Appendix — Union Pacific Railroad v. United States

f iy Or ia7&

In THE oe |

Supreme Court of the United States!!!

Ocroper Term, 1975

No. 25> 1 v4 | 8

—

Union Paciric Ramroap Company,

Petitioner,

—V.—

THe Unirep Staves or AMERICA,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF CLAIMS

APPENDIX B

Opinion of Court of Claims

Rosert J. Casey,

Attorney for Petitioner,

330 Madison Avenue,

New York, N. Y. 10017.

Joun A. Craic,

Suea Goutp Ciimenko Kramer & Casey

330 Madison Avenue,

New York, N. Y. 10017

Of Counsel

— <a a

Gu the Gnited States Court of Claims

No. 310-62

(Decided October 22, 1975)

UNION PACIFIC RAILROAD CO., INC. v.

THE UNITED STATES

Robert J. Casey, attorney of record, for plaintiff. Frank E.

Barnett, Covington Hardee, Thomas J. McCoy, Jr., John A.

Craig, James E. Pratt, David J. Sweet, Clark, Carr & Elia,

of counsel.

Theodore D. Peyser, Jr., with whom was Assistant Attor-

ney General Scott P. Crampton, for defendant.

Before Cowen, Chief Judge, Laramore, Senior Judge,

Sxetton, Nicnors, Kasurwa, Konzia, and Bennett, Judges.

OPINION

Kuwnzia, Judge, delivered the opinion of the court:

This income tax refund case comes before the court on

appeal from the Trial Division where findings and an opinion

wee filed November 9, 1973, by Trial Judge David Schwartz,

pursuant to Rule 134(h). The court has reviewed his deci-

sion on the briefs, exceptions, and oral argument of counsel,

finds itself in agreement with major portions of that recom-

mended decision and adopts them, with minor modification,

as Parts I-II and IV--X of its opinion. The court also adopts

most of the trial judge’s findings of fact, but modifies por-

tions deemed proper upon consideration of exceptions by the

parties. We limit our departure essentially to Parts III and

XI of this opinion.

594-098—75

2

In Part I we deal with plaintiff’s claim that it had a right

to “expense” certain property costing less than $500 (“mini-

mum rule” property) in its 1942 tax return. In Part II we

consider the 1942 deductibility of plaintiff’s payroll taxes

paid in 1943. In Part III we treat the issue of whether plain-

tiff may return $13 million to income based upua 1900-1907

accounting errors. In Part IV we handle plaintiff’s assertion

that certain stock subscription rights received could be in-

cluded in income. In Part V we resolve plaintiff’s request to

include stock in certain leased line subsidiaries in its capital

assets. In Part VI we answer plaintiff’s demand for interest

on a 1948 agreement with the Internal Revenue Service. In

Part VII we respond to plaintiff’s plea to include certain

land sale proceeds in its earnings and profits, In Part VIII

we decide defendant’s “additional defense” that plaintiff

erroneously included bond discounts and expenses in its total

assets. In Part IX we rule on another additional defense that

plaintiff failed to treat other bond discounts, and call premi-

ums as interest. In Part X we pass on plaintiff’s entitlement

to include certain donations and grants in its equity. Finally,

in Part XI we determine the correct amount of plaintiff’s

equity invested capital based on the value of its stock issued

for its operating assets.

We find that plaintiff is entitled to recover in Parts I, V

and in some sections of Part X. Plaintiff does not prevail in

Parts II, IV, VI and VII. We hold for defendant on its

offset claims in Parts VIII, [X and XI. Finally, we remand

the issue in Part III for reconsideration by the trial judge.

The Union Pacific Railroad Company brings suit pursuant

to the Tucker Act (28 U.S.C. § 1491) and the Internal Rev-

enue Code (§ 7422(a), 1954.Code) for a refund of income

and excess profits taxes for 1942. Plaintiff has paid over

$30 million in income tax and over $7 million in excess profits

tax. It seeks a judgment for $13,409,961.46 (consisting of

$9,222,801.78 in statutory interest for 1942 and $4,187,159.68

in income and excess profits tax and assessed interest thereon

paid for 1942) or such other amount which may be legally

refundable for 1942, together with statutory interest thereon.

The extraordinary span of time from 1942 to the filing of

suit is accounted for by the following. The taxpayer filed

3

returns in 1943 and made payments of a total of some $42

million in 1943, 1944 and 1946. Between that time and the

conclusion of the audit of the returns in 1957, various timely

claims for refunds were filed in amounts varying from $7.7

million to $348,000, and various credits, adjustments and

refunds were made in amounts ranging from $694,000 to $196.

The audit, begun in 1945, was completed in 1957. One

Internal Revenue agent spent over 5,000 hours, or about 630

working days, on the report, almost 1,000 pages long. The

major part of the work was the required preparation of the

surplus or accumulated earnings and profits accounts for 25

closely related or subsidiary corporations for the 44 years

from 1898, the year of the creation of the taxpayer on the

reorganization of the old Union Pacific Railroad. These

accounts were directly relevant to the invested capital method

chosen by plaintiff for reporting its tax under the World

War IT excess profits tax act (Title II, § 201, Second Revenue

Act of 1940, 54 Stat. 975, 26 U.S.C. §§ 710-752 (1940 ed.)).

The primary issue is the valuation of the original Union

Pacific Railroad system. This and other major issues required

the study of voluminous documents and underlying data

located at various points in the country. Various other fac-

tors contributing to the length of the audit period included

the pendency until 1954 of suits, brought by the taxpayer for

earlier tax years, affecting some of the issues involved in 1942

tax liability.

The returns were meantime kept open by consents on the

part of the taxpayer. Plaintiff did not press for an early sub-

mission of the agent’s report, for reasons connected with a

certain agreement with the Commissioner concerning freight

“cutbacks” or rate refunds, discussed below. It is agreed that

the consents were voluntary and without any pressure or

coercion and that at no time did plaintiff complain to the

Internal Revenue Service concerning the time required to

complete the audit of its returns.

The audit, completed in 1957, was the basis of a determina-

tion in 1959 of a large net overassesament of tax for 1942.

On September 16, 1960, after approval of the determination

by the Joint Congressional Committee on Internal Revenue

Taxation, a deficiency in excess profits tax for 1942 was satis-

4

fied by credits in income tax and a post-war credit, and a total

of $7,793,219.55 was refunded or paid to plaintiff, consisting

of income tax and declared value excess profits tax for 1942

and statutory interest thereon.

In 1961 plaintiff filed a timely comprehensive claim for

refund of $13,409,961.46, together with interest, and on notice

of disallowance, the instant suit was timely brought, on Sep-

tember 14, 1962. The petition as first filed contained 27 counts,

to which seven counts were added by an amended petition in

1966. In an answer and four amended answers filed in 1966

and 1968 the Government pleaded 22 separate additional

defenses.

Aspects of the case have finally been disposed of as follows.

On January 19, 1968, the court pursuant to the Government’s

additional defense 11 dismissed counts 27 through 30 and 32

through 34 as claims for refund, allowing them to remain

only as offsets to defendant’s setoffs. 182 Ct. Cl. 103, 389 F. 2d

437 (1968), cert. denied, 403 U.S. 931 (1971). Summary

judgment dismissing counts 29 and 30 was granted in 1968,

thus rendering additiunal defenses 14 and 15 moot. 185 Ct.

Cl. 393, 401 F. 2d 778 (1968), cert. denied, 395 U.S. 944

(1969), motion for reconsideration denied, 194 Ct. Cl. 1021.

Counts 7 and 31 and the additional defenses thereto, Nos. 2,

3, 4 and 10, were ordered separately tried, after final adjudi-

cation of the remaining issues, by then Trial Commissioner

(now Judge of the U.S. Customs Court) Herbert N. Maletz.

The parties have through their able and diligent counsel

engaged in extensive and fruitful pretrial proceedings and

negotiations. A substantial number of counts and affirmative

defenses were in the course of these proceedings conceded by

one or the other party, by agreements limited to this

proceeding.

Whole counts and additional defenses which have been

conceded, by agreements limited to this proceeding, are

these: it is conceded that plaintiff is entitied to prevail on

counts 1 and 16; it is conceded that plaintiff is not entitled

to prevail on counts 3, 10 through 14, and 27 (thus render-

ing additional defense 5 moot) ; and it is conceded that the

defendant is not entitled to prevail on additional defenses

12 and 13. Count 28 is entirely disposed of by agreement. A

5

number of partial concessions of counts were also made as

to counts 17, 20, 21 and 22 and additional defense 20.

Various items in counts 19-25 not agreed upon by the parties

are disposed of in other counts.

The pretrial proceedings culminated in a stipulation of

facts of approximately 500 pages, over 500 exhibits agreed by

the parties to be received in evidence or ruled upon in advance

of trial and an exchange before trial of the direct testimony

of the experts to be called by the parties on the valuation

issue. The case was tried between February 26 and March 6,

1969. Testimony consisted of the cross and redirect examina-

tion of the expert witnesses, and testimony by three additional

witnesses. Proposed findings of fact, objections to proposed

findings of fact and briefs were filed between October 13,

1969 and January 5, 1971, and further memoranda were filed

in May and June, 1973.

1. “MINIMUM RULE” ACQUISITIONS

The Interstate Commerce Commission’s rules for account-

ing by railroads, effective in 1940-1942, required that items

of road and equipment property costing less than $500 be

charged to operating expenses rather than to a capital ac-

count. Such a rule, known as the “minimum rule,” had been

in effect for many years; in 1940 the break point was raised

from $100 to $500. The Government challenges the effective-

ness for tax purposes of the change in the rule. The conten-

tion is that (1) items of property costing between $100 and

$500, concededly of a capital nature and having a useful life

of longer than a year, are “permanent improvements” under

section 24(a) (2) of the 1939 Code, must be capitalized, and

only depreciation deducted, and (2) the minimum rule does

not constitute a method of accounting under section 41 of the

Code. Plaintiff deducted $113,717.84 for such items, and it is

this deduction which is in dispute in count 2.

A similar case has been considered by the court and de-

cided in favor of the taxpayer in Cincinnati, N.O. & Tex. Pac.

Ry. v. United States, 191 Ct. Cl. 572, 424 F. 2d 563 (1970).

The minimum rule items, the court held, “are not of such na-

ture or character in relation to the pls.intiff’s business to con-

stitute permanent improvements or betterments as is con-

6

templated by section 24(a) (2)”; further, that the minimum

rule treatment of the items was “in accordance with generally

accepted accounting principles and is not such that it inhibits

the ability of plaintiff's financial statements to clearly reflect

income for tax purposes”; and, finally, that “the minimum

rule constitutes a method of accounting as contemplated by

section 41 and Treas. Reg. 111, § 29.41-3.” 191 Ct. Cl. at

587-88, 424 F’. 2d at 572-73.

Defendant seeks to distinguish the decision on the ground

that the tax consequences there were de minimis while here

they are substantial. Substantiality is attempted to be shown

by pointing to such facts as the excess of the deductions taken

by plaintiff pursuant to the minimum rule over the deprecia-

tion allowed by the Commissioner, amounting to $109,926 in

1942, $147,017 in 1943, $175,682 in 1944, $171,850 in 1945 and

$115,551 in 1946. The total of $720,026 for the 5 years is said

to be substantial.

Dollar figures, even large ones, are not a showing of sub-

stantial tax consequences in a case of this type. Whether an

accounting method distorts the reflection of income must de-

pend on a whole picture. As the court said in Cincinnati, N.O.

& Tex. Pac. Ry. v. United States, supra, “[t]he most convinc-

ing evidence that the Commissioner has abused his discretion

in prohibiting the plaintiff from treating items [in accord-

ance with the minimum rule] . . . is the statistical analysis

. which indicates the relationship of the quantum of mini-

mum rule expenses to other substantial income and balance

sheet figures.” 191 Ct. Cl. at 584, 424 F. 2d at 571.

Let us therefore compare the relationships in the instant

case with those held by the court not to inhibit the ability of

the Cincinnati’s financial statements to reflect its income

clearly. In 1942 the Cincinnati’s total operating expense was

$16,291,053; total investment account was $69,391,628; and

challenged minimum rule items were $9,688. For plaintiff

the comparable figures were $218,307,770, $442,726,752 and

$113,718. The ratio of minimum rule items to total investment

account for the Cincinnati was thus .00014; for plaintiff it

is .00026. The ratio of minimum rule items to total operating

expense for the Cincinnati was .00059; for plaintiff it is

.00052.

7

The relationships are, therefore, as minimal in plaintiff’s

fiscal picture as they were in Cincinnati’s. There is accord-

ingly no reason not to follow the court’s recent decision and

affirm the right of the plaintiff to account for the items in

question in 1940-1942, pursuant to the ICC’s minimum rule.

Plaintiff is entitled to prevail on count 2.

Il. PAYROLL TAXES

The dispute, raised by count 4, is over whether the plain-

tiff, having been permitted by the Commissioner of Internal

Revenue to deduct from its 1942 income, as a business ex-

pense, the amount of vacation pay earned by plaintiff’s em-

ployees in that year and paid to them in 1943, should also

be permitted to deduct the payroll taxes applicable to the

vacation pay, which were payable and paid in 1943. Plaintiff

is on the accrual and calendar year basis. The payroll taxes

were those imposed by section 1520 of the Internal Revenue

Code of 1939, 26 U.S.C. § 1520 (1940)? and Section 8(a) of

the Railroad Unemployment Insurance Act, ch. 680, 52 Stat.

1094, 1102 (1938), 45 U.S.C. § 358 (1940).

Plaintiff’s contentions were apparently not reflected in its

tax returns as first filed. In its return for 1942, plaintiff de-

ducted, as business expenses, $1,103,413.31 in vacation pay

1 Since plaintiff prevails on count 2, we do not decide plaintiff’s alternative

claims based on the minimum rule treatment in counts 32 and 33, nor need

we consider defendant’s contentions in additional defenses 16 and 17 based

upon counts 32 and 33.

1Ҥ 1520. Rate of Taz.

“In addition to other taxes, every employer shall pay an excise tax,

with respect to having individuals in his employ, equal to the following

percentages of so much of the compensation as is not in excess of $300

for any calendar month paid by him to any employee for services rendered

to him after December 31, 1936 © * ©

s e@ eo e e

“(2) With respect to compensation paid to employees for services

rendered during the calendar years 1940, 1941, and 1942, the rate shall

be 3 per centum ;

“(3) With respect to compensation paid to employees for services

rendered during the calendar year[s] 1943, 1944, and 1945, the rate

shall be 3% per centum;

“se @ & ® er

*Sec. 8. (a) Every employer shall pay a contribution, with respect to

having employees tn his service, equal to 3 per centum of so much of the

compensation as is not in excess of $300 for any calendar month payable by

him to any employee with respect to employment after June 30, 1939: °* * *,”

8

earned by its employees in 1941 and paid to them in 1942,

and payroll taxes on the vacation pay, in the amount of

$64,108.31, paid in 1942. Consistently, on its return for 1943

plaintiff deducted $1,518,624.02 in vacation pay earned by

employees in 1942 and paid to them in 1943, and the appli-

cable payroll taxes of $90,358.13, paid in 1943.

During the audit of its 1942 return, the plaintiff claimed,

and the Commissioner allowed, a deduction of the entire

amount of the vacation pay earned by its employees in 1942,

$1,518,624.02. Relying on the allowance, the plaintiff then

made a claim for refund on the ground that it was entitled

in 1942 to accrue and deduct the payroll taxes on the entire

amount of vacation pay whose deduction had been allowed.

The claim was actually one for $26,249.82, the difference be-

tween $90,358.13, the amount of the payroll tax claimed as a

deduction, and the deduction of $64,108.31 taken on the re-

turn. The Commissioner denied the claim and count 4 of

the petition seeks the $26,249.82 involved.

The question for decision is whether plaintiff may in 1942

accrue and deduct payroll taxes to be paid in 1943 on vaca-

tion pay which was earned, accrued and allowed to be de-

ducted in 1942, though not to be paid until 1943. The answer

here given is, no. The reasons follow.

A tax not assessed and paid until a following year may

nevertheless be deducted in the prior year, if it meets the

“all events” test of United States v. Anderson, 269 U.S. 422

(1926). By that test a deduction may be taken, in advance

of assessment, in the year when all the events take place deter-

mining liability and fixing the amount of the tax. Thus (id.

at 441):

In a technical legal sense it may be argued that a tax

does not accrue until it has been assessed and becomes

due; but it is also true that in advance of the assessment

of a tax, all the events may occur which fix the amount

of the tax and determine the liability of the taxpayer to

pay it. In this respect, for purposes of accounting and

of ascertaining true income for a given accounting per-

iod, the munitions tax here in question did not stand on

any different footing than other accrued expenses ap-

pearing on appellee’s books.

The “all events” test has been restated and applied many

times, often in cases similar to the instant case. £.g., United

9

States v. Consolidated Edison Co., 366 U.S. 380, 385, n.5

(1961) ; Clevite Corp. v. United States, 181 Ct. Cl. 652, 658,

386 FF. 2d 841, 843 (1967); Denver & Rio Grande Western

failroad Co. v. Commissioner, 38 T.C. 557, 572 (1962) ;

Turtle Wax, Inc. v. Commissioner, 43 T.C. 460, 466-67

(1965). The test is phrased in the current income tax regula-

tions as follows: “Under an accrual method of accounting,

an expense is deductible for the taxable year in which all the

events have occurred which determine the fact of the liability

and the amount thereof can be determined with reasonable

accuracy.” Treas. Reg. § 1.461-1(a) (2) (1970), promulgated

by T.D. 6282, 1958-1 Cum. Bull. 215, 22 F.R. 10686, Dec. 25,

1957, 26 C.F.R. § 1.461-1(a) (2) (1970).

