author: Kern:

text:
    Henry Hudson, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 54774.
    Promulgated May 25, 1939.

      George E. H. Goodmr, Esq., and D. F. Prince, Esq., for tlie petitioner.

      L. W. Greason, Esq., and Owen W. Stoecleer, Esq., for the respondent.
   OPINION.

Kern:

The respondent in determining the deficiencies herein treated the exchange of stock in 1922 and the exchange of Sylphon Co. stock for Reynolds Co. stock in 1928 as nontaxable exchanges. He also treated the transactions completed in 1927 between the stockholders of the Fulton Co., the Sylphon Co. and Barney & Co. as a statutory reorganization, the gain realized therefrom being recognizable under section 203 (d) (1) of the Revenue Act of 1926 “in an amount not in excess of the sum of such money” received in the exchange. In his answer to the second amended petition the respondent affirmatively alleges that the transaction whereby the petitioner received cash and Sylphon Cb. stock for his Fulton Co. stock was a sale consummated in accordance with the stockholders’ agreement with Barney & Co. and the escrow agreement, and that therefore all the gain is recognizable. He contends that the steps taken in carrying out the plan were inseparable and constituted the consummation of one indivisible contract, the underlying purpose and result of which was the sale by the stockholders of the Fulton Co. of their stock for $5,000,000, as originally contemplated by the option given the Reynolds Metal Co., namely, that the earlier stock of the Fulton Co. was purchased by Barney & Co. as agent or manager of a syndicate, of which it was a member, for cash and shares of stock of the Sylphon Co., and that the entire amount of the gain is recognizable under the general rule set forth in section 203 (a) of the Revenue Act of 1926. He claims an increased deficiency.

The petitioner contends that there were two separate transactions, i. e., (1) an exchange by the stockholders of the Fulton Co. of all their stock for 15,000 shares preferred and 120,000 shares common stock of the Sylphon Co., constituting a nontaxable reorganization under sections 203 (b) (2), (h) (1) (A), and (h) (2) of the Revenue Act of 1926, and (2) a sale by the former stockholders of the Fulton Co. of 100,000 shares of the common stock of the Sylphon Co. to Barney & Co. for $2,790,000, the amount of the gain realized or the loss sustained on such sale depending upon the determination of the March 1, 1913, value of the Fulton Co. stock.

Whether the various steps taken to carry out the agreement herein constitute one transaction or two separate and distinct transactions is a question of fact. Commissioner v. Harris, 92 Fed. (2d) 374; Helvering v. Ward, 79 Fed. (2d) 381.

It is our opinion that what was done herein must be regarded for income tax purposes as a single transaction and that as such it constituted a reorganization under clause A of section 203 (h) (1) of the Revenue Act of 1926.

The Fulton Co. and Sylphon Co. were each a “party to a reorganization” under section 203 (h) (2) of the 1926 Act, which provides that such term includes “both corporations in the case of an acquisition by one corporation of at least a majority of the voting stock * * * of another corporation.” The Sylphon Co. acquired all of the outstanding stock of the Fulton Co. In Groman v. Commissioner, 302 U. S. 82, the United States Supreme Court, referring to section 112 (i) (2) of the 1928 Act, corresponding to section 208 (h) (2) of the 1926 Act, stated tbat that section “is not a definition but rather is intended to enlarge the connotation of the term £a party to a reorganization’ to embrace corporations whose relation to the transaction would not in common usage be so denominated or as to whose status doubt might otherwise arise.” Barney & Co. was not a party to the reorganization effected. That a party not a party to the reorganization effected was instrumental in bringing about such reorganization by furnishing the cash is not material under the circumstances herein. In Groman v. Commissioner, supra, the Glidden Co. entered into an agreement with the stockholders of the Metals Befining Co., pursuant to which the assets of the latter were transferred to a newly organized company, and the stockholders of the Metals Befining Co. received in exchange for their stock shares of preferred stock of the Glidden Co., shares of preferred stock of the new company, and cash, which cash had been paid by the Glidden Co. to the new company for all of its common stock. In that case the United States Supreme Court stated:

The exchange was between Indiana’s [Metals Refining Co.] shareholders and Ohio [new company]. Do the facts that Glidden contracted for the exchange and made it possible by subscribing and paying for Ohio’s common stock in cash, so that Ohio could consummate the exchange, render Glidden a party to the reorganization? No more so than if a banking corporation had made the agreement with Indiana’s shareholders and had organized the new corporation, and, by subscription to its stock and payment therefor in money and the banking company’s stock put the new company in position to complete the exchange. Not every corporate broker, promoter, or agent which enters into a written agreement, effectuating a reorganization, as defined in the Revenue Act, thereby becomes a party to the reorganization.

It was held therein that a reorganization was effected under section 112(i) (1) (A) of the Bevenue Act of 1928 by the transfer of all the stock of the Metals Befining Co. to the new company. The Court further held that, since the Glidden Co. was not a party to the reorganization, the gain realized by the taxpayer, a stockholder of the Metals Befining Co., on the reorganization was taxable under section 112(b) (5), (c) of the 1928 Act to the extent of the cash and the fair market value of the Glidden Co. stock received by him.

To constitute a reorganization within clause A, the dissolution of the Fulton Co. was not necessary. Helvering v. Minnesota Tea Co., 296 U. S. 378; G. & K. Manufacturing Co. v. Helvering, 296 U. S. 389. A large part of the consideration may be cash. G. & K. Manufacturing Co. v. Helvering, supra; Helvering v. Minnesota Tea Co., supra; Nelson Co. v. Helvering, 296 U. S. 374; and Western Power Corporation, 34 B. T. A. 618; affd., 94 Fed. (2d) 563. Participation in the management, and the acquisition of a controlling interest, in the acquiring corporation is not requisite under clause A. Nelson Co. v. Helvering, supra. The interest of the stockholders of the Fulton Co. acquired in the Sylphon Co, was definite and material and represented a substantial part of the value of the thing transferred. See Nelson Co. v. Helvering, supra, wherein the stockholders of a corporation transferred all the corporation’s assets except cash in exchange for cash and preferred stock of the acquiring corporation. The United States Supreme Court therein held that the £<owner of preferred stock is not without substantial interest in the affairs of the issuing corporation, although denied voting rights.” The stockholders of the Fulton Co. were entitled to receive all of the preferred stock of the Sylphon Co. and in addition 20,000 shares of its oommon stock. A substantial change in the relationship of the transferor to the assets conveyed is not inhibited by the section 203 (b) (2) applicable herein. Helvering v. Minnesota Tea Co., supra; see also Helvering v. Watts, 296 U. S. 387; Commissioner v. Freund, 98 Fed. (2d) 201; Commissioner v. Kitselman, 89 Fed. (2d) 458. It is immaterial that one stockholder having a 7/75 interest in the Fulton Co. received cash only. Since section 203 (b) (2) is applicable, we need not regard section 203(b) (4), which allows tax deferment only if the existing proportion of interest is substantially preserved. There was a substantial continuity of interest, since all the remaining stockholders of the Fulton Co. continued to be represented in the Sylphon Co. either by common or preferred stock or both.

The respondent argues that the original plan of the stockholders of the Fulton Co. was to sell all their stock for $5,000,000, to which end the option of November 6, 1926, acquired by Barney & Co. was executed, and that the intent of the Barney & Co. contract was only to provide in detail the manner in which the consideration of $5,000,* 000 for the entire stock of the Fulton Co. viz., $2,690,000, plus $100,000 in cash and $2,210,000 in common and preferred stock of the Sylphon Co., might be paid. It does not clearly appear who the respondent claims to be the purchaser of the Fulton Oo. stock. We are not concerned here with the original option given to the Beynolds Co., which is not in evidence but apparently gave that company an option to acquire all of the outstanding stock of the Fulton Co. for $5,000,-000, whether in cash or stock is not disclosed. It is apparent that the plan of reorganization of the Fulton Co., as disclosed by the Barney & Co. agreement and the escrow agreement, did not contemplate a reorganization involving an exchange of stock of the Fulton Co. for stock of the Sylphon Co. only, and a subsequent sale of 100,000 shares of the common stock of Sylphon Co. to Barney & Co., as contended by the petitioner, but that it contemplated at the outset the acquisition of cash through Barney & Co. by means of a sale of the 100,000 shares of common stock of the Sylphon Co. so that the stockholders of the Fulton Co. would receive stock of the Sylphon Co. and cash in exchange for their holdings in the Fulton Co. The 100,000 shares of Sylphon Co. stock were to be issued, as provided in the escrow agreement, to one John A. Hurley, who was not a stockholder, and the escrow agent was directed to deliver the same to Barney & Co. or as it might direct, upon the payment by it of the additional $2,690,000. In the distribution of the Sylphon Co. stock and cash directed to be made in the escrow agreement the transaction was treated as an entirety. The Barney & Co. agreement provided that if that company should fail to pay the additional sum of $2,690,000 on or before January 20,1927, the escrow agent on demand should return to the stockholders of the Fulton Co. their respective number of shares deposited with it and that all obligations under the agreement should cease. The escrow agreement provides that the escrow agent should return promptly to the stockholders of Fulton Co. their respective shares deposited with it in the event Barney & Co. should fail to make the additional payment prior to the close of business on January 20, 1927, and all the Sylphon Co. stock was to be delivered to Fulton. Thus it appears that the delivery of the Fulton Co. stock to the Sylphon Co., which was necessary to effect a reorganization at all, was dependent upon the payment of the cash by Barney & Co.

