L. S. Donaldson Co. v. Commissioner , 12 B.T.A. 271 ( 1928 )

L. S. DONALDSON CO., INC., AND DONALDSON REALTY CO., PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

L. S. Donaldson Co. v. Commissioner

Docket Nos. 9974, 25359.

United States Board of Tax Appeals

12 B.T.A. 271; 1928 BTA LEXIS 3564;

June 1, 1928, Promulgated

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1. L. S. Donaldson Co., Inc., acquired in 1913 for $200,883 noninterest-bearing promissory notes payable monthly up to the date of the expiration of the lease in 1930, a lease upon certain property in the same block in which its store was located. Held, that the lease had no capital value upon which a deduction from gross income in annual tax returns for exhaustion can be predicated but that the petitioner is entitled to deduct from gross income of each year as an ordinary and necessary expense the amount paid in respect of notes maturing in such year.

2. Invested capital held not affected under Revenue Acts of 1918 and 1921 by such transaction.

3. An amount representing an adjustment on the books of the Donaldson Realty Co. in 1919 in the present value of noninterest-bearing promissory notes outstanding held not income of 1919.

4. Prior to March 1, 1913, the L. S. Donaldson Co., Inc., acquired a number of leases which had greatly appreciated in value by March 1, 1913. On January 1, 1914, it transferred the leases together with certain real estate owned in fee which had also appreciated in value between the date of acquirement and January 1, 1914, to theDonaldson Realty Co. in exchange for all of its capital stock, the value of the property transferred being greatly in excess of the par value of the capital stock received. Held, that the petitioners are entitled to deduct from gross income on consolidated returns of the taxable years a reasonable amount for exhaustion of the value of the leases, and to include in consolidated invested capital the depreciated value of the leases as at the beginning of each taxable year.

5. Where petitioners acquired by purchase in 1919 certain buildings which they were occupying under a lease expiring in 1930, and where they acquired at the same time a new 100-year lease on the land to begin at the expiration of the old lease, and where they continued to use the buildings in carrying on their business until the end of the year 1923, held, that they are entitled for such period to an annual deduction for depreciation of the buildings based on their cost spread ratably over their remaining useful life.

6. The Commissioner's adjustments of invested capital for years under appeal in respect of taxes paid or accrued approved under section 1207 of the Revenue Act of 1926.

J. S. Y. Ivins, Esq., for the petitioners.

J. Harry Byrne, Esq., for the respondent.

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SMITH

These proceedings are for the redetermination of income and profits taxes for the years 1919 to 1923, inclusive. Docket No. 9974 relates to the year 1919, and Docket No. 25359 to the years 1920, 1921, 1922, and 1923. The proceedings were consolidated for hearing and decision. The deficiencies asserted for the several years are as follows:

1919	$19,377.84
1920	22,658.90
1921	18,281.69
1922	8,543.22
1923	20,004.20

The issues are as follows:

(1) The cost for exhaustion purposes of a lease acquired by the L. S. Donaldson Co., Inc. (hereinafter sometimes referred to as the Donaldson Co.), in the year 1913 in exchange for certain promissory notes payable monthly over the entire term of the lease, which lease was transferred to the Donaldson Realty Co. (hereinafter sometimes referred to as the Realty Co.) on January 1, 1914.

(2) The computation of invested capital in respect of such lease.

(3) Whether an amount returned as income of the year 1919 for the purpose of adjusting the present value of certain promissory notes outstanding constituted taxable income to the petitioners.

(4) The value for invested capital and exhaustion purposes of certain leaseholds acquired by the Realty Co. in exchange for capital stock in the year 1914.

(5) Whether the petitioners are entitled to deductions for depreciation upon certain buildings which they acquired in the year 1919, or whether the allocated cost of such buildings constituted a part of the cost of a 100-year ground lease of the premises which the petitioners acquired at the same time.

(6) The computation of invested capital in respect of taxes for prior years.

FINDINGS OF FACT.

