys lot B on borrowed money and pays the debt with the award he gets for the condemnation of lot A, he has acquired lot B with the award. Whether the statute will permit of such a construction we need not now decide. To sustain the petitioner in the present case, we should have to construe it even more broadly and say that a taxpayer may use any of his funds to buy the new property, and, when he recoups the expense by receipt of the award, regardless of how it is actually expended, the new property may be considered to have been acquired out of the award. This would leave nothing to the statute except that the taxpayer must acquire new property with an intent to substitute it for the old. The language is much too specific to be capable of that construction * * *

The generality of the language employed might indicate that the Circuit Court thought that the use of other money to procure new property of a like nature and use, unless, as it suggests, that money was not the taxpayer’s but only borrowed, would not comply with the provision’s requirement. In other words, the “conversion” would not be the procurement of new like property under the threat of loss of the old, but the actual translation of the old property into cash and the translation of that specific cash into new property, a sequence of acts which would make impossible any anticipatory replacement such as we have in the instant case. With this view we disagree, but we do not think that B ancles’s case on its facts and apart from its language requires such a conclusion.

There the taxpayer had made no use of his land to build an apartment house before its condemnation. He might have acquired it for merely speculative purposes, with the intention of resale at a profit. The conversion of it into cash by condemnation was clearly involuntary, but we would have only the taxpayer’s statement of his intention to use the land for an apartment house to justify us in saying that the new land was a true replacement. If the benefit of the statute were extended to such cases, the way would be left open to the postponement of taxation of gainful transactions in no substantial way different from voluntary sales where the gain is immediately recognizable. In the instant case, the nature of the taxpayer’s business requiring replacement and interim maintenance of public services and the use of the new property for the same purposes as the old, guarantees the bona fides of the anticipatory reinvestment of the proceeds of involuntary conversion. The line may not always be an easy one to draw, but here seems certain. The distinction after all between that case and this is one of reality and not of merely formal logic, and taxation as a practical matter should look to realities.

Another factual distinction between Bmdes’s case and the instant proceeding is apparent from a reading of the following significant passage in the opinion of this Board accompanying the decision which that case affirmed, reported in 28 B. T. A. at page 99:

But there may be room for doubt whether the statute is to be so strictly read as to preclude its application to a case where the taxpayer has been fore-handed enough to provide for the replacement without waiting for the ultimate and complete consummation of the condemnation and payment. How important the precise sequence of events alone may be under this statutory provision need not be decided in this proceeding. These petitioners were not in the position where, to put themselves where they would have been but for the condemnation, they used the proceeds of the award to buy similar property or to pay for such property which they had already bought. So far as this record shows, the two latter parcels were bought and paid for with separate and free funds and sold to the Naside corporation, a transaction like others in which the petitioners were customarily engaged. The condemnation compensation was not used either to buy or to pay for similar property, but was invested in a loan to the Naside corporation, a separate entity, Burnet v. Clark, 287 U. S. 410. Nothing in such circumstances indicates the enforced' transaction or the hardship which this provision of the statute was designed to alleviate. * * *

Also, it may be doubted whether the facts of Bcmdes's case constitute a replacement within the meaning of the statute. Bather, it would seem to be an anticipatory substitution of one investment for another. If the taxpayer in that case had constructed and was operating an apartment house and a necessary and component part of it, such as a garage or a kitchen wing, was to be condemned, and in anticipation of this the taxpayer had constructed another garage or kitchen wing to take the place of the one to be condemned for the purpose of effectively continuing the operation of his apartment house, then there could be no question but that there had been a replacement. However in Banded’s case the taxpayer had not constructed and was not operating an apartment house. He intended to make an investment in one but before he could do so it became apparent that it would be impossible for him to make the investment in the form and at the location which he intended. Thereupon, he decided to invest instead in the construction of two other apartment houses at two other locations. It may be that his intention to invest in the first apartment house was replaced in his mind by the later intention to invest in the two apartment houses which were actually constructed, but it is difficult to understand how these two apartment houses could be considered as replacing an apartment house which was never built, within the meaning of this section of the statute. Perhaps it is this difficulty which led the Circuit Court in Bandes’s case to use the language it did in the second paragraph of that portion of its opinion which we have already quoted.

That difficulty is not present in the instant proceeding because the petitioner’s investment in a public utility company continued unchanged. It was merely necessary to replace some indispensable component parts in the physical plant of that company in order to continue its operation.

The respondent’s second reliance, Wilmore S. S. Co. v. Commissioner, 78 Fed. (2d) 667, reversing 30 B. T. A. 866, was decided by the same Circuit and is even more doubtful as authority. There the taxpayers had sustained a loss of certain ships through sinking by a German submarine in war in 1917. An award was paid to the taxpayer in August 1928 in accordance with the terms of an Act of Congress in settlement of war claims. The taxpayer had contracted for the building of new ships in June 1928 before the award and payment was made, paying for them by installments, and by the end of that year had paid more on their construction than the amount of the award. “As the payments were to be by installments”, the court said, “it must be assumed that nothing was paid in advance.” And after holding the new ships to be a replacement within the statute the court concluded with this explanatory limitation on its decision in Banded’s case:

Our decision in Bandes v. Commissioner, 69 F. (2d) 812, is not contra. It went no farther than to hold that under section 112 (f) of the Revenue Act of 1928, a taxpayer could not claim an exemption for any profit realized in a condemnation proceeding if he used the profit merely to repay his own prior expenditures in, purchasing similar property. [Italics supplied.]

It would appear from this quotation that the Circuit Court for the Second Circuit intends to limit the rule of Bandes’s case to its peculiar facts. If, in addition to the fact that “similar property” was purchased, it also appears, as in this proceeding, that the “similar property” was necessary to replace and did replace property used in the operation of a continuing investment in the form of an existing public utility company, we have a situation which would seem to be outside the orbit of that case.

We wish to again point out and stress the fact that petitioner here is operating a public utility and hence may not suspend service without incurring serious consequences to itself and grievous inconvenience to the public. Therefore it is of compelling importance to it to anticipate wherever possible necessary replacements in its plant and equipment.

No other cases dealing with the precise question here have been called to our attention, nor have we found any. As we pointed out at the outset, the very reason for enacting a relief provision requires that it be liberally construed; and where the circumstances of the case preclude all possibility of a fraud being practiced on the statute, we can perceive no valid reason why section 112 (f) does not comprehend an anticipatory conversion of condemned (or about to be condemned) property into new property such as happened here before the award was paid; at least, under the circumstances present in this proceeding, and we so hold.

It must follow that there is no deficiency in petitioner’s income tax liability for the year 1930, and, also, that petitioner has overpaid its taxes for that year.

Reviewed by the Board.

Decision will be entered wader Rule 50.

       Akt. 579. Involuntary conversion of property. — Section 112 (f) deals with cases in which property is compulsorily or involuntarily converted into similar property, or into money, as a result of fire, shipwreck, theft, condemnation, or similar causes enumerated in the Act. If the property so destroyed, stolen, seized, or condemned is replaced in kind by similar property or property related in service or use, no gain or loss is recognized. If, however, the original property is compulsorily or involuntarily converted into money, gain or loss will be recognized unless the money is forthwith, under regulations prescribed by the Commissioner with the approval of the Secretary, expended—
      (1) In the acquisition of other property similar or related in service or use to the property so converted,
      (2) In the acquisition of control of a corporation owning such other property, or
      (3) In the establishment of a replacement fund.
      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. See article 601 for the basis for determining gain or loss from the sale or other disposition of the property so acquired.


source: Caselaw Access Project

author: SteRntiagen :

license: Public Domain

text:
    N. Sobel, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 93822.
    Promulgated December 22, 1939.

