Opinion
Docket No. 106868.
1942-12-4
CLARIDGE APARTMENTS COMPANY, AN ILLINOIS CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Walter Hamilton, Esq., for the petitioner. David Altman, Esq., and George E. Gibson, Esq., for the respondent.
1. Neither expenses incident to 77B reorganization assumed by transferee nor nominal stock interest in reorganized company accorded to stockholders of predecessor held to disqualify transaction as a ‘reorganization‘ under Revenue Act of 1934, section 112. Helvering v. Southwest Consolidated Corporation, 315 U.S. 194, distinguished. Held, further, on facts exchange of property was solely for petitioner's stock.
2. Provisions of the Chandler Act relating to taxation of income resulting from reduction of indebtedness in reorganizations, held applicable to the entire calendar year 1938, and to interest forgiven, but held, further, not applicable in the case of substitution of common stock for outstanding principal of bonds. Walter Hamilton, Esq., for the petitioner. David Altman, Esq., and George E. Gibson, Esq., for the respondent.
By this proceeding petitioner charges that respondent erred in determining deficiencies in the amounts and for the years indicated as follows:
+---------------------------------------+ ¦ ¦Year¦Income tax¦Excess profits tax¦ +----+----+----------+------------------¦ ¦1935¦ ¦$844.39 ¦$57.05 ¦ +----+----+----------+------------------¦ ¦1936¦ ¦706.92 ¦----- ¦ +----+----+----------+------------------¦ ¦1937¦ ¦752.76 ¦----- ¦ +----+----+----------+------------------¦ ¦1938¦ ¦985.67 ¦10.80 ¦ +---------------------------------------+
The contested issues relate to petitioner's basis for depreciation of its apartment house property and deduction of items for painting and repairing.
FINDINGS OF FACT.
Petitioner is a corporation, organized May 28, 1935, under the laws of the State of Illinois pursuant to a proceeding under 77B of the National Bankruptcy Act. It filed its income and excess profits tax returns for the years 1935 to 1938, inclusive, with the collector of internal revenue for the first district of Illinois.
The Claridge Building Corporation, also an Illinois corporation, and hereinafter for convenience referred to as the Building Corporation, acquired the lot at 4501 Malden Street, Chicago, Illinois, from Charles F. Henry in 1924. The acquisition was pursuant to a contract whereby the Building Corporation agreed to issue and did issue its entire authorized capital stock to Charles F. Henry in consideration of the transfer of the lot by Henry. During the spring and summer of 1924 the Building Corporation caused an apartment building to be erected on the lot at a cost of $385,326.37. By August 1, 1935, $139,253.71 depreciation had been taken, on a ‘cost‘ of $424,609.19 which included a contractor's commission to Henry.
Up to 1932 the stock of the Building Corporation, with the exception of two qualifying shares, was owned by Charles F. Henry. In 1932 and thereafter it was stated to be held as follows: Minnie H. Case, sister of Charles F. Henry, 198 shares; Howard D. Henry and Albert A. Henry, brothers of Charles F. Henry, one share each.
On March 25, 1924, the Building Corporation issued its 6 1/2 percent first mortgage bonds in the principal amount of $340,000. The bond issue was secured by trust deed and chattel mortgage covering the property located at 4501 Malden Street, executed March 25, 1924, to Melvin L. Straus, as trustee. On October 1, 1931, the bonds were outstanding and unpaid in the principal amount of $277,000. Defaults having therefore occurred in the payments of principal and interest, the trustee filed a bill of foreclosure on October 1, 1931, and all of the bonds were declared immediately due and payable. A decree of foreclosure was entered on February 19, 1932, but there was no sale of the mortgaged property under the decree and the foreclosure proceeding was never consummated. The trustee took possession of the property and collected the rents after October 1, 1931.
On September 9, 1931, a bondholders' committee was organized under a deposit agreement of that date with the American National Bank & Trust Co. of Chicago. As of November 27, 1934, the committee had on deposit with the bank $258,600 of the bonds, or approximately 93 percent of the total amount of the bonds outstanding.
