text:
    Brea Canon Oil Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 42487, 48028, 55079, 61415, 71291.
    Promulgated February 20, 1934.

      George H. Rosier, Esq., for the petitioner.

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

Lansdon:

The respondent has determined deficiencies for the years 1926, 1927, 1928, 1929, and 1930 in the respective amounts of $7,294.79, $12,688.46, $7,890.69, $5,084.49, and $6,945.08, or a total of $39,906.51. Two issues are pleaded in the amended petition: (1) whether depletion is allowable at the rate of 27½ percent on the total gross income realized from the sale of gasoline extracted from casing head gas produced by the petitioner from its own wells, and (2) the correct depreciation deduction on account of wear and tear of physical assets owned by the petitioner and used in its business in the taxable year. The several proceedings were consolidated for hearing and report. Except an affidavit received in evidence by agreement of the parties, the facts have been stipulated as follows:

The petitioner is a corporation organized under the laws of the State of California with principal office at Los Angeles, California. It has filed its income tax returns for all years involved in this proceeding at the office of the Collector of Internal Revenue at Los Angeles, California.
The Commissioner of Internal Revenue has understated depreciation allowances to which petitioner is entitled for 1926 to 1929, inclusive, in the respective amounts of $9,803.37, $9,078.62, $8,927.19 and $3,515.20, and the taxable net income for each of said years, as shown by the deficiency letters attached to the petitions filed by the petitioner in these proceedings, should be reduced by the amount of the additional depreciation allowable for each of the years respectively, as above stated.
Should the Board find that petitioner is entitled to include its entire income from gasoline sales to determine gross income for percentage depletion purposes, the correct depletion deduction for each of the years involved in this proceeding is as follows: 1926, $402,712.94; 1927, $440,649.28; 1928, $271,540.00; 1929, $222,513.31; and 1930, $296,550.35.
Should the Board find that petitioner is not entitled to include income arising as a result of the processing of casing head gasoline amounting to sixty percent of income from gasoline sales, to determine gross income for percentage depletion purposes, the depletion deduction for each of the years involved in this proceeding is as follows: 1926, $365,587.72; 1927, $365.004.21; 1928, $201,608.26; 1929, $173,026.37; and 1930, $240,538.31.
All gasoline sold by the petitioner during the years 1926, 1927, 1928, 1929 and 1930 was extracted from casing head gas produced from the petitioner’s own oil and gas wells from its own oil and gas properties located in Orange County, State of California.

By stipulation, at tbe bearing tbe affidavit of Roger F. White was admitted in evidence. White was graduated from the Colorado School of Mines in 1918, with the degree of Engineer of Mines. He was in the service of the Bureau of Internal Revenue for three years as a petroleum valuation engineer and for a time was assistant chief of the engineering section thereof, and for the eight years last preceding the hearing he practiced his profession in Los Angeles as consulting engineer, specializing in the appraisal of oil and gas properties and the preparation of geological reports concerning such properties proven and prospected. In his statement agreeing that the White affidavit should be admitted in evidence, counsel for the petitioner expressly said that he was stipulating only that, if present the affiant would testify as in the affidavit. So far as material to the issue here the testimony thus adduced was as follows:

In tbe majority of oil fields of California, the producing zones consist of alternate sedimentary beds of sands, shales and sandy shales which are often hundreds of feet in thickness and which contain an intimate mixture of oil, gas and gasoline, as well as other hydrocarbon substances.
The principal products of a typical California oil well are oil and wet gas and in their natural state, that is, before disturbance by drilling, these products are so thoroughly mixed that they may be considered to be one homogenous substance since they are hydrocarbons of similar chemical and physical characteristics. The most variable characteristic is volatility which is greatly affected by heat and pressure changes. The most volatile constituent is so-called wet gas which is in a large part dissolved in the oil until the body is disturbed by the drilling.
When a well is drilled into the oil zone an outlet or source of escape is provided which releases the pressure and causes the more volatile gases, known as casing head gas, or wet gas — a mixture of gasoline and gas, to pass off. Great quantities of dry gas and gasoline remain in the petroleum or oil which comes to the surface as a fluid and can be obtained by the simple process of heating. Indeed, if allowed to stand in an open tank, a portion of the more volatile substance will evaporate, leaving a residue oil of lesser specific gravity and leaner in gasoline content. In other words, the physical state of the substance depends entirely upon the condition of heat and pressure and if the gas is compressed, it will revert to the liquid form. A typical California oil well produces crude oil as a fluid and wet gas, a mixture of vapor and gas.
The casing head gas, by compression and absorption, is separated into a liquid known as gasoline and a gas known as dry gas. This gasoline is very volatile. It partakes of the nature of a very high gravity oil and will evaporate rapidly if not confined.

In the computation of its depletion deductions for each of the years under review, the petitioner has included the gross income from its sale of gasoline extracted from casing head gas produced from its own oil and gas properties as a part of its gross income from such properties. The respondent has held in effect that the gasoline sold, by petitioner is a finished product manufactured from raw material, that not more than 40 percent of the proceeds from the sale of such produce should be regarded as income from the gas and oil properties, and that as much as 60 percent of such income is realized from manufacturing or processing operations.

Depletion of natural mineral resources is a statutory concept that was not recognized in the Excise Act passed by Congress in 1909. Up to that time and under that act all the proceeds derived from the exploitation of a natural resource reserve were regarded as income, reducible only by the costs of operation and by a reasonable allowance for the depreciation of the physical property used in the recovery of the ores. Stratton's Independence, Ltd. v. Howbert, 231 U.S. 399. This harsh rule was afterwards abrogated.

Under the provisions of all the revenue acts from 1913 to 1932, inclusive, a reasonable deduction on account of depletion of a natural resource is allowed to a taxpayer in proportion to his interest therein. In each of such acts the provision is either a part of or closely related to that section of the law which authorizes depreciation deductions on account of the wear and tear or exhaustion of properties owned by a taxpayer and used in his trade or business for the production of income. It is well established that allowances for depreciation are based upon the principle that a taxpayer is entitled to tax-free recovery of his capital investment in wasting assets used in his trade or business. There can be no question that allowances for depletion of natural resources were originally based on the same principle. Ludey v. United States, 274 U.S. 295. They continue to be so regarded except as to oil and gas reserves. Congress expressly recognized this principle in section 5 (a) (8) of the Revenue Act of 1916 by providing that when allowances for depletion equaled cost or value at March 1, 1913, no further deductions would be allowed.

For many years allowances for depletion were based universally on the taxpayer’s capital cost of his mineral reserves and in such years it was not questioned that the purpose thereof was the return of capital investment tax-free. The first departure from this rule appeared in the Revenue Act of 1919, in which the concept of discovery value was included and defined. Depletion on such' value instead of cost applied to mines and oil and gas properties and was intended to encourage the exploration and development of new fields, a type of business adventure that is highly hazardous financially and extremely expensive. In this new concept the element of reasonableness was retained, but expanded to include a reasonable reward for the risks taken in developing new areas of production.

In all the revenue acts up to 1926 the reasonable allowance for depletion was computed on the basis of the cost of an. estimated volume of the reserve at date of purchase or of value at March 1, 1913. The element of discovery value introduced into the Act of 1919 required additional estimates and approximations, including the fair market value of the property at or within 30 days of discovery, but even then there was no complete departure from the principle that depletion is allowable to permit the tax-free return of capital investment in an exhaustible asset.

It is obvious that under the pertinent provisions of all revenue acts from 1913 to 1924, inclusive, the computation of a reasonable allowance for depletion involved many difficulties, such as estimates of the volume of depletable reserve at date of acquisition and, after 1919, proof of market value at or within 30 days of discovery. Probably solely for the purpose of simplifying the computation of such allowances the Act of 1926 provides at section 204 (c) (2) for annual depletion deductions from income produced from oil and gas properties only, to be measured by 27½ percent of the gross income therefrom, with certain limitations as to the amounts thereof based on a percentage of the net income from the property, which we may presume were added to bring the new rule within reason.

In many producing areas, among other products from oil wells, are great volumes of wet gas, now commonly called casing head gas, which by fairly simple processing may be converted into a high grade of commercial gasoline. This product is usually disposed of by the owner of producing properties through a contract of sale, sometimes called a lease, under which the purchaser or lessee agrees to buy the wet gas at the mouth of the well and pay the seller an agreed rate per 1,000 cubic feet. The purchaser transfers the gas from the well through pipe lines installed at his own cost to his plant where the gasoline is extracted and sold. After a time the processors of wet gas began to claim depletion deductions on the income realized from casing head contracts. The Commissioner denied such claims and the question finally came to the Board.

