Republic Nat'l Bank v. Commissioner

*1039 This case involves an income tax deficiency of $ 28,954.50 for 1940, a declared value excess profits tax deficiency of $ 1,139 for 1941, and excess profits tax deficiencies for 1941 and 1942 in the respective *1040 amounts of $ 135,603.96 and $ 24,453.14. Certain of the adjustments made by the Commissioner are not contested.

The questions presented are:

(1) Whether for equity invested capital purposes in 1940, 1941, and 1942 petitioner's basis for certain assets acquired in 1929 from the North Texas National Bank of Dallas is petitioner's cost or the basis of the assets in the hands of North Texas.

(2) Whether in determining petitioner's equity invested capital for 1941 and 1942 petitioner is entitled to an allowance for new capital under section 718 (a) (6) of the Internal Revenue Code.

(3) Whether the amounts of $ 85,413.04 and $ 109,770.45, received by the petitioner in 1940 and 1941, respectively, in transactions with the Commodity Credit Corporation, constitute taxable or exempt income.

FINDINGS OF FACT.

Petitioner is a national banking corporation organized*28 under the laws of the United States, with its principal place of business in Dallas, Texas. Its tax returns for the years involved were filed with the collector of internal revenue for the second district of Texas.

In 1929 petitioner acquired all the assets and assumed all the liabilities of the North Texas National Bank of Dallas, hereinafter called North Texas, in a merger or consolidation, and in consideration therefor petitioner paid $ 750,000 cash and issued 25,000 shares of its capital stock, having a fair market value of $ 65 per share, or a total value of $ 1,625,000. Prior to the merger petitioner had 175,000 shares of capital stock outstanding and North Texas had 50,000 shares of capital stock outstanding.

Negotiations looking to a merger or consolidation of the two banks began in the early part of 1929. By the late summer of that year the officers and directors were in substantial agreement with respect to the merger. On October 11, 1929, the boards of directors of both banks held special meetings at which resolutions were adopted authorizing the bank officers to negotiate for a contract of merger or consolidation.

On October 12, 1929, substantially all the assets of*29 North Texas were delivered to petitioner and were thereafter managed by petitioner's officers and employees. Income thereafter derived from such assets was reported in petitioner's return. At the time of delivery of the North Texas assets to petitioner the officers and directors felt reasonably certain that the merger of the two banks would ultimately be approved by the stockholders and the Comptroller of the Currency of the United States. They recognized, however, the possibility of nonapproval and took the risk to that extent. Petitioner published an advertisement in a Dallas newspaper on October 12 announcing the merger of the two banks and stating that effective October 14 the *1041 business of the merged banks would be carried on at petitioner's quarters.

On October 14, 1929, the boards of directors of both banks again held special meetings and approved a contract of merger or consolidation of the banks under the petitioner's charter. The agreement provided that petitioner's capital stock should be increased from $ 3,500,000 to $ 4,000,000, consisting of 200,000 shares of $ 20 par value each, of which 175,000 were to be allotted to the existing Republic stockholders*30 and 25,000 to the existing North Texas stockholders. The assets of North Texas were to vest in petitioner from the effective date of the merger or consolidation. The agreement further provided that the merger or consolidation should become effective upon the ratification and confirmation by a vote of the holders of two-thirds of the stock of each bank and upon the approval of the Comptroller of the Currency.

Pursuant to due notice, the stockholders of each bank met on December 26, 1929, and voted in favor of the merger or consolidation. On December 28, 1929, the Comptroller of the Currency approved the merger or consolidation, effective at the close of business on that date. Thereupon, certificates for the 25,000 shares of petitioner's stock referred to in the consolidation agreement were issued, principally to former stockholders of North Texas.

The Republic National Co. was a corporation having 1,000 shares of outstanding stock, all of which was held by three trustees under the terms of a trust agreement executed January 29, 1929. Dividends on the Republic National Co.'s stock under the terms of the trust were payable to petitioner for the benefit of all its stockholders in*31 proportion to their holdings and were to be used by petitioner in its business as its own funds unless otherwise directed by a two-thirds vote of petitioner's stockholders. The term of the trust was for 50 years unless earlier terminated by a vote of two-thirds of petitioner's stockholders. Upon termination of the trust, the assets were distributable to petitioner's stockholders in proportion to their holdings. The owner of each share of stock in petitioner was by virtue thereof the owner of a beneficial interest in the capital stock of Republic National Co., and such interest was transferable with the transfer of stock in the petitioner.