On brief the petitioner calls attention to the language of the Barney & Co. agreement, viz., “After obtaining the stock of the Fulton Sylphon Company, we agree to sell you and you agree to buy 100,000 shares” etc., as showing a sale of such shares to Barney & Co. Whether this was a sale or a part of the plan of reorganization must be tested by the entire agreement and “by what in fact was done rather than by the mere form of words used in the writings employed.” Helvering v. Tex-Penn Oil Co., 300 U. S. 481.

The case of Commissioner v. Harris, supra, relied upon by the petitioner, is distinguishable upon the facts. In that case the acquiring company agreed to exchange six shares of its stock for one share of stock of another company and also agreed to procure the agreement of a banking house to purchase one-half of its own stock given in exchange. It was held therein that the sale was not to be identified with the exchange of stock for stock and that there were two transactions, one of which was a reorganization within clause (A) of paragraph (1) of subdivision (h) of section 203 of the Revenue Act of 1926. Peir v. Commissioner, 96 Fed. (2d) 642, is likewise distinguishable upon the facts. The facts therein clearly disclose two separate and distinct transactions, i. e., (1) a reorganization effected by the exchange of the assets of Western Oxygen for 16,342 shares of Air Beduction stock and the assumption of the liabilities of the former by the latter company, followed by (2) a sale of 1,811 shares of Air Reduction stock by Western Oxygen to obtain funds with which to retire its own preferred stock. Thereafter it distributed the remaining Air Reduction stock, except 342 shares which were transferred to its president as compensation, pro rata to its common stockholders and dissolved. In both cases the reorganization was complete and effective without the sale. Herein the reorganization was dependent upon the sale of 100,000 shares of Sylphon Co. stock through Barney & Co., and the gain resulting from the exchange is taxable pursuant to section 203 (d) (1) of the Act of 1926 to the extent of the cash received.

That section provides that if an exchange would be within the provisions of paragraph (2) of subdivision (b), “if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph to be received without the recognition of gain, but also of * * * money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money * * In order to determine the gain, if any, recognizable under section 203 (d) (1), supra, and applicable herein, it is necessary to determine the basis of the Fulton Co. stock. Under section 204 (a) (6) and (b) of the 1926 Act, the basis for determining the gain, if any, is the cost of the original 50 shares of Fulton Co. stock acquired by petitioner prior to 1913, or the fair market value as of March 1, 1913, whichever is greater.

The petitioner contends that the fair market value of the petitioner’s 50 shares of Fulton Co. stock as of March 1, 1913, was not less than $329,000, or $6,580 a share. The respondent determined a value of $21,841.66, or $556.83321 per share. The respondent determined that the assets of the Fulton Co. as of March 1, 1913, had a value as follows: Tangible assets, $156,833.21, and intangible assets, $400,000, or a total of $556,833.21. There is no controversy as to the fair market value of the tangible property owned by the Fulton Co. as of March 1,1913. The parties differ as to the March 1,1913, value of the intangible property owned by the Fulton Co., and in particular as to the value of the patents owned by the Fulton Co.

On behalf of the petitioner, Fulton testified that in his opinion the patents owned by the Fulton Co. had a value as of March 1, 1913, of $6,580,000. This amount represents 33% percent of estimated prospective earnings or net profits from 1913 to 1927, or a period of 14 years, in the amount of $19,740,000. This amount was based on prospective estimated sale of 1,015,000 units per year and net profits of $1,410,000 per year. In examining the evidence submitted it appears that in 1912 and 1913 only 130,050 and 209,272 units, respectively, were sold, and that from 1913 to 1927 the unit sales per year were far below the estimate of Fulton except 1925 and 1926, in which, the unit sales amounted to 1,086,445 and 1,588,765 respectively. It also appears that the average annual sales from 1918 to 1927, omitting 1922 however, amounted only to 599,072 units, or over 400,000 less than the estimate of Fulton. In comparing the annual net profit of $1,410,000 estimated by Fulton with the actual net income of the company, it appears that the net income of the company never reached Fulton’s estimate, even in the best years of 1925 and 1926. As compared with estimated annual net profits of $1,410,000, the company in fact had average net profits from 1913 to 1927 over a period of 14 years of approximately $219,000. The petitioner in his reply brief argues that there is nothing in the record to show what relation “unit profits” as estimated by Fulton bore to “net income” and that to assume that they are one and the same thing is erroneous. Eliminating the comparison between “net profits” as estimated by Fulton and the “net income” as reflected by the books of account of the company, there still remain the discrepancies between Fulton’s estimated unit sales and the actual unit sales as shown by the records of the company. Petitioner further argues that Fulton’s estimate was based on facts as of March 1, 1913, augmented by his judgment and opinion, and that what happened afterward is immaterial. In Sinclair Refining Co. v. Jenkins Petroleum Process Co., 289 U. S. 689, the United States Supreme Court stated:

* * * A patent is a tiling unique. There can be no contemporaneous sales to express the market value of an invention that derives from its novelty its patentable quality. * * * The law will make the best appraisal that it can, summoning to its service whatever aids it can command. * * * At times the only evidence available may be that Supplied by testimony of experts as to the state of the art, the character of the improvement, and the probable increase of efficiency or saving of expense. * *• * This will generally be the ease if the trial follows quickly after the issue of the patent, But a different situation is presented if years have gone by before the evidence is offered. Experience is then available to correct uncertain prophecy. Here is a book of wisdom that courts may not neglect. We find no rule of law that sets a clasp upon its pages, and forbids ns to look within.

See also Nachod & United States Signal Co. v. Helvering, 74 Fed. (2d) 164; Miller Industries Co. v. Commissioner, 61 Fed. (2d) 412; Simmons Co. v. Commissioner, 33 Fed. (2d) 75. It is clear that the expectations of Fulton of unit sales, upon which he based his estimated net profits and value of the patents, are not justified by the subsequent sales of the company,

On behalf of the respondent a patent lawyer, engaged in the practice of patent law since 1920, testified that in his opinion the patents here involved had a value as of March 1, 1913, of $113,312,11. He arrived at this value by taking 5 percent of $2,266,242.30, which amount represents gross sales of the Fulton Co. from 1905 to March 1, 1918, a period of 8% years, in the amount of $755,414.10, plus twice that amount, or $1,510,828.20, representing in his opinion gross sales reasonably to be expected for the next 8% years. The gross sales of the Fulton Co. from March 1,1918, to the end of 1918 were in excess of $5,000,000. In arriving at this valuation he took into consideration among other things a large number of patents which in his opinion constituted the prior art, the possibility of competition under such patents, and the possibility that the Fulton patents might be declared invalid within a period of five to 8% years because of such prior art, and any monopoly inherent therein disappear. He testified that in his opinion in view of the prior art the Fulton patents did not create a monopoly or establish a new industry. He further testified that, assuming there were no competitive patents in existence, the value of the Fulton patents as of March 1, 1913, Would, in his opinion, be approximately 10 percent of his estimated gross sales of $2,266,242.30. The respondent introduced numerous patents as illustrative of the prior art and its scope, as to which this witness testified at great length. It was the opinion of this witness that any Competitor coming into this field coüld make the bellows under the Blair machine, Patent No. 17,356 of 1889, or the Koffler machine, Patent No. 700,662 of May 20, 1902, without coming within the scope of the claims of the Fulton patent, No. 971,838, and that therefore the Fulton process patent could not be exclusive. In Fulton Co. v. Bishop & Babcock Co., 17 Fed. (2d) 999, (February 13, 1925); affd., 17 Fed. (2d) 1006, the court, after considering the prior art, including the Blair patent, stated as to the Fulton patent, No. 971, 838, as follows:

* * * Fulton’s patent is entitled to rank as a pioneer or primary patent and to have the range of equivalents accorded to patents of that class. He produced an article of commerce hitherto unknown. The process by which he did so had never before been successfully practiced, although its desirability was pointed out by Webster in 1856. His labors may be said, not only to have answered the problem, but to have ended the search. He has founded an art. * * *

In that case the Bishop & Babcock Co. claimed upon application for rehearing that it was' operating a machine strictly in accordance with the disclosures of the Blair patent, but the court held that it was not, but had “merely constructed new rolls, different in substantial respects fromi the rolls of the Blair patent, and installed them on spindles of its infringing machine in lieu of the Fulton type of rolls.” Bishop & Babcock Manufacturing Co. v. Fulton Co., 37 Fed. (2d) 293. In Sturtevant Co. v. United States, 18 Fed. Supp. 28; affd., 99 Fed. (2d) 72, which involved the determination of the value of certain patents and patent rights as of March 1, 1913, the court received a great number of patents in evidence for the purpose of showing the state of the art in 1913. As to such evidence the court stated as follows:

* * * The record is barren of any evidence tending to show what impression these earlier patents made npon the art, or whether they met with any commercial success. Assuming that these patents were properly admitted, they can be given no weight in this case in the absence of evidence showing that they had an effect upon the business which the petitioner was able to carry on by virtue of its patents.