In Una Gasoline Co., 22 B.T.A. 45, we held that casing head gas as it emerges from the well is the personal property of the owner of the producing property and that any allowable deduction from income realized under contracts for its purchase should be regarded as representing the exhaustion of the cost of such contracts and depreciation of the tangible assets used in the conversion process. The Commissioner acquiesced in that decision and no appeal was taken therefrom by either party. In Signal Gasoline Corp., 25 B.T.A. 861, the petitioner claimed depletion deductions from income realized under casing head gas contracts in the amount of 27½ percent of the gross income therefrom. Our decision was adverse to the taxpayer, on the theory that a contract to buy casing head gas is no more than an agreement to purchase personal property as and when delivered by the producer and that the owner of such a contract therefore has no depletable interest in oil and gas property. Upon appeal to the United States Circuit Court of Appeals for the Ninth Circuit, that tribunal, in Signal Gasoline Corp. v. Commissioner, 66 Fed. (2d) 886, reversed this Board upon the authority of Palmer v. Bender, 287 U.S. 551, and held that the owner of a contract to buy casing head gas has a depletable interest in the producing property.

In this proceeding there is no question as to the petitioner’s right to depletion deductions from the income realized in the recovery of casing head gas from the reserves thereof which it owns. The computation of such allowance must be made under the provisions of section 204 (c) (2) of the Revenue Act of 1926 and must give full effect to the restrictions which Congress included therein, presumably for the purpose of preserving some meaning for the word reasonableness ” used in section 214 (a) (9) of the same act. Such restrictions are (1) that the basis to which the percentage is to be applied must be gross income from the property; (2) the deduction must not exceed 27½ percent of such basis; (3) that it must not be in excess of 50 percent of the net income from the property computed without allowance of any depletion; and (4) that it must in no case be less than it would be if computed without reference lo section 204 (c) (2) of the Revenue Act of 1926.

The petitioner contends that the gross income from its casing head gas operations is the total amount of its receipts from sales of gasoline produced in its processing plant, and is the basis to which 27½ percent should be applied in the first step in the computation of the depletion allowances to which it is entitled. It relies largely on the testimony of the witness, White, which, reduced to its simplest form, is that the output of an oil well contains casing head gasoline and that processing the wet gas is no more than a mere separation and should not be regarded as a processing or manufacturing operation. He likens what he calls separation to the washing of crude oil for the purpose of removing water, dirt, and other foreign substances from the natural product and from such analogy argues that nothing new results from the processing of the wet gas into commercial gasoline.

The argument of petitioner’s counsel is quite plausible, but far from convincing. He might as well contend that if the depletion in question related to an iron mine, the owner of which operated his own smelting plant for the conversion of iron ore worth only a fraction of a cent a pound, into pig iron, worth much more, he would have the right to include his total sales of pig iron in computing gross income from the mine. If the same man owned and operated the facilities for converting pig iron into watch springs worth something like $17,000 per pound, by the same process of reasoning the sale of the finished product should be included in the gross income of the mine. Or, in this case, if in addition to its plant for processing wet gasoline the petitioner owned and operated all the necessary facilities for extracting gasoline, kerosene, and the multitude of other by-products from crude oil, he would argue that the combined receipts from the sale of all the petroleum derivatives should be included in computing gross income produced from its oil and gas properties. In each of these illustrations the finished product is in the raw material and the process of conversion is a change in form which involves the creation of nothing new. If the reasoning of counsel is carried to its logical conclusion, it means that no one using raw material produced from his own property is a manufacturer unless he creates a new natural element, a power which is commonly ascribed only to Omnipotence. If the contention of the petitioner is sustained, it is reasonable to assume that the hitherto separate activities of producing oil and gas, on the one hand, and the conversion thereof into finished products, on the other, will be merged by the entrance of all producers into the business of refining and processing of crude oil into finished commercial commodities, with the effect of indefinitely enlarging the basis for computing depletion deductions in the oil industry.

The extraction of casing head gasoline from wet gas may be a relatively simple process, but in our opinion it is, nevertheless, the conversion of raw material into a finished product and is manufacturing as that term is ordinarily understood. It requires a substantial investment in plant and equipment not in any way necessary to the production of oil and gas from the ground, as well as employment of much additional skilled and common labor. In New Orleans v. Ernest, 35 La. Ann. 746, it was held that millers who clean rice and prepare it for the market are manufacturers. The books are replete with decisions as to what constitutes manufacturing, which has been held to include such simple operations as the recovery of salt from water by evaporation, Salt Co. v. Guthrie, 35 Ohio St. 666; refining sugar, State v. American Sugar Repning Co. 108 La. Ann. 603; 32 So. 965; dyeing and bleaching cloth, Johnson v. Bleaching Co., 15 Gray, 216; drying and splitting kindling wood, People v. Roberts, 47 N.Y.S. 122; oil refining, Haws v. Petroleum Co., 101 Mass. 305; pork packing, Engle v. Sohm, 41 Ohio St. 691; splitting rough staves by hand, United States v. Ormsby, 4 Wall. 408; In re Chandler, Fed. Cases No. 2591. We conclude, therefore, that total gross receipts from the sale of casing head gasoline are income from manufacturing operations and that the fair market value of the wet gas at the well is the only part thereof that can be properly regarded as an element of the gross income from the petitioner’s oil and gas properties. Musselman v. Magnolia Petroleum Co., 231 Pac. 526; Pautler v. Franchot, 235 Pac. 209; Rains v. Kentucky Oil Co., 255 S.W. 121; Livingston Oil Corp. v. Waggoner, 273 S.W. 903.

In the circumstances herein the gasoline which the petitioner sells is produced in its processing plant from wet gas as a raw material. No part of that plant is property from which a natural resource is recovered. A very considerable percentage of the sales price of the commercial gasoline results .from operations within the plant. It is obvious, therefore, that much of the alleged basis for depletion in fact flows from the use of physical assets in a trade or business. That petitioner is entitled to depreciation deductions thereon is not open to question. It would appear, therefore, that the present claim for additional depletion allowances is one for increased depreciation deductions. The record shows that petitioner’s claims for additional depreciation have been settled by stipulation and are no longer at issue.

Petitioner contends that, as the owner of the property from which the wet gas is produced and of the plant in which such product is converted into commercial gasoline, it is in a stronger position than one who takes the natural product under a contract and converts the same in its separately owned and operated plant, as was the case in Signal Gasoline Corp., supra. This is true only as to its right to depletion deductions based on its income from oil and gas property, which is not in question here, and has no bearing on the correct method of computing such depletion allowances in conformity with section 204 (c) (2) of the Revenue Act of 1926, which is the only issue now under consideration. In the Signal Gasoline Gorp. case the court did not compute the allowance to which it held the taxpayer was entitled, nor even suggest a formula or rule for such computation. That case, therefore, established no rule governing the present controversy, which relates solely to the gross income realized from petitioner’s oil and gas producing property.

In this proceeding the respondent has determined that raw material cost of the wet gas is 40 percent of the receipts from the sale of the marketable gasoline extracted therefrom. In the absence of any proof of the actual fair market value of the petitioner’s casing head gas at the mouth of the well, this determination must be affirmed and the income in question computed with due regard to the limitations in section 204 (c) (2) of the Revenue Act of 1926.

The question of depreciation has been settled by stipulation, which should be made effective in the recomputation of the deficiencies in controversy.

Reviewed by the Board.

Decision will he entered wider Bule 50.

       (2) In the case of oil and gas wells the allowance for depletion shall be 27½ per centum of the gross Income from the property during the taxable year. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance be less than it would be if computed without reference to this paragraph.


source: Caselaw Access Project

author: Smith :

license: Public Domain

text:
    City Bank Farmers Trust Company, as Trustee under an Agreement with Gertrude Feldman James, Deceased, Dated February 21, 1930, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 72522.
    Promulgated February 21, 1934.

      Edward M. Cameron, Jr., Esq., and George II. Graven, Esq., for the petitioner.

      L. S. Pendleton, Esq., for the respondent.
   OPINION.

Smith :

This proceeding involves a deficiency in the estate tax of Gertrude Feldman James, deceased, in the amount of $11,840.03. The only question at issue is whether the value of certain securities which the petitioner conveyed in trust prior to her decease was a part of her gross estate for estate tax purposes.

