Pacific Transport Co. v. Commissioner

Pacific Transport Company and Subsidiaries, et al. 1 v. Commissioner.

Pacific Transport Co. v. Commissioner

Docket Nos. 2823-65 - 2825-65, 2928-65 - 2935-65.

United States Tax Court

T.C. Memo 1970-41 ; 1970 Tax Ct. Memo LEXIS 315 ; 29 T.C.M. (CCH) 133 ; T.C.M. (RIA) 70041 ;

February 17, 1970 .

Valentine Brookes , Richard A. Wilson, and A. Thomas Murphy , 1600 International Bldg., San Francisco, Calif., for the petitioners. Eugene H. Ciranni and James E. Merritt, for the respondent. 135

HARRON

Memorandum Findings of Fact and Opinion

HARRON, Judge: The respondent determined income tax deficiencies for three taxable periods: January 1 - September 9, 1957; September 10 - December 31, 1957; and January 1 - December 31, 1958, as follows: Docket No. Petitioner Taxable Period Deficiency

2825-65 States S.S. (New States) 1/ 1/57- 9/ 9/57 $785,465.44

2824-65 Pacific Atlantic S.S. 1/ 1/57- 9/ 9/57 $9,209.21

2823-65 Pacific Transport 9/10/57-12/31/57 52,253.01

1/ 1/58-12/31/58 63,379.14

Total amount of deficiencies $910,306.80

*320 Under section 1502, 1954 Code, respondent determined the same income tax deficiencies against the subsidiary corporations in each affiliated group which filed a consolidated income tax return, in order to protect the revenues, as follows: Docket No. Petitioner Taxable Period Deficiency

Subsidiaries of States Steamship Company (States Line, Inc.)

2928-65 States S.S. (Old States) 1/ 1/57- 9/ 9/57 $785,465.44

2929-65 Portland Stevedoring 1/ 1/57- 9/ 9/57 785,465.44

2931-65 Pacific Transport Lines 1/ 1/57- 9/ 9/57 785,465.44

2932-65 Calif. Eastern Lines 1/ 1/57- 9/ 9/57 785,465.44

Subsidiaries of Pacific Transport Co.

2930-65 Pacific Atlantic S.S. 9/10/57-12/31/57 52,253.01

1/ 1/58-12/31/58 63,379.14

2933-65 States S.S. (New States) 9/10/57-12/31/57 52,253.01

1/ 1/58-12/31/58 63,379.14

2934-65 Calif. Eastern Lines 9/10/57-12/31/57 52,253.01

1/ 1/58-12/31-58 63,379.14

2935-65 Portland Stevedoring 9/10/57-12/31/57 52,253.01

1/ 1/58-12/31/58 63,379.14

The parties have disposed of several issues under stipulations to which effect will be given under Rule 50.

The issues for decision fall into two *321 groups. One group of issues relates to and involves a claimed net operating loss for 1959 for the corporations which filed a consolidated return for 1959. The other group of issues involves adjustments to the basis of shares of stocks and other assets of some of the petitioner corporations. Petitioners claim that there was a net operating loss in 1959 and that they are entitled to carrybacks to the taxable periods in 1957 and to the year 1958. Related to the problems involving 1959, a year which is not before us, is a question about the bar of the statute of limitations against determinations by the respondent for 1959 which would affect the existence or nonexistence of a net operating loss for 1959 and the resulting carrybacks of such loss, if any, to earlier years.

The main issues for decision are as follows:

1. Whether the petitioners had a net operating loss for 1959 which can be carried back to 1957 and 1958. The determination of that broad issue involves the following questions:

A. Whether a statute of limitations prevented the respondent from making determinations with respect to an alleged net operating loss for 1959 (a closed year), in order to determine the respective *322 amounts of carrybacks, from 1959 to each one of the taxable periods, of a 1959 net operating loss, if any.

B. Whether the total sum of the payments by New States in 1959, in the net amount of $1,348,868.39, now in issue, which was paid to settle cargo loss claims under a court judgment which became final in 1959, was a deductible loss of New States in 1959, or was a capital expenditure. If this question is decided for the respondent, there are additional questions relating to allocations of such capitalized expenditure to certain assets.

C. Whether there should be excluded from the income of New States for 1959, the full amount of its deposit of $1,175,000 into the capital reserve account maintained by the Maritime Administration (Marad), pursuant to section 607 of the Merchant Marine Act of 1936, as amended; or whether respondent's theory is correct that under certain circumstances the amount of such 136 exclusion should be adjusted to a lesser amount, or to zero so that no exclusion can be allowed. 2. Whether certain adjustments of respondent to the basis of certain assets, under section 334(b)(2) , were correct, as follows:

A. The value on June 30, 1957, of the California *323 Eastern Lines stock.

B. The value on June 30, 1957, of Pacific Transport Lines stock.

C. Whether New States is entitled to include in its basis of the shares of stock of Old States (which New States purchased) the amount of the earnings and profits of three, third-tier subsidiaries of Old States, during the interim period between the acquisition of Old States' stock on July 11, 1956, and the "liquidation and merger" of Old States into New States on June 30, 1957. Immediately prior to the "liquidation and merger" of Old States into New States on June 30, 1957, Old States held a substantial part or all of the shares of stock of the three subsidiary corporations, Pacific Transport Lines, Portland Stevedoring Co., and California Eastern Lines, and when Old States was liquidated, the shares of stock of these subsidiaries were among the assets received by New States. Thus, the three subsidiaries of Old States became subsidiaries of New States on June 30, 1957. The three subsidiaries of Old States, and of New States as of June 30, 1957, had not been liquidated as of June 30, 1957. Respondent agrees that the earnings and profits of Old States during the interim period, July 11, 1956, to *324 June 30, 1957, in the amount of $744,943.86 are to be included in the basis to New States of the shares of stock of Old States which were purchased on July 11, 1956, under section 334(b)(2) , 1954 Code. Petitioners contend that the earnings of the above-named subsidiaries during the interim period in the total sum of $1,930,431.89 also should be included in the basis to New States of the shares of stock of Old States.

Findings of Fact

Some facts have been stipulated. The stipulated facts are so found. The stipulations are incorporated herein by reference.

All of the income tax returns for the taxable periods involved were filed with the district director of internal revenue at San Francisco, California. The principal office of the petitioners is located in San Francisco.

All of the income tax returns for the taxable periods involved here (and the related returns for 1959 and for the period July 11 to December 31, 1956) were made under an accrual method of accounting.

Preliminary Facts

The principal taxpayers and the taxable periods involved are: Docket No. 2823-65 Pacific Transport Co Sept. 10 to Dec. 31, 1957

Jan. 1 to Dec. 31, 1958

Docket No. 2824-65 Pacific Atlantic S.S. Co Jan. 1 to Sept. 9, 1957

Docket No. 2825-65 States S.S. Co. (New States) Jan. 1 to Sept.9, 1957

*325 The chief issues involve States S.S. Co. (New States).

1959 Net Operating Loss: The taxable year 1959 is not before us. Respondent did not determine a tax deficiency for 1959. Pacific Transport Company and its subsidiaries filed a consolidated return for 1959 in which was reported a net operating loss in the amount of $1,455,802.07. That net operating loss was carried back by some of the petitioners to a taxable period in 1957, or to 1958, or to both periods. Respondent reduced the claimed net operating loss for 1959 from $1,455,802.07 to $24,534.29, and he either reduced a claimed net operating loss carryback deduction, or he disallowed all of a claimed net operating loss carryback, in these cases. Respondent determined that certain deductions claimed on the 1959 return are not allowable. Those determinations have resulted in issues for decision here involving transactions of New States in 1959, for the purpose of claimed deductions, for a taxable period in these cases, for net operating loss carrybacks from 1959. The facts about the 1959 transactions of New States are set forth hereinafter.

The Corporation Petitioners: Because of the respondent's determinations, 11 petitions *326 have been filed in these consolidated cases. However, only seven corporations filed the 11 petitions: States Steamship Co. (New States, formerly States Line, Inc.), States Steamship Co. (Old States), Portland Stevedoring Co., Pacific Transport Lines, California Eastern Lines, Pacific Atlantic Steamship Co., and Pacific Transport Co.

For the period January 1 to September 9, 1957, a consolidated return, on an accrual 137 basis, was filed by States Steamship Co. (New States), the parent, for itself and its four subsidiaries, as shown below; and a separate tax return was filed by Pacific Atlantic Steamship Co. (Pacat). The affiliated group which filed the consolidated return consisted of:

States Steamship Co. (New States) (formerly States Line), parent corporation

Subsidiaries:

States Steamship Co. (Old States)

Portland Stevedoring Co.

Pacific Transport Lines

California Eastern Lines

For the periods September 10 to December 31, 1957, and January 1 to December 31, 1958, consolidated returns, on an accrual basis, were filed for another affiliated group, in which States Steamship Co. (New States) was a subsidiary, and there was a new parent corporation, Pacific Transport *327 Company, as follows:

Pacific Transport Co., parent corporation

Subsidiaries:

States Steamship Co. (New States)

Portland Stevedoring Co.

California Eastern Lines

Pacific Atlantic S.S. Co. (Pacat)

After the consolidated returns were filed for the respective affiliated groups listed above, but before the petitions were filed here giving rise to these cases, three corporations were dissolved, and four of the corporations were not dissolved. The four petitioner corporations which still exist, and were not dissolved, are:

1. States Steamship Company (formerly States Line, Inc.), a Nevada corporation, which is hereinafter called New States.

2. Pacific Transport Company, a Nevada corporation.

3. Portland Stevedoring Company, an Oregon corporation.

4. Pacific Atlantic Steamship Company, a Delaware corporation, which is sometimes called "Pacat" hereinafter.

The three corporations which were dissolved are: (1) States Steamship Company, a Nevada corporation, which is sometimes called "Old States" hereinafter; (2) Pacific Transport Lines; and (3) California Eastern Lines.

In 1959, the affiliated group consisted of Pacific Transport Company and three subsidiaries, (1) *328 States Steamship Company (New States), Portland Stevedoring Company, and Pacific Atlantic Steamship Company (Pacat). These affiliated corporations filed a consolidated return for 1959 on an accrual basis. As stated above, these four corporations are still in existence.

States Line, Inc., was incorporated in Nevada on June 28, 1956, by J.R. Dant. On July 11, 1956, under circumstances stated later, States Line, Inc., acquired all of the stock of States Steamship Company, a Nevada corporation, which owned all of the capital stock of Portland Stevedoring Company and Pacific Transport Lines, and 43.66 percent of the stock of California Eastern Lines. From July 11, 1956, until June 30, 1957, States Steamship Company was a subsidiary of States Line, Inc., and during that period there was only one corporation named "States Steamship Company".

On June 30, 1957, under circumstances stated later, States Steamship Company was "liquidated and merged" into States Line, Inc., under a Nevada statute, and thereupon the name of States Line, Inc., was changed to "States Steamship Company", the name of its former subsidiary. This resulting corporate entity, States Steamship Company (formerly States *329 Line, Inc.) is referred to hereinafter as New States; and its former subsidiary (which was "liquidated and merged" on June 30, 1957) is referred to hereinafter as Old States. The corporation New States (States Steamship Company) is still in existence.

Pacific Transport Company, a Nevada corporation, was organized on September 10, 1957.

For the period July 11 to December 31, 1956, States Line, Inc., which was incorporated on June 28, 1956, (which later adopted the name, on June 30, 1957, States Steamship Company, herein called New States) was a parent corporation of an affiliated group, and its subsidiaries were States Steamship Company (Old States), Portland Stevedoring Company, Pacific Transport Lines, and Quaker Line, Inc. States Line, Inc., and its subsidiaries filed a consolidated return for the period July 11 to December 31, 1956, which return was made on an accrual method of accounting.

Other Corporations and Individuals: C.E. Dant, who died in 1945, was a senior member of the Dant family of Oregon, and J.R. Dant is one of his sons. Dant & Russell, Inc., a Delaware corporation, was primarily a family holding company of the Dant family. The principal asset of Dant & Russell, *330 Inc., was a controlling interest in the stock of Coos Bay Lumber Company 138 which owned extensive timberlands and leases on such lands, saw mills and finishing mills, lumber yards, and other accessories of a lumber business. Dant & Russell, Inc., also had investments in other forest products companies, and it owned shipping interests.

J.R. Dant was the principal manager of the shipping interests. J.R. Dant was the vice president and general manager of States Steamship Company (Old States) from 1950 to 1956.

Before July 10, 1956, Dant & Russell, Inc., owned all of the capital stock of States Steamship Company (Old States), and of Pacific Atlantic Steamship Company (Pacat). At that same time, States Steamship Company (Old States) owned all of the stock of Quaker Line, Inc., 43.66 percent of the stock of California Eastern Lines, Inc., and all of the stock of Pacific Transport Lines, Inc., and of Portland Stevedoring Company.

The Transactions with Blyth & Co., Inc.: Early in 1956, Blyth & Co. began negotiations for the acquisition of all of the stock of Dant & Russell, Inc. These negotiations culminated in an "Option, Purchase and Escrow Agreement" dated March 1, 1956. The *331 option agreement was agreed to and signed by all of the stockholders of Dant & Russell other than J.R. Dant, who owned 19 percent of the stock of Dant & Russell.

J.R. Dant is the president of States Steamship Company (New States) and Pacific Transport Company. He has held that office ever since each corporation was organized; i.e., since June 28, 1956, when States Line, Inc. was organized, the name of which was changed to States Steamship Company (New States), and since September 10, 1957, when Pacific Transport Company was organized.

After the agreement of March 1, 1956, the Option, Purchase and Escrow Agreement relating to stock of Dant & Russell, Inc., had been signed by all of the Dant & Russell shareholders except J.R. Dant, negotiations between Blyth & Co. and J.R. Dant were entered into for the purpose of the acquisition of all of the shares of stock of two steamship companies owned by Dant & Russell, namely States Steamship Company (Old States) and Pacific Atlantic Steamship Co. (Pacat), which acquisition of shares of stock was to be by J.R. Dant, or his assignee. J.R. Dant was to acquire the shares of stock from Blyth & Co. in the event that Blyth should exercise its option *332 to acquire the stock of Dant & Russell. In turn, J.R. Dant would agree to the terms of the option agreement of March 1, 1956, relating to the Dant & Russell shares of stock. Dant's negotiations with Blyth culminated in the execution of a pledge agreement dated June 18, 1956, between J. (Jack) R. Dant, Blyth, and Bank of California.

On July 10, 1956, Blyth & Co. acquired all of the stock of Dant & Russell, Inc., and Blyth caused Dant & Russell to be dissolved. In that dissolution, Blyth acquired, inter alia, all of the stock of States Steamship Company and Pacific Atlantic Steamship Co. Blyth caused States Steamship Company to declare and pay it a dividend of $2,500,000 on July 10, 1956. On July 11, 1956, Blyth sold the stock of Pacific Atlantic Steamship Co. to J.R. Dant, personally, for $1,950,000, pursuant to the terms of the pledge agreement of June 18, 1956; and on July 11, 1956, Blyth also sold to States Line, Inc., as the assignee of J.R. Dant, all of the stock of States Steamship Co. for $11,050,000, pursuant to the agreement of June 18, 1956. Both sums were paid in cash to Blyth.

States Line, Inc. (referred to above) was a Nevada corporation which was incorporated on June 28, 1956, by *333 J.R. Dant, who acquired all of its issued stock for cash. States Line, Inc., borrowed additional funds from banks and other sources. States Line, Inc., then purchased from Blyth, with its funds (so obtained) all of the stock of States Steamship Company.

It was the plan of Dant that States Line, Inc., as the sole shareholder of States Steamship Company, would dissolve States Steamship and would acquire all of its assets within two years, so that such dissolution and acquisition of assets would come within section 334(b)(2) , 1954 Code. That plan was carried out.

Liquidations and Mergers of Steamship Companies: From July 11, 1956, until June 30, 1957, States Steamship Company (Old States) was a wholly owned subsidiary of States Line, Inc. On June 30, 1957, pursuant to section 78.540 , Revised Statutes of Nevada, States Steamship Company was liquidated by and merged into States Line, Inc., which then adopted the name, States Steamship Company, which is usually referred to as New States. As of June 30, 1957, the liquidated corporation known as States Steamship Company (Old States) owned all of 139 the stock of three subsidiary corporations, Pacific Transport Lines, Inc., Portland *334 Stevedoring Company, and Quaker Line, Inc., and 1,202 shares (out of 2,276 shares) of the stock of California Eastern Lines, Inc. As a result of the liquidation and merger on June 30, 1957, of States Steamship Company by States Line, Inc., the latter corporation acquired the above-described shares of stock of the four corporations, and by the end of August 1957, the remaining shares of California Eastern Lines were acquired. Thus, States Line, Inc., which was renamed States Steamship Company (New States), acquired four subsidiaries, Pacific Transport Lines, Portland Stevedoring, Quaker Line, and California Eastern Lines. However, on August 23, 1957, Pacific Transport Lines, Inc., was liquidated and merged into its parent corporation, States Steamship Co. (New States) pursuant to Nevada law, and States Steamship Co. then had three subsidiaries, named above.

