author: Tbammell

text:
    LIBBY & BLOUIN, LTD., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
    Docket No. 7416.
    Decided September 22, 1926.
    Expenditures held to be ordinary and necessary expenses.

      Isom J. Guillory, Esq., and E. Barrett Prettyman, Esq., for .the petitioner.

      M. N. Fisher, Esq., for the respondent.
    This is an appeal from the determination of a deficiency in income and profits taxes for 1918 and 1919, in the amount of $11,895.25. The deficiency is based upon the action of the Commissioner in disallowing expenditures during the years involved as a deduction as ordinary and necessary expenses and in treating them as capital expenditures.
    FINDINGS OF FACT.
    The taxpayer is a Louisiana corporation having its principal place of business at Lefourche Crossing. It is engaged in the business of growing and manufacturing sugar.
    During 1918 and 1919 the taxpayer made the following expenditures which it charged to expense and deducted from its gross income in computing its net taxable income, which deductions were disallowed by the Commissioner:
    1918
    Copper tubes for double effects in sugar factory_$12,147. 88
    Boiler tubes for locomotive_ 189.14
    Car wheels for cane cars_ 408. 00
    Expenditures on railroad tank_ 291. 85
    Supplies for harness_ 194.94
    112 feet of hoisting chain_ 47.60
    Corrugated roofing_ 346. 32
    13, 625.73

      1939
    Oar wheels for cane cars_!_$567. 00
    Supplies for harness- 31. 42
    Expenditures on railroad_ 489. 56
    Thermometers for sugar makers_ 94.08
    1,182.06
    The copper tubes were a part of a sugar evaporator in which cane juice is boiled in the sugar-making process. The evaporators are a species of cylindrical vertical boilers or vats, constructed of cast iron, into which the cane juice is introduced for boiling and concentration into thick juice, or syrup, from which sugar is produced.
    There are different kinds of evaporators in use in the making of sugar. They are sometimes single, double, triple, quadruple or multiple, and are called single effect, double effect, multiple effect, as the case may be. The evaporators used by the taxpayer were what are known as double effects. They were 9 feet in diameter and capable of evaporating cane juice from about one thousand tons of cane every 24 hours.
    In the evaporator used by the taxpayer there were about 2,400 copper tubes, each about 2 inches in diameter and 4 feet long. They stood vertically in the evaporator and were expanded at each end into an upper and lower tube. They were far enough apart to permit the introduction of steam or vapors between and among them. The steam or vapors which boils the juice is contained between the upper and lower tube sheets which are fastened horizontally at the edges to the sides of the evaporator. The cane juice is contained in the tubes. In the center of the tube sheets there is a downtake, about 24 or 30 inches in diameter, through which the juice flows from the upper to the lower part of the evaporator as it boils.
    The steam contained between the tube sheets of the first effect heats the juice in that effect and as the juice boils it forms vapors which are introduced into the second effect between the tube sheets of that effect, and it is these vapors that heat the juice contained in the tubes, downtake and the rest of the second effect.
    In the first effect steam comes in contact with the outer surface of the tubes and the boiling cane juice comes in contact with the inside surface of the tubes. In the second effect the vapors from the boiling juice of the first effect come in contact with the outside of the tubes.
    Cane juice contains ammonia and mineral salt and about 1 to iy2 per cent acid. In the manufacture of white sugar by the sulphuration process, which was the process used by the taxpayer, the cane juice is treated in sulphur and lime tanks before being conveyed into the evaporators. Sulphur is burned in an oven and the fumes which arise from it are introduced into the juice to acidulate it. As much sulphur is put in the juice as it will take in order to make high grade white sugar. The taxpayer manufactured a superior quality of white sugar and in order to do this used a larger quantity of sulphur than is ordinarily used. After the cane juice has been treated with sul-phur, lime is introduced into it in order that, when it is subsequently heated, the lime will coagulate the albumenoids, so that in the process of settling they will fall to the bottom and the juice will remain on top.
    From the sulphur and lime tanks the cane juice is introduced into the first evaporator and copper tubes. When it is boiled it contains acid, ammonia and salts. Fumes arising from the sulphur and lime produce' a corrosive scale on the inside surface of the tubes in the first effect, and in the second effect the tubes are likewise attacked on the inside by the boiling cane júice and on the outside by the vapors. This causes the tubes to become thinner and they have to be renewed from time to time.
    There are two methods of removing the scales. One is by a mechanical process with a brush or tube scraper. Another is by boiling them with a strong solution of caustic soda and afterwards with muriatic or hydrochloric acid. The taxpayer used the latter process. ■
    It is impossible to determine accurately the life of the tubes in the double effect. In general they last from two to four years, depending upon the amount of sulphur used. The more sulphur that is used the shorter the life of the tubes. They do not all wear out at the same time. Some are affected to a greater extent than others and as a consequence some deteriorate faster than others even when the same amount of sulphur is used. A certain number of tubes have to be renewed each year. Sometimes a smaller number and sometimes a larger number have to be changed — and sometimes they all have to be changed. The taxpayer in this case replaced some tubes every year and in 1918 it "replaced them all. After 1918 all of the tubes were changed within two or three years. ' '
    The life of the double effect evaporator is approximately twenty years. The renewal of the copper tubes which constitute a part of the double effect does not prolong the life of the evaporator, nor does it add to the original value thereof. The tubes used by the taxpayer during the taxable year involved were not in the nature of additions but were replacements of tubes worn out.
    It is the standard accounting practice in the sugar-manufacturing industry to charge the cost of replacing old copper tubes with new tubes to current repairs on profit and loss and not to capitalize them. It would be difficult, if not impossible, to keep a record of the acquisition, cost, life, depreciation and scrap value of each particular tube. The taxpayer charged to expense expenditures made during the year for the purpose of replacing the copper tubes.
    For the years 1918 and 1919 the Commissioner allowed the taxpayer a deduction on account of the exhaustion, wear and tear of its sugar factory and machinery on the basis of a cost or March 1, 1913, value of $214,859.68.
    During 1918 the taxpayer expended $189.14 to replace leaky boiler tubes on a five-ton railroad locomotive used for hauling cane to the factory. Not all of the tubes of the locomotive were changed but only those that were leaky.
    There was expended by the taxpayer in 1918, $408 to replace broken car wheels on 126 cane cars used in hauling cane. Each cane car has four or eight wheels. There were no additions to the equipment. During 1919, $567 was expended by the taxpayer for the same purpose.
    During 1918, $291.85 was expended by the taxpayer to repair a water tank used in connection with the railroad in replacing the bottom and patching up the tank.
    During 1918, $194.94, and during 1919, $31.42 was expended by the taxpayer in the purchase of leather from time to time to repair harness for about 100 mule teams.
    During 1918, $47.60 was expended by the taxpayer for 112 feet of hoisting chain. This was a part of a large apparatus called an American hoist grab which picks up about one and a half or two tons of cane at a time.
    During 1918 the taxpayer expended $346.32 for corrugated roofing which was used for patching the roofs of dwellings and cabins on the plantation and around the factory. The taxpayer had buildings which cost $36,629.54 on the plantation in addition to the factory buildings.
    During 1919, $94.08 was expended by the taxpayer for thermometers which were used in testing cane juice.
   OPINION.

Tbammell

: The question presented is whether the expenditures made by the taxpayer during the years involved were capital expenditures or expenses which should be deducted by the taxpayer as ordinary and necessary expense in carrying on its trade or business.

There is oftentimes a fine distinction between what is a captial expenditure and an ordinary and necessary business expense. Some items are clearly capital and other items are clearly expense, but between the two extremes a point is approached at which it is difficult to determine whether the expenditure is capital or an expense.

An item, which might be classified as a capital expenditure under certain circumstances, may, under different facts and circumstances, be considered expense. Repairs in the nature of replacements which appreciably prolong the life of the property and arrest deterioration, or acquisitions by a taxpayer which are additions to the plant or facilities, may be classed as capital expense, whereas, incidental repairs which neither materially add to the value of the property nor appreciably prolong its life but merely keep it in an ordinary, efficient operating condition, might be classified as expense items.

This, however, is not an invariable rule and the particular circumstances of the case must be taken into consideration in determining into which class the expenditures fall. In this case the tubes which were purchased by the taxpayer and used in repairing the evaporators were small parts of a large machine. They were short-lived; that is, they had to be replaced every two or three years. The tubes merely kept the evaporator in an ordinary, efficient working condition. They were not additions which added anything, to the value of the machine, except such value as was added by the fact that the machine was kept in an efficient condition. There were about 2,400 of these small tubes in the evaporator. They were not in any sense separate units but were mere parts of one machine.

Expenditures for small parts of a large machine, in order to keep that machine in an efficient working condition, under the facts of this case, are, in our opinion, ordinary and necessary expenses and are not capital expenditures. The machine as a whole was repaired by replacing the worn out parts, while the parts when they were acquired as a part of the machine were, of course, a part of the capital acquisition. The replacing of the small parts as they wear out, under such circumstances, is properly expense. When a building is erected the flooring, nails and other small supplies of course enter into the capital cost of the building, yet when a building is repaired, the cost of replacing planks in the floor, and the cost of nails in making repairs, while it might be a considerable item, is entirely different from the ordinary cost of such things when the building is being erected. As in the case of the locomotive involved in this appeal, expenditures to replace certain worn out parts, as worn out tubes, broken parts, wheels, etc., merely keep the machine in operating condition. The statute contemplates that assets used in a trade or business are to be kept in an efficient operating condition by rejaairs, and money expended in making such repairs is considered an expense and allowed as a deduction by the statute. A different situation might result if the taxpayer had acquired a large number of tubes for the purpose of making repairs in the future and had kept large quantities of supplies on hand, but the taxpayer did not do that in this case. The expenditures were for repairs which were actually made during the taxable years.