The essential facts have been stipulated. The decedent died a nonresident of the United States on May 20, 1931. Prior to her death and by a certain agreement hearing date of February 21, 1930, she transferred certain securities, consisting principally of stocks and bonds, to the City Bank Farmers Trust Co., as trustee, for the uses and purposes as follows:

1. To hold, invest, reinvest and keep the said trust property invested during the lives of Veka Nanette James, daughter of the Settlor and of Samuel James, husband of the Settlor, and Peggy Florence James, daughter of the Settlor and of the said Samuel James, that is, until the death of the survivor of the said Veea Nanette James and Peggy Florence James, said period being hereinafter designated as the “ Trust Period ”; to collect the rents, issues, and profits thereof and to apply the income from said trust property to and for the use of the Settlor until her death or until the termination of the trust period, whichever event shall first occur, and upon and after the death of the Settlor prior to the termination of the trust period, to hold the said trust property and apply the income thereof as follows:
A. To apply the income thereof to the use of the said Samuel James, husband of the Settlor, if then living, until his death or until the termination of the trust period, whichever event shall first occur, or, if not then living, or upon his death prior to the termination of the trust period, to divide the principal into so many equal shares that there shall be one for each child of the Settlor and of the said Samuel James then living and one for the descendants then living of a deceased child of the Settlor and of the said Samuel James and to dispose of the income and principal of said shares as follows:
(a) To apply the income of each share held for a child of the Settlor and of the said Samuel James to the use of such child until his or her death or until the termination of the trust period, whichever event shall first occur, and upon his or her death prior to the termination of the Trust period, to pay over the principal of such share to such child’s descendants and in such proportions as such child may have appointed by will and to pay over any part not effectively so appointed in equal parts per stirpes to his or her descendants then living or if none, in equal parts per stirpes to the surviving children of the Settlor and of the said Samuel James and the descendants then living of a deceased child of the Settlor and of the said Samuel James or, if none be then living, to such persons as shall then constitute the heirs at law of the said Samuel James according to the laws of New York then governing the descent of real estate.
(b) To pay over the principal of a share set apart for the descendants of a deceased child, in equal parts per stirpes, to such descendants.
B. Upon the termination of the trust period, to pay over the principal of the trust fund to the said Samuel James, if then living, or if not, to the Settlor, if then living, or if not, to such beneficiaries as shall then be receiving income according to the provisions of paragraph 1. A. (a) hereof, and in the same proportions as provided therein for the distribution of income, or if no such beneficiaries be then living, then to such persons as shall then constitute the heirs at law of the said Samuel James according to the laws of New York then governing the descent of real estate.
*******
3. The Trustee may from time to time apply to the use of the Settlor’s said husband and descendants or any of them, so much of the principal of the trust as in its discretion it may deem advisable for their proper education, care, comfort, support or advancement in life.
* * * ⅜ * * *
12. The Settlor shall have the right, at any time, and from time to time during her life, by an instrument or instruments in writing delivered to the Trustee to modify, alter or revoke this agreement in whole or in part, or to change any beneficial interest hereunder, provided however, that no such revocation, alteration or change of beneficial interest shall be effected without the consent in writing of the Trustee and of the said Samuel James during his life and, after his death, of the Trustee and of Frank Samuel James, brother of the said Samuel James, during his life and in case of disagreement between the Settlor and the City Bank Farmers Trust Company, then the decision of the said Samuel James or Frank Samuel James, as the case may be, shall be final; and the Settlor reserves to herself the right to increase this trust by delivering property or making insurance policies payable to the Trustee for that purpose but the duties and liabilities of the trustee shall not be substantially increased without its written consent.

The respondent has determined, as stated in his deficiency notice, that the value of the property so conveyed in trust is includable in the decedent’s gross estate “ as coming within the purview of Section 302 (d) of the Revenue Act of 1926.” The pertinent provisions of section 302 read as follows:

Sec. 302. The value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated—
(d) To the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through .the exercise of a power, either by the decedent alone or in conjunction with any person, to alter, amend, or revoke * * *.

Under the terms of the trust instrument the decedent retained a power to alter or revoke the trust, but only with the written consent of the trustee and of her husband, Samuel James, if living, or, if deceased, his brother, Frank Samuel James. The Supreme Court has held, in Reinecke v. Northern Trust Co., 278 U.S. 339, that, where the grantor’s right to alter or revoke the trust can be exercised only with the consent of one having a beneficial interest therein, the gift is complete and the property is not taxable in the grantor’s estate for estate tax purposes. The Court there said:

* * * He could not effect any change in the beneficial interest in the trusts without the consent, in the case of four of the trusts, of the person entitled to that interest, and in the case of one trust without the consent of a majority of those so entitled. Since the power to revoke or alter was dependent on the consent of the one entitled to the beneficial, and consequently adverse, interest, the trust, for all practical purposes, had passed as completely from any control by decedent which might inure to his own benefit as if the gift had been absolute.

We have since held that Reinecke v. Northern Trust Co., supra, which arose under the Revenue Act of 1921, is controlling in cases arising under the Revenue Acts of 1924 and 1926 and that the language “ through the exercise of a power, either by the decedent alone or in conjunction with any person, to alter, amend, or revoke ” contained in section 302 (d) should be construed to mean “ any person not a beneficiary of the trust.” See Colonial Trust Co. et al., Executors, 22 B.T.A. 1377; Estate of Irving Lee Stone et al., Executors, 26 B.T.A. 1; Carl F. Holmes, 27 B.T.A. 660; David J. Lit et al., Executors, 28 B.T.A. 853, and cases therein cited. As to what constitutes a revocable trust under sections 166 and 167 of the Revenue Act of 1928, see Smith v. Commissioner, 59 Fed. (2d) 56; Bessie R. Jones, 27 B.T.A. 171; Iola Wise Stetson, 27 B.T.A. 173.

There can be no doubt that the decedent’s husband, Samuel James, was a beneficiary of the trust in question. After the death of the grantor he was to receive the income from the trust for life or for the remaining term of the trust. The facts are that the grantor died in 1931 and that Samuel James has since received and is still receiving the entire trust income. Under clause 3 of the trust agreement above shown the trustee was authorized to apply so much of the principal of the trust fund as it deemed advisable to his, Samuel J ames’, “ care, comfort, support or advancement in life.” Under clause B he was entitled upon the termination of the trust, if then living, to receive the entire principal of the trust fund.

It follows that the enjoyment of the trust property was not subject ■ at the time of the decedent’s death to any change through the exercise of any power to alter or revoke within the meaning of section 302 (d) of the act.

We are of the opinion that the respondent erred in including the value of the trust property under consideration in the decedent’s gross estate.

Reviewed by the Board.

Judgment will be entered for the petitioner.


author: Black: Seawele,

text:
    Arthur C. Stifel, Petitioner, v. Commissioner of Internal Revenue, Respondent. Edward W. Stifel, Petitioner, v. Commissioner of Internal Revenue, Respondent. Henry G. Stifel, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 60738-60740.
    Promulgated February 21, 1934.

      J. Robert Sherrod, Esq., for tlie petitioners.

      E. L. Corbin, Esq., for the respondent.
   OPINION.

Black:

Petitioners seek a redetermination of deficiencies in income tax for the calendar year 1928 in the respective amounts of $104, $466.30, and $458.71. Approximately $16,760 is in controversy, due to the contention of each petitioner that he has overpaid his tax liability for the year in question. The error assigned in each petition is identical and is as follows:

The Commissioner of Internal Revenue has erroneously included in net income distributions received by the petitioner from the J. L. Stifel & Sons Company in the amount of $42,268.21 for the year 1928, which amount was paid from capital of the corporation.

The proceedings were submitted upon the pleadings. The following summary of the facts alleged in the petitions and admitted by respondent in his answers will be sufficient for the purposes of this report.

Each petitioner is an individual, with his residence and place of business in Wheeling, West Virginia. Each petitioner filed his income tax return for the calendar year 1928 on the following dates, showing the following tax liabilities:

Arthur 0. Stifel, March 16, 1929_$20,270. 91
Edward W. Stifel, March 19, 1929_ 24, 504.20
Henry G. Stifel, March 25, 1929_ 17,747.46

J. L. Stifel & Sons, a corporation, was organized on June 1, 1920, and acquired the business of J. L. Stifel & Sons, a copartnership, for 12,000 shares of $100 par value preferred stock and 60,000 shares of no par value common stock. The common stock was set up on the corporation’s books at $30 a share.

Each petitioner herein owns 20,000 shares of the no par common stock and 4,000 shares of the preferred stock of J. L. Stifel & Sons.

