Sun Pipe Line Co. v. Commissioner

*1414 This proceeding involves personal holding company surtax for the calendar year 1937 in the amount of $50,084.12, in which amount a deficiency was determined by the Commissioner. From documentary evidence and certain facts stipulated, we make the following findings of fact.

FINDINGS OF FACT.

1. The petitioner, a Delaware corporation organized on October 3, 1930, is a personal holding company, and has its principal place of business in Philadelphia, Pennsylvania. It filed its*869 income tax return for 1937 with the collector for the first Pennsylvania district at Philadelphia.

2. About the date of incorporation, the petitioner acquired, for cash, the capital stocks of the Susquehanna Pipe Line Co., Sun Pipe Line Co., and Sun Oil Line Co. At about the same time it sold, for cash, and to many individuals, its 5 percent sinking fund gold debentures in the face amount of $3,500,000.

3. Upon receipt of the cash from the sale of the debentures, petitioner loaned sums of money to the three subsidiaries for the purpose of enabling them to construct pipe lines for transporting petroleum products. The Susquehanna Pipe lines were constructed in Pennsylvania; those of the Sun Pipe Line Co. were constructed in New York, and those of the Sun Oil Line Co. in Ohio.

4. On May 18, 1934, the Middlesex Pipe Line Co. was organized under the laws of the State of New Jersey. The purpose of its organization was to build a pipe line from the Pennsylvania-New Jersey boundary line in the middle of the Delaware River to Newark, New Jersey. Its entire capital stock was acquired by petitioner for $300,000 cash. The $300,000 received by the Middlesex Pipe Line Co. for its*870 capital stock was not sufficient to construct the pipe lines contemplated at the time it was organized. A total of $800,000 was required for this purpose.

5. In the latter part of 1934 the petitioner issued for cash $4,000,000 of 3 1/2 percent serial debentures. With the receipts of this $4,000,000 issue, the debentures issued about October 3, 1930, were called in and the additional $500,000 was loaned to Middlesex Pipe Line Co. for the construction of pipe lines in New Jersey.

6. The serial debentures of $4,000,000 were sold to four banking institutions and one life insurance company.

7. The four banking institutions and the one life insurance company which on December 1, 1934, purchased for cash the $4,000,000 face value of petitioner's 3 1/2 percent serial debentures issued December 1, 1934, were not, on December 1, 1934, the owners of any of petitioner's 5 percent sinking fund gold debentures issued approximately October *1415 3, 1930. The trustee under the indenture issue of September 1, 1934, was the same as under the issue of October 1930.

8. On September 1, 1940, bonds matured in the amount of $400,000. In that year petitioner redeemed, at par, $3,400,000*871 of its 3 1/2 percent serial debentures. On its tax return for the year 1937 it deducted this $3,400,000 from its undistributed adjusted net income.

9. In his final determination of petitioner's 1937 tax liability, respondent disallowed the deduction of the $3,400,000, which disallowance resulted in his finding that petitioner's undistributed adjusted net income for the year 1937 was $67,045.49.

10. Petitioner keeps its books of account on the accrual basis, and its tax return for the year 1937 was filed on such basis.

11. Petitioner incurred certain expenses upon the issuance of $3,500,000 face value of its 5 percent sinking fund gold debentures on or about October 3, 1930.

12. The $3,500,000 face value of petitioner's 5 percent sinking fund gold debentures were sold for cash at a discount.

13. The expense in issuing said 5 percent sinking fund gold debentures, on or about October 3, 1930, and the discount allowed on the sale thereof for cash were recovered in part by petitioner as deductions from income in computing Federal income tax for the years 1930 to 1933, inclusive.

14. As of January 1, 1934, the unamortized portion of the expense incurred in issuing*872 said 5 percent sinking fund gold debentures was $3,556.86.

$15. As of January 1, 1934, the unamortized portion of the discount allowed in the issuing of the 5 percent sinking fund gold debentures was $63,259.27.