There is no evidence herein showing what effect, if any, the prior art had upon the business of the Fulton Co. The evidence, however, discloses that, whatever the situation may have been in 1913 and prior thereto, and although there were on the market other devices performing functions similar to those performed by many of the Fulton products, the Fulton Co. was able nevertheless to, and did, establish itself and increased its unit sales from 356 in 1905 to 209,272 in 1913 and its gross sales from $2,115.60 in 1905 to $359,105.84 in 1913.

An engineer of the Engineering Appraisal Section of the Bureau of Internal Kevenue since 1920 also testified as to the value of the Fulton patents. In his opinion the value of such patents as of March 1, 1913, was $400,000, which is the value used by the respondent in determining the deficiencies herein. This witness determined such value as follows: He assumed an average profit until October 1927 equal to the profits of 1913 in the amount of $82,363.32. He deducted therefrom the profits due to tangibles (8 percent of $156,-833.21), which left a profit of $69,816.67 attributable to the patents or intangibles over a period of 15 years. By the use of Hoskold’s Formula at 12 percent profit and 4 percent sinking fund ($69,816.67 x .392293 equals $410,828.86) he arrived at the value of $400,000, which he recommended in a report under date of November 5, 1930, in connection with another matter involving the value of the stock of the Fulton Co. as of March 1,1913, in which the petitioner herein was not involved. The witness testified upon cross-examination that at the time he determined such value “he needed any amount of information and did not get it” and that he particularly wanted some data as to what the conditions were on March 1, 1913; likewise, as to what happened in 1925, 1926, and 1927. Another witness, an investment counsel, statistician, and economist, also testified in behalf of the respondent. In his opinion the value of the Fulton Co. stock as of March 1, 1913, did not exceed $500,000. In reaching, such opinion of value he did not evaluate the patents. He testified' that he did not do so as he made no claim of ability to value patents. Section 204 (b), supra, provides that “In determining the fair market value of stock in a corporation as of March 1, 1913, due regard shall be given to the fair market value of the assets of the corporation as of that date.”

The respondent also submitted capital stock returns of the Fulton Co. for the years 1916 to 1926, inclusive, excepting 1920, signed by Fulton, for whatever they might be worth as a part of the cross-examination of Fulton in connection with his testimony pertaining to the value of the patents. In Nachod & United States Signal Co. v. Helvering, supra, the court stated that “capital stock returns are of no probative force in an inquiry as to the value of the patents.” To the same effect is Sturtevant Co. v. United States, supra.

The valuation of patents is a question of fact to be determined on all the evidence. Sturtevant Co. v. Commissioner, 75 Fed. (2d) 316. In our determination of the March 1, 1913, value of the Fulton Co. stock, we have considered all the evidence, and in particular all the facts in existence or within reasonable expectation on March 1, 1913, and as fairly corroborated by subsequent events. We have not overlooked the written report under date of January 25, 1926, made by Fulton to the directors of the company in which he attributes the outstanding results of 1925 to the unusual activity in general business, the marked increase of almost 200 percent in the automobile and special engineering sales, the winning of two important patent suits in the lower courts, and the most able business and factory management of its then general manager and his organization. While this report discloses that the management was a “highly potent factor” in producing such favorable results, the report also discloses that prior to April 1922, when a change in management took place, the factory organization, sales organization, and management of the company were such as seriously to hinder and impede the efficient operation of the company’s business and to affect unfavorably its trade relations. This may be an explanation in part of the low earnings of the company during 1918 and 1921 inclusive, as shown in our findings of fact. In that connection, it is to be noted that while the gross sales in 1918 and 1920 were substantially higher in amount than in any previous year, the net income was lower than in 1913. It has been stipulated that the tangible assets of the Fulton Co. had a value on March 1, 1913, of $156,833.21. After giving due consideration to all of the evidence, we have reached the conclusion and have so found that the stock of the Fulton Co. had a value of $706,833.21 as of March 1, 1913.

The next questions to be considered are whether the respondent erred in disallowing a loss of $309 claimed by the petitioner on the sale of 100 shares of Sylphon Co. stock in 1928 and in applying the first in, first out rule in determining the gain on all sales in 1928. The petitioner purchased 300 shares of the common stock of Sylphon Co. in November 1927 at $42.15 a share through Barney & Co., the stock remaining in the possession of Barney & Co. In August 1928 that company, upon the direction of the petitioner, sold 100 of the 300 shares for $3,906. This is uncontradicted. The shares were purchased at the same time in a lot of 300 shares at the same price per share and remained in the possession of Barney & Co. The result would have been the same whatever hundred of these 300 shares had been sold. In our opinion, the designation of a definite number of shares in a particular lot is sufficient to overcome the first in, first out rule. Certificates of stock are not the only possible means of identifying stock. Helvering v. Rankin, 295 U. S. 123; Miller v. Commissioner, 80 Fed. (2d) 219. Therefore, on this sale the petitioner sustained a loss of $309 (one-third of $12,645 less $3,906). Since the 100 shares were held less than two years, the loss sustained must be treated as an ordinary loss in the computation of petitioners’ tax liability for 1928 under Rule 50.

In November 1928 the petitioner sold through Barney & Co. 750 shares of the common stock of the Reynolds Co. at $34.81 a share, and 550 shares of the same stock through Bauer, Pegue, Pond & Vivian for $39.81 a share. The petitioner claims that the 750 shares of Reynolds Co. stock sold were a part of the shares of Reynolds Co. stock received in exchange for the 200 shares of Sylphon Co. stock held by Barney & Co. and a part of the lot of 300 shares purchased in November 1927 at $42.15 a share, and for the 1,300 shares of Sylphon Co. stock purchased in July 1928 at $37.65 a share, and that one-half of the purchase price of the Sylphon Co. stock is the basis to be used in determining gain on the sale of the 750 shares of common stock of the Reynolds Co. sold in 1928, and that such gain should be treated as ordinary gain. As to the 550 shares sold through Bauer, Pogue, Pond & Vivian, the petitioner testified that he “was inclined to think [they] were certificates obtained in exchange for original stock through the various transmutations.”

The respondent on brief states that he determined the bases of both the 100 shares of Sylphon Co. stock and the. 1,300 shares of Reynolds Co. stock sold by petitioner under the first in, first out rule because there was no identification of the particular shares Sold. In computing petitioner’s tax liability, he treated the gain determined by him as capital gain.

In September 1928, after the sale of the 100 shares of common stock of the Sylphon Co., the petitioner exchanged all of his Syl-phon Co. stock for Reynolds Co. stock in a nontaxable exchange. The Board and the courts have held that upon receipt of stock of a different corporation in a reorganization the first in, first out rule is not applicable, but that the cost or other basis of the stock exchanged is the basis of the stock received and that such basis must be allocated equally to all shares received. Christian W. Von Gunten, 28 B. T. A. 702; affd., 76 Fed. (2d) 670; Olive, Hume Oliver, 30 B. T. A. 1381; affd., 78 Fed. (2d) 561; P. L. Wheeler, 32 B. T. A. 917; Lewis K. Walker, 35 B. T. A. 640; Jacob Epstein, 36 B. T. A. 109; Harry M. Runkle, 39 B. T. A. 458; Helvering v. Stifel, 75 Fed. (2d) 583. Under the rule of such cases the basis for the stock received is the total of the fair market value of the Fulton Co. stock as determined by us and the purchase price of the additional stock purchased by him, less the cost of the 100 shares of common stock of the Sylphon Co. sold prior to the exchange of Sylphon Co. stock for Beynolds Co. stock. Since the petitioner received both common and preferred stock of the Beynolds Co. in exchange, however, the basis should not be allocated equally to all shares, but should be allocated to the common and preferred stock in the proportion that the fair market value of each class bears to the total fair market value of both classes. Frances Elliott Clark, 28 B. T. A. 1225; affd., 77 Fed. (2d) 89; Philip D. C. Ball, 27 B. T. A. 388; affd., 69 Fed. (2d) 439; Clifford, Hemphill, 25 B. T. A. 1351.

We must now determine whether the gain or loss realized or sustained by the petitioner on the respective sales of the 750 shares and 550 shares of common stock of the Beynolds Co. is ordinary or capital gain or loss.