From a consideration of all the evidence, we are of the opinion that the entire amount expended by the taxpayer during the years involved, which is set out in the findings of fact, was an ordinary and necessary expense and the taxpayer is entitled to deduct the same in determining its net income.

Judgment for the fetitioner. Order of re-determination wild be entered on 10 days'1 notice, under Rule 50.


source: Caselaw Access Project

author: Littleton

license: Public Domain

text:
    Appeal of FRANK E. WALL.
    Docket No. 7359.
    Decided September 22, 1926.

      Frank E. Wall pro se.

      A. 0alder Mackay, Esg., for the Commissioner.
    This appeal is from the determination of deficiencies of $72 and $68.75, respectively, for the calendar years 1921 and 1922. It is claimed that the Commissioner erred in including in the husband’s income the salary earned by the wife, and in refusing to allow him a deduction of $25 contributed to charity.
    FINDINGS OF FACT.
    During the calendar years 1921 and 1922, petitioner was a resident and citizen of California, married and living with his wife. During the taxable years, and for a number of years prior thereto, petitioner’s wife was employed by the Wall Company, a corporation, and received a salary of $600 per annum for personal services. The taxpayer filed a separate return and did not include the earnings of his wife. There existed between the petitioner and his wife an agreement that her separate income should belong exclusively to her. All income of petitioner’s wife was received directly by her and was at all times kept separate and apart from the income of her husband.
    In 1922, petitioner contributed $25 to a Christmas fund for the poor, which fund was used exclusively for charitable purposes.
    The Commissioner included as a part of petitioner’s income for 1921 and 1922, the separate earnings received by his wife, denied the deduction of $25, and computed the deficiencies hereinbefore mentioned.
   OPINION.

Littleton

: The decision' of the first issue is governed by the opinion of the Board in the Appeal of Estate of George W. Randall, 4 B. T. A. 679.

We are of the opinion that the $25 contributed by the petitioner during 1922 to charity was a proper deduction from gross income for that year.

Judgment for the petitioner.


author: Aeundell:

text:
    Appeals of JOHN F. COOK and BRADFORD C. PATCH.
    Docket Nos. 6331, 6332.
    Decided September 22, 1926.
    1. Commissions earned by a partnership which kept its books of account and made its returns on an accrual basis became income for the years in which earned and were a part of the distributive shares of the partners in those years, regardless of the year in which the commissions were collected.
    2. Petitioners, not being on an accrual basis, are not subject to tax on salaries until received.
    3. Commissioner’s adjustment of inventory approved.
    4. The Board has no jurisdiction to determine questions relating to a year for which an overassessment has been found by the Commissioner. Appeal of Cornelius Ootton Mills, 4 B. T. A. 255.

      Henry II. Bond, Esq., for the petitioners.

      John W. Fisher, Esq., for the Commissioner.
    These appeals are from determinations of income-tax liabilities as follows:

    The questions’for determination are whether the Commissioner erred (1) in including certain commissions in income of a partnership of which the taxpayers are members; (2) in his allocation of salaries of the members of the partnership; (B) in adjustment of partnership merchandise inventory for 1919.
    FINDINGS OP PACT.
    The petitioners are members of the partnership of Cook, Watkins & Co. of Boston, Mass. Distribution of income of the partnership was made for the years here involved in the ratio of 75 per cent to John F. Cook and 25 per cent to, Bradford C. Patch.
    The partnership owned all of the capital stock, with the exception of qualifying shares, of two corporations, the C. W. McMillan Granite Co. and the Cook & Watkins Manufacturing Co. The petitioner Cook was president of the Cook & Watkins Manufacturing Co., and treasurer of the C. W. McMillan Granite Co. The petitioner Patch was president of the C. W. McMillan Granite Co., and vice president and treasurer of the Cook & Watkins Manufacturing Co. ■
    The business of the partnership consisted in part of the securing of orders for granite on a commission basis for the two corporations and in part of the securing and execution of orders on its own account. When shipments were made by the corporations on orders obtained by the partnership they billed the partnership which in turn billed the purchasers in its own name. The partnership was responsible for collection of these accounts. No entry of these orders was made on the books of the partnership until shipment was made, when it charged the purchaser and credited the corporation that had filled the order. The partnership carried on its books inventories of merchandise, notes and accounts receivable and notes and accounts payable.
    Some time during 1919 the partnership entered into an agreement with the two corporations whereby it was to receive a commission of 10 per cent on orders it obtained for the corporations. This commission was to be - based on orders shipped during the year and was to be paid provided the corporations made a sufficient profit on the orders to enable them to pay at that rate. This agreement was in effect during the years 1919 and 1920, and in each of these years the profits to the corporations on orders secured by the partnership were sufficient to entitle the partnership to the agreed 10 per cent commission.
    The entries in the journals of the corporations showing commissions for 1919 and 1920 were as follows:
    Jotjbnai, or Cook & Watkiks Manotactubiitg Co.
    December 31, 1919
    Sundries Sundries
    $12, 407. 31 Commissions, Cook, Watkins & Co_ $12, 407.31
    10% on orders skipped 1919 as follows: (Shipments by month listed in journal.)
    December 31, 1920
    $11, 599.27 Commissions, Cook, Watkins & Co_ $11, 599. 27
    10% on orders shipped 1920 as follows: (Shipments by month listed in journal.)

      Journal of O. W. McMillan G-ranite Co.
    December 31, 1919
    Sundries Sundries
    $10,104. 63 Commission to Cook, Watkins Co_$10,104. 63
    (Commissions by months listed in journal.)
    December 31, 1920
    $14, 281.11 Commission to Cook, Watkins Co_$14, 281.11
    (Commissions by months listed in journal.)
    The corresponding entries in the journal of the partnership of Cook, Watkins & Co., were as follows:
    December 31, 1919
    Mfg. Ledger • Customers Ledger
    $10,104. 63 C. W. McMillan Granite Co., commission-:-$22, 511. 94
    12,407.31 Cook, Watkins & Co.
    January 18, 1921
    $11, 599.27 Cook & Watkins Mfg. Co., commission_$25, 880.38
    14, 281.11 C. W. McMillan Granite Co.
    The ledger of the partnership at the close of 1919 contained the following entries:
    December 31, 1919
    Debits Credits
    Commissions, salesman. $5, 881. 55 $22, 511. 94
    C. & W. & McM.
    Credit balance— $16, 630.39
    At the close of the year 1919 the corporations were financially able to pay the commissions on shipments during the y.ear but they did not actually pay them until some time later. At the close of the year 1920 they did not have on hand available cash with which to pay the partnership the commissions on shipments during that year. Payments for the latter year were made as follows:

    The corporations borrowed money from a bank and from the partnership. The partnership kept a running account on its books with each of the corporations. The balance of these accounts at the close of each year stood as follows:
    1919
    O. W. McMillan Granite Go., debit balance-$19, 846.01
    Cook & Watkins Mfg. Go., debit balance- 8, 536. 25

      1920
    O. W. McMillan Granite Co., debit balance_ $8, 928. 51
    Cook & Watkins Mfg. Co., credit balance_ 13, 673.65
    The McMillan Company balance for 1920 included commissions for that year. The partnership charged no interest on funds advanced to the corporations.
    The petitioners were paid salaries by the McMillan Granite Co. and by the Cook & Watkins Manufacturing Co. for 1920. Payments of salaries were received by the petitioners as follows:

    The entries with respect to salaries on the journals of the corporations were:
    C. W. McMillan Granite Oo.
    December 31, 1919
    Expense
    $2,000.00 Expense to sundries: Sundries
    Salary, B. C. Patch_ $500. 00
    Salary, J. P. Cook_ 1, 500. 00
    January 19, 1920
    Sundries • Sundries
    $1,500.00 John P. Cook to Oook, Watkins & Co_$2, 000. 00
    500.00 B. O. Patch (salaries).
    December 31, 1920
    Expense
    $3,000 Expense to sundries: Sundries
    Salary B. C. Patch- $750. 00
    Salary J. P. Cook_ 2, 250. 00
    Cook & Watkins Manufacturing Co.
    December 31, 1919
    Expense Sundries
    $8, 085. 00 Expense, J. P. Cook-$6, 063. 75
    Salaries, B. C. Patch_ 2, 021.25
    January 16, 1920
    Sundries Sundries
    $6,063.75 J. P. Cook — Cook, Watkins & Co_$8,085.00
    2, 021.25 B. C. Patch, salaries.