16. On or about September 1, 1934, the 5 percent sinking fund gold debentures were retired at 101 1/2 percent of face value.

17. The amount of the premium so paid upon the retirement was $52,500.

18. Petitioner did not file any waiver or election as provided in Treasury Decision 4603, paragraph (a)(C.B. XIV-2, p. 58) in respect of that portion of the discount and expense which was unamortized at the date of the retirement of the 5 percent sinking fund gold debentures, nor claim same as a deduction on its income tax return for 1934.

19. Respondent, in accordance with said Treasury Decision 4603, paragraph (a), allowed as deduction in computing petitioner's net income for the calendar year 1934 the following items:

(a) The unamortized portion of the bond discount incurred upon the issuance on or about October 3, 1930, of petitioner's 5 percent sinking fund gold debentures, in the sum of $63,259.27.

*1416 (b) The unamortized portion of the expense, *873 incurred in the issuance on or about October 3, 1930, of petitioner's 5 percent sinking fund gold debentures, in the sum of $3,556.86.

(c) The premium paid on the retirement on September 1, 1934, of petitioner's 5 percent sinking fund gold debentures in the sum of $52,500.

20. The allowance of the deductions, together with other adjustments to petitioner's income as reflected by its Federal corporation income tax return for the calendar year 1934, resulted in an overassessment for 1934 in the amount of $784.19.

21. Petitioner signed and filed an "Acceptance of Proposed Overassessment" on Form 873, dated July 23, 1936, a true copy of which is attached to and made a part of the stipulation of facts.

22. The overassessment was duly scheduled and said $784.19 was paid to the petitioner.

23. The debentures discharged in 1937 were to the extent of $67,045.49 retired from petitioner's income of that year, and were not paid with borrowed money or replaced by substituted indebtedness.

OPINION.

DISNEY: Stated tersely, the problem for solution here is whether section 351(b)(2)(B) of the Revenue Act of 1936, as amended by section 355(b) of the Revenue Act of 1937, ¹ by*874 the phrase "indebtedness incurred prior to January 1, 1934", was intended to cover indebtedness which existed prior to that date in the form of debentures and was retired after the crucial date, new bonds being issued for cash and the proceeds being used to retire the old debentures. In a word, the facts before us are that 5 percent bonds were issued in 1930 to certain parties and were retired in 1934 with the proceeds of a 3 1/2 percent bond issue sold to parties other than those holding the issue of 1930, though the trustee was the same for both issues. In 1937 it redeemed the 3 1/2 percent bonds and deducted the amount of such redemption from its undistributed adjusted net income, acting under the provisions of section 351(b)(2)(B) of the Revenue Act of 1936, as amended by section 355(b) of the Revenue Act of 1937. The Commissioner denied such deduction.

*875 The question is one of first impression. The petitioner cites no case specifically considering the point here raised, and the respondent *1417 agrees that there is no authority exactly in point, though he adduces and relies upon certain cases as embodying the principle properly to be applied here.

After much study of this vexing problem, we have concluded that Congress did not intend to deny credit for payments upon indebtedness which represents an actual, though not a technical, continuance of indebtedness existing prior to January 1, 1934. The statute originated in section 351 of the Revenue Act of 1934, where the language used was identical with that in the 1936 Act. Of this statute, the Senate Finance Committee report said:

* * * Considerable hardship has been avoided by permitting the deduction from the adjusted net income of a reasonable amount used or set aside to retire indebtedness incurred prior to January 1, 1934. This will substantially and properly relieve personally owned corporations which have outstanding bonds or other indebtedness that must be met from current earnings before distributions can be made.

