author: GREen: Trammell :

text:
    Appeal of Gould Coupler Co.
    Docket No. 791.
    Decided November 16, 1926.
    1. Invested capital ; assets acquired foe stock ; time of valuation. — Two West Virginia corporations, organized prior to 1903, in tbat year owned tangible and intangible property, a part of wliicb had been acquired for stock and the balance accumulated or developed in the course of their business operations. In 1903 they respectively transferred all of their property to two New York corporations, which also assumed the liabilities, for substantially all of the capital stock of the latter, the stock so received being distributed among the stockholders in exchange for their shares in the West Virginia corporations. Held, the invested capital of the New York corporations is to be measured by the value of the property at the time transferred to them for stock, and not by the cost to, or value at the time acquired by, their respective predecessors. Appeal of Regal Shoe Co., 1 B. T. A. 896; Appeal of National Balters’ Bgg Co., 3 B. T. A. 1205.
    2. Same; intansibles; valuation. — Value of intangible property paid in for stock in 1903 determined.
    3. Same; limitation on value; affiliated corporations.- — In affiliations, the 25 per cent limitation prescribed by section 326(a) (4), (5), Revenue Act of 1918, upon the amount of intangibles that may be included in invested capital, shall be measured by the total outstanding capital stock of the affiliated group. This rule applies to both classes of affiliation.

      4. Same; operating deficit; affiliated member. — In determining the consolidated invested capital of an affiliated group of corporations, the operating deficits of any member shall be offset against the earned surplus of the others; that is, only the net earned surplus of the group shall be included in invested capital.
    5. Same. — The operating losses of any member during the period of affiliation are deducted in determining the consolidated net income.
    6. Same; intercompany obliqations. — If one member of an affiliation makes advances to another to meet operating losses occurring during the period of affiliation, the intercompany obligation thus arising may not be deducted by the corporation making the advance after the obligation has become worthless.
    7. Same. — While affiliated, intercompany obligations are disregarded in determining the consolidated net income and invested capital.
    8. Same; Patents; cost of development by predecessor. — Expenditures for patent development made by a predecessor corporation are reflected in the value of patents acquired for stock by petitioner, and may not again be included in the invested capital of the latter.
    9. Same; Capitalization of cost; evidence. — Evidence held insufficient to enable the Board to determine that expenditures for patent acquisition and development, originally charged to profit and loss, should be added to surplus for determining invested capital.
    10. Depreciation. — Depreciation allowed on items of tangible assets erroneously omitted by petitioner in its original return.

      Richard T. Greene, Esq., and James L. Dohr, Esq., for the petitioner.

      E. 0. Lake, Esq., for the Commissioner.
    The petitioner appeals from the determination of a deficiency of $202,104.65 in income and profits taxes for the years 1918 and 1919. It alleges error by the Commissioner, in excluding from invested capital the value of patents acquired for capital stock; in offsetting operating deficits of some affiliated companies against the surplus of other companies in the affiliated group in ascertaining invested capital of the group; in excluding from invested capital expenditures for development of patents; in using an incorrect capital sum in computing exhaustion, wear and tear and obsolescence; in disallowing the deduction in 1918 of intercompany losses occurring prior to 1918; and in disallowing the deduction of a loss arising through the stock of subsidiary corporations having become worthless.
    FINDINGS OF FACT.
    About 1884, Charles A. Gould started in the business of manufacturing and selling car axles, locomotive axles, locomotive frames and link-and-pin couplers for railroad equipment. In 1886 he acquired a patent for an automatic car coupler known as the “ Barnes ” patent. Shortly thereafter he acquired the so-called “ Browning ” patent covering an automatic coupler with a self-opening head. Up to this time the link-and-pin coupler was being used on the railroads of the United States. Gould obtained orders from certain railroad companies, including the New York Central, the Erie, and the Lackawanna, and commenced supplying automatic couplers to them, although continuing to make and to sell the link-and-pin couplers. To obtain orders it was necessary to secure the confidence of the railroads in automatic couplers, and Gould was enabled to do this because • of the contacts he had made in selling • his other products to them. There was another ■ patent for an automatic coupler known as the “Jenny” patent which was ahead of the Barnes patent in time. This was being used on Pullman cars as well as on freight cars, and had been adopted by the Pennsylvania Railroad. The patents thus far owned by Gould were for freight cars. Thereafter he bought the Cowell patents for a platform buffer to be used on passenger cars in conjunction with the automatic coupler, and he then obtained orders from the New York Central llailroad for couplers, vestibules and platforms for passenger cars. At that time there were about twenty different patents for automatic couplers being made by as many competitors in the automatic coupler field.
    In 1889 the Gould Coupler Co. of West Virginia was organized, with an authorized capital stock of $5,000,000. In December, 1889, Charles A. Gould sold and conveyed to this company all letters patent which he owned for “ automatic car coupling device ” for the United States, in exchange for $4,999,500 par value of its capital stock. The remaining $500 of capital stock was issued for cash. The letters patent so transferred were the following:

    In addition to selling automatic couplers this company continued the business of manufacturing and selling axles, locomotive frames, and link-and-pin couplers, that had been established and carried on by Gould individually. At first- the company did not have the facilities for manufacturing the automatic couplers but it had them made for it by others under contract. In the fall of 1893 it completed a plrtnt at Depew, N. Y., where it manufactured malleable iron couplers, passenger car platforms, vestibules, draft gears, passenger car vestibules, and journal boxes. The link-and-pin coupler was covered by patents but the company did not own any of these patents.
    The “Jenny” coupler and the “Barnes” coupler each was based on contour lines and was known as a vertical plane coupler. They were made on the principle of two swinging knuckles or jaws pivoting in the head of the coupler, one knuckle engaging in the counter or recess of the opposite coupler. The Barnes coupler differed from the Jenny coupler in the means of locking the knuckle in position. The railroads would not adopt a patented device, so the owners of the Jenny patent waived their rights to the contour-lines principle in so far as its use on freight cars was concerned, but they did not waive it as to passenger cars. The Gould Coupler Co. then made some changes in the contour-lines principle so as to avoid infringing the Jenny patent on passenger cars, and acquired patents covering these changes.
    It was necessary to develop and improve the first automatic couplers in order to overcome difficulties encountered from time to time in use and to meet the requirements of the railroads for safety and increased service. On March 3, 1893, the Federal Safety Appliance Act became a law. It prohibited the use after January 1, 1898, in interstate traffic, of cars not equipped with couplers which coupled automatically by impact and which could be uncoupled without the necessity of men going between the ends of the cars. By the date prescribed in that Act the link-and-pin coupler disappeared from use on the railroads. With the advent of the automatic coupler it became possible to increase the size and capacity of cars and to increase the number of cars in a train, and this result in turn necessitated further development and improvement in the automatic coupler. The period from 1892 to 1900 was one of continuous experimentation and development. During that time there were improvements and developments of the Barnes coupler, especially in the locking device. About 1900 the Gould Coupler Co. adopted a new style of lock, known as the Allen lock. Some years later the Barnes coupler evolved into what was known as the “ D ” type, or A. R. A. standard coupler, and the “Z” type, which is still being made by the corporation which succeeded the petitioner. In 1892 there were thirty-five other automatic couplers on the market with different types of locking devices. The number of concerns making automatic couplers was gradually reduced until there were five besides the Gould Coupler Co. With the exception of McConway & Torley, who owned the Jenny patent and who made couplers for passenger cars as well as for freight cars, these concerns originally made only automatic couplers for freight cars.
    The Gould Coupler Co. of West Virginia, during the period from the date of its organization down to June, 1903, acquired a number of letters patent which were developments, improvements, or changes of the Barnes and Browning patents, and also letters patent covering buffers, passenger car platforms and vestibules, car trucks, draft gears and journal boxes. These letters patent were acquired by purchase or taken out by or on behalf of the Gould Coupler Co. upon inventions made by persons in its employ. Some of them were necessary to protect patents already owned; others covered improvements or developments of such patents.
    This company also acquired a series of patents covering improved methods of lighting passenger trains. Originally passenger cars were lighted by oil lamps. This method was replaced by the Pintsch gas system, which was in general use up to the time of the introduction of electricity. The Pintsch gas system was objectionable from the standpoint of comfort and sa'fety. About 1898, Gould acquired the American rights to an English system of lighting cars 'by electricity, known as the “Stone 55 system, whereby each car was equipped with a generator driven from the axle and with batteries for the storage of electricity for use while the car is not in motion. The “ Stone 33 system was put into use on the New York Central and the Michigan Central railroads. It did not meet the demands for service of the railroads of the United States, and the Gould Coupler Co. acquired letters patent covering American inventions for lighting systems similar to, but which were improvements over, the “ Stone 33 system.
    The following is a list of the patents acquired by the Gould Coupler Co. of West Virginia, in addition to those originally transferred to it by Gould, between the time of its organization and June, 1908. Those dated subsequent to June, 1908, are patents for which application had been filed prior thereto and the rights therein assigned to the Gould Coupler Co. of West Virginia.