      December 31, 1920
    Expense Sundries
    $8, 080. 00 Expense, J. E. Cook_ $6,063. 75
    Salaries, B. O. Patcli_ 2, 021. 25
    The petitioners kept no individual books of account. The salaries they received from, the corporations were carried in their personal accounts on the partnership books. These salaries were shown in the partnership journal by the following entries:
    January 19, 1920
    $2,000.00 O. W. McMillan Granite Oo. (Sal.):
    B. O. Patch, McM. Sal_ $500. 00
    J. E. Ooolt, McM. Sal- 1, 500. 00
    8,085.00 Cook & Watkins Mfg. Co. (Sal.) :
    B. C. Patch, McM. Sal_ 2,021.25
    J. E. Cook, McM. Sal_ 6,063.75
    February 18, 1921
    $3, 000. 00 C. W. McMillan Granite Co.:
    J. E. Cook, salary, 1920_$2,250.00
    B. C. Patch, salary, 1920- 750.00
    February 18, 1921
    $8, 085.00 Cook & Watkins Mfg. Co.:
    J. F. Cook, salary 1920_$6, 063. 75
    B. C. Patch, salary 1920_ 2,021.25
    The salaries received by the petitioners were turned over by them to the partnership as loans.
    The merchandise inventory of the partnership contained, at the beginning of 1919, an item of $5,440.11, representing salesmen’s commissions on orders unfilled at the beginning of the year. The carrying of this item in the inventory of merchandise was in accordance with the practice of the partnership in prior years. The Commissioner excluded this amount from the opening inventory.
   OPINION.

Aeundell:

In asserting the deficiencies here involved the Commissioner tabes the position that the books of the partnership were kept on an accrual basis and that commissions on orders shipped by the corporations in 1919 and 1920 were accruable items of income for those years. If the Commissioner’s contention is correct the distributive share of each of the petitioners should be increased to reflect this income of the partnership. The petitioners say that the partnership books were not kept on a strictly accrual basis; that under the agreement with the corporations commissions on orders did not become income to the partnership until actually received.

The partnership carried on its books a number of accrued items such as notes and accounts receivable, merchandise inventory, and notes and accounts payable. From these facts it is obvious that the partnership books were kept on an accrual basis. The fact that it did not accrue certain items, such as interest receivable, and prepaid insurance, and did not split the payroll for the last week in the year, is not sufficient to place the partnership on a non-accrual basis where it is plain that the accrual system was used generally in keeping its accounts. Appeal of Bartles-Scott Oil Co., 2 B. T. A. 16.

There is some doubt as to whether the agreement between the corporation and the partnership was reduced to writing. From the testimony and the bookkeeping entries made by the parties to the agreement it appears that the substance of it was that the partnership was to receive a 10 per cent commission on all orders secured for the corporation, provided the profits on these orders were in excess of 10 per cent, the commissions to be computed at the end of each calendar year on the orders shipped during the year. During the years here involved the profits to the corporations were sufficient to entitle the partnership to the commissions agreed upon and at the close of each year the corporations on their books credited the partnership with an amount representing 10 per cent of the selling price of shipments made during the year. The corporations at the close of 1919 were in a position, financially, to pay the partnership the commissions on shipments during that year, though payment was not actually made until sometime later. At the close of 1920 they did not have sufficient cash to pay the commissions due to the partnership for the year’s shipments. At the close of 1919 the partnership entered on its books the commissions on shipments for that year. For the year 1920 the partnership did not record the commissions as due until in January of the following year.

Having found, as we have above, that the partnership books were kept on the accrual basis, it seems of little importance whether or not the commissions were entered in the partnership accounts at the close of each year. The principal question is whether the commissions were accruable items at the end of each of the years. The partnership was entitled, to commissions on orders shipped during each year. When at the end of each year the amount of the orders shipped was determined, the commissions due on the shipments became liabilities of the corporations and accruable assets of the partnership regardless of the time of payment.

The situation in this case in all material respects is similar to that in the Appeal of Clarence Schock, 1 B. T. A. 528. In that case we said:

* * * Under such [the accrual] system of accounting receipt of income— actual or constructive — is not essential to constitute it income within the statutory definition of income. Under an accrual system of accounting one accrues income, if lie does not reeewe it. * * * Having adopted a method of accounting and having regularly employed that method in keeping his books, a taxpayer is compelled by law to report income in accordance therewith. * * * The amount of these items is definite and liquidated. The liability of the obligor is fixed and determined and is in nowise in dispute. The only element left to contingencies is the date when payment may be made. That element exists in a major portion of properly accruable items of income — open accounts, demand notes, and a number of similar accruable items occurring in everyday business.

The salaries of the petitioners as officers of the corporations were carried in the personal accounts of the petitioners in the partnership books. The Commissioner contends that these salaries were items of partnership income rather than income to the individual members and that salaries should be accrued as of the years in which they were earned.

The only thing in the record which might tend to support the position of the Commissioner is that the salaries of the individuals were entered in the partnership books. On the other . hand, we find that the salary accounts were carried on the books of the corporations in the names of the individuals and were paid by check directly to the petitioners, who, after indorsing the checks loaned their salaries to the partnership, and had the amounts thereof placed on the partnership books, not as partnership income, but in their personal accounts. The petitioners kept no individual books and we do not believe it can be said that they operated on an accrual basis merely because they had personal accounts on the books of the partnership which were kept on that basis. We are accordingly of the opinion that the petitioners were correct in reporting salaries from the corporations as income in the years in which such salaries were actually received and that the Commissioner erred in including the salaries in income before the dates of actual receipt.

It is apparent that the item of $5,440.11, representing salesmen’s commissions, and carried in the partnership merchandise inventory at the beginning of 1919, is not a proper item to be included in an inventory of merchandise. The action of the Commissioner in reducing the opening inventory by this amount must accordingly be approved. The evidence does not show when liability for payment of these commissions accrued, nor does it show when they were paid. Consequently, we are unable to find that the partnership is entitled to a deduction on account of this item in any of the years involved.

A considerable amount of evidence was offered with respect to the year 1921. It appears that no deficiency has been found in these cases for the year 1921, but on the contrary the Commissioner has found an overassessment. While no question was raised by the parties as to the jurisdiction of the Board to hear and determine the questions raised with respect to 1921, it is evident that, under section 274 (g) of the Revenue Act of 1926, we have no jurisdiction over the appeals for that year. The petitions, in so far as they relate to 1921, are accordingly dismissed. Appeal of Cornelius Cotton Mills, 4 B. T. A. 255.

Order of redeterrrdnation will he entered on 15 days’ notice, under Rule 50.


author: Love

text:
    Appeal of MAHONING COAL RAILROAD COMPANY.
    Docket No. 2202.
    Decided September 22, 1926.
    Upon all the evidence, held, that the petitioner was affiliated with the New York Central R. R. Co. during the years 1918, 1919, and 1920.

      Charles C. Paulding, Esq., and Wm. Mann, Esq., for the petitioner.

      P. S. Crewe, Esq., for the Commissioner.
    This appeal is from the determination by the Commissioner of a deficiency of $385,256.28 income and excess-profits tax for the years 1919 and 1920.,
    The deficiency arose by reason of the following rulings of the Commissioner, which are assigned as errors by the taxpayer:
    (1) The refusal of the Commissioner to regard the taxpayer as affiliated with the New York Central R. R. Co., and to permit a consolidated return by the two companies.
    (2) The determination by the Commissioner that income and excess-profits taxes imposed upon the taxpayer for the years 1919 and 1920, and paid by taxpayer’s lessee, the New York Central R. R. Co., in 1920 and 1921, respectively, constituted additional income to the taxpayer for the years 1919 and 1920.
    (3) The determination by the Commissioner that the additional taxes sought to be assessed against the taxpayer for the years 1919 and 1920, and to be paid by said lessee, constitute additional taxable income for said years.
    FINDINGS OF FACT.
    On July 1, 1884, the Mahoning Coal R. R. Co. leased its properties of every nature to the Lake Shore and Michigan Southern Ry. Co., in perpetuity, subject to certain conditions subsequent, and as rentals for said properties, the lessee contracted to pay to lessor, inter Elia,
      “ all taxes and assessments which may be levied or become chargeable on the said road or property, or upon the said Mahoning Company, by reason of its ownership thereof.”
    In 1914, the New York Central E. E. Co. succeeded to the rights of the Lake Shore Company, under that lease contract.
    The Mahoning Company at all times since 1884 has preserved its corporate existence and organization with its president and board of directors, and its board of directors have held annual meetings. It has not maintained an operating organization nor does it in any way operate its properties, such functions being entirely under the control and management of its present lessee, the New York Central E. E. Co.
    The stock of the Mahoning Company held by the New York Central E. E. Co., and by stockholders of the New York Central, during the years 1919 and 1920, was as listed below, and during that time there were outstanding 43,227 shares of said stock, consisting of 30,000 shares of common stock and 13,227 shares of preferred stock, both , common and preferred stock possessing voting rights.