So long as a liability remains contingent or if the liability

has attached but the amount cannot be reasonably estimated,

a business expense deduction is not allowed. Treas. Reg.

§ 1.461-1(a) (2), supra; Clevite Corp. v. United States, supra;

Tewxaco-Cities Service Pipe Line Co. v. United States, 170 F.

Supp. 644, 645 (1959) ; Denver & Rio Grande Western Rail-

road Co. v. Commissioner, supra; Turtle Waz, Ine. v. Com-

missioner, supra.

In the instant case, both the fact of liability and the amount

of tax were as of December 31, 1942 st'll in doubt. Uncer-

tainty as to two events as of that date maue it impossible then

to determine the tax.

One of the facts lacking was knowledge of the total vaca-

tion pay which plaintiff's employees would actually receive.

Under at least some of plaintiff's labor contracts, the em-

ployee forfeited the right to a vacation with pay or to pay in

lieu of a vacation, if his employment were terminated, for a

reason other than retirement, prior to the time scheduled for

his vacation in 1943. Since it could not be known by the end

0‘ December of the prior year, 1942, which of plaintiff's

employees would remain in its employ until the beginning

of their respective vacations in 1943, it could not in 1942 be

determined how much vacation pay plaintiff would be re-

quired to pay and, therefore, what would be plaintiff’s tax

liability. The uncertainty would not be resolved until the

time in 1943 of the actual payment of vacation wages or

allowances. All events fixing liability not yet having oc-

curred, a deduction in advance, in 1942, is not permitted,

10

under the foregoing authorities, and particularly 7ewxaco-

Cities Service Pipe Line Co. v. United States, supra, and

Turtle Wax, Inc. v. Commissioner, supra. Compare similar

rulings with respect to the excise tax on payrolls of employers

other than carriers. G.C.M. 19692, 1938-1 Cum. Bull. 148;

Rev. Rul. 69-587, 1969-2 Cum. Bull. 108.

Plaintiff urges that in allowing it to deduct vacation pay

earned in 1942, the Commissioner has ruled, pursuant to

I.T. 3956, 1949-1 Cum. Bull. 78, that the liability for vaca-

tion pay is not made contingent for purposes of the “all

events” test by the possibility that the employee might for-

feit his right to a vacation by leaving the employ prior to

his scheduled vacation. The Government’s position on I.T.

3956 is that the ruling was mistaken and has been revoked

in Rev. Rul 54-608, 1954-2 Cum. Bull. 8, 9-10; moreover, that

it concerned vacation pay and should not be extended to pay-

roll taxes.

In revoking I.T. 3956 the Commissioner ruled “that no

accrual of vacation pay can take place until the fact of liabil-

ity to a specific person has been clearly established and the

amount of the liability to each individual is capable of com-

putation with reasonable accuracy.” Rey. Rul. 54-608, supra.

In reaching this decision, the Commissioner relied on three

decisions of the Tax Court: 7’ennessee Consolidated Coal Co.

v. Commissioner, 15 T.C. 424 (1950) ; Morrisdale Coal Min-

ing Co v. Commissioner, 19 T.C. 208 (1952); and Z. H.

Sheldon & Co. v. Commissioner, 19 T.C. 481 (1952). In these

cases it had been held that liability for payment of vacation

pay depended on the condition precedent that the recipient

employee be working for the employer-taxpayer on the date

required by the contract, and that until that date liability

remained uncertain.

The reasoning of Rev. Rul. 54-608 and of the cases it relied

upon is preferred over that of I.T. 3956. This court has re-

cently ruled that where “payment of vacation pay * * * is

contingent upon employment up to the beginning of the va-

cation period, a taxpayer cannot accrue expenses for vacation

pay before the taxable year in which the payments are made.

Until the vacation period begins, the ‘all events’ test * * *

has not been satisfied.” Clevite Corp. v. United States, su pra.

eset sasnecnesins nsrterne

11

Plaintiff urges that the effective date of Rev. Rul. 54-608

has been repeatedly postponed (most recently in Section 903

of the Tax Reform Act of 1969, P.L. 91-172, 83 Stat. 487,

711), and thus that I.T. 3956 is “still the law.” The question

at hand, however, is not the present effectiveness of I.T. 3956,

as governing deductibility of vacation pay by certain classes

of taxpayers,‘ but whether its rationale should be extended

to the deductibility of payroll taxes on vacation pay. That

question is here answered in the negative.

The nature of the payroll tax itself is the source of the

second “event” or fact so unknown or uncertain at the close

of 1942 as to make the liability contingent and thereby pre-

vent deduction of payroll taxes in that year. The two payroll

tax acts (notes 2 and 3, supra) subjected to tax only the first

$300 of compensation paid to an employee in any calendar

month. Under plaintiff’s labor contracts, in the event plaintiff

could not release an employee for a vacation in 1943, it was

obligated to pay the employee an allowance in lieu of the

vacation. Where such an allowance was paid in-a calendar

month in which the employee had already received $300 or

more in other compensation, no tax would be due on the excess

of $300.

Plaintiff did not know, as of December 31, 1942, which of

its employees it would and which it would not be able to

release for a vacation in 1943, and to which, therefore, it

would pay allowances in lieu of vacation. Unknown, there-

fore, was how many would receive more than $300, in com-

bined regular pay and vacation allowance, in one calendar

month, and thus to what extent the payment of vacation al-

lowances would be free of tax. Liability for the tax was

necessarily contingent, until the time of the scheduled vaca-

tion in 1943. Only then would it appear how much of the

payments to the employee would be liable to tax.

The effect of the $300 maximum on a taxable monthly com-

pensation 1s confirmed by the facts of plaintiff’s actual pay-

LT. 3956, would be left with no deduction. The post

; ponement is des

to allow time for study and formulation of remedial legislation. Denver ry te

Grande Western Railroad Co. v. Commissioner, eupre ; 8. Rep. No. 91-552, 91st

12

ments of vacation pay and tax. Plaintiff paid $1,103,413 in

vacation pay in 1942. Six percent of this amount—the tax

rate in 1942 (notes 2 and 2, supra)—is $66,205, yet plaintiff

paid payroll taxes of only $64,108. In 1943 plaintiff paid

vacation pay of $1,518,624. At 6.25 percent, the tax rate in

1943 (notes 2 and 3, supra), it would have paid $94,914, yet

plaintiff paid only $90,358. The differences between the

amount of the tax payable, if the entire amount of vacation

pay were taxable, and the amount of tax actually paid, not

explained by plaintiff, can only be attributed to payments of

regular pay and vacation allowances in total amounts of over

$300 in a month, of which the portion over $300 was free

of tax.

Plaintiff contends that the effect of the tax freedom for

compensation over $300 in one month is not so great as to

disqualify the tax from deductibility because, it is said, plain-

tiff was able, in 1942, to estimate the amount of tax to be paid

with the accuracy required by the “all events” test. Not so.

While the amount of a tax may be reasonably estimated and

need not be precisely known, liability for the tax must have

attached and cannot be approximated or estimated. “[T ]he

fact that the percentage of items which will be paid can be

estimated with reasonable accuracy is not sufficient to support

accruals. The individual items must represent fixed liabili-

ties.” Denver & Rio Grande Western Railroad Co. v. Com-

missioner, supra. The accruability test is not whether there

is certainty of payment, or if a reasonable estimate can be

made, but whether there is certainty of liability. 77ans-

California Oil Co., Ltd., 37 B.T.A. 119, 127 (1938). Here,

liability was not certain or fixed. The effect of the $300 pro-

vision was to make the liability for tax uncertain, until the

time when the employee actually went on vacation or re-

ceived both pay and vacation pay. Liability for payroll tax

was thus under the “all events” test not certain or fixed in

1942. Texaco-Cities Service Pipe Line Co. v. United States,

supra; Helvering v. Russian Finance & Construction Cor-

poration, 77 F. 2d 324, 327 (2d Cir. 1935).

Lastly, plaintiff urges that since it has been allowed a

deduction for vacation pay earned in 1942, a comparable

deduction for the tax on such vacation pay is appropriate or

necessary in order clearly to reflect its income for 1942. The

13

effect on income in any year of the i

prospective ll

may be clearly enough reflected by a reserve for ro ben

er ropes» The need for such a reserve is not the

equivalent of a right to a deduction. Lucas v. Ameri

Co., 280 U.S. 445, 452 (1930). —

Plaintiff is not entitled to prevail on count 4.

Ill, $13 MILLION DEDUCTIONS

Plaintiff's count 8 also seeks a refund of excess profits taxes

based upon an alleged series of accounting errors in 1900-

190% . It asserts that certain “betterments and improvements”

during these years were “expensed” rather than debited to its

investment account. It further contends that in later vears

these “betterments” were depreciated and thus tite for

a second time. Plaintiff wants to “reverse” this $13 million

er aa by adding it back into accumulated earnings

The trial judge rejected this claim. He found insufficient

proof that the accounting transactions were erroneous and

— that ag had failed to succeed on this same argu-

ment in a case before the Inte issi

44 ICC Val. Rep. 1, 22 (1933). siieapiicis eaeliaaitaees

The trial judge discredited plaintiff’s contention that later

depreciation deductions created a “double expensing” of a

single item of property. He found that the evidence shows

that plaintiff in fact made “substantial unrecorded retire-

ments” rather than later retirement deductions. It is this

point which troubles the court. The “unrecorded retirement”

issues are still before the trial judge. Plaintiff contends that if

the court denies its “$13 million” claim for the sole reason

that these accounting entries were made to correct earlier

pan errors,” and if it is later found that its “retire-

ent” practices were correct, plaintiff wi

to — the “$13 million” — wipes a

ince the retirement issue is still before the trial j

court remands this “$13 million” issue to the ial a re

clarification of the relationship between the retirement issue

and the “$13 million” issue. Although it appears that the trial

judge rejected plaintiff’s claims solely for insufficient proof

of a “$13 million” error, we wish to make absolutely certain

that his conclusion is not tied to any findings of “erroneous

14

retirement” practices by plaintiff, or that plaintiff was not

lured into failure to present proof on the “$13 million” issue

because it believed the issue would be tried with the retire-

ment issues.

IV. STOCK SUBSCRIPTION RIGHTS

In each of the years 1922, 1923, and 1925 plaintiff and its

wholly owned subsidiary, the Oregon Short Line, both hold-

ers of common stock in the Illinois Central Railroad Com-

pany, received, as such holders, a distribution of rights to

subscribe to Illinois Central convertible preferred stock at

$100 per share. The rights were exercised in the year received.

At both the time of distribution and exercise, the market

value of the stock was higher than the subscription price. The

lower of the two aggregate “spreads” between market and

distribution prices was some $670,000.

The question presented, determinative in count 15, and

determinative in part in other counts, is whether the “spread”

at either time was income properly to be included in accumu-

lated earnings and profits of the recipient for excess-profits-

tax purposes. The answer, here given in the negative, hinges

on the checkered history of the taxation of stock dividends

prior to the enactment of the excess profits tax in 1940.

That history begins with the 1918 decision holding the 1913

tax on income inapplicable to a dividend in stock, on the

ground that the “proportional interest of each shareholder

remains the same” after the receipt of the dividend. TJowne v.

Eisner, 245 U.S. 418, 426. In 1916, however, Congress had by

statute directed that a “stock dividend shall be considered

income, to the amount of its cash value.” Section 2(a) (2),

Revenue Act of 1916, ch. 463, 39 Stat. 757 (1916). This statute

the Supreme Court soon held in violation of the Sixteenth

Amendment, in Lisner v. Macomber, 252 U.S. 189 (1920), on

the ground that no income had been received. Though the two

cases had involved simple dividends of common stock to com-

mon stockholders, Congress took the decisions as forbidding

the taxation as income of any stock dividends, and accord-

ingly provided in the 1921 Act and thereafter, through the

1934 Act, that a “stock dividend shall not be subject to tax.” ®

*Section 201(d), Revenue Act of 1921, ch. 136, 42 Stat, 228 (1921);

§ 201(f), Revenue Act of 1924, ch. 234, 48 Stat. 255 (1924); § 201(f), Rev-

enue Act of 1926, ch. 27, 44 Stat. 11 (1926); § 115(f), Revenue Act of 1928,

ch. 852, 45 Stat. 822 (1928) ; § 115(f), Revenue Act of 1932, ch. 209, 47 Stat.

204 (1932); §115(f), Revenue Act of 1934, ch. 277, 48 Stat. 712 (19384).

15

The premise of this statutory exemption of stock dividends

from taxation was upset in 1936 when the Supreme Court

decided in Koshland v. Helvering, 298 U.S. 441, that a divi-

dend in common stock to holders of preferred stock gave rise

to income (though not subjected to tax), because the resulting

interest of the stockholder was different than before. Now

appreciating that Lisner v. Macomber was not an absolute

and that some stock dividends could be taxable Congress

promptly provided, in the 1936 Act, that dividends in stock

or in rights should be taxable to the extent constitutionally

permissible.° Such taxation as was thereby imposed was to be

prospective.’ These provisions were repeated in the 1939

Code.* Under these provisions, such stock dividends as gave

rise to Income, that is, those that created interests in the re-

cipient different than before, were taxed. See Helvering v

Griffiths, 318 U.S. 371 (1943); Bittker & Eustice, Federal

: nant Taxation of Corporations and Shareholders, Sec. 5.60

Such briefly had been the prior treatment of stock divi-

dends when the excess profits tax was being considered in

1940. Though the change in the taxation of stock dividends

in 1936 did not rake up stock dividends of earlier years, the

excess profits tax would do so, by its provision that accumu-

lated earnings and profits be an element of equity invested

capital. 50 US.C. § 718 (1940 ed.). Computation of equity

invested capital would require a review and determination of

the earnings and profits account of at least some corporate

taxpayers from the beginning (one of the causes of the long

time spent in auditing the return of the instant plaintiff )

On such a review, in the absence of special statutory provi-

sion, at least some long-past stock dividends would now by

hindsight be understood as having given rise to income and

thus includible in earnings and profits, though the dividend

had been exempt from tax under the tes j

stat

1921 and 1936. atutes In force between

7 Section 1, Revenue Act of 1936, ch. 690

, , ch. , 49 Stat. 1652 (19326).

® Section 115(f) (1), 1939 Code, 26 U.S.C. § 115(f) (1) aban

16

Special statutory provision was, however, made. Congress

dealt explicitly with the effect upon earnings and profits

of past, untaxed stock dividends. The draftsmen added to

the excess profits tax law a provision that earnings and profits

should not be increased by receipt of a dividend, not taxed,

whose only effect had been to cause a reallocation of the basis

of the old stock to the old and the new stock. This section,

quoted in the note,’ was section 115(1), 1939 Code, 26 U.S.C.

§ 115(a) (1) (1940 ed.), added by § 501, Second Revenue Act

of 1940, ch. 757, 54 Stat. 1004 (1940). Retroactivity was

explicit. Section 501(c), Second Revenue Act of 1940, ch. 757,

54 Stat. 1005.*°

The precise question for present decision is simply whether

the distributions of rights to plaintiff and Oregon Short Line

were tax-free dividends subject to the bar of § 115(1) to their

inclusion in the earnings and profits of the recipient

corporation.

The issues are those of construction of § 115(1) and re-

lated sections. A first issue is whether the distribution of

rights to subscribe to the preferred stock of Illinois Central,

the distributing corporation, was a “dividend.” It is agreed,

incidentally, that Illinois Central had sufficient income avail-

able for dividends in the amounts involved.

Distribution of rights to subscribe to stock in the issuer,

such as are presently involved, are for tax purposes the

equivalent of stock dividends. It is settled that a distribution

of rights to subscribe to stock is governed by the same rules

as determine taxability of the stock itself, had it been directly

distributed. Miles v. Safe Deposit Co., 259 U.S. 247 (1922) ;

® “Where a corporation receives (after February 28, 1913) a distribution from

a second corporation which (under the law applicable to the year in which

the distribution was made) was not a taxable dividend to the shareholders of

the second corporation, the amount of such distribution sb: il not increase

the earnings and profits of the first corporation in the following cases:

“(1) No such increase shall be made in respect of the part of such

distribution which (under such law) 1s directly applied in reduction of

the basis of the stock in respect of which the distribution was made.

“(2) No such increase shall be made if (under such law) the distri-

bution causes the basis of the stock in respect of which the distribution

was made to be allocated between such stock and the property received.”

2 “For the purposes of the Revenue Act of 1938 or any prior Revenue Act the

amendments made to the Internal Revenue Code by subsection (a) of this

section [§ 501(a), adding § 115(a)(1)] shall be effective as if they were a

part of each such Revenue Act on the date of its enactment. * * *”

17

Choate v. Commissioner, 129 F. 2d 684 (2d Cir., 1 :

Charles M. Cooke, Ltd. v. Commissioner, 2 TC 147 ( march

Thus a distribution of rights to subscribe is not subject to

tax as a dividend, when the stock itself, had it been distri-

buted directly, would not be subject to tax, whether because

of the nature of the stock dividend or because of a statutory

exemption from tax. Miles v. Safe Deposit Co., supra; Charles

M. Cooke, Ltd. v. Commissioner, supra.“ And a distribution

of rights is taxable when distribution of the stock would be

taxable, as it was under the 1936 Act, which taxed stock

dividends to the extent constitutionally permissible. Choate

v. Commissioner, supra.