1. The L. S. Donaldson Co., Inc., and the Donaldson Realty Co. are Minnesota corporations organized July 1, 1899, and January 1, 1914, respectively. They are affiliated corporations, the former owning all of the capital stock of the latter, and they filed consolidated income and profits-tax returns for the years under appeal. The Donaldson Co. operates a large department store in Minneapolis covering the entire block, bounded by Nicollet Avenue, Sixth Street, Marquette Avenue and Seventh Street. The land upon which the store stands is held by the Realty Co. It is composed of several parcels or lots, some of which it owns in fee and some of which it holds under long-term leases. On January 1, 1913, the Donaldson Co. had possession of the entire block with the exception of that portion of the block occupied by buildings numbered 615, 617, 619, 621, 623, and 625 Nicollet Avenue, known as the Fitterling property.

2. In 1910 the Fitterling property was leased by the executor of the Fitterling estate to Philipsborn and Siegel for a period of 20 years. In the same year Philipsborn and Siegel subleased the entire property to the Gimbel-Zimmer Co. In 1913 the Gimbel-Zimmer Co. subleased a part of the property, numbered 623 and 625 Nicollet Avenue, known as the Shoe Mart Building, to the Shoe Mart Co., such sublease running to July 1, 1930. Also, in 1913, Philipsborn and Siegel assigned to Harzfeld, Simon, Kaufman, and Conhaim all of their interests in the lease which they had made to the Gimbell-Zimmer Co.

3. The Donaldson Co. in 1913 purchased from the Gimbel-Zimmer Co. its sublease covering the entire Fitterling tract, for which it gave noninterest-bearing promissory notes aggregating $200,883, payable monthly up to 1930. The amounts of the notes payable increased from year to year, the total amount falling due for the year 1914 being $8,688 and for the year 1929, $14,688. For such consideration the subleases of the Shoe Mart Co. and other tenants of the Gimbel-Zimmer Co. were assigned to the Donaldson Co. It entered in its books at that time under "note account," as a liability, and under "lease account," as an asset, the item of $125,000 which it estimated was the then present worth or discount value of the notes and leases. In respect of the Fitterling property the Donaldson Co. thereby became tenants of Harzfeld, Simon, Kaufman, and Conhaim for a term running until July 1, 1930, with a rental obligation of $51,000 a year. During the taxable years some of the noninterest-bearing notes were paid off at a discount prior to their due date.

4. Prior to January 1, 1913, the Donaldson Co. had acquired other leases, hereinafter described more fully, covering the entire block above designated, except for two lots which it owned in fee and the Fitterling property above described. Upon the organization of the Realty Co. on January 1, 1914, the Donaldson Co. assigned to it all of the leases and subleases which it held, together with the two lots which it owned in fee in exchange for $999,700 of its capital stock of the par value of $100 per share. The Realty Co. assumed the obligation of the Donaldson Co. upon the notes which it had given for the Gimbel-Zimmer lease, but gave no other consideration therefor. It made entries in its books in respect of the notes and leases pertaining to the Fitterling property corresponding to the entries in the books of the Donaldson Co. Both of these companies kept their books and made their income-tax returns upon the accrual basis.

5. At the end of each year the Realty Co. revalued the notes outstanding on the Gimbel-Zimmer lease and treated the difference between their estimated values at the beginning and at the close of the years as an interest charge. In 1919 it came to the conclusion that the present value of the notes had been overestimated and made an adjustment purporting to bring them to their correct present value by adding $9,557.30 to income for that year. This item was reported as income in petitioners' return for the year 1919. The amounts charged as interest and claimed as deductions from gross income in income-tax returns for the years 1920 to 1923, inclusive, were as follows:

1920	$9,000
1921	7,900
1922	4,500
1923	2,700

6. The Commissioner computed exhaustion on the Gimbel-Zimmer lease upon a basis of $125,000, the estimated value of the lease at the time it was acquired by the petitioners.

7. The leases and fee properties which the Donaldson Co. transferred to the Realty Co. January 1, 1914, with respect to the location of the several lots and the terms of the leases are described as follows:

(a) The Koon-Merrill lease covered the lot on the corner of Nicollet Avenue and Sixth Street, fronting 115 feet on Nicollet Avenue and 132 feet on Sixth Street. It ran until the year 1987 at a yearly rental of $33,000 up to July 1, 1921, the rent thereafter to be fixed by agreement or at 7 per cent of the appraised value to be determined every five years.