    The evidence does not show the amounts paid by Gonld for the patents bought by him and transferred to the Gould Coupler Co. of West Virginia when it was organized, or the amounts paid by this company for patents it acquired subsequently by purchase.
    In June, 1903, the petitioner, the Gould Coupler Co. of New York, was incorporated in that State with an authorized capital stock of $5,000,000. It acquired, for a consideration of $4,995,000 par value of its capital stock and $5,000 in cash, all of the property of the Gould Coupler Co. of West Virginia, “together with the book accounts, bills receivable, claims, demands of every kind and nature, patents, trade-marks, licenses, and all other rights and privileges, * * * subject nevertheless to the payment of all liabilities and the assumption of all obligations, contracts, etc., of the company.” The stockholders of the West Virginia corporation surrendered their shares and received a like number of shares in the New York corporation. At that time Charles A. Gould owned 49,600 shares.
    The first five years of operation of the Gould Coupler Co. of West Virginia (being for fiscal years ending June 30) show the following results:

    The net profits of the company during the five years preceding the organization of the New York corporation of the same name (being for fiscal years ending June 30) were as follows:
    Tear. Net profits.
    1899_ $446,157.09
    1900_ 475, 589. 61
    1901_ 198,118.40
    1902_ 312, 616. 37
    1903_ 259,891.36
    Five-year average. 338,474.57
    The value of the tangible property employed in the business in the same period was as follows:
    Tear. Value of tangibles.
    1899_ _ $1,382,682.42
    1900_ _ 1,428, 839. 51
    1901_ - 1, 504,429.12
    1902_ - 1,377,547.52
    1903_ - 1,440,103. 89
    B'ive-year average. - 1,426,732.49
    Allowing a return of 9 per cent on the average value of the tangible property for the preceding five years, and capitalizing the remaining average net earnings on the basis of six years’ purchase, we find that the value of the intangible property paid in to the Gould Coupler Co. for its stock on June 23,1903, was $1,260,411.90.
    In 1918 the petitioner was affiliated with the Gould Storage Battery Co. of. New York, the Gould Storage Battery Co. of California, the Gould Storage Battery Co. of Illinois, the Gould Storage Battery Co. of Massachusetts, and the Gould Storage Battery Co. of Ohio.
    The Gould Storage Battery Co. of New York was incorporated as the successor of a corporation named the Gould Storage Battery Co. of West Virginia. The latter was incorporated in April, 1899, with an authorized capital stock of $5,000,000. For $4,999,500 of its capital stock, it acquired from Charles A. Gould “letters patent of the United States No. 572,363, bearing date December 1, 1896, for improvements in battery grids,” and also all of his right, title and interest in and to “applications for letters patent of the United States made by Rufus N. Chamberlain, bearing date March 1, 1899, for improvements in processes for preparing plates for storage batteries and improvements in machines for spinning grids.” The company engaged in the manufacture of batteries of different kinds for various uses and the manufacture of electric lighting equipment for trains. It supplied batteries for train lighting to the Gould Coupler Co. Among the other uses for which batteries were made were the propulsion of automobiles and street cars, ignition of gasoline engines, telegraph and telephones, central lighting stations and isolated plants, electric launcnes and submarines, and portable batteries.
    There was competition in the train lighting field, and other companies, protected by patents, entered it. There were five or six other companies actively engaged in the business.
    During the period from 1899 to 1903, the Gould Storage Battery Co. of West Virginia developed or acquired numerous additional patents. These covered improvements in the patents originally acquired, various improvements in train lighting systems, generators, generator suspension and drive, control devices, storage batteries, separators for batteries, and processes for plates. In June, 1903, it owned the following patents:

    Tlie Gould Storage Battery Co. of New York was formed in June, 1903, with an authorized capital stock of $5,000,000, to purchase, take over and continue the business then carried on by the Gould Storage Battery Co. of West Virginia. For $4,995,000 par value of its capital stock and $5,000 in cash, it acquired from the Gould Storage Battery Co. of West Virginia “ all of its property, real and personal, wherever the same may be situated, together with all book accounts, bills receivable, claims, demands of every kind and nature, patents, trademarks, licenses, and all rights and privileges * * * and subject nevertheless to the payment of all liabilities and the assumption of all obligations, contracts, etc., of the company.” The stockholders of the old company then received stock in the new company in exchange for their holdings. Charles A. Gould was the principal stockholder.
    The evidence does not disclose the amounts paid by Gould for the patents transferred by him to the Gould Storage Battery Co. of West Virginia, or the cost to this company of patents thereafter acquired by it. Neither this company nor its New York successor ever showed any net profits. We are unable to find from the evidence that the intangible property transferred from the Gould Storage Battery Co. of West Virginia to the New York corporation of the same name had any value at the time of the transfer.
    From the time of their original organization down to 1918, the Gould Coupler Co. and the Gould Storage Battery Co. engaged in a continuous process of patent development and patent acquisition.
    It was stipulated by counsel that the dissolution of the Gould Coupler Co. and the Gould Storage Battery Co. of West Virginia, and the incorporation of the New York corporations of the same names, effected in each case a change of domicile.
    The two West Virginia corporations, during the time they were operating, and their respective New York successors, made expenditures in the amounts set forth below for patent development, applications for patents, and in litigation involving patents, which were charged to expenses and not capitalized:

    In 1918 and 1919, substantially all of the capital stock of the Gould Coupler Co. of New York and the Gould Storage Battery Co. of New York was owned or controlled by the same interests. In addition, the Gould Storage Battery Co. of New York owned all of the capital stock of the Gould Storage Battery Co. of California, the Gould Storage Battery Co. of Illinois, the Gould Storage Battery Co. of Massachusetts, and the Gould Storage Battery Co. of Ohio. The two last named discontinued business in 1918. Consolidated returns were filed for both years and their affiliation was acquiesced in by the Commissioner.
    Certain of the affiliated companies show operating deficits as follows (no dividends having been paid):

    The Gould Storage Battery Co. of Massachusetts discontinued business in 1918. On August 1, 1918, it owed the Gould Storage Battery Co. of New York $21,182.46, and the latter had invested in the capital stock of the former $2,600, being the par value of all of its outstanding stock. On that date the New York company charged off both of these amounts to profit and loss.
    The Gould Storage Battery Co. of Ohio also discontinued business in 1918. The Gould Storage Battery Co. of New York owned all of its outstanding capital stock, amounting to $8,000, which was purchased by it at par. On December 31, 1918, the account of the Ohio company with the New York company shows a debit of $46,831.93. Both of these amounts were charged oif by the New York company to profit and loss on the date named.
    On January 1, 1918, the book value of the tangible assets of the Gould Coupler Co. was $1,923,473.87. Among them were two items of non-depreciable assets, viz, land $40,993.12; small tools $147,919.75. Subtracting these two items, the depreciable items aggregate $1,736,561, which agrees with the company’s books and with the balance sheet prepared by an examining revenue agent. The Commissioner calculated depreciation on a total of $1,590,531.95, the following items not being included:
    Factory office equipment-$11,130.11
    Forge addition- 447. 00
    Booming house_ 21, 97(5. 50
    New building- 107,080. 59
    New York office equipment- 9, 447. 96
    General vehicle trucks_ 443.40
    3 ⅛ ton Waverly truck_ 510. 22
    Automobile purchased in 1917- 445. 00
    Miscellaneous equipment_ 1, 527.48
    There are two credit balances, as follows: Forge, blacksmith and carpenter áhop, $6,139.28; service truck, $S00.
    On January 1, 1918, the book value of the tangible assets was $1,917,201.79, with non-depreciable items of: land $40,993.21; small tools, $148,221.23; making the total depreciable assets $1,727,987.44. The total used by the Commissioner was $1,592,451.10, no depreciation being allowed on the following items.
    Factory office equipment-$11,130.11
    Forge addition_ 447.00
    Forge, blacksmith and carpenter shop- 4,000.00
    New buildings_ 107, 080. 59
    New York office equipment- 9, 718.49
    Power plant_ 2,405.98
    General vehicle truck_ 403.47
    Waverly truck_ 510. 22
    Automobile purchased in 1917_ 445.00
    Miscellaneous equipment_ 1,527. 48
    There are credit items of malleable plant, $1,332; and service truck, $800.

      The following table shows the amounts and rates used by the Commissioner in computing depreciation:

   OPINION.

GREen:

When the Gould Coupler Co. of West Virginia was organized in 1889, certain patents were transferred to it in exchange for $4,999,500 par value of its stock. The Gould Storage Battery Co. of West Virginia, incorporated in 1899, likewise acquired patents for $4,999,500 of its stock. In 1903 two corporations were formed in New York State, bearing the same names and having the same amounts of authorized capital stock as these West Virginia companies, and they took over the business and assets of the latter, respectively, in exchange for substantially all of the capital stock of the new corporations. At the time of the transfer in 1903, each of the West Virginia corporations, it appears, owned many more patents than they acquired originally (although the first patents acquired by the Gould Coupler Co. had expired prior to 1903). The Commissioner took the position that, in determining invested capital, the New York corporations would be entitled to have included only the value, if any, of intangibles paid in for stock of their predecessors— the West Virginia corporations — in 1889 and 1899, respectively. We held in Appeal of Regal Shoe Co., 1 B. T. A. 896, and Appeal of National Bakers' Egg Co., 3 B. T. A. 1205, that invested capital is to be measured by the value of property paid in for stock of the taxpayer, and not by property paid in to a predecessor corporation (except, of course, in cases which come within section 331, Revenue Act of 1918). Those decisions are applicable to the facts in this case.

This being so, we must determine the value of the intangible property paid in to each of the New York corporations in 1903. The value of the tangible property paid in is not in dispute.