Why, then, was the distribution of rights not a dividend?

Plaintiff claims that the transactions in which the rights

were distributed were not distributions of dividends but

offers to sell corporate property to the corporation’s stock-

holders at less than its value, which on acceptance by the

exercise of the rights gave rise to income in the amount of

the lesser of the spreads between market and subscription

price at the times of distribution and exercise. |

Palmer v. Commissioner, 302 U.S. 63 (1937) and Com-

missioner v. Gordon, 391 U.S. 83 (1968), cited by plaintiff

do support the proposition for which they are invoked—

that the sale of corporate property to stockholders at less

than its value is as much a distribution of profits subject to

tax as income as the formal declaration of a dividend in

money. In these cases the property distributed to stock-

holders was stock in a corporation other than the distributing

corporation. Such stock is when distributed as a dividend no

differently treated than is other property. Dividends consist-

ing of stock in the issuing corporation are, however, another

matter, subject, as has been seen, to special statutory treat-

ment. The rule governing dividends by offer to sell property

is therefore not relevant to the problem at hand. The aspect

of that rule, much emphasized by plaintiff, fixing the realiza-

tion of income at the time of acceptance of the offer as against

“4 Consistently, Article 39 of Treasur

x y Regulations 62, iss

weet Act of 1921, as amended by T.D. 34038, I-2 Cum. ——y oa

Provided that “Where a corporation issues to its stockholders the right to

subscribe to its stock, the value of th

income to the stockholder * * *,” me CUE Come Sat CuaeS Gasti

594-093—75——_2

18

the time of distribution of the right to buy is as irrelevant as

the rule itself.

Accordingly, the criticisms of treatment of the instant dis-

tribution as a dividend are invalid. The distributions are

dividends within the meaning of § 115(1), if the section is

otherwise applicable. The remaining questions have to do

with the two conditions for its application stated in § 115(1)

(note 8, supra).

The first of these is whether the distributions involved

were free from tax, for §115(1) by its terms governs only

a distribution “which (under the law applicable to the year

in which the distribution was made) was not a taxable

dividend.” Note 9, supra.

The distributions, made in 1922, 1923 and 1925, were in

fact not taxed. In the years in question, petitioner and Oregon

Short Line, in their consolidated returns, did not include in

gross income any amounts as attributable to the receipt of

the rights in question. The omission cannot, however, be

regarded as a conclusive recognition by the taxpayer that

the distributions were not taxable income, for in those years

100 percent of dividends received from domestic corporations

were deductible. Section 234(a) (6) (A), Revenue Act of 1921,

ch. 136, 42 Stat. 255 (1921); § 234(a) (6) (A), Revenue Act

of 1924, ch. 234, 43 Stat. 283 (1924). The text of the applicable

statute is, however, clear enough. The law applicable to the

distributions is the law in force in the years they took place,

1922, 1923 and 1925. The law in force in each of those years

provided that “A stock dividend shall not be subject to tax.”

Section 201(d) of the 1921 Act and § 201(f) of the 1924 Act,

note 5, supra. This explicit exemption from taxation fully

satisfies the condition of § 115(1) that the distributions have

been tax-free under the law in force at the time they were

made.

To dispute this conclusion, plaintiff relies upon Choate v.

Commissioner, supra, as holding that the distributions were

taxable as income. The reliance is misplaced. Choate was a

decision under § 115(f) of the 1936 Act (note 6, supra).

Stock dividends were taxed, as far as constitutionally per-

missible, both by that Act and by its successor law, the 1939

Code (note 6, supra). Both statutes, however, were applicable

)

19

only prospectively (notes 6, 7, supra), and so neither can

govern in determining whether the distributions in the 1920’s

were tax-free.

How clearly Choate depends on the prospective change

made in the law by § 115(f) appears from this excerpt from

the opinion (129 F. 2d at 688) :

In Miles v. Safe Deposit & Trust Co., 259 U.S. 247,

* * * it was said that rights issued to its common stock-

holders, to subscribe to a company’s unissued common

stock, are analogous to stock dividends. Such stock divi-

dends were not constitutionally taxable under Zisner v.

Macomber, 252 U.S. 189 * * *. But under § 115(f) stock

dividends are now taxable so far as such a tax is consti-

tutional, and so are rights to the extent that they are

dividends. A stock dividend in preferred stock issued to

common stockholders is, therefore, now subject to a valid

tax.

The second condition for the application of § 115(1) is that

the distributions have had the effect only of reallocating the

basis of the stock originally held, as between the old stock

and the new stock received in the distribution. Before 1936,

when stock dividends were not taxed in the belief they were

not constitutionally taxable, they were treated by the Treas-

ury as having the effect only of a reallocation of basis as

between the old and new stock. The practice was thereafter

codified in §214(e) of the Revenue Act of 1939, ch. 247, 53

Stat. 874 (1939) .2?

4 Section 214(e), in pertinent part, provided :

“(e) Basis Under Prior Acte.—The following rules shall be applied, for

the purposes of the Revenue Act of 1938 or any prior revenue Act, as

if such rules were a part of each such Act when it was enacted, in

determining the basis of property acquired by a shareholder in a

corporation which consists of stock in such corporation, or rights to

acquire such stock, acquired by him after February 28, 1913, In a

distribution by such corporation (hereinafter in this subsection called

‘new stock’), or consisting of stock in respect of which such distribution

was made (hereinafter in this subsection called ‘old stock’) if the new

stock was acquired in a taxable year beginning before January 1, 1936,

or acquired in a taxable year beginning after Devember 31, 1935, and its

distribution did not constitute income to the shareholder within the

meaning of the Sixteenth Amendment to the Constitution:

“(1) The basis of the new stock and of the old stock, respectively,

shall, in the shareholder's hands, be determined by allocating between

the old stock and the new stock the adjusted basis of the old stock:

such allocation to be made under regulations which shall be prescribed

by the Commissioner with approval of the Secretary.”

20

The authority for the proposition that the section is a codi-

fication of prior Treasury practice is no less than the House

Committee which wrote the section. In reporting with ap-

proval what became § 214(e), the Committee said (H.R. Rep.

No. 2894, 76th Cong., 3d Sess. 42-43 (1940)) :

Tax-free distributions in stock or in rights, whether

or not constituting income within the meaning of the

sixteenth amendment or exempt to the distributee under

section 115(f) of the Revenue Act of 1934 or a corre-

nding provision of a prior Revenue Act, and tax-free

distributions of stock or securities in a corporation a

arty to a reorganization, have consistently been treated

y the Treasury as not resulting upon receipt In an In-

crease in earnings or — but as causing the basis of

the stock in respect of which the distribution was made

to be allocated between such stock and the stock securities

received, with the result that earnings or profits are in-

creased, upon the sale of such stock or property, by the

entire amount of the recognized gain computed upon the

basis so determined by allocation. * * * [The section]

explicitly states the rules heretofore applied by the

Pressley.

Section 214(e), plaintiff says, cannot be applied, for it is

by its terms limited to distributions which are not income

(and, plaintiff would go on to say, the distributions here did

create income). The portion of the section (note 12, supra)

relied upon is this: “if the new stock was acquired in a tax-

able year beginning before January 1, 1936, or acquired in a

taxable year beginning after December 31, 1935, and its dis-

tribution did not constitute income to the shareholder within

the meaning of the Sixteenth Amendment to the Constitu-

tion.” The particular words invoked are: “and its distribution

did not constitute income.” ;

Plaintiff would read the last clause, beginning with “and,”

as applicable to acquisitions both “before January 1, 1936”

and “after December 31, 1935.” Such a reading is erroneous

in that it overlooks the disjunctive effect of the “or” which

insulates the condition “if the new stock was acquired in a

taxable year beginning before January 1, 1936” from the re-

maining words, including the “and” clause, and leaves the

category of acquisitions “before January 1, 1936” unaffected

by the conditions placed on the acquisitions “after Decem-

21

ber 31, 1935.” The section embodies a purposeful differentia-

tion, which plaintiff would ignore, between the two stated

classes of transfers—1935 and earlier, and 1936 and later.

Plaintiff’s view, were it accepted, would reduce the clause to

a great many unnecessary words and phrases.

The words should rather be taken as if they were punctu-

ated as emphasized in the following: “if the new stock was

(¢) acquired in a taxable year beginning before January 1,

1936, or (i) acquired in a taxable year beginning after

December 31, 1935, and its distribution did not constitute

income to the shareholder within the meaning of the Six-

teenth Amendment to the Constitution.” Punctuation of this

type appears in a successor statute, § 113(a) (19) (A) of the

1939 Code, 26 U.S.C. § 113(a) (19) (A), added by § 214(a) of

the Revenue Act of 1939, ch. 247, 53 Stat. 872 (1939). Prop-

erly read, the language of the section says that an acquisition

before January 1, 1936, alone and without regard to the “and”

clause, fulfills the condition for applicability of the section.

The “and” clauseis applicable only to the words, following

the word “or,” dealing with acquisitions after December 31,

1935.

Section 214(e), thus being applicable to the acquisitions

in 1922, 1923 and 1925, serves to satisfy the second and last

disputed condition of § 115(1)—that the dividend have an

effect only on allocation of basis.

Accordingly, $115(1) is operative, and directly forbids

the inclusion in a recipient’s earnings and profits of the value

of the rights distributed in 1922, 1923 and 1925. Plaintiff is

not entitled to recover on this issue in count 15 and in all of

the counts in which it is raised.

Vv. LEASED LINE SUBSIDIARIES

Plaintiff owns all of the stock of the Oregon Short Line

Railroad Company, approximately 99 percent of The St.

Joseph & Grand Island Railroad Company and (together

with Oregon) all of the stock of the Los Angeles & Salt Lake

Railroad Company. A large part of the stockholdings was

acquired soon after plaintiff’s reorganization in 1898 and most

of it has been owned by plaintiff for many years. The Oregon

Short Line was acquired in exchange for shares in plaintiff

22

whose valuation is the subject of count 5; the stock in the

latter two roads cost approximately $8 million.

During 1942 and for several of the years earlier, plaintiff

operated substantially all of the properties of these subsidi-

aries under leases.** For practical purposes, the arrangement

was a consolidation of railroad operations. Plaintiff paid all

of the roads’ expenses, including the expenses of maintaining

their corporate existence and dividends on the publicly-owned

1 percent of the stock of The St. Joseph & Grand Island, and

recorded in its books and reported in its tax returns all the

income and expenses of the operations of the lines of the

subsidiaries.

Equity invested capital, the basis on which plaintiff com-

putes its excess profits credit, is under the 1939 Code subject

to a reduction by the percentage of “inadmissible assets”

among total assets. Sections 715, 720, Internal Revenue Code

of 1939, 26 U.S.C. §§ 715, 720 (1952 ed.). An “inadmissible

asset” is by Section 720(a)(1)(A) of the 1939 Code, as

amended in 1941, defined to mean “[s]tock in corporations

- except siuck which is not a capital asset.” Admissible

assets are by section 720(a) (2) “all assets other than inadmis-

sible assets.” That is, while corporate stock held by a tax-

payer entity is presumptively to be considered as a capital

asset and as such “inadmissible” as an asset for purposes of

invested capital, where the circumstances are such as make

the stock a noncapital-asset, it becomes “admissible.”

The ultimate question raised by count 18 is therefore

whether or not the plaintiff’s stock in these subsidiaries is to

be treated as an “admissible asset” under Section 720 of the

1939 Code, and thus not be cause for any reduction of the

plaintiff’s invested capital. Resolution of the question de-

pends on whether the assets are capital assets, which in turn

is determined by whether the plaintiff acquired and holds the

stock in the lessor roads for a business or for an investment

purpose.

43 The subsidiary-lessors owned some stock which was not subject to the

leases; on this stock they may have received some dividends. In the accom-

panying findings, it is found, at defendant's urging, that the lessors filed tax

returns and could have (though they did not) paid dividends to plaintiff.

These findings are however not material to the issue presented.

23

The parties are agreed that the legislative purpose was to

make a non-capital-asset admissible, and thereby part of

equity invested capital, when the income generated by it was

includible in a taxpayer’s excess profits net income. The sim-

plest illustration of such an asset, prominent in the minds

of the drafters of the relevant amendment of the section, is

the corporate stock held by a securities dealer for sale to his

customers. When such sales take place, there is generated or-

dinary excess profits net income, the committee reports said,

“no different from any other article held for sale by a dealer.”

H.R. Rep. No. 146, 77th Cong., 1st Sess., 20 (1941) ; S. Rep.

No. 75, 77th Cong., 1st Sess., 20-21 (1941) ; 87 Cong. Rec.,

Part 2, 1638 (1941). The regulations thus provide that the

term “inadmissible assets” means “stock in all corporations,

domestic or foreign, . . . except stock which is not a capital

asset (such as stock held primarily for sale to customers by

a dealer in securities).” Treasury Regulations 112, Sec.

35.720-1.

Litigation has produced illustrations of non-capital-assets

other than the stock on the security dealer’s shelf. One is

stock in a restaurant, a going business, bought not for invest-

ment but to conduct a restaurant business by the use of the

corporate assets, there having been some doubt as to the as-

signability of the lease of the restaurant premises. John J.

Grier Co. v. United States, 328 F. 2d 163 (7th Cir. 1964).

Another illustration, one of a number of cases involving stock

bought as a source of inventory for regular business, is stock

in a distillery, bought by a liquor dealer to obtain rights to

purchase whiskey and sold promptly after the rights were

exercised. Western Wine & Liquor Co. v. Commissioner, 18

T.C. 1090 (1952). A relatively recent case in this court in-

volved stock in a manufacturer of yarn, held to be a non-

capital-asset because it was bought by the taxpayer, a yarn

sales agency, in order to obtain an extremely valuable source

of supply of yarn. Waterman, Largen Co. vy. United States,

189 Ct.Cl. 364, 419 F. 2d 845 (1969), cert. denied, 400 U.S.

869 (1970). United States v. Mississippi Chemical Corp., 405

U.S. 298 (1972), does not make Waterman, Largen less

authoritative.

24

The rule that emerges from the cases is that corporate stock

which is held for a business purpose, that is, one intimately

related to the taxpayer’s normal source of business income,

is not a capital asset. Stock not so related, and held for in-

vestment purposes, is a capital asset.

Plaintiff claims that the stock involved here meets the

business purpose test for a non-capital-asset, in that plain-

tiff acquired and has held the stock in these subsidiaries in

pursuance of its railroad operations, and not as an invest-

ment or speculation; that the operation of the leased lines

was intended to produce excess profits taxable income, to be

reported in plaintiff’s return.

Plaintiff is upheld, and the issue is decided in favor of non-

capital-asset status. The result is, however, not free from

doubt. It is quite true, as the Government emphasizes, that the

case of the securities dealer is far different from that of a

leased railroad subsidiary. It is also true that decision in

favor of plaintiff permits the money invested in a subsidiary

to be treated as invested capital (and thus reduce excess

prolits taxes) twice, once as part of plaintiff’s invested capital

and again as part of the invested capital of the subsidiaries.

Neither statute nor regulation, however, limits non-capital-

asset status to the stock on the dealer’s shelf.

The business-purpose-investment-purpose test is at best

imprecise. Nuances of the application of the test could doubt-

less be discussed at length, and a ¢ase made for the Govern-

ment’s view, on the basis of the considerations it emphasizes.

The consideration which to my mind tips the scales in favor

of plaintiff's position is the historical evidence in this case of

the intimate relationship of the subsidiaries to plaintiff's

success as a railroad system. The loss of its subsidiaries prior

to reorganization was a low point in the decline of the old

Union Pacific Railroad, plaintiff's predecessor. The reacquisi-

tion of at least the Oregon Short Line was among the first

thoughts for the future of the reorganizers and the new

management. There can be no doubt that these subsidiary and

connecting railroads, led by the Short Line, had great signifi-

cance for the prosperity of the plaintiff as a transcontinental

railroad system, in the years after it came out of reorganiza-

tion in 1898. This significance appears in the course of the

25

discussion of the valuation of the shares issued in the reorga-

nization for the old road and for the Oregon Short Line, in

count 5.

With these origins, the acquisition of the stock cannot be

treated as a mere investment unrelated to the business opera-

tions of the plaintiff. It was accomplished for an operating,

business purpose and the stock was held as part of the opera-

tion of plaintiff’s business as a railroad. If anything, the

leases that followed confirm the conclusion of business and

not investment purpose, even assuming that they were entered

into only to reduce costs. As different as are a railroad and a

restaurant, the case presented is in essence similar to the case

of the restaurant stock, John J. Grier Co. v. United States,

supra. The plaintiff bought the stock to run the railroad and

not to make an investment, and thus the stock is a non-capital-

asset “admissible” for purposes of equity invested capital

under Sections 715 and 720. Cf. Corn Products Refining Co.

v. Commissioner, 350 U.S. 46 (1955) ; Booth Newspapers, Inc.

v. United States, 157 Ct. Cl. 886, 303 F. 2d 916 (1962).