Section 101 (c) (8) (A) of the Bevenue Act of 1928 provides in substance that where property is acquired on an exchange and the property acquired takes the basis of the property exchanged for the purpose of determining gain or loss, then the period of holding the property exchanged shall be added to the period of holding of the property acquired in determining the period for which the taxpayer held the property acquired. The Commissioner has not yet published a regulation under this section dealing with the question of the period of holding stock under circumstances such as are here present, although the advisability of such a regulation was suggested by us in both Epstein’s case and Runkle’s case. In the briefs filed in the instant proceeding both parties, in considering the question of the time of holding the stock, assume that the question here involved has to do only with the identification of the dates of acquisition by petitioner of the Sylphon Co. stock exchanged for the Beynolds Co. stock. It is, therefore, apparent that both have assumed that a method analogous to the first in, first out rule should be applied to the solution of this problem. In the absence of a regulation of the Commissioner on this question containing a better method for its solution we shall, for the purposes of this case, adopt the method apparently followed by the parties.

The evidence shows that Barney & Co. held 200 shares of Sylphon Co. stock which, had been purchased in November 1927, and that the bank in Chicago held 1,300 shares as collateral which had been purchased in July 1928. As a result of the exchange of Sylphon Co. stock for Reynolds Co. stock, Barney & Co. received 100 shares of common stock of the Reynolds Co., together with 100 shares of its preferred stock, and the bank received, in addition to 650 shares of preferred stock, 650 shares of the common stock of the Reynolds Co., 565 shares of which it forwarded to the National Park Bank of New York as collateral to a loan made by the petitioner. These 565 shares were forwarded by the New York bank to Barney & Co. Hence, of the 750 shares of Reynolds Co. common stock sold by Barney & Co., 100 shares are clearly traceable to the 200 shares of Sylphon Co. stock purchased in November 1927, and 565 shares thereof are clearly traceable to the 1,300 shares purchased in July 1928. It is our opinion, therefore, that the gain or loss on 665 shares of the 750 shares sold by Barney & Co. should be treated as an ordinary gain or loss. However, the evidence fails to identify the remaining 85 of the 750 shares sold by Barney & Co. and the 550 shares of stock sold through Bauer, Pogue, Pond & Vivian. Hence, the gain or loss computed on these shares must be treated as capital gain or loss in the computation of petitioner’s tax liability.

The petitioner contends that his tax liability for 1927 and 1928 was settled and compromised and that the respondent is therefore estopped, under the circumstances herein, to claim any additional taxes for such years. The evidence in the record on this question fails to disclose that there was a compromise under the provisions of either section 3229 or section 3469 of the Revised Statutes. Under the former the Commissioner is authorized to compromise any civil or criminal case arising under the internal revenue laws “with the advice and consent” of the Secretary of the Treasury, and under the latter, the Secretary of the Treasury is authorized to compromise any claims in favor of the United States upon the report and recommendation of certain officials designated in the statute. What was said by the Court in Botany Worsted Mills v. United States, 278 U. S. 282, is equally applicable herein:

* * * Here the attempted settlement was made by subordinate officials in the Bureau of Internal Revenue. And although it may have been ratified by the Commissioner in making the additional assessment based thereon, it does not appear: that it was assented to by the Secretary, or that the opinion of the Solicitor was filed in the Commissioner’s office. * * * When a statute limits a thing to be done in a particular mode, it includes the negative of any other mode.

See also, Hughson v. United States, 59 Fed. (2d) 17; certiorari denied, 287 U. S. 630; and Hanby v. Commissioner, 67 Fed. (2d) 125.

Decision will b'e entered under Bule 50.

       Sec. 203. (a) upon the sale or exchange of property the entire amount of the gain or loss, determined under section 202, shall be recognized * * *.

       Sec. 203(b)(2). No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.
      * ******
      (h) As used in this section and sections 201 and 204—
      (1) The term “reorganization” means (A) a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation » * *.
      (2) The term “a party to a reorganization” includes a corporation resulting from a reorganization and includes both corporations in the case of an acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation.


source: Caselaw Access Project

author: Oppek : KerN, Black,

license: Public Domain

text:
    Agricultural Securities Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent. Mary W. Stewart, Petitioner, v. Commissioner of Internal Revenue, Respondent. A. O. Stewart, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 87668, 90569, 90570,
    Promulgated May 25, 1939.

      W. G. Harmon, Esq., Ernest L. Willcinson, Esq., John W. Qragwn, Esq., and Herman Langworthy, Esq., for the petitioners.

      Benjamin M. Brodsky, Esq., Paul E. Waring, Esq., Elizabeth B. Fegan, Esq., and Ellyne E. Strickland, Esq., for the respondent.
   OPINION.

Oppek :

The precise question to be decided has not previously come before us. Cases somewhat analogous have determined that profit from the disposition of Government bonds is taxable to a nonresident alien, even though the exemption of principal as well as interest was from “any and all taxation”, Hubert De Stuers, 26 B. T. A. 201; that Federal obligations are subject to gift tax even though the principal thereof as well as the interest was specifically exempted from all taxation with certain stated exceptions which did not include that tax, Lawrence C. Phipps, 34 B. T. A. 641; affd., 91 Fed. (2d) 627, (C. C. A., 10th Cir.); and that securities of the character involved in the instant proceeding are subject to inheritance tax, even though the act under which they are issued is silent in this regard, Edgar A. Igleheart, Executor, 28 B. T. A. 888; affd., 77 Fed. (2d) 704 (C. C. A., 5th Cir.).

Petitioners rely almost entirely upon the inclusion in the legislation under review of the word “income” as opposed to “interest.” They say, in effect, in the able and comprehensive treatment of the subject submitted in their behalf, that since income includes capital gains under the Sixteenth Amendment, Merchants’ Loan & Trust Co. v. Smietanka, 255 U. S. 509, the word is to be read as including them for purposes of exemption when it appears in the Farm Loan Act under which these securities were issued.

In this position we are unable to concur. It may be observed first that it is not the word “income” alone but the phrase “income derived therefrom” which we are required to construe. Stewart v. United States, 24 Fed. Supp. 145. It can no longer be doubted that capital gain is income on which an income tax may be levied. See, e. g., Eisner v. Macomber, 252 U. S. 189. But it does not follow — considering the transactions of which the security is the mere object which must take place in order for income to result from a purchase or other acquisition and a sale or other disposition — that one can say that the income resulting is derived from tbe security itself. In Willcuts v. Bunn, 282 U. S. 216, 227, the Supreme Court said:

* * * Because the tax in question is described as an “income tax” and the profits on sales are included in “income”, the distinction is not lost between the nature of a tax applied to interest and that of a tax applied to gains from sales. The federal income tax acts cover taxes of different sorts. Brushaber v. Union Pacific Railroad Company, 240 U. S. 1, 17, 36 S. Ct. 236, 60 L. Ed. 493, L. R. A. 1917D, 414, Ann. Cas. 1917B, 713; Stanton v. Baltic Mining Company, 240 U. S. 103, 114, 36 S. Ct. 278, 60 L. Ed. 546. The tax upon interest is levied upon the return which comes to the owner of the security according to the provisions of the obligation and without any further transaction on his part. The tax falls upon the owner by virtue of the mere fact of ownership, regardless of use or disposition of the security. The tax upon profits made upon purchases and sales is an excise upon the result of the combination of several factors, including capital investment and, quite generally, some measure of sagacity; the gain may be regarded as “the creation of capital, industry and skill.” Taw Commissioner v. Putnam, 227 Mass. 522, 531, 116 N. E. 904, 910, L. R. A. 1917F, 806.
The tax * * * [is not] on the obligations of the State or municipality, or on the investment therein, as such * * *. It would be far-fetched to say that such purchases and sales are instrumentalities of the State * * *.
*******
* * * the tax is not laid upon the contracts made by the State * * *, or upon the amounts payable thereunder, but is laid upon the result of distinct transactions by private owners * * *.

The word “income” may well have been used advisedly in the present connection to connote broader forms of receipt than interest without necessarily including therein the concept of capital gains. Dividends, rent, and similar items are income, see Brushaber v. Union Pacific Railroad Co., 240 U. S. 1, though evidently not interest. The periodic receipts procured from the investment of capital, which in respect to the ordinary Federal, State or municipal bond can be expected to embrace only interest in its technical sense, might well go far beyond this under the scheme envisaged by the Farm Loan Act. Farm loan bonds were not the obligation of the Federal Government. (Secs. 16, 21.) In lieu of this they were secured by a pool of farm-mortgage collateral deposited with a farm loan registrar. (Secs. 19, 22.) Upon tbe insolvency of a bank, a receiver is provided for (sec. 29) whose function it might be to take over not only the collateral but the underlying real estate and to operate it for the benefit of the bondholders. It could not have been clear that by the use of the term “interest” periodical payments to bondholders resulting from such operation would have been included. See Penn Mutual Life Insurance Co., 32 B. T. A. 839; affirmed on this point, 92 Fed. (2d) 962.