J.R. Dant, for business reasons, wanted to have all of the stock of Pacific Atlantic S.S. Co. (which he owned personally), and all of the stock of States Steamship Co. (New States) owned by one corporation. Therefore, he caused a new corporation, Pacific Transport Company, to be incorporated under Nevada law on September 10, 1957. Pacific *335 Transport Company then issued its own stock to the shareholders (J.R. Dant and others) of States Steamship Co. (New States) in return for their stock in States Steamship Co. (New States), which exchange was carried out pursuant to section 351, 1954 Code. As of September 10, 1957, J.R. Dant owned only 83.61 percent of the stock of States Steamship Co. (New States), having sold 16.39 percent thereof to other persons. Therefore, in the abovedescribed transaction, J.R. Dant acquired only 83.61 percent of the stock of Pacific Transport Company. Also, on September 10, 1957, Pacific Transport Company acquired all of the stock of Pacific Atlantic S.S. Co. (Pacat) from J.R. Dant for cash and promissory notes.

On October 29, 1957, States Steamship Co. (New States) sold all of the capital stock of Portland Stevedoring Company to Pacific Atlantic S.S. Co. (Pacat) for cash.

In addition, it is stipulated that States Steamship Co. (New States) dissolved its subsidiary, Quaker Line, during 1957 in a non-taxable transaction. Quaker Line was a dormant corporation prior to its dissolution, and it held no assets and earned no income in 1957.

On March 31, 1958, another subsidiary, California Eastern *336 Lines, Inc., was liquidated by and was merged into its parent, States Steamship Co. (New States).

As a result of the above transactions, there are still in existence the four corporations, Pacific Transport Company, a parent corporation, and its three subsidiaries, States Steamship Company (New States), Portland Stevedoring Company, and Pacific Atlantic S.S. Co. (Pacat); or four corporations (as already noted hereinbefore).

Pacific Atlantic S.S. Co. (Pacat): For the taxable period January 1 to September 9, 1957, Pacific Atlantic S.S. Co. (Pacat), Docket No. 2824-65, filed a separate income tax return. During that taxable period all of its stock was owned by J.R. Dant, who purchased the shares on July 11, 1956, from Blyth & Co. On September 10, 1957, Pacific Transport Company purchased from J.R. Dant all of the shares of stock of Pacat; Pacat became and continued to be a subsidiary of Pacific Transport Company; and the taxable income of Pacat was reported in the consolidated tax returns filed for the affiliated group for all of the taxable periods beginning on September 10, 1957, and thereafter, including 1959.

A net operating loss of $1,455,802.07 was reported in the 1959 consolidated *337 return of Pacific Transport and its subsidiaries, including Pacat. A claim on behalf of Pacat was made for a loss carryback from 1959 to the taxable period ended September 9, 1957, for which period Pacat filed a separate tax return. The tax deficiency for Pacat for the period ended September 9, 1957, results from a disallowance of a deduction for a net loss carryback for 1959.

The facts relating to questions involved in the issue of whether the affiliated group sustained a net operating loss for 1959 are set forth hereinafter. The determinations of those questions will determine whether respondent's denial of an operating loss carryback from 1959 was or was not correct.

Statute of Limitations

The period of the statute of limitations was extended for the taxable periods in these cases by the timely executions of consents, Form 872, by the respondent and the respective petitioners extending the period of assessment. The consents were executed for the taxable periods January 1 140 to September 9, 1957; September 10 to December 31, 1957; and January 1 to December 31, 1958. The consents were executed with respect to all of the petitioners.

No consent, Form 872, was ever executed *338 to extend the statute of limitations as it applies to the taxable year 1959. Pacific Transport Company and its subsidiaries executed and mailed to the Internal Revenue Service, at its request, a consent form, No. 872, for the year 1959, while the statute of limitations concerning 1959 was still open. Nevertheless, the Internal Revenue Service returned that consent, without signing it, to Pacific Transport, and thereby the period of the statute of limitations closed the year 1959, and the period of that statute was never extended for 1959.

None of the consents, Form 872, extending the periods of the statute of limitations and the periods of assessments, described above, relating to the two taxable periods in 1957, and to the year 1958, contain any references at all to the taxable year 1959, or to the matter of any net operating loss carrybacks from 1959 into any one of those three, earlier, taxable periods.

The consolidated tax return for 1959 of Pacific Transport Company and its affiliates was filed timely. The respondent did not mail any deficiency notice with respect to the year 1959 to Pacific Transport; he did not determine any tax deficiency for 1959, with respect to that *339 consolidated return, and the year 1959 is closed.

On the other hand, in determining the tax deficiencies for the three taxable periods involved here, for 1957 and 1958, the respondent made certain adjustments in deductions with respect to 1959, for Pacific Transport and its subsidiaries, and with respect to New States in particular, whereby he determined that there was not any net operating loss for 1959, for the purposes of the claimed net operating loss carrybacks from 1959 into the taxable periods in these cases; and he disallowed the deductions claimed for the taxable periods here, for the claimed carrybacks of the alleged net operating loss reported for 1959. Those determinations are in dispute in these cases under issues set forth hereinafter.

Net Operating Loss, 1959, Pacific Transport Co. and Subsidiaries

The 1959 return reported in detail the income, deductions, and gain or loss of the four affiliated corporations as follows: Pacific Transport, loss ($178,086.25)

States, loss (1,431,267.78)

Pacific Atlantic, loss (23,005.10)

Total loss ($1,632,359.13)

Portland Stevedoring, gain 176,557.06

Net operating loss ($1,455,802.07)

After the 1959 *340 return was filed, three of the affiliated corporations claimed carrybacks of the 1959 net operating loss under section 172(a) and (b) , 1954 Code, to earlier years, namely Pacific Transport Co., New States, and Pacific Atlantic. Pacific Transport Co. claimed carrybacks to the September-December 1957 period, and to 1958. New States claimed a carryback to the January-September 1957 period of $1,276,460.94. Pacific Atlantic claimed a carryback to the January-September 1957 period. The loss carryback deductions were, in each instance, tentatively allowed by the Internal Revenue Service and tax refunds were made.

As stated before, the parties executed Form 872 agreeing to extend the period of assessment with respect to the two tax periods in 1957 and the year 1958. Thereafter, upon audits of the respective tax returns for each of those three taxable periods, and particularly with respect to the tax periods into which carrybacks of the 1959 net operating loss had been claimed, the Internal Revenue Service examined in detail the various deductions in the 1959 consolidated return which had produced a net operating loss for each one of the three corporations which had reported a loss for 1959, *341 as shown above.

Under those examinations, the Internal Revenue Service made determinations having the result that New States had not sustained any net operating loss at all for 1959, thereby eliminating the reported loss of New States, $1,431,267.78, from the net operating loss of the affiliated group. Consequently, the Internal Revenue Service (IRS) determined that the consolidated net operating loss for 1959 was only $24,534.29, as follows: Net operating loss of the group $1,455,802.07

Less loss of New States 1,431,267.78

Adjusted loss of the group $24,534.29

The respondent allowed Pacific Transport Co., Docket No. 2823-65, a loss carryback to the September-December 1957 period, of a proportion of the new adjusted 1959 loss, in the amount of $21,727.54, only, whereas that corporation had claimed $158,824.37 as its share of the original 1959 loss carried 141 back to that taxable period. Also, the IRS allowed Pacific Atlantic, Docket No. 2824-65, a loss carryback to the January-September 1957 period, of a proportion of the new adjusted 1959 loss, in the amount of $2,806.75, only, whereas that corporation had claimed $10,668.68 as its share of the original *342 1959 loss, carried back to that taxable period. The sum of the two allowed loss carrybacks is $24,534.29. Pacific Transport Company also claimed a carryback from 1959 to 1958 of $48,964.48, but in Docket No. 2823-65, Pacific Transport Co., the respondent determined in the deficiency notice that it was not entitled to any loss carryback deduction because there was not any remaining net operating loss for 1959 which was available as a carryback to 1958. In Docket No. 2825-65, States Steamship Company, the respondent determined in the deficiency notice with respect to the period January 1 to September 9, 1957, that there was no net operating loss for 1959 available as a carryback to that taxable period and that, therefore, a claimed loss carryback of $1,276,460.94 was disallowed. That loss carryback had been claimed as a carryback to that taxable period of States Steamship Co. and its subsidiaries.

Apparently the IRS did not deem it necessary to keep open the taxable year 1959, of the affiliated group involved, by executing a consent to extend the period of assessment for 1959 (to which it did not agree, as stated before), because it had determined that there was a net operating loss *343 for 1959 for the affiliated group of $24,534.29 (even though the reported net operating loss of the group had been greatly reduced). Obviously, since the group had a small net operating loss for 1959, as determined upon audits by the IRS, no statutory deficiency notice for 1959 was or could be issued.

The determination that New States did not have any net operating loss for 1959 reflected the following determinations: Unallowable Deductions, $1,431,267.78:

Cargo loss payments $1,348,868.39

Disallowed depreciation 24,411.10

Maritime deposits 53,025.43

Initiation fees 4,450.00

Filing fees 512.86

$1,431,267.78

The respondent mailed a statutory notice of deficiency, on February 26, 1965, to Pacific Transport Co. and subsidiaries covering the periods September-December 1957, and 1958. In the deficiency notice, the net operating loss for 1959, $1,455,802.07 was reduced by the sum of $1,431,267.78, leaving as the revised net operating loss $24,534.29, for the group. In the deficiency notice, the five deductions set forth above were disallowed by the respondent. This is the statutory deficiency notice from which petitions were filed here in the following cases: *344 Docket No. 2823-65, Pacific Transport Co.; Docket No. 2824-65, Pacific Atlantic S.S. Co.; and Docket No. 2825-65, States S.S. Co. (New States).

Respondent's determinations with respect to the claimed net operating loss of New States for 1959, disallowing the deductions of New States, stated above, meant that respondent determined that for 1959 the deductions allowable to New States were equal to its total income of $6,527,894.96; and that New States did not realize either income or an operating loss for 1959. For 1959, New States reported gross profit from its operations of $1,457,543.09; it received net subsidy payments from the Maritime Administration (Marad) of $4,809,080.36, which was reported in income. New States received other income of $261,271.51. Respondent did not make any adjustments in the items of reported income. In more detail, reported income of New States for 1959 was: 1959

Gross receipts $22,600,409.67

Less operations cost 21,142,866.58

Gross profit $1,457,543.09

Subsidy receipts, Marad 4,809,080.36

Interest 111,634.13

Net gains 3,509.78

Other income 146,127.60

Total income $6,527,894.96

New States took deductions totaling *345 $7,959,162.74, and reported a net operating loss of $1,431,267.78. Included as one item in the deductions of New States in the consolidated return was $2,074,028.43, "Deposits of tax deferred earnings in reserve funds [held by Maritime Administration]." In making his determinations of the unallowable deductions, as set forth previously, the disallowed deductions, exclusive of Maritime deposits of $53,025.43, totaled $1,378,242.35. Other deductions on the return for New States totaled $6,580,920.39, exclusive of the disallowed deductions of $1,378,242.35 (cargo loss payments, depreciation, initiation fees, and filing fees). The difference between "other deductions" and total income reported was $53,025.43, as follows: 142 Other deductions $6,580,920.39

Total income 6,527,894.96

Difference $53,025.43

Respondent adopted the viewpoint that a deduction was allowable for those deposits provided that such deduction would not produce a net operating loss of New States for 1959. In order to arrive at a total figure for allowable deductions which would be equal to the figure for total income for 1959, $6,527,894.96, the respondent subtracted that amount of total *346 income from all of the deductions which were "allowable", $6,580,920.39. The difference in the two figures was $53,025.43. Therefore, he disallowed $53,025.43 of the deduction of $2,074,028.43 for deposits paid to the Maritime Administration (Marad) thereby allowing a deduction for those payments of $2,021,003, which determination made the figure for allowable deductions $6,527,894.96, the same as the figure for total income. In other words, respondent's determination that the amount of the Marad deposits which was not an allowable deduction was an amount which was an "adjusting" amount, arithmetically. Respondent gave the following reason in the deficiency notice for this particular determination:

It is determined that voluntary deposits to reserve funds under Section 607 of the Merchant Marine Act of 1936 as amended cannot exceed taxable income. Accordingly, the taxable income of States Steamship Company and the affiliated group filing the consolidated return for 1959 is increased $53,025.43, or such other amount as exceeds taxable income without this adjustment, as shown in the attached *347 Exhibit C.

The parties have agreed under stipulations about the disposition of several of the determinations of the respondent which contributed to the deficiencies in Docket Nos. 2823-65, 2824-65, and 2825-65, $63,379.14, $52,253.01, and $785,465.44, respectively. Under Rule 50, effect will be given to those stipulations of the parties.

There are two main issues in dispute resulting from respondent's determination that the 1959 net operating loss of New States was such less than was reported in the consolidated return so that a smaller net operating loss was available for carrybacks from 1959 to 1958 and 1957: (1) Whether payment by New States in 1959 in the net sum of $1,348,868.39, to settle a court decision awarding damages to cargo-loss claimants, is deductible as a loss, or is to be capitalized and added to New States' cost of assets of Old States received upon the liquidation and merger of Old States on June 30, 1957. (2) Whether the payment by New States to Marad for 1959 of $1,175,000, to the capital reserve account of New States maintained by Marad, is excludable (or deductible) for New States' 1959 income in whole or in part.

Cargo Loss Claims; S.S. Pennsylvania

*348 States Steamship Co. (Old States) was a subsidiary of Dant & Russell, Inc., in 1952. In July 1956, States Steamship became a subsidiary of a new corporation, States Line. On June 30, 1957, States Steamship (Old States) was liquidated and merged into States Line, which then adopted the same name, States Steamship Company. Because of this adoption of the same name of a dissolved corporation, States Steamship Company, formerly States Line, is called New States. The facts under this issue involve the original corporation, Old States, and the new corporation, New States. Since dates are of significance under this issue, the following dates are listed, for convenience:

1. January 9, 1952; the S.S. Pennsylvania, owned by Old States, sank at sea in a storm.

2. July 13, 1954; the beginning of a trial in the United States District Court, District of Oregon, of a lawsuit instituted by the owners of cargoes of grain, to be carried to Japan, which they had shipped on the S.S. Pennsylvania, against Old States.

3. November 17, 1955; date of decision of the District Court.

4. February 16, 1956, date of entry of the decision of the District Court.

5. March 22, 1956; date of advice by Erskine *349 Wood, attorney, to J.R. Dant about loss liability of Old States; Wood was attorney for Old States.

6. May 18, 1956; date of the filing of an appeal in the United States Court of Appeals for the Ninth Circuit from the District Court's decision.

7. June 28, 1956; incorporation of States Line, Inc.

8. July 10, 1956; date when Blyth & Co. acquired all of the stock of Dant & Russell, Inc., and all of the stock of Old States.

9. July 11, 1956; date when Blyth sold all of the stock of Old States to States Line, Inc., for $11,050,000.

10. May 31, 1957; date of first opinion of the Court of Appeals affirming the 143 opinion of the District Court in the cargo loss lawsuit.

11. June 28, 1957; date of filing in the Court of Appeals of petitions for rehearing.

12. June 30, 1957; date of dissolution of Old States upon its merger into States Line (New States).

13. July 23, 1957; date of filing in the Court of Appeals of the petition for rehearing by States Steamship Co. (New States), formerly States Line.

14. November 15, 1957; date of modified opinion of the Court of Appeals in the cargo loss litigation, and of remand of the case to the District Court for further proceedings. *350 See 259 F. 2d 463 .

15. August 20, 1958; date of further amendment by the Court of Appeals of its opinion in the cargo loss case. See 259 F. 2d 463 , 470 .

16. January 12, 1959, and February 24, 1959; certiorari denied by United States Supreme Court of petitions to review the final decision of Court of Appeals; 358 U.S. 993 ; 359 U.S. 921 .

