Opinion
No. 158.
March 30, 1943.
Petition to Review a Decision of the Tax Court of the United States.
Petition by Prudence Securities Corporation to review an order of the Tax Court redetermining a deficiency in tax imposed by Commissioner of Internal Revenue.
Affirmed.
Prudence Company, Inc., was reorganized under § 77B, its successor corporation, pursuant to its plan of reorganization being Prudence Realization Corporation. There was also perfected a reorganization plan under § 77B, Bankr.Act, 11 U.S.C.A. § 207, for the guaranteed collateral trust 5½% bonds of Prudence Company, Inc. Pursuant to that latter plan of reorganization, petitioner and two subsidiary corporations of petitioner were created; the object of that reorganization, as recognized in the plan and as petitioner admits, was the liquidation over a period of years of real estate and mortgages which could not be sold for an amount sufficient to retire the indebtedness which such mortgages secured. In accordance with that plan, all the assets of Prudence Company, Inc., which had been pledged as security for its 5½% bonds were transferred in part to petitioner and in part to its two subsidiary corporations. The stock of those two subsidiaries and certain bonds of one of them were issued to petitioner, which, in turn, deposited all of its stock (ten shares with an aggregate par value of $1000) under a voting trust agreement; the voting trustees issued all the voting trust certificates to the bankruptcy trustee of Prudence Company, Inc., who later transferred them to Prudence Realization Corporation.
In exchange for the outstanding 5½% bonds of Prudence Company, Inc., there were issued, and are now outstanding in the hands of the public, bonds of the petitioner known as Series A bonds due May 1, 1961, in the aggregate face amount of $6,966,850; they are secured, under an indenture, by the assets acquired from Prudence Company, Inc., and by the stock of petitioner's subsidiaries. Secured by the same indenture, but subordinate to the A bonds, there was authorized to be issued, and there were issued, Series B bonds, due May 1, 1966, in the face amount of $847,750. These B bonds were delivered to the Prudence Realization Corporation, which, as above noted, owns all the voting trust certificates for all the stock of petitioner. Thus petitioner is a wholly owned subsidiary of Prudence Realization Corporation, which owns all petitioner's B bonds.
They were issued "in exchange" for 5½% bonds of Prudence Company, Inc., not outstanding but held by that debtor itself.
The B bonds provide that interest should be paid thereon at the rate of 5½% per annum until the principal of such bonds was paid, and that unpaid interest should cumulate. But, as the Tax Court said: "The conditions under which the interest or the principal of the Series B bonds shall be paid include (1) a completed event of default, and (2) not until all bonds of Series A shall be paid, retired or redeemed or provided for in full, after which the provisions applying to the payment of interest on the Series A bonds shall apply to the payment of interest on the Series B bonds. These conditions are not in the alternative but are meticulously stated as in the conjunctive. In other words, even in the event of a default, no interest on the Series B bonds is payable unless and until all the bonds of Series A have been paid or provided for, as specified. No obligation to pay interest on the Series B bonds arose until that contingency occurred."
Between November 1, 1937 and December 31, 1940, petitioner had purchased or redeemed at an average cost of 64% of their face value, approximately $3,000,000 of its A bonds, leaving outstanding approximately $3,900,000 of such bonds. In its 1939 and 1940 income tax returns, petitioner represented to the Commissioner that it was in an "unsound financial condition." According to its 1937 income tax return, its net income for that year, including an item of approximately $55,000, constituting profit from the retirement of the A bonds, was approximately $13,400; except for this profit, petitioner's return for that year would have shown a loss of approximately $42,000. According to petitioner's income tax return for 1938, the taxable year here involved, its net income for that year was approximately $140,000; this income included an item of approximately $194,000 profit from the retirement of its A bonds; except for this profit, its income tax return for 1938 would have shown a loss of approximately $53,000. According to its return for 1939, it suffered a loss of approximately $34,000 for that year after taking into consideration a profit of approximately $67,000 from the return of the A bonds; except for that profit, its 1939 return would have disclosed a loss of approximately $100,000. Its income tax return for 1940 disclosed a loss of approximately $176,000. In computing its net income for the year 1938, petitioner, which has always kept its accounts and filed its returns on the accrual basis claimed as a deduction from its gross income the sum of $46,736.25, representing accrued interest at 5% on the Series B bonds. In fact, however, it did not pay and never has paid any interest on those bonds. This deduction was disallowed by the Commissioner, who, on that account, assessed an income tax deficiency for the year 1938.
On petition to the Tax Court, that court sustained the Commissioner's action. This case is before us on the petitioner's appeal from that decision.
Lawrence A. Baker and Henry Ravenel, both of Washington, D.C. (Baker, Selby Ravenel, of Washington, D.C., of counsel), for petitioner.
Samuel O. Clark, Jr., and Sewall Key, both of Washington, D.C., and Victor Brudney, of New York City (Arthur Manella, of Washington, D.C., arguing), for respondent.
Before L. HAND, AUGUSTUS N. HAND, and FRANK, Circuit Judges.
The B bonds, accrued interest on which taxpayer seeks to deduct, are owned by a corporation which also owns all taxpayer's stock. A corporation, ordinarily, cannot in a real sense become a creditor of one of its own incorporated departments. The situation here is substantially the same as if the taxpayer were seeking to deduct accrued interest on its own unissued bonds because it had set them aside in an envelope in its vault. While there are perhaps conceivable circumstances in which accruing interest on bonds of a wholly owned subsidiary held by its parent company might be deductible from the subsidiary's gross income, certainly when the government chooses to assail the transaction such a deduction cannot be permitted. Higgins v. Smith, 308 U.S. 473, 60 S.Ct. 355, 84 L.Ed. 406.
But, even aside from the parent-subsidiary relation, taxpayer must lose. For here the contingencies, both in form and substance, affecting the future payment of the interest on the B bonds were such that in the taxable year no reasonable person could assume that payment would ever be likely to occur. This is not a case where the unlikelihood of payment is due to the impending bankruptcy of the debtor, but one where indeed only events approximating the bankruptcy of the debtor could bring about any reasonable possibility of payment of interest on the B bonds. If ever there was a case where flimsy paper transactions were put forward as a basis for avoidance of tax, this is it.
Zimmerman Steel Co. v. Commissioner, 8 Cir., 130 F.2d 1011.
Cf. Lucas v. American Code Co., 280 U.S. 445, 50 S.Ct. 202, 74 L.Ed. 538, 67 A.L.R. 1010; Lucas v. North Texas Co., 281 U.S. 11, 50 S.Ct. 184, 74 L.Ed. 668; Commissioner v. Brooklyn Radio Service Corp., 2 Cir., 79 F.2d 833, 834; Jamaica Water Supply Co. v. Commissioner, 2 Cir., 125 F.2d 512, 513.
Affirmed.