Pittsburgh & W. v. R. Co. v. Commissioner , 9 T.C. 268 ( 1947 )

The Pittsburgh & West Virginia Railway Company, Petitioner, v. Commissioner of Internal Revenue, Respondent

Pittsburgh & W. v. R. Co. v. Commissioner

Docket No. 11116

United States Tax Court

9 T.C. 268; 1947 U.S. Tax Ct. LEXIS 116;

August 29, 1947, Promulgated

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Decision will be entered under Rule 50.

1. Petitioner's purchase of its own mortgage bonds and immediate deposit as collateral under a junior note issue, subject to retention by trustee as continuing obligations and possible resale on default, held, not to result in taxable income in year of purchase, nowithstanding that purchases were made at a discount below issue price. United States v. Kirby Lumber Co., 284 U.S. 1">284 U.S. 1, distinguished.

2. Deduction, because of uncollectibility, of claim against petitioner's bailee on account of bailee's conversion, in a prior year, of petitioner's property, held limited to amount of claim, which would not exceed value of property at time of conversion.

W. A. Seifert, Esq., and N. D. Keller, Esq., for the petitioner.

A. W. Dickinson, Esq., for the respondent.

Opper, Judge.

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OPPER

By this proceeding petitioner challenges respondent's determination of deficiencies in income tax for the calendar years 1941 and 1942 in the respective amounts of $ 109,643.16 and $ 56,620.29. Four questions are presented:

(1) Whether, under the circumstances, petitioner derived taxable income in 1941 and 1942 as a result of its purchase of a number of its bonds at amounts less than issue price.

(2) Whether petitioner is entitled to a deduction in 1941 on account of a loss of 2,649 shares of treasury stock theretofore loaned to the Pittsburgh Terminal Coal Corporation (hereinafter sometimes referred to as Terminal).

(3) Whether petitioner is entitled to deduct as worthless debts in 1941 certain accounts receivable against Terminal.

(4) Whether petitioner is entitled to deduct in 1941 amounts allegedly expended by it over a period of about ten years in an unsuccessful effort to sell a bridge and tunnel to Allegheny County, Pennsylvania.

Some of the facts have been stipulated.

FINDINGS OF FACT.

The stipulated facts are hereby found accordingly.

Petitioner is a corporation, organized under the laws of Pennsylvania and West Virginia for the purpose of operating a steam railroad. Its principal office is in Pittsburgh. Its tax returns for the year involved were filed with the collector for the twenty-third district of Pennsylvania.

Issue 1.

On July 1, 1940, petitioner borrowed $ 7,400,000 and issued its five-year 4 per cent notes in such amount, secured by an indenture dated July 1, 1940, between petitioner and First National Bank at Pittsburgh, as trustee.

Under the terms of the indenture, petitioner was required during the calendar year 1941 to devote not less than 25 per cent of its "Available Net Income" for 1940, and during each calendar year thereafter, so long as any of the notes were outstanding and unpaid, not less than 50 per cent of its "Available Net Income" for the preceding year "to the purchase at the lowest price or prices available in the open market but not exceeding the principal amounts thereof" of its then outstanding series A, B, and C first mortgage 4 1/2 per cent bonds, "and the Company [petitioner] covenants and agrees that any and all of such bonds so purchased by the Company shall remain alive and forthwith be delivered to and pledged with the Trustee to be held by the Trustee as Pledged Securities under and subject to the terms of this Indenture."

If any described event of default were to occur, the trustee was given discretion to convert into money at public sale any of the pledged securities.

Pursuant to the provisions of the indenture petitioner, in the year 1941, purchased $ 550,000 face value of its series A, B, and C first mortgage 4 1/2 per cent bonds for the sum of $ 349,220, and in the year 1942 purchased $ 282,000 face value of such bonds for the sum of $ 159,271.25, and immediately upon such purchases delivered the bonds so purchased to and pledged them with the bank as trustee under the indenture. The bonds remained pledged with the trustee until June 28, 1945, when they were returned to petitioner by the trustee upon the payment of petitioner's five-year 4 per cent notes.