In 1952, Old States owned and operated the S.S. Pennsylvania, a Victory-type ship; and it operated that ship for carrying freight. This ship was 455 feet long; 62 feet beam; and its gross tonnage was 7,608 tons. On January 5, 1952, the Pennsylvania sailed from Seattle, Washington, carrying cargoes of grain. Its destination was Yokohoma, Japan. Its route was over the great circle route from Seattle. On January 9, 1952, there was a heavy storm in the Gulf of Alaska where the ship had arrived. In the storm, the ship was wrecked and lost 505 miles northwest of Seattle. The ship, crew, and cargo were completely lost. No wreckage ever was found.

Lawsuits were instituted against Old States and its insurers for damages from the loss of life and property. Prior to 1956, Old States settled all lawsuits *351 involving claims for the loss of the crew.

The shippers of the grain cargo filed a lawsuit against Old States and its insurers for the recovery of the value of the lost cargo. The trial of the lawsuit in the United States District Court for the District of Oregon began on July 13, 1954. The plaintiffs were the United States and Canada, each having shipped a separate shipment of grain. Atlantic Mutual Insurance Co. and Pacific National Fire Insurance Co., insurers, also were plaintiffs because they had insured the grain shipments. The combined cargo loss claims of United States and Canada amounted to $1,199,674.45. (Canada's claim seems to have been $24,392.14.) The claim of Atlantic Mutual Insurance was $434,936.52, and the claim of Pacific National Fire Insurance was $525,400. The total amount of all of the claims was $2,160,010.97.

Section 183(a) of Title 46 of the U.S. Code limits the liability of the owner of a vessel. It provides, inter alia, that the liability of the owner of a vessel for any loss of any property, goods, or merchandise shipped or put on board of such vessel shall *352 not exceed the amount of the value of the interest of the owner in the vessel, and her freight then pending (freight charges), if the loss was without the privity or knowledge of the owner. Since the Pennsylvania was never recovered or salvaged, the value of the vessel after the disaster was zero, so that under section 183(a) Old States' liability might be, or could be, limited to the freight charges.

During the trial of the lawsuit, it was established that the bills of lading provided that Old States would not be liable for the loss of cargo "by a peril of the sea". Old States had the burden of proving that the loss was caused by a peril of the sea.

On November 17, 1955, the District Court rendered its opinion in an unreported memorandum opinion consisting of two typewritten pages. The court's findings included the following facts: That the storm was not of such magnitude as to constitute a peril of the sea; and that latent defects and faults in the Pennsylvania had developed. Although it was not stated in the opinion, it was established during the trial that a 14-foot crack had developed *353 in the hull of the ship during the storm, through which water had flowed into the engineroom, and before aid could arrive, the ship sank. The court found that the vessel had been unseaworthy, but that any defects in the vessel which had caused her to sink were not apparent, and that those charged with her inspection had used reasonable and prudent care.

A question to be decided in the litigation was whether, under the facts and circumstances, knowledge that the vessel was not seaworthy could be imputed to Old States. The District Court held that those charged with the inspection of the ship, and the owner, Old States, were without privity or knowledge of any defects in the ship, and that therefore, Old States was entitled to the limitation of liability provided by 144 section 183(a) , U.S. Code. This meant that the liability of Old States was limited to $82,256.25, the pending freight charges.

The parties have stipulated that the decision of the District Court on November 17, 1955, was to the effect that Old States was liable to the shippers for their loss of cargo, but that the liability *354 was limited under section 183(a), 46 U.S. Code , to an amount which was less than the insurance protecting Old States against liability. On February 16, 1956, the District Court entered its decree, or judgment, under its decision.

All of the parties, including Old States, filed appeals from the District Court's decree in the United States Court of Appeals for the Ninth Circuit. Old States appealed from the findings that the Pennsylvania was not lost because of a peril of the sea and that she was unseaworthy. Old States' appeal was filed on May 18, 1956. The United States and Canada, who were the cargo loss claimants, and the insurance companies appealed from the District Court's ruling that there was not privity and knowledge in Old States of the existence of the conditions which had made the Pennsylvania unseaworthy, and from the holding that the liability of Old States was only the limited liability consisting of only the pending freight, or the freight charges paid by the shippers. The cargo loss claimants and the insurance companies also claimed on appeal that the evidence showed that Old States had privity and knowledge of the unseaworthiness of the Pennsylvania.

On March 22, 1956, soon *355 after the entry of the District Court's decree, Erskine Wood, the attorney for Old States in the litigation, sent J.R. Dant and Old States a letter in which he advised Dant that the possibility that the liability of Old States for the loss of the cargo would be limited by the court to the insurance coverage, and would not be in excess thereof, was a strong possibility, and that there was a reasonable expectation, about 80 percent, that Old States would not have a liability for the loss of the cargo in excess of the insurance coverage. The date of Wood's letter was 14 months before the Court of Appeals affirmed the decision of the District Court, on May 31, 1957.

In his letter of advice on March 22, 1956, to J.R. Dant and Old States, Wood stated that the appeal to the Ninth Circuit Court of Appeals probably would not be argued until the fall of 1956, and probably would not be decided until January 1957, at the earliest. He stated also that the total amount of the insurance covering the Pennsylvania had been $1,331,400; that $401,376.13 of this amount had been paid in settlement of the claims for the loss of the crew and other expenses; and that the available balance of the insurance *356 to cover the cargo loss claims was $835,023.87, after the payment of legal fees and expenses of $95,000.

The conclusion stated by Wood, in the letter of March 22, 1956, was as follows:

I emphasize that I do not think you will ever be called upon to pay this. I feel quite confident that you will not. But no lawsuit is a certainty and it must be reckoned with as a possibility. However, I would not be scared by it, if I were you. If I had to put it in a percentage, I would say that you had about a 75% to 80% chance to win. I do not like the defeatism of a settlement, with its implications in the public mind that you were unwilling to refute in the Appellate Court the alleged unseaworthiness of the ship with its consequent loss of cargo and life.

As the case stands now you have been held liable only up to the amount of the freight, $82,256.25, with interest and costs. The interest would be at six percent from January 5, 1952, to date, and the costs are undetermined as yet. The interest would amount to about twenty-five percent and the costs perhaps $5,000.00. Let us estimate, therefore, that the interest and costs would be $25,564.06.

All of this is covered by insurance. Thus *357 far you have suffered no loss whatever and it is my hope and ambition to keep you that way.

The District Court opinion of November 17, 1955, limiting Old States' liability to

the pending freight (freight charges paid by the shippers), which was not in excess of the insurance protecting Old States from liability, according to a stipulation of the parties, was affirmed in all respects by the United States Court of Appeals on May 31, 1957, in States Steamship Company v. United States, 259 F. 2d 458 (C.A. 9, 1957).

Petitions for rehearing were filed in the Court of Appeals by some of the cargo loss claimants on June 28, 1957, which was two days before June 30, 1957, the date on which Old States was merged into New States. New States had purchased all of the stock of Old States on July 11, 1956, for $11,050,000, and on June 30, 1957, Old States was liquidated and merged into New States. 145

The liquidation and merger of Old States was a statutory merger under Nevada statutes. New States received all of the assets of Old States and, in accordance with Nevada law, New States assumed all of the liabilities of Old States.

On July 23, 1957, New States, successor *358 to Old States, also filed a petition for rehearing in the Court of Appeals in view of the other petitions for rehearing filed on June 28, 1957.

The Court of Appeals granted a rehearing on the claimants' petitions, but denied the petition for rehearing filed by New States. On November 15, 1957, about 3 i/2 months after Old States was liquidated and merged into New States, the Court of Appeals changed its original opinion of May 31, 1957. The Court of Appeals held on November 15, 1957, that the District Court had erred in its ruling to the effect that the liability of Old States for the loss of the cargo was a limited one, which was limited to the pending freight, and it remanded the case to the District Court; 259 F. 2d 463 .

In its second opinion, on November 15, 1957, the Court of Appeals held that there had been a lack of due diligence on the part of Old States because there was a lack of due diligence on the part of its port engineer and acting marine superintendent, Lester A. Vallet, and the court charged Old States with privity and knowledge of the unseaworthiness of the Pennsylvania because of Vallet's lack of diligence. This conclusion was a complete reversal *359 of the Court of Appeals' earlier conclusions in its original opinion, on May 31, 1957, wherein it had concluded that Old States could not be charged with privity and knowledge of latent and potential weakness in the ship and, therefore, Old States' liability was limited.

Contrary to its first conclusion, the Court of Appeals held in its second opinion on November 15, 1957, that Vallet had been negligent in failing to detect latent defects in the Pennsylvania; that Vallet was an "executive officer, manager or superintendent" of Old States whose authority included supervision over the phase of the business in which the loss had occurred; and that, therefore, the privity to or knowledge of the latent defects in the vessel, which caused the loss, was imputable to Old States through one of its supervisory personnel. The Court of Appeals accordingly reversed that portion of the District Court's decision, as well as its own conclusion of May 31, 1957, which had limited the liability of Old States under section 183(a) of the U.S. Code so that its liability was limited to the pending freight. The court remanded the case to the District Court for further proceedings consistent with its opinion *360 of November 15, 1957.

Thereafter, New States filed another petition for rehearing in the Court of Appeals, which was granted. On August 20, 1958, the Court of Appeals further amended its original opinion of May 31, 1957, while adhearing to its conclusion in its opinion of November 15, 1957, which reversed the limitation of Old States' liability to the amount of the pending freight charges. The court's opinion of August 20, 1958, 259 F. 2d 470 , was issued to clarify the court's conclusions in its opinion of November 15, 1957, holding that Old States, and since June 30, 1957, New States, was not protected by section 183(a) of the U.S. Code limiting the liability of the owner of a vessel.

On January 12, 1959, the Supreme Court denied New States' petition for certiorari, and on February 24, 1959, it denied a petition for rehearing. States Steamship Company v. United States, 358 U.S. 993 , and 359 U.S. 921 . Thereafter, the cargo loss claims were settled by the parties in 1959. This settlement resulted in a liability owing by New States which New States was required to pay by virtue of the fact that Old States had been liquidated and merged into *361 New States under Nevada law on June 30, 1957. New States paid during 1959 the net sum of $1,445,394.22, which included interest and attorneys' fees, on account of the settlement of the cargo loss claims under the adverse court decision. This amount was claimed as a casualty loss deduction by New States in the 1959 consolidated return of Pacific Transport Company, and the deduction contributed to the net operating loss for 1959 reported by New States and by the affiliated group, which operating loss was carried back to 1957 and 1958 as loss carryback deductions.

As stated before, in his review of the 1959 return of the affiliated group, for the purpose of determining whether the loss carryback deductions for 1957 and 1958 were allowable, respondent allowed New States a deduction for 1959 of the accrued interest on the cargo loss claims which were paid, $96,525.83, but he determined that the balance of the payments, $1,348,868.39, was not a proper current deduction and that the payments should be treated as a capital 146 expenditure, an additional cost to New States of the assets of Old States acquired through the liquidation and merger of Old States on June 30, 1957. Respondent's *362 allocation thereof is stated hereinafter.

As noted above, after the first Court of Appeals decision (May 31, 1957) and two days after some of the cargo loss claimants had filed petitions with the Court of Appeals for a rehearing, Old States was liquidated and merged into New States on June 30, 1957. This liquidation and merger was pursuant to a resolution of the board of directors of New States dated June 24, 1957, which incorporated a plan for the liquidation of Old States and the merger of Old States into New States. Under this plan Old States was to distribute all of its assets to New States and the latter was to assume all obligations of Old States which were outstanding as of the date of the distribution of the assets of Old States to New States in the merger. This liquidation and merger was accomplished on June 30, 1957. Under section 78.540 of the revised Nevada Statutes, the merger of Old States into New States, and the vesting in New States of all of the assets of Old States was effected by the filing by New States with the Secretary of State of Nevada of a "Certificate of Ownership For Purpose of Merger of States Steamship Company" into New States. According to a stipulation *363 of the parties, that certificate was filed by New States on June 30, 1957. As of that date all of the assets of Old States were distributed to New States, subject to the then outstanding obligations and liabilities of Old States; New States assumed all of the obligations of Old States outstanding on June 30, 1957; and the distribution of all of its assets (subject to obligations) by Old States to New States was in complete cancelation and liquidation of all of the shares of stock of Old States. In effect, this meant that all of the shares of Old States were transferred to Old States by New States in exchange for Old States' assets, and the shares were canceled. Also, as of June 30, 1957, New States (States Line) changed its name from States Line to States Steamship Company, and operated under the latter name thereafter.

After the Supreme Court denied New States' petition for certiorari on February 24, 1959, New States and the parties to the litigation, the claimants, entered into negotiations for the settlement of the claims and all of the parties agreed upon the total amount of principal and interest to be paid by New States. The settlement made it unnecessary for the District Court *364 to hear the case upon the remandment by the Court of Appeals. Under the settlement, New States paid the sum of $1,445,394.22 in 1959, which included the principal amount of $1,348,868.39, in payment of the cargo loss claims, attorneys' fees, and interest accrued on the judgment from July 1, 1957, to the date of payment by New States in 1959.

Contingent Liability for Cargo Losses: The officers, directors, and the attorneys of Old States, including J.R. Dant and Erskine Wood, and later those in control of New States, and the accountants of both corporations, understood and believed that any and all liability of the corporations for damages for the loss of the cargo aboard the Pennsylvania was covered by the insurance carried by Old States and that, therefore, any liability in an amount in excess of the insurance covering that loss of property was very remote and was unlikely. The undetermined liability of Old States, and later of New States, was a contingent liability at all times, and a liability to claimants for a judgment for damages in excess of the insurance covearge of such loss was a remote contingent liability. The factors which contributed to the status of the liability as *365 a remote and contingent one were as follows:

Section 183 of Title 46 of the U.S. Code , originally the Limited Liability Act of 1851, and later section 4285 of the Revised Statutes, was enacted to change the common law rule of absolute liability to the limited liability known as "liability without fault." Section 183 , supra, limited or excused the carrier's liability under enumerated circumstances, and section 183(a) limited the owner-carrier's liability if the loss was due to a defect "without the knowledge of such owner". States Steamship Co. v. United States, 259 F. 2d 458 , 464 , supra. The purpose of that statute was to limit the liability for loss of a carrier under certain conditions.

The second factor contributing to the contingent and remote nature of the possible liability was the fact that Old States was insured against loss and liability for loss.

The third factor was that Old States continuously denied, and contested, the claim that its liability was more than a limited liability, liability without fault, under section 183(a), Title 46, U.S. Code , and that issue *366 was in litigation from July 13, 1954, the beginning of the trial of the case, until 147 February 24, 1959, when the Supreme Court rendered its final denial of review.

The fourth factor was that the United States District Court decided on November 17, 1955, and the Court of Appeals affirmed that decision on May 31, 1957, to the effect that Old States was without fault with respect to latent defects in the Pennsylvania and, therefore, that it came within the provisions of section 183(a) , supra, and that it had only a limited liability for the loss of the cargo, which liability was limited to the amount of the freight charges, $82,256.25, plus costs and interest of about $25,564.06. Old States' insurance covered that total amount of liability, which was less than the insurance coverage.

The fifth factor was that under accepted principles of accounting, the accountants for Old States, under all of the circumstances described above, deemed a contingent liability which is covered by adequate insurance not to be a balance sheet liability as such or one for which a reserve account should be carried in the accounts of the corporation. Accordingly, the books of Old States, and later *367 of New States, did not contain a reserve or other account for a liability for the payment of the loss of the cargo; and the balance sheets of both corporations did not include a reserve for such contingent liability. For example:

The balance sheet of Old States as of December 31, 1954, for 1954, prepared by George Black & Co., accountants, submitted to Old States on May 27, 1955, did not set forth any liability for the contingent cargo loss liability, and it included only a footnote, as follows:

There have been cargo claims filed against the Company in the aggregate amount of $2,184,403.11 arising from the loss of a vessel at sea in 1952, all liability in connection with which is disclaimed by the Company. Decision by the Court is pending as to the Company's liability. Any losses arising therefrom, are, in the opinion of Company officials and its counsel, adequately covered by insurance.

The same procedure was followed by the same accounting firm in preparing Old States' balance sheet for 1955, submitted to Old States on May 29, 1956, in which the following footnote was included:

There have been cargo claims filed against the Company arising from loss of a vessel at sea in *368 1952 which, including interest, court costs, attorneys' fees, etc., aggregate approximately $2,900,000. A memorandum opinion issued by United States District Court, District of Oregon, in November 1955, indicated that the Company's liability extended only to the amount of freight charges involved, which is $82,256. Claimants have appealed from that decision but counsel for the Company has expressed opinion that the aggregate of any damages which may eventually be awarded will be within the amount of insurance coverage, approximately $835,000.