Prior to August 23, 1929, Robert Harris of New York owned 4,250 shares of North Texas stock. Harris was an old friend of Everett S. Owens, then the president of North Texas. Owens, knowing that the merger with petitioner was under consideration, wanted to acquire the Harris stock so that it would be available to him and his North Texas associates in connection with working out the details of merger. Owens asked Florence, the president of petitioner, to buy the stock, and they agreed that Republic National Co. should acquire the stock *1042 *32 and Owens thereafter could designate to whom the stock should be delivered. On August 23, 1929, Republic National Co. purchased Harris' 4,250 shares of North Texas stock. Owens thereafter directed that the stock should go to W. B. Head, C. L. Norsworthy, and E. H. Cary, directors of North Texas. Accordingly, on November 29 and 30, 1929, Republic National Co. sold the 4,250 shares to them at a profit of about $ 44,000, which was reported in a consolidated return filed by petitioner and Republic National Co. for 1929.

The net worth of the North Texas assets as reflected by North Texas' books on October 11, 1929, was $ 1,589,755.56. It was subsequently determined that $ 13,218.75 of the North Texas assets (loans) were worthless prior to October 11 and, in addition, petitioner paid taxes of North Texas in the respective amounts of $ 11,597.06 and $ 23,350.21. The total of these adjustments, $ 48,166.02, reduced the net worth of North Texas assets as of October 11 to $ 1,541,589.54. Respondent, in computing petitioner's equity invested capital for 1940, 1941, and 1942, allowed only $ 791,589.54 on account of the assets acquired from North Texas for stock, that figure being the difference*33 between the net worth of the North Texas assets and the $ 750,000 cash paid by petitioner.

On October 16, 1941, petitioner increased its capital by a million dollars by issuing 50,000 shares of new stock, which were sold for $ 20 a share paid in cash. In its excess profits tax returns for 1941 and 1942 petitioner, in computing its equity invested capital, took this increased capitalization into account under section 718 (a) (1) of the code as money paid in for stock, in the respective amounts of $ 208,219.18 and $ 1,000,000, the figure for 1941 being reduced on account of the fact that the increase in capital existed for only a fractional part of that year. In addition, petitioner claimed an extra 25 per cent allowance for "new capital" under section 718 (a) (6) in the respective amounts of $ 52,054.79 and $ 250,000 for 1941 and 1942.

On December 31, 1940, petitioner had inadmissible assets in the amount of $ 17,821,121.74, which was 17.48356 per cent of its total assets at that time. The foregoing figure does not include $ 8,034,116.08 of cotton producers' notes referred to hereinafter in connection with Commodity Credit Corporation transactions.

On October 16, 1941, petitioner*34 had inadmissible assets in the amount of $ 20,105,751.67, which was 17.41981 per cent of its total assets.

In determining the deficiencies, respondent refused to make any additional allowance for new capital, on the ground that the increase in inadmissible assets on October 16, 1941, over December 31, 1940, exceeded the amount of new capital.

The Commodity Credit Corporation, an agency of the United States Government, was created by Executive Order pursuant to the Soil Conservation and Domestic Allotment Act of 1935 and was continued *1043 under the Agricultural Adjustment Act of 1939. Pursuant to contract with the Commodity Credit Corporation, petitioner in 1938 and 1939 made loans to cotton producers on the standard form "Cotton Producers' Notes and Loan Agreements." These notes bore interest at 4 per cent and were secured by a pledge of warehouse receipts covering cotton in storage. The producer was not to be liable for any deficiency upon the sale of the pledged cotton, unless the loan were obtained through fraudulent representations on his part. The notes were payable on or before July 31, 1939. Petitioner also purchased similar notes from other banks and lending agencies.

*35 Under the "Contracts to Purchase" between petitioner and the Commodity Credit Corporation, the latter agreed to purchase the cotton producers' notes from petitioner at par, with accrued interest at the rate of 2 1/2 per cent to the date of payment of the purchase price.

For the purpose of allowing petitioner to continue its investment in the cotton producer's notes beyond July 30, 1939, the Commodity Credit Corporation in 1939 entered into "Supplemental Contracts to Purchase," whereunder the corporation agreed to purchase deposited notes after July 30, 1939, at face value, with interest through July 30, 1939, at the rate of 2 1/2 per cent and interest thereafter to the date of purchase at the rate of 1 per cent.