(b) The Welles lease covered the lot fronting 50 feet on Nicollet Avenue and ran until 1987 at a yearly rental of $5,000.

(c) The Gimbel-Zimmer lease covered several lots, the Fitterling property, fronting 121 feet on Nicollet Avenue and ran until 1930 at a yearly rental of $51,000.

(d) The Associates Realty Co. lease covered the lot at the corner of Nicollet Avenue and Seventh Street, fronting 44 feet on Nicollet Avenue and 132 feet on Seventh Street. It ran until the year 1956 at a yearly rental of $10,000 with the right to renew for 33 1/3 years thereafter at a rental to be based on revaluation.

(e) The lot known as the Seventh Street property fronting 66 feet on Seventh Street was owned by the Realty Co. It was carried in its books at a valuation of $100,000.

(f) The Lewis lease covered the lot at the corner of Seventh Street and Marquette Avenue, fronting 132 feet on Seventh Street and 70 feet on Marquette Avenue. It ran until the year 2009 at a yearly rental of $10,500.

(g) The Place lease covered the lot fronting 65 feet on Marquette Avenue and ran until 1987 at yearly rentals of $4,000 until 1917, $5,000 from 1917 to 1932, $6,000 from 1932 to 1957, and thereafter the rentals to be fixed at 5 per cent of appraisal values.

(h) The lot known as the Donaldson First Avenue property, fronting 30 feet on Marquette Avenue, was owned by the Realty Co. It was carried in their books at a value of $35,000.

(i) The Forman lease covered the lot fronting 45 feet on Marquette Avenue and ran until the year 2009. The yearly rentals were to be $3,500 from 1914 to 1919, $4,000 from 1919 to 1934, $4,500 from 1934 to 1959, 5 per cent of the appraisal value at 1959, but not to fall below $4,500 until 1974, and thereafter 5 per cent of appraisal values until 2009.

(j) The Merriam lease covered the lot at the corner of Marquette Avenue and Sixth Street, fronting 120 feet on Marquette Avenue and 50 feet on Sixth Street. It ran until 2009 at a flat yearly rental of $10,500.

(k) The Peterson lease covered the lot fronting 99 feet on Sixth Street and ran until 2009 at a flat yearly rental of $10,000.

(l) The Linton lease covered the lot fronting 99 feet on Sixth Street and ran until 1987. The yearly rentals were to be $18,000 until 1931 and thereafter 6 per cent of appraised values made every 20 years.

8. Prior to the year 1913 all of the leases and fee properties above described were carried on the books of the Donaldson Co. at cost. About the close of the year 1913, in anticipation of the assignment to the Realty Co., the Donaldson Co. increased the book values of certain of the leases and the fee properties and credited the amount of the increase to surplus account. The increase in the value of the leases as distinguished from the real estate is not shown. The total appreciation in the value of both was approximately $519,000. After the transfer to the Realty Co. corresponding entries were made in that company's books and the estimated increase in the values of the leases and fee properties were thereafter reflected in its surplus account. In their income and profits-tax returns for the years in dispute the petitioners did not include in invested capital any amount in respect of the leases, but did claim a deduction on account of their exhaustion, which deduction was disallowed by the respondent.

9. On July 7, 1919, the petitioners secured from the Fitterling heirs a ground lease on the entire Fitterling property, numbers 615, 617, 619, 621, 623, and 625 Nicollet Avenue, to begin July 1, 1930, and to run for 100 years.

Part VII of the said lease of July 7, 1919, under the heading "Removal of Buildings" provided as follows:

The lessors agree that when the lessees either prior or subsequent to the commencement of the term of this lease, shall have given the bond provided for in Paragraph IX of this lease, for the purpose of removal of the building or buildings now on said premises, or any building or buildings hereafter to be erected by them on said premises, and erecting on the demised premises any new building or buildings, the lessees may wreck the building or buildings or parts thereof so to be rebuilt or replaced, and have such wreckage for their own use; but this authority for wrecking and removal shall be subject to the rights of the lessees under said lease of May 14th, 1910, hereinbefore referred to.