      Benjamin Maider, Esq., for the petitioner.

      B. M. Brodsky, Esq., for the respondent.
   OPINION".

SteRntiagen :

The Commissioner disallowed the petitioner’s deduction of 1935 of the $10,850 for which it finally in that year settled the litigation over its note. He denied the loss “for the reason that the stock to which it pertained became worthless prior to the taxable year under consideration.” He then added to petitioner’s gross income the other $10,850 half of the face amount of the note on the ground that this was a gain resulting from the “settlement of an obligation amounting to $21,700 for one-half the face value.” The Commissioner argues that the taxpayer bought the shares in 1929, that they became worthless some time before 1935, with the result at that earlier time of a realized and deductible loss of the cost of $21,700; that the note, however, continued as a subsisting liability for its face amount, and its discharge by the payment of one-half its face brought about a gain of the other half, taxable as realized income.

If this were simply a case where a taxpayer bought property, giving its note in payment, and the property became worthless, the rule would apply that a deduction for loss would be available to it only in the year the property became worthless. But the facts are not so certain. There is question whether the taxpayer bought property in 1929 and question as to its liability and the amount thereof, and this question was suspended in litigation until the 1935 compromise agreement with the state superintendent of banks. Until 1935 the loss was not actual and present by any practical test. The litigation was, so far as this record shows, bona fide. There were enough other suits involving similar sales by the bank of its own shares during the 1929 “drive” to indicate that this petitioner was not alone in doubting its ownership of the shares or its liability on the note. Whether it could have avoided either the sale or the note can not be decided in this proceeding, for the claims were compromised and legal rights were never recognized. It can not be said as a postulate that if the litigation had proceeded to judgment it would have established that petitioner invested $21,700 in the shares and owed the full amount of the note. It is not clear that petitioner could rightfully have taken a deduction prior to 1935 — not clear enough to carry the correlative denial of the deduction when the final amount was definitely fixed and the loss became actual and present. Burnet v. Huff, 288 U. S. 156. From every practical standpoint it had no loss until its liability was definitely fixed in 1935 for $10,850. It correctly took the deduction then.

This also establishes that the release of the note was not the occasion for a freeing of assets and that there was no gain under the doctrine of Kirby Lumber Co. v. United States, 284 U. S. 1.

The Commissioner’s determination disallowing the loss of $10,850 and adding a further $10,850 to income is reversed.

Decision will be entered umder Bule SO.


author: Hill:

text:
    Macon, Dublin & Savannah Railroad Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 90592.
    Promulgated December 22, 1939.

      Harold J. Gallagher, Esq., for the petitioner.

      Conway N. Kitchen, Esq., for the respondent.
   OPINION.

Hill:

Respondent determined a deficiency in petitioner’s income tax liability for the year 1933 in the amount of $3,206.48. Such deficiency results from respondent’s holding that petitioner, sometimes hereinafter called the M. D. & S., was not affiliated during the taxable year, within the purview of the applicable revenue act, with the Seaboard Air Line Railway Co., hereinafter for convenience called the Seaboard.

Petitioner was included in a consolidated income tax return filed by the Seaboard for 1933, and it is conceded that if petitioner was not affiliated with Seaboard in that year for tax purposes, the deficiency determined by respondent is correct, but if so affiliated, no-deficiency in tax is due.

The Revenue Act of 1932, in section 141 (a), (d), provides that, an affiliated group of corporations shall have the privilege of filing a consolidated return for the taxable year in lieu of separate returns, and defines the term “affiliated group” as meaning one or more-hhains of corporations connected through stock ownership, if at least 95 per centum of the voting stock of each corporation, except the parent, is owned directly by one or more of the other corporations and the parent corporation owns directly at least 95 per centum of the voting stock of one of such other corporations. Thus, the ultimate question presented for decision here is whether or not Seaboard owned directly at least 95 per centum of the stock of the M. D. & S. during the taxable year.

Petitioner is a railroad corporation, organized under the laws of the State of Georgia, with its principal office at Macon, Georgia, and its principal accounting office in Portsmouth, Virginia.

The Seaboard Air Line Railway, also referred to as Seaboard, a railroad corporation organized under the laws of Virginia and other states and predecessor of the Seaboard Air Line Railway Co., purchased all of the outstanding securities of the M. D. & S. from the Atlantic Coast Line Co. in January 1907, pursuant to an agreement dated October 11, 1908. The securities so acquired by Seaboard included all of petitioner’s outstanding capital stock, consisting of 20,400 shares.

On October 23, 1907, the board of directors of Seaboard adopted a resolution authorizing a committee to sell, under advice of counsel, all or any part of the company’s holdings of M. D. & S. stock, reserving an option, if the committee deemed it advisable or practicable, to repurchase the stock at a figure to be determined by the committee.

Pursuant to such resolution, Seaboard entered into a written agreement dated November 29, 1907, with S. D. Loring & Son of Boston, Massachusetts, sometimes hereinafter referred to as Loring, whereby Seaboard purported to sell to the latter firm 11,000 shares of M. D. & S. stock for a consideration of $1,000, and Seaboard purportedly was granted an option to repurchase the stock at any time within five years for the sum of $2,000. The instrument further provided that the stock should be transferred into the name of S. D. Loring & Son and deposited with the New York Trust Co., endorsed or assigned in blank, to be held by the trust company subject to the terms of the instrument.

At the time of the transfer of stock to Loring, the shares had a value substantially in excess of the “purchase price.” At the time the purported option to repurchase was granted by Loring, and at the dates of subsequent similar options hereinafter referred to, the 11,000 shares of stock had a value substantially in excess of the respective option prices.

It was further provided in the agreement between Seaboard and Loring that if Seaboard exercised its “option to repurchase” within the five-year period, the trustee should deliver the 11,000 shares to Seaboard and the stock should “thereupon become the absolute property of Seaboard Air Line Railway, its successors or assigns.” The agreement also provided that until Seaboard exercised its option, S. D. Loring & Son should be “clothed with all rights of ownership, and * * * entitled to all rights and privileges incident to said stock.” Each of the subsequent agreements hereinafter mentioned contained similar provisions.

Petitioner offered evidence to establish that, although the transaction between Seaboard and Loring took the form of a sale with an option to repurchase, Loring had no intention to buy, and Seaboard had no intention to sell, the 11,000 shares of petitioner’s stock. The understanding of both parties was that Loring would act as nominee of the stock for Seaboard. Loring regarded the transaction as an accommodation to Seaboard, with which the firm then had close connections.

The transaction between Seaboard and the Loring firm was negotiated in behalf of the latter by Homer Loring, who, at the suggestion of Seaboard, became president and a director of the M. D. & S. during the time the stock stood in the name of his firm. However, Loring never participated in the management of the M. D. & S. nor attended any of its stockholders’ or directors’ meetings. Loring executed proxies fon the annual meetings of the M. D. & S. in feci-' cordance with the request of Seaboard. The stock was not considered an investment by Loring and was not carried as such on its books.

In 1912 Loring requested Seaboard to relieve the firm of its relationship to the 11,000 shares of M. D. & S. stock. Thereupon the secretary of Seaboard made arrangements with one James A. Blair, Jr., of New York City, to transfer the stock into his name. Blair at that time was associated with Blair & Co. which controlled Seaboard.

