South Carolina Continental Tel. Co. v. Commissioner

South Carolina Continental Telephone Company, Petitioner, v. Commissioner of Internal Revenue, Respondent South Carolina Continental Tel. Co. v. Commissioner Docket No. 10212 United States Tax Court 10 T.C. 164; 1948 U.S. Tax Ct. LEXIS 279; January 28, 1948, Promulgated *279 Decision will be entered under Rule 50. Held, that the transactions here involved between petitioner and the holder of all its outstanding old bonds did not constitute purchase and sale transactions, but an exchange or substitution of new bonds for old as evidence of a continuing indebtedness between the same parties; held, further, that the premium paid and unamortized discount and expense upon retirement of the old bonds in 1941 are not deductible in full in that year, but should be amortized over the life of the new bonds issued in exchange for the old. Milton E. Carter, Esq., for the petitioner. Gene W. Reardon, Esq., for the respondent. Tyson, Judge. Van Fossan and Johnson, JJ., dissent. TYSON *164 This proceeding involves income tax deficiencies determined by respondent against the petitioner in the amounts of $ 2,965.71 and *165 $ 12,801.54 for the calendar years 1941 and 1942, respectively. Petitioner seeks a redetermination of no deficiency for each of those years and of an overpayment of $ 1,063.95 for the year 1942. The petitioner assigns the following errors in the respondent's determination: (1) The disallowance, for the year 1941, *280 of a deduction of $ 44,086.28 claimed as the premium paid and unamortized discount and expense upon the retirement of petitioner's first mortgage series A bonds in that year; (2) the failure to allow, as a deduction for the year 1942, the amount of $ 15,490.26 as amortization of the cost of defense facilities constructed or acquired under necessity certificates; and (3) the failure to allow, as a deduction for the year 1942, the amount of $ 30,757.10 as a net operating loss carry-over from the taxable year 1941. Certain other adjustments made by respondent are not involved herein. The second issue raised by the pleadings has been settled by stipulation that petitioner is entitled to a deduction of $ 14,151.12 for the year 1942 on account of amortization of defense facilities, and effect thereto will be given in the recomputation under Rule 50. At the hearing it was further stipulated that with the exception of the first issue the parties are in complete agreement as to the essential facts involved herein, including those under the third issue, and that upon this Court's decision on the first issue they can recompute petitioner's tax liability for the years 1941 and 1942 under Rule*281 50. The proceeding was submitted upon the pleadings and a stipulation of facts, including exhibits attached thereto. The stipulation, included herein by reference, is adopted as our findings of fact and will be summarized herein. FINDINGS OF FACT. The petitioner, a Delaware corporation, has its principal place of business at Sumter, South Carolina, and owns and operates telephone exchanges, properties, and systems within the latter state. Petitioner's books of account have been kept on the accrual basis and, for the years involved herein, its tax returns were made on that basis and filed with the collector of internal revenue for the district of South Carolina. On July 16, 1941, the petitioner had outstanding its first mortgage 5 per cent 25-year bonds, series A (hereinafter referred to as series A, or old bonds) in the principal amount of $ 387,000, maturing July 1, 1961. Those bonds had been duly authorized, issued, and sold prior to January 1, 1941, to the John Hancock Mutual Life Insurance Co. of Boston, Massachusetts (hereinafter referred to as the insurance company) and were secured by an indenture of mortgage to the City National Bank & Trust Co. of Chicago, Illinois, and*282 Arthur T. Leonard of Chicago, as trustees, dated as of July 1, 1936, and a supplemental indenture dated November 1, 1939. The indenture as supplemented provided, *166 inter alia: By article three, for the redemption of series A bonds at any time prior to maturity at petitioner's option upon payment of the principal amount, interest accrued to date, and specified premiums depending on the date of redemption; by article four, for the issuance of additional bonds of series A, or bonds of any other series, "for the purpose of refunding, principal amount for principal amount, any outstanding underlying bonds, * * * theretofore or simultaneously paid or redeemed," but petitioner had the option of depositing with the trustee either the new bonds for an exchange for old bonds or "funds in an amount sufficient to redeem or pay" the old bonds; and by article six, for the issuance of additional series A bonds, or bonds of any other series, for the "purpose of creating a cash fund" available for redemption of outstanding bonds or for physical property additions. The indenture did not give the holder of the series A bonds