At the time the said lease was executed there were two buildings situated on the property, one a six-story building reconstructed in the year 1891 and the other having been built just prior to that time. They were both of ordinary brick construction with wood interiors and each had a normal useful life of approximately 40 years. On July 7, 1919, the petitioners purchased these buildings for a consideration of $152,530, securing a bill of sale executed by the Fitterling heirs. At that time the petitioners had no definite plans for the immediate destruction of the buildings or for the erection of other buildings. It had been the intention of Donaldson (the principal stockholder and founder of the Donaldson Co.) for many years to erect a large department store covering the entire block, and it was with this in view that the leases above described, as well as the buildings, were purchased. Plans for such an undertaking were later made and reconstruction was to be commenced at the corner of Marquette Avenue and Seventh Street, but the project was abandoned before the work was actually begun. On May 31, 1921, the petitioners bought out the rights of Harzfeld, Simon, Kaufman, and Conhaim, assignees of Philipsborn and Siegel in the Gimbel-Zimmer lease. During that year the petitioners made plans for beginning reconstruction at the corner of Marquette Avenue and Sixth Street, but these plans likewise did not materialize. The petitioners continued to occupy the buildings on the Fitterling property until the end of the year 1923. Early in the year 1924 they removed the buildings and began construction of the present building at that point. Thereafter the petitioners wrote off annually in their books for depreciation one-sixth of the cost of the buildings.

10. For certain of the years under appeal the respondent has made adjustments in respect of income and profits taxes paid or accrued which the petitioners admit to come within section 1207 of the Revenue Act of 1926.

OPINION.

SMITH: The petitioners contend that for the purposes of exhaustion and invested capital the aggregate face value of the notes given in payment for the lease, that is, $200,883, should be taken as a basis and that the item of $9,557.30 was erroneously reported in income for the year 1919. These questions comprise the first three issues hereinafter discussed.

The Donaldson Co. purchased the lease in the year 1913 for $200,883 of noninterest-bearing notes payable monthly up to the year 1930. It then set up in its books under "lease account" an item of $125,000, which it estimated was the present value of the lease, and under "note account" an item of like amount which it estimated was the present worth or discount value of the $200,883 of notes outstanding. Thereafter, at the end of each year, the notes outstanding were revalued and the difference between the values at the beginning and at the end of the year was charged to interest. The value of $125,000 was taken as the basis for exhaustion.

The essence of this transaction from the standpoint of the petitioners was the acquirement of a lease at a monthly rental increasing in amount from year to year. The giving of rental notes was incidental and does not affect the treatment properly to be accorded the transaction. The liability of the petitioners was substantially the same as it would have been had no notes been given. The lease had no capital value in excess of the liability of the petitioners to pay the notes as they fell due. Since the lease had no capital value the petitioners are not entitled to deduct from gross income in annual tax returns any amount for exhaustion thereof. In effect what we have is a lease under which the rental to be paid is represented by notes which fall due at various dates, over the life of the lease, in the same manner that the rentals stipulated under the ordinary lease fall due. A deduction should, therefore, be allowed on account of the payment of these notes as ordinary and necessary expenses of operation.

The petitioners claim the right to include in invested capital an amount in respect of this transaction. We fail to see, however, under the circumstances that the petitioners' invested capital was in any wise affected. Upon the evidence of record the lease had no capital value. In the computation of invested capital the liability of the petitioners in respect of the rentals to be paid under the lease should be ignored. Even if we should concede that the lease had a capital value equal to the present value of the notes, we should likewise have to hold that there existed a corresponding liability which would prevent an increase in invested capital on this account.

In these proceedings for the first time the petitioners claim the right to include in invested capital the appreciation in the value of the leases which the Donaldson Co. transferred, together with property owned in fee to the Realty Co. on January 1, 1914, for $999,700 of its capital stock. They likewise claim a deduction for the exhaustion of the several leases upon the basis of the cost or proven value on January 1, 1914, of each lease spread ratably over its remaining life. These issues constituted the fourth assignment of error.