The fair market value of the assets paid in for the preferred and common stock of J. L. Stifel & Sons on June 1, 1920, was $3,326,-502.88, which was set up on the books of the corporation as follows:

Preferred stock-$1, 200, 000. 00
Common stock, no par value_ 1, 800,000.00
Paid-in surplus- 326, 502. 88
Total_ 3,326, 502. 88

For the seven-month period from June 1 to December 31,1920, and for each of the calendar years 1921 to 1928, inclusive, the operating profits and losses of J. L. Stifel & Sons were as follows:

From the date of its organization up to January 1, 1929, J. L. Stifel & Sons made the following distributions on its capital stock:

1922. $104, 000
1923. 204, 000
1924. 180, 000
1925. 180, 000
1926. $180, 000
1927. 126, 000
1928. 180, 000

In his income tax return each petitioner included as dividends distributions of $60,000 received from J. L. Stifel & Sons, a corporation, in 1928.

The respondent in determining the deficiencies herein made several minor corrections in petitioners’ returns, which are not disputed here, but did not change the amount of dividends each petitioner reported as set forth in the preceding schedule.

Each petitioner now contends that under section 115 (a) and (b) of the Eevenue Act of 1928 only $1T,T31.T9 of the $60,000 received is taxable as a dividend, and that the balance, or $42,268.21, is a distribution of capital and is not taxable. The respondent contends that each petitioner is taxable on the full $60,000 received.

For the purpose of clearly illustrating the manner in which petitioners and respondent arrive at their respective results, the detailed computation of each is set forth in the following schedule:

Note: Petitioners accordingly contend that the dividends paid on the following dates were paid out of capital to the extent that they exceeded the “earnings or profits” available on the date of payment, as follows:

If the respondent’s method is correct, it is apparent that the corporation at all times had sufficient earnings or profits to pay each and every dividend, in which event the entire amount of the dividends paid during 1928 would be income to petitioners in that year. If the petitioners’ method is correct, it is apparent that of the $180,000 dividends paid during 1928 only $53,195.36 was paid from earnings or profits, and the balance or $126,804.64 was paid from capital. One third of $126,804.64 (each petitioner received one third of the dividends paid) is $42,268.21, which is the amount petitioners claim was paid out of capital during the taxable year.

The only difference between the two methods involves the treatment afforded the operating loss of $532,026.24 in 1920, carried through to December 31, 1928. Petitioners contend that before there could be any “ earnings or profits accumulated ” this loss would have to be made good by subsequent profits. The respondent contends that the loss was partially made good to the extent of the paid-in surplus of $326,502.88, and that only $205,523.36 of the loss should be made good out of subsequent profits.

We think petitioners’ contention must be sustained. J. L. Washburn, 16 B.T.A. 1091; Louise Glassell Shorb, 22 B.T.A. 644, acquiesced in by the Commissioner, C.B. X-1, p. 60. In the Shorb case we said:

It is our opinion that in the case of a corporation organized subsequent to March 1, 1913, there can be no accumulated earnings or profits until an operating deficit is made good, and that the Glassell Development Company did not have in 1924 any accumulated profits or earnings from which to pay dividends. The distribution in question was, therefore, made out of capital and did not constitute taxable income to the recipients. J. L. Washburn, 16 B.T.A. 1091.

Counsel for respondent in his brief bases his whole argument upon the assumption that petitioners’ surplus of $326,502.38 was earned surplus, but the allegations of the petition are to the contrary and respondent in his answer has admitted that the facts alleged in the petition are true. Despondent seems to assume that the surplus of $326,502.38 was earned surplus by assuming that it was earned surplus of the partnership, J. L. Stifel & Sons, and therefore it retained its same character when it was transferred to the newly created corporation, J. L. Stifel & Sons, notwithstanding it was set up on the books of the corporation as “ Paid in Surplus.” Despondent’s contention in this respect might be correct, although we do not undertake to decide that question at this time, if we had proof before us that the surplus in question was earned surplus while in the hands of the partnership. Cf. Helen V. Crocker, 29 B.T.A. 773, and cases there cited. But we have no proof whatever that the $326,502.88 in question was earned surplus in the hands of the partnership. The allegations of the petition on this point are as follows:

(b) The J. L. Stifel & Sons Corporation was organized on June 1, 1920, under tlie laws of tlie State of West Virginia. It took over the business of J. L. Stifel & Sons, a co-partnersliip, on June 1, 1920. It issued to the partners of J. L. Stifel & Sons co-partnership 12,000 shares of its preferred stock, par value $100.00 and 60,000 shares of no par value common stock, set up on its books at $30. per share. This stock issuance represented a capitalization of $3,000,-000.00, $1,200,000.00 in preferred stock and $1,800,000.00 in no-par common stock. Petitioner owned 4,000 shares of preferred stock and 20,000 shares of no par common stock of J. L. Stifel & Sons Corporation.
(c) The fair market value of the partnership assets paid in for the preferred and common stock of J. L. Stifel & Sons at the time of organization was $3,326,502.88 which was applied as follows:
Preferred stock_$1, 200, 000. 00
No Par Common Stock_ 1,800,000.00
Paid in surplus_ 326, 502. 88

These allegations were admitted to be true by respondent in his answer. From an inspection of the above quoted allegations in the petition it will be seen that there is no allegation that the partnership had any accumulated earnings at the time of the transfer of its assets to the corporation. The allegations simply are that these partnership assets had a fair market value of $3,326,502.88 and were paid in to the new cprporation as $3,000,000 capital stock and $326,502.88 paid-in surplus. Therefore our decision must be based on the fact that petitioners’ surplus was a paid-in surplus and not an earned surplus. There is nothing on which to base any other assumption. As we have already pointed out, the law governing the two situations is quite different. The court in Thorsen v. Commissioner, 65 Fed. (2d) 234, pointed out this distinction in the following language:

In Leland v. Commissioner, 50 Fed. (2d) 523 (C.C.A. 1, 1931), the surplus was paid in, not earned; the court assumed that such a paid in surplus, if diminished by losses, could be restored out of later profits, in holding that the losses of 1921, the year of incorporation, would be deductible from the profits of the succeeding years, in determining the taxability of a subsequent dividend distribution. There was, of course, on January 1, 1921, no earned surplus from which these losses could have been deducted. Unlike an earned surplus, a paid in surplus is, for these purposes, properly treated like capital.

Was the validity of the distinction heretofore made by the Board and the courts between the treatment of paid-in surplus and earned surplus impaired by the recent decision of the Supreme Court in Helvering v. Canfield and Thorsen v. Helvering, 291 U.S. 163? We think not.

Mr. Chief Justice Hughes, in delivering the opinion of the Court in those cases, took pains to point out that the Court was dealing with earned surplus and not paid-in surplus. In discussing this phase of the case he said:

The argument that the surplus of March 1, 1913, constituted capital is unavailing. We are not here concerned with capital in the sense of fixed or paid-in capital, which is not to he impaired, or with the restoration of such capital where there has been impairment. No case of impairment of capital is presented. We are dealing with a distribution of accumulated profits. Nor is it important that the accumulated profits as they stood on March 1, 1913, constituted capital of the company as distinguished from the gains or income which the company subsequently realized. When a corporation continued in business after March 1, 1913, the dividends it later declared and paid to its stockholders, whether out of current earnings or from profits accumulated prior to that date, constituted income to the stockholders, and not capital, and were taxable as income if the Congress saw fit to impose the tax. Lynch v. Hornby, 247 U.S. 339. The provision of the Act of Congress under consideration was a “ concession to the equity of stockholders ” with respect to receipts as to which they had no constitutional immunity. There is no question here of the receipt of “ capital.”

It seems to us that there is nothing said in the Supreme Court’s opinion in the Canfield and Thorsen cases which overrules our holding in the Shorb case and other cases to the effect that in the case of a corporation organized subsequent to March 1, 1913, there can be no accumulated earnings or profits until an operating deficit is made good. It is true that under the laws of some states a corporation is permitted to declare dividends out of its paid-in surplus without having earnings or profits available for such a dividend, but a dividend so declared would be a return of capital to the stockholder and would not be a taxable distribution to him, except in cases where the amount received exceeds the cost basis of the stock. Distributions from capital other than distributions in liquidation are applied against and reduce the basis of the stock. This is made so by reason of section 115 (d) of the Revenue Act of 1928. For the reasons above stated we sustain petitioners’ assignment of error.

Reviewed by the Board.

Decision will be entered wader Rule 50.

Seawele,

dissenting: The opinion of the Board in this case appears to me to be in conflict with the applicable statutes and the decision of the Supreme Court in the Canfield and Thorsen cases, decided January 15, 1934.


author: Smith:

text:
    Havana Electric Railway, Light & Power Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 40304, 42570, 47339.
    Promulgated February 21, 1934.

