author: Black: Van Fossan,

text:
    Lane-Wells Company, Petitioner, v. Commissioner of Internal Revenue, Respondent. Technicraft Engineering Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 99829, 99830.
    Promulgated January 31, 1941.

      Raphael Decider, Esq,, for the petitioners.

      E. A. Tonyes, Esq., and Alvai 0. Baird, Esq., for the respondent.
   OPINION.

Black:

Iss-ues (a) and (b). — These two assignments of error raise essentially the same issue, which is that the Commissioner erred in his determination in the notice of deficiency that Technicraft was a “personal holding company” as defined in section 351 (b) (1) of the Revenue Acts of 1934 and 1936, and section 352 (a) of the Revenue Act of 1936 as amended by section 1 of the Revenue Act of 1937, and that it was subject to the surtax imposed by section 351 (a) of the Revenue Acts of 1934 and 1936 and by section 351 of the Revenue Act of 1936 as amended. Petitioners contend that the amounts of Technicraft’s income designated on its income tax returns as “royalties” were in fact compensation for tangible services rendered to affiliated corporations and did not constitute “personal holding company” income.

All of the license agreements in evidence apply the term “royalty” to the amounts paid to Technicraft thereunder, although the terms of the licenses vary as to the exact nature of the consideration for which the payments were made. Technicraft granted to the Lane-Wells Co. of California merely “any and all rights, privileges and remedies” which Technicraft “might or could do, exercise or perform” under the assignment of the exclusive license to use and sell devices, embodying the Mims patent, but it is quite clear from the language of the other two license agreements that the “royalty payments” thereunder were not confined to receipts from the use of the Mims patent alone. Under each of the license agreements with the Lane-Wells Co. of Oklahoma and the Lane-Wells Co. of Texas, Technicraft granted a nonexclusive license “to make or purchase for the Licensee’s own use only, and to use but not to sell, rent, or lease to others said Perforators.” In those agreements the term “perforators” was broadly defined “to mean not only the patent specifically mentioned hereinbefore, but also any and all inventions, applications, patents and any continuations, divisions, and/or reissues thereof and whether in the nature of apparatus or processes which the licensor now owns or controls or which it may at any time during the life of this agreement own or control and which relate or are accessories to said Perforators.” The agreements provided that “The royaltj' payments on the Patent Rights herein licensed shall be fifteen percent (15%) of the gross receipts; minimum royalties shall be not less than Seven Hundred and Fifty dollars ($750.00) per month”, that “The term ‘Patent Rights’ shall be construed to embrace as a group all the patents and applications herein specified or referred to or implied”, and that “The term ‘gross receipts’ shall be construed to mean the total receipts derived in any manner whatsoever from the manufacture and/or use of any and all apparatus or processes covered by said Patent Rights without deductions of any kind or character.”

Under the license agreements with the Lane-Wells Co. of Texas and the Lane-Wells Co. of Oklahoma, Technicraft was the grantor of the patents and applications used by the Lane-Wells companies. The payments received by it were proportionate to the use of the patents and applications, since the payments were 15 percent of the gross receipts from any and all inventions, applications, and patents which related or were accessories to the perforators. The payments thus fall clearly within the definition of “royalty” given in Black’s Law Dictionary, 3d. ed., as “A payment reserved by the grantor of a patent, lease of a mine, or similar right, and payable proportionately to the use made of the right by the grantee.” This definition is well supported by authority. Western Union Telegraph Co. v. American Bell Telephone Co., 125 Fed. 342; In re Elsner's Will, 206 N. Y. S. 765; Bellport v. Harrison, 123 Kans. 310; 255 Pac. 52; Volk v. Volk Manufacturing Co., 101 Conn, 594; 126 Atl. 847; Kiesau Petroleum Corporation, 42 B. T. A. 69.

It seems clear that some of the payments made to Technicraft were not covered by express license agreements. For example, Tech-nicraft had no license agreement at all with Lane-Wells International, Inc., although it collected 15 percent-of that corporation’s gross receipts from gun perforation. In February 1937 Techni-craft’s agreements with the Lane-Wells Co. of Texas and the Lane-Wells Co. of Oklahoma expired, but those corporations continued to pay to Technicraft 15 percent of their gross receipts from gun perforation. The facts further show that on June 1, 1937, Techni-cr'aft was furnishing the Lane-Wells companies with from 85 to 100 patents or patent applications, of which only 7 or 8 related to the basic principle of the Mims patent.

In their argument that the payments in question did not constitute royalties, petitioners rely on Kiesau Petroleum Corporation, supra, wherein a certain percentage of the proceeds from the sale of oil received by a taxpayer under contracts with lessees of oil producing land in return for equipment was held not “derived from royalties” within the meaning of section 351(b)(1) of the Bevenue Acts of 1934 and 1936 and the taxpayer was held not to be a personal holding company. The Board held that under the contracts the taxpayer “did not reserve an interest in the oil producing properties; it acquired such an interest for the first time.” The instant case is clearly distinguishable, since Technicraft had an interest in patents and applications and under the license agreements “reserved” an interest rather than “acquiring” it for the first time, and in those cases where there were no license agreements it seems clear that the nature of the income was the same.

Petitioners also rely upon Affiliated Enterprises, Inc., 42 B. T. A. 390, wherein the taxpayer operated a sales promotion plan, known as “bank night”, which was not and could not be patented or copyrighted, except for some instruction sheets which were copyrighted. The taxpayer provided a few simple articles to execute the idea, derived income in the form of a fiat sum weekly payment from “license agreements” with theatre operators, and was held not to be a personal holding company, since its income was not derived from royalties. The case is distinguishable in that Technicraft owned patents and applications, many of which were patentable, and received not a flat -sum, but 15 percent of the gross receipts derived by each Lane-Wells company from the use of such patents and applications in gun perforation. Moreover, it has been held that the term “royalty” may be applied to receipts derived in respect of nonpatentable improvements. Volk v. Volk Manufacturing Co., supra.

Petitioners have not shown what portion of Technicraft’s income, if any, was derived from engineering services or from nonpatentable devices, as distinguished from patents, and they have not shown the amounts derived under the written license agreements, as distinguished from the amounts received from Lane-Wells International, Inc., and from the Lane-Wells Co. of Texas and the Lane-Wells Co. of Oklahoma after the written license agreements had expired in February 1937. Although Technicraft furnished the Lane-Wells companies with from 85 to 100 patents or applications, of which only 7 or 8 x-elated to the basic principle of the Mims patent, petitioners have not shown what portion of the amounts received by Technicraft was consideration for patents related to the basic principle of the Mims patent. The facts show that on its books for all the years involved and on its income tax returns for 1934,1936, and 1937, Techni-craft treated the payments made to it as royalties. We agree, of course, with petitioners that merely calling these receipts “royalties” in the license agreements and on petitioner’s books Avould not make them “royalties” if, in fact, the evidence showed that they were something else. However, for reasons already stated, we think these payments were “royalties” within the meaning of the applicable revenue act.

These amounts did not constitute royalties merely to the extent of an amount equal to the $200 per month paid by Technicraft for the Mims patent, as petitioners suggest, since the payments to Techni-craft were not made solely for the use of the Mims patent, which by itself was not very valuable. It was the improvements and developments to the basic Mims patent, conceived and carried out by Techni-craft, which made its use of great value. Manifestly the chief business purpose of Technicraft was to improve and develop the Mims patent and other patents and devices used in the oil business by the Lane-Wells companies. For the use of these patents and devices and their improvements, it received 15 percent of the gross receipts of the different Lane-Wells companies which they in turn received from the gun perforating business. These were none the less royalties, we think, even though they were not received in anything like their entirety for the use of the basic Mims patent.

Therefore, the payments received by Technicraft must be held to be “royalties” within section 351 (b) (1) of the Revenue Acts of 1934 and 1936, and, since petitioners do not contest the fact that Techni-craft otherwise falls within the definition of a “personal holding company” for the taxable years 1934, 1935, and 1936, the respondent’s position as to those years is sustained. Logan Coal & Timber Association, 42 B. T. A. 529. The payments were also “royalties” within section 353 (a) of the Revenue Act of 1936, as amended by section 1 of the Revenue Act of 1937, but an additional objection is raised by petitioners in respect of taxability for 1937.

Issues (i) and (j). — Petitioners contend that even if Technicraft be considered a personal holding company in the years 1934 through 1936, it could not have been a personal holding company in 1937 “for the reason that during the latter half of 1937, it had neither assets nor income, and 50% or more of its stock was not held by less than five individuals or their families.”

Section 352 (a) of the Revenue Act of 1936, as amended by section 1 of the Revenue Act of 1937, includes in the definition of a “personal holding company” any corporation if at least 80 percent of its gross income is personal holding company income and, in addition:

At any time during the last half of the taxable year more than 50 per centum in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals.

The question in issue hinges upon the meaning of “at any time during the last half of the taxable year.” Section 357 of the Revenue Act of 1936, as amended, provides that “The terms used in this title shall have the same meaning as when used in Title I”, and section 48 of Title I of the Revenue Act of 1936 provides, in part:

When used in this title^—
(a) Taxable Yeab. — “Taxable year” means the calendar year, or the fiscal year ending during such calendar year, upon the basis of which the net income is computed under this Part. “Taxable year” includes, in the case of a return made for a fractional part of a year under the provisions of this title or under regulations prescribed by the Commissioner with the approval of the Secretary, the period for which such return is made.