The leases under discussion had been acquired by the Donaldson Co. prior to January 1, 1913, at a cost not in excess of rentals and had been carried upon its books at cost, as were the fee properties which were transferred with the leases, until just prior to the assignment of these properties to the Realty Co. in exchange for the capital stock of that company. The Donaldson Co. then set up the amount of approximately $519,000, which it estimated was the excess of the cash value of the leases and fee properties over cost. This amount was likewise set up on the books of the Realty Co. after it had acquired the leases and fee properties. The petitioners now claim as paid-in surplus of the Realty Co. additional invested capital in respect of the leases in the amount of at least $406,300. In support of the value claimed, they rely chiefly upon the testimony of two witnesses who have been familiar with the real estate conditions in the City of Minneapolis, as well as with the particular property in question, for a number of years and were thoroughly qualified to express an opinion as to the value of the leases at January 1, 1914. One of the witnesses testified that five of the leases had values at January 1, 1914, in excess of rentals as follows:

Property	Value
Koon-Merrill	$16,500
Welles	198,000
Assoc. Realty Co	137,500
Place	49,500
Forman	11,000
	412,500

The other witness ascribed the following values to the same leases:

Property	Value
Koon-Merrill	$26,232
Welles	183,750
Assoc. Realty Co	156,950
Place	63,000
Forman	15,000
	444,932

He gave as his opinion that some of the other leases were liabilities rather than assets and that all of the leases taken together had an aggregate value of $406,300. Both of these values included an additional 10 per cent which was added for plottage.

The valuations seem to be reasonable. The property in question was situated in the heart of the business district of Minneapolis and had been steadily increasing in value for several years. We are convinced from all of the evidence that the leases had a fair market value at January 1, 1914, in excess of the rentals which the petitioners were obligated to pay, of not less than $406,300.

We will consider now the question whether this appreciation in value of the leases may be included in invested capital. The only argument made by the respondent against such inclusion was that the leases had no fair market value at January 1, 1914, when they were transferred with other assets to the Realty Co. in exchange for all of its capital stock. No argument was made that the values contended for could not be included in invested capital provided a valuation for them was proven. Since, however, the issue is placed squarely before the Board as to whether the amount may be included in consolidated invested capital it is necessary to consider the issue.

At the outset it should be noted that had the Realty Co. not been created and had not the Donaldson Co. transferred the leases to the Realty Co. there would be no ground for the contention that the $406,300 in issue be included in invested capital. Here, appreciation in the valuation of assets owned by a corporation may not be included in invested capital. La Belle Iron Works v. United States,256 U.S. 377">256 U.S. 377. It should be further kept in mind that we are here concerned with a transaction which occurred when consolidated returns were neither permitted nor required, and long before the enactment of an excess-profits or war-profits revenue act, where invested capital is a factor. Also, it is obvious that had the transaction occurred subsequent to March 3, 1917, there could be no question that the increase sought would be denied. (Section 331, Revenue Act of 1918.)

As stated above, no contention is made by the respondent that the increase sought can not be included in invested capital, provided the values are properly substantiated. This is consistent with his regulations and rulings. Under the Revenue Act of 1913, not only were parent and subsidiary corporations looked upon as separate and distinct corporate entities, but also were required to file separate returns and pay the tax shown due by such returns. Treasury Decision 2137, promulgated January 30, 1915, contains the following provisions:

Returns of subsidiary companies - Where made. - Under the provisions of the Federal income tax law and the regulations of this department, every corporation, joint-stock company or association, and every insurance company, regardless of its relation to another corporation, is held to be separate and distinct entity and unless it comes within the class of organizations specifically enumerated in the act as exempt must make a separate and distinct return, complete in every detail.

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Subsidiary companies must make returns. - In the case of parent corporations owning all or practically all of the stock of subsidiary companies it is held that both corporations are separate and distinct entities and that each must make true and accurate returns, accounting for, in detail, their separate gross income and deductions therefrom, and each such company will be required to pay the income tax on the net earnings shown by such return. * * *

That is, each corporation was looked upon as separate and distinct, and we think properly so. Under such circumstances, when the Donaldson Co. was required to file a return for the year in which the transaction in question took place, the regulations of the respondent required it to report as income subject to tax the difference between the cost or March 1, 1913, value of the leaseholds and the considerations received, which was the stock of the Realty Co. The entire difference between the cost of the leaseholds and the value of the stock received would represent profit to the Donaldson Co. It is immaterial that the fair market value of the stock of the Realty Co. is not proven by sales of the stock, since, under the circumstances of this case, the fair market value of the assets back of the stock is considered sufficient to establish the fair market value of the stock of the same amount. Had the leaseholds been sold by the Realty Co. in 1915, the basis for gain or loss on the sale would have been the cost to the Realty Co. in 1914 without regard to the prior cost to the Donaldson Co.