The bonds were secured by an indenture of mortgage and supplemental indentures between petitioner and the Union Trust Co. of Cleveland, Ohio, and Robert S. Crawford, as trustees, dated December 1, 1928, April 1, 1929, April 30, 1929, and April 1, 1930, covering all properties owned or which should subsequently be acquired by petitioner, except cash, accounts receivable, bills receivable, stocks, bonds, notes, and similar intangible property and such of the real estate of petitioner as is not included within its right of ways and real estate upon which no structures used for railroad purposes are located, and engines, tenders, cars, and other rolling stock.

Respondent has included in petitioner's gross income for the years 1941 and 1942 the difference between the face value and the purchase price of its bonds purchased and pledged by petitioner as aforesaid.

Issues 2 and 3.

In October 1917 petitioner purchased 3 shares of its common stock at a cost of $ 75.39 and in March 1918 received as a donation 2,646 shares of its common stock. At the time the stock was donated it had a fair market value of not less than $ 26.25 per share. Subsequent to their acquisition by petitioner, the 2,649 shares of common stock were held by petitioner as treasury stock.

Petitioner was guarantor of the interest on Terminal's outstanding bonds. On July 27, 1933, petitioner loaned the 2,649 shares of its common stock to Terminal for the sole purpose of their pledge by Terminal as security for an appeal and supersedeas bond in the amount of $ 200,000, executed by Terminal as principal and by petitioner as one of two sureties, pursuant to an appeal taken by Terminal from a judgment in favor of S. A. Williams entered by the United States District Court for the Western District of Pennsylvania against Terminal in the amount of $ 142,561.31.

The shares of stock were transferred to the name of Terminal and, together with $ 10,000 face value of bonds of petitioner owned by Terminal, were deposited by Terminal with the First National Bank of Pittsburgh in escrow, pursuant to an agreement between Williams and the bank, wherein the bank was authorized to hold the stock and bonds as collateral security and to sell the same in the event of the affirmance of the District Court's judgment by the Circuit Court of Appeals and the failure of Terminal to pay the judgment.

The Circuit Court of Appeals for the Third Circuit affirmed the judgment of the District Court in November 1934 and thereafter Terminal made certain payments on account of the judgment.

On September 6, 1938, North American Coal Corporation (hereinafter called North American) advanced to Terminal the sum of $ 31,933.42, being the amount of the unpaid judgment plus interest at that date, which amount Terminal paid to Williams and the judgment was thereupon satisfied, and the collateral, consisting of the aforesaid 2,649 shares of common stock and $ 10,000 face value of bonds of petitioner, was returned to Terminal. At the same time Terminal delivered to North American Terminal's demand note in the amount of $ 31,933.42, bearing interest at 5 per cent per annum, and pledged with North American as collateral security for the payment thereof the 2,649 shares of common stock and $ 10,000 face value of bonds of petitioner. As of September 6, 1938, the fair market value of the common stock of petitioner was $ 11.50 per share.

During March 1939 petitioner, by letters to North American, sought the return of the stock, but North American replied that it would be returned only upon payment of $ 31,933.42, with accrued interest at 5 per cent from September 8, 1938.

On April 19, 1939, the United States District Court for the Western District of Pennsylvania appointed S. W. Blakslee and the late John M. Rayburn receivers (in equity) of Terminal's property and assets when the debtor found itself unable to pay the wages due its miners and other employees for the last half of March 1939. The properties were operated in receivership under the direction of the court until January 2, 1940, when Newell G. Alford was appointed a disinterested trustee and Horace F. Baker operating trustee under the provisions of chapter X of the Bankruptcy Act. On October 7, 1940, Newell G. Alford resigned as disinterested trustee and William G. Heiner was appointed by the court as successor disinterested trustee.

In his formal report of January 29, 1941, the disinterested trustee in bankruptcy reported that Terminal was "heavily insolvent" as of November 1940, and was of the opinion that, even if it were assumed, and the assumption was considered unwarranted, that the fair market value of Terminal's coal lands equaled their assessed value, "the ratio of liabilities to realizable asset values would still be approximately two to one."

On October 14, 1941, the District Court entered an order authorizing the trustees to employ a firm of engineers to make a survey of Terminal's properties as a basis for a plan of reorganization. Thereafter, the survey having been made, the disinterested trustee concluded sometime in December 1941 that it would be necessary to liquidate Terminal, as at that time it had no operating properties, having disposed of its last operating mine in October 1941.