Technicraft’s income tax return for 1937 was filed for the period which began January 1,1937, and ended August 31,1937. If “the taxable year”, for purposes of determining whether Technicraft falls within the definition of a “personal holding company” in section 352 (a) of the Revenue Act of 1936, as amended, is held to be the fractional part of a year from January 1, 1937, to August 31, 1937, for which the income tax return was filed, then Technicraft falls within the statutory definition of a “personal holding company”, since at least as late as May 31, 1937, more than 50 percent of Technicraft’s outstanding stock was owned directly, or indirectly, by or for not more than five individuals.

But no personal holding company return appears to have been filed by Technicraft and the parties in arguing this point in their briefs appear to have considered the taxable year in question as the calendar year ended December 31, 1937. The deficiency notice determined personal holding company surtax liability “for the taxable years ended * * * December 31, 1937” and, in the explanation of adjustments to net income, stated:

The return filed for the taxable year purports to account for the taxable income for the period from January 1 to August 31, 1937; after which latter date the business of your corporation was taken over and its activities conducted by Lane-Wells Company, pursuant to an agreement for reorganization entered into on or about June 1,1937.
The contention made in your protest, that the said return erroneously accounted for income accruing after June 1, 1937 which should have been returned by the successor corporation, is denied for the reason that the transfer of your assets and business was not effected at the time indicated in your protest and the items of income and deduction involved were properly reflected in your books and return.

In Technicraft’s petition the taxable year is treated as ending December 31, 1937, and petitioner alleged as a fact that its “last taxable year was the calendar year 1937.”

If the entire calendar year 1937 is treated as “the taxable year” in this case, Technicraft meets the requirements for a “personal holding company” as set forth in section 352 (a), as amended, since the facts clearly show that Technicraft continued to exist as a corporation and had stock outstanding in the names of Lane and Wells and their wives up until July 29, 1937. The reorganization agreement whereby the stock of Technicraft and the other corporations owned by Lane and Wells and their wives was to be transferred to the Lane-Wells Co., the Delaware corporation, in return for shares of its stock was signed June 1, 1937. It was not until July 22, 1937, however, that a permit was granted by the State Corporation Department of California authorizing the Delaware corporation to issue its stock. The actual issuance took place a week later, July 29, 1937. At that time Technicraft issued a new certificate of its shares to the Delaware corporation. Not until that date was there a reorganization. National Iron Works, 22 B. T. A. 382; A. T. Evans, 30 B. T. A. 746.

The instant case is clearly distinguishable on its facts from Novo Trading Corporation v. Commissioner, 113 Fed. (2d) 320, urged as an authority by petitioners, wherein liquidation of a corporation was held effected so that refunds of import duties were not taxable to it although the certificate of dissolution which had been executed was never filed with the Secretary of State, since in that case at the time in question all the stock certificates had been canceled on the corporation’s books and the corporation had completely ceased business activities.

On the facts we bold tbat tbe Commissioner did not err in bis determination tbat petitioner was a personal bolding company for tbe year 1937. Tbis disposes of assignment of error (i) adversely to the contention of petitioners. It likewise disposes of assignment of error (j) adversely to petitioners because that assignment of error is based upon tbe same contention as is made in support of assignment of error (i).

Issues (g) and (h). — In the notice of deficiency the Commissioner stated:

The further contention raised in your protest, that you should be allowed a further dividends paid credit (not claimed in your return) on account of assets distributed in complete liquidation, is denied for the reason that Article 27 (f)-l of Kegulations 94 provides that no such credit is allowable in respect of nontaxable distributions.

Petitioners contend tbat, even if Technicraft could be construed to be a personal bolding company, it nevertheless was entitled to a dividends paid credit for amounts distributed at tbe time of its reorganization to tbe extent tbat such distribution represented earned surplus, and tbat of tbe amounts distributed in tbe liquidation of Technicraft not less than $65,814.75 was properly chargeable to earnings and profits accumulated subsequent to February 28, 1913, and tbat it has overpaid its surtax on undistributed profits for 1937 in the' sum of $10,248.87.

As we have already stated, all of Technicraft’s assets were transferred in 1937 to tbe Lane-Wells Co. of Delaware, its sole stockholder, and both parties agree that there was a tax-free reorganization under section 112 (b) (6) of tbe Revenue Act of 1936. The parties agree that the question in issue depends upon whether subsection (f) of section 27 of the Revenue Act of 1936 is ¡limited by subsection (h) in computing the “dividends paid credit” which is to be deducted under section 355 of the Revenue Act of 1936, as amended by section 1 of the Revenue Act of 1937, from “adjusted net income” to determine the “undistributed adjusted net income” subject to surtax under section 351 of the Revenue Act of 1936, as amended.

In Credit Alliance Corporation, 42 B. T. A. 1020, the Board decided a similar question in accordance with the views of petitioners in this case and we now follow that decision. On the issue raised by these assignments of error, the Commissioner’s determination was in error, but cf. Centennial Oil Co. v. Thomas, 109 Fed. (2d) 359; certiorari denied, 309 U. S. 690.

From petitioner’s exhibit 28, introduced in evidence by agreement between the parties, Technicraft’s earned surplus, at the time of its merger with the Lane-Wells Co. of Delaware, August 31, 1937, was $55,660.84 and not $65,814.75 as alleged in its assignment of error. The correct amount of Technicraft’s earned surplus transferred to the Lane-Wells Co. of Delaware in the reorganization should be used in a recomputation under Rule 50.

Issues (e) and (/). — Petitioners in assignments of error (e) and (f) contend that the three-year period of limitations contained in section 275 (a) of the Revenue Act of 1934 has run for the years 1934 and 1935. The facts show that on March 15, 1935, and March 16, 1936, respectively, Technicraft filed its corporation income and excess profits tax returns on Form 1120 for the calendar years 1934 and 1935, respectively. These returns appear to be full and complete, aside from some minor adjustments which the Commissioner made in his determination of the deficiencies. Technicraft answered “No” to the following question appearing on the face of both returns:

Is the Corporation a personal holding company within the meaning of Section 351 of the Revenue Act of 1934? — -(If so, an additional return on Form 1120H must be filed.)

Technicraft did not file any returns on Form 1120 H because, in good faith, it did not believe it was a personal holding company.

The respondent’s deficiency notice is dated June 1, 1939, which is over four years and two months after the 1934 return was filed on Form 1120 and over three years and two months after the 1935 return was filed on Form 1120. He contends that the statute never commenced to run, for the sole and only reason that no returns were filed on Form 1120 H, and relies upon section 276 (a) of the Revenue Act of 1934, which provides that in the case “of a failure to file a return the tax may be assessed * * * at any time.”

Section 275 (a) of the Revenue Act of 1934 provides that the tax imposed by Title I “shall be assessed within three years after the return was filed * * Section 351 (c) provides:

(c) Administrative Provisions. — All provisions of law (including penalties) applicable in respect of the taxes imposed by Title I of this Act, shall insofar as not inconsistent with this section, be applicable in respect of the tax imposed by this section, except that the provisions of section 131 of that title shall not be applicable.

Article 351-8 of Regulations 86, promulgated under the Revenue Act of 1934, in so far as is material, provides:

Art. 351-8. Return and, payment of fa®. — A separate return is required for the surtax imposed under section 351. Such return shall be made on Form 1120H. * * * The same provisions of law relating to the period of limitation for assessment and collection which govern the taxes imposed by Title I also apply to the surtax imposed under Title IA. However, since the surtax imposed under Title IA is a distinct and separate tax from those imposed under Title I, the making of a return under Title I will not start the period of limitation for assessment of the surtax imposed by Title IA. If the corporation subject to section 351 fails to make a return, the tax may be assessed at any time. * * * The administrative provisions applicable to the surtax imposed by section 351 are not confined to those contained in Title I but embrace all administrative provisions of law which have any application to income taxes.

The returns filed on Form 1120 were made under Title I.

Petitioner, in support of its contention that the statute has run, relies upon Germantown Trust Co. v. Commissioner, 309 U. S. 304. In that case a trustee in charge of a certain fund filed a return as a trust on Form 1041. After the statute had run for assessing an additional tax against the trust, the Commissioner determined that the fund was an association taxable as a corporation and that, since no return had been filed on Form 1120 as an association taxable as a corporation, as required by section 52 of the Revenue Act of 1932 and article 391 of Regulations 77, he was not barred from assessing the determined deficiency against the trustee in charge of the fund. The Supreme Court held that the return on Form 1041 was a return within the meaning of section 275 (a) of the Revenue Act of 1932, and that the proposed deficiency in that case was barred by the statute of limitations. Among other things, the Court said:

The respondent’s contention is that where a fiduciary, in good faith, makes what it deems the appropriate return, which discloses all of the data from which the tax, treated as one imposed upon an association (classified as a corporation under the statute), can be computed, such a return is to be deemed no return. We think this view inadmissible.
It cannot be said that the petitioner, whether treated as a corporation or not, made no return of the tax imposed by the statute. Its return may have been incomplete in that it failed to compute a tax, but this defect falls short of rendering it no return whatever.