In view of the foregoing separateness of the two corporations for income-tax purposes when the transaction in question occurred, should the affiliated group be denied the benefit of the increase in surplus for invested capital purposes in the years when consolidated returns are required? We think not. While the regulations of the respondent do not cover the exact situation here presented, the right of a taxpayer to have the benefit of the increase here sought has long been recognized by him. See Law Opinion 1108, Cumulative Bulletin III-1, p. 412, and Solicitor's Memorandum 3384, Cumulative Bulletin IV-1, p. 277.

In our opinion a practice of the department adhered to over a period of years for the purpose of determining invested capital in a situation such as here presented should not be lightly disturbed. The situation is analogous to that which obtained in the case before the Circuit Court of Appeals, Third Circuit, inBellefield Co. v. Heiner, 25 Fed.(2d) 560, where the Court said:

These departmental interpretations of the statute promulgated by formal regulations we think clearly put the instruments in suit in the class of notes. If the regulations have the force of law they dispel any lingering doubt raised by the few defining words of the statute. Such a pronouncement made "by a department of the government, addressed to and reasonably adapted to the enforcement of an act of Congress, the administration of which is confided to such department, has" on authority of the cases "the force and effect of law if it be not in conflict with express statutory provision." Maryland Casualty Co. v. United States,251 U.S. 342">251 U.S. 342, 349; United States v. Grimaud,220 U.S. 506">220 U.S. 506; United States v. Birdsall,233 U.S. 223">233 U.S. 223, 231; United States v. Smull,236 U.S. 405">236 U.S. 405, 409, 411; United States v. Morehead,243 U.S. 607">243 U.S. 607 (251 U.S. 349">251 U.S. 349); Red Wing Malting Co. v. Willcuts, 15 Fed.(2d) 626. Moreover, in cases of ambiguity, contemporaneous construction by a department, long followed in practice, is generally held to be controlling. Schell's Exts. v. Fanche,138 U.S. 562">138 U.S. 562.

Does there exist justification for changing this established practice of the Bureau and holding in effect that because the Donaldson Co. and the Realty Co. are required to file consolidated returns for the years on appeal and have their invested capital determined on a consolidated basis, adjustments should be made to eliminate from the surplus of the group, surplus which was earned on account of a transaction which occurred prior to the time when consolidated returns were required? We fail to find any language in the revenue acts requiring consolidated returns which, in our opinion, authorizes such a construction of the statute. The language of the statute negatives such a construction. Section 240 of the Revenue Act of 1918 requires that corporations which are affiliated shall "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." (Italics supplied.) To hold that the foregoing provision requires the elimination of transactions of the character here in question would mean giving to the statute a retroactive effect which could be justified only where the language used plainly requires such an interpretation. There exists a very strong presumption against any construction of a statute which gives to it a retroactive effect and makes it apply to transactions occurring prior to its passage. Eidman v. Martinez,184 U.S. 578">184 U.S. 578; Shwab v. Doyle,258 U.S. 529">258 U.S. 529.

Since consolidated returns were not required prior to 1917, it seems reasonable to suppose that Congress did not intend that earnings of corporations which arise on account of dealings between the members of the group prior to 1917 should be eliminated in determining consolidated invested capital.

This is not inconsistent with the definition of consolidated invested capital which the Board laid down in Farmers Deposit National Bank,5 B.T.A. 520">5 B.T.A. 520, as follows:

* * * "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. * * *

We also stated in the same opinion that:

If it is the purpose of the 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 of a single taxpayer.

See also H. S. Crocker Co.,5 B.T.A. 537">5 B.T.A. 537, wherein these statements appear, which are dicta in so far as the decision of the case is concerned:

It is our conception of the law that, for purpose of taxation, the affiliated group must be considered as a single economic unit. The requirement with respect to computing the taxes of an affiliated group upon the basis of a consolidated return was first introduced into the law to prevent avoidance and resulting injustice, either to the Government or to the taxpayer, as the case might be, and not to create that situation. The normal treatment in the case of an affiliated group as a single economic unit, therefore, is to disregard the internal structure, to break down the separate legal existence of the constituent members, and to treat them in all respects, so far as taxation is concerned, as one.