Plaintiff is entitled to prevail on count 18.

VI. INTEREST ON 1948 AGREEMENT

Count 26 makes a claim for interest of over $12 million

under a certain 1948 “cutback” agreement between plaintiff

and the Commissioner relating to plaintiff's tax liabilities for

1942 and subsequent years. “Cutbacks” are refunds of rail-

road freight charges which have been paid by the Govern-

ment. There is little or no dispute as to the facts; only a

dispute as to their significance in the light of the agreement.

In transporting war material in 1942, when considerations

of secrecy or the novelty of the material made it impossible

to determine that a preferential, land-grant rate should be

applied, plaintiff charged the Goverment the full commercial

tariff. Thereafter, on audit by the General Accounting Office

between 1943 and 1957 (delayed because of the great volume

of auditing of wartime charges), the correct rates were de-

termined, and plaintiff refunded the overcharges as they

were determined. The refunds of overcharges for 1942

amounted to $12.8 million. ,

26

Plaintiff had accrued the full charges made in 1942 as in-

come in that year and reported them as such in its tax return

for that year. The charges having been received under a

claim of right, income for 1942 could not be recomputed to

exclude the »mount of the refunds or cutbacks. Under normal

tax procedures, the cutbacks could be treated only as deduc-

tions from taxable income in the years in which the cutbacks

were paid over to the Government. See Healy v. Commis-

sioner, 345 U.S. 278 (1953) ; United States v. Lewis, 340 U.S.

590 (1951). Large amounts of income, reported in years of

high, wartime tax rates, were thus, by virtue of the delays

in the audit, about to be reversed by reductions in income in

postwar years of lower, peacetime tax rates.

In recognition of the prospective inequity, the Commis-

sioner of Internal Revenue and the plaintiff agreed, on No-

vember 29, 1948, that normal practice would not be followed—

that plaintiff would be permitted to allocate the amounts of

the cutbacks not to the years of their payment but to the

years in which the original charges had been included in

taxable income. Accrued income for 1942, for instance, would

be retroactively reduced by the amount of the cutbacks of

rates included in income in that year and the cutbacks would

be disallowed as reductions in income in the various years—

1943 through 1957—in which they were actually made.

The letter from the Commissioner to plaintiff embodying

this agreement, called the Cutback Agreement, stated as

follows:

In view of the facts and circumstances presented, per-

mission is granted under the authority conferred in sec-

tion 43 of the Internal Revenue Code to allocate, on the

terms and conditions hereinafter stated, repayments

heretofore or hereafter made of excessive transportation

charges of the class described above to the years in which

such charges were included in taxable income. However,

the allocation of any such repayments of excessive trans-

portation charges to any year shall be made only to the

extent the refund or credit of the overpayment of income

and/or excess — tax, if any, resulting therefrom is

not prevented for any reason, and the deficiency, if any,

of income and/or excess profits tax resulting therefrom

may be assessed.

i ameill

3

;

3

;

i

;

27

The letter then goes on to set out the “terms and condi-

tions” of the agreement, in numbered paragraphs:

| In this connection, it is understood that you agree, as

follows:

1. All amounts received by you as transportation

charges from the Federal Government Departments and

Agencies shall be included in taxable income on the

accrual basis.

2. All refunds of transportation cha made by ou

to the Federal Government shall be allowed as deduc-

tions in the year or years in which such transportation

charges were included in income, and any deductions

claimed in the year or years such refunds were made will

be disallowed. * * *

The result of the permitted reduction in income for 1942

and the corresponding increase in income, distributed over

1943-1957, all other things being equal, would be an over-

payment of tax for 1942 and underpayments in 1943-1957,

and thus a refund for 1942 and deficiencies for 1943-1957.

(This would all the more be true if, as seems to have been the

case, plaintiff did not in the years following the making of

the cutback agreement in 1948 cease its practice, in its tax

returns, of reducing its annual income by the respective

amounts of cutbacks made in those years.) And interest pay-

able to plaintiff on the refund would exceed interest payable

by plaintiff on the deficiencies, by reason of the longer span

of time involved in the refund than in the deficiencies.

To relieve the Commissioner of such a net interest liability,

the parties further agreed, in the Cutback Agreement, that

the maximum interest payable to the plaintiff on a refund

caused by the cutbacks should be limited to the amount of

interest payable by the plaintiff on the deficiencies caused

by the cutbacks, as follows:

3. The amount of interest on refunds of income and

excess profits taxes resulting from these adjustments

shall be allowed only to the extent of, and limited to, the

amount of interest on deficiencies resulting from these

adjustments.

Plaintiff’s tax returns for 1942 were, as noted above, not

finally audited until 1959. The tax years following 1942 are by

reason of waivers still open; deficiencies for these years, re-

28

sulting from the cutbacks, have thus not been assessed, al-

though they have been disallowed in revenue agents’ reports

for those years.

Plaintiff tiled an excess profits tax return (Form 1121 under

the 1939 Internal Revenue Code) for 1942 showing no liabil-

ity; there followed certain additional payments by plaintiff

in anticipation of a deficiency. (The precise amounts, and

other details not here necessary, are set out in the accompany-

ing findings of fact.) On audit, and after making general ad-

justments, the Commissioner computed a deficiency of $15.9

million unrelated to the cutbacks reduction in income.

The cutbacks redyction in income of $12.8 million, alone,

would have resulted in an overassessment of $11.3 million.

An adjustment attributable to cutbacks therefore required a

deduction of $11.3 million from the deficiency of $15.9 mil-

lion. When this adjustment was made, there remained a total

proposed deficiency of $4.6 million, on which $.3 million in

interest was payable, or a total assessed deficiency of $4.9

million. |

Plaintiff's income and declared value excess profits tax re-

turn (form 1120) showed a tax of $38.4 million. On audit,

the Commissioner determined that liability for income tax

was $30.4 million and that plaintiff had no liability for de-

clared value excess profits tax. The consequent overassessment

of income tax, with adjustments for certain subsequent as-

Sessments, was $7.9 million.

The computations for the two taxes were netted out as fol-

lows. The deficiency of $4.9 million in excess profits tax was

satisfied by a credit of $4.2 million of the $7.9 million over-

assessment in income tax, and a certain postwar credit of

$.7 million. This left &3.7 million due to plaintiff as the net

balance of the $7.9 miilion overassessment of income tax, on

which interest of $4 million was payable. The total, $7.7

million, was then paid to plaintiff.

The cutbacks had played a part only in the excess profits

tax; the adjustment for cutbacks, the parties are agreed, had

no effect on plaintiff’s income tax. While the cutbacks of $12.8

million reduced plaintiff’s 1942 income subject to income tax

by that amount, the effect of the reduction was completely off-

set by the reduction of an allowable credit, under Section 26

29

(e) of the Internal Revenue Code of 1939, for income subject

to excess profits tax.

There was, also, no connection between the cutbacks and

the payment of the deficiency in excess profits tax by credit of

a portion of the overassessment of income tax and the inter-

est paid to plaintiff on the refund. It is agreed that the inter-

est of $4.0 million, paid as part of the $7.7 million refunded

to plaintiff, was attributable to the overassessment of income

tax and was not reiated to the cutback adjustment or the

interest in respect of cutbacks now claimed by plaintiff.

With the apparent complexities created by two tax returns

stripped away, and, thereby, the income tax return, the re-

fund of income tax and the interest thereon all set aside, the

remaining relevant facts, all related to excess profits tax, are

seen to be quite simple. The cutbacks reduced excess profits

tax income and had there been no other factors the reduction

would have meant an overassessment and 4 refund of excess

profits tax of $11.3 million. Simultaneously, however, other

items of income, not in question, increased income by a

greater amount, which increase, alone, would have meant a

deficiency of $15.9 million. When combined, the two adjust-

ments resulted in a deficiency of $4.6 million. The actual tax

liability figures were $18.807 million, on the basis of all ad-

justments except thg cutback adjustment, and $7.484 million

on the basis of all adjustments; the difference was the $11.3

million due to cutbacks. This sum was used to reduce the lia-

bility otherwise existing. In simplest terms possible, a tenta-

tive underassessment of $15.9 million, reduced by a tentative

overassessment of $11.3 million due to cutbacks, produced a

net actual underassessment and deficiency.

No refund was payable or paid. Since a refund, due to cut-

backs or otherwise, was not made, no interest was due or pay-

able. Interest is payable only on a refund. Hence plaintiff can

have no claim to interest, at least on the basis of general tax

law.

Plaintiff contends, however, that the Cutback Agreement

took the payment of interest in connection with the diminu-

tion of income by reason of cutbacks “out of the normal

process of assessment and collection,” made it “subject solely

to the provisions” of the Cutback Agreement, and required

30

the payment of interest on the overassessment of $11.3 million

resulting from cutbacks.

The Cutback Agreement does no such thing. It displaces

normal rules of assessment, collection and liability for inter-

est on refunds only so far as the terms of the agreement go.

And the terms of the agreement have a narrow effect upon

interest. Paragraph 3, the only relevant provision of the

agreement, does not in any wise provide for or require the

payment of interest to plaintiff. It rather sharply limits pay-

ments of interest on refunds resulting from cutback adjust-

ments. Interest to plaintiff on refunds resulting from cut-

backs, it is provided, “shall be allowed only to the extent of,

and limited to” the amount of interest payable by plaintiff on

the deficiencies from the cutback adjustments in the to-be-

assessed years of the actual refunds.

There is no limit put on the interest payable by the plain-

tiff. That was not the problem deemed needful of any agree-

ment. The problem to which the paragraph is directed is that

the large refunds to be expected for the war years, and the

long span of time involved, would entail a large liability for

interest to be paid by the Commissioner. The parties therefore

provided in paragraph 3 that interest should be paid to plain-

tiff on refunds only in the amount of the interest paid by -

plaintiff on deficiencies.

The effect is to eliminate any payment of interest to plain-

tiff on refunds resulting from cutback adjustments. No actual

payment of interest could be made to plaintiff until the limit

on the payment becomes known, and when the limit—the

amount of interest payable by plaintiff on deficiencies in the

subsequent years—does appear, the cross-obligations wash

out and nothing is payable to plaintiff.

A more fundamental reason for the failure of plaintiff's

claims is that no refund was made and thus no interest was

due, on general principles, unaffected by paragraph 3. Plain-

tiff seeks to overcome the fact of no refund by arguing that

because the agreement required the Commissioner to refund

an overassessment by reason of cutbacks, he should therefore

not have wiped out the overassessment of $11.3 million result-

ing from cutbacks. To this plaintiff adds a complaint that its

liability for interest on the deficiencies to be assessed for

7

31

1943-57 is still running, and that the Commissioner’s action

has deprived it of a fund of interest with which to minimize

its interest bill on the future deficiencies.

Restated to include the relevant facts, the plaintiff’s con-

tention is that the agreement requires that interest be paid,

as if on a refund, on the tentative overassessment of $11.3

million by reason of one item of income—the reduction in

income by the cutbacks—though it was in the final computa-

tion wiped out by a larger underassessment of $15.9 million

by reason of other items of income. So stated, the lack of

merit becomes clear. Interest is payable only on the net, the

refund, and not on individual items merged into the net

refund. The overassessment of $11.3 million, by reason of the

cutbacks, was required to be “wiped out” by the larger under-

assessment. The Cutback Agreement did not bear on the

normal processes of audit and collection. In the paragraph of

the agreement preceding the numbered paragraphs, quoted

above, there is explicit recognition that the agreed-upon allo-

cation of cutbacks to the year of the original overcharge

might result in either “refund or credit.” Here it resulted in

a credit.

Had the Commissioner not applied the $11.3 million over-

assessment of excess profits tax resulting from the cutbacks

to the $15.9 million deficiency, plaintiff would have been

called upon to pay the $15.9 million deficiency resulting from

adjustments other than cutbacks, instead of the actual defi-

ciency of $4.6 million. Had plaintiff been granted its wish

that it be paid interest for the years since 1943 on the $11.3

million overassessment, it could not have escaped liability for

interest on the $15.9 million deficiency. In economic effect,

therefore, plaintiff has received the interest on the $11.3 mil-

lion which it is now claiming.

Finally, plaintiff complains of the continued running of its

liability for interest on the deficiencies yet to be assessed.

This is as it must be. The Cutback Agreement shows no sign

of an intention to limit plaintiff’s liability for interest ; para-

graph 3 limits interest paid ¢o plaintiff, not interest to be paid

by plaintiff. Interest on a deficiency compensates the Govern-

ment for the withholding of the money. Since the time of the

Cutback Agreement in 1948, the burden of continued accrual

32

of interest has been deliberately assumed by plaintiff, by its

continuation of the practice of deducting the cutback amount

from income in the year of the cutback, though the agreement

contemplated deduction in the year of the original charge.

Moreover, plaintiff could stop the running of interest by one

method or another, all of which would involve payment.

The claim on the Cutback Agreement has no merit and

plaintiff is not entitled to recover on count 26.

VIT%® 1898-1918 LAND SALES’

This count 34 is one of those before the court as offsets to

defendant’s setoffs. 182 Ct. Cl. 103, 389 F. 2d 437 (1968). The

facts needful to be stated for present purposes are few.

In count 34 a claim is made to include in plaintiff’s income,

and thus in earnings and profits for excess profits tax pur-

poses, some $23 million received as gross proceeds of sales of

land between 1898 and 1918.

The facts are these. Among the properties of its predecessor

acquired by plaintiff in the 1898 reorganization were 6,577,000

acres of land in Colorado, Kansas, Nebraska, Wyoming and

Utah. By 1919, plaintiff owned only 971,348.64 acres. It can-

not be found that the entire difference, 5,604,942.85 acres, was

sold, for lack of evidence as to the amount of land acquired

in the intervening period, and because the figure for 1919 is

one for non-carrier and. A great quantity of land was how-

ever sold.

Immediately after the reorganization, plaintiff had trans-

ferred the land to the Union Pacific Land Company, which

it created for the purpose, in return for the stock and bonds

of the Land Company. The bonds—$10 million in par value—

were secured by a mortgage on all the Land Company’s assets.

The Land Company stock and bonds were then pledged by

plaintiff as collateral under the first mortgage on plaintiff’s

own property.

This last mortgage provided that the net proceeds from

sales of non-railroad land were to be paid to plaintiff to re-

imburse it for expenditures for betterments, improvements

and equipment, exclusive of expenditures charged to operat-

ing expenses. Accordingly, the trustee paid over to plaintiff,

between 1898 and 1918, $23,286,091.13, of his own total re-

3

;

33

ceipts of $23,392,717.22. On its books, plaintiff credited the

sum received to its investment in road equipment account. No

credit was made to income or surplus. The receipt of the

money seems to have been simply the occasion for a credit to

the ‘avestment account, that is, a decrease in the amount

shown as invested.

No more is known than is set out above. We can only spec-

ulate on why the plaintiff’s accountants and management

omitted to show on the books as income or surplus the receipt

from the trustee of what plaintiff now says was income. In

any event, plaintiff did not in whole or in part record the re-

ceipt of the $23 million as income or surplus or as an addi-

tion to earnings or retained earnings and profits.

In its post-trial brief and requested findings of fact, plain-

tiff urged, from the foregoing facts (supplemented only by

taking it as a fact that 5,604,942.85 acres of land were sold),

that the original credit to the investment in road equipment

account was error, and that the proceeds of $23,286,091.13

from the sale of 5,604,942.85 acres of land should now be in-

cluded in its accumulated earnings and profits for excess pro-

fits tax purposes. No suggestion was made that a sum less

than the $23 million might be earnings and profits; no find-

ings were requested concerning a cost or basis for the lands

claimed to have been sold for the $23 million.

In condensed fashion, pleintiff’s case was this: land was

sold for $23 million, and therefore that sum was income

which belonged and belongs in accumulated earnings and

profits, whatever the contemporaneous accounting treatment.

Of course this is not the law. For one thing, gross proceeds of

the sale of land are not gain or ineome ; only the difference

between sales price and cost or basis is realized income. Gross

payments on bonds are not income; only the difference be-

tween payments and cost is realized income. Section 111, 1939

Code. And this is what the Government replied.

The Government in its reply also pointed out that plaintiff

had failed to mention in its proposed findings or brief that

$6,972,025 93 of the $23 million—the portion consisting of

interest ‘*—had already been included by plaintiff in its ac-

“The stipulated facts on the source of the trustee's receipts and the

Portion of these receipts represented by the $6.9 million are these:

(Continued)

594—093—75——__3

34

cumulated earnings and profits for purposes of computation

of its excess profits tax, and allowed by the Commissioner,

and that this sum could hardly again be claimed. °

On this, plaintiff abandoned the claim for $23 million. Ad-

mitting that it was entitled to treat as accumulated earnings

and profits only the difference between sales price and basis,

and admitting that it was not again entitled to the $6.9 mil-

lion, it now claimed not $23 million, but $5 million. Specifi-

cally, it claimed, in newly requested findings proposing fig-

ures for each year from 1898 to 1916, that it had sold, for

$9,987,507.94, 5,972,197 acres of land which had cost $6,533,-

664.62, with a realized gain of the difference, $3,453,843.32,

and that the Land Company, a “wholly-owned subsidiary,”

had sold for $9,900,387.23, 3,620,615 acres of land which had

cost $8,312,812.83, with a realized gain of the difference,

$1,587,574.40. The request for these findings was filed with

plaintiff's post-trial reply brief, 10 months after the date on

which proposed findings were due and were submitted.