We will first consider the Gould Coupler Co. By June, 1903, all of the ten patents transferred by Gould to the West Virginia corporation had expired, so we can give no weight to the petitioner’s argument that the Browning and Barnes patents were peculiarly valuable as basic patents. The Gould Coupler Co¡ of West Virginia had, however, practically from the time of its organization down to June, 1903, engaged continuously in developing and improving the first automatic couplers, and patents were obtained covering these improvements and developments. It also acquired patents covering a number of other railroad appliances, and its engineers from time to time devised improvements in those appliances to meet the demands of railroad service. The improvements also were covered by patents. At the date of the transfer to the New York corporation, it owned 109 patents classified as follows:

Car couplings- 26
Passenger platform buffers- 17
Locomotive buffers- 2
Car trucks_ 13
Passenger car vestibules_ 9
Freight car buffers_ 5
Passenger car couplers_ 5
Passengers car buffers without platforms_ 3
Passenger car draft gear_ 1
Locomotive vestibule and buffer_ 1
Coupler unlocking device_ 1
Steel platform frames_ 2
Journal boxes_ 7
Draft gear_ 7
Electric car lighting equipment_ 10

There is no doubt in our minds that these patents were valuable in the enterprise as income-producing factors. It is also apparent that there was in the business a considerable good will value which contributed materially to its success. The products of the company were being used on some of the principal railroads, such as the New York Central, the Erie, the Michigan Central, and the Lacka-wanna. As Gould testified, the management of the Lackawanna Bailroad had directed that all axles for that railroad be bought from him. By 1903 the business was well enough established so that it was not affected by the expiration of the ten original patents. These had expired on various dates between February 28, 1899, and March 9, 1903. By that time the West Virginia corporation had developed or acquired the series of patents mentioned above, and it was so organized in personnel as to enable it to continue experimentation and the further development and acquisition of patents. The 109 patents then owned had different periods of unexpired life, as follows:

From the date of its organization down to 1903 the company continuously showed large net earnings. During the flye years preceding June 30, 1903, with an average tangible capital of $1,426,-782.49, it showed average net profits of $338,474.57. The only paid-in tangible property was $500 in cash. Upon this showing we are satisfied that there was paid in to the Gould Coupler Co. of New York intangible property of considerable value. We believe it proper, upon the evidence, to determine its value by the formula method. The petitioner contends for a valuation, by this method, arrived at by allowing a return of 8 per cent on the average tangible assets, and capitalizing the balance of the average net profits at 10 per cent, which gives a value for intangibles of $2,243,359.70. This attributes about two-thirds of the net earnings to intangibles. We believe, however, after careful consideration of all of the evidence, a fairer basis would be to allow 9 per cent return on the tangible property and to capitalize the remaining average net earnings on the basis of six years’ purchase, or 16% per cent, which results in a valuation of $1,260,411.90.

The Gould Storage Battery Co. of New York acquired all of the assets of the Gould Storage Battery Co. of West Virginia. Among them were 32 patents relating to batteries, plates, processes, and train lighting equipment. Two of these had been acquired by the West Virginia corporation from Gould upon its formation; the remainder were acquired or developed subsequently. The evidence does not disclose the amount paid by Gould for the two original patents, or the cost to the company of the patents obtained later. The company had no net earnings. There is nothing in evidence from which we can determine that the intangibles transferred to the Gould Storage Battery Co. of New York had value at June, 1903.

The total outstanding stock of the Gould Coupler Co. of New York was $5,000,000. Therefore, the value of the intangibles paid in to this company for stock exceeds 25 per cent of the par value of its total stock outstanding on March 3, 1917- — 25 per cent being the limitation placed by section 326 (a) (4), Revenue Act of 1918, upon the amount of intangibles that may be included in invested capital. The petitioner claims this limitation should, in affiliations, be applied to the total outstanding stock of the affiliated group and not to each member of the group separately. Section 240(b) defines two classes of affiliations:

(1) If one corporation owns directly or controls through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if substantially all the stock of two or more corporations is owned or controlled by the same interests.

Regulations 45, article 865, provides that, in the case of the former class of affiliations, the limitation on the amount of intangibles shall be in the aggregate 25 per cent of the total outstanding stock, but as to the latter class, it provides that the limitation shall be applied to each corporation separately. In the present case we have a combination of the two classes. Gould owned substantially all the stock of the Gould Coupler Co. and of the Gould Storage Battery Co. of New York, but the stock of the other four battery companies was all owned by the Gould Storage Battery Co. of New York. The question thus indicated is, What is the correct method for either or both of the two classes of affiliation or for an affiliation which is a combination of the two?

This leads to a consideration of what Congress intended when it said in section 240(a) “corporations which are affiliated * * * shall * * * make a consolidated return of net income and invested capital for the purposes of this title [income tax] and Title III [profits taxes], and the taxes thereunder shall be computed and determined on the basis of such return ”, and, later, “ the total tax shall be computed in the first instance as a unit.” There are two other questions in this case, to be referred to presently, the answers to which also depend upon the construction of this language. Much controversy has arisen over what was meant by the term “ consolidated return,” and there are current two conflicting points of view. One, commonly referred to as the “legal theory,” maintains that “ consolidation ” is a matter of procedure, and the consolidated invested capital and net income should be the sum of the amounts of invested capital and net income, separately computed for each of the several affiliated corporations. Under the other, known as the “ accountant’s ” or “ economic unit ” theory, all intercompany transactions and relationships are eliminated, and a resulting balance sheet and profit and loss statement is obtained which shows the situation as though it were a single business. The advocate of either theory generally insists that his theory should be adhered to consistently in applying section 240.

In the Revenue Act of 1917 there was no express provision for affiliation. However, the Commissioner, with the approval of the Secretary of the Treasury, promulgated Regulations 41, relating to the profits tax, which provided (articles 77 and 78) that certain corporations should be deemed affiliated and that the Commissioner might require consolidated returns from such corporations whenever necessary more equitably to determine the invested capital and net income. These articles are quoted in full below:

Art. 77. When affiliated corporations must furnish information as to inter-corporate relations. — For the purpose of the excess profits tax every corporation will describe in its return all its intercorporate relationships with other corporations with which it is affiliated, and will furnish such information in relation thereto as will enable the Commissioner of Internal Revenue to compute the amount of the tax properly due from each corporation on the basis of an equitable and lawful accounting.
For the purpose of this regulation two or more corporations will be deemed to be affiliated (1) when one such corporation owns directly or controls through closely affiliated interests or by a nominee or nominees, all or substantially all of the stock of the other or others, or when substantially all of the stock of two or more corporations is owned by the same individual or partnership, and both or all of such corporations are engaged in the same or a closely related business; or (2) when one such corporation (a) buys from or sells to another products or services at prices above or below the current market, thus effecting- an artificial distribution of profits, or (b) in any way so arranges its financial relationships with another corporation as to assign to it a disproportionate share of net income or invested capital.
Art. 78. When affiliated corporations may he required to malee consolidated return. — Whenever necessary to more equitably determine the invested capital or taxable income, the Commissioner of Internal Revenue may require corporations classed as affiliated under article 77 to furnish a consolidated return of net income and invested capital. Where such consolidated return is required it may be made by any one or more of such corporations or by all of them acting jointly; but if such affiliated corporations, when requested to file such consolidated return, neglect or refuse to do so, the Commissioner of Internal Revenue may cause an examination of the books of all such corporations to be made and a consolidated statement to be made from such examination. In cases where consolidated returns are accepted, the total tax will be computed in the first instance as a unit upon the basis of the consolidated return and will be assessed upon the respective affiliated corporations in such proportions as may be agreed among them. If no such agreement is made the tax will be assessed upon each such corporation in accordance with the net income and invested capital properly assignable to it.

The substance of these articles was later enacted into section 1331 of the Revenue Act of 1921. Provisions with respect to affiliations and consolidations were incorporated into the Revenue Act of 1918 in section 240 thereof. That section changed the definition of affiliation and made the filing of consolidated returns mandatory, but the underlying principle expressed in articles 77 and 78 was adopted. This is shown by the report of the Finance Committee on the Revenue Bill when it was before the Senate, which contains the following explanatory statement (Sen. Hep. ISTo. 617, 65th Cong., Bd sess., pp. 8, 9):

Provision has been made in section 240 for a consolidated return, in the case of affiliated corporations, for purposes both of income and profits taxes. A year’s trial of the consolidated return under the existing law demonstrated the advisability of conferring upon the commissioner explicit authority to require such returns.
So far as its immediate effect is concerned consolidation increases the tax in some cases and reduces it in other cases, but its general and permanent effect is to prevent evasion which can not be successfully blocked in any other way. Among affiliated corporations it frequently happens that the accepted intercompany accounting assigns too much income or invested capital to company A and not enough to company B. This may make the total tax for the corporation too much or too little. If the former, the company hastens to change its accounting method; if the latter, there is every inducement to retain the old accounting procedure, which benefits the affiliated interests, even though such procedure was not originally adopted f<y: the purpose of evading taxation. As a general rule, therefore, improper arrangements which increase the tax will be discontinued, while those which reduce the tax will be retained.
Moreover, a law which contains no requirement for consolidation puts an almost irresistible premium on a segregation or a separate incorporation of activities which would normally be carried as branches of one concern. Increasing evidence has come to light demonstrating that the possibilities of evading taxation in these and allied ways are becoming familiar to the taxpayers of the country. While the committee is convinced that the consolidated return tends to conserve, not to reduce, the revenue, the committee recommends its adoption not primarily because it operates to prevent evasion of taxes or because of its effect upon the revenue, but because the principle of taxing as a business unit what in reality is a business unit is sound and equitable and convenient both to the taxpayer and to the Government.