      J. Marvin Haynes, Esq., and R. R. Loaning, Esq., for the petitioner.

      Philip M. Clark, Esq., and Stanley B. Pierson, Esq., for the respondent.
   OPINION.

Smith:

The question presented is whether or not certain taxes paid to the Municipality and Province of Havana, Cuba, by the petitioner may be used as a credit on petitioner’s tax liability to the United States. Section 288 (a) of the Revenue Act of 1918 and a similar section in the Revenue Acts of 1921, 1924, and 1926 are as follows:

That in the case of a domestic corporation the total taxes imposed for the taxable year by this title and by Title III shall be credited with the amount of any income, war-profits and excess-profits taxes paid during the taxable year to any foreign country, upon income derived from sources therein, or to any possession of the United States.

After the filing of the agreed statement of fact's, respondent introduced Dr. Cardenas as an expert on Cuban tax laws. His evidence was objected to by petitioner, and it is now earnestly argued on brief by petitioner that his evidence is incompetent and should be excluded. Petitioner insists that the proper method of proving Cuban statutory laws is by proper certified copies of the statutes, and not by the evidence of an expert witness, and that in this case the statutes themselves were put in evidence by the agreed statement of facts.

Ordinarily the law of a foreign country may be proved by certified copies of the law, an expert witness, or an examined copy of the law. Where the statutes have been introduced in evidence we see no objection to obtaining the assistance of an expert also, though we are not bound to follow the construction placed on the law by the expert. In 4 Wigmore on Evidence, § 1953, the law is thus stated:

No doubt has ever been made that properly skilled testimony may be sought in proving the existence of a foreign rule of law in general. The question that involves the present principle is: When the text of a foreign statute is before the Court, may any aid be received in construing or interpreting It? No one doubts that the aid of a mere translator is proper. But when a translation, if necessary, has been made, is anything further needed in the way of comment on the text?
The answer has always and properly been that such aid may at any time be needed and may always be offered. The effect of this conclusion, however, must be distinguished from the effect of the rule of producing the verbatim text (ante, § 1271) ; that is, assuming the production of the complete text, the present question remains, whether an expert’s interpretation of that text is admissible:
1844, Denman, L. C. J., in Baron de Bode’s Case, 8 Q. B. 265: “ There is another general rule, that opinions of persons of science must be received as to the facts of their science. That rule applies to legal men .... Properly speaking, the nature of such evidence is, not to set forth the contents of the written law, but its effect and the state of law resulting from it. The mere contents, indeed, might often mislead persons not familiar with the particular system of law; the witness is called upon to state what law does result from the instrument.”
1844, Lord Brougham, in Sussex Peerage Case, 11 Cl. & F. 115: “ It is perfectly clear that the proper mode of proving a foreign law is not by showing to the House the book of the law; for the House has not organs to know and to deal with the text of that law, and therefore requires the assistance of a lawyer who knows how to interpret it.”

Tn Slater v. Mexican Nat'l. Ry. Co., 194 U.S. 120, the Supreme Court had before it the proper construction of certain Mexican laws relative to the liability of the railway company, to the widow and children of one of its employees killed through negligence of the railway company in Mexico. The written or statutory law was introduced in evidence, but the trial court rejected the expert testimony of a Mexican lawyer as to its effect and construction. In holding tills to be error, the Court said:

But what we last have said brings into consideration another error of the Circuit Court which hitherto we have not mentioned. The defendant offered the deposition of a Mexican lawyer as to the Mexican law. This was rejected, subject to exception, seemingly on the ground that the agreed translation of the statute was the best evidence. So no doubt they were, so far as they went, but the testimony of an expert as to the accepted or proper construction of them is admissible upon any matter open to reasonable doubt. Many doubts are left unresolved by the documents before us. The expert would have testified that where no criminal proceedings had been had, the right of the widow and children was dependent upon the court’s finding that the killing was a crime as defined by the penal code, and that the right was in the nature of alimony or pension to be paid in installments for periods of time fixed by the court. Without stating his testimony more fully, we have said enough to show that it should have been received.

See also In re Mahogany Co., 147 Fed. 147, where it was held that the evidence of an expert was admissible to explain the mortgage laws of Cuba, and Herbst v. S. S. Asiatic Prince, 108 Fed. 289, where a like ruling was made as to the laws of Brazil. The court said in the latter case:

* * * Whether or not it is the law and usage in Santos is a question of fact, the burden of proving which is on the party asserting its existence. The law of a foreign country [is] proved here by calling its lawyers * * * and interrogating them. That has been done in this case, with a result which certainly warrants the conclusion that the proof is overwhelmingly the one way. It is true that as to the law of Brazil the only witness called by the claimant was a young lawyer, but his statements are direct, positive, and reiterated, ⅜ ⅜ ⅝ and there is no reason apparent why his statements should not be accepted. * * * There was abundant opportunity to take the testimony of some other lawyer, * ⅞ ⅜ if the statements of claimant’s witness were inaccurate; * * * but libelant has contented himself with printing copious excerpts from the statute law of Brazil, which he insists do not sustain the witness’ statement. * * ⅜ Such a method of criticising the testimony of a foreign lawyer as to the law which prevails in his country is unpersuasive. There is much more than the text of a statutory enactment to be considered. Departmental regulations, administrative construction, judicial exposition, are often quite as important.

Dr. Cardenas was shown to be qualified to appear and testify as an expert on Cuban tax laws, and we hold that his testimony was competent and admissible.

Taxes paid to the Municipality of Havana by petitioner were paid under ¶ 131 of the Third Tariff of the Annexes to the Municipal Tax Law and Collection Procedure of Cuba as follows:

Gas and Electric Light Works belonging to stock companies or private persons, shall pay six per cent of their net earnings. For the purposes of the tax, the net earnings shall be considered to be the amount resulting from their balances, deducting from their receipts the expenses, properly vouchered, for all items of operation and maintenance of the business to which they are dedicated.

The taxes paid, the Province of Havana were paid under article 63 of the Organic Provincial Law of Cuba as follows:

Article 63. The Councils (Provincial Councils), besides the income from properties owned by the Province, may establish the necessary revenue in order to meet the expenses established in their budgets, which revenue, which is hereby declared compatible with the tax system of the state, shall be calculated, as surcharge, on some or all of the municipal taxes, provided for in the municipal budget, then in force, at a rate which in no case shall exceed 4% on the real estate tax in the Province of Havana and, in the other provinces, 20% on urban properties and 15% on rural properties. On other municipal taxes the surcharge may be as high as 25% in all the provinces.

The provincial taxes were collected by and paid through the Municipality of Havana. In his evidence Dr. Cardenas gives in great detail the history, purpose, and construction of the above taxing acts from 1877 to the present time, showing that they have always been considered and construed as among taxes upon the carrying on and exercise of industries, commerce, professions, arts, and trades, viz., a tax upon the privilege of doing business and not an income tax. Without -following the history of these laws in detail it is sufficient for our purpose to state that industrial taxes have been in force in Cuba since 1877. Originally they were levied by and for the benefit of the central government, with the right in the municipalities to levy a surcharge of 25 percent. These taxes were fixed and assessed in various ways. In some instances a fixed sum was prescribed, dependent upon the size of the community where exercised; some industries paid on gross output; insurance companies paid on the amount of premiums collected; and in some instances the municipalities had the right to fix the amount of the tax. Between 1877 and 1908 the benefit of these industrial taxes was transferred from the central government to the municipalities and back again by various military orders until in 1908, at the time of the second 'American intervention, a commission was established by the Provisional Governor, Charles E. Magoon, for the purpose of codifying and classifying the various tax laws of Cuba and assigning them to the different governmental units. The result of the work of the commission was properly promulgated by governmental decrees. The laws so established were the Organic Municipal Law of Cuba, Exhibit 1 in this record, and the Municipal Tax Law and Collection Procedure of Cuba, Exhibit 2 in this record, which were in effect during the taxable years. Title Y of the Organic Municipal Law of Cuba treats of the municipal treasury. Chapter I of that title contains general provisions for the conduct of the treasury. Chapter II relates to municipal budgets; chapter III provides for collections; and chapter IV relates to the municipal revenues.

In article 216 of chapter IY is found the authority of municipalities to provide revenue as follows:

The municipal councils may establish the revenues necessary to meet the expenditures provided for in the budgets, aside from the income of the municipality derived from its communal property and from any other legitimate sources, conforming, for this purpose, to the following basis and maximum rates of taxation which, for said purpose, are declared compatible with the system of taxation of the state.