Nor is it by any means clear that even from the investor’s standpoint the exemption from capital gains tax would have been an advantageous feature. As Mr. Chief Justice Hughes remarked in Willcuts v. Bunn, supra, p. 231:

* * * While the tax is laid on gains, there is also a deduction for losses on sales, and whether investors in such securities would consider it an advantage if both provisions were eliminated is a matter of mere speculation.

It follows that the elaborate argument advanced here that Congress must have intended to include these exemptions solely because of its desire to make the securities attractive to purchasers is reduced to the purest conjecture.

In our view, therefore, the assumption that by the use of the phrase “income derived therefrom” Congress necessarily and unmistakably intended to include capital gains may not be indulged. That the term is merely susceptible of such an interpretation will not suffice because other considerations lead to the opposite conclusion. As we said in Hubert De Stuers, supra, 204.

An exempting statute such as this one should be strictly construed and the exemption allowed only where founded on plain language [citing cases]. We do not believe that a government, issuing its obligations at par, would have sufficient interest in the purchase and sale of those obligations below par to provide tax exemption in any case lor the profit derived from a purchase below par and subsequent redemption at par. The benefits, if any, which the government would thus derive would be unreasonably remote.

To the .use of the language in Willcuts v. Bunn, supra, petitioners object that, being unnecessary for the decision in the case, it should be disregarded. Without conceding that, an argument no less impelling flows from the direct decision in that case. Congress exempted these obligations from state, municipal, and local taxation to the same extent and by the use of the same language as from Federal taxation. It said:

* * * farm loan bonds issued under the provisions of this Act, shall be deemed and held to be instrumentalities of the Government of the United States, and as such they and the income derived therefrom shall be exempt from Federal, State, municipal and local taxation. (See. 26.)

The doctrine of Willcuts v. Bunn, supra, that state obligations are not constitutionally exempt from a Federal capital gains tax, coupled with the recognition that similar principles govern state and Federal enjoyment of such immunities, Ambrosini v. United States, 187 U. S. 1, 7, leads inevitably to the conclusion that there was serious doubt whether the Congress was authorized to exempt these obligations from capital gains taxes of states, localities and municipalities. Since Congress should not be presumed to have undertaken to provide an immunity possibly beyond its power, United States v. Jin Fuey Moy, 241 U. S. 394, and since the language it used demonstrates that exemption from Federal and state taxation was to be identical, it follows that the words “income derived therefrom” are not in this context to be construed as including the gain, derived from such transactions as those now before us. See Plummer v. Coler, 178 U. S. 115, 134, 135.

Several further points remain to be considered. It is urged that, regardless of the use of the word “income”, the exemption of the bonds themselves is sufficient, at least where sale or redemption took place at or below par. This contention is sufficiently answered by the decision in Hubert De Stuers, supra, and many similar cases. Exemptions so broad as to include “the bond” or “principal and interest” have repeatedly been held to be insufficient to prevent the operation of the taxing act upon collateral transactions of which the securities are the subject. Plummer v. Coler, supra; Edgar A. Igleheart, Executor, supra; Lawrence C. Phipps, supra; Central Hanover Bank & Trust Co. v. United States, 14 Fed. Supp. 541; certiorari denied, 300 U. S. 678; see Willcuts v. Bunn, supra. It is not clear that petitioners seek to make any distinction between those bonds which were sold at or below par and those which were redeemed. If such a contention were advanced we should not be able to accept it. The argument was made and answered in Hubert De Stuers, supra, and in our view the determination there is conclusive upon the question.

It is further contended that the income is clearly derived from the bonds when they are sold because were it not for the bonds this income could not have arisen. To this contention the same answer may be made. Were it not for the bonds they could not have been bequeathed by a decedent, Edgar A. Igleheart, supra; nor have been the subject of a gift, Lawrence O. Phipps, supra; nor of disposition by a nonresident alien, Hubert De Stuers, supra; nor of a sale, Central Hanover Bank & Trust Co. v. United States, supra.

Petitioners urge the legislative and administrative history of the subject as conclusive in their favor. In our view, however, the circumstances advanced to support this contention are far from sufficient. We are referred to no instances of a specific administrative reference to the taxability of capital gains on these securities save three. In all other cases set forth the statements used are in the same general, unspecific language as the statute itself. They are therefore no greater indication of administrative construction than is the wording of the act. The first instance specifically dealing with the question is an unpublished memorandum of the General Counsel of the Bureau of Internal Revenue, dated April 3, 1933, which concludes:

In the instant ease, the bonds in question were issued by this taxpayer, and purchased by it at a discount, both under specific authority of the Federal Farm Loan Act. As a result of the purchase, the taxpayer derived income within the meaning of the Revenue Act of 1928. Kirby Lumber Company v. United States, supra. Under such circumstances, it is the opinion of this office that the income so derived, was derived from the bonds as contemplated by the Federal Farm Loan Act. It is concluded, therefore, that the discount on the taxpayer’s own, bonds purchased during the taxable year, constitutes exempt income and is, therefore, non-taxable. * * *
* * * < * * *
* * * (4) that the discount on the taxpayer’s own bonds purchased during the taxable year constitutes exempt income and is, therefore, non-taxable.

This was followed by a circular letter dated May 2, 1933, and addressed by the Federal Farm Loan Bureau “To all joint Stock Land Banks”, in which the statement is made: “Fourth: That the discount on, your own bonds purchased during the taxable year constitutes exempt income and is, therefore, non-taxable.”

On February 28, 1935, the Assistant General Counsel for the Bureau of Internal Revenue issued a memorandum in which the following appeared:

It does not follow, because a joint stock land bank is exempt from tax upon the income resulting from a purchase of its own bonds, that the profit realized by an individual from a sale of such bonds is not taxable. * * *

For an administrative determination to be so persuasive as to be of assistance in the construction of a statute it must be definitely settled, uniform, and of long standing. United States v. Missouri Pacific Railroad Co., 278 U. S. 269, 280; Alexander v. Cosden Pipe Line Co., 290 U. S. 484, 498; Central Real Estate Co., 17 B. T. A. 776, 780; affd., 47 Fed. (2d) 1046. It will at once be seen that the ruling urged here as an administrative construction complies with none of these requirements. On its face it purports only to affect the. banks themselves and not other individuals or corporations such as these petitioners. If by implication it could be more broadly construed, that possibility was soon destroyed by the memorandum issued less than two years later and specifically negativing any such construction. And in any event the original memorandum was in effect, without the benefit of the clarification of the later memorandum, for less than two out of the more than twenty years during which the act itself was operative. It is objected that the reasoning of the second memorandum is faulty. This seems to us to be beside the point. The argument is that the administrative construction was in accord with the position now being urged, but, at least taking the two memoranda together, that appears not to be correct. In fact, it may be that the earlier ruling rather than the later was erroneous, and it does not seem to us permissible for a litigant to rely upon one administrative construction as conclusive and in the same breath to seek to escape another by impugning its correctness.

And even if it be assumed that Congress was contemporaneously aware of any such construction, there was in the interim no reenactment or reaffirmance of the original section which could be said to place the stamp of Congressional approval upon the position so taken. Cf. Helvering v. Reynolds Tobacco Co., 306 U. S. 110. If any tiring the intermediate enactment dealing with the subject indicates the contrary. For the Eevenue Act of 1934 contains in section 22 a definition of gross income obviously broad enough to include these profits,* and the exempting provision contained in section 22 (b) (4) (B) covers only interest and no other category of income. As far as the record shows the first action taken by Congress which can be said to have recognized the existence of an administrative position in this regard was the passage of section 817 of the Eevenue Act of 1938 which was, as its legislative history shows, designed to correct only the narrow conception of the earlier ruling which the later ruling embodies.

Nothing to which we have been referred in the legislative history of section 26 of the Federal Farm Loan Act, save the section just cited, can be said to have any bearing upon the present problem. Here again such statements as appear are so general that they are no more illuminating as to the true meaning of the section than the language of the act itself. As to section 817 itself, if it be assumed that a later Congress may, by legislation not purporting to be retroactive, place a controlling interpretation upon the act of a much earlier Congress, it is still impossible to say that by the Eevenue Act of 1938 any such interpretation as that now pressed upon us was made. The reason for the enactment of section 817 clearly appears from the Committee Report: “This section subjects to federal income taxation the capital gain realized by a joint stock land bank on the purchase of its own obligations or of mortgages made by it. * * * Under the Federal Farm Loan Act, however, which governs the taxability of obligations of joint stock land banks, such income is exempt. The Committee is of the opinion that such income ought to be taxed.” It will be observed that this explanation limits the purview of the section to the realization of gain by a joint stock land bank on the purchase of its own obligations, the very limitation which was placed upon the 1933 ruling by that made in 1935. And in fact the section as originally introduced was also limited to that subject. The earlier draft appearing as section 816 read:

Notwithstanding the provisions of section 26 of the Federal Farm Loan Act, as amended, gain realized on the acquisition by a joint stock land bank of obligations issued by it or mortgages made by it if such obligations or mortgages are made or issued after the date of the enactment of this act shall not be exempt from federal income taxation.