It will be observed that the Finance Committee recommended the adoption of section 240 because, as it states, the principle of taxing as a business unit what really is a business unit is sound and equitable and convenient. As pointed out above, one of the respects in which this section differs from articles 77 and 78 is that it prescribes as the basis of affiliation control of the stock, without regard to the kind of business the different corporations may be engaged in or what their other relations to each other may be. The test is unity of control of substantially all the stock, it being apparent that such control would enable the “ unit ” to make intercompany arrangements affecting the invested capital or net income of the separate members. It was recognized by Congress that the equitable and convenient way of dealing with such a situation was to treat a group of corporations thus controlled as a business unit, and hence it provided for a consolidated return. It is plain that the purpose was to circumvent intercompany dealing and accounting practices, of whatever origin or object, through which the invested capital or net income of a corporation in a group under common control might be artificially increased or diminished, with the attendant effect on the taxes upon such company if separately assessed. The so-called “ legal ” theory does not fulfill this purpose, nor does the language of the statute support this theory. Section 240 provides that the taxes shall be computed as a unit — not as an aggregate — and upon the basis of a consolidated return. The verb “ to consolidate ” means more than to add together; it means to weld into one things that previously were separate. It is derived from the Latin verb consolidare, “ to make firm or solid.” The following definitions are given in Murray’s New English Dictionary: “ To make solid, to form into a solid or compact mass; to solidify; to combine compactly into one mass, body or connected whole (territories, estates, companies, administrations, commercial concerns and the like).” The participial adjective “ consolidated ” is defined to mean “ made solid, firm or compact; solidified ; combined, unified.” The language of section 240 and its legislative background show that Congress used the word “ consolidated ” in the sense of “ unified ”; there is nothing to indicate they used it in the sense of summarized.” Further, it appears from the report of the Finance Committee that section 240 was recommended after a year’s trial of the consolidated return under the 1911 law. This is the time during which Regulations 41, articles 77 and 78, quoted above, were in force. These articles, it will be noted, provide that the Commissioner may cause an examination of the books of all of the affiliated corporations to be made and a “ consolidated statement ” to be made therefrom. The word “ consolidated ” had become current in accounting nomenclature to describe balance sheets, profit and loss statements, and income statements of a group of companies connected with each other by control of stockholdings. Such statements are used in business to show the financial condition or earning power of an undertaking thus constituted after eliminating all the relations of the constituent companies one to another. The consolidated balance sheet represents the ultimate financial position of the group to the outside world after the elimination of the intercompany relationships.

In the light of the genesis of section 240, the object sought to be attained, and the sense in which the word “ consolidated ” is used in accounting practice, we are led to the conclusion that Congress intended to require consolidated returns of net income and invested capital arrived at by constructing a single composite invested capital for the group from which duplications and intercompany obligations would have been eliminated, and one statement of net income based on a profit and loss statement from which would have been eliminated all intercompany losses, profits, and other transactions affecting income. We are not to be understood as approving any particular accounting practice, but are pointing out the method to be followed in applying the provisions of the statute. If any inconsistency appears between the so-called “ accountant’s ” theory and any provision of the statute, the latter, of course, will control.

It follows from what we have said that, in applying the limitation on the amount of intangibles, the group shall be treated as a unit, i. e., the limitation shall be measured by the par value of the total outstanding stock of the group. This rule should be followed in both classes of affiliation, and hence in a combination of the two. There is no authority in the statute for treating the two classes differently.

We come now to the question, Should the earned surplus of the Gould Coupler Co. be reduced by the operating deficits of the other affiliated corporations in arriving at the consolidated invested capital ?

In considering this question, the place of invested capital in the scheme of the profits taxes should not be overlooked. These taxes are measured and graded, not by net income, but by the relation of net income to the invested capital which contributed to its production. They are imposed upon net income in excess of credits, and the credits are measured by the amount of the invested capital.

In defining “ invested capital ” Congress limited it to the actual cash value ” of property paid in (with certain limitations and qualifications not here material) and earned surplus. The measure is actual contributions made for stock or shares and actual accretions in the way of surplus. The purpose of Congress was to confine the capital, the income from which was to be in part exempted from these special taxes, to the risks accepted by the investors in embarking in the enterprise, including earned surplus or undivided profits left in the business. LaBelle Iron Works v. United States, 256 U. S. 377. The common sense motive was to have a check on inflation. In the case of an affiliation, treating the group as a unit — as we hold it should be treated — it is apparent that the amount at risk, in addition to the paid-in capital, is the net earned surplus.

There is a further consideration impelling us to answer this question in the affirmative. The paid-in invested capital of a corporation, as represented by its capital stock, remains fixed, that is to say, it is not reduced by an operating deficit. Appeal of Guarantee Construction Co., 2 B. T. A. 1145. Hence, in an affiliation, if the operating deficits were not offset against earned surplus, the consolidated invested capital could be inflated by building up an artificial earned surplus in one member at the expense of others whose invested capital would not be correspondingly reduced. It was just this kind of result which Congress intended to circumvent when it enacted section 240.

Further questions relating to the consolidated return arise out of the claim of the petitioner for deduction of alleged losses sustained by the Gould Storage Battery Co. of New York upon the cessation of business by the storage battery companies of Ohio and .Massachusetts. These companies discontinued business in 1918— the Ohio corporation on December 80, and the Massachusetts corporation on August 1.

The Ohio corporation was indebted to the Gould Storage Battery Co. of New York in the sum of $45,855.22 on January 1, 1918; on December 31, 1918, the indebtedness was $46,331.93. The latter owned all of its outstanding stock of $8,000 par value.

The Massachusetts corporation owed the New York corporation on January 1, 1918, $23,534.46; on August 1, 1918, $21,182.46. The latter owned all of the capital of the Massachusetts corporation, amounting to $2,600, par value.

The Commissioner disallowed the deduction of both the debts and the investment in stock on the ground that they were intercompany losses. The petitioner’s claim for their allowance is based on its argument that the invested capital and net income of an affiliation should be separately determined in the first instance and then added together to arrive at the consolidated invested capital and net income; that the deductions would be allowed to the New York corporation, under section 234(a)(4), if it had made a separate return. Neither party drew any distinction between the debts and the investment in stock, or between debts incurred while the companies were affiliated and those arising before affiliation.

Operating losses sustained by any member during the period of affiliation are deducted in arriving at the consolidated net income. It is, of course, immaterial in determining consolidated net income that such losses are met from advances made by one of the other members. That is an internal arrangement which does not afifect the group as a taxable entity. The loss of any member is a loss of the group, and the loss may not be deducted again in the form of an intercompany obligation which may have become worthless. Through the group having received the benefit of the deduction, each constituent corporation has benefited by virtue of its being a member of the group. This disposes of any question of the deductibility of indebtedness resulting from operating losses of the subsidiaries during the period of affiliation.

The petitioner asserts, in its brief, that the Ohio and Massachusetts corporations were dissolved. In a careful examination, we are unable to find that this is shown by the evidence, and we can not assume it to be a fact. A witness testified, with respect to the Massachusetts corporation, “ So far as I know the company went out of business at that time”; and as to the Ohio corporation, “ I understand that the company discontinued business in Ohio.” It is well settled that dissolution is not effected by a cessation of corporate business and acts; mere non-user does not dissolve a corporation. 3 Cook on Corporations, 8th ed., section 631, p. 2301, and cases cited. The record shows merely that the two subsidiaries discontinued business and that the parent company charged off their indebtedness to it and also its investment in their stock. There is no evidence of what assets the subsidiaries had, or that they did not have any, and there is nothing to show that their assets were liquidated. There is nothing showing that the parent corporation did not continue to control the stock. Hence the subsidiaries continued to be members of the affiliated group. During the continuance of this status intercompany obligations are disregarded for the purposes of the tax. We are not called upon, therefore, to decide questions which would arise if the affiliated group were broken up by the dissolution of some of the members.

The petitioner seeks to increase invested capital by adding to surplus expenditures of both the two West Virginia corporations and their Few York successors for patent development, applications for patents, and in litigation affecting patents, which had been charged to expense.

The expenditures of the West Virginia corporations were reflected in the value of the patents at the time they were transferred to the New York corporations. It is this value that the latter paid for, and there is no ground for adding thereto sums spent by the prior owner in bringing the patents to the state they were in when acquired by the New York corporations.

The testimony tends to show that the sums expended by the New York corporations were in their nature capital expenditures, but the evidence is insufficient to enable us to determine what part thereof, or that any of them, should be added to surplus in 1918 and 1919. The petitioner claims the full amount. The items making up the totals were identified in the corporations’ books, by accountants, as having been spent for the purposes stated. However, just what the corporations got for the money expended is not disclosed. They did acquire many patents after 1903, but these expenditures are not connected up with any of those patents. Further, it is obvious that any patents thus acquired were exhausting with the lapse of time, and it is only the proportion of the cost representing their unexpired life in 1918 and 1919 that might be added to surplus in those years. We have no evidence of what their unexpired lives were in those years. Also a large part of the money was spent in litigation over patents, and it does not appear with what results. If any of the patents were declared invalid, the expenses connected with the litigation may not be included in invested capital.