    A summary of holdings of Mahoning Coal E. E. Co. stock for the years 1916 to 1920, inclusive, follows:

    At the annual meeting of the stockholders of the taxpayer company held May 2, 1917, there were voted 35,267 shares of stock of the taxpayer company, of which number Alfred EL Smith and Dwight W. Pardee, president and secretary, respectively, of the New York Central R. R. Co., held proxies representing 35,245 shares of stock, executed by the holders of said shares of stock authorizing said Alfred H. Smith and Dwight W. Pardee, or either of them, to represent said stockholders at said meeting, or any adjournment or postponement thereof, and to vote in the name, place and stead of said stockholders for the election of directors of said taxpayer company or upon any matter or question presented at said meeting, with full power of substitution to them or either of them. Twelve shares of stock were voted by S. H. West, an attorney for the New York Central R. R. Co., in person. Said 35,245 shares of stock were voted by Dwight W. Pardee pursuant to said proxies.
    Of the seven directors of the taxpayer company elected May 2, 1917, whose terms of office expired May 1, 1918, two were directors, one president, one a vice president, one an attorney, and two were other officials of the New York Central R. R. Co. During that year all of the five members of the executive committee of the taxpayer company were officers or directors of the New York Central R. R. Co. The president, vice president, secretary and treasurer of the taxpayer company were president, vice president, secretary and treasurer, respectively, of the New York Central R. R. Co., and all other officers of the taxpayer company were officers of the New York Central R. R. Co.
    At the annual meeting of stockholders of the taxpayer company, held on May 1, 1918, the number of shares of stock voted was 35,301. Proxies were executed by stockholders owning 35,297 shares to Alfred H. Smith, formerly president of the New York Central R. R. Co., and at that time acting as Regional Director of the United States Railroad Administration, and Dwight W. Pardee, secretary of the New York Central R. R. Co., or either of them, to represent said stockholders at said meeting, or any adjournment or postponement thereof, and to vote in the name, place and stead of said stockholders for the election of directors of said taxpayer company or upon any matter or question presented at said meeting, with full power of substitution to them or either of them. Said 35,297 shares of stock were voted by Dwight W. Pardee pursuant to said proxies. The balance of stock, namely, four shares, voted at said meeting was voted by F. J. Jerome, a director of the New York Central R. R. Co.
    During the year 1918 one of the directors of the taxpayer company was president, one a vice president, and two -were directors of the New York Central R. R. Co. Of the two members of the executive committee of the taxpayer company one was president and the other a director of the New York Central R. R. Co. During said year the president, secretary and treasurer of the taxpayer company were president, secretary and treasurer, respectively, of the New York Central R. R. Co., and all the other officers of the taxpayer company were officers of the New York Central R. R. Co.
    A special meeting of the stockholders of the taxpayer company was held on September 27, 1918, for the purpose of considering a preamble and resolution adopted by the board of directors of the taxpayer company at a meeting held on August 27, 1918, fixing the amount of compensation to be received annually by the taxpayer company for the use and possession of its railroad during the period of Federal control, and the joining by the taxpayer company in the execution of the contract made by the New York Central R. R. Co. with the United States of America for the use of its property during the period of Federal control and approving a revision of the by-laws of taxpayer. At said meeting stockholders owning 34,324 shares of stock of the taxpayer company executed proxies authorizing William K. Vanderbilt, Jr., president, Dwight W. Pardee, secretary, and Frank J. Jerome, a director, of the New York Central R. R. Co., or any of them, to represent said stockholders at said meeting, and to vote in the name, place and stead of said stockholders upon any matter or question presented at said meeting with full power of substitution. Said 34,324 shares of stock were voted by Frank J. Jerome, pursuant to said proxies. The total number of shares of stock represented and voting at said meeting by proxy or in person was 35,464.
    On December 31, 1918, the New York Central R. R. Co. owned 25,288 shares of stock, common and preferred, of the taxpayer company, and stockholders of the New York Central R. R. Co. owned 8,387 shares of stock of the taxpayer company, making a total of 33,675 shares of stock of the taxpayer company owned by the New York Central R. R. Co. and stockholders of said company, or 77.8 per cent of the total number of shares-of stock of the taxpayer company issued and outstanding on said date.

      At the annual meeting of the stockholders of the taxpayer company held on May 7,1919, the total number of shares of stock voted was 33,932. Stockholders of said company owning 33,192 shares of stock executed proxies authorizing William K. Vanderbilt, Jr., a director and chairman of the finance committee of the New York Central It. E. Co., and president of said company during part of the year 1919, Albert H. Harris, vice president, and Dwight W. Pardee, secretary, or any one of them, to represent said stockholders at said meeting, or any adjournment or postponement thereof, and to vote in the name, place .and stead of said stockholders upon any matter or question which might be presented at said meeting, with full power of substitution, and said 33,192 shares of stock were voted by Frank J. Jerome, a director of the New York Central E. E. Co., under power of substitution contained in said proxies.
    During the year 1919, of the seven directors of the taxpayer company, two were directors, one was president and one a vice president of the New York Central E. E. Co. The president, vice president, secretary, treasurer, comptroller, and chief engineer of the taxpayer company were president, vice president, secretary, treasurer, comptroller, and chief engineer, respectively, of the New York Central E. E. Co., and all other officers of the taxpayer company were officers of the New York Central E. E. Co.
    On December 31, 1919, the New York Central E. E. Co. owned 25,308 shares of stock, common and preferred, of the taxpayer company, and stockholders of said company owned 7,094 shares of stock of the taxpayer company, making the total number of shares of stock of the taxpayer company held by the New York Central E. E. Co. and stockholders of said company 32,402, being 74.95 per cent of the total number of shares of stock of the taxpayer company issued and outstanding on said date.
    At the annual meeting of stockholders of the taxpayer company held on May 5, 1920, 32,923 shares of stock were voted. Three hundred and forty-two shares were voted in person and stockholders holding 32,581 shares executed proxies to Alfred H. Smith, president, Albert H. Harris, vice president, and Edward F. Stephenson, secretary, of the New York Central E. E. Co., authorizing them, or any one of them, to represent said stockholders at said meeting, or any adjournment or postponement thereof, and to vote in the name, place and stead of said stockholders for the election of directors of said company, and upon any other matter or question presented at said meeting, with full power of substitution, and said 32,581 shares of stock were voted by Edward F. Stephenson pursuant to said proxies.
    During the year 1920, of the seven directors of the taxpayer company two were directors of the New York Central E. E. Co., one was president, and one a vice president of the New York Central E. E. Co. The president, vice president, secretary, treasurer and comptroller of the. taxpayer company were, respectively, president, vice president, secretary, treasurer and comptroller of the New York Central E. B. Co., and all the other officers of the taxpayer company were officers of the New York Central B. B Co.
    During the year 1920, the New York Central B. B. Co. owned 32,403 shares of stock, common and preferred, of the taxpayer company, and stockholders of said company owned 7,094 shares of stock of the taxpayer company, making the total number of shares of stock of the taxpayer company held by the New York Central B. B. Co. and stockholders of said company 32,402, being 74.95 per cent of the total number of shares of stock of the taxpayer company issued and outstanding on said date.
    No meetings of the stockholders of the taxpayer company were held during the years 1917 to 1920, inclusive, except those above mentioned.
    A list of stockholders of the Mahoning Company who held no stock of the New York Central shows that said stock was held by aproxi-mately 160 persons, said holdings ranging in size from 1 share to 1,500 shares, by far the greater number being below 200 shares, and the owners being located in a number of cities in a number of States.
    At none of said annual meetings did any of the stockholders other than those above accounted for take part.
    The New York Central B. B. Co. paid the income and profits taxes due by the taxpayer for the year 1919, and first quarter of the year 1920, on the basis of returns made for those years.
    The lease under which the road of the taxpayer was operated by the New York Central during 1919 and 1920, except during the period of Federal control, provides:
    (a) That the taxpayer will make any and all other or further conveyances or contracts which may be necessary to protect the Lake Shore Company in its operation of the road and property or in the enjoyment and exercise of its rights.
    (b) That if at any time the Lake Shore Company shall consider it necessary to lay a second track or extend the main track of the road of the Mahoning Company or construct branches or make any substantial improvements, the parties shall, by mutual agreement, subject to the approval of two-thirds of the stockholders of the Mahoning Company,, decide as to the necessity of such improvement and as to the method of providing for the payment therefor, and in case of disagreement arbitrators are to be chosen. ■
    (c) That the Lake Shore Company will at all times keep full, true and accurate accounts of all traffic carried or business done over taxpayer’s road and of the gross earnings derived from.such operations, which shall be open to inspection by the taxpayer; that it will render semiannually a full and correct account of the earnings and will at the time of rendering such account pay to the Mahoning Company 40 per cent of the gross earnings of the road; “ that such Mahoning Company’s said 40 per cent shall be sufficient every six months to pay the current half year’s interest per annum on said Mahoning Company’s issue of $1,500,000 of bonds and upon any bonds that may be issued at request of said Lake Shore Company to provide for the retirement of said issue or any subsequent issue of bonds, at maturity, and the current half year’s dividend of 2% per cent upon any preferred stock of said company, not, however, to exceed $400,000 in amount, issued and outstanding; and also the cost not to exceed $1,000 per annum of maintaining the corporate organization of said Mahoning Company; and in case said earnings are at any time insufficient in that behalf, it, the said Lake Shore Company, will advance the money needed to make good the deficiency; provided, however, that in case it shall at any time be required to make and shall make any advance of money, the money so advanced shall remain a charge upon any future earnings to which said Mahoning Company shall become entitled over and above the amount required to pay such interest and dividends and cost of maintaining the organization of said company.”
    By supplemental agreement of October 12, 1918, the taxpayer and New York Central B. It. Co. agreed that the annual compensation of the taxpayer during the period of Federal control should be $1,309,845.67; this sum being payable in addition to the liability of the New York Central to pay taxes and assessments under the clause quoted in the findings of fact above.
    The interest on the debt and dividends on the preferred stock amounted during the years in question to approximately $108,000. The income under the lease was, for 1918, $1,309,845.67, for 1919, $1,309,845.67, and for 1920, $2,329,473.21.
    The road of the taxpayer runs north from Youngstown, Ohio, to Andover and Mann, both in Ohio, in two branches. At each of these terminals it joins the road of the Lake Shore and Michigan Southern By., operated by the New York Central. This connection of the Lake Shore runs to Ashtabula, Ohio, on Lake Erie, where it makes connections with the main line of the New York Central B. B. The lines from Youngstown to Ashtabula are operated by the New York Central as the Franklin division, the operation being without respect to the fact that the trains operate over the roads of two independent companies, except as it is necessary under the terms of the lease to apportion the revenue received from the operation on the basis of mileage and tonnage.
   OPINION.