A written assignment was executed by Loring to Blair, dated November 23, 1912, for the recited consideration of $2,000 in cash. On the same date Loring and Seaboard by letter directed the New York Trust Co. to cause the 11,000 shares of petitioner’s stock to be transferred into the name of Blair and to continue to hold the stock subject to the terms of the option agreement. A written instrument was executed between Blair and Seaboard under date of November 29, 1912, which purported to grant to Seaboard an option to repurchase the shares of stock from Blair within one year for $2,120. This instrument was substantially the same as that previously executed by Loring and Seaboard. The purported option price represented the $2,000 paid by Blair, plus 6 percent interest. The agreement was renewed from year to year to and including November 29, 1924.

It was the intention of both parties to the agreement between Seaboard and Blair that Blair was to serve as Seaboard’s nominee. Blair considered that Seaboard was the owner of the stock, and consented to have the stock transferred into his name as an accommodation to Seaboard. Blair did not regard the stock as an investment. He served as president and director of the M. D. & S. during the time the stock stood in his name, but took no part in its management and received no compensation. He executed proxies for the annual meetings in accordance with instructions of officers of Seaboard.

In 1915, during which year the 11,000 shares of stock stood in Blair’s name, the Seaboard Air Line Railway was consolidated with another company to form Seaboard Air Line Railway Co., which succeeded to all of the rights of the Seaboard Air Line Railway in the M. D. & S. stock.

The Seaboard had agreed on request to take the 11,000 shares of stock out of Blair’s name at any time, and accordingly at his request in 1925 Seaboard arranged to transfer the stock to the Continental Trust Co., Baltimore, Maryland, hereinafter called Continental. The relationship between Seaboard and Continental at that time was close, and has continued through the Maryland Trust Co., Continental’s successor, down to the present time. In 1925 the president of Continental was also president of Seaboard.

On November 14-, 1930, the Maryland Trust Co., successor to Continental, executed a written instrument purporting to grant to Seaboard an option to repurchase the 11,000 shares of petitioner’s stock within one year for $4,265.86, the recited consideration for the transfer of the stock from Blair to Continental. Provision was made for an automatic annual extension of the so-called option up to and including November 14, 1935, and thereafter until 60 days after notice of termination by the trust company.

In October 1933 petitioner’s outstanding capital stock was reduced from 20,400 to 17,500 shares, and this resulted in the reduction of the number of shares held by the Maryland Trust Co., from 11,000 to 9,434 shares. The agreement of November 14, 1930, was amended accordingly.

In entering into the transactions above mentioned, neither the Continental Trust Co. nor the Maryland Trust Co. had any intention to buy, nor did Seaboard have any intention to sell, the 11,000 shares of petitioner’s stock. At the time the stock was transferred to it, Continental made no inquiry as to the value of the stock, and considered the amount paid to Blair as an advance to Searboard. Both Continental and the Maryland Trust Co. caused their nominees, in whose names the stock was registered, to follow Seaboard’s instructions as to voting and giving proxies in respect of the stock.

At the hearing respondent objected to admission of the evidence offered by petitioner to show that the transactions above mentioned were in fact not what they purported to be according to the terms of the various written instruments. The objection is based on the ground that the testimony violated the parol evidence rule. The presiding Board Member reserved ruling on the objection until consideration of the case on the merits.

Decision of the issue submitted herein turns upon this point.

On brief respondent quotes an extract from Jones on Evidence to the effect that “parol evidence can not be received to contradict, vary, add to or subtract from the terms of a valid written instrument”, and argues that such rule is applicable in suits involving third persons, not parties to the written instrument. Respondent further contends that one of the chief functions of the parol evidence rule is to protect innocent third parties, and says that admission in evidence of the oral testimony offered by petitioner “would prejudice an innocent third party, namely, the Commissioner of Internal Revenue.”

We are unable to agree with the respondent’s contentions. If it be true that Seaboard did in fact own directly more than 95 percent of petitioner’s capital stock during the taxable year, then under the statute there is no deficiency in tax due from petitioner, and it is difficult to comprehend, in the absence of any considerations invoking equitable estoppel, how the admission of evidence to establish the true facts could be prejudicial to the rights of respondent, or how in that connection he could properly be regarded as an innocent third party. We see no question of estoppel involved here. There is no suggestion that respondent has been induced to change his position to his injui’y in reliance upon the written instruments in controversy, and hence, if no tax is due, respondent has no rights in the premises and is not an innocent third party. Surely, the doctrine urged by respondent, even if applicable in some circumstances, could not be invoked by respondent to permit him to collect as a tax, upon a purely technical ground, an amount not rightly owing by petitioner.

In support of the second proposition that the parol evidence rule is applicable in cases involving third persons who are not parties to the written instrument, respondent cites Pugh v. Commissioner, 49 Fed. (2d) 76, affirming 17 B. T. A. 429; certiorari denied, 284 U. S. 642; and also Mountain Producers Corporation, 34 B. T. A. 409, which was reversed by the Circuit Court at. 92 Fed. (2d) 78, which decision of the Circuit Court was reversed at 303 U. S. 376.

The Pugh decision, we think, is not in point. There the parol evidence, excluded by the Board, was offered to show that the parties to a written instrument had agreed that the depletion allowance on oil sold by Pugh should go to him, contrary to the terms of the statute allowing such deduction only to the owner, which there was the purchaser from Pugh. The court held that parol evidence could not be used “to give to the recorded instrument an effect according to the wishes of the parties rather than that attributable to it by law, and thus to control as against the United States the application of the tax l'aws.” The court further pointed out that the parol evidence rule “operates to protect all whose rights depend upon the instrument though, not parties to it”, only where such evidence “is offered merely to vary the legal effect” of the terms of the instrument. It is to be noted that the parol evidence offered in the instant case was not intended to vary the legal effect of the terms of the instruments, but to show that the transactions in fact were entirely different from what the instruments purported to indicate.

What we said in Mountain Producers Corporation, supra, respecting application of the parol evidence rule was not necessary to a decision of any issue in the case, and the point was not discussed in the opinion of either the Circuit Court of Appeals or the Supreme Court. We are not persuaded, therefore, in the light of the conclusions reached below, that the decision in that case is authority for application of the parol evidence rule in the case at bar. In other cases cited by respondent, parol evidence was held inadmissible for the purpose of interpreting or construing the terms of written instruments. Such decisions are so obviously distinguishable from the instant proceeding as not to require discussion here.

Application of the parol evidence rule under the facts of the present case would be inconsistent with the broad, general principles of construction applied to taxing statutes. “Taxation is an intensely practical matter* and laws in respect of it should be construed and applied with a view of avoiding, so far as possible, unjust and oppressive consequences.” Farmers Loan & Trust Co. v. Minnesota, 280 U. S. 204. To deny petitioner the right here to show the true and controlling facts respecting affiliation and thereby to require payment of a tax not lawfully due would, it seems to us, be both unjust and oppressive.

Again, it was said by the court in Central Life Assurance Society v. Commissioner (C. C. A., 8th Cir.), 51 Fed. (2d) 939, 941, that it is a basic principle in the application of tax laws that substance and not mere form be regarded as governing. Substantially the same view was expressed by another court in Board v. Commissioner (C. C. A., 6th Cir.), 51 Fed. (2d) 73, 75, where it was said that “tax laws should be applied, as equitable principles are applied, with regard to substance rather than to form.”

While extraneous evidence is not generally admissible for the purpose of construing the terms of a written instrument, “it is competent to show by parol what the transaction was.” Brick v. Brick, 98 U. S. 514, 516. In determining the true nature of a transaction, this Board is not confined “to an inspection alone of the written instruments by which it was consummated.” Extraneous evidence is admissible “to inform it of the material facts bearing upon it.” Commissioner v. Neighbor Realty Co., 81 Fed. (2d) 173, 175.