Haskins & Sells, a nation-wide firm of certified public accountants, prepared Old States' audit report for 1956, and in the balance sheet as of December 31, 1956, the same procedure was followed and only a footnote was included about the cargo loss claims, in which it was stated that the officers and counsel of Old States were of the opinion that any eventual award by a court to claimants would be within the outstanding insurance coverage.

In connection with the negotiations which culminated in Blyth's purchase of all of the shares of stock of Dant & Russell, Inc., on July 10, 1956, various financial reports of Dant & Russell, Inc., and of *369 its subsidiary, Old States, were submitted to Blyth & Co., in which no liability was set forth or reflected for the pending lawsuits of the cargo loss claimants. Although Blyth & Co. was advised by its attorneys that the existence of the cargo claims had not been disclosed in the financial reports and that Blyth could rescind, for that reason, its option agreement to purchase all of the shares of Dant & Russell, Inc., Blyth & Co. nevertheless purchased all of the shares of Dant & Russell, Inc. Upon the acquisition of all of the shares of Dant & Russell, Inc., Blyth then controlled its subsidiaries, including Old States.

J.R. Dant negotiated with Blyth & Co. for the purchase of all of the shares of Old States, which were to be, and were, purchased by Dant's assignee, States Line (New States). States Line purchased all of the shares of Old States on July 11, 1956. J.R. Dant believed, on the advice of counsel, as well as on the basis of the favorable decision of the District Court on November 17, 1955, (which held that Old States' liability was a limited one) and on the basis of the insurance coverage, that the liability of Old States for the loss of cargo would not exceed the outstanding *370 insurance coverage. As part of the negotiations for the purchase from Blyth of the stock of Old States, Dant retained Haskins & Sells to study the financial position of Old States 148 (and of Pacific Transport Lines), and to make projections of the net earnings those corporations could expect from future operations. Pursuant to this employment, Haskins & Sells prepared and submitted a report entitled "Acquisition of Steamship Interests and Projection of Earnings," dated July 26, 1956. This report projected the net earnings of the corporations, including Old States, through the year 1961. This report included pro forma balance sheets both before and after the projected net earnings. The pro forma balance sheets did not show any reserve or other provision for the payment of the shippers' claims for lost cargo arising from the loss of the Pennsylvania, and the projected earnings did not reflect any deduction on account of the cargo loss claims. An explanatory comment accompanied the projection of net earnings wherein the following was stated:

There are also suits and claims involving vessel and cargo damages and personal injuries arising in the normal course of business, which, *371 with the exception of deductible amounts provided for in the policies, are presumably covered by insurance. No consideration has been given to these suits and claims in the preparation of this projection.

Haskins & Sells were aware of the pending cargo claims, but they were not taken into account in preparing the projections of net earnings because of the fact that Haskins & Sells had been advised by Dant's counsel that there was little likelihood of any liability beyond the insurance coverage.

Early in 1957, in support of loan applications for Old States, New States, and Pacific Transport Co., financial and projected earnings statements were submitted to the Crocker-Anglo National Bank in San Francisco. No provisions were made in any of those financial and projected earnings statements for any loss from the Pennsylvania cargo loss claims and litigation either by means of a contingent liability, a reduction of surplus, a deduction from income, or otherwise. On June 26, 1957, the Crocker-Anglo Bank committed itself by a letter to make loans aggregating $8,000,000 to New States and to Pacific Transport Co., apparently accepting the financial and projected earnings statements as correctly *372 reflecting the financial position of Old States, New States, and Pacific Transport Co.

In connection with an application of Old States on March 9, 1955, to the Maritime Commission (Marad) for an operating-differential subsidy agreement (as Old States was not a subsidized carrier), Old States, and later New States, submitted several statements of contemporaneous financial condition and projections of future earnings to Marad in support of the application for a subsidy. Old States had acquired on October 22, 1954, all of the stock of Pacific Transport Lines, Inc., which held an operating-differential subsidy agreement with Marad. There was not any provision in the financial and projected earnings statements submitted to Marad for any loss from the cargo loss claims and litigation by means of a contingent reserve, reduction of surplus, deduction from income, or otherwise. However, Marad was continuously aware of the litigation of the claimants for compensation for their losses of cargo on the Pennsylvania. Prior to the liquidation and merger of Old States into New States, New States was substituted for Old States as the applicant for the subsidy. On August 23, 1957, Marad granted the *373 subsidy application and an operating-differential subsidy agreement was executed on that date between Marad and New States.

Purchase of Stock of Old States: J.R. Dant negotiated with Blyth & Co., on behalf of States Line (New States) for the purchase of all of the stock of Old States, and he also was obliged to submit a bid to Blyth for the stock. There were three bidders for the stock of Old States, including J.R. Dant. Dant's bid for Old States' stock, of $11,050,000, was accepted by Blyth & Co. in a competitive situation involving the three bidders. The eventual sale of all of the stock of Old States to Dant's assignees, States Line (New States) on July 11, 1956, was an arms-length transaction in which the selling price of $11,050,000 represented the fair market value of all of the shares of stock of Old States. The cost of the shares to New States was $11,050,000, plus legal expenses of $58,843.43. In accepting Dant's bid of $11,050,000, Blyth & Co. was not under any compulsion to accept Dant's bid, which was made with the intention that his assignee, New States, would purchase Old States' stock. Moreover, Blyth & Co. was in the position of having three competitive bids for *374 the stock. Furthermore, J.R. Dant was motivated by business considerations, rather than by some sort of familial loyalty considerations, in making the bid of $11,050,000 for Old States' stock.

Dant's bid for the stock of Old States, as stated above, was not reduced in any 149amount to provide for any contingent liability of Old States for the pending claims of the shippers of the lost cargo which were the issue in the lawsuits for those claims. In his negotiations with Blyth & Co. for the purchase of all of the stock of Old States, J.R. Dant did not discuss the cargo loss claims, and he did not attempt to negotiate a lower price for the shares on account of any contingent liability of Old States for the cargo loss.

Assets Acquired by New States from Old States, June 30, 1957: Respondent determined that the payments in 1959 in settlement of the adverse court decree to the lost cargo claimants represented a capital expenditure rather than a deductible casualty loss. He then allocated the capitalized expenditure to and among various assets. An alternative issue relates to respondent's allocation determinations.

Just prior to the time when New States and Old States were merged *375 and Old States was liquidated, on June 30, 1957, Old States had three subsidiaries, wholly owned, Pacific Transport Lines, Inc. (PTL), Portland Stevedoring Company, and Quaker Line, Inc. Also, Old States owned the majority of the shares of California Eastern Lines, Inc., 1,202 shares out of 2,276 shares. Upon the liquidation and merger of Old States, New States acquired the assets of Old States, and among them were the shares of stock owned by Old States of the four corporations named above, so that PTL, Portland Stevedoring, and Quaker became subsidiaries of New States. By the end of August 1957, New States acquired the balance of the shares of California Eastern, when it then became New States' subsidiary.

On August 23, 1957, PTL was liquidated and merged into New States. In that merger, the basis to New States of the assets acquired from PTL was determined under section 334(b)(1) , 1954 Code. The tax consequences of that transaction are not in issue here.

During 1957, New States dissolved Quaker Line in a nontaxable transaction. On October 29, 1957, New States sold all of the capital stock of Portland Stevedoring Co. to Pacific Atlantic Steamship Co. (Pacat) for cash. On March 31, 1958, California *376 Eastern Lines, Inc., was liquidated and merged into New States.

The parties are agreed that New States' liability for the payment of the cargo claims under the court's judgment and decree, $1,348,868.39, accrued on February 24, 1959, and that if any portion, or all, of the above sum is to be capitalized, such capitalization of that sum must be made as of February 24, 1959. If the alternative issue of the respondent's capitalization as of February 24, 1959, of the above payment in 1959 were to be considered, there would be a question whether such capitalization, as of February 24, 1959, shall be allocated to and apportioned among the assets owned by New States on that date which are traceable to the assets of Old States which were acquired by New States on June 30, 1957, as petitioners claim; or whether the allocation of the capitalized expenditure as of February 24, 1959, should be made only to the assets originally received by New States on June 30, 1957, without regard to whether those specific assets still were in existence on February 24, 1959, which in effect is respondent's determination.

Respondent's claimed allocation of a capitalized $1,348,868.39, as of February 24, 1959, is *377 allocation of that sum to the following: Vessels $333,447.42

Stock of Pac. Trans. Lines 972,659.42

Stock of Portland Steve. Co 42,761.55

$1,348,868.39

On February 24, 1959, the stock of Pacific Transport Lines, Inc. (PTL) was not in existence because that corporation had been liquidated and merged into New States on August 23, 1957. On February 24, 1959, the stock of Portland Stevedoring Co. was not owned by New States, but was owned by Pacific Atlantic Steamship Co. (Pacat), which had purchased the stock from New States for cash on October 29, 1957.

Respondent's method of allocating a capitalized sum of $1,348,868.39, as of February 24, 1959, represents an allocation of more than 70 percent thereof to assets which no longer existed, or were not owned by New States, on February 24, 1959.

On February 24, 1959, New States owned and possessed 12 vessels. Four of those vessels were acquired by New States from Old States when Old States was merged into New States, and liquidated. Eight of those vessels were acquired by New States from Pacific Transport Lines, Inc. (PTL), which had been a subsidiary of Old States, when PTL was merged into New States, and liquidated, *378 on August 23, 1957. There is in evidence a schedule prepared by petitioners which reflects a method of allocating a capitalized sum of $1,348,868.39, if that were to be done, to and among the 150 eight vessels mentioned above which New States owned on February 24, 1959. In that schedule (exhibit 57 of petitioners) all of the above sum would be allocated to and among those eight vessels, which are traceable to the assets of Old States which were acquired by New States. If such allocation of $1,348,868.39 were to be made, each one of those eight vessels would receive an increased basis, of a proportion of the above sum, and New States would receive allowances for additional depreciation for 1959, with respect to those eight vessels, in the total amount of $165,998, which would be additional depreciation of $120,698.40, because the depreciation for 1959, of the eight vessels, allowed by the respondent amounted to $45,299.60.

Ultimate Findings of Fact, Cargo Loss

1. The liability of Old States, and of its successor, New States, for loss of cargo aboard the Pennsylvania was contested by both corporations and was in dispute on the critical dates, July 11, 1956, date of purchase *379 of stock, and June 30, 1957, date of merger and liquidation, and thereafter until February 24, 1959. The liability was founded upon and governed by a statute, section 183 of Title 46, U.S. Code , and it arose out of the contracts of Old States with the shippers of the cargo. The cargo loss claims were not tort claims.

2. The contested and disputed liability of Old States, and of its successor, New States, for the loss of cargo did not become established and fixed and did not become certain as to amount, until on and after February 24, 1959, on which date the liability became accrued.

3. The liability of Old States was a contingent liability. The contingencies related to and involved the statutory limitations contained in section 183, Title 46, U.S. Code , which prescribed limited liability, and the existing insurance coverage. Since a limited liability was fully covered by Old States' insurance, the liability of Old States, and later of New States, was a remote as well as a contingent liability on July 11, 1956, when New States purchased the stock of Old States, and on June 30, 1957, when Old States was liquidated and merged into New States. On both of those dates the belief of the *380 officers of Old States and of New States, respectively, that the then pending litigation would result in a judicial determination that Old States' liability for the loss of the cargo was a limited liability which would be fully covered by the existing insurance, and that the determined liability would not be in an amount in excess of the insurance, was a reasonable belief.

4. The price, $11,050,000, paid by New States for all of the stock of Old States was not a price arrived at on the basis of a discount and reduction of some larger amount to allow for a reserve in any amount for the contingent, cargo-loss liability. It was not a discounted price, and Old States, and later New States, did not set up on their books any reserve for such contingent liability.

5. The sum paid by New States in 1959 in settlement of the decree awarding compensation to the claimants for the loss of their cargo, $1,348,868.39, exclusive of interest, was not part of the cost of the stock of Old States, or of any of the assets of Old States acquired by New States as a result of the liquidation and merger of Old States.

6. The sum, $1,348,868.39, paid by New States in 1959 to the claimants was a loss, *381 not compensated for by insurance or otherwise, which was fully deductible in 1959.

New States Deposits for 1959 in Marad Account

In the 1959 consolidated return, in reporting its own income and deductions, New States deducted $2,074,028.43 as "deposits of tax-deferred earnings in reserve funds". This deduction was part of the total amount of all of the deductions totaling $7,959,162.74. Since the total income reported by New States was $6,527,894.96, the total amount of all of the deductions resulted in a net operating loss of $1,431,267.78. As stated hereinbefore, the respondent made an adjustment in the amount of the deduction of $2,074,028.43 for Marad deposits, upon his audit of the 1959 net operating loss, whereby he reduced the deduction for the Marad deposits from $2,074,028.43 to $2,021,003, and he disallowed $53,025.43. Thus, he appeared to "allow" a deduction for Marad deposits of $2,021,003, but the figure, $53,025.43, was only an "adjusting" figure to make the allowed deductions, $6,527,894.96, the same amount as income, so that New States would have neither a profit nor a loss from its operations for 1959.

Respondent adopted the position that the so-called "voluntary *382 deposits" with Marad to reserve funds under section 607 of the Merchant Marine Act, $1,175,000, could not 151 exceed the amount of "taxable income", and his disallowance of a deduction of $53,025.43 was in fact a denial of a deduction for part of the deposit of $1,175,000. Under respondent's theory, the figure $53,025.43 is subject to further adjustment up to $1,175,000 depending upon the decision here relating to other disputed deductions. However, as explained hereinafter and in detail in the Opinion, under respondent's theory, the figure $53,025.43 is subject to further adjustment up to $2,074,028.43, which could be disallowed by respondent, depending upon the decisions here relating to other disputed deductions.

The issue about Marad deposits involves the deposits with Marad of $2,074,028.43.

The figure, $2,074,028.43, the total deposits in 1959 by New States with Marad into reserve funds, is the sum of four types of Marad deposits as follows: The so-called voluntary deposits $1,175,000.00

Excess profits, 1959 591,701.97

1959 interest accumulated in fund 32,563.14

Net depreciation on vessels 274,763.32

$2,074,028.43

It is necessary to state *383 under this issue the amounts reported by New States as its total income for 1959, and the total amounts of the allowed and disallowed deductions, respectively, as follows: Total income $6,527,894.96

Allowed deductions $6,527,894.96

Disallowed deduc- tions 1,431,267.78 7,959,162.74

Net operating loss ($1,431,267.78)

The deductions allowed by respondent were for salaries, wages, depreciation, bad debts, repairs, rents, taxes, interest, pension contributions, and similar business expenses.

The following explains the items of the disallowed deductions totaling $1,431,267.78: Disallowed deductions

Depreciation (in issue) $ 24,411.10

Cargo loss payments 1,348,868.39

Marad deposits 53,025.43

Initiation fees (not in issue) 4,450.00

Filing fees (not in issue) 512.86

$1,431,267.78

The finding made above that the payment of $1,348,868.39 to settle the claims for the lost cargo was a fully deductible loss in 1959, reduces the total sum of the deductions denied by the respondent from $1,431,267.78 to $82,399.39. Respondent determined that New States, as a member of the affiliated group, did not have any net operating loss for *384 1959. The finding that the total cargo loss payment was deductible means that New States had a net operating loss of at least $1,348,868.39.

On January 1, 1953, Pacific Transport Lines, Inc., entered into an "operating-differential subsidy agreement", Contract FMB-21, with the Maritime Administration, after hearings held to determine whether Pacific Transport Lines qualified for the subsidy. The operating-differential subsidy agreement was granted to Pacific Transport Lines by Marad in accordance with section 607 of the Merchant Marine Act, 1936, as amended, 46 U.S.C.A. 1177 .