Petitioner acquired several million dollars' worth of these notes and subsequently sold them to the Commodity Credit Corporation pursuant to the purchase contracts. On such transactions it realized income in 1940 and 1941 in the respective amounts of $ 85,413.04 and $ 109,770.45. About 99 per cent of these amounts grew out of notes purchased by petitioner from other lending agencies, and the remainder out of direct loans by petitioner to cotton producers. In its returns*36 petitioner treated these amounts as exempt from normal taxes and excess profits taxes. In determining the deficiencies, the respondent held that the income was not exempt.

OPINION.

The first issue concerns the amount includible in petitioner's equity invested capital under section 718 (a) (2) of the Internal Revenue Code as property paid in for stock, on account of the North Texas assets acquired by petitioner in 1929. That section provides that "Such property shall be included in an amount equal to its basis (unadjusted) for determining loss upon sale or exchange." The question is whether that basis is petitioner's cost, i. e., fair market value of the stock at the time of its issuance (Regulations 109, sec. 30.718-1; Regulations 112, sec. 35.718-1), or a substituted basis, i. e., the same as it would be in the hands of North Texas. The respondent *1044 contends that it should be a substituted basis under section 113 (a) (7), which provides that where property was acquired "by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 50 per centum or more remained in the same persons or any of them * * *37 * then the basis shall be the same as it would be in the hands of the transferor."

The respondent's position is based on the somewhat technical theory that all the petitioner's stockholders prior to the merger of North Texas owned an equitable interest in the Republic National Co., which in turn held 4,250 shares of stock in North Texas; that, therefore, immediately before the transfer all the stockholders of petitioner and all the stockholders of North Texas together owned the entire interest or control in North Texas' assets; and that immediately after the transfer all of the petitioner's stockholders, then including the former stockholders of North Texas, owned the entire interest or control in such property. This theory, however, is predicated on the assumption that the merger or consolidation became effective in October 1929 when the assets of North Texas were physically delivered to petitioner. The issue before us has been considerably simplified by respondent's concession on brief that if the merger or consolidation did not become effective until December 28, 1929, there was lacking the necessary continuity of control to make section 113 (a) (7) applicable.

It is the respondent's*38 view that the merger or consolidation became effective in October 1929, and that the ratification by the stockholders of both banks and the approval by the Comptroller of the Currency were mere formalities. With that view we are unable to agree. The agreement between the banks expressly provided that the merger or consolidation should become effective only upon ratification and confirmation by the necessary two-thirds vote of the stockholders of both banks and the approval of the Comptroller. Moreover, both banks being national banks, their consolidation was governed by Federal banking laws and could not become effective without the approval of the Comptroller. 40 Stat. 1043; 12 U. S. C. § 33. The stockholders did not ratify and confirm the merger or consolidation until December 26 and the Comptroller did not approve it until December 28, 1929, and his approval was made effective as of the close of business on that day. We accordingly hold that the petitioner should be sustained on the first issue.

The second issue is whether petitioner is entitled to any allowance for new capital on account of the million dollar increase in its capital stock*39 on October 16, 1941. Under section 718(a)(6), the concept of "new capital" embraces money paid in for stock during a taxable year beginning after December 31, 1940. In such case an additional amount equal to 25 per cent of the new capital is allowed in computing equity *1045 invested capital. The effect of such allowance, coupled with the provisions of section 718(a)(1), is to take new capital into account at 125 per cent. There are, however, certain limitations upon the allowance, among which is that contained in section 718(a)(6)(D), which provides that "The new capital for any day of the taxable year * * * shall be reduced by the excess, if any, of the amount computed under section 720(b) with respect to inadmissible assets held on such day, over the amount computed under section 720(b) with respect to inadmissible assets held on the first day of the taxpayer's first taxable year beginning after December 31, 1940." Section 720(b) is set out in the margin. ¹

*40 Petitioner contends that the limitation in section 718(a)(6)(D) merely requires that the ratio between inadmissible assets and total assets must not increase. We do not agree. Section 720(b) provides that in computing the amount of assets, both admissible and inadmissible, the adjusted basis of each asset is the amount attributable to that asset. We think it clear that the term "amount computed under section 720 (b) with respect to inadmissible assets held on such day," appearing in section 718(a)(6)(D), means simply the mathematical sum of the adjusted bases of the inadmissible assets.