Love

: The exact nature of the decision in this appeal depends on the decision

(1) Whether or not the New York Central R. R. Co. and the Mahoning Company, in 1919 and 1920, were affiliated corporations; and if not, then

(2) Whether or not the income and excess-profits tax due by the taxpayer corporation for those years and paid by its lessee under the lease contract constituted taxable income to the taxpayer.

The Revenue Act of 1918, in dealing with corporation income and profits taxes, in paragraph (b) of section 240, prescribes:

For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns directly or controls through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if substantially all the stock of two or more corporations is owned or controlled by the same- interests.

The part of paragraph (a) of section 240, pertinent to the question here involved, prescribes:

That corporations which are affiliated within the meaning of this section shall, under regulations to be prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income and invested capital * * *.

This Board has not, and no appellate court has, prescribed an exact percentage of stock necessary to be held or controlled to constitute affiliation. In the very nature of the subject, the problem must be solved in the light of the actual facts as they exist in each case, always bearing in mind that actual control of substantially all the voting stock is essential and that such control does not, necessarily, depend upon ownership.

In the Appeal of Canyon Lumber Co., 1 B. T. A. 473, and Appeal of Isse Koch & Co., 1 B. T. A. 624, this Board held that the control “ referred to in the statute, whether it be legal or otherwise, means control of the voting rights of stock.” This Board further held in the last cited appeal that The object sought to be accomplished by Congress, in enacting section 240 of the Revenue Act of 1918, was to tax as a business unit what really was a business unit.” See, also, Appeal of Hagerstown Shoe & Legging Co., 1 B. T. A. 666; Appeal of Hamilton & Chambers Co., 1 B. T. A. 694; and Appeal of Rowe Transfer & Goal Co., 1 B. T. A. 593.

It will be noted that during the taxable years the New York Central owned in its own right more than 58 per cent of the stock of the Mahoning Company; that the New York Central and its officers and stockholders owned from 74 to 80 per cent of said stock; that the officers of the New York Central were also officers of the taxpayer corporation, and that at all annual stockholders’ meetings the officers of the New York Central voted by right of proxy, or otherwise, more than 81 per cent of the stock of the taxpayer corporation, same being practically all the stock that participated in said meetings, and there was no opposing vote to the policies adopted.

It will be further noted that the stock of the Mahoning Coal B. 11. Co. held by persons who held no stock in the New York Central, was held by a comparatively large number of persons in small amounts, the owners being scattered over a large territory, evidencing the fact, which is corroborated by the facts established, that there was no organized group of minority stockholders, and that their failure to take part in annual meetings resulted from a feeling of satisfaction with the management, and a predetermination to acquiesce in the policies adopted rather than from an unfriendly or antagonistic attitude toward such management.

In the Appeal of Hartford & Connecticut Western R. R. Co., 2 B. T. A. 211, where the taxpayer claimed affiliation with the New Haven E. E. Co., this Board said:

Tlie contract is not a mere lease by wbicb a lessor lets its property to a lessee for a rental. It is a virtual relinquishment by tbe taxpayer to the New Haven of its rights and powers as a subsisting business institution and places the New Haven in control of its destiny. Not only does the New Haven possess and operate the properties, it also may require the taxpayer to acquire more property and to mortgage them as the New Haven directs. All of the taxpayer’s railroad business is out of its hands, including its operating income; and whatever franchises it acquired have been placed at, the New Haven’s disposal. That under these circumstances the New Haven actually controls the business and properties of the taxpayer is plain to be seen.
But it is said that this alone is not enough to bring the statute into operation, because the control of the business and properties is not the control of substantially all the stock. And it is true that in many cases the two are distinct. It does not follow from a lease of the entire properties of a corporation that the lessee can be said to control the stock. Appeal of Old Colony R. R. Co., 1 B. T. A. 1067. There must be substantially more. Certainly there must be a common interest above that of the ordinary lessor in his rent and the preservation of his property. In the present case, however, it is contended that the existence of a substantial minority of outstanding stock should defeat affiliation. It is not shown that by any act such minority has or could frustrate any purpose or plan of the New Haven, but, on the contrary, the insignificant number of minority shares which voted at the stockholders’ meetings in 1917 and 1918 indicates an unobstructed control by the New Haven. Whatever the New Haven requested was done. And how could it be otherwise? The New Haven had the property and it also held sufficient votes to overcome any opposition to its management. Although theoretically the lessor had the right to enforce the terms of the lease and demand forfeiture or other remedy in default of any of the covenants, how was this to be accomplished if the New Haven resisted? Its officers controlled the properties and management, both as officers and directors of the taxpayer, and its majority of shares was behind these directors. The sum total of the affairs of the taxpayer was therefore in the hands of the New Haven.
All 'that the shares of stock represented to the minority holders was the right to receive dividends on their stock. And it may be questioned how that right was to be preserved in the event of financial failure of the New Haven. Even a minority stockholders’ proceeding would hardly be adequate where the effectiveness of the business depends on its relation to the larger transportation system of which it is a part. When one corporation so far controls the property and affairs of the other as to leave in the minority stockholders nothing but a bare interest in a division of the rental, it is quibbling to say that the minority stock is not controlled. We must conclude that the New Haven owned directly or controlled substantially all the stock of the taxpayer, and that they were affiliated within the meaning of the statute.

Under such conditions we reach the conclusion that the two companies were affiliated.

The counsel for the Commissioner cites the Appeal of Old Colony R. R. Co., 1 B. T. A. 1067, and urges that it is controlling in this appeal. Control by one corporation of the business operations of another corporation, while a significant circumstance in determining the main question, i. e., control of the stock, is not sufficient within itself to bring the companies within the statutory definition of affiliation. If control of business operations were a dominating factor in this question the decision in the Appeal of Old Colony R. R. Co. would likely have been different. In that case the dominant company held a 99-year lease, the terms of which gave it almost absolute control of all business activities of the other company, but it controlled only 44 per cent of the stock of that other company, and there was no evidence tending to show that it controlled or influenced the voting rights of the other outstanding 56 per cent of stock.

This Board has not held, and the statute does not prescribe, that ownership by one corporation of practically all the stock of another is the only ground for affiliation. The statute prescribes and it is sufficient if “substantially all of the stock” (that is, voting rights) “of two or more corporations is owned or controlled by the same interests.” As stated in the Appeal of Isse Koch & Co., supra, each case must be considered and decided on its own facts and surrounding circumstances. Control need not be legal control, but community of interest may, if recognized and acted upon, constitute sufficient basis to determine the question of control.

In the Old Colony R. R. Co. case it was not shown that more than 44 per cent of the stock of one corporation was in any way controlled by the other corporation as a corporate entity, or by its stockholders. There was no concert of action or harmony of interests as between the holders of the 44 per cent and the 56 per cent of stockholders. The conditions are materially different in the instant appeal. Here we have present all the circumstances relative to business control that were urged in the Old Colony R. R. Co. appeal, and further, we have one company and its officers and stockholders actually voting no less than 81 per cent of the stock of the subsidiary company regularly, through a long period of years, with no opposition votes at any time. Clearly the two companies acted as a business unit, prompted by a potent common interest.

If the statute means that affiliation results from a condition of stock ownership and control, such as enables one person, or one group of persons, to control practically all the voting stock, whether that control arises from actual ownership, or such community of interest as to place practically all of the voting stock subject to disposal in stockholders’ meetings by that single dominating unit, we believe the conditions contemplated by the statute have been met.

In view of the fact that it was conceded on the hearing before the Board that in the event of a decision by this Board that a consolidated return 'is proper, then the second and. third assignments of error necessarily become moot questions, no decision is here made on those questions.

Judgment will be entered on 15 days'1 notice, under Rule 50.

Littleton, Mohris, and Phillips dissent. •


author: Smith

text:
    Appeal of CAPITAL CITY INVESTMENT COMPANY.
    Docket No. 5376.
    Decided September 22, 1926.
    1. Tbe value of a leasehold at March 1, 1913, determined.
    2. In determining the profit on the sale in 1919 of a leasehold acquired prior to March 1, 1913, the value at the basic date should be reduced by the amount of exhaustion. taking place between that date and the date of sale.

      Walter E. Barton, Esq., for the petitioner.

      Arthur H. Fast, Esq., for the Commissioner.
    This is a proceeding for the redetermination of a deficiency" in income and profits tax for the year 1919 in the amount of $18,382.05. The points in issue are (1) the value of a "certain leasehold on March 1, 1913, which was acquired prior thereto, and which was sold on May 28, 1919; (2) whether the value at the basic date should be reduced on account of the exhaustion which took place between March 1, 1913, and the date of sale, which exhaustion it is alleged could neither by the provisions of the law nor the regulations of the Commissioner be deducted from gross income in income-tax returns.