Then follow 19 subsections to article 216 providing for the various kinds of taxes and the rates thereof which the municipalities are permitted to levy. The two subsections authorizing the taxes in controversy herein are (3) and (7) (b). Subsection (3) reads:

Tax on the exercise of industries, commerce, professions, arts and trades, which shall not exceed the rates fixed by classes and headings in the first three tariffs attached to the law of municipal taxation, and which may be freely regulated by the municipal council as to the remaining tariffs.

Subsection (7) authorizes:

A tax not exceeding eight per cent of the net profits of companies or copartnerships doing business with funds contributed by the members thereof at one time, or at periodical or irregular intervals. When their by-laws or regulations contain penal clauses for nonpayment, or other clauses of a similar character, they shall pay not more than eight per cent on their gross receipts.
This tax shall be paid to the municipality in which the company has its legal domicile. The following are excepted: (a) Savings banks, pawnshops and mining companies; insurance companies and banks of issue and discount, which pay taxes to the state by virtue of another law. (b) Those companies or copartnerships which are comprised in any manner in the tariffs attached to the law of municipal taxation, or in the tariffs freely regulated by the municipal councils, and which, as industrial enterprises, pay taxes to the municipality.

It appears from subsection (7) and its exceptions that it does not apply to certain classes of taxpayers that pay taxes to the state, nor does it apply to such as pay taxes to the municipalities under the tariffs attached to the law of municipal taxation as industrial enterprises. Coming now to consider the Municipal Tax Law, Exhibit 2, and referred to in exception (b) to subsection 7 above quoted, we find that Title II thereof is entitled “ Tax upon the exercise of Industries, Commerce, Professions, Arts and Trades,” and that article 62 provides “ The tax, to which this title refers is number three of Article 216 of the Organic Municipal Law,” and article 63 provides:

Persons subject to the payment of this tax are such as carry on within the territory of a municipality, whether a permanent resident of the district or not, any industry, commerce, profession, art or trade included in the tariff regulated by each municipal council, except those exempted in the table appended to this law.

Article 67 provides:

* * * for each industry, commercial enterprise, profession, art or trade, the quota assigned thereto in the respective tariff shall be paid to the municipality, according to the basis of population, or the basis that the municipal council may have determined upon.

The tariffs or schedules of taxes annexed to the Municipal Tax Law are entitled “ Maximum Tariffs for the collection of the taxes and fees on the operation of Industries, Commercial Pursuits, Professions, Arts and Trades.” Then follow three sets of tariffs in which the amount or rate of the tax is fixed, and a list of such industries which are subject to whatever tax or rate the municipal council may fix. In Tariff 3, section 131, it is provided:

Gas and electric light works belonging to stock companies or private persons, shall pay six per cent of their net earnings. For the purposes of the tax, the net earnings shall be considered to be the amount resulting from their balances, deducting from their receipts the expenses, properly vouchered, for all items of operation and maintenance of the business to which they are dedicated.

From this resume of the Cuban laws under which these municipal and provincial taxes were assessed and collected it seems clear to us that they were taxes upon the doing of business, or industrial taxes, and not income, war profits, or excess profits taxes. They are so denominated in every instance where they are mentioned or authorized. Article 62 of the Municipal Tax Law states that the tax to which it refers is authorized by number three of article 216 of the Organic Municipal Law, and number three of article 216 only provides for taxes on the exercise of industries, commerce, professions, arts, and trades. By reason of the exception (b) to subsection (7) of article 216 of the Organic Municipal Law, it is clear that these taxes are levied under subsection three pf article 216, and that they are expressly excepted from the operation of subsection 7 by exception (b).

The expert witness, Dr. Cardenas, answering a hypothetical question based on the facts of this case, gave it as his opinion that these taxes were taxes for the privilege of doing business, and were not income taxes, and that the mere fact that petitioner paid a certain per centum on net earnings did not constitute the tax an income tax, as the same method of fixing the tax was employed with reference to insurance companies for the privilege of doing business. The witness referred to and fortified his opinion by citations of decisions of the Havana Court of Appeals and the Supreme Court of Cuba. In the first case, being respondent’s Exhibit B, hereby referred to as Sentencia 685, pages 253-4 Repertorio Judicial, number of June 1931, the court held that the petitioner was not taxable under subsection 7 of article 216 of the Organic Municipal Law, requiring it to pay the tax to the municipality where it had its domicile, but that it was taxable under section 131, Tariff 3, and should pay the tax therein provided in each municipality where it had factories according to the income earned in each. This case was affirmed by the Supreme Court, but on a question of procedure. It is proper here to say that the taxes in controversy have been allowed as deductions.

Beginning in 1911 and extending down to the present time the National Cuban Government has levied and collected a national income tax in some form, concerning which there is no controversy. The petitioner has paid and been allowed credit for payments made on account of this income tax in the amounts shown in paragraph 13 of the agreed statement of facts and on recomputation will be allowed as credits the amounts set up in paragraph 14.

It is insisted by petitioner that because the taxes involved here were measured by net earnings, they are necessarily income taxes, but such is not the law. Many kinds of taxes such as franchise taxes, privilege taxes, and different forms of excise taxes may be and are based on gross receipts, net earnings, or income. The purpose for which the tax is levied must be considered, and the language used in the law and in denominating it by the lawmaking body is entitled to great respect. Here there is nothing in any of the municipal tax laws of Cuba which indicates an income tax or a purpose to tax incomes as such, but on the contrary it is everywhere called a tax on the exercise of an industry. The only clause which leans toward an income tax is subsection 7 of article 216, Organic Municipal Law, which the Court of Appeals of Havana held did not apply to petitioner.

In Flint v. Stone Tracy Co., 220 U.S. 107, the Court said:

While the mere declaration contained in a statute that it shall be regarded as a tax of a particular character does not make it such if it is ai)parent that it cannot be so designated consistently with the meaning and effect of the act, nevertheless the declaration of the lawmaking power is entitled to much weight, and in this statute the intention is expressly declared to impose a special excise tax with respect to the carrying on or doing business by such corporation, joint stock company or association, or insurance convpany. * * *

In that case the Court had before it the validity of the corporation tax imposed by the Tariff Act of 1909, which depended on whether it was a direct tax or an excise tax. The act provided in substance that every corporation, joint stock company, or association organized for profit and having a capital stock represented by shares, and every insurance company shall be subject to pay annually a special excise tax with respect to the carrying on or doing business equivalent to one per centum upon the entire net income over and above five thousand dollars. The Court held that the tax was imposed on the doing of business of the character described, and that the measure of the tax was the income, and that it was an excise tax. It was further held that the tax was constitutional and not subject to apportionment as income taxes were prior to the Sixteenth Amendment. To the same effect is the case of Spreckels Sugar Refining Co. v. McClain, 192 U.S. 397, in which a special tax measured by the gross receipts of the business of refining oil and sugar was sustained as an excise in respect to the carrying on or doing of such business.

In Security Savings & Commerce Bank v. District of Columbia, 279 Fed. 185, a tax on gross earnings was held a franchise tax, and in Potomac Electric Power Co. v. Rudolph, 29 Fed. (2d) 634, a tax on gross receipts was held a franchise tax as distinguished from a property tax.

The cases of Herbert Ide Keen, 15 B.T.A. 1243, and Chicago Portrait Co., 16 B.T.A. 1129; affd., 285 U.S. 1, relied upon by petitioner, do not militate against our views herein. In the first we sustained a French tax levied as and denominated an income tax by the French Government, and in the latter it was held that a self-governing province of Australia was a foreign country and that income taxes paid to it were a credit against United States income tax liability. In those cases the foreign taxes were income taxes, while in the instant case they are not. We hold that the taxes in controversy were not income, war profits or excess profits taxes paid to a foreign country within the meaning of section 238 (a) and may not be used as a credit on United States income taxes for the taxable years.

The respondent’s action in so holding is approved, but, on account of certain corrections to be made under the agreed statement of facts,

Reviewed by the Board.

Judgment will be entered under Rule 50.


author: Tkammell:

text:
    Arthur E. Braun, Surviving Trustee under the Last Will and Testament of T. H. Given, Deceased, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 54556.
    Promulgated February 23, 1934.

      Maynard Teall, Esq., for the petitioner.

      F. B. Shearer, Esq., for the respondent.
   OX-UNION.

Tkammell:

The first matter of xvhich petitioner complains is the refusal of the respondent to allow as; a deduction from gross income for each of the taxable years 1927 and 1928 the amount of $37,500 paid in each of those years to the trustees for their services in managing, conserving, and operating the two publishing companies. By amendment to the amended petition, petitioner further alleges that, since respondent did not allow these payments as compensation for services rendered, he erred in refusing to take account of the payments as additional cost of the stock of the publishing companies and reduce the taxable profit from the sale of the stock accordingly.