On October 22, 1954, Old States acquired all the stock of Pacific Transport Lines, Inc. Old States was not a subsidized carrier on this date. It has been stipulated that a principal purpose of Old States in this acquisition was to become a subsidized carrier through amendment of the subsidy contract of Pacific Transport Lines to include routes operated, and ships owned, by Old States. Prior to the acquisition of all of the outstanding capital stock of Pacific Transport Lines by Old States on October 22, 1954, Old States obtained approval of that transaction from Marad. Marad's approval *385 was required if the operating-differential subsidy agreement (Contract FMB-21) was to continue in effect. On March 9, 1955, Old States applied to Marad for an operating-differential subsidy for its operations (routes and ships) previously conducted by Old States, but not within the scope of operations encompassed in Contract FMB-21, the operating-differential subsidy agreement between Marad and Pacific Transport Lines, Old States' subsidiary. On July 11, 1956, New States (then States Line) acquired all of the outstanding stock of Old States, and on June 30, 1957, Old States was liquidated and merged into New States. Prior to this liquidation and merger, Marad authorized the substitution of New States for Old States under the original application for an operating-differential subsidy agreement.

Pacific Transport Lines, a subsidiary of Old States, became a subsidiary of New States as a result of the merger of Old States into New States on June 30, 1957. On August 23, 1957, New States caused Pacific Transport Lines to be liquidated and merged into New States. New States acquired, by operation of law, all of the rights and assets of Pacific Transport and assumed all of its obligations *386 including, without limitation, all of the rights and obligations of Pacific Transport under its 152 subsidy agreement with Marad. Prior to the liquidation of Pacific Transport, Marad notified New States that its application for a subsidy agreement, submitted by Old States on March 9, 1955, would be granted, and on August 23, 1957, Marad granted a subsidy agreement to New States, as Addendum 19 to Contract No. FMB-21, the subsidy agreement with Pacific Transport Lines. That contract and addendum became effective for New States for the period August 23, 1957, to December 31, 1957. In addition to that short-term agreement, New States was granted a subsidy agreement, Contract No. FMB-62, for the period January 1, 1958, to December 31, 1977. On August 23, 1957, New States and Marad also entered into a letter agreement concerning the subsidy agreement which stated in part the following:

In acting on the application dated March 9, 1955, as amended December 14, 1955 and July 30, 1957, filed by States Steamship Company and its predecessor corporation, for the award of an operating-differential subsidy agreement to cover the operations of cargo vessels on Trade Routes Nos. 29 and 30, the *387 Federal Maritime Board, as a condition precedent to the granting of said application and the execution of Addendum No. 19 to Contract No. FMB-21 and Contract No. FMB-62, required the acceptance by States Steamship Company of the following provisions: * * *

C. States Steamship Company shall make annual deposits in the statutory reserve funds of mandatory deposits of excess profits and voluntary deposits of free earnings totaling not less than $1,200,000 per annum, on a cumulative basis for the eight year period (1958-1965 inclusive), provided that the United States: The operating-differential subsidy agreement was granted to New States in accordance with the provisions of the Merchant Marine Act of 1936, as amended. Under section 607 of the Act, as amended, the contract with New States required the establishment of two funds with Marad, the capital reserve fund and the special reserve fund. The purpose of the capital reserve fund was to insure the prompt payment of New States' obligations to the United States, and to insure the replacement of the contractor's (New States') subsidized vessels as might be required. The purpose of the special reserve fund was to insure the continued *388 maintenance and successful operation of the subsidized vessels, and to insure that the contractor had sufficient funds to meet the general operating expenses or losses of the subsidized operations.

The reserve funds are essentially joint accounts under the control of the contractor (New States) and Marad. Certain provisions of the subsidy agreement, and of the Act, required that New States would make deposits into these reserve funds.

Certain deposits to reserve funds by the contractor, in accordance with the provisions of the contract and the Act, are given beneficial tax treatment under section 607(h) of the Merchant Marine Act. Section 123 (a)(7) , 1954 Code, refers by a cross-reference to section 607(h) of the Merchant Marine Act. Section 123(a)(7) of the Code and section 607(h) of the Act provide that certain deposits to the reserve funds with Marad shall be exempt from all Federal taxes. Section 123(a)(7) of the Code states that earnings of ship contractors deposited in special reserve funds *389 shall be excluded from gross income and, therefore, shall be exempt from tax according to section 607(h) of the Merchant Marine Act.

Section 123(a) of the Code is part of subtitle A, Ch. 1B, Part III of the 1954 Code. Part III contains various items which are "specifically excluded from gross income", including the item described in section 123(a) . Chapter 1B of Subtitle A of the Code deals with gross income, adjusted gross income, and taxable income, and with items included and excluded, respectively from gross income.

The deposits to reserve funds administered by Marad which are given beneficial tax treatment are described in section 607 of the Merchant Marine Act. The letter agreement of August 23, 1957, between Marad and New States required New States to make deposits to reserve funds of not less than $1,200,000 per year on a cumulative basis. The deposits of New States were to consist of either mandatory deposits of excess profits, or so-called voluntary deposits of free earnings.

In the Merchant Marine Act and the regulations of Marad there are definitions of excess profits and *390 of free earnings. Excess profits from subsidized operations are defined as annual profits in excess of 10 percent of the capital necessarily employed in the subsidized operations. Under certain provisions of the Act, annual profits from subsidized operations in excess of 10 percent of the capital necessarily employed in subsidized operations, the excess profits, are subject to being recaptured in part by Marad. 153 Generally, 50 percent of the excess profits from subsidized operations are recaptured by Marad. Under certain provisions of the Act, parts of the remaining 50 percent of excess profits may be required by Marad to be deposited in the contractor's capital reserve fund administered by Marad. Free earnings are defined in Marad's regulations as those annual profits from subsidized operations which do not exceed 10 percent of the capital necessarily employed in the subsidized operations of the operator's business.

Section 607 of the Merchant Marine Act, as amended, provides, in part, as follows:

*391 Profits; reserve funds - Percentage of net profits permitted for distribution

(a) Every contract for an operating-differential subsidy made under authority of this subchapter shall provide that the contractor shall be entitled to annually withdraw from net earnings of subsidized vessels and services incident thereto as profit, if the contractor is a natural person or a partnership, or may pay to its shareholders or stockholders, as dividends, if the contractor is an association or corporation, a sum not in excess of 10 per centum per annum on the contractor's capital necessarily employed in his business, except subject to the further provisions of this section which likewise shall be incorporated in such contract.

Capital reserve fund; deposits required.

(b) To insure the prompt payment of the contractor's obligations of the United States and the replacement of the contractor's subsidized vessels, as may be required, the contractor shall create and maintain, out of gross earnings, during the life of such contract, a "capital reserve fund", in such depository or depositories as may be approved by the Secretary of Commerce. In this fund the contractor shall deposit annually or oftener, *392 as the Secretary may require, an amount equal to the annual depreciation charges on the contractor's vessels on which the operating differential is being paid, * * * Provided, however, that, if, during any accounting year, the annual depreciation charges of the contractor's line of subsidized vessels has not been earned in whole or in part over and above the annual expense of operation of such vessels (exclusive of said annual depreciation thereon, the contractor shall not be required to deposit in his capital reserve fund for such accounting year a sum in excess of the amount of annual depreciation actually earned during that year but shall make up any and all deficiencies in his capital reserve fund as soon as the earnings of his subsidized vessels in excess of annual expenses of operation shall permit. The proceeds of all insurance and indemnities received by the contractor on account of total loss of any subsidized vessel and the proceeds of any sale or other disposition of such vessel shall also be deposited in the capital reserve fund.

The contractor shall also deposit in the capital reserve fund, from time to time, such percentage of the annual net profits of the contractor's *393 business covered by the contract as the Secretary of Commerce shall determine is necessary to further build up a fund for replacement of the contractor's subsidized ships; but the Secretary shall not require the contractor to make such deposit of the contractor's net profits in the capital reserve fund unless the cumulative net profits of the contractor, at the time such deposit is to be made, shall be in excess of 10 percentum per annum from the date the contract was executed. * * *

Special reserve fund; deposits; disbursements permitted

(c) To attain the public objects for which the financial aid provided for in such contract is extended and to insure the continued maintenance and successful operation of the subsidized vessels, the contractor shall create and maintain, during the life of such contract, a "special reserve fund" in such depository or depositories as the Secretary of Commerce shall approve.

If the profits, without regard to capital gains and capital losses, earned by the business of the subsidized vessels and services incident thereto exceed 10 per centum per annum and exceed the percentage of profits deposited in the capital reserve fund, as provided in subsection *394 (b) of this section, the contractor shall deposit annually such excess profits in this reserve fund. * * *

Rules and regulations for administration of reserve funds; investment of funds

(d) The Federal Maritime Board or Secretary of Commerce shall adopt and prescribe rules and regulations for the administration of the reserve funds contemplated by this section and shall include therein a definition of the terms "net earnings" and the term "capital necessarily employed in the business", as such terms are employed in this section: * * *

Increase and transfer of reserve funds; interest on overpayment of taxes

(g) With the approval of the Secretary of Commerce, the contractor may voluntarily increase the amount of either or both reserve funds by depositing in such fund or funds any or all of the earnings 154 otherwise available for distribution to stockholders, or may transfer funds from the special reserve funds to the capital reserve fund. If a voluntary deposit of earnings approved by the Secretary under this subsection after December 31, 1950, results in an overpayment of Federal taxes for any year, interest shall not be allowed on such overpayment for any period prior *395 to the date of approval of the deposit by the Secretary.

Exemption of reserve funds from taxation

(h) The earnings of any contractor receiving an operating-differential subsidy under authority of this chapter, which are deposited in the contractor's reserve funds as provided in this section, except earnings withdrawn from the special reserve funds and paid into the contractor's general funds or distributed as dividends or bonuses as provided in paragraph 4 of subsection (c) of this section, shall be exempt from all Federal taxes. Earnings withdrawn from such special reserve fund shall be taxable as if earned during the year of withdrawal from such fund. * * *

In addition to the provisions of the Act, and the contracts of New States, Nos. FMB-21 and FMB-62, New States was also subject to the provisions of a closing agreement which became effective in January 1958, as is explained hereinafter.

It is stipulated that on June 10, 1953, and August 3, 1953, Pacific Transport Lines and the Commissioner of Internal Revenue executed a closing agreement as to a final determination covering specific matters under section 3760 of the 1939 Code. This closing agreement was approved by the *396 Acting Secretary of the Treasury on September 3, 1953. The closing agreement relates in part to the tax treatment of deposits into reserve funds with Marad. Essentially, in this regard, the closing agreement provided that "all earnings, including capital gains, (not tax exempt under the Internal Revenue Code), which are deposited in the taxpayer's Reserve Funds, shall be tax-deferred income."

The above closing agreement between Pacific Transport Lines and the Commissioner was in effect on October 22, 1954, when Old States acquired all of Pacific Transport Lines' stock, and also on June 30, 1957, when New States acquired all of the stock of Pacific Transport Lines in the liquidation and merger of Old States into New States.

On or about the date Pacific Transport Lines was liquidated and merged into New States, August 23, 1957, New States filed a request that the closing agreement between Pacific Transport Lines and the Commissioner should be continued with New States as a recognized party in interest. It is stipulated by the parties that on January 14, 1958, the Commissioner notified New States, in response to its request, that the closing agreement between the Commissioner and *397 Pacific Transport Lines was to continue in effect, with New States becoming a recognized party in interest under that closing agreement. In a letter from the Commissioner to New States dated January 14, 1958, the following was stated:

* * * it is the opinion of this office that, as successor to Pacific, States acquired the rights and incurred the obligations of Pacific under Pacific's closing agreement with the Commissioner of Internal Revenue relative to the operating differential subsidy agreement awarded Pacific by the Federal Maritime Board. Accordingly, your understanding that States has become and is recognized as a party-in-interest under said closing agreement is hereby confirmed.

Under the circumstances, the entering into a separate closing agreement by States and the Commissioner will not be necessary.

The closing agreement, executed in 1953 by Pacific Transport Lines and the Commissioner, which continued in effect with respect to New States as of January 14, 1958, provided in part as follows:

I. Definitions As used herein, unless otherwise stated, the following quoted terms shall mean:

(a) "The Act" means the Merchant Marine Act, 1936, or that Act as amended, *398 as the case may be. * * *

(c) "Reserve Funds" mean Capital Reserve Funds or Special Reserve Funds established under and for the purposes stated in section 607 of the Act.

(d) "Tax deferred" or "Tax deferment" referring to ordinary income and capital gains deposited in Reserve Funds means that such items are not to be recognized as taxable income, except as provided in paragraph VI(C) hereof, and likewise are not to be recognized in the determination of cost basis or invested capital.

(e) "Ordinary income" means taxable income other than capital gains. * * * 155

II. Tax treatment of deposits in reserve funds All earnings including capital gains, (not tax exempt under the Internal Revenue Code), which are deposited in the taxpayer's Reserve Funds, shall be tax deferred income; provided, however, that the taxpayer shall not be bound by this commitment beginning with the calendar year in which a decision of any court, sustaining the contention that Section 607(h) of the Act gives a tax exemption, instead of a tax deferment as herein provided, shall become final. * * *

VI. Allocation of deposits in Reserve Funds: * * * (b) Any deposit of income in the taxpayer's Reserve *399 Funds, which is not tax deferred by paragraph I(d) shall be treated as capital for all purposes and shall not be taxed upon withdrawal or otherwise.

(c) Any withdrawal made by the taxpayer from its Reserve Funds, either before or upon termination of its operating-differential subsidy contract with the Administration, shall be taxable as if earned during the year of such withdrawal, to the extent, as determined under subparagraph (a) hereof, that such withdrawal consists of ordinary income or capital gains tax deferred under this agreement.

On June 24, 1952, Marad issued a statement entitled "Maritime Administration Policy on the Approval of Applications for Voluntary Deposits in the Capital Reserve Funds". In this statement the Maritime Administrator, E.L. Cochrane, stated his intention to approve the recommendations of the Working Group on Voluntary Deposit Policy.

The Working Group on Voluntary Deposit Policy had made a study of the merchant marine operating under subsidy agreements with Marad, and the observations and recommendations of the Working Group which were accepted by Marad are, in pertinent part, as follows, pp. 10, 14, 15:

Obviously, the capital reserve funds *400 must be increased. The 1936 Act recognizes the need to build up those funds for replacement purposes. Section 607(g) authorizes voluntary deposits and section 607(h) authorizes earnings voluntarily deposited to be tax free, with certain exceptions. * * *

RECOMMENDATION:

I. After considering all phases of this very important and difficult subject, it is recommended that the Administrator approve voluntary deposits on the basis of the following formula. * * *

D. If there is a deficit between the funds required and the funds available, voluntary deposits be allowed in an amount, which when added to that part of the estimated tax savings on such deposit not subject to recapture, would be equal to such deficit;

E. That subsidized operators be required, whenever possible to make deposits to the capital reserve fund to meet the minimum 25% down payment of replacement ships and be allowed permissive voluntary deposits in an amount sufficient to bring available funds up to 35% of the replacement costs to meet future impairment of capital reserve funds resulting from cyclical periods of depressed profits or operating losses.

By letter dated May 29, 1958, Marad modified its voluntary *401 deposit policy, stating as follows:

Voluntary deposits will be permitted in such amounts (if any) as are required to increase funds available under the foregoing formula to not in excess of (a) 25 percent of replacement costs of those vessels with respect to which replacement obligations have not been assumed by contract and (b) the replacement costs of those vessels with respect to which replacement obligations have been assumed by contract, * * *

On March 18, 1960, New States made a written request to Marad for approval to make a deposit of not less than $1,175,000 and not more than $1,200,000 into its capital reserve fund out of its free earnings for the year 1959. The purpose of the deposit was to provide for reserve funds to pay for the new vessels for which New States had entered into a contract. New States and Marad had entered into a contract with Newport News Shipbuilding & Dry Dock Company for the construction of four Mariner-type vessels on February 29, 1960. In the above request to make the deposit out of free earnings New States set forth its profits from its subsidized operations in 1959 as follows: Loss before subsidy subsidized operations ($2,872,691.50)

Gross subsidy receipts 5,396,172.73

Profit before recapture (subsidized net earnings) $2,523,481.23

Free earnings, 10% of capital necessarily employed 1,349,296.50

Excess profits $1,174,184.73

Less recapture 587,092.37

Company's one-half of excess profits, depositable in special reserve fund upon collection of applicable subsidy $ 587,092.36

*402 By a letter dated July 19, 1960, Marad gave New States its approval to make a deposit into its capital reserve fund out of free earnings in an amount not to exceed $1,200,000. In that letter, it was provided that "in the event said subsidized 'free earnings' (after audit) are less than the amount so deposited, said voluntary deposit shall be reduced to the amount of the actual subsidized 'free earnings' for calendar year 1959 by off-set against future mandatory deposits." On July 26, 1960, pursuant to the approval of Marad, New States deposited $1,175,000 into its capital reserve fund. Although the deposit was made in 1960, it was a deposit of earnings or amounts received by New States in 1959, and the parties are agreed that if the deposit of $1,175,000 is deductible, or excludable, from income, in whole or in part, the deduction or exclusion, is to be taken into account in computing the income of New States for 1959. Likewise, the balance of the $2,074,028.43 in issue, or $899,028.43, is to be taken into account in 1959.