At the conclusion of the foregoing language the Court in a footnote cited the following cases: Zellerbach Paper Co. v. Helvering, 293 U. S. 172; Commissioner v. Stetson & Ellison Co., 43 Fed. (2d) 553; United States v. Tillinghast, 69 Fed. (2d) 718; Abraham Werbelovsky, 8 B. T. A. 442; Estate of F. M. Stearns, 16 B. T. A. 889; J. R. Brewer, 17 B. T. A. 704.

We think the instant case is distinguishable from the Germantown Trust Co. case, supra. In that case both the returns on Form 1041 and 1120 dealt with in the opinion were what might be properly termed Title I returns. The tax involved was a Title I income tax. In the instant case the tax involved is a Title IA tax. Treasury Regulations 86, article 351-8, above quoted, states:

* * * However, since the surtax imposed under Title IA is a distinct and separate tax from those imposed under Title I, the making of a return under Title I will not start the period of limitation for assessment of the surtax imposed under Title IA.

Is the above regulation a valid one ? We think it is. In Blenheim Co., Ltd., 42 B. T. A. 1248, we held that the taxpayer was liable for a delinquency penalty of 25 percent in income tax deficiency for failure to file a return on Form 1120 for the normal income tax, although it had filed a return on Form 1120II as a personal holding company. In that case, among other things, we said: “Clearly, the normal and surtax here in dispute are separate and distinct taxes. Revenue Act of 1934, Title I, Title I-A * *

In Will County Title Co., 38 B. T. A. 1396, the Commissioner determined a deficiency in income tax for 1934 and an overassessment of excess profits tax greater than the amount of the deficiency in income tax, thus making a net overassessment of the two taxes. On these facts we held that the petition for redetermination was within our jurisdiction in so far as it pertained to the deficiency in income tax, but not as to the OA^er assessment in excess profits tax. We based our decision upon the fact that “the two taxes are imposed by entirely separate provisions of the statute”, the income tax by Title I and the excess profits tax by Title Y, and are separate and distinct taxes. To the same effect is Hobbs Western Co., 43 B. T. A. 5.

If the question of our jurisdiction is determined under certain circumstances by the character of the tax, then it is difficult to see hoAv a return filed on Form 1120 under Title I of the Revenue Act of 1934 would start the running of the statute of limitations as to a separate and distinct tax imposed by Title IA of the Revenue Act of 1934, where no return has been filed by the taxpayer on Form 1120 H, as required by the Treasury regulations. The two returns are quite different, as pointed out by us in Blenheim Co., Ltd., supra.

We, therefore, hold that, since Technicraft did not file personal holding company returns on Form 1120 H, the statute of limitations has not run and the deficiencies in personal holding company surtax for the years 1934 and 1935 are not barred by the statute of limitations.

Issues (o) and (d). — In the notice of deficiency the Commissioner added a 25 percent penalty for each year as “mandatory” under section 291 of the Revenue Act of 1934, section 406 of the Revenue Act of 1935, and section 291 of the Revenue Act of 1936, for failure to file a personal holding company return.

Petitioners contend that this was error and that, although no personal holding company returns were filed on Form 1120 H, the returns filed contained all the necessary data to enable the Commissioner to compute petitioners’ liability for personal holding company surtax. In making this contention, petitioners also rely on Germantown Trust Co., supra, above discussed in connection with the statute of limitations issue. We think our discussion under the statute of limitations issue is equally applicable here.

In the Board’s recent decision in Olean Times Publishing Co., 42 B. T. A. 1277, among other things, we said:

Petitioner filed no personal holding company return, and hence the penalty of 25 percent imposed by the Revenue Act of 1936, section 291, is mandatory. Reasonable cause is only effective to avoid the penalty if the return is delayed— not when the return is omitted entirely, Alex Holmstrom, 35 B. T. A. 1092; dismissed, 94 Fed. (2d) 747; National Contracting Co. v. Commissioner, 105 Fed. (2d) 488. This is true as to a personal holding company return even though an income tax return has been filed, Collateral Mortgage & Investment Co., 37 B. T. A. 630; Rotorite Corporation, 40 B. T. A. 1304 (on review C. C. A., 7th Cir.); Lone Pine Lawn Corporation, 41 B. T. A. 638 (on review C. C. A., 2d Cir.).

On the issue as to delinquency penalties, we sustain the Commissioner. See Noteman v. Welch, 108 Fed. (2d) 206.

Issue (/«). — Petitioners do not press issue (k) in their brief and it will be considered as abandoned. This assignment of error raised the issue that the Commissioner was estopped by his past acts and conduct from asserting any claim of liability against Technicraft for surtax on personal holding company or penalties thereon. Even if the issue be not considered as abandoned, it is clear that the evidence in the record does not sustain it. There is nothing to show that the Commissioner is estopped.

Beviewed by the Board.

Decision will be entered under Buie 50.

Van Fossan,

dissenting: I believe this case is controlled by the decision of the Supreme Court in Germantown Trust Co. v. Commissioner, 309 U. S. 304.

       SEC. 364. SUETAX ON PERSONAL HOLDING COMPANIES.
      ♦ *»«***
      (b) Definitions. — As used in this title—
      (1) The term “personal holding company” means any corporation * * * if — (A) at least 80 per centum of its gross income for the taxable year is derived from royalties, * * * and (B) at any time during the last half of the taxable year more than 50 per centum in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals. * * *
      SEC. 352. DEFINITION OF PERSONAL HOLDING COMPANY.
      (a) General Rule. — For the purposes of this title and of Title I the term “personal holding company” means any corporation if—
      (1) Gross Income Requirement. — At least 80 per centum of its gross income for the taxable year is personal holding company income as defined in section 353; * * *
      (2) Stock Ownership Requirement. — At any time during the last half of the taxable year more than 50 per centum in value of its outstanding stock is owned, directly or Indirectly, by or for not more than five individuals.

       (f) DISTRIBUTION in Liqdidation. — In the case of amounts distributed in liquidation the part of such distribution which is properly chargeable to the earnings or profits accumulated after February 28, 1918, shall, for the purposes of computing the dividends paid credit under this section, be treated as a taxable dividend paid.

       (h) Nontaxable Distributions. — If any part of a distribution (including stock dividends and stock rights) is not a taxable dividend in the hands of such of the shareholders as are subject to taxation under this title for the period in which the distribution is made, no dividends paid credit shall be allowed with respect to such part.


source: Caselaw Access Project

author: Hill :

license: Public Domain

text:
    Refiners Production Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 85659.
    Promulgated January 31, 1941.

      Lows W. Pratt, Esq., for the petitioner.

      J. E. Marshall, Esq., for the respondent.
   OPINION.

Hill :

The first question for decision in this case involves a deduction of $4,200 claimed by petitioner in its original return on account of expenses alleged to have been incurred and paid by petitioner’s three stockholders and directors, and which was repaid to them by petitioner in equal amounts of $1,400 each. The Commissioner first proposed to disallow the entire amount of the claimed deduction, but, after conferences were held in the latter part of 1935, it was agreed between the parties that one-half of the amount should be allowed and that additional tax should be assessed and paid on the basis of the disallowance of one-half. Accordingly, on December 31,1935, petitioner signed a waiver of restrictions on assessment and collection (Form 870) and an additional tax of $288.75 was assessed, which petitioner paid in January 1936, all prior to the mailing of the deficiency notice on April 10, 1936.

The deficiency here in controversy was computed by respondent as follows:

Net income reported on amended return-$50, 507.94
Add:
(1) One-half expenses paid Messrs. Pratt, Johnson and Green disallowed-s- 2,100.00
(2) Income from Katy and Buchanan leases- 43, 643.32
Adjusted net income_ 96, 251.26

On brief petitioner contends that respondent’s action in computing the deficiency results in the disallowance of that portion of the claimed deduction which was allowed in the settlement in 1935, and argues that “The settlement of the controversy by the allowance of $2,100.00 and the payment of the tax on the balance of $2,100.00 should be allowed to stand.” In his brief respondent refers to the settlement in 1935, and says: “In view of the evidence, it is submitted that the allowance of $2,100 of the claimed, deduction, and no more, is proper. This will conform to tbe agreement of the parties reached before the mailing of the deficiency notice.” Thus, it appears that the controversy here arises from the misconception by petitioner of the effect of respondent’s computation of the present deficiency. This item in the full amount of $4,200 was claimed as a deduction in petitioner’s original return, and no change in that respect is shown to have been made in the amended return. Therefore, since respondent started his computation of the deficiency with the net income shown on the amended return, it was necessary to add to such net income the amount of expenses theretofore disallowed. Otherwise, the deficiency would have reflected in effect an allowance of the entire deduction claimed, which petitioner does not here contend for. Respondent’s determination on this point is approved.

Petitioner further contends that respondent was without lawful authority to determine the deficiency in controversy, in view of the agreed settlement of tax liability in 1985. Petitioner has cited no statute or other authority in support of its contention, and we find it is without merit. Form 870, which petitioner executed at the time mentioned, constituted merely a waiver of restrictions on assessment and collection of additional tax, and plainly stated on its face that it was not a final closing agreement under section 606 of the Revenue Act of 1928.