The question of the application of the parol evidence rule, in cases similar to the present proceeding, has been specifically considered by us many times and its application uniformly denied. In J. W. Solof, 1 B. T. A. 776, we admitted parol evidence to show that a transfer of stock, described in a written instrument as a sale, was in fact a loan, saying at page 785:

The rule against varying or contradicting writings by parol evidence obtains only in suits between and is confined to parties to the writing and their privies and has no operation with respect to third persons nor even upon the parties themselves in controversies with third persons. [Citing authorities.]

This rule is supported by the great weight of authority. See 22 C. J. 1291, 1292, ¶ 1725.

Arthur B. Grover, 8 B. T. A. 508, held that a written instrument, in form a contract creating the relation of principal and agent, was in fact a contract for the sale of land.

In Stratton Grocery Co., 8 B. T. A. 817, oral evidence was admitted to show that a written contract for the sale of the assets of a corporation, which purported to include therein only one item of good will at a profit, was intended to include two items of good will at cost.

Dome Co., 26 B. T. A. 967, involved a question of affiliation which turned upon the ownership of stock as in the present case. There it appeared that one Bobbins was the owner of a portion of the stock in controversy; the certificates were issued in his name; the contract recited that he was a stockholder; and he was made an officer and director of the company. On extraneous evidence, we held that Bobbins was merely the nominee of Warner Brothers, saying: “But, in the absence of estoppel, the corporate record will not serve to bind petitioner if it is contrary to facts, as we believe it was.”

In United National Corporation, 33 B. T. A. 790, the taxpayer delivered certain stock to another corporation, subject to a purported repurchase agreement. Notwithstanding the transaction was described in the written agreement between the parties as an absolute sale, subject to the right to repurchase, we held on the evidence that the transfer was not a sale but security for a loan, and that hence no taxable profit was realized thereon by the petitioner.

In many cases both this Board and the courts have denied loss deductions claimed on transactions appearing from contracts or other written instruments to be sales, where such instruments were contradicted or varied by other evidence indicating a lack of intent to change ownership. See cases cited in United National Corporation, supra, beginning on page 799.

In Indianapolis Glove Co. v. United States (C. C. A., 7th Cir.), 96 Fed. (2d) 816, the court pointed out that the parol evidence rule could not be invoked by a third person not a party to the written instrument, and held that, in an action to recover income taxes paid, oral evidence was properly admissible to show that purported purchases of taxpayer’s stock by its employees were in fact intended as additional compensation, contrary to the terms of the written instruments involved.

Eespondent’s objection to the admission of the oral testimony in the present case is overruled, and exception noted.

Respondent makes one further contention which requires brief consideration, namely, that even if admissible the oral evidence establishes only beneficial ownership in Seaboard of the 11,000 shares of petitioner’s stock, and this does not meet the statutory requirement of direct ownership. In other words, respondent here urges the proposition that ownership through a nominee is not “direct ownership.” This contention, in our opinion, is not only untenable but contrary to the conclusions reached in G. O. M. 7331, C. B. VIIX-2, p. 135, the syllabus of which reads as follows:

Where a parent corporation, for a legal intra vires purpose, has placed the record ownership of a share of stock of a subsidiary in a nominee, such nominee being at all times legally obligated to hold and deal with such share according to such orders and directions as the parent corporation may, from time to time, give him, the ownership of the parent corporation is “direct’' within the meaning of section 141 (d) of the Revenue Act of 1928.

Section 141 (d) of the Revenue Act of 1928 is identically the same in terms as section 141 (d) of the 1932 Act, which governs the instant proceeding.

The direct ownership required by the statute is not merely possession of the naked legal title, but beneficial ownership, which carries with it dominion over the property. Any other conclusion would lead to absurd and ridiculous results. For illustration, if Seaboard had transferred to the Continental Trust Co., as its nominee, the legal title to more than 95 percent of petitioner’s stock, for some lawful intra vires purpose, would the trust company and petitioner thereby have become affiliated and entitled to file a consolidated return within a fair interpretation of the “direct ownership” clause of section 141 (d) ? To state the question is to indicate its answer beyond the need of discussion. “But taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed * * that is, the beneficial ownership. Corliss v. Bowers, 281 U. S. 376, 378.

We hold that petitioner was affiliated with Seaboard during the taxable year, and hence there is no deficiency in tax due from petitioner.

Decision will loe entered for the petitioner.


author: Opper: Murdock,

text:
    S. Rossin & Sons, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent. Estate of Marco Fleishman, by Arthur J. Cohen and Michael Schaap, as Executors, (Transferee), Petitioner, v. Commissioner of Internal Revenue, Respondent.

      Docket Nos. 92942, 92943.
    Promulgated December 26, 1939.

      Harry J. Lefert, Esq., for the petitioners.

      G. G. Holmes, Esq., for the respondent.
   OPINION.

Opper:

It may be conceded that the Commissioner’s failure to object to the corporation’s evident change of its treatment of accounts receivable was tantamount to the approval required by the statute and regulations. Ganahl Lumber Co., 21 B. T. A. 118. Since, however, the Commissioner was not asked for an express approval, and did not give it, there never has been any specific ruling imposing as a condition that the existing reserve be taken up in income simultaneously. Cf. I. T. 2348, C. B. VI-1, p. 67. Although in 1928 the corporation purported to change its method of dealing with debts from a prospective standpoint, and substituted for periodic additions to its reserve a system of deductions for individual bad debts, it does not appear that at any time prior to the present year it changed its method of treating the then-existing reserve. The corporation continued to have accounts receivable which might become bad, even though they did not exist in 1927. A reserve for bad debts is not limited to accounts existing at the end of a given year. Thus, as long as tlie reserve was carried as an open item and not written off, as it was during all the time until the year before us, it remained theoretically possible for outstanding bad debts to be charged against that account rather than being specifically deducted. That course was not precluded by any express ruling on the part of the Commissioner in this instance, although it may be a usual and justifiable practice for him to do so. See I. T. 2848, supra. In fact, in his treatment of the present year he has credited the taxpayer with a debit to this reserve on account of debts then outstanding which were considered to be uncollectible.

Such treatment, moreover, although perhaps unusual, is nowhere expressly prohibited. Such cases as Arthur J. Marks, 9 B. T. A. 1047, and Rogers Peet Co., 21 B. T. A. 577, are not to the contrary. They hold merely that in a given year a taxpayer may not obtain the benefit of both methods by deducting from gross income additions to a reserve as well as charge-offs for specific bad debts. Even this result has been said to yield to the Commissioner’s approval. Manistique Lumber & Supply Co., 29 B. T. A. 26, 29; and cf. Arthur J. Marks, supra. And it would certainly be anomalous to argue that the Commissioner’s consent to a change of method could be implied from his failure to object to a course of action actually adopted by a taxpayer, and in the same breath that the implied consent does not include a permission to retain the existing reserve, although that is equally a part of the taxpayer’s actual conduct. As we have said, we need not speculate upon the conditions which the respondent might, is some other case, have attached to an express approval. Here that was neither asked nor given.

Since the method of treatment so described was not inherently illegal or impossible, and was not forbidden by any express condition or ruling communicated by the respondent to the corporation, the petitioners’ contention narrows to the position that the corporation’s method of accounting was incorrect and did not properly reflect income, and that from this result the petitioners can achieve an advantage. But it is the prerogative of the Commissioner to determine that a taxpayer’s method did not properly reflect its income, Revenue Act of 1936, section 41, and this he has never done.