Before final passage the section was amended to take its present form and to cover all profit from the purchase and sale of such bonds, but the reason for the broadening of the language does not appear, and under the circumstances it seems clear that it was merely so enacted with the familiar precautionary regard for the possibility that the exempting statute might later be construed in the way now contended for. This is far from permitting us to assume that it was a legislative construction of the earlier statute broader than that then being asserted by the administrative agency concerned. “The purpose of the variation may be to clarify what was doubtful and so to safeguard against misapprehension as to existing law.” Helvering v. New York Trust Co., 292 U. S. 455, 468; Mead Corporation,, 38 B. T. A. 687, 705.

Finally, it is argued that, regardless of other considerations, respondent is now estopped to contend that the present petitioners are liable for these taxes. It appears that the petitioner Stewart was aware of statements made by officials of the Government, relating to tax exemption of farm loan bonds, that he examined such statements, that he construed them as applying to the present transactions, and that he relied thereon in connection with the purchases undertaken by him. It would seem a complete reply to this contention that, as we have said, the statements referred to are without application to the present situation, and that any error made in so applying them is attributable to petitioners.

To this statement it may be added, however, that ordinarily a representation of law will not support an estoppel, Sturm v. Boker, 150 U. S. 312; that the restriction unless otherwise provided upon the power of administrative officers to construe the law is well known and well established, Old Farmers Oil Co., 12 B. T. A. 203, 214; that the existence of the exemption here asserted was purely a question of the proper construction of the basic law; and that one who, notwithstanding these considerations, relies upon such statements if they are not justified by the law under which they are made must be held to have done so at his peril.

It does not follow that the petitioner, Agricultural Securities Corporation, is subject to the penalty imposed by section 291 of the Revenue Act of 1934 for failure to file a return. We have found as a fact that the return was actually filed, although not within the time prescribed by law, and that the failure to file it sooner was due to reasonable cause and not to willful neglect. Under these circumstances the provision is inapplicable.

Reviewed by the Board.

Decision will be entered wider Bule 50.

KerN,

dissenting: The principal question involved in these proceedings is whether capital gains resulting from the sale or redemption of bonds issued under the Federal Farm Loan Act of 1916 constitute income derived from the bonds within the meaning of the provisions of the act which expressly exempt such bonds “and the income derived therefrom” from Federal, state, municipal, and local taxation.

That capital gains constitute income derived from the investment was expressly pointed out by the Supreme Court in Eisner v. Macomber, 252 U. S. 189, and Merchants Loan & Trust Co. v. Smietanka, 255 U. S. 509. In tbe former case the Court, after setting out its now classical definition of income, said by way of explanation and with particular reference to capital gains:

* * * Here we Rave the essential matter: not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being “derived,” that is, received or drawn by the recipient [the taxpayer] for his separate use, benefit, and disposal; that is income derived from property. Nothing else answers the description.

In the latter case the Court, in answering the contention that capital gam did not constitute income, used the following pertinent language:

* * * since the fund here taxed was the amount realized from the sale of the stock in 1917, less the capital investment as determined by the trustee as of March 1, 1913, it is palpable that it was a “gain or profit” “produced by,” or “derived from,” that investment, and that it “proceeded,” and was “severed” or rendered severable, from it, by the sale for cash, and thereby became that “realized gain” which has been repeatedly declared to be taxable income within the meaning of the constitutional amendment and the acts of Congress.

That capital gains do not constitute income derived from the act of sale or conversion of the capital investment was implicit in the decisions by the Supreme Court in the cases of Doyle v. Mitchell Brothers Co., 247 U. S. 179, and Lynch v. Turrish, 247 U. S. 221. In those cases, the Court held that capital gains accrued prior to the effective date of the Sixteenth Amendment, but only realized by sales occurring after such effective date, did not constitute taxable income. If the income had been derived from the act of sale (and not merely realized by it), instead of from the capital investment, it is evident that a different result would have been reached, since the act of sale occurred after the effective date of the Sixteenth Amendment, and, if the proceeds had been considered as income derived from such sales, they must have been held to be taxable income.

Respondent contends, however, that a dictum of the Supreme Court, contained in its opinion rendered in the case of Willcuts v. Bunn, 282 U. S. 216, must lead us to the conclusion that capital gains do not constitute income derived from the capital investment. That case held that the capital gains realized by a taxpayer on the purchase and sale of state bonds were subject to Federal income taxation, since the tax was not on the obligations of the state or on the investment therein, as such, and did not impose a substantial burden on the state’s borrowing power, and therefore, the tax was not interdicted by any constitutional implication.

We do not consider that the dictum from Willcuts v. Bunn, supra, quoted in tbe majority opinion, intends to or does reverse tbe bold-ing by tbe Supreme Court either expressly or by implication in tbe cases wbicb are cited supra to tbe effect that capital gains constitute income derived from capital investments wbicb is merely realized by tbe sale or conversion of sucb investments. While the income may result from both the increase in the value of the investment, and its sale or conversion, the income, under the decided cases of tbe Supreme Court, is derived from the capital investment. This principle is recognized by the Supreme Court in MacLaughlin v. Alliance Insurance Co. of Philadelphia, 286 U. S. 244, 249, a case subsequent to Willcuts v. Bunn, supra, in which the Court used this language: “while increase in value of property, not realized as gain by its sale or other disposition, may, in an economic or bookkeeping sense, be deemed an addition to capital in a later period, * * * it is nevertheless a gain from capital investment which when realized Toy conversion into money or other property, constitutes profit which has consistently been regarded as income within the meaning of the Sixteenth Amendment and taxable as such in the period when realized.” [Italics ours.]

Applying this rule to the facts of the instant case, it is obvious that the income subject to the tax out of which arises the deficiency involved herein is income derived from Federal farm loan bonds, and is, therefore, exempt from taxation pursuant to the express provisions of section 26 of the Federal Farm Loan Act.

It should be borne in mind that we are here called upon to construe an express exemption. The case of Hubert De Stuers, 26 B. T. A. 201, construed an entirely different exemption. Therefore, that case is not in point, and is only “analogous” in that it construed an exemption. The statute in that case exempted the “principal and interest” of certain Government bonds. The question was whether a tax on capital gains resulting from the redemption at par of bonds which had been purchased at a discount might be considered as a tax upon the principal of the bonds. In the instant cases the question is whether capital gains constitute “income derived from” the bonds, an issue not present in the De Stuers case. The Phipps case and Igleheart case, cited as “analogous”, are even less pertinent.

The majority opinion indicates that the case of Willcuts v. Bunn may be considered as authority for the proposition that “there was serious doubt whether the Congress was authorized to exempt these obligations from capital gains taxes of states, localities, and municipalities.” It is difficult to understand how the majority opinion reaches this astonishing result, since that case in no way, inferentially or otherwise, dealt with the question of whether Congress had the power under the Constitution to exempt obligations by specific statutory provision from tax. That case was solely concerned with the question of whether, by reason of our Federal system of Government, there would be, by implication, a prohibition on the power of the United States to levy an income tax on capital gains derived from state bonds. The startling conclusion of the majority opinion that, when Congress expressly exempts from tax capital gains derived from bonds issued under its authority as instrumentalities of the United States, it is granting “an immunity possibly beyond its power” may only be explained by the fact that the conclusion is based upon an erroneous reading of the case of Willcuts v. Bunn.

The conclusion of the majority opinion that the word “income”, as used in section 26 of the Farm Loan Act, may have been used in order to include not only interest, but also periodic payments to bondholders by receivers of insolvent banks in liquidation of the principal of such bonds, together with accrued interest (the only claims which the bondholders would have for liquidation), presumes such a naive misconception of legal principles on the part of Congress as to be incredible.

For all of these reasons, I respectfully dissent.

Leech agrees with this dissent.

Black,

dissenting: I agree with most of what is said in Member Kern’s dissent, but I wish to add some words of my own. I do not think the majority opinion gives sufficient consideration to the fact that what the Supreme Court was deciding in Willcuts v. Bunn, 282 U. S. 216, was not an express congressional exemption but an implied constitutional immunity. The two subjects are very different and different rules of construction apply.

The applicable revenue act which was before the Supreme Court in Willcuts v. Bunn was the Revenue Act of 1924. Section 213 (b) (4) of that act reads in part as follows:

(b) Tbe term “gross income” does not include the following items which shall be exempt from taxation under this title: * * *
(4) Interest upon (A) the obligations of a State, Territory or any political subdivision thereof or the District of Columbia: * * *

Manifestly profits derived from the purchase and sale of state and municipal bonds was not interest upon such bonds. Therefore, plainly Congress had not specifically exempted such gains from taxation under section 213 (b) (4). The taxpayer in that case was not so contending, but was contending that such profits and gains were constitutionally immune from taxation. This contention the Supreme Court denied upon the ground that the language contained in section 213 (a) of the Eevenue Act of 1924 plainly included gains from the purchase and sale of capital assets and was broad enough to include profits from the purchase and sale of state and municipal bonds and that a tax on such gains was not a tax on either the principal or the interest of such bonds and, therefore, there was no constitutional immunity.