Petitioner also pleads that assessment and collection of the deficiency in controversy are barred by limitation. The statute applicable is section 275 (a) of the Revenue Act of 1932, which provides that “the amount of income taxes imposed by this title shall be assessed within two years after the return was filed.” Petitioner’s return was not offered in evidence, and there is no proof in the record as to when it was filed. The burden is upon petitioner to prove the facts necessary to show that the period provided in the statute had expired prior to the mailing of the deficiency notice, and for lack of such proof its plea must be denied. Edward M. Lawrence, 3 B. T. A. 40; L. J. Christopher, 13 B. T. A. 729, 740; J. Friedman & Co., 16 B. T. A. 1119, 1122; Elnora C. Haag, 19 B. T. A. 982, 986; Lester L. Robison, 22 B. T. A. 395, 399; M. A. Nicholson, 22 B. T. A. 744, 746.

The second and principal issue involves the amounts of income taxable to petitioner as its shares of production from the Katy and Buchanan oil and gas leases. Petitioner contends that it owned only one-sixteenth of the working interest of each lease, and so was taxable only on that proportion of the production, which it reported in its income tax return. Respondent takes the position that during the taxable year petitioner owned one-half of the working interest in the Katy lease and three-sixteenths of the working interest in the Buchanan lease. There is now no controversy respecting the amount of the proceeds from production in the taxable year, since respondent accepts petitioner’s own figures, which show that the total gross production from the seven-eighths working interest in the Katy lease was $58,969.92, and that the amount derived from the three-fourths working interest in the Buchanan lease was $21,915.52. Thus, the issue submitted requires us to determine only the amount or proportion of the gross production from each well which constitutes income taxable to petitioner.

We shall consider first the ownership of the working interest in the Katy lease during the taxable year. In its brief petitioner says that it erroneously reported in its amended return one-sixteenth of the proceeds from the working interest in the Katy well; that it was the agent or trustee only for the owners of fifteen-sixteenths of such working interest, and in fact distributed the entire taxable income for 1932 from the working interest to those legally entitled to it, that is, one-fourth to' the railroad company as bonus for the lease, one-lialf to the drilling company under the drilling contract and assignments, and one-fourth to Frank Kussell on his assignment as security for the repayment of a loan. The facts disclosed by the record, we think, do not support petitioner’s contentions.

Under its original contract with the railroad company, the pertinent provisions of which are set out hereinabove, petitioner acquired a seven-eighths working interest in the Katy lease, subject to the provisions of article VI of the contract to the effect that, in addition to the one-eighth royalty reserved to the railroad company, that company should be paid the proceeds from the sale of one-fourth of seven-eighths of the oil produced until the sum of $15,000 had been paid thereby. However, the provisions respecting the payment of the bonus of $15,000 out of proceeds from the sale of oil were eliminated by a supplemental agreement subsequently entered into during 1931 between petitioner and the railroad company, whereby it was stipulated that in lieu of such payment out of oil petitioner should deliver fuel oil to the railroad company equal in value of one-fourth of seven-eighths of the oil produced on the day the same was run into the pipe line with which petitioner connected its well. Petitioner did not produce fuel oil, but during the taxable year purchased fuel oil in the amount agreed upon and delivered it to the railroad company.

From the recital of the foregoing facts, we think it is clear that the railroad company owned no interest in the oil production so far as concerns the $15,000 bonus to be paid in fuel oil. The supplemental agreement was in lieu of the provisions of article VI of the original contract, pursuant to which the railroad company had acquired an oil payment of $15,000 out of one-fourth of seven-eighths of the gross production. Such oil payment the railroad company relinquished by the supplemental agreement and accepted in lieu thereof the promise of petitioner to deliver fuel oil to tbe value of $15,000 in proportion to or as measured by the daily gross production of the well. The railroad company was not required to look to production from the Katy lease for payment of the $15,000 bonus, and petitioner was not required to purchase fuel oil out of the proceeds from such production. It could have discharged this obligation by the use for that purpose of any funds available to it. Cf. Hoe Estate Co. v. Commissioner, 85 Fed. (2d) 4, affirming 32 B. T. A. 903. We conclude, therefore, that the income derived from the one-fourth of the seven-eighths working interest, mentioned in article VI of the contract above referred to, was taxable to petitioner. Anderson v. Helvering, 310 U. S. 404.

On March 10,1932, petitioner entered, into a contract with the Hugh Hodges Drilling Co. to drill an oil and gas well on the Katy lease, and as part consideration therefor transferred to the drilling company a one-half interest of the seven-eighths working interest thereof until $103,750 had been paid out of oil therefrom as and when produced. It follows that one-half of seven-eighths of the proceeds from production in the taxable year was not income to petitioner. Thomas v. Perkins, 301 U. S. 655. Cf. Palmer v. Bender, 287 U. S. 551. The parties are in agreement on this point, and further discussion is deemed unnecessary.

However, petitioner contends that of the proceeds from the remaining one-half of seven-eighths of production from the Katy well, one-fourth was owned by Frank Russell. The evidence shows that petitioner borrowed $20,000 from Russell, and on June 17, 1931, executed an instrument entitled “Assignment of Oil and Gas Lease”, which purported in terms to assign and convey to Russell a one-fourth of seven-eighths undivided interest in the Katy lease until he should have been paid the sum of $25,000 from the proceeds of such interest; but the instrument contained the further provision that, “This assignment shall be construed as a first mortgage of $25,000.00 on said undivided one-fourth interest of said oil and gas lease.” This would indicate that the relation between petitioner and Russell was that of debtor and creditor. Such conclusion is further strengthened by the following extract quoted from the report of proceedings at the hearing:

The Member. * * * I take it, from tbis instrument here (tbe so-called assignment above mentioned), wbat bas been read to me, and the testimony, it is probably security for tbe repayment of money. Is that wbat it is?
Mr. Pratt. [Petitioner’s counsel.] Yes.
Mr. Marshall [Respondent’s counsel]. Tbe parties will admit that.

Under this construction of the so-called assignment, certainly Russell owned no present interest in the production of the Katy well during the taxable year. His interest was contingent; it was merely collateral security for the loan, and Russell had no enforceable interest unless and until petitioner defaulted in the payment of its obligation. There is nothing in the record to indicate that Bussell was to look to production of oil for repayment of the loan, and no part of the proceeds from such production constituted income taxable to him. He had no depletable interest therein during 19S2. Anderson v. Helvering, supra. Hence, the proceeds from the one-fourth of the working interest in the lease mentioned in the Bussell “assignment” was petitioner’s income and taxable to it, whether or not petitioner paid over the whole or any portion thereof to Bussell in satisfaction of its obligation to him.

Since the Hugh Hodges Drilling Co. owned one-half of seven-eighths of the oil produced from the Katy well in 1932, the proceeds of which the parties now agree did not constitute income to petitioner, and neither the railroad company nor Frank Bussell owned any interest in any portion of the oil produced, it follows that the remaining one-half of the proceeds, or the sum of $29,484.96, constituted income taxable to petitioner.

' In this connection it is to be noted that there is no contention that any portion of the proceeds of production from the Katy well in the taxable year was either distributed or distributable to the Centorp Corporation or the other assignees of future and contingent interests referred to in our findings of fact above.

On October 31, 1931, petitioner acquired a three-fourths working interest in the Buchanan lease by assignment from C. L. Norris, the original lessors having retained a one-eighth royalty interest and Norris a one-eighth overriding royalty interest. On November 16, 1931, petitioner entered into a contract with the Hugh Hodges Drilling Co. for the drilling of a well on this lease, and as part payment therefor assigned on March 1,1932, to the drilling company five-eighths of its three-fourths working interest until $95,000 had been paid out of oil as and when produced. The parties now agree that five-eighths of three-fourths of the proceeds from gross production from the Buchanan lease during 1932 was not income to petitioner. The question for decision is whether or not any portion of the proceeds from production of the remaining three-eighths of the three-fourths working interest was taxable to petitioner.

There is no contention that any portion of the income from the Buchanan well in 1932 was paid or payable to Green, Johnson, and Pratt, petitioner’s stockholders and directors, under the assignments of future and contingent interests executed April 7, 1932. It is petitioner’s contention that three-eighths of the proceeds from production, or the full amount remaining over and above that assigned to the drilling company, belonged to the Centorp Corporation and that no part thereof constituted income taxable to petitioner.

Centorp furnished, the casing for the Buchanan well, amounting to about $22,500, and also a bond of $200,000 required by Oklahoma City. In consideration therefor, petitioner assigned to Centorp on February 17, 1932, an undivided three-eighths of its three-fourths working interest, but the instrument evidencing such assignment specifically provided that three-sixteenths, or one-half of the interest so assigned, was subject to the payment out of oil, as and when produced and saved, of $32,500 of the cost of drilling and equipping the well. Since the total production during 1932 amounted to only $21,915.52, it is apparent that three-sixteenths, or one-half of the undivided interest assigned to Centorp, was during the taxable year a future and contingent interest, and that Centorp was the unconditional owner in that year of only a three-sixteenths interest in petitioner’s three-fourths working interest. There being no other assignments, it follows that three-sixteenths of three-fourths working interest belonged to petitioner, and three-sixteenths of three-fourths of the proceeds from the gross production, or the amount of $4,109.16, was income taxable to petitioner. We so hold.