The requirement spoken of by the committee, *876 "that must be met from current earnings before distributions can be made", seems to apply alike to "bonds or other indebtedness" already issued on the effective date, and those with which the original issue is supplanted, but where the economic position of the taxpayer is not altered. We think that no distinction was intended between a corporation which after the date set, changes the form of its obligation, even changes the obligee, but remains equally obligated, and one which merely remains bound by the original obligation. True, the statutory date must be given meaning and effect, but we think this is reasonably done and Congressional intent accomplished by denying credit to indebtedness which is new in an economic sense to the taxpayer, i.e., does not merely take the place of indebtedness existing prior to the effective date. This seems to be the thought behind the language of the Ways and Means Committee Report on the Revenue Act of 1937 when, denying a recommendation that the credit for retirement of indebtedness provision be repealed, it said:

* * * While recognizing the reasons which impelled the joint committee to make this recommendation, your committee feels, from*877 further study of the question, that the denial of this deduction would cause hardship in numerous cases where, due to the particular circumstances of the corporation, a dividend distribution can not be made because of a necessity for legal reasons of using the earnings and profits to discharge the debts. Moreover, any loss of revenue caused by the continued allowance of this deduction can not increase, since indebtedness incurred after 1933 can not be used as a basis for the deduction. No corporation can be formed for the purpose of taking advantage of this deduction. Furthermore, it is inevitable that the revenue loss must decrease as pre-1934 debts are retired. * * * [Italics supplied.]

The Committee seemed to think that if "pre-1934 debts are retired" and new corporations for taking advantage of the deduction prevented, *1418 justice will be subserved. The intent in our opinion was to prevent further incorporating of the pocketbook, but not to affect those incorporations already existing. Here the incorporation of pocketbook was done when the corporation was formed and the original bonds were issued, not when the state of indebtedness was continued in a slightly*878 different form. In Commissioner v. Tennessee Co., 111 Fed.(2d) 678, the court considered the question whether "indebtedness" included indebtedness contingent at the effective date set by the act. After pointing out that the word "indebtedness" has both a strict and a broad meaning, the court came to the conclusion that a broad implication was required by the act and stated that "the operation of the statute is 'cushioned' so as to make it prospective in case of debt retirement payments", and though the court was of the opinion that the kind of debt in the case considered was one "most calculated to accomplish avoidance", nevertheless upheld the deduction, saying: "So we must await the happy day when pre-1934 indebtednesses are finally extinguished."

The Revenue Act of 1936 provides, in section 351(b)(3)(B), that credit shall be allowed for certain contributions of gifts:

* * * including, in the case of a corporation organized prior to January 1, 1936, to take over the assets and liabilities of the estate of a decedent, amounts paid in liquidation of any liability of the corporation based on the liability of the decedent to make any such contribution or gift, *879 to the extent such liability of the decedent existed prior to January 1, 1934; * * *

The case of such corporation was new in the act. Commenting on the inclusion thereof, the Report of the Conference Committee says:

Contributions or gifts to charitable organizations pledged by an individual who died prior to January 1, 1936, and assumed by a corporation organized to take over the assets and liabilities of the estate of such decedent after that date are allowed as a deduction in computing the adjusted net income for the purposes of this tax. This deduction seems meritorious, for the liabilities assumed by the corporation are with respect to gifts going to charitable organizations and were actually incurred prior to January 1, 1936, but due to the delay in the organization of the corporation were not actually incurred by the corporation as such until after that date.

It would seem from such language that there was Congressional intent not to exclude from credit, where the debt was not "actually incurred" after the effective date, but represented indebtedness existing prior thereto; and that such thought applies equally in case of new bonds to take up those prior to the date*880 involved.

The question as to what constitutes the incurrence of indebtedness has received the attention of the courts in connection with municipal bond issues in excess of constitutional or statutory limits. Though there are decisions to the contrary, the weight of authority is that a *1419 bond issue which of itself would be void, as contravening such constitutional limit beyond which the municipality might not become indebted, is not void if the bonds are exchanged for, or their proceeds are used to take up, a previous valid issue. Here that is true to the extent of $3,500,000 and not true as to $500,000. Obviously any claim for deduction from adjusted net income must be and is denied to the extent of $500,000, since that amount may, so far as the record herein shows, represent the retirement of bonds the proceeds of which went to the new purpose of laying a pipe line. However, petitioner, though it set up a claim in its return and petition for credit of $3,400,000, is in effect asking only for a credit of $67,045.49, since only that amount is necessary to eliminate the deficiency set up. Petitioner's adjusted net income was returned as, and by the respondent found*881 to be, $1,307,845.49. Dividends paid credit allowed in the amount of $1,240,000 leaves undistributed adjusted net income of $67,045.49. Therefore that amount of deduction out of the $3,400,000 claimed would eliminate any deficiency. The debentures discharged in 1937 were to the extent of $67,045.49 retired from petitioner's income of that year, and were not paid with borrowed money or replaced by substituted indebtedness.