New States made or accrued deposits in 1959 in its reserve funds with Marad in the total sum of $3,487,613, as follows: 1959 depreciation on capital assets $1,410,887.55

Marad adjustments, 1957 and 1958 depreciation 2,696.75

1,413,584.30

Total of several other deposits 2,074,028.43

$3,487,612.73

*403 The parties are agreed that the deposits totaling $1,413,584.30 are not entitled to be treated as tax deferred income, or as exclusions from 1959 income. Those deposits represented deposits of capital.

The deposits in Marad reserves totaling $2,074,028.43 were deposits which were authorized or required as deposits to reserve funds by the Merchant Marine Act. These deposits were made from 1959 subsidized net earnings of New States. The $2,074,028.43 is the sum of the following deposits in 1959 in reserve funds with Marad: 1. Interest earned on deposits in reserve funds $32,563.14

2. Excess profits:

Adjustments of prior years 4,609.61

Year ended Dec. 31, 1959 587,092.36

3. Voluntary deposits 1,175,000.00

4. Depreciation:

Total per books and deposited in reserve funds $1,685,650.87

Less depreciation allowable for tax purposes 1,410,887.55 * 274,763.32

$2,074,028.43

Items 1, 2, and 4, in the above schedule, aggregate $899,028.43: 1. $ 32,563.14

2 4,609.61

587,092.36

4 274,763.32

Total $899,028.43

*404 Respondent has allowed the above deposits of 1959 earnings of $899,028.43 as "deductions" of New States for its taxable year 1959. On the basis of his determinations with respect to claimed deductions of New States for 1959, he has determined that of the so-called voluntary deposits of $1,175,000 of 1959 earnings, the amount of $53,025.43 was not entitled to tax-deferred treatment (i.e., was not an allowable "deduction").

The amount computed by respondent as an unallowable deduction, $53,025.43, was an adjusting figure which brought into balance the 1959 income of New States and the total allowable deductions, so that New States did not have income or loss for 1959, since income and allowed deductions amounted to the same figure, $6,527,894.96. Respondent's explanation of his treatment of $1,175,000 was that the deduction for the deposit would be limited to the extent that the deposit did not exceed the amount of the finally determined taxable income of New States for 1959, computed without any deduction for the deposit of $1,175,000. In the deficiency notice, respondent determined that other deductions were not allowable, deductions for depreciation and the payments of the cargo *405 loss claims, and, therefore, New States had taxable income 157 of $1,121,974.57, without any deduction for the deposit of $1,175,000. He disallowed the deduction for the deposit to the extent of $53,025.43, the excess of $1,175,000 over taxable income of $1,121,974.57. According to respondent's theory, the amount which could be deducted for the deposit is an adjustable figure which depends upon the finally determined amount of New States' income for 1959, determined without any adjustment for the deposit, either as a deduction or exclusion from income.

Respondent has not determined what adjustments would be made if the deductions which he has disallowed are allowed here. For example, the cargo loss deduction claimed by petitioners is in the amount of $1,348,868.39. If this amount is determined to be an allowable deduction here, "taxable income" as determined by respondent, $1,121,974.57, would be reduced to an operating loss figure. In that event, according to respondent's theory, all of the voluntary deposit of $1,175,000 would be in excess of "taxable income" and would be an unallowable deduction. Also, as a logical consequence of respondent's theory of disallowing the "deductions" *406 for deposits to reserve funds to the extent that the adjustment results in a balancing of New States' income for 1959 with its deductions, part or all of the other deposits to Marad reserve funds, totaling $899,028.43, would be disallowed by respondent, if the claimed deductions for cargo loss payments and depreciation in issue are determined here to be allowable deductions and produce a negative "taxable income" or, in other words, an operating loss for New States in 1959. Under respondent's theory, the "deductions" for the deposits of $899,028.43 would be unallowable as deductions to the extent that there was an operating loss, thereby bringing New States' income and deductions into balance for 1959. As the result of respondent's theory and the facts of this case relating to the claimed "deductions" for cargo loss payments attributable to the loss of the Pennsylvania and relating to depreciation deductions, all of the deposits to Marad's reserve funds in 1959 in the amount of $2,074,028.43 are in issue.

New States, in the 1959 return, treated its several deposits for 1959 to Marad reserve funds as deductions from income. A "deduction" of the deposits of $2,074,028.43 appeared *407 to contribute to the net operating loss of New States for 1959, but that treatment was due to an accounting procedure of Marad, and to the method employed in preparing the tax return. However, if the deposit of earnings of $2,074,028.43 to the Marad reserve funds had been treated as an exclusion from New States' income, rather than as a deduction, the 1959 net operating loss of New States would have been the same, $1,431,267.78, as the following schedule shows, and the net operating loss would be the result of operating expenses of the unsubsidized business. Income

Earnings from operations $1,457,543.09

Other income, includ- ing Marad subsidy, $4,809,080.36 5,070,351.87

$6,527,894.96

Less deposit of earnings to Marad capital reserve fund as an ex- clusion of tax-deferred income 2,074,028.43

Total income $4,453,866.53

Deductions * 5,885,134.31

Net operating loss ($1,431,267.78)

*408 During 1959, New States received subsidy payments from Marad in the net amount of $4,809,080.36 under the subsidy contract. New States was obliged to report, and did report, the subsidy payment of $4,809,080.36 in its gross income.

Under Marad's accounting, New States had free earnings in 1959 in the amount of $1,349,296.50. Since it had free earnings in that amount, Marad approved New States' payment of $1,175,000 to the capital reserve fund.

For 1959, New States' gross income was $6,527,894.96, including the subsidy receipts of $4,809,080.36, but its gross taxable income was $4,453,866.53, after the exclusion of the deposits of $2,074,028.43. The deposits of $2,074,028.43 were from subsidized net earnings for 1959, which amount to $2,523,481.23.

Part III, Ch. 1B of Subtitle A, 1954 Code, sets forth various items which are "specifically excluded from gross income", among which are deposits of ship contractors ( section 123(a)(7) ) in special reserve funds with the Maritime Administration (Marad), referred to in section 607(h) of the Merchant Marine Act. For 1959, New States had net *409 subsidized earnings and gross income for the purposes of section 607(h) , Merchant Marine Act, and section 123(a)(7) 158 of the Code, in the amount of at least $2,074,028.43. That amount represented earnings of a ship contractor deposited in special reserve funds under section 123(a)(7) of the Code, and section 607(h) of the Merchant Marine Act.

Ultimate Finding of Fact

The entire amount of the deposit, $2,074,028.43, was excludable from New States' gross income for 1959 as tax-deferred income.

Basis Adjustments under Section 334(b)(2)

New States purchased all of the capital stock of Old States on July 11, 1956, and liquidated and merged Old States into itself pursuant to Nevada law on June 30, 1957. The parties are agreed that this transaction came within section 334(b)(2) , for the purpose of determining the basis of Old States' assets to New States' which provides that in certain circumstances, where the stock of a corporation is acquired by purchase and the assets of the corporation thereafter are distributed to the parent-owner of the stock in a nontaxable liquidation under *410 section 332 , the basis of the property so distributed shall be derived from the basis of the stock interest in the subsidiary, with certain adjustments.

The following assets were among those received by New States in the liquidation of Old States on June 30, 1957, and the parties are agreed that these assets are the equivalent of money, and therefore have a basis equal to value: Cash $ 864,775.13

Accounts receivable 1,399,706.89

Shipping inventories 68,427.70

Spare parts 129,766.96

Prepaid and deferred items 719,347.66

$3,182,024.34

The remaining assets received by New States in the liquidation of Old States and their fair market values on June 30, 1957, were as follows: Assets Received in Liquidation of Old States 6/30/57 FMV

Vessels

4 VC2 AP3's $4,800,000.00

2 C2's 2,500,000.00

Building (Vancouver, Wash.) 86,000.00

Assets Received in Liquidation of Old States 6/30/57 FMV

Land 55,000.00

Pac. Trans. Lines, Inc., stock In issue

Portland Stevedoring Co. stock 615,555.00

Calif. Eastern Lines, Inc., stock In issue

Furniture and fixtures 2,775.00

Automobiles 7,844.00

The parties are agreed that the following amounts *411 and adjustments were properly computed under the statute and regulations:

(1) The original acquisition cost to New States of the capital stock of Old States, on July 11, 1956, was $11,108,843.43. This sum includes legal expenses of $58,843.43 incurred in connection with the purchase of that stock.

(2) The basis of the Old States stock should be reduced in the amount of $300,000 for dividends paid to New States by Old States before Old States was liquidated on June 30, 1957.

(3) The basis of the Old States stock to New States should be reduced by $3,182,024.34, which represents "money received".

(4) The basis of the Old States stock to New States should be increased by $2,061,520.96, which is the sum representing "liabilities assumed or subject to which the property was received." This amount does not include the payment in 1959 for the S.S. Pennsylvania cargo loss claims.

(5) The basis of the Old States stock should be increased by $744,943.86 for the interim earnings and profits of Old States for the period from July 11, 1956, to June 30, 1957.

(6) The basis to New States for the stock of Old States should be reduced by $119.80 of the interim earnings and profits deficit *412 of Quaker Line, Inc., for the period from July 11, 1956, to June 30, 1957.

(7) The basis to New States for the stock of Old States should be increased by $45,362.68 for the interim capital gains realized by Old States for the period from July 11, 1956, to June 30, 1957.

Thus the parties are agreed that the basis of the Old States stock to New States, after all adjustments, is at least $10,478,526.79 as shown by the following schedule: Adjusted basis of Old States (subsidiary) stock held by New States (parent) - cash purchase 7/11/56 - 334(b)(2) $11,108,843.43

Cash dividend distribution by Old States to New States between 7/11/56 and 6/30/57 - 1.334-1(c)(4)(ii) $ 300,000.00

"Money" (i.e., cash, accts. receivable, inventories, etc.) re- ceived byNew States - 1.334-1(c)(4)(v)(b)(1) 3,182,024.34

159 Liabilities of Old States assumed by New States (excluding S.S. Penna. loss payments) - 1.334-1(c)(4)(v)(a)(1) $ 2,061,520.96

Interim (7/11/56 to 6/30/57) earnings and profits of Old States - 1.334-1(c)(4)(v)(a)(2) 744,943.86

Interim (7/11/56 to 6/30/57) earnings and profits (Deficit of Quaker Line) - 1.334-1(c)(4)(v)(b)(2) $ 119.80

Interim (7/11/56 to 6/30/57) capital gains realized by Old States - 1.334-1(c)(4)(vii)(a) 45,362.68

$3,482,144.14 $13,960,670.93

-3,482,144.14

$10,478,526.79

*413 Three questions remain in issue with respect to the determination of the basis, under section 334(b)(2) , and the regulations, of assets received by New States in the liquidation and merger of Old States into New States, as follows:

(1) The fair market value of 1,202 shares of California Eastern Lines stock, out of a total of 2,276, on June 30, 1957, the date New States received the 1,202 shares of stock in the liquidation and merger of Old States.

(2) The fair market value of all of the stock of Pacific Transport Lines on June 30, 1957.

(3) Whether the basis of Old States' stock in the hand of New States should be adjusted for the earnings and profits of Old States, and of its three subsidiaries, Pacific Transport Lines, Portland Stevedoring Co., and California Eastern Lines, for the interim period between the date of the acquisition of all of Old States' stock on July 11, 1956, and the date of the liquidation and merger of Old States on June 30, 1957; or whether the basis of Old States' stock in the hands of New States should be adjusted only for the interim earnings and profits realized by Old States.

During the period July 11, 1956, to June 30, 1957, the subsidiaries *414 of Old States realized earnings and profits as follows: Subsidiaries Earnings and Profits

Pacific Transport Lines $1,772,148.01

Portland Stevedoring Co 126,303.49

California Eastern Lines 31,980.39

$1,930,431.89

Quaker Line, Inc (loss) (119.50)

Total $1,930,312.39

Petitioners, in their schedules, have increased the adjusted basis of the Old States stock to New States by the aggregate amount of net earnings and profits of all of the subsidiaries. Respondent has disallowed the claimed adjustment for the interim earnings and profits of Pacific Transport Lines, Portland Stevedoring, and California Eastern Lines.

Among the assets received by New States on June 30, 1957, were 1,202 shares of California Eastern Lines' stock. It is stipulated that on July 11, 1956, California Eastern Lines had 2,753 shares of its stock issued and outstanding, of which 1,202 shares were owned by Old States; that after July 11, 1956, California Eastern Lines offered to redeem its stock at $136.50 per share, except the shares owned by Old States; and that between June 18 and June 30, 1957, 477 shares were so redeemed, so that on June 30, 1957, Old States owned 1,202 shares *415 out of the total of 2,276 outstanding shares of California Eastern Lines.

It is stipulated that on June 30, 1957, the assets of California Eastern Lines consisted only of cash, United States Government securities, and interest accrued thereon; and that California Eastern Lines' liabilities on that date, June 30, 1957, consisted solely of accrued Federal income taxes.

It is also stipulated that on June 30, 1957, the fair market value of the assets of California Eastern Lines was $323,092.

When New States received all of the stock of Pacific Transport Lines on June 30, 1957, Pacific Transport Lines was operating as a subsidized carrier under an operating-differential subsidy agreement with Marad. Included among the assets of Pacific Transport on June 30, 1957, were deposits with Marad of tax-deferred earnings, in the amount of $1,220,583.71. These funds could be withdrawn and used only with the permission of Marad, and any such withdrawals would be included in taxable income for the year of withdrawal, except to the extent they were used, with the approval of Marad, for the purchase of vessels for use in subsidized operations. Up to June 30, 1957, Pacific Transport Lines had made *416 withdrawals, with the approval of Marad, from its tax-deferred reserve accounts with Marad, in the 160 aggregate amount of $2,640,928.43, of which the sum of $2,420,294.35 continued to be tax deferred as of June 30, 1957, because it was invested in subsidized vessels. Assets of Pacific Transport Lines in the total amount of $3,640,878.25 (the total of $2,420,294.54 invested in subsidized vessels, and $1,220.583.71 on deposit in reserve accounts with Marad) represented earnings or income of the subsidized operator which had not been taxed as of June 30, 1957, and which was subject to a potential income tax liability on June 30, 1957.

When Old States was liquidated and merged into New States on June 30, 1957, all of the assets of Old States were distributed or transferred to New States. Among the assets received by New States in the liquidation of Old States were the earnings and profits realized by Old States during the interim period between July 11, 1956, and June 30, 1957, (less the amount of any distribution therefrom made by Old States during that period). New States also received from Old States the stock of Pacific Transport Lines, Portland Stevedoring Co., and California *417 Eastern Lines which was held and owned by Old States as of June 30, 1957. The interim earnings and profits realized by Pacific Transport Lines, Portland Stevedoring Co., and California Eastern Lines during the interim period between July 11, 1956, and June 30, 1957, were not distributed to New States on June 30, 1957, when Old States was liquidated and merged into New States.

Between the period July 11, 1956, and June 30, 1957, Pacific Transport Lines realized earnings and profits in the amount of $1,772,148.01. The fair market value as of June 30, 1957, of the stock of Pacific Transport Lines held by Old States on that date is in dispute. The fair market value as of July 11, 1956, of the stock of Pacific Transport Lines held by Old States is also in dispute.

Portland Stevedoring Co. realized earnings and profits for the period July 11, 1956, to June 30, 1957, in the amount of $126,303.49. The fair market value of the stock of Portland Stevedoring Co., held by Old States on July 11, 1956, was $688,792; and the fair market value, as of June 30, 1957, of the Portland Stevedoring Co. stock held by Old States immediately prior to its liquidation and merger into New States, was $615,550.

*418 California Eastern Lines realized earnings and profits for the period July 11, 1956, to June 30, 1957, in the amount of $31,980.39. On July 11, 1956, the 1,202 shares of California Eastern Lines stock, owned by Old States, had a fair market value of $145,948. The fair market value as of June 30, 1957, of the 1,202 shares of California Eastern Lines held and owned by Old States as of that date is in dispute.