The amounts derived from gross production from the Katy and Buchanan leases which we hereinabove found to constitute income taxable to petitioner represent its total proportionate shares and will be reduced by the amounts reported as income from such sources by petitioner in its original or amended income tax returns for 1932. The deficiency will be recomputed accordingly.

Decision will he entered under Rule 50.


author: Mellott:

text:
    William H. Noll, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 98305.
    Promulgated January 31, 1941.

      John A. Selby, Esq'., and George B. Buist, O. P. A., for the petitioner.

      L. W. Shaw, Esq., for the respondent.
   OPINION.

Mellott:

This proceeding involves a deficiency in income tax for the years 1935 and 1936 in the aggregate amount of $71,737.27. According to the notice, there was an overassessment for the year 1934 in the amount of $2,330.78. The proceeding was submitted upon a stipulation of facts. The facts are found to be as stipulated; but for present purposes they may be summarized.

Petitioner, a resident of Fort Wayne, Indiana, filed his income tax returns for the years 1935 and 1936 with the collector of internal revenue at Indianapolis, Indiana.

Prior to 1935 petitioner purchased the following bonds:

The joint stock land banks above mentioned were chartered under the provisions of the Federal Farm Loan Act, approved July 17,1916. The bonds had been issued pursuant to that act, and, as provided therein, each bond contained a provision stating that it “and the income derived therefrom shall be exempt from Federal, State, municipal and local taxation.”

On May 2, 1932, a receiver was appointed by the Farm Credit Administration for the Southern Minnesota Joint Stock Land Bank in accordance with section 29 of the Farm Loan Act and on October 1, 1932, a receiver was likewise appointed for the Chicago Joint Stock Land Bank. The receiverships for the two banks were still in effect when the instant proceeding was submitted.

Prior to October 1,1932, all matured interest coupons on the bonds of the Chicago Joint Stock Land Bank purchased by petitioner had been paid in full. On that date there were amounts of interest accrued on the bonds for the period between the date of the last preceding matured (and paid) interest coupons and October 1, 1932, as follows:

At the time petitioner acquired the bonds purchased on January 21,1933, no part of the interest referred to in the preceding paragraph had been paid. No amounts of interest were considered by the receiver of this bank to have accrued after October 1,1932.

In 1934 petitioner delivered the bonds of the joint stock land banks, together with proofs of claim, to the respective receivers, who issued to him “Beceiver’s Certificates of Delivery of Coupon Joint Stock Farm Loan Bonds and Proof of Claim.” The certificates stated that petitioner was “the registered holder of this certificate who (or whose predecessor in interest) has delivered to the Beceiver * * * Joint Stock Farm Loan Bonds [in the aggregate amount shown] and made proof of claim thereon * * By the terms of the certificate it, and the claim represented thereby, was transferable only on the books of the receiver'. It was also stated that “dividends payable on the claim represented by this certificate may be paid by mailing checks therefor to the registered owner at the address appearing on the books of the receiver * * *”, and that “the Beceiver may require that this certificate be surrendered at the time of payment of the final dividend * * *.”

Beginning in 1934 and continuing during the years 1935 and 1936 petitioner received payments of dividends. Each of the dividends received by petitioner on account of his claims on the bonds of the Chicago Joint Stock Land Bank was accompanied by a statement explaining that the payment made included dividends of the “face amount of bonds and unmatured interest accrued thereon up to and including September 30, 1932.” Upon the bonds aggregating $290,-000 which had been purchased by petitioner on January 21, 1933, at a total cost of $58,100, the receiver made aggregate payments to petitioner of $207,358.98, allocating it as follows: To principal, $203,-000; to interest, $4,358.98. Upon the remaining $25,000 of Chicago Joint Stock Land Bank bonds, which had been purchased by petitioner on December 14, 1925, at a cost of $25,500, the receiver made aggregate payments to petitioner of $17,893.76, allocating $17,500 of said amount to principal and $393.76 to interest.

The dates and amounts of dividends received during tbe year 1935 by petitioner on account of his claims represented by the five blocks of deposited bonds of the Southern Minnesota Joint Stock Land Bank -were as follows (no dividends were received on these bonds during the years 1934 and 1936):

Dividend payments received in the years 1934 to 1936, inclusive, resulted in gains as follows:

1934_$30,775.23
1935_ 116,075.23
1936_ 29,625.07

(The last paragraph is copied verbatim from petitioner’s brief and the figures correspond to those shown in the notice of deficiency. We have therefore adopted it as a fact, assuming that the parties intended to include it in their stipulation though they did not do so.)

The respondent has treated the gains as ordinary income, taxable in full. Petitioner claims: (1) That the gains are wholly exempt from Federal income tax; (2) that if they are subject to such tax they should be taxed as capital gains; and (3) that in computing his income tax for each of the years 1935 and 1936 the Commissioner has included, in his gross income, tax-free or tax-exempt interest. These contentions will be considered in the order stated.

Petitioner, upon brief, placed his chief reliance upon Stewart v. United States, 106 Fed. (2d) 405, which held that section 26 of the Federal Farm Loan Act, under which the bonds had been issued, exempted from Federal income tax the gains or profits derived from purchasing and selling such bonds as well as the interest received on them. The Board, several members dissenting, reached a contrary view in Agricultural Securities Corporation, 39 B. T. A. 1103 (on appeal C. C. A., 9th Cir.). The Circuit Court of Appeals for the Eighth Circuit, in Stern Brothers & Co. v. Commissioner, 108 Fed. (2d) 309, affirmed the holding of the Board, which had been entered as a memorandum decision upon the authority of the Agricultural Securities Corporation case, and the Supreme Court granted certiorari in the Stewart and Stern cases. Under date of November 12, 1940, the Supreme Court held that only interest upon such bonds is exempt. United States v. Stewart, 311 U. S. 60. A similar holding must be made in the instant proceeding. The Commissioner committed no error in including the gains and profits upon the bonds — other than interest — in petitioner’s gross income.

Did the gains constitute ordinary income or were they capital gains subject to the limitations of section 117 of the Revenue Acts of 1934 and 1936? The act (sec. 117 (b)) defines capital assets as “property held by the taxpayer”, not including stock in trade, property of a kind which would be included in inventory if on hand at the close of the year, or property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. Apparently respondent does not contend that the bonds purchased by petitioner were not capital assets, his contention being that the bonds had been delivered to the receivers “to evidence petitioner’s claims to payment of said bonds”; that certificates “in a form suitable for assignment and transfer” had been delivered to him; that he continued to own the certificates during the taxable years; and that “there is no evidence that any of these certificates have been disposed of, cancelled, withdrawn from circulation, or otherwise affected and it must be assumed, therefore, that at ali times material to this proceeding they were owned by petitioner as a bondholder * * * and represented all of his rights and claims under his bonds.”

Prior to the enactment of the Revenue Act of 1934 the courts and this Board uniformly held that discharge of a bond by payment did not constitute a sale or an exchange as such words were used in the section of the revenue acts dealing with capital gains and losses. As pointed out in John H. Watson, Jr., 27 B. T. A. 463, 465 (approved Fairbanks v. United States, 306 U. S. 436), it was “merely the payment of an obligation according to.its fixed terms.” Cf. Felin v. Kyle, 102 Fed. (2d) 349; Arthur E. Braun, Trustee, 29 B. T. A. 1161. It was therefore held that any gain resulting from such payment was to be treated as ordinary income and any loss was deductible as a bad debt. Commonwealth Commercial State Bank v. Lucas, 41 Fed. (2d) 111; Pacific National Bank of Seattle v. Commissioner, 91 Fed. (2d) 103. Congress, evidently aware of this interpretation, in 1934 enacted section 117 (f) providing:

SEC. 117. CAPITAL GAINS AND LOSSES.
$$$$$$$
(f) Retirement op Bonds, Etc. — For the purposes of this title, amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor.

The gist of respondent’s argument is that there has been no “retirement” of the bonds owned by petitioner and hence the above section is not applicable. This is in substantial accord with his statement in the deficiency notice — “The distributions received by the holder of bonds of a corporation which is in process of final liquidation are not considered amounts received upon the retirement of bonds as contemplated by section 117 (f) of the Revenue Act of 1934.”

Upon brief both parties discuss S. C. Thomson, 40 B. T. A. 60. In that case the Board upheld the Commissioner’s determination that the payment of $5 to debenture holders for each $1,000 face amount of the debentures held by them, the receivers having been authorized to pay such amount to those who would surrender their debentures with all coupons attached before a fixed time, constituted a “retirement” within the purview of section 117 (f), supra. The Court of Appeals for the Second Circuit reversed, holding that the case was one of bad debt. Thomson v. Commissioner, 108 Fed. (2d) 642. The Supreme Court reversed the holding of the Circuit Court, pointing out that it was “plain that Congress intended by the new subsection (f) to take out of the bad debt provision certain transactions and to place them in the category of capital gains and losses.” McClain v. Commissioner, and Helvering v. Thomson, 311 U. S. 527. By a parity of reasoning, Congress also intended to take out of the ordinary income provisions of the revenue act, gains realized by a taxpayer’“upon the retirement of bonds.” The first question to be determined, therefore, is whether under the stipulated facts petitioner’s bonds were retired.