On June 16, 1934, the Building Corporation filed a voluntary petition in the District Court of the United States for the Northern District of Illinois, Eastern Division, under section 77B of the National Bankruptcy Act as amended.
On November 27, 1934, the bondholders' committee, the Building Corporation, and Minnie H. Case agreed on a reorganization plan. The plan recited that Minnie H. Case was the record holder of the title to the property in question, but that she held title for the benefit of the Building Corporation, and that she owned the furnishings of some of the apartments.
The plan provided, inter alia, as follows:
1-A new corporation shall be organized under the laws of the State of Illinois with an authorized capital stock consisting of 3,080 shares of common stock without par value, or with such par value as may be agreed upon by the parties hereto. Upon completion of the reorganization, Minnie H. Case shall convey title to the property to said new corporation and the (Building) corporation shall execute a confirmatory quit-claim deed to the neu corporation. 2,770 shares of the common stock of the new corporation shall be issued to three Trustees to be selected by the Committee subject to the approval of the court. Trust certificates shall be issued to the holders of the first mortgage bonds and each first mortgage bondholder shall receive a trust certificate representing one share of sock for each $100.00 in face amount of bonds owned by him. The stock so issued to said Trustees shall constitute 90% of the outstanding stock of the new corporation. 10% of the outstanding stock of the new corporation shall be issued to or upon the order of the Owner (the stockholders of the Building corporation).
4-The new corporation shall by written agreement indemnify the present Trustee under the bond issue against any and all liability which he may suffer or incur by reason of his operation of the property (other than for wrongful acts of the Trustee) and against any and all taxes, assessments or other governmental charges which may be levied or assessed against him covering the period of his possession of the property. The new corporation shall also by written agreement indemnify the Committee against any and all taxes, assessments or against any and all liability which may be suffered or incurred by the Committee by virtue of the reorganization plan, including the expenses and reasonable attorneys' fees in the event that litigation is instituted against the Committee or any member thereof.
The new corporation shall assume and agree to pay the reorganization expenses hereinafter referred to and these expenses shall be paid in full before any dividends shall be declared or paid upon the stock of the new corporation. Subject to the approval of the court, the following reorganization expenses shall be allowed: a) To cover the general expenses and compensation of the Committee including the charge of Securities Service Corporation, 1 1/2% of the face amount of deposited bonds plus out-of-pocket expenses;
(b) Charge of the Depositary on the basis of three-fourths of 1% of the face amount of deposited bonds plus out-of-pocket expenses;
(c) Compensation of counsel for the Committee;
(d) Compensation of counsel for the owner.
In addition there shall be allowed the expenses and charges in the foreclosure proceeding, including the Trustee's fee, the fee of Trustee's counsel, court costs and Master's fees. There shall also be allowed and paid the actual expenses to be incurred in connection with the organization of a new corporation, printing of the trust agreement and the new securities, stamp taxes, title guaranty expense, court costs in the bankruptcy proceeding and other similar items.
Upon consummation of the reorganization, the present Trustee shall surrender possession to the new corporation and all net assets of the Trustee over and above the liabilities of the Trustee in connection with the operation of the property shall be applied towards the payment of the reorganization expenses.
The plan also provided that Minnie H. Case was to execute and deliver to the new corporation a bill of sale covering all of the personal property owned by her which was located in the apartments, for which she should be paid the sum of $1,400. The new corporation was to enter into a management contract with Minnie H. Case and she was to be one of the three directors of the new corporation. The plan, after amendment not material here, was confirmed and approved by the court in an order dated May 14, 1935.
The court order provided for the release of the trust deed and chattel mortgage of March 25, 1924, and stated that the bonds and interest coupons were satisfied and of no further force and effect and authorized the issuance of the new securities.
The final decree in the 77B proceeding entered March 1, 1937, provided in part as follows:
1: The plan of reorganization theretofore confirmed by this court is hereby declared to be in all respects fully executed, carried out and accomplished.