In the instant case the specific exemption contained in the Eevenue Acts of 1932 and 1934 exempting interest upon bonds issued under the provisions of the Federal Farm Loan Act is exactly the same as the provision we have quoted above from the 1924 Eevenue Act exempting interest from municipal and state bonds. So if that were all the specific exemption there is, I would certainly say that Willcuts v. Bunn controls and petitioners should lose. But that is not all.

There is still to be considered section 26 of the Federal Farm Loan Act which reads in part as follows: “Section 26. * * * First mortgages executed to Federal Land Banks or to joint stock land banks and farm loan bonds issued under the provisions of this Act, shall be deemed and held to be instrumentalities of the Government of the United States and as such they and the income derived therefrom shall be exempt from Federal, municipal and local taxation.” Section 26 of the Federal Farm Loan Act, although not specifically carried in the Eevenue Acts of 1932 and 1934, applicable to the taxable years here in question, was not repealed by any provision in said acts and was in full force and effect in both taxable years. It was not materially altered until section 817 of the Eev-enue Act of 1938 altered the exemption in a very material manner, but then only as to future bond issues. Therefore, during the two taxable years under consideration we have to construe an exemption which was much broader than a mere interest exemption. It was an exemption which specifically exempted from Federal taxation the “income derived” from Federal farm loan bonds.

It should require no citation of authorities to support the rule that, in construing this language of Congress, Congress will be deemed to have used the words in their plain, ordinarily understood meaning. Can it be plausibly argued that at the time Congress wrote these words into section 26 of the Federal Farm Loan Act it was not commonly and ordinarily understood that the expression “income derived from property” included gains and profits derived from the purchase and sale of property as well as such things as interest and rents derived from the property.

I don’t tbinlr it can plausibly be so argued. I will concede that if Congress were now writing such a statute as section 26 of the .Federal Farm Loan Act, and used the same language, the construction contended for by respondent would be entirely reasonable in the light of the Supreme Court’s decision in Willcuts v. Bunn, but we are construing a statute written in 1916 and not one written in 1939, and it is what Congress meant in 1916 that should control us in the instant case.

The case of Hubert De Stuers, 26 B. T. A. 201, is also cited and relied upon in the majority opinion. In my judgment, as Member Kern points out in his dissent, that case has no bearing on the question we have here to decide. In that case we had before us for construction section 3 of the Liberty Loan Act as amended exempting United States bonds while beneficially owned by nonresident aliens, “both as to principal and interest, from any and all taxation, etc.” We held that a tax derived from the purchase and sale of such bonds was not a tax on either the principal or the interest upon such bonds, following Willcuts v. Bunn, supra.

If the exempting statute which we have to construe in the instant case, section 26 of the Farm Loan Act, is no broader than the one present in the De Stuers case, then the Government should undoubtedly win because a tax on the gain derived from the purchase and sale of Federal farm loan bonds is not a tax on the principal of such bonds nor is it a tax upon the interest of such bonds.

But for reasons I have already endeavored to point out, the exemption which we have here to construe is considerably broader than the one which we had in the De Stuers case because an income tax on the profits arising from the purchase and sale of such bonds is a tax on the “income derived therefrom” as that expression was intended to mean when used by Congress in section 26 of the Federal Farm Loan Act. Interest is, of course, income, but it is only one kind of income. As used in the revenue act and the Federal Farm Loan Act, it is the premium paid for the use of money. Income, on the other hand, as used in the same acts, is a generic term, which has a meaning considerably broader than interest and certainly broad enough at the time Congress wrote the act to include gains and profits derived from the purchase and sale of capital assets, including farm loan bonds.

For the reason that I think the majority opinion construes section 26 of the Federal Farm Loan Act more narrowly than Congress intended, I respectfully record my dissent.

Leech and HakroN agree with this dissent.

       Federal Farm Loan Act, 39 Stat. 380, 12 U. S. C. 931:
      Sec. 26. * * * First mortgages executed to Federal land banks, or to joint stock land banks, and farm loan bonds issued under the provisions of this Act, shall be deemed and held to be instrumentalities of the Government of the united States, and as such they and the income derived therefrom shall be exempt from Federal, State, municipal, and local taxation.

       * * « “Income may be defined as the gain derived from capital, from labor, or from both combined,” provided it be understood to include profit gained through a sale or conversion of capital assets * * *. [Page 207.]

       The occasion for the foregoing discussion, as set forth in the opening sentence of the paragraph first quoted, is as follows :
      “But it does not follow, because a tax on the interest payable on state and municipal bonds is a tax on the bonds and therefore forbidden, that the Congress can not impose a non-discriminatory excise tax upon the profits derived from the sale of such honds.” [Emphasis added.]
      This was evidently thought to be necessary in order to distinguish Pollock v. Farmers Loan & Trust Co., 157 U. S. 429, where the language used was:
      “Another question is directly presented by the record as to the validity of the tax levied by the Act upon the income derived from municipal honds * * *. But we think the same want of power to tax the property or revenues of the states or their instrumentalities exists in relation to a tax on the income from their securities * * [Emphasis added.]

       See “Joint Stock Land Banks, Progress in Liquidation Including Statements of Condition”, Report of U. S. Farm Credit Administration, U. S Government Printing Office, 1938, pages 8, 4, 47-51, e. g., page 48 being statement of condition of Chicago Joint Stock Land Bank In Receivership, wherein the following appears under “Liabilities” :
      Interest on farm loan bonds:
      Matured interest unpaid at date of receivership_$134, 955. 00
      Unmatured interest accrued to date of receivership- 747, 672. 91
      Total-$S82, 627. 91
      Less liquidation dividend- 639, 905. 24
      242, 722. 67

       The fact that the 1938 Act (sec. 817) limited the term to interest, presumably in the strict sense, is inconsequential, since in the meantime joint stock land banks had been put in course of liquidation, Emergency Farm Mortgage Act of 1933, part 2, 48 Stat. 46, 12 U. S. C. 810. See footnote 4, supra.

       See also Darby-Lynde Co. v. Alexander, 51 Fed. (2d) 56, 59; certiorari denied, 284 U. S. 666; Lester W. Fritz, 28 B. T. A. 408.

       This concept floes not appear to Rave been impaired by later decisions culminating in Graves v. People of the State of New York ex rel O’Keefe, 306 U. S. 466. Speaking of the possible differences in the two immunities, the Supreme Court there said: “So far as now relevant, those differences have been thought to be traceable to the fact that the Federal Government is one of delegated powers in the exercise of which Congress is supreme; so that every agency which Congress can constitutionally create is a governmental agency.” And again: “All the reasons for refusing to imply a constitutional prohibition of Federal income taxation of salaries of State employees, stated at length in the Gerhardt case, are of equal force when immunity is claimed from State income tax on salaries paid by the National Government or its agencies.”

       And see Graves v. New York, supra: “* * * if it appears that there is no ground for implying a constitutional immunity, there is equally a want of any ground for assuming any purpose on the part of Congress to create an immunity.”

       “The application of a couple of simple tests should demonstrate this beyond peradventure of doubt.
      i(i ***** *
      “Test Number Two: Recall that it is among the stipulated facts that every penny paid to the taxpayers on the surrender of the Kansas City Joint Stock Land Bank bonds was paid to them under and by virtue of the covenants of the bonds. In other words, every penny paid flawed directly from the bonds.” Brief for petitioners, p. 16.
      “Again, even if the words “income derived therefrom” are construed to mean “interest” only, still the exemption of the bonds themselves exempts the income involved in all the cases at bar. For a bond is only a promise to pay a certain amount — a right to receive the face amount thereof. If the bonds themselves are exempt, clearly any moneys received by a bondholder for his bond — up to the amount of its face value — is likewise exempt. Consequently even if we accept respondent’s premise that capital gains are not exempt, only that amount received which is in excess of the face amount of the bonds sold or surrendered, is taxable.” Reply brief for petitioners, p. 4.

       See, e. g., footnote 9.

       “The petitioner however seeks' to distinguish this case because the purchased bonds were not sold but were redeemed by the Government, a special qualifying circumstance not present in the above case [Willcuts v. Bunn, supra] and not distinct from the contracts made by the Government in the bonds themselves. The return in question, he argues, came ‘to the owner of the security according to the provisions of the obligation and without any further transaction on his part’ * * *.
      “ * * * The profit in this case was not paid as such by the United States, but resulted from purchases at low prices and retention until the bonds were redeemed when worth par. This profit resulted from a combination of several factors, including capital investment and probably some measure of sagacity. If profit results from these factors where there has been both purchase and sale in the ordinary sense, we see no reason to hold otherwise where there has been either an ordinary purchase or an ordinary sale, as where bonds subscribed for and obtained at par are later sold at a premium or where bonds have been purchased at less than the amount at which they are redeemed. In all such transactions capital has been invested. Generally some measure of sagacity has been a factor in the purchase as well as in the sale. The gain may be regarded as ‘the creation of capital, industry, and skill’ and a tax on it is not on the obligation of the United States.” [Pp. 204, 205.]