Certain items of depreciable assets were not included in the petitioner’s original returns and were also omitted by the Commissioner in recomputing depreciation. It is apparent to us that they were omitted in error, as the total cost of fixed assets shown in the balance sheet prepared by the revenue agent agrees with the amount now claimed by the petitioner. A list of'the property omitted is set forth in the findings. The petitioner is entitled to depreciation on this property at the rates respectively used by the Commissioner for the petitioner’s other property of the same kinds upon which depreciation has already been allowed.

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

Trammell :

I dissent with respect to the limitation on intangibles in a class “ B ” affiliation.


source: Caselaw Access Project

author: ARtjndell :

license: Public Domain

text:
    Appeal of Farmers Deposit National Bank and Affiliated Banks.
    Docket No. 6220.
    Decided November 16, 1926.
    1. The provisions of section 240(a) of the Revenue Act of 1918, which require affiliated corporations to make a consolidated return of net income and invested capital, contemplate that the affiliated group shall be treated as existing with the attributes of a single taxpayer.
    2. Shares of capital stock of any of the members of an affiliated group, outstanding in the hands of the public, are shares of capital stock of the affiliated group.
    3. The sale by one member of an affiliated group to other than members thereof, of shares of capital stock owned by it in another member of the group, the affiliation continuing, is a sale by the affiliated group of its own capital stock.
    4. The sale by an affiliated group of shares of its own capital stock must be treated as if it were a sale by a corporate taxpayer of its own capital stock — a capital transaction which does not result in either a taxable gain or a deductible loss.
    5. The consolidated invested capital should be increased from the date of the sale by the amount of the proceeds realized by the affiliated group from the sale of its own capital stock.

      Maynard Teall, Esq., for the petitioner.

      E. 0. Lake, Esq., for the Commissioner.
    This is an appeal from the determination of deficiencies for the years 1919 and 1920, aggregating $47,834.60. The questions for determination are whether the gain realized on the sale of stock of an affiliated company constitutes income, and whether the proceeds of such sale may be included in invested capital.

      FINDINGS OF FACT.
    The Farmers Deposit National Bank, hereinafter called the petitioner, is a national bank incorporated under the laws of the United Stales, with its principal office at Pittsburgh, Pa. In 1919 it was affiliated, under' the provisions of the Revenue Act of 1918, with the Farmers Deposit Trust Co, and the Farmers Deposit Savings Bank, and for that year the three banks filed a consolidated return.
    On January 1, 1919, the Farmers Deposit Trust Co. owned 232 shares of stock of the petitioner which it had purchased prior' thereto for $24,492. On April 17, 1919, the Farmers Deposit Trust Co. purchased 2,183 additional shares of stock of the petitioner company for $218,300, making a total of 2,415 shares acquired at a total cost of $242,792. On October 15, 1919, it sold all of the 2,415 shares for $338,003.40, which is $95,211.40 in excess of the cost of the stock. This amount ($95,211.40) has been included by the Commissioner in income for the year 1919. The Commissioner has not included the sale price of the stock ($338,003.40) in invested capital for 1919.
   OPINION.

ARtjndell :

The record shows that the Farmers Deposit Trust Co., the Farmers Deposit Savings Bank, and the Farmers Deposit National Bank were affiliated throughout the years 1918 and 1919, and that these affiliated companies filed consolidated returns of net income and invested capital for those years. The Commissioner’s deficiency notice indicates that he regarded the affiliation as still existing throughout the year 1920, for he has computed the tax liability of the three companies on the basis of a consolidated return of net income and invested capital, and this action is not contested by the petitioner and affiliated companies. At the beginning of the taxable year 1919, the Farmers Deposit Trust Co. owned but 232 shares of the capital stock of the Farmers Deposit National Bank. On April 17, 1919, it acquired 2,183 additional shares, making a total of 2,415 shares owned in the Farmers Deposit National Bank. On October 15, 1919, it sold its entire holdings. If the three companies were affiliated throughout the years 1918 and 1919, as admitted by the parties, as well as during the year 1920, as the deficiency letter indicates, then it is obvious that the ownership by the Farmers Deposit Trust Co. of this stock in the Farmers Deposit National Bank was not the basis for the affiliation of those two companies, and the sale of that stock did not effect a break-up ” of the affiliation. Consequently, we will assume what we think is apparent in this case — that the sale by the Farmers Deposit Trust Co. of its stockholdings in the Farmers Deposit National Bank did not disturb the existing affiliation of these companies, and our decision upon the issues before us will be made in the light of that assumption.

The appeal presents two issues: (1) Where one member of the affiliated group purchases the capital stock of another member of the affiliated group and later sells that stock at a price in excess of cost, the purchase and sale of the stock having no effect whatever upon the existing affiliation of the two companies, does the amount received from the sale of the stocks in excess of the cost thereof constitute a taxable gain to the member making the sale, and, consequently, to the affiliated group? (2) Should the proceeds derived from the sale of the capital stock, referred to in (1) above, be included in the consolidated invested capital of the affiliated group?

There can be no doubt whatever that under the provisions of section 213(a) of the Revenue Act of 1918, a corporate taxpayer is liable for taxes upon any gain derived from the sale of the capital stock owned by it in another corporation with which it is not affiliated. The gain resulting from such a transaction is a gain derived from dealings in personal property, which is specifically made subject to the tax by the provisions of section 213(a). That a corporate taxpayer realizes no taxable gain from the sale of its own capital stock is a well established principle of the taxing statutes. It is a principle which the Commissioner has consistently adhered to in all of the regulations promulgated under the several Revenue Acts. In the Appeal of Simmons & Hammond Mfg. Co., 1 B. T. A. 803, this Board held that the sale by a corporate taxpayer of its own capital stock constituted a capital transaction and that no deductible loss resulted therefrom. It follows, per contra, that a corporate taxpayer realizes no taxable gain from the sale of its own capital stock. If, then, the Farmers Deposit Trust Co. and the Farmers Deposit Rational Bank are to be regarded and treated, for the purpose of the income and profits taxes, as separate and distinct entities, the liability of the Farmers Deposit Trust Co. for taxes on the gain derived from the sale of the capital stock owned by it in the Farmers Deposit Rational Bank is hardly open to question. On the other hand, if it is the purpose of the statute to disregard the separate entities of these two companies and to treat them, other than for the actual assessment and payment of the taxes, as one business enterprise and one taxpayer, then any capital stock emanating from either one, irrespective of the name its shares may bear, emanates from and is the capital stock of the consolidated group; and a sale by one member of shares of capital stock owned by it in another member of the group is a sale by the consolidated group of its own capital stock, and, a fortiori, a sale by a corporate taxpayer of its own capital stock, which can not result in either a taxable gain or a deductible loss.

Let us proceed to an examination of the statute to determine the status of these affiliated companies for the purpose of the income and profit taxes. The statute, pertinent in its parts to the matter under consideration, reads as follows:

See. 240. (a) That corporations which are affiliated within the meaning of this section shall, under regulations to be prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income and invested capital for the purposes of this title and Title III, and the taxes thereunder shall be computed and determined upon the basis of such return: Provided, That there shall be taken out of such consolidated net income and invested capital, the net income and invested capital of any such affiliated corporation organized after August 1, 1914, and not successor to a then existing business, 50 per centum or more of whose gross income consists of gains, profits, commissions, or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. In such case the corporation so taken out shall be separately assessed on the basis of its own invested capital and net income and the remainder of such affiliated group shall be assessed on the basis of the remaining consolidated invested capital and not income.
In any case in which a tax is assessed upon the basis of a consolidated return, the total tax shall be computed in the first instance as a unit and shall then be assessed upon the respective affiliated corporations in such proportions as may be agreed upon among them, or, in the absence of any such agreement, then on the basis of the net income properly assignable to each. There shall be allowed in computing the income tax only one specific credit of $2,000 (as provided in section 230) ; in computing the war-profits credit (as provided in section 311) only one specific exemption of $3,000; and in computing the excess-profits credit (as provided in section 312) only one specific exemption of $3,000.

Here in the provisions of section 240(a) we have the key to the whole situation. Underlying these provisions of the statute is a purpose which must be ascertained, and the statute must be construed in such a manner as to make that purpose effective. While the return required by the provisions of section 240(a) is “a consolidated return of net income and invested capital,” it is entirely clear from other provisions of the same section that the return contemplated is a return of “consolidated net income and invested capital.” For instance, Congress has specified that the net income and invested capital of certain affiliated corporations shall be taken out of “ such consolidated net income and invested capital,” and that the remainder of the affiliated group shall be assessed on the basis of the remaining “consolidated invested capital and net income.”