4: That all of the first mortgage bonds in the principal amount of $277,000.00 and interest coupons thereto attached, secured by trust deed and chattel mortgage to Melvin L. Straus, dated March 25, 1924, recorded in the office of the Recorder of Deeds of Cook County, Illinois, as document No. 8340617, and said trust deed and chattel mortgage, are hereby declared to be of no further force and effect as against the Debtor or its property, and the holders thereof shall be entitled to receive only the new securities provided for in said plan of reorganization, and all holders, pledgees and owners of bonds and interest coupons secured by said first mortgage trust deed and chattel mortgage, and Melvin L. Straus, Trustee, thereunder, shall be and they are hereby forever jointly and severally enjoined from commencing and/or prosecuting any proceedings of any nature whatsoever against the Debtor, its grantees, successors or assigns, or against any of the property of the Debtor on any of said first mortgage bonds or interest coupons, and all creditors and stockholders of the Debtor, secured and unsecured, are hereby forever enjoined and restrained from taking or continuing any action, steps or proceedings or bringing or continuing any suit or action at law, in equity or otherwise against the Debtor or its property for, on account of, or by reason of any claim, matter, judgment or thing, excepting only such liabilities and claims which the Debtor has expressly assumed or agreed to pay pursuant to the terms and provisions of said plan of reorganization.
5: Melvin L. Straus, as trustee, complainant in the suit entitled ‘Melvin L. Straus, trustee, v. Claridge Building Corporation, et al,‘ case No. 544125, Superior Court of Cook County, and all other persons be and they hereby are permanently restrained and enjoined from taking any further action in connection with said proceedings.
Pursuant to the plan petitioner was organized and the property transferred to it. Minnie H. Case also transferred the furniture which she owned in the apartment building to petitioner.
As of August 1, 1935, there were delinquent taxes outstanding of $13,000. The reorganization expenses amounted to approximately $13,500. The trustee had approximately $8,000 on hand.
Expenses of the foreclosure proceeding in the state court were as follows:
+-------------------------------+ ¦Master's fee ¦$1,250.00¦ +---------------------+---------¦ ¦Trustee's fee ¦1,050.98 ¦ +---------------------+---------¦ ¦Attorneys for trustee¦2,970.98 ¦ +---------------------+---------¦ ¦ ¦5,271.96 ¦ +-------------------------------+
Minutes of petitioner's board of directors meeting of August 7, 1935, recited as follows:
WHEREAS, pursuant to the Reorganization Plan as amended of Claridge Building Corporation (Claridge Apartments), this corporation is required to assume and agree to pay the unpaid reorganization expenses, the approximate amount of which is $13,500.00; and
WHEREAS, the Claridge Apartments are subject to delinquent taxes, the approximate amount of which, including estimated taxes for the first half of 1934, is $13,000.00; and
WHEREAS, from the funds available and about to become available from the operation of the property approximately $8,000.00 can be applied on account of the payment of the unpaid reorganization expenses and taxes, so that a sum of approximately $18,500.00 is required to provide for the payment of the balance of such unpaid reorganization expenses and taxes;
On a reference of the matter to the stockholders similar recitals were made in the minutes of their meeting held September 9, 1935.
In order to meet these obligations it was necessary for petitioner to borrow $18,500. A loan in this amount secured by a mortgage on the property was obtained by petitioner and approved by the court on July 26, 1935.
The reorganization expenses in the approximate total amount of $13,500 were paid by petitioner in the latter part of 1935 or the early part of 1936.
The certificates of deposit which were issued by the bondholders' committee were traded in as an over-the-counter security in Chicago during the year 1935 at a market price ranging from $190 to $207.50 from a certificate representing a $1,000 bond. In December of 1935, after most of the petitioner's stock had been issued, the market price for certificates of deposit not yet turned in for petitioner's stock was $190 per thousand-dollar certificate of deposit. The market for securities of Chicago real estate corporations, organized or in the process of being reorganized, was poor during the year 1935.