In the McClain and Thomson case, supra, the Court stated: “The statute does not use the word [retirement] in an unusual or artificial sense. In common understanding and according to dictionary definition the word ‘retirement’ is broader in scope than ‘redemption’; is not, as contended, synonymous with the latter, but includes it. Nothing in the legislative history of the provision requires us to attribute to the term used a meaning narrower than its accepted meaning in common speech.”

Respondent sums up his argument on this phase of the case in the following language: “Where, as here, petitioner merely received payments on account of his obligations with the balance still remaining due and owing, the bonds being in public circulation, available for public assignment and transfer and petitioner retaining all rights thereunder, no retirement occurred.” The latter part of the statement is only partially true. Petitioner, as the owner of the bonds, of course retained his rights under them. It must be kept in mind, however, that the bonds were in default. In addition the obligors, having failed to meet their outstanding obligations, had been de-dared to be “insolvent” and receivers bad been appointed under section 29 of the Federal Farm Loan Act. (U. S. C. A., Title XII, ¶ 961.) It was the duty of the receivers to pay off or retire all of the obligations of the banks, including the bonds which had been issued, and they did so, during the taxable years, through dividends, “distributed” — in the language of the receiver’s letter — “without preference or distinction as to series or maturities of bonds or preference as to principal and interest out of proceeds of pledged assets on the basis of all outstanding bonds with unmatured interest accrued thereon, at the rates carried by the several issues of bonds, up to and including [in connection with the Chicago bonds] September 30, 1932.”

It is obvious that the receivers were retiring the bonds as rapidly as possible. 203/290 of the face amount of the bonds owned by petitioner was paid to him. In “common speech” the bonds were partially retired. The statute (sec. 117 (f), supra) does not require that the bonds be wholly retired. “Amounts received by the holder upon the retirement of bonds * * * shall be considered as amounts received in exchange therefor.” Being of the opinion that the stipulated amounts were received by this petitioner “upon the retirement” of his bonds, we hold that the gains realized by him are to be taxed as capital gains.

Petitioner’s third contention is unsound. This issue involves only the Chicago bonds, having an aggregate par value of $290,000, which petitioner purchased on January 21, 1933. The bonds which he owned while the interest was accruing — $25,000 face amount purchased December 14, 1925 — and the interest thereon are not in dispute. The pertinent facts, it will be recalled, are: Bonds of the par value of $290,000, having accrued interest amounting to $6,227.12, were purchased by him on January 21, 1933, at a total cost of $58,100. During the taxable years he received payments aggregating $207,358.98, $203,000 of which the receiver allocated to principal and $4,358.98 of which he allocated to the accrued interest.

It is immaterial that the receiver allocated a portion of the amount to interest. It was not interest to petitioner but a gain upon his capital investment. Cf. Erskine Hewitt, 30 B. T. A. 962; Drier v. Helvering, 72 Fed. (2d) 76; L. A. Thomson Scenic Railway Co., 9 B. T. A. 1203; Harr v. MacLaughlin, 20 Fed. Supp. 27; affd., 99 Fed. (2d) 638. In other words, petitioner invested $58,100 in bonds and matured interest and received during the taxable years the whole of his investment and a profit of $149,258.98. The gain is includable in his gross income. United States v. Stewart, supra.

The stipulation states that on July 17, 1939, petitioner paid the collector $23,000 on account of the deficiencies and that said sum was assessed by the Commissioner. The notice of the deficiencies was mailed on January 31, 1939. It, as pointed out in the opening paragraph of this opinion, shows an overassessment of $2,330.78 for the year 1934. Appropriate adjustments will no doubt be agreed upon by the parties in recomputing the deficiencies in accordance with the views herein expressed.

Decision will be entered under Rule 50.


author: Mellott :

text:
    Charles N. Spratt, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97917.
    Promulgated January 31, 1941.

      Philip Neville, Esq., for the petitioner.
    Z. W. Shaw, Esq., for the respondent.
   OPINION.

Mellott :

The issues as set out at the beginning will be considered in the order stated.

Issue No. 1.

Petitioner contends that the preferred shares or trust certificates of Building Number One Trust were legally and in effect a mortgage, and that, following well recognized principles, upon foreclosure (or in lieu thereof a deed from the mortgagor to the mortgagee) he is entitled to deduct the loss sustained ($10,757.17) in computing his net income for 1936; that Minnesota law clearly holds such a trust to be a mortgage; that the law as enunciated by the courts of Minnesota is controlling in this proceeding; and that the initial acquisition of the preferred shares can not be said to constitute a capital investment because all that petitioner did was to lend money and receive security therefor which he subsequently had to foreclose and ripen into title in himself.

Respondent contends that no loss whatsoever is allowable for the reason that at all times after 1927 petitioner was the owner of a beneficial interest in the trust property and no identifiable event occurred with respect thereto in 1936 which could serve as the foundation for a loss; that the record fails to show the necessary facts with respect to computation of the alleged loss; that the proof with respect to value of the property conveyed to petitioner in 1936 was inadequate; and, in the alternative, if petitioner suffered any loss in 1936, it must be treated as a capital loss on the ground: (1) That the so-called trust was in reality an association to be treated under the revenue acts as a corporation and the property received by petitioner was a distribution in complete liquidation; or (2) the transaction whereby petitioner acquired the property in 1936 constituted a sale or exchange within the meaning of section 117 of the Revenue Act of 1936.

In support of his contention that the preferred shares or trust certificates were legally and in effect a mortgage, petitioner points to the definition of that term contained in Buse v. Page, 32 Minn. 111; 19 N. W. 736. In that case the Supreme Court of Minnesota defined a mortgage to be a “conveyance of real estate, or some interest therein, defeasible upon the payment of money or the performance of some other condition.” The court also stated, however, that, in considering whether or not a transaction is a mortgage, the important question is, What was the intention of the parties ?; and the intention is to be ascertained by looking at the written memorials of the transaction and its attendant facts and circumstances.

For the $40,500 which petitioner invested in Building Number One Trust, he received all of its preferred shares and 45 percent of its common shares. These shares were in the usual form of certificates of interest in a land trust. One of the certificates for preferred shares introduced in evidence is headed “Land Trust Certificate of Equitable Ownership in Real Estate — The Building Number One Trust.” It certifies that the petitioner is the owner of preferred shares of beneficial interest of the par value of $100 each, transferable only on the books of the trustees upon surrender of the certificate properly endorsed. It also contains a statement to the effect that the preferences and rights of the various classes of shares are set forth in the trust agreement, the material portions of which are printed on the back of the certificate.

The trust agreement provided that the holders of the preferred shares should receive 7 percent cumulative annual dividends; that these dividends should be paid from net earnings after payment of expenses and principal and interest on the first mortgage; and that any net earnings remaining should be used to retire the preferred shares outstanding. The preferred shares contained no fixed obligation or agreement on the part of the trust to retire them or return to the owner or owners, at a specified time, his or their capital investment.

Petitioner devotes much argument on brief to the proposition that Federal courts are bound by state rules of law in determining whether or not a trust is a mortgage and that in Minnesota a mortgage may be in the form of a trust deed. We do not question the soundness of this argument, but it seems to have no application here. Before the rule petitioner seeks to apply can be applicable, the intention to create a mortgage must be proved by clear and convincing evidence. Bernard Long, 1 B. T. A. 792, 794; Federal Land Bank of St. Paul v. Smaagaard, 192 Minn. 21; 256 N. W. 102. The evidence introduced by petitioner fails to disclose any such intention here. On the contrary, it discloses an intention to create a relationship analogous to that which exists between a corporation and its preferred shareholders. The interest petitioner acquired was called a “share”, and the return which he was to receive a “dividend.” While these appellations are not decisive, they can not be lightly ignored in determining the nature of the transaction. Kentucky River Coal Corporation, 3 B. T. A. 644, 649; Greensboro News Co., 31 B. T. A. 812. Other indications that a shareholder relationship rather than that of debtor-creditor was intended are the provisions for payment of dividends out of net earnings, and the absence of a fixed maturity date for the retirement or repayment of the principal sum. United States v. South Georgia Railway Co., 107 Fed. (2d) 3; Haffenreffer Brewing Co., 41 B. T. A. 443 (C. C. A., 1st Cir.); William Cluff Co., 7 B. T. A. 662, 669. It is apparent petitioner made a capital investment and acquired an ownership-beneficiary interest in Building Number One Trust, and we so hold. Any loss sustained by him in 1936 is not, therefore, deductible as a bad debt.

There remain for consideration the contentions of respondent (1) that petitioner is entitled to no deduction whatsoever with respect to the building trust and (2) that, if he suffered a loss in 1936, it was subject to the limitations of section 117 of the Bevenue Act of 1936. These contentions will be considered together.