Prior to this, on August 13, 1941, petitioner, by instrument in writing, waived, released, and surrendered to North American any claims which petitioner might otherwise have against North American with respect to the ownership of or any interest in or with respect to the validity of the lien of North American upon the aforesaid 2,649 shares of common stock and $ 10,000 face value bonds of petitioner, without prejudice, however, to such rights and claims as petitioner might have against Terminal in so far as the same did not impair the rights of North American. The fair market value of the common stock of petitioner as of August 13, 1941, was $ 12.75 per share.

This was followed by a letter from petitioner's general auditor to the Bureau of Accounts, Interstate Commerce Commission, under whose jurisdiction and rules petitioner's books of account were kept, in which he advised that:

* * * In order to reflect the present situation it is proposed that an entry be made on our books clearing this stock from Account 729, "Securities Issued or Assumed-Pledged" to Account 621, "Miscellaneous Debits", and concurrently show stock outstanding. We will proceed with this entry unless you advise to the contrary.

The Commission shortly thereafter approved this action.

Petitioner then debited the par value of the aforesaid 2,649 shares of stock in the amount of $ 264,900 to profit and loss on its books of account for the year 1941 and deducted that amount under "Other Deductions" on its Federal income tax return for the year. The respondent disallowed the entire amount as a deduction for the year 1941, and as reasons therefor stated:

It is determined that the loss claimed by you for the year 1941 in the amount of $ 264,900.00, as arising from a transaction in your treasury stock, which amount was included in "Other Deductions" totalling $ 4,001,894.33, is unallowable as unsubstantiated and, in any event, not attributable to the year 1941.

Among "Other Deductions" in its return for the year 1941 petitioner deducted a net amount of $ 13,563.87 representing certain accounts receivable against Terminal and a past due note of Terminal, aggregating $ 16,931.48, less the amount of $ 3,367.61 due to Terminal from petitioner.

Respondent in his notice of deficiency has disallowed the deduction of $ 13,563.87 on the ground that it is unallowable and not attributable to the year 1941.

Issue 4.

Petitioner is, and has been since some years prior to 1931, the owner of a railroad bridge in Pittsburgh crossing the Monongahela River a short distance above the Ohio River and is and has been for the same period the owner of a railroad tunnel connecting with the bridge on the southerly side of the Monongahela River and extending in a southerly direction through Mt. Washington hill.

In the year 1931, after considerable time and effort, petitioner and the County Commissioners of Allegheny County, Pennsylvania, entered into an agreement for the purchase by the county of petitioner's bridge and tunnel for use as a traffic artery from the south hills section of Allegheny County into downtown Pittsburgh. This agreement was disapproved by the grand jury.

After such disapproval, petitioner continued its efforts to sell the bridge and tunnel to the County of Allegheny and in pursuance of its efforts expended substantial amounts of money for legal fees, appraisals, plans and blueprints, engineering services, publicity, promotion, and similar purposes.

The amounts expended by petitioner in this connection were charged on its books to an account designated "Sale of Bridge and Tunnel." The sum of $ 68,068.60 was expended from 1931 to 1939, when petitioner abandoned its program of expenditures to bring about the sale. The property remained unsold. An additional expenditure of $ 500 in 1941 was charged to the account, being a contribution to the Pittsburgh Regional Planning Association.

By resolution of December 30, 1941, petitioner's directors determined that the item of $ 68,568.60 carried as a deferred expense be charged to profit and loss.

The expenditures in connection with the efforts to sell the bridge and tunnel were neither taken as a deduction by the petitioner nor allowed as a deduction by the respondent for the year 1941.

OPINION.

Both parties accept the principle of , as applicable to the present transaction. They differ as to the year in which gain to petitioner would be realized thereunder. The facts are unusual.

Petitioner had outstanding a first mortgage bond issue. It borrowed additional funds on its five-year notes, and in that connection obligated itself to devote part of its earnings to the reduction of the mortgage bonds. When acquired, however, the bonds were not to be retired, but had to "remain alive" and be delivered to the trustee under the note issue, who was to hold them as additional collateral for payment of the notes and, if necessary, resell them for the creditors' benefit. During the years now in controversy bonds were purchased by petitioner at substantial discounts from the issue figure and forthwith delivered to the noteholders' trustee, who retained them for several years until, in a year not now before us, petitioner paid off the notes and received the bonds unencumbered.