Under the plan the petitioner's stock was issued at the rate of one share per $100 face value of bonds of the old company. The fair market value of petitioner's stock never exceeded $45 per share at any time during the year 1935.
Petitioner's capital stock consisted of 3,080 shares of common stock without par value. On September 5, 1935, 2,770 shares were issued to certain nondepositing bondholders and to voting trustees for the depositing bondholders to whom were issued trust certificates, each certificate representing one share of stock. Three hundred and eight shares of petitioner's stock were issued to the old stockholders, Minnie H. Case receiving 300 shares and Charles F. Henry 8 shares. Two shares remained unissued.
The building at 4501 Malden Street is a three-story and basement court type apartment building with a large terrazzo floored lobby from which stairways lead up to the various groups of apartments. It contains 106 apartments. There are eight 2 1/2-room apartments (living room, in-a-door bed, large dressing closet, dinette, kitchen, and bath) and twenty-six 3 1/2-room apartments (extra bedroom). The first story of the building is fireproof and the other two stories are brick and frame, with brick walls surrounding each apartment unit. Pressed brick was used on the street fronts and courts. Each apartment has a refrigerator, gas range, tall china cabinet and linen case, a full size door mirror, vitreous china lavatory and toilet, and a bay window. The building has two large Kewanee boilers (one of which gives sufficient service), six laundries, intercommunicating telephone system, Government approved mail boxes, push bells and speaking tubes, carpeted stairs and hall, and best grade clear oak floors.
The property in question, including the apartment building and furnishings and the lot on which situated, was sold in July 1940, for $126,200, plus an assumption of about $20,000 of liabilities. The market in 1940 was much higher and more active than in 1935.
The fair market value of the apartment building located at 4501 Malden Street, Chicago, exclusive of the land as of May 14, 1935 (the date on which the court confirmed the plan) was not in excess of $141,000. The fair market value of the land on that date was $16,000.
The adjusted basis of petitioner's predecessor in 1935 was $239,377.33.
At the date of acquisition by petitioner the building had a remaining useful life of 25 years.
Petitioner reported its income and deductions on an accrual system of accounting. Under the system of accounting used by petitioner it deducted on its returns all expenses for painting and decorating and repairs in the year in which such expenses were paid. On its 1936 return petitioner included in its expense deductions an amount of $1,219.44 expended in that year for painting and decorating and $389.60 expended in that year for repairs. These identical items were deducted for a second time in petitioner's 1937 return, and for that reason were disallowed by respondent for that year.
OPINION.
OPPER, Judge:
The first point in controversy is the correct basis for depreciation on petitioner's property, the problem being whether that is cost to petitioner or its predecessor's adjusted basis. The primary question is whether under Revenue Act of 1934, section 112, and particularly under the recent decisions of the Supreme Court
interpreting it, there was a reorganization when, in a 77B proceeding, petitioner's predecessor transferred to it its only asset, a building called the Claridge Apartments, in exchange for the issuance to the predecessor's creditors of 90 percent, and to its stockholders of 10 percent of petitioner's stock.
Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179; Palm Springs Holding Corporation v. Commissioner, 315 U.S. 185; Bondholders Committee, Marlborough Investment Co. v. Commissioner, 315 U.S. 189; Helvering v. Southwest Consolidated Corporation, 315 U.S. 194.
Whatever doubt there may have been that creditors of an insolvent predecessor corporation can furnish the continuity of proprietary interest necessary to a technical reorganization has recently been dispelled. Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179; Palm Springs Holding Corporation v. Commissioner, 315 U.S. 185. Nor are we by any means satisfied of the correctness of respondent's assertion that Helvering v. Southwest Consolidated Corporation, 315 U.S. 194, determines the present issue in his favor. It is true that that case emphasizes the requirement of the 1934 Act that to constitute a reorganization the transfer of property must be solely in exchange for the transferee's voting stock, and holds that even an indirect payment partly in cash defeats the attempt to apply it.