The result is that taking up the reserve into income in the present year was the direct consequence of the corporation’s method of treatment. Until it was so treated the item was in suspense. Such an account becomes taxable income when converted from an anomalous item into an income fund, the use of which the taxpayer acquires as a result of its own act. Charleston & Western Carolina Railway Co. v. Burnet, 50 Fed. (2d) 342 (App. D. C.), affirming 17 B. T. A. 569; G. M. Standifer Construction Corporation, 30 B. T. A. 184; Creamette Co., 37 B. T. A. 216, 221. Under such circumstances we see no reason why the treatment which the corporate petitioner itself elected to apply should be disregarded by us to reach a result which would permit a substantial amount of income to escape tax completely.

Reviewed by the Board.

Decision will be entered for the Respondent.

Leech and Tyson dissent.

Murdock,

dissenting: The Commissioner advances only two arguments in support of his determination in this case. The first is that he never consented to any change and no change was ever made. The prevailing opinion properly rejects that argument, since the facts show that the petitioner changed in 1929 from the reserve method to one whereby specific debts were ascertained to be worthless and charged off, the Commissioner knew of the change and he gave his permission by approving of the returns in which specific debts were deducted.

The Commissioner recognizes that if a change was made and if permission to change is to be inferred, then the item in question was income for a prior year and the only other argument he makes is estoppel. I agree that the Board is right in rejecting that argument as a basis for its decision. The Commissioner raised that point at the hearing and has the burden of proof. He has not shown that the statute of limitations bars him from collecting the taxes due for the earlier year or that he did not know all of the facts in time to make assessment for that year. The retention of the reserve on the books, while specific bad debts were being charged off, not only did not mislead him but should have been a constant reminder that he was making a mistake in not including it in income for the year of the change. Thus the petitioner wins on the only two arguments advanced by the Commissioner and should receive judgment. But the prevailing opinion holds the other way on reasoning injected by the author, which reasoning is not only unsound but contrary to the practice of the Treasury and the decisions of the Board.

The Commissioner recognizes that if a change was permitted he should have applied I. T. 2348, which was designed for the express purpose of taking care of such a change. It completely and permanently disposes of the reserve by including it in income for the year of the change and requires that all subsequent deductions be by way of ascertainment of worthlessness and charge-off of specific debts. The reserve is not recognized thereafter for any tax purpose and the reserve method must be discontinued. A. J. Marks, 9 B. T. A. 1047; Atlantia Bank & Trust Co., 10 B. T. A. 796; affd., 59 Fed. (2d) 363; Rogers Peet Co., 21 B. T. A. 577; Manistigue Lumber & Supply Co., 29 B. T. A. 26. It is error to assume, as is done in the prevailing opinion, that the Commissioner would allow a reserve to be continued after a change from the reserve method. The contrary inference drawn from a sentence of the Manistigue Lumber case quoted in the fifth footnote is obviously a non seguitur. The Commissioner does not make any such contention. If the reasoning of the opinion is correct, either the taxpayer or the Commissioner could have chosen the year in which to include this reserve in income. Cf. Avery v. Commissioner, 22 Fed. (2d) 6. Actually the petitioner never took the amount into income. See findings of fact.

The reserve should have been included in computing the income and tax of this petitioner for 1929, when the change was made and when the collection of the outstanding accounts removed the reason for the creation and retention of the reserve and made the fund available for other purposes. I. T. 2348, supra; Peabody Coal Co., 18 B. T. A. 1081; affd., 55 Fed. (2d) 7; certiorari denied, 287 U. S. 605; G. M. Standifer Construction Co., 30 B. T. A. 184; Creamette Co., 37 B. T. A. 216. The reserve was not increased after April 30, 1927, and all accounts and notes receivable then on the books, to which alone the reserve could and did relate, were collected in full prior to February 1, 1929. The retention of the reserve balance on the books during and after 1929 and the failure to take it into income was erroneous accounting. The retention of the balance was meaningless for income tax purposes. “Bookkeeping entries do not make income, but neither does a failure to record an item as income permit it to escape taxation when the time arrives that it represents income.” G. M. Standifer Construction Co., supra. If the fiscal year ended April 30, 1929, were before us, neither party could successfully resist the effort of the other to include the item in income for that year. The Commissioner does not argue to the contrary. But the year 1929 is not before the Board and the Board may not arbitrarily correct an error of a prior year by an improper adjustment for the year in litigation. Tide Water Oil Co., 29 B. T. A. 1208.

No authority is cited and I find none in decided cases, statutes, regulations or published rulings of the Treasury for including the reserve or any part of it in income for 1936. The respondent does not argue any ground save estoppel, if permission to change is found in the facts. There is reason to believe that he would not want to win this case on the reasoning advanced in the prevailing opinion. When the Commissioner approves of a change in method, whether expressly or by acceptance of a return, his approval is all inclusive and he must be presumed to have satisfied himself in regard to any necessary adjustments to make the change complete. Such is the effect of the decisions in Home Ice Cream & Ice Co., 19 B. T. A. 762, and Ganahl Lumber Co., 21 B. T. A. 118. Cf. Norwich Woolen Mills Corporation, 18 B. T. A. 303, and Clark Brown Grain Co., 18 B. T. A. 937. There is no sound reason or authority for holding that a corporation effecting a change of method without receiving express permission must report the unused reserve balance as income in the year it dissolves. The decision of the Board in the Standifer case, supra, holding that unclaimed wages were income in the year of dissolution, is not such authority. It is in line with the other cases cited with it above, since there the year of dissolution was the first time when that fund was released and became available for other purposes. See also Dallas Title & Guaranty Co., 40 B. T. A. 1022. Some adjustment would have been proper in the Home Ice Cream and Ganahl cases, supra, yet the change was permitted in each case in the absence of any adjustment. Here, likewise, it was permitted without any adjustment and no correction of the 1929 error may be made in 1936.

Arundeul, Van Fossan, Black, and TüeneR agree with this dissent.

       Revenue Act of 1936.—
      SEC. 23. DEDUCTIONS FROM GROSS INCOME.
      In computing net income there shall be allowed as deductions :

      (t) Bad Debts. — Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts) ; * * *

       Regulations 74, art. 191. Athol Manufacturing Co., 22 B. T. A.105, 110; affd., 54 Fed. (2d) 230.

       “While this [the reserve] method produces an equitable distribution of bad debt losses among periods, it may result in a very inaccurate statement of the net value of the accounts receivable in the balance sheet. For instance, with yearly closings, the reserve set up at the end of one year is eapeeted to he adequate to absorb all losses discovered during the succeeding year. But some of these losses may result from sales of the succeeding year * * [Emphasis added.] 1 Finney Principles of Accounting, ch. 30, p. 6.

         “Methods of Estimating Bad Debts. — There are two principal methods of estimating uncollectibles at the close of the period. First, all customers’ balances may be appraised, one by one, and the accounts deemed bad or very doubtful written off entirely or scaled down. The second method consists in estimating a blanket allowance based largely upon past experience. Under this method individual accounts are later charged against this allowance as their worthlessness is demonstrated. A combination of these two methods may also he employed." [Emphasis added.] W. A. Paton, Accountants’ Handbook, 2d Ed., p. 249.

       “Under the law and the authorities, petitioner had the option to adopt and use either one of these methods, but it did not have the right, without the approval of the Commissioner, to use both, according to its caprice or its interest. * * *”

       Revenue Act of 1936.—
      SEC. 41. GENERAL RULE.
      The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * *


author: Haeeon :

text:
    Bear Gulch Water Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 87921.
    Promulgated December 26, 1939.