Bespondent’s argument in support of his contention that no deduction should be allowed may be briefly summarized. He says: Building Number One Trust owned one specific property; petitioner as the owner of all the preferred shares was the sole beneficiary thereof until these shares were fully retired, which never happened; and the mere conversion of his equitable interest in the property into a legal interest in 1936, when the legal title was conveyed to him, did not constitute such an event as to result in a deductible loss of any kind to petitioner. In this connection he relies upon certain obiter dictum contained in a decision rendered by the Circuit Court of Appeals for the Second Circuit in Allen v. Commissioner, 49 Fed. (2d) 716.

In the Allen case, the court held that one of several beneficiaries of a trust, the purpose of which was to secure a new bank against unknown debts of a merged institution, was taxable on the gain resulting from a distribution to him by the trust of his pro rata share of certain securities. The court stated that the question whether gain or loss should or should not be recognized on such a transaction depended upon whether the distribution effected a substantial change in the beneficiaries’ interest, and, if the change was enough to justify saying that they received new property for their former rights, then there was taxable profit, even though strictly the transaction were not an exchange under section 202 (c) of the Revenue Act of 1921. While holding that there was a sufficient change in that case, the court said:

It does not follow that the same would he true generally, as for example in the ordinary case of a trust of land, of one or of several parcels, for the benefit of a single cestui que trust or of voting trusts of corporate shares, where the res is a mass of fungibles to be returned in kind upon dissolution, or of similar transactions. The result may well vary with the relation of the beneficiaries to the fund while the trust is being administered. In any event we have to decide no more than the case before us.

In our opinion the quoted language is not authority for holding that the distribution to the petitioner of the corpus of Building Number One Trust did not effect such a substantial change in his interest as to warrant the recognition of gain or loss for tax purposes. Petitioner made an investment of $40,500 in preferred and common shares of the trust, which entitled him to receive all of the dividends on preferred shares until they had been retired at par and thereafter to receive his proportionate share of any dividend distributions on common shares. His right to receive the trust corpus as the owner of all the preferred shares was dependent upon the happening of a condition subsequent, viz., the failure of the trust to pay dividends on its preferred shares over a period of 18 months. This event occurred in 1936 and the trust property was transferred to him in that year, free of all claims of the holder of a majority of the common shares to share in its earnings and in the proceeds of the sale of the property upon the termination of the trust. Then for the first time he was free to exercise the complete dominion and control over the property which until then could be exercised only by the trustees. There was, therefore, a substantial change in his interest in the property and any gain or loss resulting from this change should be recognized for tax purposes.

Although the respondent urges on brief that petitioner has not proved the amount of the loss sustained by him in 1936, we are satisfied that he has done so. Petitioner paid $40,500 for all of the preferred shares and a minority interest in the common shares of Building Number One Trust. It is true, as respondent points out, that a portion of petitioner’s cost was allocable to the common shares (Cyrus S. Eaton, 37 B. T. A. 715, 718; Collin v. Commissioner, 32 Fed. (2d) 753), and that petitioner did not prove the amount allo-cable to them. This failure of proof is not fatal, however, since it is apparent from the evidence that the common shares did not become worthless until the trust had been in default in the payment of dividends on its preferred shares for a period of 18 months. This occurred in 1936, and the loss sustained by petitioner in that year on his investment in both preferred and common shares is the difference between the value of the property transferred to him (less the amount of the outstanding first mortgage) and his investment of $40,500 reduced by payments of $16,492.83 theretofore received in retirement of a portion of the preferred shares. When computed in this manner, the loss sustained is $10,757.17, the amount used by the respondent in determining the deficiency.

The remaining question is whether the loss sustained by petitioner is deductible in its entirety as an ordinary loss, or whether the deduction is limited by the provisions of section 117 of the Revenue Act of 1936, relating to losses sustained in connection with the sale or exchange of capital assets.

Both parties agree that Building Number One Trust was an association. We see no reason for holding to the contrary. Morrissey v. Commissioner, 296 U. S. 344; Swanson v. Commissioner, 296 U. S. 362 (in which a trust to operate a single building was involved); Helvering v. Coleman-Gilbert Associates, 296 U. S. 369; Helvering v. Combs, 296 U. S. 365; Solomon v. Commissioner, 89 Fed. (2d) 569. Section 1001 (a) (2) of the Revenue Act of 1936 provides that such associations shall be treated for tax purposes as though they were corporations. On December 4, 1936, petitioner, as holder of all of the preferred shares of the trust, received all of its property in accordance with the provision in the preferred share certificates that such a distribution should be made if there was a failure to pay dividends on such shares for a period of 18 months. Fiad such a distribution been made by a corporation it would be treated as a distribution in complete liquidation. When made by an association it must be accorded similar treatment. Tyrrell v. Commissioner, 91 Fed. (2d) 500. Section 115 (c) of the Revenue Act of 1936 provides that gain or loss is to be recognized with respect to amounts received in complete liquidation of corporations, and that such amounts are to be treated as in full payment “in exchange for the stock.” Section 117 (a) of the Revenue Act of 1936 provides that “upon the sale or exchange of a capital asset” held by a taxpayer for more than 5 years but not for more than 10 years only 40 percent of any loss sustained shall be taken into consideration in computing net income. The shares of Building Number One Trust were a capital asset held by petitioner for approximately 9 years. He is therefore entitled to deduct 40 percent of the loss sustained by him in 1936, in computing his net income for that year, as the respondent originally determined, and we so hold.

Issue No. £.

Section 23 (j) of the Revenue Act of 1934 provides that in computing net income there shall ibe allowed as deductions “Debts ascertained to be worthless and charged off within the taxable year.”

In support of his contention that the $1,500 due on the Breen note should be allowed as a bad debt deduction in computing his net income for 1935, petitioner urges that he kept no regular set of books; that he mentally charged off the debt when it became outlawed in 1935; that he failed to deduct it in his return for that year because he was showing no tax due anyway; and that under certain decisions of the courts and this Board he is entitled to the claimed deduction.

The statute gives him no right to make a mere “mental” charge-off. In some cases it has been held that the second portion of the statute has been sufficiently complied with where it is shown that a taxpayer, keeping no books of account, deducted the amount of his alleged bad debt in a return, timely filed. William H. Redfield, 34 B. T. A. 961; Estate of C. T. Grant, 36 B. T. A. 1233. In another line of cases it had been held that, where a “charge-off” was made during the taxable year, the petitioner’s right to take the deduction may be litigated in a proceeding involving the year the charge-off was made, even though no deduction was claimed in the return. Estate of Henry N. Brawner, Jr., 36 B. T. A. 884; Peters v. United States, 10 Fed. Supp. 145. This petitioner would have us extend the doctrine of the cited cases to hold that a deduction may be allowed if a taxpayer ascertains a debt to be worthless, though he makes no attempt to make a charge-off within the taxable year or when he files his return and postpones making any attempt to deduct it until the Commissioner, three years later, determines a deficiency against him; but we do not believe that the doctrine should be so extended.

Even if petitioner’s belated claim should, under the rationale of William H. Redfield, supra, be held to be a sufficient charge-off, petitioner has not proved to our satisfaction that there was an ascertainment of worthlessness within the purview of the statute. After stating that Breen had severed his connection with the Bridger bank in 1930 or 1931, and thereafter was engaged in managing farm properties, petitioner testified on cross-examination as follows:

Q During that period after he severed his connection with the bank, from 1930 or 1931, his financial condition remained approximately the same until 1938, did it not, as far as you know?
A Well, I don’t know about that, what his financial condition was.
Q Did you make any effort during that period to find out what his financial condition was?
A I wrote him many times what he was going to do about his note, and he said he was out of a job and had a family to support. He had some prospects in land of striking oil, and he hoped to pay it.
Q You had written him inquiring a number of times during those years from 1930, say to 1933, had you not?
A Yes.
Q And each time you received the same reply to the effect you just stated?
A Yes, his condition stayed the same.

Petitioner also testified that nothing was paid on the note, and that he consulted an attorney concerning the commencement of a suit “along about in 1935 before the note became outlawed.” The attorney advised against any suit “because most people after 1929 had very little left to pay any notes, especially Breen”, and no suit was ever instituted on the note.

A taxpayer must exhaust all the usual and reasonable means of collecting a debt before there can be an ascertainment of worthlessness. Petitioner took no action to collect the debt other than an occasional letter asking Breen what he was going to do about the note. While legal action is not always necessary to prove that a debt is worthless, in the absence of such action it must appear from the surrounding circumstances that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment. Petitioner admits that he knew very little about the financial condition of Breen, other than the statements contained in his letters. These statements do not convince us that the debt became worthless or uncollectible in 1935. According to petitioner’s testimony the conditions and prospects for payment were no poorer in that year than they had been for several years prior thereto. Breen always indicated his willingness to pay the debt as soon as he was in a position to do so. The only change in the situation in 1935 appears to have been the running of the statute of limitations. This Board has repeatedly held that the availability of such a defense to a debtor is not a sufficient ascertainment of worthlessness to justify a charge-off of a note or other debt. Leo Stein, 4 B. T. A. 1016; Ralph H. Cross, 20 B. T. A. 929; affd., 54 Fed. (2d) 781. In our opinion there was no ascertainment by the petitioner of the worthlessness of the Breen note in 1935. It follows that the claimed deduction may not be allowed.