The newly proposed findings contain minutely detailed and

varied contentions as to facts and practices over 50 years old.

Entries on many pages of the books of account of the plain-

tiff, exhibits whose significance for this purpose had not been

mentioned before, were cited to establish cost and sales prices

for land parcels said to have been acquired and sold in the

years 1898 to 1916.

Only one of the fatal defects in these proposed findings is

that so far as can be determined plaintiff did not earlier give

(Continued)

Part already

included in

Source Amount plaintiff's

and ts

(1) Proceeds from sales by plaintiff of land and equip-

Sebencesasaccasnaseesensenenncsiinccsocecusceecese $2,381,688.36 ............

(2) Principal of deferred payments, interest thereon,

and other receipts from lands of plaintiff less ex-

i bacesenessecoceitensnnnnesenetpenseusnececes: . 10,208,367.53 $1, 231, 264.60

(3) Interest received from U. P. Land Co. with respect

EE EE ae 5, 713, 967. 20 5, 713, 967. 20

(4) Amounts received from U. P. Land Co. in payment

IT el a aa ae eee 6,067,000.00 =...

(5) Interest on uninvested cash..................._... 26, 794. 13 26, 704. 13

35

defendant notice of such contentions, on trial or in pretrial

or at any other time in the many years in which the case

had been pending.

In the pleadings, plaintiff had alleged and defendant de-

nied that lands acquired on reorganization were carried on

the books at no value and had been disposed of bet ween 1898

and 1919 for $23,286,091.13, which had been erroneously

credited to investment in road and equipment and not cred-

ited to accumulated earnings and profits. Only the acquisition

of Jands in the reorganization was admitted.

All the pretrial papers exchanged by the parties—state-

ments by each party of its contentions of law and facts, state-

ments by each party of the controverted facts it proposed to

prove and a joint statement of the issues which identified the

documents and witnesses with respect to each issue—show

on the one hand that plaintiff claimed a zero basis for all the

land sold, and on the other hand that defendant never re-

treated from its denial of the claimed zero basis and from

its positions that income is realized only to the extent of the

difference between gross receipts and cost, and that plaintiff

realized no income from the land transactions beyond the

sums (the $6.9 million) already included in accumulated

earnings and profits.

These pretrial papers were exchanged and filed as part of

extraordinarily extensive pretrial] proceedings, which took

place under pretrial orders providing that facts, issues and

witnesses not proposed, stated or disclosed by a party prior

to trial would not be permitted to be proved, raised or called

on the trial, except as required by the exigencies of the case.

The exigencies of the case most emphatically do not require

that plaintiff, having failed in pretrial and trial to mention

the facts, contentions and issues it now relies upon, be per-

mitted to raise these issues for the first time after trial, ina

reply brief, long after the time for requested findings has

expired.

Plaintiff has until now been committed to a zero basis,

which it apparently intended to prove as a matter of law by

the arguments and testimony relating to its accounting prac-

tices in the opening years of the century concerning retire-

ments of equipment. These were the arguments and testimony

36

which it relied upon in count 8, concerning $13 million de-

ducted from income in those years and credited to investment

account. For this position, plaintiff would now substitute a

new theory, on new facts, on newly requested findings. It is

too late. The disorder of permitting such a step and the

consequent prejudice to defendant are unthinkable.

It may be added that even were plaintiff's proposed

findings to be considered, they could not be adopted. As

might be expected from extemporized findings, the record

does not support what plaintiff sets out to prove—the acreage

on hand and its cost, the acreage acquired and its cost, and

the acreage sold and its proceeds, for plaintiff and the Land

Company, for each year from 1898 to 1916. Figures are lack-

ing for major elements in the purported chain of proof; pro-

jections and assumptions, offered to fill in the gaps, are hope-

lessly insufficient. For instance, the proposed figures for gross

proceeds are often only contract sale prices, and the lands

acquired are often lands surrendered by deferred payment

purchasers. Another type of defect is the inconsistency be-

tween the new contentions, which ignore the Land Company’s

bonds, and the earlier position of plaintiff, already imbedded

in its tax returns, that this is a case of income from the hold-

ing and redemption of bonds.

On the failure of the newly proposed findings, one short

statement of this whole affair could be that a basis for the

lands sold has not been shown and thus no income is provable.

Another is that plaintiit fails to overcome the force of its

own books. The crediting of the proceeds to investment in

equipment and the failure to credit income and thus add to

surplus or earnings or profits, as inexplicable as they may

be on looking backwards, were the deliberate choice» of plain-

tiffs management and accountants. As the Interstate Com-

merce Commission said in connection with the deductions

from income involved in count 8, some purpose must be

ascribed to the accountants who’madae up the books. Plain-

tiff has the burden of proof when it undertakes to show other-

wise than is said in its books. For lack of proof of error or

meaninglessness, these entries cannot be undone after they

have existed for half a century.

4

Ry

:

ij

:

i

;

3

”

|

37

Plaintiff is not entitled to prevail on count 34."°

VUI. UNAMORTIZED BOND DISCOUNT AND EXPENSE

When a corporation sells bonds at less than their face

value, e.g., 20 year 4 percent bonds with a $1,000,000 face

value for $950,000, the difference between the face value and

the proceeds, or in the illustration $50,000, is called bond dis-

count. (If the bonds are sold at more than face value the

excess is called premium.) The expenses of the issue, say

$10,000, which reduce still further the net proceeds of the

issue, are called bond expense.

By the customary accounting treatment the $1,000,000 pay-

able at maturity goes on the right or liability side of the cor-

porate balance sheet. The $940,000 net proceeds go into cash,

and are recorded on the left or asset side. Where shall the

$60,000 in bond discount and expense go? It will have to be

paid at maturity, one way or another, and it. will have to be

defrayed, somehow, from income or capital. One type of

treatment is to charge it off immediately against surplus, and

this is how plaintiff recorded on its bouks, presumably in

accordance with ICC regulations, the bond discount and

expense arising from its sales, in its early years, of bonds at

a discount. Another method, the approved income tax treat-

ment, call for a systematic annual charge against income of

a ratable portion, over the life of the bonds, and this is what

plaintiff did in its tax returns. Helvering v. Union Pacific

P.RP., 293 U.S. 282 (1934).

The question here presented by additional defense is

whether unamortized bond discount and expense, remaining

in the years 1940 through 1942 after plaintiff’s earlier income

tax deductions, was correctly treated by plaintiff as an asset

for purposes of the excess profits tax, more specifically, for

“ With respect to additional defenses 7, 8 and 18, the plaintiff has agreed

that, to the extent defendant establishes that certain income was realized

subsequent to March 1, 1913, plaintiff withdraws the amounts so established

from plaintiff's accumulated earnings and profits. Since such a finding has

been made as to the amounts of $375,974.45, $566,431.20 and $13,228.89, whose

total is $955,629.54, this latter sum shall be excluded from plaintiff's accumu-

lated earnings and profits, and to this extent defendant is entitled to prevail

on additional defenses 7, 8 and 18.

38

purposes of the reduction in equity invested capital by the

percentage of inadmissible assets among total assets, required

by sections 715 and 720 of the 1939 Code as amended, 26

U.S.C. §§ 715, 720 (1952).

While the Commissioner of Internal Revenue did not dis-

turb plaintiff’s treatment of the sum as an asset, the Govern-

ment here challenges the propriety of such treatment, in an

additional defense, No. 9, by way of a setoff. The amount

involved for 1940 through 1942, in excess profits tax credit

for 1942 and in credit carryovers from prior years, is $11,-

526,629, of which $10,355,828 is bond discount and $1,170,801

is bond expense.

The Government is here upheld in its position that un-

amortized bond discount and expense is not an asset for pur-

poses of the cited sections.

Unamortized bond discount has none of the characteristics

of an asset, except for its position on the left side of the

ledger. It is essentially interest—the cost to the borrower of

the borrowed money or the compensation paid for the use of

the borrowed money—and it is to be amortized until maturity

of the bonds, and then paid. Helvering v. Union Pacific R.R..,

supra. The unamortized portion, interest not yet paid, is

patently not an “asset,” whatever be the definition of that

seldom construed term."*

The origins of bond discount determine its character as a

reflection of interest rates—real or market and nominal. The

corporation which so chooses can simply sell its bonds or other

obligations at the market rate of interest and encounter no

discount. When, however, an issuer desires to sell bonds which

will bear on their face a lower rate of interest than that which

will cause the bonds to be bought, it perforce must set the

price of the bond lower than maturity value. The buyer is

offered, in addition to the face rate of interest per annum, the

1 There is little authority on the definition of assets for purposes of excess

profits taxes. It is held that treasury stock is not an asset for purposes of

the use of the term in the definition of equity capital in section 437(c) of the

Excess Profits Tax Act of 1950, 26 U.S.C. § 437(c) (1952 ed.). Colt’s Manu-

facturing Co. v. Commissioner, 300 F. 24 929 (2d Cir. 1962); Penn-Tevas

Corporation v. United States, 158 Ct. Cl. 575, 308 F. 2d 575 (1962). And an

asset has been described, in the context of the excess profits tax for 1919,

as an item valuable and used in the taxpayer's business. Isbell Porter Co. y.

Commissioner, 40 F. 24 432 (2d Cir. 1980).

ns

£

39

difference between face value and sales price in the form of a

lump sum at maturity. This difference is called discount. The

yield to the buyer takes two forms—the nominal coupon rate

and the deferred lump sum.**

Both forms, together called effective interest, are tosts to

the issuer of the borrowing and compensation to the lender

for the loan. Both must be found by the issuer and paid to

the lender. Coupon interest is paid annually from income.

Discount is accumulated annually (the term “accumulation”

is, by accounting authorities, preferred to “amortization”),

from income, and paid over at maturity. If the coupon rate,

payable annually, is interest, then the lump sum payment, the

product of annual accumulation, is also interest.

The income tax treatment of discount—accumulation of

the total discount by a charge of a ratable portion against

income in each year of the life of the bond—is a recognition

of the reality that discount is in essence the same as coupon

interest, and that each is a cost of the borrowing to be charged

annually against income in the years of the borrowing. The

unaccumulated, to-be-charged-against-income interest repre-

sented by the remaining years’ coupons is of course not an

asset, and the similarly unaccumulated to-be-charged-portion

of effective interest represented by unamortized bond dis-

count is, therefore, equally not an asset. Interest, payable this

“Bond discount is defined as the excess of face or maturity value over

the amount of cash or equivalent paid in by the original bondholder, and,

conversely, premium is defined as the excess of cash paid in over maturity

value. The explanation of this excess lies tn the fact that, in the discount

case, the nominal or ‘coupon’ rate of interest stated on the bond is less than

the market or effective rate. In this case the investor is unwilling to pay

maturity value for the bond, since this price would yield only the coupon

rate. Instead, the price of the bond is set at some lower point where the

yield to the buyer is the same as the market rate of interest on comparable

securities. In the case of a premium, the coupon interest rate exceeds the

market rate, and the price of the bond is set at a point above maturity vaiue

that will yield to the investor only the market rate of interest.” R. Wixon,

W. G. Kell, & N. M. Bedford, Accountants’ Handbook (5th ed. 1970) 20.30.

“Authorities generally agree that bond discount should be charged systemati-

cally to income as interest expense over the life of the bond issue.” /bid., 20.37.

“Bonds are sold at a discount because the rate of interest specified in the

indenture is less than the rate that the issuing company must pay for the

use of money. This discount, together with the expense of issue, is customarily

charged to unamortized debt discount and expense and written off over the

period from the date of issue to the date of maturity of the bonds. The

sum of the interest paid and the amortization of debt discount, by periods,

represents the effective rate of interest on the outstanding bonds.” N. J. Len-

hart & P. L. Defilese, Montgomery's Auditing, 311 (8th ed. 1957).

40

year or next or to be set aside year by year and paid at a fixed

future date, is not an asset.

Judicial, administrative and accounting authority recog-

nize that bond discount is interest. Discount is held to be de-

ferred interest, “likely to arise when the stated rate of

interest on the obligation is less than the rate demanded by

the market. American Smelting and Refining Co. v. United

States, 130 F. 2d 883 (3d Cir. 1942) * * * [E]conomic and

business reality * * * recognizes that to the issuer bond in-

terest is reflected both by the stated rate of interest and by the

amount below or above par received by the issuer when the

bonds are originally distributed.” Atchison, Topeka and

Santa Fe R. Co. v. United States, 443 F. 2d 147, 151, 153 (10th

Cir. 1971).

An early, leading decision of the Securities and Exchange

Commission held discount to represent “additional inter-

est,” “part of the cost which the issuer must eventually pay

for the use of the funds.” The Commission noted that “[a]c-

counting authority recognizes that bond discount should be

considered as part of the interest cost of the capital obtained.”

In Re Alleghany Corporation, 6 SEC 960, 962 (1940). The

American Institute of Certified Public Accountants, in a 1961

reissue of earlier research bulletins entitled “Unamortized

Discount, Issue Cost, and Redemption Premium,” is to the

same effect."

The attempted characterization of unamortized bond dis-

count as prepaid interest and the likening of it to prepaid

“1. Until the early days of the century, bond discount was commonly

regarded as a capital charge. When the unsoundness of this treatment was

recognized, alternative methods of treatment became accepted, under one of

which the discount ws distributed over the term of the issue, and under the

other the discount was charged immediately against surplus, the latter being

regarded generally as the preferable course.

“2. Present-day treatment recognizes that on an issue of bonds the

amount agreed to be paid (whether nominally as interest or as principal)

in excess of the net proceeds constitutes the compensation paid for the use

of the money. Where tonde are issued at a discount it is customary to

distribute the discount over the term of the bond issue and to charge both

the coupon interest and the allocated discount directly to income.

“3. In the committee's opinion it is a sound accounting procedure to treat

such discount as a part of the cost of borrowed money to be distributed

systematically over the term of the issue and charged in successive annual

income accounts of the company. * * *” American Institute of Certified Public

Accountants, ACCOUNTING RESEARCH AND TERMINOLOGY BULLETINS (1961)

ch. 15, Unamortized Discount, Iesue Cost, and Redemption Premium on Bonds

Refunded.

Cel cell i i ee a cits pt

41

insurance or rent is without basis. Discount represents the

portion of the face amount of the bonds not received by the

debtor, an amount uwed and to be paid on maturity. It is more

a nonreceipt, an unpaid cost or charge, a liability or a de-

ferred loss, a deficit or an offset to maturity value, than an

asset. Prepaid insurance or rent has been paid, could be re-

funded and will save an expenditure of equal amount in the

time to come. Unamortized bond discount has not been paid,

is a liability and remains to be expended in the future.”

The custom of recording unamortized bond discount on the

left side of the balance sheet, even had plaintiff followed it,

gives no support to the notion that it ia an asset. Expert testi-

mony in the record, made the basis for one of the accompany-

ing findings of fact, is that unamortized bond discount and

expense is put on the asset side of the balance sheet “solely to

make the balance sheet balance.” Double entry bookkeeping

and its compelled symmetry may not alter the nature or con-

trol the tax treatment of financial realities. Doyle v. Mitchell

Brothers Co., 247 U.S. 179 (1918); United Profit-Sharing

Corp. v. United States, 66 Ct. Cl. 171, 182 (1928).

Percipient auditors have long reognized that not every-

thing that appears on the left side of the ledger warrants the

caption “asset.” Robert H. Montgomery, a leading authority,

writing that bond discount was not an asset but a deferred

loss, attributed its inclusion among assets to the “curse of

balancing.” Despairing of the acceptance of a realistically

unbalanced balance sheet, he suggested changing the balance

w“ The argument t}hat bond discount should be interpreted as prepaid

interest and therefore deserves recognition as an asset similar in nature to

prepaid insurance or rent * * * bis no logical justification. Bond discount,

far from being prepaid interest, represents unpaid interest, or that portion

of effective intereet that will not be paid until the bond matures. No pay-

ment of interest has occurred. The issuer has simply borrowed less than the

maturity value of the bonds.”" R. Wixon, W. G. Kell, & N. M. Bedford, Aooownt-

ant'’s Handbook, eupra note 15, 20.34.

“Especially objectionable is the practice of labeling discount on bonds or

notes—the difference between actual proceeds and the amount due at

maturity—as ‘prepaid interest,’ and this treatment requires further com-

ment. * * * In the case of a loan effected at a discount the borrowing com-

pany actually makes no advance or prepayment whatsoever. Far from being

“prepaid” interest the amount of the discount represents unpaid or future

interest—that portion of the total interest which is not paid until the date

of maturity.” W. A. Paton, Advanced Accounting (1941) 611-12 (emphasis tn

original).

also D. J. Dohr, What Is An Asset, 73 J. of Accountancy 213, 216-11

(1942).

42

sheet heading to “Assets ete.” and making discount on bonds

an “etc.” R. H. Montgomery, Zhe Curse of Balancing, or

Theory v. Practice, 63 J. of Accountancy 279 (1937). Pro-

fessor W. A. Paton, another authority, concurs in the opinion

that bond discount is not an asset.?°

Plaintiff would support its claim that unamortized bond

discount is an asset by the charge-off, on its books, of the

entire amount of the discount to surplus, at the time the bonds

were first issued. Such accounting for bond discount and ex-

pense, while doubtless proper under ICC regulations, is in

disfavor with the accounting profession and is not proper tax

practice. The profession prefers ** and the tax law requires

the systematic charge to income over the life of the bonds.