Respondent contends that the written agreement of November 3, 1927, between the life tenant, on the one side, and the two remainder-men, who were also trustees, on the other, these parties being the only persons interested in the trust estate, provided in effect for the distribution of a portion of the corpus of the estate, namely, $75,000, to the remaindermen and $150,000 to the life tenant, prior to the time of distribution fixed in decedent’s will, which created the trust estate. Respondent further contends that if the payments to the trustees did not constitute a partial distribution of the corpus of the trust to the remaindermen, the amounts can not in any event be regarded as a capital expense to be reflected in computing capital gain on the sale of the stock of the publishing companies, and that, even if the payments are properly deductible as business expense in determining ordinary net income, the allowance of such deductions would result in a corresponding reduction of the net income distributable to the fife tenant, and would not affect the tax liability of the petitioner. We think the latter contention of the respondent must be sustained.

Respondent also argues that if the payments in controversy are allowable deductions from ordinary gross income, then the amount of $37,500 paid to the trustees in 1928 was constructively received by them in 1927, since the evidence shows that the whole amount of $75,000 was due and payable immediately after the written agreement was executed and the trustees at that time had in their hands sufficient funds to pay the amount in full. In the view we take of this issue, the question of constructive receipt is unimportant and need not be decided by us, as will be more fully indicated below.

The Revenue Act of 1928, applicable to the year 1928, provides as follows:

SEC. 161. IMPOSITION1 OP TAX.
(a) Application of tax — The taxes imposed by this title upon individuals shall apply to the income of estates or of any kind of property held in trust, including—
* * * ⅜ * * #
(2) Income which is to be distributed currently by the fiduciary to the beneficiaries * * *.
SEC. 162. NET INCOME.
The net income of the estate or trust shall be computed in the same manner and on the same basis as in the case of an individual, except that—
* * ⅜ ⅜ ⅜ * *
(b) There shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is to be distributed currently by the fiduciary to the beneficiary * * *.

Substantially the same provisions are contained in section 219 of the Revenue Act of 1926, applicable to the taxable year 1927.

It must be borne in mind that we are concerned here only with the tax liability of the trust' estate created by the decedent’s will. Neither the life tenant nor the trustees, individually, are before us.

Plainly the statutes above referred to contemplate that the tax liability of this trust estate shall be computed in the same manner and on the same basis as in the case of an individual, except that the income upon which the trustee is required to pay the tax shall be reduced by the additional deduction of the income distributable to the life tenant, which, under the decedent’s will, embraces all of the ordinary net income. The only income taxable to the trustee is capital net gain. It is clear, then, that the allowance of the deductions claimed by the petitioner as compensation for personal services cannot affect in any manner the tax liability of the trustee. To allow these deductions from ordinary income would merely result in decreasing the amount of ordinary net income distributable to the life tenant, and whatever the amount of such income might be, whether more or less than that reported in the fiduciaries’ return, the capital net gain would not be changed by such adjustment.

If the decedent’s will had provided that the net income of the trust should be distributed to the life tenant within the discretion of the trustees, and for the taxable years they had distributed only a portion of such income to the beneficiary and had retained the balance and paid tax thereon, then the allowance of the claimed deductions would reduce the tax liability of the trust estate. But where, as here, the entire amount of the ordinary net income is distributable, the whole tax thereon is payable by the beneficiary and any adjustment of the amount of the distributable income does not affect the tax liability of the fiduciaries.

Therefore, it is unnecessary for us to decide in this proceeding whether or not the payments made to the trustees during the taxable years constituted allowable deductions from ordinary income as compensation for services rendered, or whether the whole $75,000, if so allowable, should be deducted from the income for 1927 on the theory that one half of this amount was actually received and one half was constructively received by the trustees in that year. These are matters which affect only the tax liability of the trustees, individually, and of the life tenant, and they are not before us. The only question material here is whether or not these payments constitute capital deductions to be taken into account in determining the net gain derived from the sale of the stock of the publishing companies in 1927. The profit realized from the sale of the stock was reported by the trustees in their return for 1927 as capital net gain and the tax was paid by the trust estate. The trustees kept their books of account and made their tax returns on the basis of cash receipts and disbursements, and, if the amounts paid to the trustees in 192T constituted capital deductions, such deductions would serve to reduce the deficiency determined by respondent against the trust estate, petitioner herein; otherwise not.

The amounts paid to the trustees in 1927 were deducted by them in computing the profit returned from the sale of said stock, while the amounts paid to the trustees in 1928 were deducted from ordinary income. In determining the deficiencies respondent disallowed both deductions.

Section 208 (a) (3) of the 1926 Act defines “ capital deductions ” as meaning “ such deductions as are allowable by section 214 for the purpose of computing net income, and are properly allocable to or chargeable against capital assets sold or exchanged during the taxable year.”

In our opinion the preponderance of the evidence indicates that the deductions claimed by the petitioner are not properly allocable to or chargeable against the capital assets sold during the taxable year 1927, and, hence, are not allowable as capital deductions. The agreement of November 3, 1927, authorized the payment of $75,000 to the trustees “ as full compensation for all their services rendered heretofore :fc * * in the management of The Post Publishing Company and The Sun1 Publishing Company.” And at the hearing Arthur E. Braun, surviving trustee of the trust estate, testified in reference to these payments as follows:

Q. Did both you and Mr. Moore, or you or Mr. Moore, prior to 1927, at or about the time of the sale of the stock of these two companies, ever receive any compensation for the work you have described?
A. We did not.
Q. Was it for the effectuating of the sale that you were paid, or for your work over the years, or for both?
A. It was not for effectuating the sale particularly, although, if we had not sold the papers, I don’t think we would have asked any compensation for our work. It was for the services that we had rendered in taking care of these properties, conserving them, and of course, we did negotiate the sale; but as I say, we did not claim any compensation for that particular thing.

This witness again later testified that the compensation paid to the trustees was “ for the management of the newspapers” and that the matter of their compensation for such services was first brought up “ subsequent to the time when the sale of the papers was made to Paul Block.”

This evidence we think is insufficient to establish that the $75,000 paid to the trustees as compensation for their services in managing and conserving the newspaper properties constituted a commission for the sale of the stock, or that it should be regarded as additional cost of the stock sold or otherwise as an expense incident to the sale. Respondent’s determination on this issue is approved.

The second issue involves the question of the proper basis for computing gain from the sale in 1928 of stock of the Radio Corporation of America. Pursuant to the decree of the Orphans’ Court entered May 20, 1925, 20,000 shares of class A common stock in that corporation were distributed to the trustees, and pursuant to the decree of the same ;£gurt entered November 8, 1927, an additional 15,000 shares ⅛⅞⅜⅜⅜⅛ were distributed to the trustees.

During the"y&&,r Í928 the trustees sold 1,000 shares of the stock distributed to them under the decree of May 20, 1925, for a total consideration of $100,910. In their tax return for 1928 the trustees 1’eported net gain from the sale of 1,000 shares of stock in the amount of $48,972.50, computed by deducting from the proceeds of sale the stipulated fair market value of the stock at June 11, 1925, which was $51.9375 per share. Respondent computed net gain upon the sale of said stock in the amount of $42,410, on the basis of the stipulated fair market value of the stock at May 20, 1925, the date of the decree of distribution, which was $58.50 per share. Thus respondent reduced by the amount of $6,562.50 the amount of net gain reported by the trustees.

During the year 1928 the trustees also sold 8,500 shares of stock of the Radio Corporation of America distributed to them under the decree of November 3, 1927, for which they received the net amount of $1,576,055.79. The trustees reported net gain from the sale of this stock computed by deducting from the net proceeds of sale the stipulated fair market value of the stock at November 26,1927, which was $94.6875 per share, while respondent increased the net gain so reported by the trustees to the extent of $121,656.25, using as the basis for his computation the stipulated fair market value of the stock at November 3,1927, the date of the court’s decree, which value was $80,375 per share.

The specific point of controversy between the parties under this issue is whether the proper basis for computing gain from the sale of the Radio Corporation of America stock is the fair market value at the dates of the decrees of distribution or at the dates on which distribution was directed by the decrees.

The stock involved was. acquired by the trustees by general bequest under decedent’s will, and the Revenue Act of 1928, in section 113 (a) (5), provides that in the case of personal property so acquired the basis for determining gain or loss “ shall be the fair market value of the property at the time of the distribution to the taxpayer.” Both parties concede the applicability of this statute, but they are in disagreement as to what date constitutes “the time of the distribution to the taxpayer.”