      FINDINGS OF FACT.
    1. Prior to dissolution on January 11, 1921, the taxpayer was an Iowa corporation with its principal place of business in Des Moines. Its business was that of renting property to tenants.
    2. On December 31, 1896, the taxpayer purchased by assignment from the lessee a certain lease of lots numbers 7 and 8 in Block 12 in Fort Des Moines, now included in and forming a part of the City of Des Moines. The lease commenced on October 1, 1895, and expired on September 30, 1912. The annual rental for the first 10 years was $4,000, and for the last 7 years was $5,000. The lessee was required to pay all public taxes and assessments which should be assessed upon the leased premises during the term of the lease, to construct and keep in repair the sidewalks and street pavements, and to keep in repair and to reconstruct all sewers, curbings, etc., adjacent to said premises. The lease further provided that the lessee should have the privilege of removing all his improvements made on said' premises. On December 31, 1896, certain buildings belonging to the lessee were located .on said leased premises, which said buildings were also acquired by the taxpayer from the lessee on said date.
    3. The consideration paid for the lease and the buildings located on the leased premises was stock of the taxpayer of the par value of $29,500, of which $2,500 was paid for the lease and $27,000 was paid for the buildings.
    4. Before the expiration of the lease, to wit, on November 11, 1902, the lessor and the taxpayer extended said lease to September 30, 1927. In consideration of the extension, the taxpayer agreed to pay a rental of $5,000 per annum quarterly from October 1, 1902, until September 30, 1912, and a rental of $6,000 per annum quarterly from October 1, 1912, until September 30, 1927. The other terms and conditions of the original lease were unchanged and were made applicable to the period of extension from October 1, 1912, to September 30, 1927.
    5. The buildings upon the leased premises were known as the Meek Block. The location of this block is one-half block north of the intersection of Sixth Avenue and Walnut Street in the City of Des Moines, which, in 1913, was the business center of the city. The site of the Meek Block was generally' recognized by real estate men familiar with conditions in Des Moines as the second best business site in the city. The Meek Block, although generally thought of as a unit, consisted of a two-story brick building in the main with a full basement on the Sixth Avenue side; on the west side of the property the building was three stories with basement and there was another building located on Locust. Street east of the three-story building, in a sense independent from the other two. The building on the Sixth Avenue side was 132 feet long and contained six stories, although only four occupants, namely, a bank, one of the best bakeries and restaurants in the city, the largest meat market, and a prominent drug store. The upper floors were rented as offices. The buildings had either been built or extensively remodeled by the lessee or the tenants. They were all good stout buildings in 1913 and in the opinion of the witnesses had a life of from twenty to twenty-five years from March 1, 1913.
    6. The taxpayer sold its lease and interest in the buildings on the leased premises to the Equitable Life Insurance Company of Iowa, on May 28, 1919, for $150,000, and assumed taxes in the amount of $3,916.35, leaving a net selling price of $146,083.65.
    7. The Commissioner determined a value of the lease, including the taxpayer’s interest in the buildings upon the leased premises as of March 1, 1913, of $79,000, from which he deducted $33,857.25 on account of alleged amortization or exhaustion of the leasehold between March 1,1913, and May 28,1919. He determined that the amortized value of the leasehold on May 28, 1919, was $45,142.75 and that the profit realized on the sale thereof was $100,940.90. His computation of the profit is shown by the following statement attached to the Commissioner’s letter to the taxpayer dated September 23, 1924:
    Amount treated as income in previous audit-$137,066.65
    Less:
    Profit on salé of leasehold reflected in the above- $137, 864.44 Correct profit on sale of leasehold as computed in accordance with the decision of the Commissioner _ 100, 940. 90
    - 36, 923. 54
    Corrected taxable income_ 100,142.11
    The $100,940.90 which the Commissioner found as the profit on the sale of the leasehold was arrived at in the following manner:
    Value March 1, 1913_$79,000. 00
    Lease terminated September 30, 1927.
    Lease sold May 28, 1919.
    Period of time from March 1, 1913, to sale of lease, 75 months.
    Amortization of lease per month___ 452. 43
    Amortization of lease 75 months_ 33, 857.25
    March 1, 1913, value of lease ($79,000.00) less amortization to end of May, 1919 ($33,857.25) results in $45,142.75 March 1, 1913, value of leasehold unexhausted at date of sale.
    Selling price___$146, 083. 65
    March 1, 1913, value unexhausted at date of sale- 45,142. 75
    Taxable profit from sale. 100,940.90

      The Commissioner, after careful examination of, all of the evidence of record, has concluded that on March 1, 1913, the expected net earnings from this property over the remaining life of the lease would represent a figure of approximately $175,000. This amount discounted to present worth as at March 1, 1913, by the application of Hoskold’s formula (interest on present worth and sinking- fund provided for annually at the respective rates of 10% and 4%) produced a figure of approximately $79,000.00. Inasmuch as it is impossible to segregate the value of the improvements from the value of the lease, it is considered fair and equitable to depreciate the improvements over the life of the lease.
    8. The value of the taxpayer’s lease and interest in the buildings located on the leased premises on March 1, 1913, was $130,000, which was in excess of the cost thereof.
    9. For the years 1913, 1914, 1915, and 1916, the taxpayer made no deduction in its income-tax returns for exhaustion or amortization of its leasehold. In each of the years 1917 and 1918, it made a deduction from gross income of $4,264.81 for exhaustion of its leasehold interest, which the Commissioner disallowed.
   OPINION.

Smith

: The Commissioner determined the value of the taxpayer’s leasehold interest as of March 1, 1913, to have been $79,000. The taxpayer contends that the value was $238,120.59, of which amount $118,600 was the fair market value of the lease and $119,520.59 the fair market value of the buildings. In support of its claim.it has introduced in evidence the depositions of live individuals, citizens and residents of Des Moines, all of whom were acquainted with the property on March 1, 1913. The deponents were all requested to place a value upon the buildings upon the leased premises as of March 1, 1913, and also upon the lease without buildings on the land on the same date.

It does not appear from the record what, if any, buildings were located upon the property at the time the premises were first leased in 1895. The lease provided that the lessee should have the privilege of removing all his improvements made on or to the leased premises at the expiration of the lease. It also provided:

It is further agreed that in case the improvements, now or hereafter made by said Second party upon said premises, are at any time destroyed or made untenable by fire, the lessee hereof, his heirs or assigns, shall have the privilege of terminating this lease at the end of one year from date of said fire, paying during that year the rate of rental provided for in this lease; and he shall have and retain possession of the ground for six months after the date of fire; and the privilege of keeping this lease in force or terminating it as above provided for. At the expiration of said six months, unless he then elects to terminate [sic] this lease, the lessor, his heirs or assigns, shall have full possession of said premises with the right to improve the same, either personally or through another.

Apparently the lessee was not, in case of fire, required to rebuild the structures, if any, upon the premises at the time the lease was first entered into.

There has not been introduced in evidence any information as to the income of the taxpayer from the leasehold premises during any of the years prior to the date of the sale of the lease in 1919. The Board is not able to determine what income the taxpayer could reasonably have expected to receive during the life of the lease on March 1, 1913. The Commissioner has apparently based his March 1, 1913, value of the lease solely upon the expected rentals to be received during the life of the lease from March 1, 1913. Apparently he has not taken into consideration any prospective value of the lease arising from the fact that the site of the leased premises was the second best business location in the City of Des Moines. The testimony of the witnesses as to the value of the leasehold on March 1, 1913, appears to be predicated largely upon this factor. In our opinion the deponents are men well qualified to express an opinion as to the value of the leasehold premises on March 1, 1913.

One of the witnesses was W. E. Tusant, who testified that he had been a general contractor since 1909 in the City of Des Moines. He had been familiar with the Meek Block since 1909. He had made certain repairs and improvements to the leased premises from 1909 to 1915 or 1916. He stated that in his opinion it would have cost on March 1,1913, $165,826.80 to replace the buildings new and that their sound value on the same date was $142,602.96. This estimate was an estimate simply of the physical valuation of the buildings without reference to any lease whatever.

T. A. Harding testified that he was 74 years, old and that he had been engaged in the real estate business in Des Moines for a period of 35 years. He had sold almost all of the downtown business section once or twice and some of'these properties three times; he had valued property for the Federal and State Governments frequently and had valued property in the vicinity of the Meek Block for insurance companies. He placed a'value on the buildings as of March 1, 1913, of $80,000, and a value on the lease as of that date of $130,000. He further testified that he had an offer of $200,000 from a party to purchase the taxpayer’s leasehold interest in 1912 or 1913 but that the taxpayer had rejected the offer. Upon cross-examination he was asked:

Q. Do you remember any of the details of tbis offer that was made in 1913?
A. I do not, except that the owners wouldn’t accept it. I was simply concerned in making the deal and getting paid for it.
Q. The owners wouldn’t accept it?
A. No, they wouldn’t.
Q. Do you know the exact date when this offer was made?
A. I do not.
Q. Do you know whether it was in 1912 or 1913?
A. It might have been 1912, I have no means of refreshing myself.
Q. Yon don’t know who made the offer?
A. I think it was the Iowa National Bank or some members of the Board of Directors of the Iowa National Bank.