But effect is given, of course, to the retroactive amendment of 1939 removing from consideration the assumption of a transferor's indebtedness or acceptance of property subject to it; and the Court is at pains to point out that the transferee in the Southwest Consolidated case did more than this when it undertook under the plan to repay cash which had been borrowed to satisfy nonassenting creditors. ‘But in substance,‘ it remarks, ‘the transaction was precisely the same as if respondent (the taxpayer) had paid cash plus voting stock for the properties. * * * part of the consideration which respondent paid for the properties of its predecessor was cash in the amount of about $106,680. The fact that it was paid to the bank rather than to the old corporation or its creditors is immaterial. The requirement to pay cash arose out of the reorganization itself. It derived, as did the requirement to pay stock, from the plan pursuant to which the properties were acquired. * * *‘
Here the only payments of cash contemplated by the plan were for past-due taxes on the property, expenses of an abortive foreclosure action previously instituted against it, and costs and disbursements of the 77B proceeding itself. Respondent's brief concedes that ‘the delinquent realty taxes, fees paid to the counsel for the debtor corporation, and possibly fees paid in connection with foreclosure proceedings brought by the indenture trustee, * * * quite possibly (had petitioner offered and introduced the proof relating thereto) might have been shown to represent liabilities of the old debtor company.‘
We can not conceive that the only remaining item, the expense connected with the reorganization itself, including fees and disbursements to the bondholders' committee and its depositary, court costs, and payments for printing and for the organization of petitioner can be of the character to which the Supreme Court referred when it excluded items of which the ‘nature and amount were determined and fixed in the reorganization.‘ Such payments did not, like those in the Southwest Consolidated case, go indirectly to the old corporation or its creditors. True, in a general sense they constituted part of the cost paid by petitioner for the property received. But they were of a nature characteristic of all reorganizations of this kind, and normally there is no source of payment for them save the new corporation or its property. If they are fatal here, then it is difficult to envision any plan growing out of an equity or 77B receivership which would qualify under section 112. We can not believe such a result was intended.
But, however that may be, we think petitioner has shown enough here to sustain its contention that nothing was paid except liabilities of the predecessor or its property. In Illinois real estate taxes are imposed, if not on the owner, at least on the land and building— Edward C. Kohlsaat, 40 B.T.A. 528, 535; Pyramid Metals Co., 44 B.T.A. 1087, 1088— upon which they constitute a lien. These amounted to $13,000. The foreclosure proceedings likewise set up a liability for costs and expenses to which any conveyance of the property would presumably be subject. Benton State Bank v. Bennett, 249 Ill.App. 539; Christensen v. Niebert, 259 Ill.App. 96; Chicago Trust Co. v. 12-14 West Washington St. Building Corporation, 278 Ill.App. 117. These amounted to $5,270.98. In addition, the cash in the hands of the trustee for the old company was committed to payment of expenses to its full extent, namely $8,000.
There was thus a total of $26,270.98 which must be regarded either as indebtedness of the transferor assumed by the transferee or as a charge against the transferred property within the express terms of the 1939 amendment. The small balance of $229.02 is not only negligible under the circumstances, but we may take notice that it could reasonably have covered only such items as cost of petitioner's incorporation, stamp taxes, printing bills and the like, which were clearly no part of any payment by the transferee to the transferor ‘in exchange‘ for the transfer of the property. In the premises we are unwilling to say that petitioner has failed to sustain its burden of showing the necessary facts to invoke the provisions of section 112.
Respondent suggests that this fell short of a tax-free reorganization for the additional reason that, while the creditors received 90 percent of petitioner's stock, indicating that they had acquired effective ownership of the predecessor, the stockholders were given a 10 percent interest, which demonstrated that the creditors had not succeeded to an exclusive interest. It is urged, which is the fact, that no such situation existed in the cases recently decided by the Supreme Court.