Issue No. 3.

At the hearing petitioner was permitted to introduce in evidence, over the objection of the respondent, two pages from “Moody’s Manual of Investments” for the year 1936. One of these sheets contained the following statement of the assets and liabilities of the Central Public Utility Corporation as of December 31,1935:

Notes immediately following the balance sheet state that the Central Public Utility Corporation owned all of the outstanding common and class A stock and 74,493 shares of $5 preferred stock of the Consolidated Electric & Gas Co.; that the value at which the class A and preferred stock are carried on the balance sheet, $49,197,501, is $40',268,201.49 in excess of the par or stated values on the books of Consolidated Electric & Gas Co.; and that no provision has been made in the balance sheet for accrued interest on 5% percent income bonds of the Central Public Utility Corporation, which interest is cumulative from date of issue (in most instances, Aug. 1, 1932) and is payable upon maturity of the principal of the bonds if unpaid prior thereto.

Section 23 (k) of the Revenue Act of 1934 provides that “when -satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.” The Commissioner was not satisfied that the bonds owned by petitioner were worthless to the extent claimed in his return for 1935, and the question presented for our determination is “whether the evidence is sufficiently strong to require a holding that he reasonably should have been so satisfied.” Bing & Bing, Inc., 35 B. T. A. 1170, 1177. We do not think it is. There is no evidence as to the market value of the bonds of the Central Public Utility Corporation as of December 31, 1935. In support of bis contention that the bonds had little value on that date, petitioner attempted to prove that the principal asset of the corporation, the stock of the Consolidated Electric & Gas Co., was practically worthless. One witness for petitioner, a broker, testified that the stock was practically worthless on December 31, 1935, and based his opinion upon a statement to that effect in one of the investment services of which he was a subscriber. The only other evidence on this point is the statement in Moody’s Manual, heretofore mentioned, that the class A and preferred stock of the Consolidated Electric & Gas Co. was carried on the balance sheet of the Central Public Utility Corporation at a figure of $40,268,201.49 in excess of the par or stated values on the books of Consolidated Electric & Gas Co.

The value of the assets of the Central Public Utility Corporation can not be determined from the testimony of petitioner’s witness or from the statement contained in Moody’s Manual. For aught that may be gleaned from the evidence, the stock of the Consolidated Electric & Gas Co. as of December 31, 1935, had a value greatly in excess of the par or stated values at which it was carried on the books of the issuing corporation. We are not convinced, therefore, that petitioner ascertained in 1935 that the financial condition of the Central Public Utility Corporation was such that he would recover on the maturity of its bonds only a part of the debt evidenced by them. It is our conclusion that the respondent’s action in disallowing a deduction based upon the partial worthlessness of the bonds was not unreasonable, and this issue must be decided against the petitioner. Cf. Ruth Wight Bill, 38 B. T. A. 196; Securities Allied Corporation v. Commissioner, 95 Fed. (2d) 384, 386; certiorari denied, 305 U. S. 617.

Finding no error in the deficiencies originally determined by the respondent, we decline to increase or decrease them.

Judgment that there is a deficiency m the amoimt of $668.16 for 1935 cmd $506.99 for 1936 will he entered.


author: Steenhagen :

text:
    Bethlehem Silk Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 103861.
    Promulgated January 31, 1941.

      Sidney J. Schwartz, Esq., for the petitioner.

      Brooles Fullerton, Esq., for the respondent.
   OPINION.

Steenhagen :

The Commissioner determined deficiencies of $6,169.98, $5,589.42, and $2,852.64 in petitioner’s income taxes for 1936, 1937, and 1938, respectively. The petitioner bases a claim for credit on an alleged contract prohibiting dividends, and the question narrows down to whether a written contract was executed prior to May 1,1936, as section 26 (c) (1) requires. The facts are not in dispute.

After making application for a loan, petitioner received a letter from the Federal Reserve Bank of Philadelphia, dated March 25, 1936, advising that the bank had approved a loan of $37,500, subject to eleven conditions. One condition was that no dividends should be paid until the loan was paid in full. Other conditions required petitioner to secure the loan by a mortgage on its real estate, plant, and equipment; to procure from another bank a new mortgage loan with a maturity beyond the period of this loan, and to liquidate a certain claim.

It is understood that this approval shall not he considered as binding on this bank until all papers necessary to complete this loan shall have been executed hy you, delivered to and finally approved and accepted by this bank.

By letter dated March 27, 1936, petitioner advised the bank “that we accept this loan under all the conditions mentioned in your letter of approval.” The conditions were met after May 1, 1936; the mortgage was executed and delivered to the bank; the final papers were approved, and the amount of the loan was received by petitioner on June 5,1936. The loan has not yet been repaid.

The petitioner contends that the letters of March 25, 1936, and March 27, 1936, constitute the prohibitory contract which the statute requires. This contention must be rejected. The letters placed no enforceable duty on petitioner to refrain from distributing a dividend. They served only as an admonition to petitioner that if it exercised its right to pay a dividend, no contract would be executed and no loan made. If the loan had been tendered by the bank before May 1, petitioner would have been entitled to refuse it, just as it was entitled to pay a dividend if it chose. The bank had no remedy if the petitioner failed to go forward with the necessary acts preliminary to the execution of the written contract. The bank made a conditional promise to execute a loan agreement if it approved the papers. This promise it fulfilled; but not until June, 1936, when the contract was executed whereby the petitioner was bound to pay no dividends.

The petitioner’s letter of acceptance of March 27, 1936, can not be regarded as the execution of the prohibitory contract, for the bank had expressly stated that its approval of the loan would not be binding until the papers were executed, approved, and accepted by it. Petitioner could not, in the face of this, make the contract nevertheless binding by its letter of acceptance, even though the bank had asked for a written acceptance of the conditions.

The prohibition against paying dividends was not operative until June 1936, and not until then could a dividend have been regarded as in violation of a contract. The contract was not executed before May 1,1936. The credit was properly denied.

Decision will be entered for the respondent.


author: Sternhagen :

text:
    Guanacevi Mining Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 99764, 101902, 102712.
    Promulgated February 4, 1941.

      Nathan Moran, Esq., for the petitioner.

      E. A. Tonjes, Esq., for the respondent.
   OPINION.

Sternhagen :

1. On its income tax returns for 1935, 1936, and 1937 petitioner claimed as deductible mining expense $27,027.11, $31,971.93, and $34,936.20, respectively, representing an apportionment of its expenditures for mill, tunnels, and operating devices based on the amount of ore extracted in each year. The Commissioner disallowed these deductions on the ground that the expenditures “should be capitalized and recovered through deduction for depletion.”

The petitioner treats the tunnels, mill, and equipment as if they were facilities acquired during normal production for the purpose of maintaining operations at normal production and did not increase the efficiency of operation or add to the value of the property. Upon that postulate the cost of the facilities would be brought within the doctrine of United States v. Roden Coal Co., 39 Fed. (2d) 425; Marsh Fork Coal Co. v. Lucas, 42 Fed. (2d) 83; Commissioner v. Brier Hill Collieries, 50 Fed. (2d) 777, and deductible as expense. The postulate is contrary to the evidence. The ore which was available for extraction by the primitive method had been practically exhausted in 1929, and petitioner terminated the lease in 1931. The survey was made to ascertain whether a new start by a different method was worth trying. The new cost was not to maintain production by continuing existing methods, but to institute a new method and provide for new production. In practical effect it was an investment in a new mining venture with a new period of development. It was not unlike the opening of a newly discovered mine. The expenditure was therefore a capital investment and not an ordinary and necessary expense of operation. See Blockton Cahaba Coal Co. v. Commissioner, 24 Fed. (2d) 180; Enterprise Coal Co. v. Phillips, 12 Fed. Supp. 49; affd., 84 Fed. (2d) 565; W. M. Ritter Lumber Co., 30 B. T. A. 231, 272; Rainbow Gasoline Corporation, 31 B. T. A. 1050, 1057. To one using the percentage method of depletion, the cost was recoverable through depletion out of income from the property.

The disallowance of the deduction as deferred expense of any part of such expenditures in the taxable years is sustained.

2. In computing the deduction for percentage depletion based on the net income from the property, the Commissioner treated the interest paid by petitioner on its borrowings as an expense of mining operations, thereby reducing the basic net income. Petitioner contests this reduction. The contention was considered in Mirabel Quicksilver Co., 41 B. T. A. 401, and St. Marys Oil & Gas Co., 42 B. T. A. 270, and the taxpayer’s position was rejected. The Commissioner’s determination is sustained.

3. Petitioner claims a credit because it was forbidden by the California Code to pay a dividend. The contention is contrary to Helvering v. Northwest Steel Rolling Mills, Inc., 311 U. S. 46; Crane-Johnson Co. v. Helvering, 311 U. S. 54, and Belle-Vue Manufacturing Co., 43 B. T. A. 12, and the Commissioner’s determination is sustained.

Other matters have been settled by the parties and will be reflected in the computation of the redetermined deficiency.

Decision will be entered under Rule 50.