What is meant by “ consolidated invested capital and net income ” ? To consolidate is defined as “to combine; to cause to become united; to merge.” Appeal of Frank G. Shattuck Co., 2 B. T. A. 7. “Invested capital ” and “ net income ” are statutory concepts and are clearly defined by the statute. Section 326(a) defines “invested capital ” as: (1) Actual cash paid in; (2) actual cash value of tangible property paid in for stock or shares; (8) paid-in or earned surplus and undivided profits; (4) and (5) intangible property paid in for stock or shares, subject to certain limitations. Section 232 states that, in the case of a corporation, the term “ net income ” means the gross income, as defined in section 233, less the deductions allowed by section 234. From these definitions we are able to deduce the meaning of “consolidated invested capital and net income.” “Consolidated invested capital” means: (1) Actual cash paid in to the affiliated group; (2) actual cash value of tangible property paid in for stock or shares of the affiliated group; (3) paid-in or earned surplus and undivided profits of the affiliated group; (4) and (5) intangible property paid in for stock or shares of the affiliated group, subject to certain limitations. “ Consolidated net income ” means the gross income of the affiliated group, as defined in section 233, less the deductions allowed to the affiliated group by section 234.

Then, by the provisions of the second paragraph of section 240(a), we find that, in any case in which a taxpayer is assessed upon the basis of a consolidated return, the total tax is to be computed in the first instance as a unit and then assessed upon the respective affiliated companies in such proportions as may be agreed upon among them. That is, the total tax liability of the affiliated group is to be computed and determined upon the basis of the consolidated net income and invested capital, as shown in the return, in the same manner as though the return was that of a single corporate taxpayer filed in accordance with the provisions of section 239. Further than this, the specific credit and exemptions allowed to an affiliated group, for the purpose of computing the income, war-profits, and excess-profits taxes, respectively, are the same specific credit and exemptions allowed to a single corporate taxpayer by the provisions of sections 236, 311, and 312, respectively.

Thus we find from the provisions of section 240(a) that in any case where two or more corporations are affiliated, within the meaning of the provisions of subdivision (b) of the same section, a single return setting forth the items of gross income and the deductions of the affiliated group satisfies the requirements of section 239 that every corporation subject to taxation shall make a return; that the tax liability of the affiliated corporations is to be determined upon the basis of the consolidated net income and invested capital, in the same manner as though the tax liability of a single taxpayer was being determined; and that in computing the tax liability of the affiliated corporations as a unit only such specific credit and exemptions are to be allowed as are allowed to a single taxpayer by the provisions of sections 236, 311, and 312. That is, for the purpose of determining the tax liability of the members of an affiliated group, the group is to be regarded and treated as a single corporate taxpayer.

The object sought to be accomplished by Congress, in enacting section 240 of the Revenue Act of 1918, was to tax as a business unit' what, in substance and in fact, as distinguished from legal theory, was a single business enterprise; to prevent the component parts thereof from evading taxation through the arbitrary shifting of .income by way of false or artificial market standards; and to protect from an inequitable and unjust burden of taxation, which might otherwise obtain if subjected to the tax upon the basis of their own financial history, those members of an affiliated group whose income may be attributable in part to the facilities and capital of other members placed at their use and disposal. Thus, with reference to the insertion of the consolidated returns provisions in the Revenue Act of 1918, the Committee on Finance, in its report to the Senate, said (Sen. Rep., No. 617, 65th Cong., 8d sess., pp. 8, 9) :

Provision Ras been made in section 240 for a consolidated return, in tbe ease of affiliated corporations, for purposes both of income and profits taxes. A year’s trial of tbe consolidated return under the existing law demonstrated the advisability of conferring upon tbe commissioner explicit authority to require such returns.
So far as its immediate effect is concerned consolidation increases the tax in some eases and reduces it in other cases, but its general and permanent effect is to prevent evasion which can not be successfully blocked in any other way. Among affiliated corporations it frequently happens that the accepted intercompany accounting assigns too much income or invested capital to company A and not enough to company B. This may make the total tax for the corporation too much or too little. If the former, the company hastens to change its accounting method; if the latter, there is every inducement to retain the old accounting procedure, which benefits the affiliated interests, even though such procedure was not originally adopted for the purpose of evading taxation. As a general rule, therefore, improper arrangements which increase the tax will be discontinued, while those which reduce the tax will be retained.
Moreover, a law which contains no requirement for consolidation puts an almost irresistible premium on a segregation or a separate incorporation of activities which would normally be carried on as branches of one concern. Increasing evidence has come to light demonstrating that the possibilities of evading taxation in these and allied ways are becoming familiar to the taxpayers of the country. While the committee is convinced that the consolidated return tends to conserve, not to reduce, the revenue, the committee recommends its adoption not primarily because it operates to prevent evasion of taxes or because of its effect upon the revenue, but because the principle of taxing as a business unit tohat in reality is a business unit is sound and equitable and convenient both to the taxpayer and to the Government. (Italics ours.)

If it is tbe purpose of tbe statute to disregard the separate and distinct legal entities of the members of an affiliated group and to treat the group as a single corporate taxpayer, then the treatment accorded to the group should recognize it as existing with the attributes oí a single taxpayer.

In the Appeal of American La Dentelle, Inc., 1 B. T. A. 575, we stated as follows:

From July 1, 1919, however, Congress has said that the generally recognized principle of corporate identity was to be overridden for the purpose of the income and profits tax and that a consolidated return should be filed “ if substantially all the stock of two or more corporations is owned or controlled by the same interests,” which is the situation here. From July 1, in other words, the separate existences ceased for tax purposes just as effectually as if under a State statute the corporations had been consolidated for all corporate purposes. A new tax status was created.

The effect of the consolidation of two or more companies is to weld them together for the purpose of computing the tax, as though they existed, in fact, as a single business enterprise. Their separate and distinct identities are merged in the interest of their community, just as effectively, so far as concerns the determination of the income and profits taxes, as though they existed under a single charter. These principles are fundamental and go to the very root of the theory underlying the statutory requirement of consolidated returns for affiliated corporations. If these are not the correct principles, and if it was not the purpose of Congress to treat an affiliated group as a single taxpayer, then, certainly, Congress in enacting the provisions of section 240 of the Revenue Act of 1818 has fallen far short of accomplishing its purpose to prevent the evasion and inequality of taxes arising out of the arbitrary shifting of income and capital among affiliated corporations. Let us examine this phase of the case a little further.

If the separate identities of the members of an affiliated group are to be recognized and the tax determined accordingly, then the term “ consolidated net income,” as used in section 240(a), must mean the combined net income of the affiliated members, and the term “consolidated invested capital ” must mean the total of invested capital to which each of the members would be entitled as separate companies. But consider the anomalies which would arise from such a construction. These are not so apparent in their effect upon net income as they are in their effect upon invested capital, because intercompany transactions would generally offset themselves; that is, the intercom-pany transactions included in the net income of one company would be offset by the deductions taken by the company with which the transactions originated. But assume that company “ A ” is organized on January 1, 1918, with a paid-in cash capital of $100,000, and that it immediately organizes company “ B ” and acquires all of that company’s capital stock for $100,000 cash. Assume further that “ A ”, being a holding company, has no income other than the dividends received on the stock of B ”, which are nontaxable, and that the income of “ B ” for the year 1918 is $20,000. Undoubtedly, if they were to be treated as separate companies and taxed as such, each would be entitled to an invested capital of $100,000, and together they would hare a combined invested capital of $200,000. “ B ”, as a separate company, would be liable for a tax computed on the basis of a net income of $20,000 and an invested capital of $100,000. If the consolidated invested capital is the total of invested capital to which each would be entitled as separate companies, then the amount thereof is $200,000, and the consolidated tax liability would be computed on the basis of a net income of $20,000 and an invested capital of $200,000, notwithstanding that no part of the capital of “A” was responsible for any part of the income, that the income was entirely attributable to the employment of the capital of “ B ”, and that, in truth and in fact, there has been but $100,000 paid in to the whole business enterprise.

Throughout the entire Title III of the Revenue Act of 1918 there stands out in bold relief the purpose of Congress to levy a profits tax, varying in rates from 30 to 80 per centum, for the calendar year 1918, upon the net earnings of all corporations in excess of a fair return upon the actual investment in the business. Does any one suppose that Congress intended that the fair return which a business enterprise was entitled to have, free from the profits taxes, should be predicated upon the actual investment in the business multiplied by the number of times it was transferred from one holding company to another? If so, corporate taxpayers would have experienced little difficulty in avoiding the profits taxes entirely. But Congress never intended that such a vehicle might be successfully employed by taxpayers to escape their just burden of taxation. On the other hand, it said, plainly enough we think, in section 240(a) of the Revenue Act of 1918, that the generally recognized principle of corporate identity was to be overridden for the purpose of the income and profits taxes; that the separate existences of the affiliated companies ceased for tax purposes. It created out of two or more affiliated companies, otherwise having separate identities, a new tax status; and when it did so Congress intended that the group should have the attributes of a single taxpayer. And where, in other sections of the statute, Congress speaks of corporations as individual taxpayers, it means as to the sections dealing with consolidated units to treat the consolidated unit as a single corporation.

Applying these principles to the facts in this case, what is the situation? The Farmers Deposit Trust Co. and the Farmers Deposit National Bank were, during the taxable year 1919, affiliated within the meaning of section 240(b) of the Revenue Act of 1918. They were, for the purposes of the income and profits taxes, one and the same taxpayer. The sale by the Farmers Deposit Trust Co. of its capital stock holdings in the Farmers Deposit National Bank must be treated, for the purpose of the tax, as nothing more than a sale by the affiliated group of its own capital stock. The entire proceeds from the sale of this stock represented additional capital to the affiliated group — the investment of the new stockholders who purchased the stock. The sale was a capital transaction which could not give rise to a taxable gain or a deductible loss. The Commissioner erred in treating the excess of the selling price over the cost of this stock as taxable income to the Farmers Deposit Trust Co. and the affiliated group.