      Herbert E. Hall, Esq., for the petitioner.

      T. M. Mather, Esq., for the respondent.
   OPINION.

Haeeon :

The broad issue presented is whether the petitioner’s net income for each year, 1933 and 1934, is exempt from Federal income tax under the provisions of section 116 (d) of the Revenue Acts of 1932 and 1934. The pertinent statutory provision is quoted in full below.

The facts show that petitioner is a private corporation engaged in the business of selling water to private consumers in residential communities. Petitioner does not furnish water for public uses and it was not organized to furnish water to citizens of any community for any municipal government, or under any contract with a municipal government, or political subdivision of the State of California. Cf. Jamestown & New fort Ferry Co., 16 B. T. A. 688; reversed, 41 Fed. (2d) 920; Citizens' Water Co., 32 B. T. A. 750; affd., 87 Fed. (2d) 874; certiorari denied, 302 U. S. 694. In the taxable years all of the capital stock of petitioner, and all of its outstanding bonds were owned by the Regents of the University of California, a corporation existing under the constitution of the State of California, and were held by the regents for the benefit of the university. In the hands of the regents, the stock and the bonds of petitioner were the same as investment holdings, held to produce income for maintaining the College of Commerce and for general useg of the university. The regents manage and invest the funds of a general endowment pool, and the stock which was not acquired by gift, and the bonds were both acquired by investment of funds in the hands of the regents.

Petitioner’s business was a business enterprise conducted for gain.

Petitioner contends that its corporate entity should be disregarded, and that it should be held that its business was an enterprise conducted by the Regents of the University of California without any intervening corporate person, so as to make its income in the taxable year the income of the regents. Petitioner contends, further, that the Regents of the University of California is part of the entity which the university constitutes, and that the entity of the university constitutes a political subdivision of the State of California, or a branch of the state itself, by virtue of its creation by statute.

We disagree with the contention that, under the facts, the entity of petitioner, as a corporation, is not a separate entity. It is well settled that, for purposes of taxation as well as for other purposes, a corporation is a taxable entity separate and distinct from its stockholders. Petitioner’s stock is held in the name of the Eegents of the University of California, which is a private corporation, charged with the public trust of the general government and superintendence of the University of California. City Street Improvement Go. v. Regents of the University of California, 153 Cal. 176; 96 Pac. 801; In Re Royer’s Estate, 123 Cal. 614; 56 Pac. 461. The powers and duties of the regents are prescribed by statute. See article IX, section 9, of the Constitution of California, supra, and section 1432 of the Political Code of California. While the regents are authorized to hold title to property for the benefit of the university, they are not authorized to engage in a private business for gain. It is open to question, at least, whether the power conferred upon the regents to manage and dispose of the property of the university extends to and is an authorization to engage in a private business enterprise. Petitioner offers no proof to support that proposition. Petitioner’s theory that it is not a separate corporate entity, in itself, amounts to alleging that it is a corporation within a corporation. Such theory is incompatible with the underlying concept of the corporation as a legal person. The theory is rejected, and it is concluded that petitioner is a corporate entity separate and distinct from the private corporation known as the Eegents of the University of California. It is also concluded that petitioner is not an agency of the State of California, or of the University of California.

Also, it is well settled that the income of a corporation is not the income of its stockholders, per se. Eisner v. Macomber, 252 U. S. 189. A stockholder is not entitled to the income of a corporation, or any part of it, until the income has been set apart for the benefit of the stockholders by proper corporate action. It is not material that all of the stock of a corporation is owned by one stockholder.

A clear understanding of the issue requires consideration of the nature of the entity of the University of California. The university is declared a public trust in article IX, section 9 of the Constitution of the State of California. It is a state institution of learning, formed for scientific, literary, or solely educational purposes. “The University, while a governmental institution, and an instrumentality of the state, is not clothed with the sovereignty of the state, and it is not the sovereign.” In Re Royer's Estate, supra. The university is not a corporation under the laws of the state. It is a unique entity, a governmental agency, created by the legislature, having such characteristics as to make it a public corporation or quasi-corporation. The Regents of the University of California is a private corporation, organized under the laws of the state, but it is a part of the university, and is not distinct from it. It appears to be an anomalous situation, but the courts of California regard the above as true under all the organic legislation, with the result that, by statute, there is apparently a corporation, the Regents of the University of California, within a public corporation, the university. The members of the board of regents of the university are not public officers, and they are not required to take any oath of office. The employment of a regent is deemed to be exclusively a private trust. Lundy v. Delmas, 104 Cal. 655; 38 Pac. 445. From the above it is clear that the University of California is not a political subdivision of the state, and it is not such within the intendment of section 116 (d). Petitioner’s contention that the university is a political subdivision of the state must be rejected.

Section 116 (d) has been drafted, having in view a taxpayer which is subject to taxation under the Federal revenue acts and whose income is derived from a public utility. It is the established rule of law that a state, or a political subdivision of a state, or a governmental agency of a political subdivision is not within the taxing power of the Federal Government. So Congress could not have had in mind, in enacting section 116 (d), a taxpayer other than a person which is within the taxing power of the Federal Government. Petitioner is such person. Neither the State of California, nor the state university, nor the Regents of the University of California are a party to this proceeding. What separate rights the state, or the state university, may have, as distinguished from those of petitioner, are not before us.

Section 116 (d) clearly contains an express limitation that only income accruing to the state is exempt. The question is whether any income derived by petitioner from its business accrued to the State of California, in 1933 and 1934.

Having it in mind that the title to the stock of petitioner was held by the Regents of the University of California, nevertheless, it is to be regarded as part of the state university. In Re Royer’s Estate, supra. The regents hold property and funds as a custodian for the state university. Whatever property the regents hold is the property of the state university, and, since it is a public trust, such property is the property of the State of California. So it has been held that a mortgage of land executed to the regents, to secure money due to that body for any purpose for which it was created, and the interest which the regents thereby hold in the land, is the property of the state. Webster v. Board of Regents of the University of California, 163 Cal. 705; 126 Pac. 974. In this case, it must be concluded that the ownership of petitioner’s stock by the regents is tantamount to ownership thereof by the State of California.

The next question is, whether any income of petitioner accrued to the State of California in 1933, and in 1934. According to the statement attached to the notice of deficiency, the adjusted net income of petitioner is $50,099.61 for the year 1933, and $55,605.36 for the year 1934. The facts show that in 1933 petitioner owed $400,000 on outstanding bonds. Also, that no dividends on capital stock were declared in 1933, and no income was set aside or credited to stockholders. The facts do not show what amount was available for stockholders in 1933. In Citizens' Water Co., supra, at page 753, we stated, in construing section 116 (d) of the 1928 Act (which is the same as section 116 (d) of the 1932 and 1934 Acts), that “This paragraph was intended to exempt the city [or state] from taxation upon income which it actually receives from any public utility * * The petitioner in