Griff Johnson testified that he was 54 years old, resided in Des Moines, and that he has had charge of the investments of tñe Equitable Insurance Company of Iowa for 14 years. Prior to that time he was engaged in the mortgage, real estate, loan, and investment business. He has valued real estate in Des Moines. He has been familiar with the Meek Block nearly all of his life. He placed a value on the buildings of $125,000 to $150,000 and a value on the lease of $50,000, separate and apart from the buildings, as of March 1, 1913.

John Gibson testified that he was 55 years old, resided in Des Moines, and that he was president of the United States Bank. He has been acquainted with the Meek Block for 25 years. He valued the property at March 1, 1918, at $25,000 to $150,000, a.nd the lease at $10,000 a year, or $145,000.

B. F. Kauffman testified that he was president of the Bankers Trust Company of Des Moines, and that he has been familiar with the Meek Block for 30 years. In his opinion the value of the buildings on March 1, 1913, was approximately $75,000, and the value of the leasehold $150,000. He further stated that in his opinion the value of the buildings and leasehold together as of March 1, 1913, was not $225,000, the sum of the value placed by him upon the buildings and the leasehold separately, but $200,000.

It will be noted from the foregoing that the March 1, 1913, value placed upon the buildings by the deponents varied from $75,000, in the case of Kauffman, to $150,000 in the case of Johnson and Gibson, and that the March 1,1913, value of the lease was variously estimated at from $50,000 by Johnson to $150,000 by Kauffman.

Nowhere does the evidence disclose the investment of the taxpayer in the buildings or. the March 1, 1913, value of its investment. Neither does the evidence disclose the net income from the lease for any j^ear. One of the witnesses estimated that the leasehold interest, without taking into consideration the buildings, should have produced a net income of $7,000 per year from March 1, 1913, to September 30,1927, and that a purchaser of the leasehold interest should have looked for a net income of at least $10,000 per year from March 1. 1913. In making such an estimate of value, the deponents did not take into account the speculative value of the lease. Apparently the leasehold interest had a considerable speculative value by reason of the fact that the site upon which the buildings were located was a valuable business site, and further by reason of the fact that apparently the lessor was willing to sell at a reasonable price. Griff Johnson, one of the deponents for the taxpayer, was an officer of the Equitable Life Insurance Company of Iowa, which purchased the taxpayer’s leasehold interest in 1919. He testified that the insurance company would not have considered purchasing the leasehold interest unless it could have gotten the fee to the land.

From a careful consideration of the entire record, we are of the opinion that the taxpayer’s lease and interest in the buildings on March 1, 1913, had a fair market value of $130,000. The deduction for exhaustion of the leasehold interest for the taxable year should be computed upon the basis of such value.

In making his determination of the profit upon the sale of the leasehold interest the Commissioner deducted from the March 1, 1913, value an amount representing the exhaustion of the value of the leasehold interest from March 1, 1913, to the date of sale. He computed such exhaustion by spreading the March 1, 1913, value ratably over the unexpired term of the lease from March 1, 1913, and took as the amount of the exhaustion such proportion of the March 1, 1913, value as the number of months elapsing from March 1, 1913, to the date of sale bears to the total number of months of the unexpired term of the lease from the basic date. The taxpayer alleges error on the part of the Commissioner in deducting exhaustion in this manner from the March 1, 1913, value as a part of the computation of the profit realized by sale. It claims that for the purpose of ascertaining the loss sustained or gain derived from the sale or other disposition of an asset, section 202 of the' Eevenue Act of 1918 does not authorize or require the reduction of the cost or fair market value of the assets sold as of March 1, 1913, by an amount representing exhaustion; that is particularly the case where the taxpayer did not take a deduction for exhaustion in its income-tax returns; and more particularly where under the various income-tax acts or under Treasury Decisions promulgated by authority thereof the taxpayer was not permitted to take such deduction. In making such contention it relies upon the decision of the United States Supreme Court in Doyle v. Mitchell Bros. Co., 247 U. S. 179, wherein it was held that under the Excise Tax Act of August 5, 1909, the taxpayer was entitled to deduct from gross income the January 1, 1909, value of timber consumed in manufacturing lumber, the sale of which was the source of the gross income.

Section 202 of the Eevenue Act of 1918 does not declare that profit upon the sale of an asset shall be determined by deducting from the sale price the March 1, 1913, value. It simply provides, as was pointed out by this Board in Appeal of Even Realty Co., 1 B. T. A. 355, that the March 1, 1913, value is the basis for the determination of whether a gain or loss is derived, from the sale of an asset. As was pointed out in that decision, this basis may be reduced by losses sustained in respect of the property and may be increased by improvements. made to the property. ' The taxpayer contends, however, that such cases are not the taxpayer’s case; that there is no legal assumption that the value of the leasehold as of March 1, 1918, suffered a decline between that date and the date of sale as the result of exhaustion; and that since for years prior to 1917 the taxpayer was not permitted under the statute to deduct from gross income any amount representing exhaustion of its leasehold, there is no warrant of law for deducting from the March 1, 1913, value the pro rata exhaustion of the value of the leasehold on that date in computing the amount of gain realized from the sale.

We are of the opinion that the cost, or in case of a leasehold acquired prior to March 1, 1913, the value on that date, is subject to exhaustion ratably over the period of the lease. We have so held in respect of tangible property. Appeal of Even Realty Co., supra. We have found no difference between tangiblé property and leasehold interests in this regard. Appeal of Grosvenor Atterbury, 1 B. T. A. 169. We have held that exhaustion actually occurring must be taken into consideration in computing the value of an asset having a definite life, usually spread ratably over such life, whether or not there is an actual decline in value year by year. Appeal of Union Metal Mfg. Co., 1 B. T. A. 395.

Order of redetermination will be entered on lb days’ notice, under Rule 50.

ARttNdell not participating.

MtjRdock and SteRNhageN dissent.


author: Sterni-iagen

text:
    Appeal of CANYON LUMBER COMPANY.
    Docket No. 4917.
    Decided September 22, 1926.
    Tire 0 Co. owned 50 per cent of the stock of the D Co. The J Co. owned the other 50 per cent, and because of its financial obligations to the C Co. it placed its stock in escrow and agreed not to vote. The C Co. and D Co. were closely related in business. Séld, under all the circumstances, that C Co. and D Co. were ■affiliated under the Revenue Act of 1918.

      W. W. Spalding, Esq., for the petitioner.

      Percy S. Grewe, Esq., for the Commissioner.
    Proceeding to set aside a deficiency of $28,406.74 for 1919 because the Commissioner erroneously refused to recognize the affiliation of the petitioner with another corporation.

      FINDINGS OF FACT.
    The Canyon Lumber Co. (hereinafter referred to as the Canyon Company), being in need of working capital, arranged with C, H. Johnson, representing tbe W. W. Johnson Lumber Co. (hereinafter referred to as the Johnson Company), for the purchase by the Johnson Company of one-half of the stock of a corporation to be organized to take over the properties then owned by the Canyon Company at Kobe, Wash. This corporation was organized in 1908 under the corporate name of the Johnson-Dean Lumber Co. (hereinafter referred to as the Dean Company). As an inducement to the Johnson Company to invest in the enterprise, the Canyon Company entered into the following agreement with the Johnson Company:
    That this company would protect and save the W. W. Johnson Lumber Company from loss on its investment in the stock of the Johnson-Dean Lumber Company and that this guarantee was to be performed by the purchase of such stock by this company from the W. W. Johnson Lumber Company at a price equal to cost plus certain agreed amounts.
    This agreement was a material inducement to the Johnson Company, and had such obligation not been assumed by the Canyon Company, the investment by the Johnson Company in the stock of the Dean Company would not have been made.
    The same persons were president and secretary of the Canyon Company and the Dean Company and their offices were at the same place.
    The operations of the Dean Company were not profitable, and this fact caused the Canyon Company to be called upon from time to time to make advances to the Dean Company or on its account, which was done. The Canyon Company also made advances on loans to C. H. Johnson, the principal stockholder of the Johnson Company. Such advances to the Dean Company and to C. H. Johnson remained unpaid throughout 1919.
    In 1912 the Dean Company issued and sold its bonds in the amount of $300,000, secured by a mortgage or deed of trust covering its timber holdings, equipment, and mill property. These bonds were secured by the joint and several guarantee of the Canyon Company and the Johnson Company, which guarantee .was as follows:
    For value received tbe undersigned, W. W. Johnson Lumber Company, of Minneapolis, Minn., and Canyon Lumber Company of Everett, Wash., do hereby jointly and severally guarantee due payment of the principal and interest of the within bond, and do hereby jointly and severally further agree that the undersigned shall in no respect and to no extent be released from the obligation of this guaranty by any act or proceedings taken under or in pursuance of any of the terms or provisions of the collateral mortgage or deed of trust referred to in the within bond, or by any extension of the time of payment of any bond or bonds secured by said mortgage or deed of trust.
    During the year 1919 and until May 1920, the capital stock of the Dean Company, having a par value of $800,000, was owned one-half by the Canyon Company and one-half by the Johnson Company, subject to the escrow agreement hereinafter mentioned. The only property owned by the Johnson Company was its interest in the stock of the Dean Company.
    In 1916 the Dean Company defaulted in the payment of the principal of and interest on its bonded indebtedness above mentioned; and it became necessary for the Canyon Company to advance to the Dean Company a sufficient amount to discharge these obligations. When this default occurred the Johnson Company was under duty to pay one-half of the bonded obligation then maturing, but could not do so and did not do so, for want of funds. Consequently, the Canyon Company was called upon to advance, and did advance, the entire amount needed for this purpose. In December, 1916, it was apparent that other similar defaults would be made by the Dean Company as the principal of and interest on its bonds matured. Therefore the Canyon Company sought and obtained in 1917 an additional agreement with C. H. Johnson which read in part as follows:
    That tbe W. W. Johnson Lumber Company would deposit its stock in the Johnson-Dean Lumber Company with a Seattle bank as collateral security that the former company would reimburse this [Canyon] Company for one-half of its advances on account of the Johnson-Dean Company and that this [Canyon] Company should have the exclusive right at any time to purchase and take over such stock at a price equal to that specified in the original agreement of 1908, above referred to.
    This agreement was made in the summer of 1917 and not later than August of that year. Pursuant thereto the stock in the Dean Company owned by the Johnson Company, being 50 per centum of its outstanding stock, was delivered by the Johnson Company to the Dexter Horton National Bank of Seattle on September 3, 1918, where such stock remained until it was formally taken over in May, 1920, by the Canyon Company under the above-mentioned agreement between that company and the Johnson Company.
    Although the escrow agreement was made not later than August, 1917, formal delivery of the certificates was not made to the bank at an earlier date on account of the inattention of the officers of the two interested companies and the friendship, confidence and trust that existed between them.
    Johnson would not transfer the stock directly to the Canyon Company, but when he placed it in escrow he did so with the understanding that it would not be voted during such time.