We pass now to a consideration of the second issue raised by this appeal, viz, whether the proceeds from the sale of this stock should be included in the consolidated invested capital for the year 1919, in which year the sale took place. The Commissioner has refused to so include them, apparently on the ground that the transaction constituted a dealing in personal property giving rise to a taxable gain, and that the proceeds are a part of the undivided profits earned during the year 1919, which, by the express .provisions of section 326(a)(3) of the Revenue Act of 1918, may not be included in invested capital for the year 1919. But as we have held in connection with the first issue, the affiliated group exists, by virtue of statutory provisions, as and with all of the attributes of a single corporate taxpayer. When the Farmers Deposit Trust Co. purchased the shares of capital stock of the Farmers Deposit National Bank, which we have under consideration, assuming that they were purchased from others than members of the affiliated group, the transaction constituted in substance a partial retirement of the outstanding capital stock of the consolidation, a repurchase by a corporate taxpayer of its own capital stock, a withdrawal of a part of the capital of the consolidated group, and a return to the stockholders of their investment in the consolidation. The effect of the purchase of this stock upon the consolidated invested capital was the same as though the transaction was that of a single corporation repurchasing its own capital stock. To the extent that the purchase price of this stock exceeded the earnings available therefor, the consolidated invested capital was reduced by the transaction. When the stock was resold, assuming that it was sold to others than members of the affiliated group, the proceeds of the sale represented additional capital to the consolidation, an investment in the consolidation by a new group of stockholders, and the consolidated invested capital of the year in which the sale took place was increased, from the date of the sale, by the amount of the proceeds realized from the sale of the stock.

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

Teammell dissents.


author: Littleton:

text:
    Appeal of Interurban Construction Co.
    Docket No. 2687.
    Decided November 16, 1926.
    The taxpayer was the owner during the taxable year of stock of a subsidiary which had cost $31,980.38 and was sold to stockholders of the parent (affiliation continuing) for $85,000. The Commissioner computed a profit on this transaction. Held, that the sale made under the circumstances set forth did not give rise to taxable gain.

      Frederick L. Thornton, G. P. A., for the petitioner.

      P. S. Crewe, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency in income and profits taxes for the year 1919 in the amount of $9,165.60. The petitioner alleges error in the determination of a profit upon the sale of the stock of a subsidiary corporation, the Oklahoma Union Railway Co.
    FINDINGS OF FACT.
    The petitioner is an Oklahoma corporation with its principal office at Tulsa. During the taxable year it was affiliated with the Oklahoma Union Railway Co., the Sapulpa Interurban Electric Railway Co., and the Park Addition Co. At the beginning of the taxable year 1919 the petitioner was the owner of all of the outstanding capital stock of the Oklahoma Union Railway Co. in the amount of 5,250 shares. During that year the petitioner sold 1,750 shares of the stock of the Oklahoma Union Railway Co., which it owned, to certain individuals, who were stockholders of the petitioner, for the amounts and on the dates indicated below:

      The cost of the stock so sold was $31,980.38.
    The Commissioner computed the profit upon the above transaction to be the difference between $31,980.38 and $85,000. The Commissioner did not increase the petitioner’s consolidated invested capital on account of the sale and issuance of the above-mentioned stock. The entire stock owned by the petitioner in the Oklahoma Union Railway Co. was acquired by it in the year 1917 in consideration of the construction of that railway.
   OPINION.

Littleton:

Our decision of the issue involved in this appeal is governed by the decision of the Board in the Appeal of Farmers Deposit National Bank, 5 B. T. A. 520. Upon the authority of that decision, it is held that no taxable gain was realized by the petitioner from the sale of the stock of the Oklahoma Union Railway Co., and the Commissioner’s determination of the deficiency, in so far as it resulted from the inclusion of a profit of $53,019.62 upon the sale of the stock, was erroneous.

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


author: TRAmmell :

text:
    Appeal of Risdon Tool & Machine Co.
    Docket No. 6474.
    Decided November 16, 1926.
    Where corporations are affiliated during the taxable year, but were not affiliated during the prewar years, the prewar invested capital is the aggregate of the average invested capital of the separate corporations.

      Sanford Robinson, Esq., for the petitioner.

      L. G. Mitchell, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency in income tax for 1918 in the amount of $19,489.05. The question involved is the correctness of the method used by the Commissioner in determining the prewar invested capital of corporations which were affiliated in the taxable year but not in the prewar period. The taxpayer contends that the prewar invested capital should consist of the invested capital of the parent company alone, and that the Commissioner should find an increase of $84,864.57 between the two periods instead of a decrease of $283,481.49.
    FINDINGS OF FACT.
    The taxpayer is a Connecticut corporation with its principal office at hi augatuck. On or about August 16, 1918, it purchased the entire outstanding capital stock of the Novelty Manufacturing Co., a Connecticut corporation, for cash. Both corporations were in existence during the prewar period.
    In computing the consolidated invested capital for 1918, the Commissioner eliminated all of the capital and surplus of the subsidiary corporation and valued the assets of the subsidiary at the cost of acquisition to the taxpayer. The two corporations were not affiliated during the prewar period. The Commissioner in computing the invested capital for the prewar period took the aggregate of the average invested capital of the two corporations for that period. On this basis the invested capital for the prewar period was determined to be $397,268.41, and the invested capital for 1918 to be $118,-786.92, resulting in a decrease of $283,481.49.
    It was stipulated that “ the average invested capital of the Risdon Tool & Machine Co. for the prewar period with the average invested capital of the subsidiary eliminated was $28,922.35. The capital and surplus of said subsidiary for the taxable year amounted to $483,260.48. The average invested capital of said subsidiary for the prewar period was $368,346.06.”
   OPINION.

TRAmmell :

The only question we are called upon to decide is how to compute, for the purposes of the war-profits credit provided by section 311 of the Revenue Act of 1918, the average prewar invested capital of a consolidated group, where one corporation owns or controls the stock of another, and the members thereof were not affiliated during the prewar period. The Commissioner has determined the average prewar invested capital to be the aggregate of the average invested capital of the separate companies for the prewar period. This is in accordance with article 869 of Regulations 45, which reads as follows:

The invested capital of affiliated corporations for the prewar period shall be computed on the same basis as the invested capital for the taxable year, except that where any one or more of the corporations included in the consolidation for the taxable year were in existence during the prewar period, but were not then affiliated as herein defined, then the average consolidated invested capital for the prewar period shall be the average invested capital of the corporations which were affiliated in the prewar period plus the aggregate of the average invested capital for each of the several corporations which were not affiliated during the prewar period.

The taxpayer contends .that, since the Commissioner has eliminated from the consolidated invested capital of the taxable year the capital and surplus of the subsidiary, he should likewise eliminate from the aggregate of the average invested capital of the separate companies, for the prewar period, the average capital and surplus of the subsidiary for that period. It relies upon the provisions of the last paragraph of section 330 of the Revenue Act of 1918, which are as follows:

If any asset of the trade or business in existence during both the taxable year and any prewar year is included in the invested capital for the taxable year but is not included in the invested capital for such prewar year, or is valued on a different basis in computing the invested capital for the taxable year and such prewar year, respectively, then under rules and regulations to be prescribed by the Commissioner with the approval of the Secretary such readjustments shall be made as are necessary to place the computation of the invested capital for such prewar year on the basis employed in determining the invested capital for the taxable year.

The taxpayer further cites in support of its contention article 934 of Regulations 45, which provides as follows:

In any case in which as a result of a reorganization or for any other reason any asset in existence both during the taxable year and any prewar year is included in computing the invested capital for the taxable year, but is not included in computing the invested capital for such prewar year, or is valued on a different basis in computing the invested capital for the two years, the difference resulting therefrom shall not be included in determining the difference 10 per cent of which is added to or deducted from the war profits credit under section 311 (a) (2) of the statute.

We do not think that the provisions of the statute or of the regulations upon which the taxpayer relies are applicable to the question under consideration. Those provisions merely prescribe the rule to be followed where assets, which were owned by the business during the taxable year and any prewar year, are included in invested capital for the taxable year but are not included in the invested capital of the prewar year, or are valued on a different basis in computing the invested capital for the two years. It has not been shown, and as a matter of fact the taxpayer apparently does not contend, that any assets have been included by the Commissioner in the consolidated invested capital for the taxable year which are not reflected in the aggregate of the average invested capital of the separate companies for the prewar period. Nor has the taxpayer shown that the Commissioner’s computation of invested capital for the taxable year includes any asset which has been valued upon a basis different from that employed in computing the invested capital for the prewar period.

The provisions of section 330 of the statute, which are pertinent to the question, are as follows:

That in the case of the reorganization, consolidation, or change of ownership after January 1, 1911, of a trade or business now carried on by a corporation, the corporation shall for the purposes of this title be deemed to have been in existence prior to that date, and the net income and invested capital of such predecessor trade or business for all or any part of the prewar period prior to the organization of the corporation now carrying on such trade or business shall be deemed to have been the net income and invested capital of such corporation.