We think, however, that this is a distinction without a difference. In the first place, if it were possible to imagine a set of circumstances where a corporation was insolvent to the extent that a 90 percent proprietary interest had accrued to its creditors but 10 percent was left in its former stockholders, no reason is apparent why the statutory language would not apply to a plan which gave effect to that division of ownership. The preservation of proprietary interests would be respected quite as much there as in, say, Helvering v. Southwest Consolidated Corporation, supra. The bondholders here ‘acquired substantially the entire proprietary interest of the old stockholders.‘
But in any event, the insolvency of the transferor in the present case is inescapable. There can be no question but that in fact and in law the creditors were in exclusive control. If the plan was improper and subject to disapproval upon the bondholders' objection, see Northern Pacific Railway Co. v. Boyd, 228 U.S. 482, that would not make it any the less a plan of reorganization upon acceptance by the necessary percentage of bondholders and confirmation by the court, although it might fail to qualify as an ‘exchange‘ under 112(b)(5). See Helvering v. Cement Investors, Inc., 316 U.S. 517. What reason there may have been for the voluntary recognition of the old stockholders to the extent of a nominal share in the new enterprise does not appear. It may well have been a desire not to be ungenerous, or, more likely, a selfish hope that their pecuniary interest would encourage the former shareholders to more effective efforts under the management agreement. Certainly we need not view it as a concession that they retained any equity when the facts deny that possibility. It follows that, as far as the reorganization question goes, petitioner was entitled to the original basis.
Apart from this, however, respondent insists that the provisions of the so-called ‘Chandler Act,‘
particularly section 270, as amended, require that petitioner's basis be reduced to the fair market value of the property when petitioner received it, but he concedes that under The Commodore, Inc., 46 B.T.A. 718, no year earlier than 1938 would be affected.
Public No. 696, 75th Cong., 52 Stat. 840, as amended:‘SEC. 268. Except as provided in section 270 of this Act, no income or profit, taxable under any law of the United States or of any State now in force or which may hereafter be enacted, shall, in respect to the adjustment of the indebtedness of a debtor in a proceeding under this chapter, be deemed to have accrued to or to have been realized by a debtor, by a trustee provided for in a plan under this chapter, or by a corporation organized or made use of for effectuating a plan under this chapter by reason of a modification in or cancelation in whole or in part of any of the indebtedness of the debtor in a proceeding under this chapter.‘SEC. 269. Where it appears that a plan has for one of its principal purposes the avoidance of taxes, objection to its confirmation may be made on that ground by the Secretary of the Treasury, or, in the case of a State, by the corresponding official or other person so authorized. Such objections shall be heard and determined by the judge, independently of other objections which may be made to the confirmation of the plan, and, if the judge shall be satisfied that such purpose exists, he shall refuse to confirm the plan.‘SEC. 270. In determining the basis of property for any purposes of any law of the United States or of a State imposing a tax upon income, the basis of the debtor's property (other than money) or of such property (other than money) as is transferred to any person required to use the debtor's basis in whole or in part shall be decreased by an amount equal to the amount by which the indebtedness of the debtor, not including accrued interest unpaid and not resulting in a tax benefit on any income tax return, has been canceled or reduced in a proceeding under this chapter, but the basis of any particular property shall not be decreased to an amount less than the fair market value of such property as of the date of entry of the order confirming the plan. Any determination of value in a proceeding under this chapter shall not be deemed a determination of fair market value for the purposes of this section. The Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury, shall prescribe such regulations as he may deem necessary in order to reflect such decrease in basis for Federal income-tax purposes and otherwise carry into effect the purposes of this section.‘SEC. 276. c. The provisions of sections 77A and 77B of chapter VIII, as amended, of the Act entitled 'An Act to establish a uniform system of bankruptcy throughout the United States', approved July 1, 1898, shall continue in full force and effect with respect to proceedings pending under those sections upon the effective date of this amendatory Act, except that—(1) if the petition in such proceedings was approved within three months prior to the effective date of this amendatory Act, the provisions of this chapter shall apply in their entirety to such proceedings; and(2) if the petition in such proceedings was approved more than three months before the effective date of this amendatory Act, the provisions of this chapter shall apply to such proceedings to the extent that the judge shall deem their application practicable; and(3) sections 268 and 270 of this Act shall apply to any plan confirmed under section 77B before the effective date of this amendatory Act and to any plan which may be confirmed under section 77B on and after such effective date, except that the exemption provided by section 268 of this Act may be disallowed if it shall be made to appear that any such plan had for one of its principal purposes the avoidance of income taxes, and except further that where such plan has not been confirmed on and after such effective date, section 269 of this Act shall apply where practicable and expedient.‘
The provision does not apply to the petitioner's 1938 tax liability, however, seems to us not subject to serious doubt. The act was made effective September 22, 1938, before the end of the petitioner's 1938 tax year, and long before its return for that year became due. The reasons advanced in The Commodore, Inc., supra, including reference to the legislative history, are hence inappropriate. The ‘future‘ liability to which the Committee referred was evidently an apt description of the present situation, since the end of the year as of which the tax was to be computed and the date when the first installment would become due both lay ahead when the act became effective.