The respondent made no new capital allowance because the inadmissible assets on October 16, 1941, exceeded the inadmissible assets on December 31, 1940, by more than the amount of the new capital. His action was in accord with his regulations on the point (Regulations 109, sec. 30.718-4, as amended by T. D. 5092; Regulations 112, sec. 35.718-4), which we think properly interpret the statute in accord with Congressional intent. See H. Rept. No. 1040, 77th Cong., 1st sess., 1941-2 C. B. 434, 450; S. Rept. No. 673, 77th Cong., 1st sess., 1941-2 C. B. 496.*41 It follows that the petitioner is not entitled to the claimed allowance for new capital.

The third issue relates to income received by petitioner in 1940 and 1941 in the Commodity Credit Corporation transactions, which petitioner contends is exempt from normal and excess profits tax. In support of its contention petitioner relies on section 5 of the Act of March 8, 1938, 52 Stat. 108, 15 U. S. C. section 713a-5, which reads as follows:

*1046 Bonds, notes, debentures, and other similar obligations issued by the Commodity Credit Corporation under the provisions of this Act shall be deemed and held to be instrumentalities of the Government of the United States, and as such they and the income derived therefrom shall be exempt from Federal, State, municipal, and local taxation (except surtaxes, estate, inheritance, and gift taxes). * * *

Section 4 of the same Act, in pertinent part, is as follows:

With the approval of the Secretary of the Treasury, the Commodity Credit Corporation is authorized to issue and have outstanding at any one time, bonds, notes, debentures, and other similar obligations in an aggregate amount not exceeding $ 500,000,000. *42 Such obligations shall be in such forms and denominations, shall have such maturities, shall bear such rates of interest, shall be subject to such terms and conditions, and shall be issued in such manner and sold at such prices as may be prescribed by the Commodity Credit Corporation, with the approval of the Secretary of the Treasury. Such obligations shall be fully and unconditionally guaranteed both as to interest and principal by the United States, and such guaranty shall be expressed on the face thereof, and such obligations shall be lawful investments and may be accepted as security for all fiduciary, trust, and public funds the investment or deposit of which shall be under the authority or control of the United States or any officer or officers thereof.

Petitioner contends that the cotton producers' notes or the contracts it had with the Commodity Credit Corporation constitute obligations which are exempt under those statutes.

The mechanics of the transactions in question were that petitioner made loans to producers of cotton or, in the majority of instances, purchased cotton producers' notes from other banks or lending agencies. Loans were made to producers of cotton under*43 the program of loans on agricultural commodities authorized by the Act of February 16, 1938, section 302 (c), 52 Stat. 43, 7 U. S. C. § 1302 (c). The obligations in the first instance were those of the cotton producers who received the loans and were the makers of the notes. It is true that the notes were secured by pledged warehouse receipts covering cotton in storage, and that the producer was not to be liable for any deficiency upon the sale of the pledged cotton except in the case of fraudulent representations. These notes bore interest at 4 per cent. Petitioner had contracts with the Commodity Credit Corporation whereby the latter agreed to purchase eligible cotton producers' notes at face value, plus interest in certain cases of 2 1/2 per cent and in others of 1 per cent. After making direct loans or purchasing cotton producers' notes from other banks or lending agencies, petitioner would subsequently sell the notes to the Commodity Credit Corporation and collect the face value, plus the stipulated interest.

That petitioner, in entering into these transactions, may have thought they would be tax exempt is of course not controlling. Only*44 in a very broad, loose sense of the term can it be said that the cotton producers' notes and the purchase contracts were "obligations" of the *1047 Commodity Credit Corporation. We think it quite apparent on the face of the statute upon which petitioner relies that they were not the types of obligations which Congress, by section 5 of the Act of March 8, 1938, intended to exempt from taxation. The terms used are "Bonds, notes, debentures, and other similar obligations issued by the Commodity Credit Corporation." Under section 4 of the Act, the obligations were to be in such forms and denominations, to have such maturities, to bear such rates of interest, to be subject to such terms and conditions, and to be issued in such manner and sold at such prices as might be prescribed by the Commodity Credit Corporation with the approval of the Secretary of the Treasury. They were to be fully and unconditionally guaranteed by the United States, and the guaranty was to be expressed on their face. These provisions obviously do not fit either the cotton producers' notes or the purchase contracts here in controversy.

For the reasons stated, we hold that the income received by the petitioner*45 in 1940 and 1941 from the Commodity Credit transactions was not tax exempt.

Decision will be entered under Rule 50.