      While this stock was thus on deposit in escrow with the-Seattle bank, and prior to the time it was formally purchased by the Oanyon Company in May, 1920, it was not voted by the Johnson Company or by any one on its behalf.
    In the summer of 1917, as on other occasions, C. H. Johnson, acting for the Johnson Company, urged the Canyon Company to purchase the Johnson Company’s stockholdings in the Dean Company under the 1908 agreement; and as a result thereof the Canyon Company did purchase such stock in May, 1920, at the 1908 agreed purchase price.
    The certificates representing the stock in the Dean Company owned by the Johnson Company were unassigned when delivered to the Seattle bank. The purposes for which the delivery was made were set forth in the letter of the Johnson Company to the bank of September, 1918, as follows:
    We are inclosing herewith certificates No. 11, 12, 13, and 14, being 3,977 shares oí the Johnson-Dean Company. These shares, according to my talk with yon last spring, are to be held in escrow as a guarantee to the Canyon Lumber Company for their payment of the half interest of the W. W. Johnson Lumber Company on the bonds of the Detroit Trust Company.
   OPINION.

Sterni-iagen

: In Canyon Lumber Co., 1 B. T. A. 473, the Board determined that the evidence was not sufficient to establish affiliation in 1917 between this petitioner and the Dean Company. The petitioner now seeks to prove affiliation in 1919 and supplements the proof in the former proceeding so as to supply, as it contends, the earlier omissions.

The parties have agreed upon most of the facts and the petitioner has in addition to the stipulation introduced further evidence by deposition. The Commissioner, although joining in the stipulation, has reserved the objection of incompetency to all the evidence on the ground that the facts are res adjudicata. The objection was properly overruled, not only for the reason set forth in Union Metal Mfg. Co., 4 B. T. A. 287, but also because the petitioner is clearly entitled to prove the facts existing in 1919 which tend to establish affiliation in that year, irrespective of whether they be the same or different facts from those relied upon in the earlier proceeding to establish affiliation in 1917. Affiliation is a statutory status which is determinable separately for each year, and the failure of a taxpayer to establish for one year the facts prescribed by the statute can not operate to prevent a full presentation of the facts for a subsequent year.

In 1919 the stock of the Dean Company was owned one-half by the Canyon Company and one-half by the Johnson Company. By its own agreement, made necessary by reason of its obligations to the Canyon Company for the financing of the Dean Company and the loans to Johnson, the Johnson Company relinquished the possession and control of the Dean stock which it owned. It retained only the bare legal title, and this was subject to the demand of the Canyon Company to purchase. The demand was made and the purchase fulfilled in the following year. During 1919 the Canyon Company and the Dean Company were operated and managed together, and as the Johnson Company had agreed not to vote its Dean stock while in escrow, the Canyon Company controlled all of the voting stock. The Commissioner points to the fact that the Johnson Company might have voted its stock if it were so minded. But this would have been in direct violation of its agreement with the Canyon Company which was so clearly understood by the parties that such vote was not attempted. In the light of the evidence of the agreement by the Johnson Company to refrain from voting, which agreement was made in the interests of the Canyon Company, we are of the opinion that the Canyon Company owned or controlled all of the stock of the Dean Company and that the two corporations were therefore affiliated within the statute.

Judgment will be entered on 15 days’’ notice, under Rule 50.


author: Ahóndele

text:
    Appeal of PENNSYLVANIA MATCH COMPANY
    Docket No. 6537.
    Decided September 22, 1926.
    1. Evidence held insufficient to support claimed valuation of building for invested capital and depreciation purposes.
    2. Commissioner’s allocation of loss on account of returned merchandise approved.
    3. Commissioner’s adjustment of invested capital on account of prior years’ taxes approved.

      Benjamin Mahler, Esq., for the petitioner.

      F. 0. Graves, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency in income and profits taxes for each of the fiscal years ended June 30, 1919, and June 30, 1921, in the respective amounts of $173.05 and $954.66. At the hearing that part of the petition relating to the year 1919 was withdrawn, leaving in issue only the deficiency of $954.66 for the fiscal year 1921. The petitioner alleges that the Commissioner erred (1) in refusing to accept the claimed value of a building for invested capital purposes and for the purpose of computing depreciation; (2) in disallowing a part of a loss claimed on account of returned merchandise; (3) in reducing invested capital on account of taxes for prior years.
    FINDINGS OF FACT.
    The petitioner is a Pennsylvania corporation with its principal office at Bellefonte. It was organized in 1911 and succeeded a partnership which had been formed in 1899.
    At the time of its organization the petitioner issued capital stock in the amount of $500,000, of which $77,499.20 was issued to cover an alleged excess of value of the building acquired over the value at which it was shown on the books of the partnership. The petitioner determined the value which it placed on its building by having an appraisal made by its superintendent, who is an engineer, the appraisal being made on the basis of the cost of replacing the building at that time when the cost of labor and materials was , higher than in 1899 when the building was constructed. The stock of the corporation was issued to the former partners.
    The Commissioner reduced the petitioner’s invested capital by the amount of the claimed excess of $77,499.20 over the book value at the date of acquisition.
    The petitioner marketed the matches which it manufactured through one jobber. During the year 1920 the jobber returned to the petitioner and made claim for several shipments of matches as being defective. The amounts of the returned shipments and the dates of their return to the factory were as follows:
    March 23, 1920_$2,826.54
    May 10, 1920_ 1,452.69
    May 25, 1920_ 239.57
    Sept. 30, 1920_ 1,262. 76
    Dec. 31, 1920_ 442.04
    Total_ 6,223.60
    These amounts were carried as assets in the petitioner’s accounts until April 1, 1922, when the total amount of $6,223.60 was charged off. At the time these returned shipments were received the petitioner accepted the jobber’s statement that they were defective, but it stored them for some time and then inspected them and destroyed them.
    The Commissioner restored to income for 1921 the amount of $4,518.80, representing that portion of the claimed loss made up of the shipments returned prior to the beginning of the fiscal year 1921.

      In computing invested capital for the fiscal year 1921 the Commissioner deducted from the amount claimed $4,547.06 as representing additional tax for prior years.
   OPINION.

Ahóndele

: The only evidence offered by the petitioner in support of its claim for the valuation of its building at a figure higher than that at which it was carried on the books of the predecessor partnership was the statement of the president of the company that an appraisal was made in 1911, the time of acquisition of the building, by the superintendent, who was an engineer. This evidence is not sufficient to permit our finding as a fact that the value of the petitioner’s building is the amount which it claims, either as of the date of acquisition for invested capital purposes, or as of March 1, 1913, for depreciation purposes. Appeals of Kilburn Lincoln Machine Co., 2 B. T. A. 363, and Rockford Malleable Iron Works, 2 B. T. A. 817.

The petitioner claims the right to deduct from income for the fiscal year ended June 30, 1921, all the shipments of defective matches which were returned during the calendar year 1920. Some of these shipments were received in the fiscal year 1920 and the total of the returned shipments was charged off in the fiscal year 1922. The evidence is to the effect that the petitioner accepted the word of the jobber that the matches returned were defective, although it later made an inspection and then destroyed them. Under this state of facts any loss on the returned shipments was sustained in the taxable year in which the shipments were received, and the amount of the loss on each shipment could have been then determined. Accordingly, we find no error on the part of the Commissioner in refusing to allow a deduction during the fiscal year 1921 on account of the shipments returned prior to the beginning of that year.

No evidence was offered to show that the computation of the Commissioner, whereby he reduced invested capital on account of taxes for prior years, is not in accordance with the method prescribed by article 845 of Regulations 62, which has been approved by section 1207 of the Revenue Act of 1926. Appeal of Russel Wheel & Foundry Co., 3 B. T. A. 1168.

Judgment for the Commissioner,