While not strictly a revenue act, the legislation by its terms dealt with taxes, and can be assumed to have envisaged like principles as to periods to which it would apply. It is now so familiar as to be virtually traditional that revenue acts cover calendar years during which they take effect. See United States v. Hudson, 299 U.S. 498. In fact, it possibly requires express language to avoid application even to earlier periods. Cf., e.g., Revenue Act of 1938, secs. 1 and 903. And our system of administering income tax computation on an annual basis makes impractical such suggestions as petitioner's that if relevant at all the Chandler Act should be construed to fix depreciation only for the part of the year remaining after it went into effect.
The question remains, however, whether in this case the ‘indebtedness * * * has been canceled or reduced‘ as described in section 270. Section 268 is an obvious legislative effort to release 77B reorganizations from the tax burden of the Kirby case,
and, since section 270 is manifestly in pari materia with it, we have to consider whether this is the sort of situation to which either section was intended to apply. It may advance us little to grant that in the meantime some courts have devised a formula for lifting certain types of debt adjustment out of the Kirby rule. E.g., Hirsch v. Commissioner (C.C.A., 7th Cir.), 115 Fed.(2d) 656. But cf. Frank v. United States (U.S. Dist. Ct., E. Dist. Pa.), 44 Fed.Supp. 729 . For the theory of that limited group of cases is that the property for the purchase of which the debt was incurred has so declined in value that the cancellation may be regarded as no more than a retrospective readjustment of the original purchase price. That being so, there is no reason to grant the owner a deduction for depreciation computed on a larger base, any more than to permit him to report ultimate gain or loss on disposition by using the original higher cost. See Hirsch v. Commissioner, supra.
Kirby Lumber Co. v. United States, 284 U.S. 1.
But in another setting, the same result has been reached on a totally different theory. The substitution of common stock for bonds is not a cancellation or reduction of the liability represented by the bonds, no matter how much less the stock may be worth, since ‘the assets are not thereby freed from obligation. * * * While the bond loan has been terminated, the amount borrowed is now committed to capital stock liability instead of to the liability of a fixed indebtedness.‘ Capento Securities Corporation, 47 B.T.A. 691.
Using this approach, it is evident that there was here no true reduction or cancellation of the original indebtedness, but what amounts to a continuation of it in another form. It follows that neither the language nor the reason for section 270 has any application here. Both gain or loss and depreciation to the new corporation can appropriately be measured by the old basis, without doing violence either to the tax consequences of the reorganization or to the doctrines upon which those consequences rest.
What we have said, however, relates only to the outstanding principal of the bonded debt. The interest was also due, and that it was forgiven rather than transformed into stock appears affirmatively, although its amount is not shown. Adjustment for this item must be made. Capento Securities Corporation, supra. True, the statute excludes ‘accrued interest unpaid‘ from the write-down of basis on account of forgiveness, but only if ‘not resulting in a tax benefit on any income tax return.‘ We can not say from the evidence what the facts are in this respect, and accordingly must assume, in respondent's favor, that petitioner's predecessor had obtained a tax benefit as to the entire amount. What that amount should be can, it is to be hoped, be agreed upon by the parties in connection with the computation under Rule 50.