Respondent's contention that this is a typical case for application of the Kirby doctrine can not be sustained. Petitioner did not, in reality, obtain a cancellation of its debt in the instant years, ; it did not effectively free any part of the mortgaged assets from the continuing lien of the bonds, see ; and it could not be said with certainty at that time that, if the pledged bonds had to be resold, the entire transaction might not result in a loss. See .

The most troublesome suggestion is that, if the ultimate gain, clearly and in fact concededly secured by petitioner, is not subject to tax in the years of purchase, it will escape taxation altogether. See . But this is not a case as that was, of voluntary retention, in the debtor's own hands of securities which, when acquired, became extinct as both obligation and collateral. See .

Petitioner insists in its brief that "The obligation embodied in these bonds thus remained alive in the hands of another and was not extinguished until June 1945 when the five-year notes were paid * * *." Since we are in accord with that statement as a correct interpretation of the present facts, and perceive no obstacle to the taxability of the transaction at that time, we are unable to share respondent's fears that petitioner's gain will ultimately escape all taxation. On this issue, and as to the present years, the deficiency is disapproved.

The second and third issues may be considered together. In a previous year petitioner had loaned some of its own stock to Terminal, another corporation, for use as collateral on a bond on appeal from a judgment against Terminal. The judgment had become final, but upon the apparent inability of Terminal to pay it, a third corporation, North American, advanced the funds for that purpose and took over petitioner's stock as security for its advance. The parties are in apparent agreement that this constituted a conversion of the stock by Terminal, giving rise to a claim against it at that time. They also seem to agree that North American, which was willing to surrender the stock only upon payment of its advance, was within its rights, and that petitioner acquired no valid claim against it. Petitioner had also some miscellaneous loans and accounts receivable against Terminal, and it is the deductibility of all of these items in the tax year, as uncollectibles, which gives rise to the controversy.

We think enough has been shown by the record before us to demonstrate that only in the present year could these debts be regarded as wholly worthless. While a receiver had already been appointed, and his preliminary report had indicated that Terminal was "heavily insolvent," there was still the prospect of a reorganization with the consequent possibility of some, if not complete, recovery. The debt may have been partially uncollectible earlier, but that would not foreclose its charge-off in full when, in the instant year, the last operating property was sold and all hope of any reorganization and, with it, collection even in part, disappeared. .

The claim against Terminal for the stock, however, was limited to its fair market value at about the time of conversion, as petitioner concedes, 8 C. J. S. 365-366; . Although that sum, which is stipulated, is radically less than petitioner's basis, we view it as the limit of the present deduction. The balance, presumably, was lost when the conversion transformed the property itself into a mere cause of action, and one, besides, for a reduced amount. But whatever the time and theory of proper deduction for the remainder, it is clear, at least, that all that remained of the property in the year before us was a claim for damages, and that this is the utmost that can be said to have been lost by the uncollectibility of that claim. To this extent, the deficiency is disapproved.

Petitioner's position on the final issue must, it seems to us, prove unsuccessful, as an inadmissible attempt to compromise two opposite concepts. For a number of years petitioner had made efforts to sell to the county a bridge and tunnel no longer useful to it. In these endeavors sums were expended for promotion, publicity, and the gathering of information. But the attempt had proved unsuccessful.

In seeking to deduct the total expended over all the previous years, petitioner argues, on the one hand, that the outlays were not deductible currently as ordinary and necessary business expense, and, on the other, that they were not capital items to be added to the basis of the property and recovered when it is finally disposed of. The theory advanced is that they constitute a sort of intermediate capital investment which may be charged off in the present year because of the abandonment of the selling project.

The most that can be said, however, for the testimony adduced to support this position is that it shows a decision to discontinue expenditures of the same type. There is not shown any cessation of efforts to sell the property, still less any abandonment of the property itself. Petitioner's president, having referred to an action two years earlier as that "we abandoned any effort as to putting any further money in it," described the outcome in the year under review only as "a very definite conclusion in 1941 that there was no hope through that source." (Emphasis added.) Petitioner's claim to deduct the sums expended in prior years to dispose of a property which it continues to own, and may in fact sell at any time, is not founded upon a sufficiently specific event in the tax year to warrant its allowance as either a current expense or a capital item. It must be rejected.

Decision will be entered under Rule 50.