       “Tegt Number One: Eliminate the bonds entirely from the transactions in question and what is there left? Nothing. Without the bonds there could have been no transactions, no gains. The bonds are of the very essence, the proximate cause of the gain.” [This is the omitted portion of the quotation in footnote 9, supra.]

       SEC. 22. GROSS INCOME.
      * ******
      (b) Exclusions fbom Geoss Income. — The following items shall not be included in gross income and shall be exempt from taxation under this title :
      * * * * * * *
      (4) Tax-tree interest. — Interest upon * * * (B) obligations of a corporation organized under Act of Congress, if such corporation is an instrumentality of the united States; * * *

       Hearings before Committee on Finance, U. S. Senate, 75th Congress, 3d session on H. R. 9682 [Rev. Bill 1938] pp. 641-3.

       SEC. 817. INCOME FROM OBLIGATIONS AND MORTGAGES ISSUED BX JOINT-STOCK LAND BANKS.
      Notwithstanding the provisions of section 26 of the Federal Farm Loan Act, as amended, in the case of mortgages made or obligations issued by any joint-stock land bank after the date of the enactment of this Act, all income, except interest, derived therefrom shall be included in gross income and shall not be exempt from Federal income taxation.

       Senate Finance Committee Report, Revenue Bill of 1938, 75th Cong., 33 sess., Report No. 1567, p. 47.

       Sec. 816, H. R. 9682, 75th Cong., 3d sess., Jan. 5 (Calendar day April 5), 1938.

       E. g., Revenue Act of 1928, sec. 606, as amended by Revenue Act of 1938, sec. 801; Securities Act of 1933, 48 Stat. 85, as amended 48 Stat. 908, 15 U. S. C., sec. 77 s.


author: Turner:

text:
    C. G. Ganopuls, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 87985.
    Promulgated May 26, 1939.

      Mel W. Werden, C. P. A., for tbe petitioner.

      Edward 0. Adams, Esq., for tbe respondent.
   OPINION.

Turner:

Tbis proceeding was brought to redetermine a deficiency m income tax for tbe year 1934 in the amount of $230.56. Tbe only question presented is whether a certain loss sustained by petitioner, as assignee of tbe vendee in a contract to purchase real property, resulting from tbe vendor’s declaring the contract forfeited constituted an ordinary loss or a capital loss. The facts were stipulated and as stipulated are adopted as our findings herein. Only those facts essential to the discussion of the issues will be recited.

Petitioner is an individual, residing at Detroit, Michigan.

On June 19,1926, a contract was entered into by William T. Leigh-ton and his wife, Mary Leighton, as vendors, and George J. Sidwell, as vendee, for the sale of certain property situated in Avon Township, Oakland County, Michigan. The contract recited a down payment of $4,000 and the vendee agreed to pay the balance of $5,800 in monthly installments of $75 each. The vendee also agreed to keep the building insured and to pay all taxes and assessments against the premises and in the event he failed to do so the vendor could pay such taxes and insurance premiums and the sums so paid would be a further lien on the land payable by the vendee to the vendor; and if proceedings were taken to enforce the contract in equity, after default by the vendee, the entire amount owing thereon should be due and payable forthwith. The contract provided that the vendee should have possession of the premises after the execution of the contract and so long as be did not default in carrying out the terms thereof, and if lie should fail to perform the contract or any part thereof, the vendor immediately after such default had the right to declare the contract void and retain whatever may have been paid thereon and be entitled to take immediate possession of the premises.

The contract further provided that no assignment or conveyance by the vendee should create any liability against the vendor until a duplicate thereof duly witnessed and acknowledged, together with the residence address of such assignee, should be delivered to the vendor and receipt thereof endorsed thereon, and further that “The covenants shall bind their heirs, assigns, and successors of the respective parties.”

On March 10,1927, the above vendee, for a valuable consideration, sold and assigned his interest in the above land contract to petitioner and the latter agreed in writing to assume and pay the balance owing on the contract in the amount of $5,425.96.

On April 23, 1929, petitioner paid to Samuel L. Wareham et al., $1,500 for the release of their claim to an interest in the contract and property in question. Their interest was alleged by them to have been attached to the property prior to the time the land contract was assigned to petitioner and the payment of the $1,500 was made pursuant to a judgment rendered against petitioner and in favor of the claimants. After receipt of such payment the claimants executed and delivered to petitioner an assignment of all their interest in the contract.

After acquiring the vendee’s interest in the contract, petitioner paid the vendor the installment payments under the contract and by October 3, 1932, the principal balance had been reduced to $2,466.43. No payments were made on the contract after that date.

On February 12, 1934, petitioner being in default in his payments on the contract, the surviving vendor, Mary Leighton, mailed to him a notice of forfeiture declaring the contract forfeited and notifying him to surrender and deliver up possession of the premises.

On May 18,1934, petitioner executed and delivered to the surviving vendor a quitclaim deed of his interest in the contract and property and on the same date the latter executed and delivered to petitioner a release from any and all liability under the contract. This release provided that the petitioner would have the privilege of removing from the premises any and all trees planted by him, provided that they were removed within 30 days.

Petitioner’s total investment in the property amounted to $6,694.88 all of which was lost as a consequence of the forfeiture of the contract. Petitioner was solvent throughout the taxable year.

In bis income tax return for 1934 petitioner deducted as an ordinary loss in respect of tbe aforesaid transactions the amount of $6,848. The respondent determined that the loss sustained was a capital loss and, applying section 117 (d) of the Kevenue Act of 1934, limited the deduction to $2,000.

That petitioner’s interest in and rights to the parcel of property above described was a capital asset is in our opinion beyond question. Harold R. Smith, 39 B. T. A. 892. Also, it is equally obvious that the loss in question resulted from his parting with or the extinguishment of that capital asset. The statute, however, applies the limitation in question to losses sustained with respect to such assets only where they result from “sales or exchanges.”

We have previously held that where the vendor and vendee, under a contract for the sale of real estate, mutually agree to cancel the contract, resulting in the acquisition by the vendor of the vendee’s interest in the real estate and in the release of the vendee by the vendor from further liability under the contract, such a transaction is a sale or exchange within the meaning of the statute. Harold R. Smith, supra. See also Betty Rogers, 37 B. T. A. 897; affd., 103 Fed. (2d) 790. In the instant case, however, there was no such transaction. The parties did not mutually agree to an exchange such as was present in the Smith case. Here the petitioner did not exchange his interest in property for a release from liability under the existing contract. To the contrary his property rights were extinguished solely by the act of the vendor in declaring the contract forfeited. Property acquired by a vendee under such a contract is subject to the right of the vendor to do exactly what the vendor did in this case, namely, to declare the contract void in case of default on the part of the vendee and to reacquire the interest previously sold and disposed of to the vendee. Chicago Boulevard Land Co. v. Apartment Garages, 245 Mich. 448; 222 N. W. 697. In that case the Supreme Court of Michigan made the following statement:

* * * The purpose and effect of a valid declaration of forfeiture are to end the contract and discharge vendor of the duty to convey and vendee of duty to pay. Consequently, after forfeiture, action at law will not lie for recovery of any part of the purchase price. Goodspeed v. Dean, 12 Mich. 352; L. R. A. 1916C, 893, note. By the same token, suit in equity for foreclosure and deficiency decree cannot be maintained. “If the vendor exercises his option to declare the contract at an end, he cannot change his position and thereafter hold the purchaser liable to complete the purchase or pay any part of the unpaid purchase money. The remedy of the vendor by way of a cancellation of the contract and the continued liability of the purchaser for the purchase money are totally inconsistent, and thfc exercise of the former terminates any further liability of the purchaser for the purchase money.” 27 R. C. L. 666.

In this case we think it is apparent that the petitioner’s rights in the property in question were extinguished and terminated by the act of the vendor in declaring the forfeiture and that this termination and extinguishment of his rights have none of the characteristics of a sale or exchange. The respondent places considerable emphasis on the fact that on May 18,1934, subsequent to the notice of forfeiture of February 12,1934, the petitioner executed and delivered to the surviving vendor a quitclaim deed of his interest in the property and on the same date the vendor executed and delivered to the vendee a release from any and all liability under the contract. That occurrence, however, was not sufficient to change the previous forfeiture into a sale or exchange. Chicago Boulevard Land Co. v. Apartment Garages, supra. The petitioner’s property rights had already been extinguished by the act of the vendor and not by agreement of the parties, as in Harold R. Smith, supra. We accordingly conclude that the petitioner is entitled to a deduction in respect of the loss herein in accordance with the provisions of section 23 (e) of the Revenue Act of 1934 and that the deduction is not subject to the limitations prescribed in section 111 (d), supra.

Decision, will Toe entered wider Bule 50.