Ue are not concerned by fears for the constitutionality of such an interpretation in so far as it involves a retroactive application to reorganizations previously completed, like the one before us. The legislative intention to deal with such cases must be accepted. The Commodore, Inc., supra. Only the tax liability for the year of enactment is in question. See United States v. Hudson, supra. A new basis growing out of a previously completed reorganization may constitutionally be provided. Schweitzer & Conrad, Inc., 41 B.T.A. 533. And in any event, the doctrine of the Hendler case
prevented this from being a tax-free reorganization at the time it took place. See Helvering v. Southwest Consolidated Corporation, supra. The proper depreciation basis then became petitioner's cost. Only the retroactive amendment of 1939 eliminated the Hendler principle and in the meantime the Chandler Act had been enacted. There was hence no hiatus in petitioner's continuing liability, and the provision, if it can be said to be retroactive at all, certainly made no change in petitioner's position and hence obviously had no unconstitutional effect upon its substantial rights.
United States v. Hendler, 303 U.S. 564.
This conclusion requires that we find both the predecessor's basis, for the years 1935
through 1937, and the fair market value on confirmation for 1938. The latter is necessary in the event that adjustment for the forgiven interest would otherwise reduce the adjusted basis below that amount. The required figures have been included in our findings of fact. Although petitioner and its predecessor consistently used a higher basis, we have found the one determined by the Commissioner, since the petitioner's witness failed to convince us that any amount was actually paid by the old company for contractor's services, or that the original stock issue in fact covered any more than the land.
Petitioner conceded at the hearing that as owner for only the last five months of 1935 it was entitled to only that proportion of the year's depreciation.
In ascertaining fair market value upon confirmation we have given consideration to the highest figure estimated by respondent's expert for the property as a whole, bearing in mind the actual sale in 1940, and the value placed upon the land alone by petitioner's witness, as being most conducive to a computation which is reasonably fair under all the circumstances. This market value may constitute petitioner's basis for 1938, if it develops that it is higher than the original basis reduced by the part of the debt adjustment ratably allocated to the depreciable property in the proportion of original land value to total basis. See Regulations 94, art. 113(b)-2, as amended (1940-2 C.B. 107).
There remains the question of petitioner's claim for deductions of decorating and repair items as business expense for 1937. While the parties are in accord that petitioner's books and tax returns were figured on the ‘accrual‘ basis, the explanation given rather resembles a cash or reverse accrual system. The deductions in question were customarily taken in the year payment was made, but they were set up as a sort of reserve running into the following year, not because payment was not due, but apparently on the theory that leases to which they were applicable would return income during that period.
For tax purposes, however, there seems little question that items deducted in one year can not properly be duplicated in the next, and that, whatever the system of accounting, it can not be authorized if it calls for that treatment. Since we are satisfied from the evidence that petitioner is seeking for 1937 a deduction already taken and allowed for the prior year, respondent's disallowance is approved.
Reviewed by the Court.
Decision will be entered under Rule 50. SMITH, J., concurring:
I agree that the basis for depreciation of petitioner's assets for 1938 is the fair market value of the assets at the date of reorganization. It is stated, however, in the Court's opinion that:
* * * The substitution of common stock for bonds is not a cancellation or reduction of the liability represented by the bonds, no matter how much less the stock may be worth, since ‘the assets are not thereby freed from obligation.
* * * While the bond loan has been terminated, the amount borrowed is now committed to capital stock liability instead of to the liability of a fixed indebtedness.‘ Capento Securities Corporation, 47 B.T.A. 691.
I think that this observation is contrary to well recognized principles of law. Where a corporation substitutes shares of stock in exchange for bonds the corporation is freed from indebtedness. A corporation does not owe any debt in respect of its capital stock.