the Citizens’ Water Co. case contended that a tax on its surplus earnings would directly affect its surplus earnings by reducing the surplus earnings which would be available to the city of Burlington, and, therefore, would amount to a tax upon the city. The Circuit Court of Appeals (Eighth Circuit) sustained this Board’s conclusions and rejected the above contention. While the facts in that case differ from the facts here, the above question appears to be involved in petitioner’s contentions. As was stated by the court in Citizens' Water Co. v. Commissioner, 87 Fed. (2d) 874, 878, it is clear that a tax on petitioner’s earnings for the year 1933 will reduce, by the amount of the tax, the surplus available for stock dividends, if and when declared. But is that material? The petitioner’s net earnings in 1933 did not belong to and become the property of the State of California in that year. The petitioner’s net income in 1933 was its own income, and since no dividends were declared in 1933, none of petitioner’s income accrued to the state in 1933. Accordingly, it is held that none of petitioner’s income for 1933 is exempt from Federal income tax, under section 116 (d). Respondent’s determination for 1933 is sustained. Cf. Helvering v. Mountain Producers’ Corporation, 303 U. S. 376, where it is stated that “immunity from nondiscriminatory taxation sought by a private person for his property or gains * * * cannot be supported by merely theoretical conceptions of interference with the functions of government. Regard must be had to substance and direct effects.” (Section 116 (d) was not involved in the above cited case.) See, also, Curran v. Arkansas, 15 How. 304, where the Court pointed out that a state, by owning all of the capital stock of a private corporation, does not impart to that corporation any of its privileges or prerogatives, and, we may add, immunities. Cf., also, Keifer & Keifer v. Reconstruction Finance Corporation, 806 U. S. 381, deciding another question, but pointing out that government, itself, is not a conduit of its immunity to its agents or instrumentalities. Cf. Allen v. Regents of University System of Georgia, 304 U. S. 439.

In 1934 petitioner declared and paid $10,000 in dividends on its capital stock. In 1934, therefore, some of petitioner’s income accrued to the State of California by virtue of its ownership, through the regents, of petitioner’s capital stock. Section 116 (d) of the 1934 Act applies to this $10,000 of petitioner’s income. On the basis of what has been concluded hereinbefore, petitioner is taxable on at least the remainder of its net income, $45,605.36, for the year 1934. Citizens' Water Co., supra.

There remains a question whether petitioner’s income to the extent of $10,000 is exempt from tax in 1934, or whether petitioner is taxable on its total net income, and there shall be refunded to the State of California upon its duly filing a claim, “an amount which bears the same relation to the amount of the tax as the amount which (but for the imposition of the tax imposed by this title) would have accrued directly to * * * State, bears to the amount of the net income from the operation of such public utility for such taxable year.”

The quotation above is from subsection (1) of section 116 (d), which follows immediately below the second paragraph of section 116 (d). There appears to be some ambiguity in the manner in which section 116 (d) has been drafted. Does the section mean that in some instances a taxpayer is to exclude part of its income from gross income, so as to make such part exempt from tax; or did Congress intend that the taxpayer should report its total net income for taxation, and that the State or political subdivision should obtain a refund? This question was considered by the Board in the Citizens' Water Co. case. In that case, dividends on preferred and common stock were declared and paid in the taxable years. The city of Burlington owned preferred and common stock of the utility corporation, and, presumably, it actually received the dividends paid on its stock. However, we held that the utility corporation must pay tax on its entire net income. The result was that the city of Burlington would, thereafter, if it saw fit, apply for a refund of the amount of income it. lost as an imposition of the tax. See pages 754 and 755 of the Citizens' Water Co. case. The Board’s interpretation of section 116 (d) was affirmed, and the court specifically approved the above construction of 116 (d).

It is concluded,that the petitioner is liable for the entire amount of the tax upon its total net income for the year 1934, under section 116 (d). The respondent is sustained.

Reviewed by the Board.

Decision will be entered for the respondent.

Yah Fossan and Opper concur only in the result.

       SEC. 116. EXCLUSIONS FROM GROSS INCOME.

      (d) Income op States, Municipalities, Etc. — Income derived from any public utility or tile exercise of any essential governmental function and accruing to any State, Territory, or the District of Columbia, or any political subdivision of a State or Territory, or income accruing to the Government of any possession of the United States, or any political subdivision thereof.
      Whenever any State, Territory, or the District of Columbia, or any political subdivision of a State or Territory, prior to September 8, 1916, entered in good faith into a contract with any person, the object and purpose of which is to acquire, construct, operate, or maintain a public utility—
      (1) If by the terms of such contract the tax imposed by this title is to be paid out of the proceeds from the operation of such public utility, prior to any division of such proceeds between the person and the State, Territory, political subdivision, or the District of Columbia, and if, but for the imposition of the tax imposed by this title, a part of such proceeds for the taxable year would accrue directly to or for the use of such State, Territory, political subdivision, or the District of Columbia, then a tax upon the net income from the operation of such public utility shall be levied, assessed, collected, and paid in the manner and at the rates prescribed in this title, but there shall be refunded to such State, Territory, political subdivision, or the District of Columbia (under rules and regulations to be prescribed by the Commissioner with the approval of the Secretary) an amount which bears the same relation to the amount of the tax as the amount which (but for the imposition of the tax imposed by this title) would have accrued directly to or for the use of such State, Territory, political subdivision, or the District of Columbia, bears to the amount of the net income from the operation of sueh public utility for sueh taxable year.
      (2) If by the terms of such contract no part of the proceeds from the operation of the public utility for the taxable year would, irrespective of the tax imposed by this title, accrue directly to or for the use of such State, Territory, political subdivision, or the District of Columbia, then the tax upon the net income of such person from the operation of such public utility shall be levied, assessed, collected, and paid in the manner and at the rates prescribed in this title.

       Article IX, section 9, of the Constitution of the State of California.—
      The University of California shall constitute a public trust, to be administered by the existing corporation known as “The Regents of the University of California,” with full powers of organization and government, subject only to sueh legislative control as may be necessary to insure compliance within the terms of the endowments of the university and the security of its funds. * * * Said corporation shall be vested with the legal title and the management and disposition of the property of the university and of property held for its benefit and shall have the power to take and hold, either by purchase or by donation, or gift, testamentary or otherwise, or in any other manner, without restriction, all real and personal property for the benefit of the university or incidental to its conduct.

       In the Finance Committee Report accompanying the revenue bill of 1928, Rept. No. 960, p. 19. the following is stated with reference tc section 116 (d) : “The section does not relieve the utility from tax It merely refunds to the state or municipality the amount by which its income was reduced directly because of the tax.” To the same effect, see Cumulative Bulletins, 1928, vol. VII-2, p. 147, I. T. 2436.


author: Kern :

text:
    Jessie Pritchard, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 90172.
    Promulgated December 26, 1939.

      Mark F. Mathewson, Esq., Joe 8. Pearson, Esq., and J. E. Ballinger, Esq., for the petitioner.

      B. E. Neblett, Esq., for the respondent.
   OPINION.

Kern :

This case involves a deficiency of $551.88 in income tax for the year 1934, and raises the single question whether the transaction between two national banks was a corporate reorganization and tax-free to the petitioner shareholder, or was a sale.

The facts for the most part were stipulated and are as follows:

Sometime before June 7, 1934, the First National Bank of Seattle, Washington, hereinafter called “Seattle”, approached the First National Bank of Shelton, Washington, hereinafter called “Shelton”, with the object of establishing a branch at the location of Shelton. Permission to do this was obtained by Seattle from the Comptroller of the Currency on June 15, 1934, and to carry it out, it was decided that Seattle should purchase or otherwise acquire the assets of Shelton, and it was, therefore, agreed on June 7, 1934, that Seattle should assume all Shelton’s liabilities in exchange for certain assets of Shelton’s, the exchange being on the basis of so much of Shelton’s assets as equaled its liabilities on a day certain.

Such assets as might exceed the liabilities were not touched upon in this agreement, but were left to be covered by an agreement entered into on the same day between all stockholders of Shelton, on the one side, and Seattle, the First National Co., a wholly owned subsidiary of Seattle, and William G. Reed as liquidating agent designated by Shelton’s stockholders to handle the settlement of its affairs, on the other.