There can be no question but that the business carried on by the consolidation during the taxable year under consideration was the same business which was carried on by the separate companies during the prewar period. Hence, under the foregoing provisions of section 330, the prewar net income and invested capital of the separate companies, now members of the affiliated group, must be deemed to have been the prewar net income and invested capital of the consolidation, and the war-profits credit provided for by section 311 of the Revenue Act must be determined on the basis of such a prewar history. What constitutes the prewar invested capital of a group of corporations affiliated by virtue of the fact that one corporation owns or controls the stock of the other or others? Is it the aggregate of the average prewar invested capital of the separate companies; or is it something less, as the taxpayer contends? The taxpayer suggests that, since the Commissioner has eliminated the capital and surplus of the subsidiary from the consolidated invested capital for the taxable year, a similar elimination should be made in computing the prewar invested capital. But we know of no authority which will support that view. We realize that under certain circumstances the invested capital of such a consolidation may be materially less than the aggregate of the average invested capital of the separate companies for the prewar period; and that the reduction may have been brought about solely through the investment made by the parent company in its subsidiary’s capital stock. In fact, such is the case in the instant appeal. During the prewar years the separate companies had invested an average of $397,268.41, while during the taxable year, as a result of the consolidation, the invested capital was only $113,796.92. But is this not the result of the working out of the theories underlying the requirement of consolidated returns in the case of corporations which are deemed to be affiliated under the provisions of section 240 of the statute? Those theories contemplate that the members of the affiliated group shall be treated as a single business enterprise, and when the capital stock of one of the group has been taken from the hands of the public and ownership thereof vests thereafter in another member of the group, that stock, so far as the consolidation is concerned, is, in effect, no longer outstanding, since it is held entirely within the group and its. acquisition for cash by the parent company adds nothing to the consolidated group. The invested capital, then, of the group is less than the combined invested capital of the separate companies.

In our opinion the principle set out in article 869 of Regulations 45 is a proper interpretation of the statute. Since that rule has been applied by the Commissioner in this case in the determination of the consolidated invested capital for the prewar period, we must affirm his determination.

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


text:
    Appeal of Ruckman Coal Co.
    Docket No. 4277.

    Decided November 16, 1926.
    1. A note receivable of a stockholder held to represent a tona tide indebtedness to the corporation and should be included in invested capital.
    2. The earned surplus of corporations included in a consolidated return should be reduced by an operating deficit of one of the corporations in the group in excess of its own earned surplus, earned during a year when a consolidated return is required by statute.

      Attilla Gox, Esq., and E. J. Wells, Esq., for the petitioner.

      Percy S. Crewe, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency of $3,820.98 in income and profits taxes for 1920. The taxpayer alleges error on the part of the Commissioner in excluding from the consolidated invested capital a note receivable and an account receivable, and by reducing the consolidated earned surplus by an operating deficit of an affiliated company in excess of its own earned surplus.
    FINDINGS OF FACT.
    The taxpayer is a Kentucky corporation with its principal office in Providence.
    The taxpayer, during the taxable year involved and also during 1919, was affiliated with the Highland Mining Co. and the Clover Creek Coal Co. The officers of these companies and their stock-holdings were as follows:
    Ruckman Coal Oo.: Shares.
    D. J. Ruckman, president_58½
    F. V. Ruckman, vice president_61½
    A. J. Ruckman, secretary and treasurer_62½
    Highland Mining Oo.:
    A. J. Ruckman, president_57 ¾
    F. V. Ruckman, vice president and treasurer_54¾
    D. J. Ruckman, secretary_57¾
    Clover Creek Coal Co.:
    F. V.- Ruckman, president_24⅝
    A. J. Ruckman, vice president_25 ⅛
    D. J. Ruckman, secretary and treasurer_24⅝

      Prior to 1918, F. Y. Ruckman became indebted to the Highland Coal Co., and about January, 1918, gave his note to the company in the amount of $43,000. This represented substantially all net profits of the company. Ruckman borrowed the funds from the company and intended to repay the amount. The note has not been paid and is still held by the company and listed among its assets.
    During a period of years D. J. Ruckman made withdrawals from the taxpayer company in excess of salary, and in January, 1920, was indebted to it in the amount of $12,235.52, which the taxpayer carried on its books as an account receivable. On January 1, 1918, the account amounted to $34,030.85. From time to time payments were made which reduced it to $12,235.52 as of January 1, 1920.
    Both F. Y. Ruckman and D. J. Ruckman carried life insurance in the amount of $25,000, payable to their estates, for the purpose of making provision for liquidating any indebtedness that might exist at the time of their death.
    Both the note and the account above stated were accounts receivable, and as such are a part of invested capital.
    As of December 31, 1919, the Clover Creek Coal Co. had an operating deficit of $18,183.34. The earned surplus of the other two companies exceeded this amount. The Commissioner reduced the earned surplus of these two affiliated companies by the operating deficit of the third affiliated company in determining the consolidated invested capital.
   OPINION.

TRAmmell :

There are three questions involved in this appeal, all of which affect invested capital. The first is whether invested capital should be reduced by excluding a note given by F. Y. Ruckman to the Highland Coal Co. in the amount of $43,000. The second is whether the amount of indebtedness of $12,235.52, alleged to be owing by D. J. Ruckman to the Ruckman Coal Co., should be excluded from invested capital; and the third question is whether the earned surplus of the Ruckman Coal Co. and the Highland Mining Co. should be reduced by the operating deficit of the Clover Creek Coal Co. to the extent that it exceeds the earned surplus of that company.

In determining whether the note of F. Y. Ruckman to the Highland Coal Co, and the account set up on the books as an indebtedness of D. J. Ruckman to the Ruckman Coal Co. were actual assets of the respective companies or were withdrawals of earnings and profits or payments to those individuals, we must look to and consider all the facts and circumstances in connection therewith.

The amount of the note given by F. Y. Ruckman represented substantially all the profits of the Highland Coal Co. F. Y. Ruck-man, however, did not own in excess of one-third of the stock of that company. The record does not disclose the exact amount of stock owned by him. The other stockholders did not receive any portion of the profits. If it were not intended that the said Ruckman should repay the amounts secured by him from the corporation for which the note was given, the other stockholders who owned at least two-thirds of the stock would receive practically nothing on their investment in the corporation. The corporation listed the note among its assets and included it as a note receivable which was reflected in its invested capital.

It also appears that D. J. Ruckman made withdrawals from the Ruckman Coal Co. in excess of his salary over a period of years. On January 1, 1918, the amount received from the company by D. J. Ruckman amounted to $34,030.85. From time to time he made payments thereon to the corporation so that on January 1, 1920, according to the books of the company, he owed it $12,235.52. The Ruckman Coal Co. at all times carried the amounts on its books as accounts receivable. While the record does not disclose the exact stock ownership of all the stockholders or the total capital stock outstanding, it does appear that D. J. Ruckman did not own as much as one-third of the stock. The fact that he had paid something on the account and had reduced it by continually making payments thereon, indicates that both he and the company treated it as an actual liability and not as withdrawals of profits or as payment for services.

The circumstances surrounding the account of D. J. Ruckman should be taken into consideration in connection with the note of F. Y. Ruckman. It would seem unreasonable that D. J. Ruckman would be permitted to make withdrawals from the Ruclonan Coal Co. and be required to repay the same if F. Y. Ruckman were not required to repay the amounts withdrawn by him. If D. J. Ruck-man was actually indebted to the corporation for his withdrawals, the same situation would seem to exist with respect to F. Y. Ruck-man. F. Y. Ruckman owned more stock in the Ruckman Coal Co. than D. J. Ruckman, and D. J. Ruckman owned more stock in the Highland Mining Co. than F. Y. Ruckman. Both of the transactions should be considered together. It would seem unreasonable that other stockholders would permit a stockholder in a corporation to withdraw earnings and profits in which they did not participate, especially when the other stockholders owned more stock than the individuals receiving from the corporation the amounts referred to.

It also appears from the evidence that both of the Ruckmans took out life insurance on their lives for the purpose of making provision for liquidating any indebtedness that might exist at the time of their death.

The facts and circumstances lead us to believe that the note and the account receivable given to the respective corporations were actual existing obligations for the respective amounts during the years involved.

This leads us to the remaining question, that is, whether the earned surplus of two of the affiliated companies should be reduced by the operating deficit of the other affiliated company in excess of its own earned surplus. There is no evidence before the Board as to when the deficit occurred or whether the corporations were affiliated during the period of operation in which it was sustained. The Commissioner has reduced the earned surplus of the entire group of corporations by the deficit of one company in excess of its own earned surplus.

In the absence of any evidence as to when the deficit occurred, or whether the corporations were affiliated during the period when it was incurred, we are not called upon to determine whether in every case an operating deficit of one of a group of affiliated companies must be set off against the earned surplus of other corporations in the group. We are clearly of the opinion that any operating deficit in excess of its earned surplus, incurred by one corporation during the years when the corporations were required to file a consolidated return, is to be deducted from the earned surplus of any corporation in the group. See Appeal of Valdosta Grocery Co., 2 B. T. A. 727. If this were not true, one of the principal purposes of consolidated returns would be defeated and the invested capital could be manipulated within the group of corporations in such a way as artificially to increase the invested capital. We express no opinion as to what would be the result if the deficit had been shown to have occurred when the corporations were not required or permitted to file a consolidated return.

Judgment will he entered on 10 days' notice, under Bule 50.