Each of the decrees in question directed that distribution be made in accordance with an attached schedule “ unless exceptions be filed within ten days, or an appeal be taken herefrom within three weeks.”

Respondent contends that because the decrees ordered distribution in accordance with a petition or agreement filed by all known parties having an interest in the estate, there wa^j8HKg»vho could file exceptions or appeal therefrom, and thereío«®|Íjp¡|fies on which the decrees were entered should be taken as®®t£e time of the distribution.”

The petitioner contends that each decree directed distribution to be made only in the event an appeal was not taken therefrom within three weeks, and hence the trustees did not acquire legal title to the stock by distribution until the expiration of the full period of 21 days from the entry of the decrees.

In the case of the decree of May 20,1925, the period of three weeks for appeal expired on June 10, 1925, and petitioner asserts that the following day, June 11,1925, was the date of distribution of the 1,000 shares of stock sold in 1928.' In computing the profit reported the trustees used as a basis the fair market value of the stock on the last mentioned date.

In the case of the decree of'November 3, 1927, the 21 days specified for appeal expired on November 24, 1927, which date was Thanksgiving Day, a legal holiday. Petitioner argues, therefore, that the following day, November 25, must be included within the period during which an appeal might have been taken, and that the next day, November 26,1927, was the date of distribution of the 8,500 shares of stock sold in 1928.

Respondent cites Brewster v. Gage, 280 U.S. 327, in support of his contentions, while petitioner- argues that that decision does not rule the present proceeding. We are in accord with the petitioner’s view on this point.

The cited case arose under the Revenue Act of 1921, which provided in section 202 (a) (3) that, in the case of property acquired by bequest, devise or inheritance, the basis for computing gain or loss should be the price or value of such property “ at the time of such acquisition.” And the Court held that the value of stock at the time of testator’s death determined the amount of taxable gain realized from the sale thereof by the legatee, and not the value of the stock at date of the decree of distribution.

However, in that connection the Court pointed out that the Revenue Act of 1928 in section 113 (a) (5) expressly fixed fair market value “ at the time of the distribution to the taxpayer ” as the basis in all cases other than personal property acquired by specific bequest and real estate acquired by general or specific devise or by intestacy. The Court further stated in its opinion that “ The deliberate selection of language so differing from that used in the earlier acts indicates that a change of law was intended.” We think, therefore, that Brewster v. Gage, and the line of our own decisions in accordance with or following that case, can not be regarded as decisive of the issue here.

Respondent argues that in Pennsylvania, and in other jurisdictions as well, “ distribution ” is accomplished by the probate court’s decree of distribution and that the “ time of the distribution ” does not mean some later date on which the beneficiary may demand delivery of the property, or on which the personal representative carries out the mandate of the court’s decree by delivering possession thereof, citing, among others, In re Piper's Estate, 57 Atl. 1118; In re Donnelly's Estate, 116 Atl. 165; In re Harned's Estate (Pa.), 116 Atl. 895.

The cited cases do not appear to establish definitely respondent’s contention. In some of them it is said substantially that distribution is made by the probate court or effected by that court’s decree; others speak of distribution as being made by the personal representative pursuant to the probate court’s decree; but in none of the cases referred to was this question specifically presented to or decided by the court. However, if we assume, without attempting to decide, that distribution is accomplished by the decree, we think this does not help respondent’s position. Certainly in such case distribution can not consistently be regarded as accomplished by the decree except in strict accordance with the terms and conditions of the decree itself.

The decrees involved in the present case ordered distribution only in the event exceptions were not filed within ten days or an appeal taken within three weeks. If either of the contingencies specified had happened, then the decrees did not direct distribution.

As we construe these decrees, they directed in effect that distribution be made at a future date, upon the happening of specified events, and until those events transpired, the decrees by their terms were not operative to effect distribution. To illustrate, the decree of May 20, 1925, in substance ordered distribution on June 11, 1925, unless prior to that date exceptions had been filed or an appeal taken. It follows, we think, that no distribution was made to the trustees by the decrees prior to the dates fixed therein, even though it might have been known before that time that no exceptions would be filed or appeal taken.

A decree of distribution is in the nature of a judgment in rem, and is binding upon all concerned unless appealed from. Rice v. Braden, 243 Pa. 141; 89 Atl. 877. Such a decree, when complied with, protects the personal representative, but if he makes distribution or partition of the property otherwise he not only may not claim protection of the decree, but may be rendered liable to surcharge.

The dates on which the executors in this case delivered actual possession of the stock to the trustees, we think, are immaterial. The dates on which the decree directed distribution constitute the “ time of the distribution to the taxpayer ” within the meaning of section 113 (a) (5), supra, and the fair market value of the stock on those respective dates is the basis provided for determining gain or loss. Such basis was properly used by the taxpayer in computing the gain derived. Respondent’s action on this issue is reversed.

The third and final issue raised by the petitioner concerns the rate of tax applicable to the profit derived from the prepayment, or redemption before maturity, of certain bonds of the Post Publishing Co. held by the trust estate. These bonds were distributed to the trustees under the decree of May 20, 1925, at their face value of $150,000. They were subject to call prior to maturity at a premium of 5 percent, and on August 1, 1927, the bonds were so called and redeemed. The trustees received $157,500 for the bonds and reported in their tax return for 1927 as capital net gain the amount of $7,500. In auditing the return respondent made no change in this item. Petitioner contends that the profit of $7,500 is properly taxable as ordinary income.

Petitioner’s contention on this point must be sustained. The Revenue Act of 1926 (sec. 208 (a)) defines “ capital gain ” as meaning taxable gain from the sale or exchange of capital assets consummated after December 31, 1921. The bonds in question were capital assets, but they were not sold or exchanged. Payment of the amount specified in a bond, either at maturit]*' or pursuant to an authorized call prior to maturity, is not a sale or exchange of such bond, and the gain derived from the transaction is taxable as ordinary income. John H. Watson, Jr., 27 B.T.A. 463. The deficiency for 1927 will be redetermined accordingly.

There remains for consideration the issue raised by the respondent in his answer to the amended petition, to the effect that in determining the deficiency for 1927 he failed to' disallow a deduction of $150,000 representing the amount paid to the life tenant, Annie Given Kerr, under the agreement of November 3, 1927, and thereby understated the petitioner’s net income for that year, subject to tax as capital net gain.

Prior to that agreement there had been controversy between the life tenant and the trustees respecting the amount of income distributable to the life tenant under decedent’s will. On August 1. 1927, the trustees had sold the stock of the two publishing com-pañíes, and thereafter, by the contract mentioned, the trustees and remaindermen agreed to pay to the life tenant out of the principal of the corpus of the trust estate the sum of $150,000 in full settlement of her claim for additional income, and the life tenant agreed to allow the trustees and remaindermen the total sum of $75,000, to be paid out of the proceeds of the sale of stock of the publishing companies, as compensation for services rendered in the management of the companies.

In their income tax return for 1927 (Form 1040), the trustees reported as capital net gain taxable to the trust estate the gain computed on the fiduciary return of income (Form 1041) less said amount of $150,000, thus in effect claiming a deduction from capital gain of the amount paid to the life tenant.

Petitioner’s contentions, briefly summarized, are that this amount represents a distribution of additional income to the life tenant, which is deductible in computing the net income of the trust estate under subdivision (b) (2) of section 219 of the Revenue Act of 1926, supra, or, if not so deductible, the amount represents the settlement of a claim against the estate and is deductible as expense.

If either of these contentions is sound, it would not affect the tax liability of the petitioner as trustee of the trust estate, but only the tax of the life tenant, since under decedent’s will all the ordinary net income was distributable to her. The trust estate was liable for and ¡said the tax only on the capital net gain, and this is true even though the payment of the $150,000 was actually in fact made out of the corpus or principal of the trust. It is the nature of the expenditure which determines the question of deductibility, not the fund out of which it is paid. In m> event could this item be regarded as expense properly allocable to or chargeable against capital assets sold in the taxable year.

What we said hereinabove in respect of the $75,000 paid to the trustees applies with equal force to the $150,000 paid to the life tenant under the same contract. The deduction claimed by petitioner from capital gain is disallowed.

The deficiencies for 1927 and 1928 will be redetermined in accordance with the foregoing opinion, and the deficiency for 1927 will then be increased in an amount equal to the aggregate by which the deficiencies for both years have otherwise been decreased, but not to exceed the maximum increase of the 1927 deficiency resulting from the disallowance of the deduction above referred to.

Reviewed by the Board.

Judgment will be entered under Rule 50.