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There is the further consideration that, under the affiliation provisions of the statute, the acquisition by one company of the stock of another, thereby creating affiliation, creates no additional investment in the affiliated group. By the act which creates the affiliation the group acquires a part of its own capital stock. The affiliation continues its existence until the stock of the subsidiary is disposed of by the parent corporation. * * *

Likewise see American La Dentelle, Inc.,1 B.T.A. 575">1 B.T.A. 575; Gould Coupler Co.,5 B.T.A. 499">5 B.T.A. 499; Interurban Construction Co.,5 B.T.A. 529">5 B.T.A. 529; and Risdon Tool & Machine Co.,5 B.T.A. 530">5 B.T.A. 530. But the foregoing rulings do not hold that the affiliated group should be treated as a single economic unit or that such a group should be considered to have taken on the attributes of a single taxpayer prior to the time when consolidated returns were required. The status to which we referred in these decisions was the status after consolidated returns were required.

As we understand the issue here presented, it is not whether both the cost of the leaseholds to the Realty Co. and cost of the stock to the Donaldson Co. should be included in invested capital of the consolidated group. Of course, elimination would have to be made on account of this duplication when consolidated invested capital is determined. Our issue, in effect, is whether when Corporation "A" has an asset which cost it nothing, and prior to 1917 sells this asset to Corporation "B" for the entire issue of the latter corporation's stock of $50,000, which had a fair market value of this amount, the consolidated group would be allowed the benefit of $50,000 in its invested capital. In our opinion, by this transaction, Corporation "A" realized a profit of $50,000 which represents earned surplus to it, and that when invested capital is determined for the consolidated group, full effect must be given to this earned surplus. In the case at bar, we have already determined that the fair market value of the stock received by the Donaldson Co. was not less than $406,300 in excess of the cost of the leaseholds to this corporation. This represented earned surplus to the Donaldson Co. The Board is, accordingly, of the opinion that in determining consolidated invested capital of the petitioners for the years on appeal, full effect should be given to this earned surplus.

A further issue presented in this case is whether the petitioners are entitled to deduct from consolidated gross income an amount for the exhaustion of the leases for the years 1919 to 1923, inclusive. Since the effect of our decision with respect to the previous issue is to hold that there was a new cost of the leaseholds at January 1, 1914, it follows that the allowable deduction to the consolidated group on account of the exhaustion of the leaseholds should be on the basis of the cost or value of the leaseholds at January 1, 1914. If the leaseholds had been retained by the Donaldson Co., the basis for exhaustion would have been their value on March 1, 1913, but since they were acquired by the Realty Co. on January 1, 1914, the basis for exhaustion must be such acquisition cost at January 1, 1914.

The petitioners are claiming annual deductions for depreciation on the Fitterling buildings from July 7, 1919, to the end of 1923, in amounts equal to a pro rata part of the cost of the buildings in 1919 spread ratably over their remaining useful life. The respondent contends that the cost of the buildings should be capitalized and treated as a part of the cost of the 100-year lease secured at the same time, or as a part of the cost of the new building which was later erected upon the site.

It is alleged in the petition and admitted in the answer that the petitioners purchased the buildings July 7, 1919, for a consideration of $152,530. The evidence shows that they had made no definite plans at that time for removing the buildings or for erecting a new building. They continued to use the buildings in carrying on their merchandising business until the end of the year 1923. Early in the year 1924 they removed them and began construction of a new building.

The statute provides that in computing net income there shall be allowed as a deduction a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business. The petitioners purchased the buildings in question and used them in carrying on their business and are, therefore, entitled to the deduction for exhaustion which they claim.

Since the remaining issue relating to certain adjustments of invested capital on account of taxes for prior years admittedly comes within section 1207 of the Revenue Act of 1926, the determination of the Commissioner in respect of such adjustments is approved.

Reviewed by the Board.

Judgment will be entered under Rule 50.