*“One of the least excusable of the standard practices of accounting {s

that which treats bond discount on the issuer’s books as ap asset either related

to such current balances as unexpired insurance and prepaid rent or as a

long-term deferred charge allied to organization cost. Unaccumulated discount

on a bond or similar security is in no sense an asset, but represents an element

of the total ‘Interest’ charged during the life of the contract. The discount is

the difference between the amount of the actual capital received from the

investor and the par or face value—the amount payable at maturity. It is

neither a prepayment of cost by the borrower nor income recelved in advance

by the investor; it is rather that portion of the effective interest which

remains unpaid by the corporation and uncollected by the bondholder until

the due date of the security.” W. A. Paton, Advanced Accounting, eupra note 17,

608-9.

=“The anticipation of this income charge [bon discount] by a debit to

insome of a previous year or to surplus has in principle no more justification

than would a corresponding treatment of coupons due in future years.

“4. The argument advanced in favor of immediately writing off discount

was that it extinguished an asset that was only nominal in character and

that it resulted in a conservative balance sheet. The weight attached to this

argument has steadily diminished, and increasing weight has been given to

the arguments that all such charges should be reflected under the proper

head in the income account, and that conservatism in the balance sheet is of

dubious value if attained at the expense of a lack of conservatism in the

income account, which is far more significant.” The American Institute of

Certified Public Accountants, ACCOUNTING RESEARCH AND TERMINOLOGY BUL-

LETINS (1961) ch. 15, Unamortised Discount, Issue Cost and Redemption

Premium on Bonds Refunded, note 16, eupra.

“If discount on bonds issued is charged directly to income or surplus as a

loss the immediate effect is to understate the proprietary equity and the later

effect is to free the income statements through the life of the bonds from a

portion of the true interest burden. This procedure, accordingly, resulte in a

continuing error, in both statements, from the time the bonds are issued

until date of payment.” W .A. Paton, Advanced Accounting, supra note 17, 610.

“Irregular absorption of discount or premium, such as is permitted under

the accounting rules of the Interstate Commerce Commission, is unsatisfactory.

Failure to accumulate or to amortize until date of maturity is still more

objectionable. If discount is not accumulated until date of payment this

means that there has been no recognition of the increase in the bond

Mability from issue price to maturity value—that profits have been over-

>

ee see LO Bee

ee POE ee Eee eee ye eee De ek Vee fee

43

The source of both the professional preference and legal re-

quirement for an annual charge to income is the character of

bond discount as interest, a cost of borrowing, and the conse-

quent feeling that both types of interest—coupon interest and

the discount variety—should equally be reflected in the in-

come account by an annual expense item, else income 1s

overstated. An immediate write-off against earned or paid-in

surplus, in effect a charge to past income or to capital, is an

over-statement of income by the annual cost of the borrowing.

Plaintiff’s charge of the entire discount to surplus was thus

inconsistent with the nature of discount and cannot give

grounds for characterizing it as an asset. =

In a final effort to show that discount is an asset, apy

ur with support in the expert testimony given on trial,

that the ated portion of bond discount would have

value to a purchaser of the business, as a source of future tax

deductions. Such value is surely limited. Unamortized dis-

count would have no value to a purchaser of the assets, no

weight to a lender considering a loan. It has not been bought

or paid for, it produces no income and it could not be sold or

assigned. The value it might have to a purchaser of the going

business, as a source of income tax deductions, could only be

realized if profits were made by the use of the admitted assets

of the enterprise. That purchase, moreover, would find the

same “value” in the obligation to pay the fixed, coupon rate

of interest, which like the annual accumulated share of dis-

count, must each year be a charge on income. Discount, actu-

ally a cost to be defrayed in the years to come, has the same

f failure to include accruing discount in interest charges. It

= ¢oecometinelinnntn to accrue the entire amount of discount at one stroke

by a charge to income or surplus, and if income and surplus are not avail-

able in sufficient amount the result is a deficit. Similarly, if premium has not

been amortized this means that there has been no recognition of the oe

Mability from issue price to maturity value—that profits have been un “

stated throughout the life of the business by failure to exclude from —

charges the amortization of premium. It then becomes necessary to ry -

entire amount of premium to income or _— in one figure as a

orrection of the proprietary equity.” Jbid., .

. “Cole phen pe omer-n accepted accounting principles, bond discount and

expense should be written off over the life of the issue by periodic —

against income. In the past, debt discount and expense was often c ame

off to earned surplus at the date of issue, or at a later date; this procedure

is no longer acceptable.” N. J. Lenbart & P. L. Defilese, Montgomery’s

Auditing, eupro note 15, 811-12.

44

type of value, as a source of income tax deductions, as the

corporation’s contracts with its executives, the lease of its

premises, its pension plan, or, for that matter, a large tax loss

carried over from past years. All give rise to tax savings.

Since such “value” does not make an asset of next year’s tax

loss, it cannot transform unamortized bond discount from

unpaid interest to an asset, at least for purposes of an excess

profits tax based on concepts of invested capital and total

assets,

There remains the unamortized bond expense. It, too, must

be regarded as is unamortized bond discount—as a non-asset.

Bond issuance expense may differ factually from bond

issuance discount, in that expenses are actually paid out for

services such as printing, legal fees and commissions, and,

sometimes or always to an extent, are paid out by the issuer

itself as distinguished from the issuer’s underwriter. Accord-

ingly, some accounting authorities distinguish between dis-

count and expense, and hold the latter to be a genuine asset.2?

If the question were open for fresh decision, perhaps the

unamortized portion of bond expense paid out by the issuer

(as distinguished from expenditures for services by under-

writers which merely reduce the proceeds of sale paid over

to the issuer) might be held to be an asset. Plaintiff has, how-

ever, failed to show that the bond issuance expenses here

involved were of any different character than those held in

=“It is common practice to lump actual discount with the legal fees,

printing costs, underwriting commissions, and other charges associated with

the issuing of bonds, but this is not good accounting. The various service

costs which must be incurred in ralsing capital are a genuine asset (not a

money fund but a legitimate cost factor) and should be dealt with accordingly.

Where such costs are incurred in issuing a terminable security it is reasonable

to assume that their significance expires during the life of the security, and

complete amortization in this period is therefore indicated.” W. A. Paton,

Advanced Accounting, supra note 17, 612.

“Charges connected with the issue of new bonds—euch as legal expenses in

preparing the bond contract and mortgage, cost of printing certificates, regis-

tration costs, commission to underwriters, etc.—are costs of tie use of

capital obtained for the whole life of the issue and should be written off

over that period. * © *¢

“It ls common practice to lump these costs with actual discount (or net

them against premium, as the case may be). Good accounting requires careful

distinction between a true asset and bond discount, which f{« properly an

offset to the maturity value of the bonds.” R. Wixon, W. G. Kell, & N. M.

Bedford, Accountants’ Handbook, supra note 17, 20.39.

45

Helvering v. Union Pacific R.R. Co., supra, to be as much

interest as bond issuance discount.**

In Helvering v. Union Pacific R.R. Co., the Supreme Court

held that commissions paid out on the issuance of bonds, one

of the customary bond issuance costs, were to an accrual tax-

payer (as is the instant plaintiff) to be capitalized, amortized

over the life of the bond and the amortized amount deducted

annually from income. The decision has been applied in this

court to bond issuance costs generally. Chicago, Milwaukee

R. Co. v. United States, 186 Ct. Cl. 250, 262, 404 F. 2d 960,

967 (1968).

The Supreme Court in its opinion said that discount and

expense were both “factors in arriving at the actual amount

of interest paid for the use of capital procured by a bond

issue” which “must be added to the aggregate coupon pay-

ments in order to arrive at the total interest paid.” 293 U.S.

at 286. The Court went on as follows (293 U.S. at 286-87) :

But even if the commissions, unlike discount, may, as

the Government insists, be rded as a contemporary

expense of procuring capital, it is one properly charge-

able to capital account. ractice it is taken out of the

proceeds of the bonds by the banker. But in any case it

must be deducted from the selling price to arrive at the

capital realized by the taxpayer from the sale of the

bonds, in return for which he must, at maturity, pay the

face value of the bonds. The effect of the transaction in

reducing the capital realized, whether through the pay-

ment of commissions or the allowance of discount, is the

om °° * aS

Here the commissions, when paid, were properly

chargeable against capital, and reduced by their amount

the capital realized by the taxpayer from the bond issue.

They come out of the pocket of the taxpayer only on

payment of the bonds at maturity. But, unlike the pur-

chase and sale of property, the transaction contemplated

a

f the copy ed date, the due date of the

bende at which the difference between the net amount of

= The burden of proof on the issue, though raised by defendant's setoff,

is on the plaintiff-taxpayer, for the contested issue is obviously one of sub-

stance and is involved in the very tax return on which plaintif! seeks a

refund. Missouri Pactfio Railroad Co. v. United States, 168 Ct. Cl. 86, 338 F. 2d

668 (1964).

46

capital realized upon the issue and the par value of the

bonds must be paid to bondholders by the taxpayer.

*_* *

Given the Supreme Court’s ruling on the essentia] same-

ness of discount and expense, albeit in an income tax case, the

decision in the instant case can only be that expense goes with

discount, and since discount is surely not an asset, expense,

too, is not an asset. |

Accordingly the defendant is entitled to prevail on ad-

ditional defense 9.

IX. DISCOUNT AND PREMIUMS

In additional defense 6, also involving bond discount and

expense, the Government contends that plaintiff erroneously

failed to treat as “interest,” under section 711(a)(2)(B) (26

U.S.C. § 711(a)(2)(B) (1952)), amortized bond discount

and expense for 1940-42 (excess profits tax credit carryovers

for 1940 and 1941 are involved, in addition to 1942 taxes),

and call premiums and unamortized bond discount paid out

when certain bonds were retired in 1940 at their face value

plus a premium, as required by their terms on an early

retirement.

Under section 719(b) (26 U.S.C. §719(b) (1952)) only

50 percent of borrowed capita] may be included in invested

capital and, consistently, when invested capital is the method

used (as it is here) to determine the excess profits credit

(which in turn is the basis of the tax), interest deductible

from excess profits net income is required by section 711(a)

(2) (B), supra, to be reduced by 50 percent of the interest on

borrowed capital. In other words, since only half of borrowed

capital may be included in invested capital for purposes of

the credit, only half of the interest paid on borrowed capital

is allowed to be deducted from income for purposes of this

tax. See Amana Refrigeration, Inc. v. United States, 152 Ct.

Cl. 406, 410, 285 F. 2d 770, 772 (1961).

Plaintiff and its subsidiaries deducted in full—that is, did

not reduce by 50 percent—a certain sum of $10,253,706.34,

composed of $546,273.70, the amount of amortized bond dis-

count and expense in the tax years 1940-42, $3,265,051.46, the

amount of unamortized bond discount remaining in 1940, the

47

year of the retirement of a certain bond issue, and paid on

the retirement, and $6,442,381.18, the call premium paid in

that year on the retirement.

In additional] defense 6, defendant contends that these de-

ductions were all for “interest” and pursuant to section 711

(a)(2)(B) must be halved. Plaintiff maintains, to the con-

trary, that amortized discount and the call premiums were

ordinary and necessary business expenses under section 23 (a)

of the 1939 Code, and that the unamortized bond discount on

the bonds reacquired at face value plus call premiums wasa __

loss under section 23(f) of the 1939 Code.

The regulations provide that on retirement of bonds issued

at « discount the excess of the price paid over the issue price

plus the amount of discount already deducted is a deductible

expense, Treas. Reg. 111, § 29.22(a)-17(3) (1943). The regu-

lations are not helpful in determining whether the amounts

are deductible as “interest.”

Bond discount has already, in the preceding section of this

opinion, been noted to be essentially interest. Helvering v.

Union Pacific R.R., 293 U.S. 282, 286 (1934). See Frie Lacka-

wanna R.R. v. United States, 190 Ct. Cl. 682, 686, 422 F. 2d

425, 427-28 (1970). To the seller the difference between the

discounted purchase price of a promissory note and the higher

sale price is held to be ordinary interest income. United States

v. .idland-Ross Corp., 381 U.S. 54 (1965). The precise ques-

tion has been several times decided, in favor of the Govern-

ment. Discount has repeatedly been held to be interest under

section 711(a)(2)(B) or its successor in the Excess Profits

Tax Act of 1950, section 433(a)(1)(O), ch. 1199, 64 Stat.

1187, 1148, 26 U.S.C. §433(a)(1)(O) (1952). Central

Stations Signals, Inc. v. Commissioner, 10 T.C. 1015, 1020-21

(1948), affirmed per curiam, 174 F. 2d 479 (2d Cir. 1949) (fi-

nance charge for factoring contract held interest under sec-

tion 711(a)(2)(B) and not expense) ; Warne? Co. v. Com-

missioner, 11 T.C. 419, 432 (1948), affirmed per curiam, 181

F. 2d 599 (3d Cir. 1950) (amount of state tax on loans, im-

posed on bond purchaser but paid by issuer in addition to in-

terest, held interest under section 711(a)(2)(B) and not a

tax); L-R Heat Treating Co. v. Commissioner, 28 T.C. 894,

897 (1957) (negotiated bonus for loan withheld by lender

48

from loan proceeds, in addition to 6 percent interest, held

interest under 26 U.S.C. § 433(a)(1)(O) (1952 ed.) ; Ring-

master, Inc. v. Commissioner, August 6, 1962, T.C. Memo

1962-187, 21 TCM 1024, 1030-32, dismissed per curiam, 319

F. 2d 860 (8th Cir., 1963) (amounts paid as commissions for

securing loans held interest under § 433(a) (1) (O), not bro-

kerage fees).

The amounts of bond discount already amortized are thus

to be deducted as interest. It may well be that an interest ex-

pense is also an ordinary and necessary business expense, but

it is interest on borrowed capital and thus within the intent

and subject to the reach of section 711(a) (2) (B).

Unamortized bond expense on bonds reacquired, and call

premiums payable and paid at such retirement prior to

maturity, are no different in principle from amortized bond

discount. When an issuer sells bonds at a discount, the en-

tire difference between issue price and face value is interest,

to be paid at maturity, and to be charged to income each

year and accumulated over the life of the bonds. Whether the

bonds are early retired, pursuant to the terms of the issuance,

by payment of face value plus a call premium, or are retired

on maturity by payment of face value alone, there is no dis-

tinction to the lender or borrower between the constituent

parts of the amount of discount on the loan.

What has been said indicates that call premiums, too, are

additional interest, in this case payable for the privilege of

converting a longer term loan to a shorter. A payment closely

similar to a bond call premium, a charge paid by a borrower

when he prepays, before maturity, the principal of a mort-

gage or promissory note, has been held in this court to be

“interest” gross income to an insurance company. In Equit-

able Life Assurance Society v. United States, 149 Ct. Cl. 316,

319, 181 F. Supp. 241, 242, cert. denied, 364 U.S. 829 (1960),

the court held:

The precise —— before us was considered by the

Tax Court in General American Life Insurance Com-

pany, 25 T.C. 1265 (1956). That court decided that pre-

yment are in reality an additional fee for the

use of the len money for a shorter period of time

than originally upon, and that this fee represents

the generally er cost of a short-term, as opposed to a

49

roar by vane loan. The charges are part of the compensation

to the lender for the use of money. Deputy v. duPont, 308

U.S. 488, 498; Old Colony R. Co. v. Commissioner, 284

U.S. 552, 560-61. They are thus directly related to the

economic cost of borrowing money and are not merely

incidental to the loan transaction, but fall within the

statutory term “interest.”

See also The Prudential Insurance Co. of America v.

United States, 162 Ct. Cl. 55, 65-66, 319 F. 2d 161, 166-67

(1963) ; United Benefit Life Insurance Co. v. McCrory, 242

F. Supp. 845, 850-51 (D.C. Neb., 1965) (penalty payment for

early repayment of mortgage held interest income of life in-

surance company). Contrary dicta in Central & South West

Corp. v. Brown, 249 F. Supp. 787 (D.C. Del., 1965), cannot

prevail over the cited authorities.

There would be no rational basis, in the light of the es-

sential sameness of character between discount and call

premiums, for holding one to be and the other not to be inter-

est under section 711(a) (2) (B). The sums over the original

amount of the loan constitute compensation for the use of the

money—interest—payable when the loan is repaid, whether

earlier than contemplated or on schedule. The early repay-

ment is for the convenience of the borrower and works no

change in the nature of the payment as interest. The deci-

sion here is, I believe, all but concluded by the decision of this

court that difference between agreed redemption price and

issue price (in a case of non-interest-bearing debentures re-

deemed a year after iseue) is income “in lieu of the payment

of interest,” because it constituted “the agreed compensation

for the use of the purchaser’s money for the prescribed pe-

riods.” Pattiz v. United States, 160 Ct. Cl. 121, 127-28, 311 F.

2d 947. 950 (1963). If part of that difference is a loss, it is a

loss which is in the form of additional interest payable for

the privilege of early retirement. Cf. Helvering v. Union

Pacific R.R., 293 U.S. 282, 286 (1934) .**

* Both commissions and discount, as the Government concedes, are factors

in arriving at the actual amount of interest paid for the use of capital

procured by a bond issue. The difference between the capital realized by the

issue and par value, which is to be paid at maturity, must be added to the

aggregate coupon payments in order to arrive at the total interest paid.