Ultimate Findings of Fact

The basis of Old States' stock in the hands of New States should be adjusted only for the interim earnings and profits of Old States in the amount of $744,943.86, and it should not be adjusted for the interim earnings and profits of Pacific Transport Lines, Portland Stevedoring Co., and California Eastern Lines.

The fair market value of the 1,202 shares of stock of California Eastern Lines was $170,631, as of June 30, 1957, when the stock was received by New States in the liquidation and merger of Old States and the transfer of Old States' assets to New States.

The fair market value of the shares of stock of Pacific Transport Lines was $14,001,505 as of June 30, 1957, when the stock of Pacific Transport Lines was received by New States from Old *419 States.

Opinion

Most of the questions for decision involve New States, called States Line when it was organized. For the taxable period January 1 to September 9, 1957, New States was a parent corporation having four subsidiaries. A consolidated return was filed for the group. Prior to 1959, New States had become a subsidiary of Pacific Transport Company, and for the period September 10 to December 31, 1957, and for the calendar years 1958 and 1959, the affiliated group was Pacific Transport Company and four subsidiaries, including States Steamship Company, and consolidated returns were filed for those periods.

The respondent determined income tax deficiencies for the three taxable periods, 1/1/57-9/9/57, New States, Docket No. 2825-65, $785,465.44; 1/1/57-9/9/57, Pacat, Docket No. 2824-65, $9,209.21; and for Pacific Transport Co., Docket No. 2823-65, 9/10/57-12/31/57, $52,253.01, and for 1958, $63,379.14. 161

The deficiencies for each of the taxable periods result in the larger part from respondent's determinations that for the year 1959, New States, a subsidiary of Pacific Transport, was not entitled to deductions totaling $1,431,267.78 and, therefore, New States did *420 not have any net operating loss. Those determinations, in turn, reduced the 1959 net operating loss of the affiliated group from the reported amount of $1,455,802.07 to $24,534.29. Therefore, the available operating loss for 1959 for carrybacks to earlier years was only $24,534.29, and respondent disallowed in whole or in part claimed deductions for loss carrybacks to 1957 and 1958. Other determinations which are in dispute have raised questions which are set forth hereinafter.

After the 1959 consolidated return was filed, deductions were claimed by New States, Pacific Transport, and Pacat for loss carrybacks of the net operating loss of $1,455,802.07, as follows, which respondent disallowed in whole or in part: Petitioner Taxable Period 1959 Loss Carryback

States S.S. Co. Jan. 1 to Sept. 9, 1957 $1,276,460.94

Pac. Transport Sept. 10 to Dec. 31, 1957 158,824.37

Pac. Transport Jan. 1 to Dec. 31, 1958 48,964.48

Pacat Jan. 1 to Sept. 9, 1957 20,516.76

Total * $1,504,766.55

*421 The determination that New States did not have a net operating loss for 1959 results from his determinations that New States was not entitled to receive a deduction of $1,348,868.39 for its payment in 1959 of that amount to the owners of cargoes aboard the S.S. Pennsylvania when it was lost in a storm at sea; and that New States also was not entitled to receive a deduction for its deposit of $1,175,000 to its capital reserve fund held by the Maritime Administration, Marad, which was made under the Merchant Marine Act of 1936, except as adjusted so that there would not be any net operating loss.

Most of the determinations of the respondent involving the 1959 net loss of New States totaling $1,431,267.78 are in issue unless his determinations were barred by the statute of limitations, excepting those now conceded by petitioners if the statute of limitations issue is decided for the respondent.

Issue 1. Statute of Limitations

The statutory notices of deficiencies in all of these cases were mailed on February 26, 1965. As of that date, the respondent could not make a determination of *422 a deficiency in the 1959 income tax liability of Pacific Transport and its subsidiaries because of the bar of the statute of limitations in section 6501(h) , 1954 Code. On this point, the parties are in agreement.

It is a fact, of course, that the respondent's determinations disallowing certain deductions taken on the 1959 consolidated return were not made for the purpose of determining that there was a deficiency in the income tax liability of the affiliated group for 1959, and that there remained a net operating loss of the affiliated group in the amount of $24,534.29 after the respondent's determination that New States, one member of the affiliated group, did not sustain a net operating loss in any amount and, also, did not realize any taxable income.

The taxable periods in 1957, and the taxable year 1958, were open tax periods as of February 20, 1965, because the parties had executed timely consents extending the period of limitations. Therefore, the respondent was not barred from making the determinations of the tax deficiencies which resulted in the filing of the petitions in these cases. Among those determinations were the determinations that claimed deductions, for the taxable *423 periods involved here, for loss carrybacks from 1959 were not allowable either for the whole amount claimed, or for part thereof. The ground for those determinations was that the 1959 net operating loss was not more than $24,534.29, rather than $1,455,802.07.

Petitioners contend that since 1959 was a barred or closed year, the respondent was barred from making recomputations of the amount of the income, or loss, for 1959, of any of the affiliated corporations whose income or loss was reported in the 1959 consolidated return, for the purpose of making determinations of the amount of any allowable net operating loss carrybacks from 1959. Petitioners cite Edward G. Leuthesser 162 18 T.C. 1112 (1952) in support of their contention.

This Court's reasoning and conclusions in State Farming Co., 40 T.C. 774 (1963) are applicable here, and are dispositive of petitioners' contentions. It was held in State Farming Co. that the Commissioner could recompute the amount of a taxpayer's income or loss for a closed year where such computation was for the purpose of ascertaining *424 what amount, if any, of net operating loss of a closed year was available for carrying over or carrying back to an open taxable year. We pointed out in State Farming Co., supra, pp. 781-783 , that "[recomputations] of barred years' income for determinations of net operating loss carrybacks have been upheld as proper", citing Phoenix Coal Co. v. Commissioner, 231 F. 2d 420 (C.A. 2), affirming a Memorandum Opinion of this Court, and Commissioner v. Van Bergh, 209 F. 2d 23 (C.A. 2). We stated, further, that this Court "may consider such facts of other years as may be necessary to a proper determination of a deficiency for an open year. * * * If petitioners had income in 1952, we may consider that fact in determining a deficiency for the open years of 1953 or 1955."

In these cases, respondent's determinations with respect to the closed year 1959 were only for the purpose of ascertaining whether there was a net operating loss for 1959, and the amount thereof, which could be carried back to the open taxable periods, 1957 and 1958, so as to be deducted *425 from the income of those taxable periods. Under the reasoning of State Farming Co., supra , and the cases cited there, it is held that respondent was not barred by the statute of limitations from recomputing the amount of the 1959 net operating loss of Pacific Transport and its subsidiaries; and that he was not barred from making the determinations involving the deductions claimed by New States so as to ascertain the correct amount of the net operating loss of New States for 1959, if any.

Consideration has been given to Edward G. Leuthesser, supra, cited by petitioners, and to petitioners' argument, but it must be concluded that Leuthesser, on its facts, is distinguishable from these cases.

Issue 2: Payment by New States in 1959 of Judgment for Cargo Lost on S.S. Pennsylvania in 1952

In 1959, New States paid $1,445,394.22 in settlement of a judicially determined liability for cargo lost when the S.S. Pennsylvania sank in the Gulf of Alaska in 1952. The payment represented $1,348,868.39 in settlement of claims, and $96,525.83 interest to the date of payment. Upon reviewing the 1959 consolidated return, reporting a net operating loss for 1959, respondent concluded *426 that a deduction for interest in the above amount was allowable in determining whether New States realized income or sustained a net operating loss in 1959; but he concluded that $1,348,868.39 could not be treated as a loss, deductible in full from the income of New States for 1959, and that this amount represented a capital expense to be allocated among capital assets of New States. That conclusion, along with others in issue, resulted in the determination that New States did not sustain a net operating loss for 1959, and carrybacks of a claimed net operating loss were disallowed, contributing to the deficiencies for the taxable years.

The ultimate question is whether the expenditure in 1959 represents a fully deductible loss for the purpose of computing the amount of New States' alleged net operating loss for 1959, if any, or was a capital expense to be included in the basis of certain assets of New States. If it is held that the expenditure was not a capital expense, there will not be another issue involving the allocation of such expense to and among certain assets.

The S.S. Pennsylvania was an asset of and was operated by Old States in 1952. One aspect of the general issue *427 relates to New States' assumption of all of the liabilities of Old States as of June 30, 1957, when New States was in the process of acquiring the assets, and the liabilities, of Old States.

It is respondent's position that the liability in excess of insurance paid by New States was a capital expenditure because it was a liability of Old States which arose in January, 1952, when the S.S. Pennsylvania sank while being operated by Old States. He asserts that the key fact is that the liability arose during the course of Old States' business operation, and, though it was not fixed and determined in amount in 1957, during Old States' corporate existence, was Old States' liability, even though a contingent one. He recognizes that $1,348,868.39 163 was an amount in excess of the amount which could or would be paid under Old States' insurance coverage of a liability for loss of cargo. Respondent argues that New States assumed all of the possible liability for cargo losses when it acquired the assets of Old States on June 30, 1957, even though a possible liability for an amount in excess of insurance was a contingent liability at that time, and that therefore the amount paid in 1959 constituted *428 part of the cost of acquiring Old States and therefore should be capitalized. He argues that it could not be a deductible expense in 1959 because it was not connected with New States' operating expenses since the alleged liability arose prior to New States' existence.

Respondent argues that it makes no difference whether the liability for the cargo losses, as finally determined by judicial determinations, was an undetermined or unknown liability at the time New States acquired Old States' stock on July 11, 1956, or when it acquired the assets of Old States and assumed its liabilites on June 30, 1957. In other words, he takes the position that it makes no difference whether New States or its executives (particularly J.R. Dant took into account an amount or any amount for a contingent liability in determining the amount of their bid to Blyth for Old States' stock, which was accepted by Blyth. He contends that it makes no difference whether the purchaser of the stock of New States discounted or made any adjustment in the amount of the bid submitted, with respect to any amount for a contingent liability for cargo losses. He argues that the understanding or "intent" of the parties to *429 the sale is irrelevant in the determination here of whether the expenditure in 1959 was or was not a capital expenditure. He argues that if the final liability arose during the operations of the predecessor corporation, it is nevertheless part of the cost of New States' acquisition of Old States' assets no matter how contingent and speculative the particular liability of Old States was when that corporation and its assets were acquired by New States.

Respondent relies principally upon Holdcroft Transportation Co. v. Commissioner, 153 F. 2d 323 (C.A. 8, 1946), affirming a Memorandum Opinion (1945) of this Court.

Petitioners contend that the cargo loss liability and the amount thereof, in excess of the insurance coverage and beyond the limited liability of Old States under statutes, was so contingent and speculative at the time Old States' stock was purchased from Blyth that in fact it was not taken into consideration by the purchaser in the determination of the amount of its bid, and therefore cannot be regarded as part of cost. They argue that the decision of the District Court, which preceded the purchase of the Old States' stock, affirmatively held that there would *430 be no liability for the cargo losses in excess of applicable insurance coverage and therefore the management of the new corporation, New States, particularly J.R. Dant, believed that the dollar amount of the bid for Old States' stock need not be discounted or adjusted for the cargo claims, and that, in fact, the amount of the bid which was accepted by Blyth was not discounted for such liability. Petitioners argue that the amount of the liability, and the liability in excess of insurance, which was paid in 1959, nearly two years subsequent to the assumption of Old States' liabilities, was so speculative, contingent, and unexpected, that it should not be considered as part of the cost of acquiring Old States, but, instead, must be held to have been a deductible loss in 1959, when the liability was judicially and finally fixed both as to amount and as a legal obligation.

Petitioners recognize that, in part, section 334(b)(2) of the Code governs the transactions of July 11, 1956, and June 30, 1957, in which Old States' assets were acquired and its liabilities assumed by the process of acquiring Old States' stock and subsequently acquiring its assets upon its liquidation. They point out *431 that section 334 (b)(2) deals with the basis of assets received by an acquiring corporation in transactions qualifying under that section and they argue that Holdcroft Transportation Co. v. Commissioner, supra , is distinguishable because it did not involve a situation governed by section 334(b)(2) .

Petitioners also argue that section 334(b)(2) (and its regulations) does not specifically provide that the basis of assets received in the liquidation of a subsidiary should be adjusted for contingent liabilities, and that if contingent liabilities are required to be added to the aggregate basis of the assets acquired, and then allocated to the assets received upon liquidation when that liability does subsequently accrue, upon becoming fixed and determined in amount, then tremendous accounting difficulties would result, such as recomputation of the bases of the assets received; recomputation of gain or loss on the sale or exchange of assets disposed of during the interim period 164 prior to the addition and allocation of the amount of the subsequently determined liability to bases of assets received; and the recalculation of allowable depreciation on depreciable or amortizable *432 assets received during the interim years.

Petitioners have made an alternative argument: That the transaction involving the acquisition of Old States' assets and the assumption of its liabilities was a statutory merger under Nevada law, which was a qualified reorganization under section 368 (a)(1)(A) ; and that New States was entitled to carry over the loss deduction, which Old States would have been entitled to for the cargo loss liability if it had remained in existence until the time when the liability finally became fixed and determined in amount. They contend that section 381(a)(2) provides that where a transaction qualifies as a statutory merger under section 368(a)(1)(A) , the acquiring corporation is entitled to carry over the items of the acquired corporation which are described in section 381(c) . They argue that section 381 (c)(16) is applicable to the situation here and operates to allow New States a deduction for the contingent cargo loss liability which they contend did not accrue until after the acquisition, where, as is required in section 381(c)(16) , there was no adjustment or discount in price for the contingent liability. 2 Respondent contests petitioners' reliance *433 on section 381(a)(2) and section 381(c)(16) , pointing out that section 381 (a)(1) specifically prohibits the application of section 381(c) to transactions involving liquidations of subsidiaries where the bases of assets received are determined under section 334(b)(2) , and he also points out that section 381(a)(2) allows that the items described in subsection (c) of section 381 can carry over only in reorganizations such as a section 368(a)(1)(A) reorganization, where section 361 applies. Respondent argues that section 361 (relating to the nonrecognition of gain or loss) applies where a corporation, a party to a reorganization, exchanges its property solely in exchange for stock or securities in another corporation, a party to the reorganization, and that, here, Old States exchanged its property in the liquidation of June 30, 1957, for its own stock, not the stock of another corporation. 3 Respondent argues, therefore, that New States does not qualify under either section 381(a)(1) or section 381(a)(2) for the application of section 381(c)(16) .

*434 Because the parties have discussed at great lengths petitioners' alternative argument described immediately above, it will be dealt with briefly, even though we feel 165 it is apparent that petitioners' argument is without merit.

It has been stipulated that Old States was "liquidated and merged" into New States on June 30, 1957. And there is ample evidence in the record to the effect that the subsidiary, Old States (being a subsidiary since July 11, 1956, when New States purchased all of Old States' stock from Blyth) was merged into New States on June 30, 1957, pursuant to the Nevada merger statute, section 78.540 of the Nevada Revised Statutes , and the merger, therefore, was a statutory merger under Nevada law.

Given the fact that this was a statutory merger under State law, and without deciding whether it was a statutory merger within the meaning of section 368(a)(1)(A) , it is nevertheless clear that the transaction of June 30, 1957, was not a reorganization described in section 381(a)(2) which would allow the items described in section 381(c) , and specifically section 381(c)(16) , to carry over from Old States to the acquiring corporation, New States. *435 Section 381(a)(2) provides for the application of section 381(c) in various types of reorganizations (as described in section 368(a) ) to which section 361 applies. Section 361 provides for nonrecognition of gain or loss to a corporation, a party to a reorganization, which transfers its property solely in exchange for the stock or securities of another corporation, a party to the reorganization. When Old States was merged into New States, pursuant to Nevada statute, its property was distributed to New States in exchange for its own stock (i.e., Old States' stock which New States had purchased) in the process of liquidation and dissolution of Old States. Old States did not receive the stock of another corporation. Upon the receipt of its own stock in exchange for its property, Old States' stock was canceled and the corporation was dissolved. It is apparent then that section 361 does not apply in this situation, and that the transaction resulting in the "liquidation and merger" of Old States does not qualify for carryover of the tax attributes *436 listed in section 381(c) from Old States to New States. In this regard, it is well to note that section 1.381(a)-1(b)(ii), Income Tax Regs. , reiterates what is provided in section 381(a)(2) of the statute and specifically provides that a statutory merger qualifying for treatment under section 381 must be:

(ii) A statutory merger or consolidation qualifying under section 368(a)(1)

(A) to which section 361 applies; And, as we have discussed above, section 361 does not apply to the transaction of June 30, 1957.