By the terms of this agreement the excess of assets over liabilities was determined to be $183,750, which was the amount of cash on deposit to the credit of Shelton remaining after Seattle had taken over the assets equal to the amount of the liabilities of Shelton. This sum of $183,750 was received by the liquidating agent as trustee for the stockholders of Shelton and was used to purchase 7,350 shares of stock of Seattle from the First National Co. The liquidating agent by check drawn on Shelton dated June 19,1934, paid to the First National Co. this amount in payment for this stock. These 7,350 shares were distributed ratably to stockholders of Shelton, the petitioner as a stockholder being entitled to receive 955.5 shares.

The terms of this agreement were fully carried out, in excess of 99 percent of the entire assets of Shelton being allocated pursuant to the terms of the agreements. The remaining assets of less than one percent consisted of an odd amount of cash resulting from a change in Shelton’s cash on hand at the close of the last banking day, including service charges; refund of prepaid insurance premiums; refund on reserve for taxes; and an odd amount of cash resulting from the excess of the subsequent sale price over the appraised value of certain municipal bonds transferred to Seattle, such assets amounting to $4,601.76.

This amount was turned over to the stockholders of Shelton in addition to the stock in Seattle, and the stockholders of Shelton surrendered their stock in the latter bank to the liquidating agent for cancellation.

The distribution was based on 14.7 shares of Seattle stock for each share of Shelton stock owned. However, to obtain some additional cash, petitioner entered into an arrangement with the liquidating agent to dispose of the proceeds received in exchange for 5 shares of Shelton stock, i. e., 73.5 shares of Seattle stock, and to receive the balance in shares of Seattle.

Accordingly, the petitioner received 882 shares of stock of Seattle, which had a fair market value when received of $22,050, and $2,377 in cash, representing proceeds of the sale of 73.5 shares of stock of Seattle in the sum of $1,837.50, and additional cash of $539.50, being a total of $24,427. In her return the petitioner reported the sum of $1,835.35 as the amount of gain to be taken into account in computing net income.

The shares of stock owned by the petitioner in Shelton had a basis of $15,015.94.

In the deficiency notice taxable gain is determined on the basis of receipt, by the petitioner, of a liquidating dividend in the amount of $24,427 less the petitioner’s basis for her shares of stock in the First National Bank of Shelton of $15,015.94, or a net gain of $9,411.06, of which gain 100 percent is taken into account in computing net income.

The agreement between Seattle and Shelton and that between the shareholders of Shelton, Seattle, the First National Co., and William G. Reed, as liquidating agent of Shelton, were put in evidence, and are incorporated here by reference.

The sole question is whether this transaction constitutes reorganization under the Revenue Act of 1934. The respondent objects that the language of the two agreements is that of seller and buyer; and that the First National Co. is a third party and not a party to the reorganization. Respondent insists that the transaction was not a statutory merger or consolidation under the National Banking Act, and so not within section 112 (g) (1) (A); that the acquisition by Seattle of Shelton’s assets was only of that part of them which equaled the bank’s liabilities and so not of “substantially all the properties of another corporation”; and that the simultaneous and parallel exchange of Seattle stock for the balance of Shelton’s assets, $183,750, in cash, was made not by the Seattle bank but by its wholly owned subsidiary, First National Co.; so that the requirements of subsection (B) would not be met; and, obviously, as may be admitted, subsections (C), (D), and (E) are inapplicable.

We think that such a view of the transactions is too narrow and fails to see them, as they really were, as merely steps in a single plan. Undoubtedly what was sought to be done was that Seattle’s stock should be acquired by Shelton’s shareholders in exchange for Shelton’s assets and that Shelton’s shareholders, including petitioner, would thus become the owners in part of Seattle and with an interest, therefore, in the branch of Seattle which was to supersede Shelton in the banking business in that town. The record does not inform us whether Seattle’s branch was established at Shelton, as contemplated, but is very clear that the whole transaction had that object in pros-pecfc and was conditioned on the Comptroller of the Currency’s approval of it. We may assume in petitioner’s favor that this was accomplished. When this is said, however, all has been said in petitioner’s favor which can be on the record; for even if this were not a sale, as respondent contends, but in essence a reorganization, it still does not conform to the definition of a reorganization provided by section 112 (g) of the Revenue Act of 1934, set out in the margin.

The transaction was not carried out as a statutory merger under the National Banking Act, as amended (paragraph 33, Title 12, U. S. Code Annotated), but was a liquidation under section 181 of the same title. Therefore, it follows that the transaction was not covered by subsection (A). No contention is made by petitioner that the transaction is covered by subsections (C), (D), and (E), and it is obvious that these subsections are inapplicable. The only portion of subsection 112 (g) which might possibly be applicable to the transaction here involved is subsection (B), containing the definition of a reorganization as “the acquisition by one corporation in exchange solely for all or a part of its voting stock * * * of substantially all the properties of another corporation.” An analysis of the facts disclosed in this proceeding indicates clearly that the transaction was one not covered by this subsection. The assets of Shelton which were acquired by Seattle were not acquired “solely for all or a part of its voting stock”, but were acquired in consideration of Seattle’s assumption of an equivalent amount of Shelton’s liabilities. The remainder of Shelton’s assets, represented by cash in the hands of the liquidating agent, was acquired by the First National Co., and was not acquired by it in exchange for its stock, but in exchange for the stock of Seattle.

Moreover, the transaction lacks what the Supreme Court has said in no uncertain terms is a sine qua non of a tax-free transaction, a continuity of interest in the old shareholders, whose corporation’s assets are transferred, in those same assets after the transfer. Groman v. Commissioner, 302 U. S. 82; Helvering v. Bashford, 302 U. S. 454.

The significant thing here is that the transfer of Shelton’s assets by the liquidating agent was made to the First National Co., and not to Seattle. That company, it is true, was a wholly owned subsidiary, but this fact does not alter €ne fundamental fact that a distinct corporate entity had been interposed between Shelton’s former shareholders who had now become Seattle’s shareholders, and their interest in the assets formerly held by Shelton. As shareholders of Seattle, had Seattle taken over directly and held Shelton’s assets, they would have had a continuing interest in what they had held before while shareholders of Shelton, but all they held now was an interest in the stock of the First National Co. to which the Shelton assets had been transferred, by virtue of their ownership of Seattle stock. The continuity of interest was forever broken. We must hold the exchange, therefore, not a reorganization. Groman v. Commissioner, supra. And the result would be the same even if it could have been shown, a fact which the record contradicts, that Shelton’s assets had been transferred momentarily to Seattle and then by Seattle to the First National Co., for the interest would have been only transitory, fleeting, and illusory. It must be material and permanent. Helvering v. Bashford, supra.

The point need not be labored, since it has been fully discussed in our decisions. , Cf. Whitney Corporation, 38 B. T. A. 224; affd., 105 Fed. (2d) 438; Anheuser-Busch, Inc., 40 B. T. A. 1100. See note, 51 Harvard Law Review 893.

Reviewed by the Board.

Decision will he entered for the respondent.

       (g) Definition of Reorganization. — As used in this section and section 113.
      (1) The term “reorganization” means (A) a statutory merger or consolidation, or (B) the acquisition by one corporation in exchange solely for all or a part of its voting stock; of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of another corporation; or of substantially all the properties of another corporation, or (C) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its shareholders or both are in control of the corporation to which the assets are transferred, or (D) a recapitalization, or (E) a mere change in identity, form, or place of organization, however effected.