Both discount and commissions are included in this difference. If the dif-

ference be viewed as a loss resulting from the funding operation, it is one

which is realized only upon the payment of the bonds at maturity.”

594-093—75——4

50

Against the foregoing wealth of authority, plaintiff puts

forward only inferences from the legislative history of a

nearby section, section 711(b)(1)(D), added by section 201

of the Second Revenue Act of 1940, ch. 757, 54 Stat. 974,

26 U.S.C. §711(b)(1)(D) (1952). Section 711(b) (1)

(D), not involved in the instant case, disallows certain de-

ductions from taxable income of expenses and losses on the

retirement or discharge of bonds, issued at a discount and

outstanding for more than 18 months, in computing excess

profits income for base period years beginning before Janu-

ary 1, 1940, the computation of which is necessary where the

excess profits credit is based on average income rather than

invested capital.

The House bill which became section 711(b)(1)(D) read

much as does the section in final form, and affected only the

computation of excess profits net income for base period

years, not here involved. H.R. Rep. No. 2894, 76th Cong., 3d

Sess. 13, 14, 19 (1940). The Senate Finance Committee, how-

ever, extended the provision to the computation of excess

profits net income for the later years as well-—the years in-

volved in the instant case—to apply whether income was to

be based on either income credit or invested capital method,

thereby proposing an amended section 711(a) (2) which had

it been enacted would have disallowed “the deduction other-

wise allowable under section 23(a) for expenses paid or

incurred in connection with such retirement or discharge

(including any premium paid upon any such retirement or

discharge), the deduction for losses otherwise allowable in

such connection, and the deduction otherwise allowable on

account of the issuance of the bonds or other evidence of

indebtedness at a discount.” S. Rep. No. 2114, 76th Cong.,

3d Sess. 11-12 (1940). At the same time the committee was in

the quoted words speaking of disallowing “expenses” and

“losses,” plaintiff emphasizes, the committee spoke of “inter-

est” as the subject matter of section 711(a) (2) (B). S. Rep.

No. 2114, supra, at 12. The conference committee report elim-

inated the proposed change for all years, retaining it only in

section 711(b)(1)(D) for the base years. H.R. Conf. Rep.

No. 3002, 76th Cong., 3d Sess. 46 (1940).

51

Plaintiff would see in the Senate’s bill an understanding of

Congress that the deductions for amortized bond discount,

unamortized bond discount and call premium were expenses

and losses rather than interest. In other words, that proposed

change in the law was on the premise that discount and pre-

mium were not, as interest, already subject to section 711(a)

(2) (B).

The contention aggrandizes an ambiguous legislative inci-

dent into the full-blown status of an intent of the whole Con-

gress of material significance on the construction question

which is presented. It may be, as plaintiff contends, that the

premise and thus the understanding of the framers of the

Senate bill was that call premiums and unamortized bond dis-

count were not interest covered by section 711(a) (2) (B).

It may also be that though believing that such items, as inter-

est, were subject to section 711(a) (2) (B) and thus to halving

only, the draftsmen desired to change the law and achieve a

100 percent disallowance, and thought that section 711(b)

(1)(D) was a convenient vehicle because discount and the

like were also expenses and losses. We do not know the prem-

ise of the Senate bill. We do know that the conference com-

mittee rejected the bill as drawn in the Senate, and so what-

ever was the premise of the Senate bill, it was not Congress’

premise, |

The conference committee’s thinking is equally unknown.

Its report gives only the fact of what it did.** We do not

know if it felt that discount and call premiums were interest,

already covered by 711(a) (2) (B), and should not be treated

as losses and expenses under section 23, or whether it felt that

such items were not interest, but should nevertheless not be

disallowed in full. But whatever were the conference com-

* The committee said :

“(2) The adjustment requiring that certain deductions otherwise al-

lowable on account of the retirement or discharge of bonds, etc., should

be excluded from the computation has been eliminated for taxable years

after the base period. As retained relative to taxable years in the base

period, it has been redrafted so as to make certain that the excluded

deduction on account of the issuance of bonds, etc., at a discount relates

only to discount unamortized on the date of the retirement or discharge.

The ordinary deduction for amortization of bond discount accrued for

that portion of the taxable year preceding the retirement or discharge

is not to be excluded from the computation.” H.R. Conf. Rep. No. 3002,

supra, at 46.

52

mittee’s views, it cannot be said that it concurred in the ver-

sion of the Senate’s view which squares with the plaintiff’s

position.

The Senate’s view, whatever it was, was surely not the

intent of Congress in enacting or construing section 7i1(a)

(2) (B). The understanding of existing law by one house in

the course of legislation, at least in such ambiguous circum-

stances as are here present, cannot be given effect as the intent

of Congress. Too many doubts and questions would surround

the result, and as nas been said, it is the function of legislative

history to resolve doubts and not to create them. The indeci-

sive evidence of legislative intent presented by plaintiff may

not gainsay the abundant authority, set out above, supporting

the conclusion that amortized bond discount, unamortized

bond discount and call premiums paid on retirement of bonds

are, all, interest under section 711(a) (2) (B).

The Government is entitled to prevail on additional

defense 6.

X. DONATIONS AND CREDITS

By count 17 and related counts, plaintiff seeks to add

$3,675,562.72 to its equity invested capital for the year 1942

and $9,798,364.02 and $9,891,701.23 to the equity invested

capital of its subsidiaries and itself for the respective years

1940 and 1941, when it filed returns consolidated with its

subsidiaries.** The additions would decrease plaintiff’s tax

by increasing its excess profits tax credit for 1942 and its

unused consolidated excess profits tax credit carryover from

1940 and 1941 to 1942.27

* Counts 17, 21 and 24 directly seek the increase in equity invested capital

described in the text. Counts 19, 22 and 25 seek consistent treatment for pur-

poses of computing total assets.

To put the issue in ite context, it may be sald that the Excess Profits

Tax Act of 1940, as amended in 1942, levied a tax of 90 percent (subject to a

post-war credit of 10 percent and an overall ceiling of 80 percent on combined

income and excess profits tax) on corporate “excess profits net income” remain-

ing after an allowance of an exemption and an excess profits credit represent-

ing normal profit. Title II, Second Revenue Act of 1940, as amended, § 710

et seq., 54 Stat. 974, 975, as amended, I.R.C. (19389) as amended, § 710 et #eq.,

26 U.8.C. (1940 ed. and Supp. II). The taxpayer wae given the alternative of

computing the credit on the basis either of average income over a base period

or (the method chosen by plaintiff) “invested capital.”

53

These sums are the account balances, as of the close of the

years in question, representing facilities which were con-

structed with or composed of the cash and property trans-

ferred by nonstockholders to plaintiff and its subsidiaries in

literally thousands of “donations and grants” from non-

shareholders during the years 1914 through 1942. No income

tax was paid on the receipts. They were recorded as assets in

the books of plaintiff and its subsidiaries (henceforth, to-

gether, called the plaintiff) and were held in the tax years in

question for use in plaintiff’s trade or business.

The Commissioner of Internal Revenue with a few

exceptions disallowed the inclusion of these manifold dona-

tions and grants in plaintiff’s equity invested capital. Plain-

tiff challenges the disallowance. In a defense of setoff, the

Government challenges the Commissioner’s allowance of the

inclusion in equity invested capital of six donations and

grants.

The parties have by agreement reduced the thousands of

transfers involved to 56, to represent all the transfers, and

they have also agreed, in the course of their proposals for

findings, upon individual transfers to represent the several

classes of transfers. These classes are as follows, the amounts

stated being those for transfers made prior to January 1,

1940:

Class 1, by far the largest, accounting for $5,992,110 of the

$9,798,364 involved, is governmental transfers to relocate line

on account of dams. It is represented by transactions in which

the Federal Government paid the plaintiff the cost of relocat-

ing or protecting such parts of its line as would be flooded or

threatened by a rise in water level by reason of a Govern-

ment dam about to be built.

The Act took a historical approach to the computation of invested capital ;

it would be composed of “equity invested capital” or the total money and

property paid in and left in the corporation (excluding “inadmissible assets”

such as stocks and bonds), a prescribed percentage of outstanding borrowed

capital and accumulated earnings and profits up to the beginning of the taxable

ear.

: Once invested capital is determined, graduated percentages are applied to

determine the excess profits tax credit. The percentages in 1942 were 8 percent

of the first $5 million of invested capital, 7 percent of the next $5 million,

6 percent of the next $190 million and 5 percent of amounts over $200 million.

The Act was repealed in 1945. 59 Stat. 556, 558.

54

Class 2, $251,669, governmental transfers to relocate line

on account of highways, is represented by a case in which the

City of Long Beach, as part of a plan to build a new high-

way, by agreement paid the plaintiff $240,000 for the latter’s

right to operate on certain streets and the right to use, for

pedestrian and vehicular traffic, the plaintiff’s drawbridge

across a harbor entrance.

Classes 3 and 4, $1,947,206, governmental transfers for

highway underpasses and other highway construction, are

represented by transfers in which a state or city, in the inter-

est of public convenience and safety, and in many cases us-

ing federal funds made available for the purpose, paid the

cost of railroad highway crossings such as a new grade cross-

ing or the replacement of a viaduct with a highway subway

under the railroad’s line. These transfers are governed by

United States v. Chicago, Burlington & Quincy R.R.,

412 U.S. 401 (1973), in which substantially identical ** trans-

fers were held not to effect contributions to capital.

Class 5, $320,601, governmental miscellaneous transfers,

is divisible as follows: (1) 12 percent is represented by trans-

fers substantially identical with classes 3 and 4; (2) 87.2 per-

cent is represented by payments for fences and street lights

on land leased from the plaintiff, cables for utility lines,

water mains and irrigation waterways under the right-of-

way, and (3) 0.8 percent is represented by a transfer to build

sanitary facilities on the plaintiff’s premises.

Class 6, $891,354, private transfers for spur and other

tracks, is represented by several transfers by shippers for

the construction of spur tracks to the transferor’s plant or

installation and two transfers by nonshippers, one identical

with those in class 1, supra, except that the transferor was a

private power company, and the other a railroad with whom

plaintiff maintained a joint installation at a highway crossing.

Class 7, $395,422, private miscellaneous transfers, is repre-

It is of no consequence that it does not appear in the instant case, as it

did in Ohicago, Burlington 4 Quincy R.R., supra, that in all of the transfers

the taxpayer railroad assumed a contractual obligation to maintain and repair

the facility which was the subject of the transfer. There is every reason to

expect that a railroad will in fact maintain, repair and renew the facilities

which it owns, in this context typically that portion of a subway structure

upon which its track rests or that portion of a grade crossing which it owns.

55

sented by vransfers involving payments for street lights on

leased property paid for by the lessees; a private road and

gates across the right-of-way for the use of, and paid for by,

the owner of the land on both sides; feed racks and a scale

paid for by a stock yard for its use; a culvert needed and

paid for by a water company; a storage facility and a power

line for the use of an express company, paid for by it; and a

retaining wall needed for a spur track to a shipper’s plant,

paid for by the shipper.

The issue is whether the facilities built with the cash and

property transferred may properly be treated as “money”

and “property” “paid in” by nonshareholders “as a contribu-

tion to capital,” and thus includible in equity invested capital

under the 1939 Code.** See Treasury Regulations 112

§ 35.718-1 (1944).

The dispute centers first on classes 1 and 2 of the transfers

in question. As noted above, classes 3 and 4 are governed by

Chicago, Burlington & Quincy R.R., supra, and classes 5-7

are of a miscellaneous nature whose disposition will best

be discussed after decision on classes 1 and 2.

In briefs filed before the decision of Chicago, Burlington &

Quincy R.R., supra, plaintiff contended that the transfers

were made to induce the construction and operation of its

railroad for the service and safety of the public and were

therefore contributions to capital under Edwards v. Cuba

R.R., 268 U.S. 628 (1925). See Tewas &: Pacific Ry. v. United

States, 286 U.S. 285 (19382). Edwards v. Cuba R.R., supra,

held that payments of money and property by the Govern-

*=§ 718, Equity invested capital—(a) Definition.

The equity invested capital * * * shali be the sum of the following

amounts * * *

(1) Money paid in.

Money previously paid in for stock, or a# paid-in surplus, or as a contribution

to capital ;

(2) Property paid in.

Property (other than money) previous!y paid in (regardless of the time

paid in) for stock, or as paid-in surplus, or as a contribution to capital. Such

property shall be included in an amount equal to its basis (unadjusted)

for determining loss upon sale or exchange. If the property was disposed of

before such taxable year, such basis shall be determined in the same manner as

if the property were still held at the beginning of such taxable year. If such

unadjusted basis is a substituted basis it shall be adjusted, with respect to

- the period before the property was paid in, in the manner provided ia section

118(b)(2); °° °"

56

ment of Cuba to a railroad corporation, conditioned on the

construction of a railroad line—so much per mile—were

made as reimbursement for capital expenditures rather than

as a gift or to obtain rate concessions and in consequence were

not profits or gains taxable as income. The distinctive feature

of the transaction was that the Cuban Government was act-

ing deliberately to induce the construction of a railroad, and

to promote its success by making a grant towards its capital.

The transfers were akin to those made by Congress to the

first Union Pacific Railroad, in the Pacific Railway Acts in

the last century. Such transfers are utterly unlike those pres-

ently in question. Edwards v. Cuba R.R. is therefore not

helpful.

The remaining arguments of the parties are based on

Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943) and

Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), from

which the Supreme Court in Chicago, Burlington & Quincy

L.R., supra, recently distilled a number of the characteris-

tics of a contribution to capital under the Code.*°

A contribution to capital, the court wrote, “must become

a permanent part of the transferee’s working capital struc-

ture”; it “may not be compensation, such as a direct payment

for a specific, quantifiable service provided for the trans-

feror by the transferee.” It “must be bargained for” {and

thus assets granted by a governmental body for replacement

of existing facilities, where none otherwise would have been

deemed necessary, are not contributions to capital), and the

asset transferred “foreseeably must result in benefit to the

transferee in an amount commensurate with its value.” Fi-

nally, “the asset ordinarily, if not always, will be employed

© The decision in these cases, involving primarily the issue of depreciability

of assets transferred to the taxpayer, turned on whether the asset involved

was a contribution to capital, for the income tax act beginning in 1932

provided that the basis of a contribution to capital should be the basis of the

transferor, and thus the contribution to capital would be depreciable though

having had no cost to the transferee. Section 118(a)(8) as added by the

Revenue Act of 1932 c. 209, 47 Stat. 198; I.R.C. 1939, § 118(a)(8). The sec-

tion confirmed the exemption from income taxation for the class of shareholder

contributions, a class broadened by Edwardes v. Ouda R.R., eupra, to include

the nonsuareholder contributions described in the text, supra. In the 1954

Code, the former result was changed by a provision for an exclusion from

income for all contributions to capital of corporations, with the proviso that

the basis of the contribution by a nonshareholder should be zero, §§ 118,

862(c), Int. Rev. Code of 1954.

57

in or contribute to the production of additional income and

its value assured in that respect,” and thus assets intended

for the safety of the public are not contributions to capital,

because they were “peripheral to the road’s business” and

“did not materially contribute to the production of further

income by the railroad.” 412 U.S. at 413-414.

As already noted, the facts of classes 3 and 4 of the trans-

fers in the instant case are substantially identical with those

in Chicago, Burlington & Quincy R.R., supra, and thus the

decision there decides that classes 3 and 4 here are not con-

tributions to capital.

The other classes may be summarily disposed of in the

light of the characteristics of a contribution to capital set out

in Chicago, Burlington & Quincy R.f., supra.

The transfers in class 1, typified by a transfer by the Fed-

eral Government to the plaintiff to replace a portion of the

right-of-way to be flooded by a projected dam, were matter-

of-fact business transactions in which the parties made an

equal exchange, without altruism or donative intent. The

closest analogy is a condemnation proceeding ; no one would

contend that payment of a condemnation judgment or of a

sum in settlement to avoid an eminent domain proceeding is

a contribution to capital. In the words of the majority opin-

ion in Chicago, Burlington & Quincy R.R., supra, the trans-

fers in class 1 “simply replaced existing facilities” and “did

not materially contribute to the production of further in-

come by the railroad.” 412 U.S. at 414.

In Los Angeles & S.L. R.R. v. United States, 86 Ct. Cl. 87,

21 F. Supp. 347 (1947), a railroad (actually a subsidiary of

the present plaintiff) gave up a portion of its line to a min-

ing company in need of the land for an extension of the mine’s

tailings dumps and received in return a new line as a replace-

ment. This court said that the new line, though costlier than

the old, “was of no more use to the railway company than the

old line and would not produce a cent more income” or in-

crease the value of the railroad’s assets “by a single dollar.”

86 Ct. Cl. at 99-100, 21 F. Supp. at 353.

Class 2 transfers are essentially the same as those in class

1 and are equally with class 1 not contributions to capital.

Classes 3 and 4, as already noted, are not contributions to

58

capital on the authority of Chicago, Burlington & Quincy

R.R., supra; 12 percent of the transfers in class 5, found to

be essentially the same as the transfers on classes 3 and 4,

are also not contributions to capital.