In Aetna Life Insurance Co. v. Lyon County, Iowa,82 Fed. 929, the issuance and sale of bonds by a county for the purpose of discharging outstanding indebtedness, executed pursuant to statute, was held not to create a debt within the meaning of a constitutional debt limitation. The controlling thought was that the actual indebtedness was not increased.

In City of Huron v. Second Ward Savings Bank,86 Fed. 272, it was held, considering bonds in the territory of Dakota, that "Bonds which are issued to fund a valid indebtedness neither create any debt nor increase the debt of the municipality which issues them. They merely change the form of an existing indebtedness." The organic law of the territory of Dakota*882 provided that "no municipal corporation should ever become indebted exceeding 4 per centum on the value of the taxable property within such corporation." The bonds were sold and the proceeds applied to pay warrants.

In City of Los Angeles v. Teed,44 Pac. 580, this question was considered. The California Constitution, article 11, § 18, forbids any city to "incur any indebtedness or liability in any manner, or for any purpose, exceeding in any year the income and revenue provided for it for such year, without the assent of two-thirds of the qualified electors * * *." The court said: "* * * merely to fund or refund an existing debt is not to 'incur an indebtedness or liability.' A bond is not an indebtedness or liability; it is only the evidence or *1420 representative of an indebtedness. And a mere change in the form of the evidence of indebtedness is not the creation of a new indebtedness within the meaning of the constitution [citing cases]."

In City of Poughkeepsie v. Quintard,32 N.E. 764, the Court of Appeals of New York interpreted a statute providing that a city council shall not "create" any obligation not payable in*883 the current year. Bonds were sold and the proceeds used to pay prior bonds. It was said: "There is a new creditor, and a reduced rate of interest, but the same old debt. The municipal liability is not increased, but merely suffered to remain; and not a dollar of new or added debt results."

The respondent cites Helvering v. California Oregon Power Co., 75 Fed.(2d) 644, and cases to the same effect, that is, that where one bond issue is issued at a discount and expense incurred, the amount of expense and discount amortized and new bonds later issued to a different creditor, in retirement of the earlier issue, the portion of the discount and expense of the old bond issue unamortized at the date of the new issue was properly deducted in the year of the new issue, and not amortized over the life of the later bond issue. It was there held that "the two bond issues were not interrelated in any legal sense, but were in fact substantially separate transactions and should be so treated." We think, however, that from such treatment, for the purpose of that case, it does not follow that the treatment must be the same here and that the new bonds represented "indebtedness*884 incurred" after the crucial date. Though there the bond issues were separate for purposes of considering expense and discount, and such expense of the first issue logically was deductible only when it was closed, upon the question herein presented the indebtedness involved in the second was that involved in the first, under the above cases.

Being unable to distinguish the instant situation in principle from the cases above reviewed to the effect that indebtedness is not incurred by new bonds with the proceeds of which an old issue is retired, we conclude and hold that there was error in the denial of the deduction under section 351(b)(2)(B) of the Revenue Act of 1936, to the extent of $67,045.49. This is obviously "reasonable with reference to the size and terms" of the indebtedness of $3,500,000, and the requirement of paying $400,000 in 1937, within the requirement of section 351(b)(2)(B) of the Revenue Act of 1936, as amended, and we so hold.

Reviewed by the Board.

Decision will be entered under Rule 50.

STERNHAGEN dissents.