Section 1.368-2(a), Income Tax Regs. , also is enlightening with respect to the question of whether the transaction constituted a reorganization qualifying under section 381 (a)(2) so that the tax attributes of Old States, specifically those items referred to and described in section 381(c)(16) , carry over to New States. Petitioners have argued that the transaction was a statutory merger under Nevada law and that it qualifies as a statutory merger within the meaning of section 368(a)(1)(A) . In section 1.368-2(a) of the regulations, *437 with respect to the meaning of the term "reorganization" as used in section 368(a) , the following is provided:

§1.368-2 . Definition of Terms. - (a) The application of the term "reorganization" is to be strictly limited to the specific transaction set forth in section 368(a) . The term does not embrace the mere purchase by one corporation of the properties of another corporation, for it imparts a continuity of interest on the part of the transferor or its shareholders in the properties transferred. (Emphasis supplied.)

The parties are agreed that the acquisition of Old States and the assumption of its liabilities is governed, in part, by the basis provisions of section 334(b)(2) . Section 334(b)(2) is the codification in the 1954 Code of the holding of this Court in Kimbell-Diamond Milling Co., 14 T.C. 74 (1950) , affirmed per curiam 187 F. 2d 718 (C.A. 5, 1951), cert. den. 342 U.S. 827 , where it was concluded that where a corporation acquired stock of *438 another corporation with the purpose of liquidating that other corporation to acquire its assets, the transaction, in substance, constituted a purchase of the acquired corporation's assets, and, consequently, it was held that the basis of the assets so acquired was equivalent to the cost of acquiring the predecessor corporation's stock. 4 The Court 166 treated the essentially two-step transaction (consisting of (1) the purchase of the subsidiary's stock and (2) the acquisition of its assets and properties upon liquidation) as in substance and effect, an outright purchase of the acquired corporation's assets.

*439 In the instant cases we view the purchase of Old States' stock on July 11, 1956, from Blyth, and its liquidation and distribution of its assets on June 30, 1957, events which the parties are agreed is controlled by section 334(b)(2) , as essentially a purchase of Old States' assets.

The two steps occurring July 11, 1956, and June 30, 1957, were in substance, one transaction constituting a purchase. See The South Bay Corporation v. Commissioner, 345 F. 2d 698 (C.A. 2, 1965), reversing in part sub nom. Utilities & Industries Corporation, 41 T.C. 888 (1964) , Argus, Inc., 45 T.C. 63 (1965) , and Kimbell-Diamond Milling Co., supra. In The South Bay Corporation v. Commissioner, supra , the Court of Appeals for the Second Circuit set forth a test for determining whether an acquisition of another corporation is a purchase or an acquisition in connection with a reorganization, when it stated the following, p. 703:

When, as here, the transaction presents the determining elements of a change in ultimate ownership and an initial *440 purpose or intention to acquire assets rather than stock as such, each intermediate stage to the final end is not to be given the separate tax significance that belongs only to self complete business transactions, but the full transaction is to be weighed in its overall terms for its tax characterization. (Emphasis supplied.)

Applying this test, it is clear that there was a change in ultimate ownership of Old States when New States acquired it from Blyth on July 11, 1956, and it is clear that there was an intent to acquire the assets case to the District Court; 259 F. 2d 463 . rather than the stock of Old States, for the parties have stipulated and agreed that it was Mr. Dant's plan of acquisition that New States would dissolve Old States and acquire its assets within the two years after the purchase of Old States' stock contemplated by section 334(b)(2) of the Code. It is therefore concluded that the transaction was essentially a purchase of Old States' assets from Blyth, and that "each intermediate stage to this final end is not to be given separate tax significance." The liquidation and merger of Old States on June 30, 1957, was one of the two-step transaction which *441 is not to be regarded as of independent tax significance. Although there was a reorganization or merger within the framework of Nevada's statute, it will not be given recognition as a section 368 (a)(1)(A) reorganization for the purposes of qualifying under section 381(a)(2) for the carryover of Old States' contingent liability for cargo losses under section 381 (c)(16) . The transaction was essentially a purchase and not a reorganization qualifying under section 381(a)(2) , and our analysis of the question whether the cargo loss payment in 1959 was a capital expenditure or a deductible loss will proceed hereinafter on this basis.

With respect to the purchase of Old States by New States, the question remains whether the sum paid in satisfaction of the contingent liability, which did not accrue 167 until almost two years after the acquisition process was completed with the "liquidation and merger" of Old States into New States on June 30, 1957, was a part of the cost of acquiring Old States, or whether it was a deductible loss of New States in 1959. After having given careful consideration *442 to all of the arguments of the parties, it is our judgment that the payment in the amount of $1,348,868.39 was a loss deductible by New States in 1959, rather than a capital expenditure.

We cannot accept respondent's contention that if the liability arose out of the business operations of the acquired corporation, it is part of the cost of acquisition when subsequently paid, regardless of the purchaser's understanding or awareness of the contingent liability, and regardless of whether it is unknown or so speculative that the bid which is accepted, or the purchase price which is agreed upon by the vendor and vendee, is not discounted or adjusted on account of the liability. We cannot agree that an unexpected liability stemming from activities of an acquired corporation, which becomes fixed and determined in amount subsequent to the acquisition, is, as a matter of law, a capital expenditure even though the liability has not been taken into consideration by the parties to the sale in the determination of the consideration to be exchanged for the corporation acquired. In our opinion, *443 the understanding of the parties to the transaction, or, as it has been described on brief, their "intent" as to the purchase price is relevant to the question. See, for example, the case cited by petitioners, Eaton v. Commissioner, 81 F. 2d 331 (C.A. 9, 1936) affirmed 95 F. 2d 628 (C.A. 9, 1938). In Eaton, the determination of whether payments made by the taxpayer subsequent to the purchase of a farm were deductible losses or capital expenditures depended upon the intent of the taxpayer on the date of purchase. The question was whether the taxpayer at the time of purchasing the farm intended to destroy certain apple trees on the property acquired. If this were his intention on the date of acquisition, then the amounts were to be treated as a capital expenditure. If this was not his intention at that time, then the amounts expended were to be treated as deductible losses. Where there was no finding of this Court with respect to taxpayer's "intent" the Court of Appeals for the Ninth Circuit remanded the case, stating the following:

It is apparent from a reading of these excerpts from the opinion of the *444 Board of Tax Appeals that it did not expressly find was was the intention of the taxpayer at the time he purchased the apple and pear orchard * * *. But, as stated by counsel, the question was the intention in the mind of the taxpayer at the time he made the purchase. There is no finding of fact upon this issue.

See also United States v. Minneapolis St. Louis Railway Co. 260 F. 2d 663 (C.A. 8, 1958), where payments in settlement of a wage dispute by the acquiring corporation, though the payments represented wages of the railroad workers for a period of time that they were working for the predecessor-acquired corporation, were held to be a deductible expense and not part of the cost of acquisition. One of the facts considered by the District Court in making its determination was that there was not "the slightest indication that any settlement of the dispute was given consideration by the parties in arriving at the sales price." It is clear that the court there considered the intent or understanding of the parties with respect to what constituted the purchase price as relevant to the question of whether the payments made by the acquiring corporation are capital expenditures *445 or deductible expenses. Therefore, we feel it is relevant to the question of the nature of the cargo loss payments that they were not expected to accrue as a liability payable by New States out of its own corporate funds and that the purchase price of Old States was not discounted or adjusted to take into account the liability because it was not expected to result in a liability in excess of insurance.

We think it should be noted that Minneapolis St. Louis Railway Co. also cast some doubt on respondent's fundamental premise that if expenditures are made by the successor corporation for expenses connected with the operations of the predecessor corporation, they must, of necessity, be an element of cost, because they are not operating expenses of the successor. In Minneapolis the successor paid for wages, retroactive to a date prior to the acquisition for work performed by railway workers during the course of the predecessor's business operations. Nevertheless, the costs, not arising out of the successor's business operations, were held to be deductible expenses, not capital expenditures.

Other cases cited by respondent and petitioners have been considered, and it is our judgment *446 that they are not applicable 168 to the facts involved here. Holdcroft Transportation Co., supra , relied on extensively by respondent, is distinguishable because it dealt with an incorporation of a partnership in a tax-free transaction. In that case the basis of the partnership assets carried over to the enterprise in its corporate form. In addition, at the time of the incorporation it was quite evident that a monetary liability would be incurred by the successor corporation, a judgment, although not final, having been rendered against the partnership or its partners prior to the acquisition. Moreover, it does not appear that the tort liability was covered by insurance. In the instant cases we are not concerned with a tax-free incorporation or reorganization with a carryover of basis. As we have discussed above, we are dealing with a factual situation which is, in substance, a purchase of Old States' assets from Blyth. It was not a tax-free transaction, Blyth without question recognizing gain or loss on the sale of Old States' stock. The bases of Old States' assets do not carry over to New State, but rather new bases of the assets received are determined under section *447 334(b)(2) , depending upon their cost, as adjusted for earnings and profits, and distributions of the acquired corporation during the interim period between the acquistion of its stock and the liquidation and distribution of its assets to the acquiring corporation. Moreover, in the instant cases, in contrast to Holdcroft, there was insurance which appeared, at the time of purchase, to adequately cover the potential liability, and there were favorable decisions which appeared to limit the liability for the cargo losses to less than the applicable insurance.

Recognizing that we are dealing with a purchase involving essentially a two-step transaction, we think that the principles set forth by this Court in Albany Car Wheel Co., 40 T.C. 831 (1963) , affirmed 333 F. 2d 653 (C.A. 2, 1964), are applicable here in regard to the question of whether contingent liabilities incurred or assumed in connection with the purchase of another corporation are capital expenditures or deductible expenses. Albany Car Wheel Co. involved the direct purchase of the operating assets of a predecessor company, and does not involve the application of section 334(b)(2) . In these cases, *448 the assets were acquired by the indirect approach of acquiring the subsidiary's stock and liquidating it. Nevertheless, both cases involve essentially the purchase of the assets and for this reason we consider Albany's principles applicable here. In Albany Car Wheel Co., where the petitioner purchased its predecessor corporation's assets, the purchase price consisted of cash and the assumption of certain specified liabilities and obligations. In addition, with respect to an obligation of the predecessor-acquired company for vacation, holiday, and severance pay and pensions under a union collective bargaining agreement, the taxpayer, in making its offer to purchase the predecessor company, provided that it would negotiate an agreement with the union releasing the predecessor from obligations to its employees under the collective bargaining agreement. In the petitioners' offer to purchase, which was accepted, it was provided, in part, as follows, p. 834:

* * * and the New Corporation shall deliver to the Company a document executed by the Union evidencing a full and complete release of any and all obligations to the Union or the members thereof, including any obligation with respect *449 to vacation, holiday, and severance pay and pensions, whether accrued or not. * * *

In negotiating for the release, and in consideration for the release, the petitioner executed a new and different agreement with the union which made petitioner's obligations for severance pay contingent upon lack of sufficient advance notice to employees of the termination of work. It was petitioner's position that the contingent obligation for severance pay was part of the cost of acquiring the predecessor and that an amount for the contingent liability should be added to the bases of the assets acquired. With respect to whether an amount for the contingent liability for severance pay should be considered a part of the cost of acquiring the predecessor, this Court stated the following, pp. 839-841:

The starting point in this case is section 1012 of the 1954 Code which provides that "The basis of property shall be the cost of such property * * * [except in certain situations not applicable here]." Accordingly, the decisive question before us is: What did petitioner pay for the assets that it acquired from the Old Co.?

According to the stipulation of facts and the evidence before us, petitioner *450 paid $15,000 in cash on a note to the Old Co., and assumed certain specified liabilities of the Old Co. in the net amount of $74,360.35. The Commissioner insists that 169 the sum of these two figures, namely, $89,360.35, represents the "cost" of the assets purchased. Petitioner, on the other hand, claimed a cost of $137,543.95, 4 which was the book value of the assets in the hands of the Old Co. Petitioner undertook to support its higher cost basis by contending that, in addition to the foregoing $89,360.35 which it paid for the assets in the manner described, it also assumed an obligation of the Old Co. for severance pay to its employees under a union contract, that such obligation was equal to at least the difference between the $89,360.35 and the book value of the assets in the hands of the Old Co., and that it therefore represented an additional item cost for the assets which it thus acquired. We disagree. We hold that although petitioner did in fact procure the cancellation of the Old Co.'s contingent liability in respect of severance pay by executing a new and different type of contract with the union, petitioner's obligation under the new contract was of such contingent *451 character that it could not be considered part of the cost of the assets which it acquired, and that any such obligation which might actually result in a fixed liability in a later year may properly be taken into account in petitioner's behalf as a deduction in such later year. * * *

Of course, there was always the possibility that petitioner might become liable for severance pay, if, for example, the plant should burn down and the employees were thrown out of work without having received the required notice. But petitioner protected itself against this contingency by insurance, and the premiums paid therefor were plainly deductible as a business expense. We think that petitioner's liability for severance pay, in view of the notice provisions, was so speculative that its obligations under the union contract cannot fairly be regarded as part of the "cost" of the assets acquired from the Old Co. * * *

The same principles should be applied here. Here, as in Albany Car Wheel Co., the purchaser was protected against liability by insurance, and it appeared from court decisions prior to the purchase of Old States that any liability would be limited to an amount less than the amount of *452 applicable insurance. New States' obligation for the cargo losses was of such contingent character that it cannot be considered part of the cost of the assets which it acquired, and we think that when the obligation was determined and actually resulted in a liability of a fixed amount in a later year, it was properly taken into account by petitioners as a deduction of New States in such later year. Employing the language of Albany Car Wheel Co., we think that the liability for cargo losses was so speculative that it cannot fairly be regarded as part of the "cost" of the assets acquired.

The proper focus under the facts of this case should be upon the unexpected nature of the liability which was determined to be in excess of applicable insurance, after the purchase, and only after the previous decision of the District Court (on February 16, 1956), affirmed on appeal by the Court of Appeals (on May 31, 1957), was modified by the same Court of Appeals (on November 15, 1957), and later clarified and reversed (on August 20, 1958). Petitioners have adequately demonstrated that the liability *453 in excess of insurance was not contemplated at the date Old States was purchased and that it was not taken into consideration in the calculation of the bid which was submitted to Blyth and accepted. In fact, on the basis of the decision of the District Court prior to the purchase of Old States' stock, there was the affirmative belief on the part of New States' management, particularly J.R. Dant, that no liability in excess of insurance would be incurred. Mr. Dant had weekly meetings with his attorney, Erskine Wood, with respect to the potential liability for the cargo claims. Mr. Wood advised J.R. Dant on several occasions prior to July 11, 1956, the date J.R. Dant effected the purchase of Old States by New States, that there was very little likelihood that the liability finally determined would exceed the applicable insurance. Mr. Wood advised Dant by letter of March 22, 1956, of the minimal chance that the liability would exceed insurance. And it would appear that the New States management believed that this possibility was even further reduced when on May 31, 1957, prior to the liquidation of Old States, the Court of Appeals affirmed the District Court's decision which the parties *454 have stipulated limited liability for the cargo losses to less than the insurance. The belief that no liability would be incurred in excess of insurance is shown by other events. The audit reports of Old States by independent accountants referred to it in footnotes as a possible liability amply covered by insurance. It was not disclosed to Blyth when Blyth acquired Old States from the Dant family on July 11, 1956. Blyth was advised by its attorney that this non-disclosure would justify Blyth's calling the deal off, but Blyth went ahead anyway. The corporate books of account for the years prior to the sale of Old 170 States' stock by Blyth to New States, made no provision for any loss from the cargo claims, and no reserve was set up on the books of account for such liability. No reference to the possible liability was made in the financial statements submitted to the bank when an $8,000,000 loan was obtained by New States (through the efforts of J.R. Dant), nor was reference made in the projections of earnings and financial position of New States submitted to the Maritime Administration in support of its application for an operating-differential subsidy contract. Therefore, it is *455 our finding that the parties were affirmatively convinced that there would be no liability and that they did not consider it in computing the bid which was submitted and accepted.

When the liability was finally determined not to be limited by the Court of Appeals, on August 20, 1958, reversing the District Court's earlier decision limiting liability, it constituted an unexpected, unanticipated loss to New States. It is held that this unexpected liability for cargo losses, resulting in the payments in settlement of the liability in excess of insurance, was a deductible loss of New States when the liability was finally det

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