Of the remaining 88 percent of the transfers in class 5,

87.2 percent are represented by these transfers: (1) a state

prison, as required by its lease of a portion of the plaintiff’s

right-of-way for use as a pasture, paid for a “hog-tight”

fence for the prison farm; (2) a state paid its share of a

municipal assessment for street lighting on the railroad’s

grounds at a railroad station, in accordance with the ease-

ment contract covering encroachment of the state’s highway

on the station grounds; (3) a municipal department of power

and light paid for the cost of cables for telephone and tele-

graph lines, to replace open wire lines; the record gives no

further details; (4) a town paid for the cost of a water main,

under the right-of-way, to the municipal stockyard; (5) and

(6) federal irrigation agencies paid for the cost of irrigation

waterways under the plaintiff’s line.

In all of these it appears that the transfers were essentially

an exchange of values or a payment for a specific quid pro

quo which left the plaintiff transferee no better off than be-

fore and did not materially contribute to the production of

further or additional income. Accordingly, under United

States v. Chicago, Burlington & Quincy R.R., supra, the

transfers did not effect contributions to the capital of the

plaintiff.

The final subgroup of 0.8 percent of the transfers in class

5 is represented by a transfer in 1938 in which a town in

Kansas furnished $129 worth of W.P.A. labor to construct

four new sanitary privies, notice having been given the rail-

road by the town to abate the nuisance of unsanitary privies.

The scanty record leaves a net impression that in this transfer

the town intended, in the interest of the users of the facilities,

to confer a benefit upon the railroad, and that the transfer

replaced existing facilities with new and better ones which

plaintiff would otherwise have been required to construct out

of its capital funds and thus that the transfer resulted in a

benefit to the transferee in an amount commensurate with its

value in that it enabled the plaintiff to avoid a capital expend-

59

iture to the value of the assets transferred. The sum whose

expenditure was avoided was employed in the production of

further or additional income. This group of transfers there-

fore meets the Chicago, Burlington & Quincy R.R. test for

a contribution to capital.

The Government maintains that in any event the thing

contributed was services, and neither “money” nor “prop-

erty,” as required by §718 for inclusion in equity invested

capital. There is authority that services compensated with

stock are neither “money” nor “property” includible in in-

vested capital. Bard-Parker Co. v. Commissioner 218 F. 2d

52 (2d Cir. 1954), cert. denied, 349 U.S. 906 (1955) ; Western

Maryland Ry. v. United States, 227 F.2d 576 (4th Cir. 1955),

cert. denied, 351 U.S. 907 (1956). The more pointed cases,

however, albeit decided under an earlier excess profits tax

act, recognize that such one-time services as those of archi-

tects and engineers which go directly into the creation of a

tangible capital asset are so sufficiently reflected in capital

assets that their value is includible in invested capital. Fed-

eval Plate Glass Co. v. Commissioner, 6 BTA 351 (1927) ;

Coatesville Boiler Works v. Commissioner, 9 BTA 1242

(1928) ; see Palomar Laundry v. Commissioner, 7 TC 1300

(1946). By the thinking of those cases, the cost of the labor

used in building the privy is, as much as the lumber and roof-

ing used, a capital asset and includible in equity invested cap-

ital. Money actually passed to workmen who labored to build

a structure which became a capital asset. No case holds the

cost of such labor not includible in equity invested capital.

No principle or policy requires that it be not includible, for

the transaction is wholly realistic, without any possibility of

exaggeration or evasion. See Union Pacific R.R. v. United

States, 185 Ct. Cl. 398, 401 F. 2d 778 (1968), cert. denied,

395 U.S. 944 (1969), rehearing denied, 194 Ct. Cl. 1021, cert.

denied, 403 U.S. 931 (1971). .

In the nongovernmental transfers, classes 6 and 7 described

above, the transfers were substantially identical to those in

class 1 and to the transfers comprising 87.2 percent of the

transfers in class 5, or were direct payments for specific things

or services. The transfers in those two classes, therefore, are

under Chicago, Burlington & Quincy R.R., supra, not con-

tributions to capital.

60

The transfers challenged in the plea of setoff, and the

decisions thereon, are as follows:

(1) $200,000 for a spur track to a smelter about to be built,

paid for in 1901 by the owner of the smelter; held a payment

for a specific quantifiable service and therefore not a capital

contribution under Chicago, Burlington & Quincy R.R.,

supra.

(2) $1,076 for railroad line from Orchard, Idaho, to Boise

Idaho, to connect with the existing line from Boise to Nampa,

to provide through train service for Boise; paid for in 1925

by the Chamber of Commerce of Boise, Idaho; held this

transfer was not a payment for a thing or a service, was bar-

gained for, resulted in benefit to the transferee in an amount

commensurate with its value, and the assets transferred were

employed in the production of further or additional income.

It was therefore a contribution to capital under Chicago,

Burlington & Quincy R.R., supra, Brown Shoe and Edwards

v. Cuba R.R., supra. See Federated Department Stores v.

Commissioner, 426 F. 2d 417, 420 (6th Cir. 1970).

(3) $28,338 for land for a new line from Rogerson, Idaho,

to Wells, Nevada, provided in 1925 by a citizens right-of-

way committee for the purpose of obtaining a more direct

outlet to the California market for Southern Idaho agricul-

tural products, and to open up for tonnage shipments numer-

ous copper mining properties adjacent to the new line, This

transfer had the same characteristics as the immediately fore-

going transfer and is equally a capital contribution.

(4) $100,000 paid by a citizens committee in 1928 to ac-

quire and transfer to plaintiff a small road which had ceased

operations, in consideration of plaintiff’s promise to operate

it permanently. This transfer was essentially similar to the

two foregoing transfers and is equally a capital contribution.

(5) $46,125 paid by the Utah Copper Company to reim-

burse the plaintiff for the additional expenses of operating a

relocated line, in the circumstances detailed in Los Angeles

& SL.R.R., v. United States, supra. This transfer is held not

a capital contribution for the reasons stated above in con-

nection with classes 1 and 2.

(6) $240,421.01 transferred by a citizens committee in 1925.

61 -

Plaintiff has conceded that defendant is entitled to prevail on

this transfer.**

XI. EQUITY INVESTED CAPITAL

Plaintiff also seeks a refund of taxes paid on excess profits

based on an alleged erroneous determination by the Com-

missioner of Internal Revenue [Commissioner] of its 1942

equity invested capital credit. Plaintiff contends that the

Commissioner undervalued its equity investment and, there-

fore, unduly restricted its credit. In a most unusual counter-

attack, defendant also asserts that the Commissicner erred

in his equity investment appraisal. However, defendant

claims that the Commissioner overvalued plaintiff’s equity.

It, therefore, seeks to “offset” any other refunds due plain-

tiff.2* Significantly, neither party supports the Commis-

sioner’s determination.

The Excess Profits Tax Act of 1940 grants taxpayers a

“credit” for equity invested capital.** The Act defines equity

invested capital as money and property “paid in” for stock.**

Where a corporation is organized by issuing stock for prop-

erty, the property received (invested capital) is valued with

reference to the fair market value of the stock issued.**

%‘Thus by agreement and by our opinion, counts 17, 19, 21 and 22 are

resolved along with additional defenses 19-22.

The Government may “offset” refunds due plaintiff by taxes underpaid.

Lewia v. Reynolds, 284 U.S. 281 (1932): Dysart v. United States, 169 Ct.

Cl. 276, 283, 340 F. 2d 624, 628 (1965). If defendant can successfully assert

its offset based upon excess profits tax credit overdeterminations, he may

“seale down” the recovery allowed plaintiff in Parts I and V, supra.

® Int. Rev. Cope or 1939, § 712.

*IxT, Rev. Cope or 1939. § 718 provides:

Equity Invested Capital.

(a) Definition.—The equity invested capital for any day of any taxable

year * * * shall be the sum of the following amounts, ees

(1) Money paid in.—Money previously paid in for stock, or as paid in

surplus, or as a contribution to capital.

(2) Property paid in.—Property (other than money) previously paid in

(regardless of the time paid in) for stock, or as paid-in surplus, or as a

contribution to capital. Such property shall be included in an amount equal

to its basis (unadjusted) for determining loss upon sale or exchange * * *.

(Emphasis added)

Int. Rev. Cope or 1939, §113(a) defines unadjusted basis for property

acquired. It provides: “The basis of property shall be the cost of such

property.’ (Emphasis added)

If the taxpayer's basis {s cost and stock was issued for the property,

then cost is the fair market value of the stock issued for such property at

the time of issuance. Treas. Reg. 112, § 35.718-1, Int. Rev. Code of 1939.

ee

62

In 1898 plaintiff received the assets of the old bankrupt

Union Pacific Railroad [U.P.]. On January 31, 1998, plain-

tiff issued 610,000 shares of $100 par common stock and

750,000 shares of $100 par, four percent preferred stock. In

return, it received the stock of the old U.P. and cash (here-

inafter referred to as the reorganization).** Later in 1899,

plaintiff acquired control of the Oregon Short Line Railroad

[Oregon] ** by issuing an additional 273,493 shares of $100

par common for the Oregon common and cash (hereinafter

referred to as the acquisition ) .**

Our problem, finding the correct amount of U.P.’s 1942

excess profits tax credit, then resolves into a determination

of the value of the U.P. stock issued in these nineteenth

century transactions.

In its return for 1942, plaintiff used par values to com-

pute the value of its stock issued for these assets ($163.3

million).** The Commissioner disputed this valuation and,

at first, attached a value of $122.5 million to the shares. He

later modified the stock values to $79.4 million, lowering

plaintiff’s valuation substantially. Plaintiff paid the 1942

deficiency and filed this refund suit claiming that its original

return was correct. In addition to the stock issued, plaintiff

also asserted that it was entitled to include the cash contribu-

tions received in the reorganization ($9.1 million) and the

acquisition ($0.8 million) in its equity invested capital.‘

Defendant claimed that the value of plaintiff’s stock was

less than even the Commissioner had determined and asserted

an offset against other amounts recoverable by plaintiff.

Defendant argued in its pleadings that the fair market value

of the U.P. stock was only $57.5 million.

* The U.P. received one share of old U.P. common and $15 in return for

one, new share of U.P. common.

* Actually the U.P. issued the shares over a period of time and gradually

acquired common stock of the Oregon. See page 16, infra. However, the

U.P. acquired control of the Oregon in 1899.

*In return for each share of U.P. common stock issued {n the acquisition,

the U.P. received one share of Oregon common and $3 cash.

* Plaintiff contended that its equity invested capital was $61 million for

the reorganization common, $75 million for the reorganization preferred, and

approximately $27.3 million for the acquisition common—a total equity

invested capital of $163.3 million.

# See notes 36 and 38, eupra.

63

During the trial, plaintiff sought to prove an even greater

valuation, and defendant continued to support the value

that it had alleged in its pleadings. Plaintiff's valuation ex-

pert testified that the proper valuation date for the re-

organization stock was January 31, 1898. However, he stated

that the true value of the stock must take into account the

U.P.’s rapid rise in fortunes during the post-reorganization

period. Thus he evaluated the U.P. reorganization and acqui-

sition stock by use of 1907 stock market figures and found

values of $175-200 per share for the common and $100 per

share for the preferred. His total value estimate was $251.7

million. Defendant’s trial expert testified that after consider-

ing all valuation techniques,*? the reorganization common

was worth $22.50 per share and the reorganization preferred,

$40 per share. Since he rated the acquisition common at $10

million, he assessed plaintiff’s total equity invested capital

at $57.5 million.

Both plaintiff and defendant contend that the Commis-

sioner’s valuation was incorrect and both ask the court to

find a per share value for the stock. Significantly, there is

absolutely no justification in the record for the Commis-

sioner’s valuation since neither party supported it.

The threshold question is whether either party’s evidence

overcomes the Commissioner's presumption of correctness.

A. Presumption of Correctness:

The Commissioner's determination of taxes due is entitled

to a presumption of correctness. Helvering v. Taylor, 293 U.S.

507 (1935); Northlich, Stolley, Inc. v. United States, 177 Ct.

Cl. 435, 442, 368 F. 2d 272 (1966). This presumption applies

to excess profits tax credit determinations. 7ri-State Realty

Co. v. Commissioner, 180 F. 2d 593 (5th Cir. 1950). However,

in our case an unusual situation is presented because neither

party supported the Commissioner's determination. Each at-

tempted to assert its own conclusion for asset valuation.

The court believes that there is sufficient evidence in the

record to rebut the presumption. Presumptions are not evi-

© Defendant's expert testified on stock market values, net asset values, price-

earnings estimates, capitalization of earnings, and comparison of the U.P.

stock with similar railroad stocks.

64

dence, and they disappear in the face of substantive evidence

tending to disprove them. United Aniline Co. v. Commis-

sioner, 316 F. 2d 701, 704 (1st Cir. 1963); Kentucky Trust

Co. v. Glenn, 217 F. 2d 462, 465 (6th Cir. 1954). Defendant

provided sufficient probative evidence of the U.P. value by

offering stock market prices for the U.P. stock to rebut the

Commissioner’s presumption of correctness.

Once we find that the presumption has been rebutted, we

must then determine whether either party has met its burden

of proof and, therefore, is entitled to a refund or offset.

B. Burden of Proof:

Where plaintiff sues for a refund he has the burden of

proving that the refund is “legally due” him. Helvering v.

Taylor, supra; Lewis v. Reynolds, 284 U.S. 281 (1932).

Where defendant counters with an offset claim, allocation of

the burden depends on the nature of the offset. If the offset

is based upon the same tax return as plaintiff’s refund claim,

the ultimate burden of proof remains on plaintiff. However,

defendant has the burden of “coming forward” with suffi-

cient facts to show that it “has a reasonable basis for its set-

off.” Missouri Pacific R.R. Co. v. United States, 168 Ct. Cl.

&6, 338 F. 2d 668 (1964). In the instant case, plaintiff has the

ultimate burden of proving that the Commissioner under-

valued its equity. Since its offset claim involves the same tax

return, defendant must “come forward” with sufficient evi-

dence to show that there is a reasonable basis for its claim

that the Commissioner overvalued the U.P. stock.

Valuation of assets is a question of fact. American Steel

Foundries vy. United States. 153 Ct. Cl. 234 (1961). The

question before the court is the value of the U.P. investment.

The court may adopt plaintiff’s conclusions, may adopt de-

fendant’s, or any reasonable value in between. 7 oronto,

Hamilton & Buffalo Nav. Co. v. United States, 116 Ct.

Cl. 184, 207-08, 88 F. Supp. 1016, 1022 (1950). We find from

the stock market prices presented by defendant that it has

met its burden of coming forward. There is sufficient evi-

dence to find a reasonable basis for defendant’s allegation

of overvaluation by the Commissioner. We also find that

plaintiff has failed to meet its burden of proving that the

et Secrest ee re

a Ft Se e e ce

= TET

AOE SRT BA Seta

2

65

Commissioner undervalued the investment. We hold that

defendant is entitled to an offset.

C. Equity Valuation:

Valuation of property is at best an inexact science or highly

imprecise art, and there are as many approaches to valuation

as there are valuation experts. Asset appraisal, therefore,

requires a reasonable or rational approximation rather than

exactitude. Primary valuation techniques include actual sale

prices, actual or original cost, replacement cost, capitalized

income, price-earnings ratios, and comparison with similar

property. I J. Bonbright, Valuation 113-269 (1937). Each

method has its own variations, strengths and weaknesses. We

have received evidence of U.P. value based upon stock market

prices, net asset values, capitalization of earnings, price-

earnings ratios and comparison of the U.P. with similar

stock.

While each valuation method has shortcomings, we find

sufficient evidence to adduce a reasonably accurate value for

U.P.’s reorganization and acquisition stock.

The departure point for our valuation inquiry begins with

the proposition that “fair market value is the rrice at which

property would change hands in a transaction between a

willing buyer and a willing seller, neither being under a

compulsion to buy or sell, and both being reasonably in-

formed as to all relevant facts.” Bankers Trust Co. v. United

States, 207 Ct. Cl. . , 518 F. 2d 1210, 1219 (1975) ;

Jack Daniel Distillery v. United States, 180 Ct. Cl.

308, 315-16, 379 F. 2d 569, 574 (1967). This court has fre-

quently used stock market prices to value stock. As Judge

Davis noted in Bankers Trust, “Where stock is freely traded

in an open, organized market, stock exchange quotations for

the valuation date generally provide the best evidence of

value.” Bankers Trust Co., supra, slip opinion at 13 citing

Moore-McCormack Lines, Inc. vy. Commissioner, 44 T.C. 745,

759 (1965) ; Southern Natural Gas Co. v. United States, 188

Ct. Cl. 302, 351-52, 412 F. 2d 1222, 1252 (1969) ; 10 J. Mer-

tens, The Law of Federal Income Taxation $§ 59.13 at 42-43,

59.14 at 47 (1970). The Bankers Trust opinion contains an

excellent analysis of the situations in which stock market

594-093—75——_5

66

values are not accurate value determinants.*? We note that

such situations are not present in the instant valuation.**

Two factors which give us pause in considering stock

market values are the “pessimistic” nature of the market in

1898-99, and the likelihood of reacquisition of the Oregon

stock at the time of reorganization. While these factors

might possibly cause some doubt as to the reliability of

market evaluation, we find that, in the instant case, they do

not. The pessimism of investors in the then c

This text is long and has been trimmed here. Open the source document for the complete record.