any option to exchange old bonds for new in any refunding operation. *283 On July 16, 1941, by a written instrument dated July 11, 1941, the petitioner and the insurance company entered into an agreement providing for the simultaneous cancellation of petitioner's outstanding series A bonds, all of which were then owned by the insurance company, and the issuance to the insurance company of petitioner's first mortgage 4 per cent 25-year bonds, series B (hereinafter referred to as series B, or new bonds) in the aggregate principal amount of $ 600,000, maturing July 1, 1966. Such agreement, wherein petitioner is referred to as the "Company," provided, inter alia, that the "Company is desirous of purchasing the said Series A Bonds and cancelling and retiring the same, and at the same time * * * is desirous of procuring additional funds" for physical property additions, and for such purpose the company would execute and deliver a supplemental indenture creating a second series of bonds known as series B, which it would issue in the aggregate principal amount of $ 600,000 "and $ 387,000 principal amount thereof will be issued under the provisions of Article Four of the Original Indenture and the remaining $ 213,000 principal amount of the Series B Bonds will*284 be issued under the provisions of Article Six of the Original Indenture"; that the Company warrants that "the consummation of the refinancing program herein provided for, including the purchase and retirement of the said Series A Bonds and the issuance and sale to you of the said Series B Bonds, * * * will not result in any breach" of any instrument to which the Company is a party; that subject to all the terms of the agreement, "the Company hereby agrees to sell to you and you hereby agree to purchase from the Company $ 600,000 principal amount of the said Series B Bonds issued under and secured by the Original Indenture (as supplemented *167 by the said Supplemental Indenture)" at a price of $ 106.56 of the principal amount plus accrued interest and the "Delivery of the said bonds will be made at the office of City National Bank and Trust Company of Chicago in Chicago, Illinois, against payment therefor in Chicago funds on the Closing Date," and, further, "you hereby agree to sell to the Company and the Company hereby agrees to purchase from you the said $ 387,000 principal amount of outstanding Series A Bonds" at a price of $ 110 of the principal amount thereof plus accrued*285 interest and the "said Series A Bonds shall be delivered to the Company simultaneously with the delivery by the Company to you of the said Series B Bonds," and the "Company shall make payment for the said Series A Bonds in Chicago funds"; that in no event shall the insurance company "be required to sell or deliver the said Series A Bonds to the Company," nor shall the company "be required to issue and sell the said Series B Bonds to you" unless both be done "simultaneously," and the "Company agrees that it will, forthwith upon receipt from you of the said Series A Bonds, cancel the said bonds"; that the bonds purchased by insurance company under the agreement "will be purchased for your own account for investment" and not present resale; and, further, paragraph 11 of that agreement provided: 11. As stated above, $ 387,000 principal amount of the Series B Bonds will be issued under Article Four of the Original Indenture against the cancellation and retirement of an equal principal amount of the said outstanding Series A Bonds and the remaining $ 213,000 principal amount of the Series B Bonds will be issued under Article Six of the Original Indenture against the deposit with the Trustee*286 thereunder of $ 213,000 cash. The cash so deposited will be withdrawn by the Company in accordance with the provisions of Section 6.02 of the Original Indenture. The issuance of petitioner's series B bonds was duly authorized in the manner provided by law and duly secured by the original indenture of mortgage dated as of July 1, 1936, as modified by the indenture dated November 1, 1939, and as supplemented by a supplemental indenture of mortgage dated as of July 1, 1941. On July 30, 1941, in accordance with the above mentioned agreement of July 16, 1941, and at the office of the trustees under the indenture of mortgage, the petitioner issued its series B bonds in aggregate principal amount of $ 600,000 and delivered them to the insurance company, and simultaneously the insurance company delivered to the petitioner the latter's then outstanding $ 387,000 principal amount of series A bonds, which were duly retired and canceled. On July 30, 1941, and in accordance with the above mentioned agreement of July 16, 1941, the petitioner issued its check payable to the insurance company in the amount of $ 427,258.75 ($ 387,000 principal *168 amount, $ 38,700 premium, and $ 1,558.75 interest*287 from July 1 to July 30, 1941) and simultaneously the insurance company issued its check payable to petitioner in the amount of $ 641,293.33 ($ 600,000 principal amount, $ 39,360 premium, and $ 1,933.32 interest, from July 1 to July 30, 1941). The insurance company's check was endorsed by petitioner and deposited to the credit of its account with the City National Bank & Trust Co. of Chicago, and prior to such deposit petitioner did not have sufficient cash on hand to cover its above mentioned check issued to the insurance company. In its income and declared value excess profits tax return for the year 1941 the petitioner, in computing its taxable net income, claimed a deduction in the net amount of $ 44,481.06 as representing $ 44,100.53 premium and expenses in connection with the cancellation of its series A bonds during that year and $ 1,050.01 discount on funded debt, less a credit of $ 669.48 release of premium on funded debt. In determining petitioner's tax liability for the year 1941 the respondent, inter alia, determined an amount of bond amortization in the total sum of $ 394.78 as deductible, and he disallowed $ 44,086.28 of the above mentioned claimed deduction on *288 the ground that petitioner's "issuance of new bonds in the year 1941 for the purpose of retiring outstanding bonds, and other purposes constituted merely a substitution and exchange of new bonds for old," and further determined that the premium paid upon the retirement and the unamortized discount and expenses of the old bonds were not deductible in full in 1941, but were amortizable over the life of the new bonds. The transactions carried out on July 30, 1941, whereby petitioner issued $ 387,000 principal amount of its new series B bonds, under article four of the indenture of mortgage, for the purpose of refunding and the simultaneous cancellation and retirement of an equal principal amount of old series A bonds, and further issued additional new series B bonds in the principal amount of $ 213,000 under article six of the indenture of mortgage for the purpose of creating a cash fund for physical property additions, constituted essentially an exchange or substitution of petitioner's new bonds or obligations for its old ones, to the extent of $ 387,000 principal amount for principal amount. OPINION. The first assignment of error presents the only remaining issue for our redetermination. *289 The parties are in agreement as to the principles of law applicable to that issue, viz., that, generally, where an outstanding issue of bonds is retired for cash, even though the cash is obtained by the sale of a new issue of bonds, the premium paid upon the retirement and the unamortized discount and *169 expenses of the old bonds are deductible in the year of retirement, 1*290 but that where an outstanding issue of bonds is retired by an exchange or substitution of old bonds for new, those same items are deductible only through amortization over the life of the new bonds. 2 The parties are in further agreement that the question herein narrows itself into one of whether the July 30, 1941, transactions carried out pursuant to the terms of the July 16, 1941, agreement constituted, in fact, (1) an exchange or substitution of petitioner's new bonds to the extent of the principal amount of $ 387,000 thereof for its old bonds thus retired and an issue of additional new bonds in the principal amount of $ 213,000 for cash, as contended by respondent, or (2) a purchase and retirement by petitioner of its outstanding old bonds from the proceeds of the sale of its new bonds, as contended by petitioner. In Great Western Power Co. v. Commissioner, supra, the holders of the old bonds exercised an option to exchange them for new *291 bonds at par, plus a cash premium, and the Court, after referring with approval to cases involving a retirement of bonds for cash, stated that "The question then is whether, upon an exchange of one obligation for another which is to be retired, the transaction is to be viewed as if the retirement were accomplished by the payment of cash," and held that the taxpayer had substituted a new obligation for the old, and that the unamortized expense of issuance of the old bonds and the expense of the exchange were both attributable to the issuance of the new bonds and accordingly were amortizable over the life of the new bonds. The principle of tax law decided in that case is controlling in the instant case if it be determined as an ultimate fact that the transactions here involved constituted an exchange of petitioner's old bonds for its new bonds. In the instant case we have concluded and found as an ultimate fact that petitioner issued its new series B bonds in the principal amount of $ 387,000 in exchange or substitution for an equal principal amount of its then outstanding old series A bonds simultaneously canceled and retired. In our opinion the essential facts herein lead to such*292 conclusion. It is true that the written agreement of the insurance company and petitioner dated July 16, 1941, uses numerous expressions which, *170 if given the emphasis contended for by petitioner, would seem to cloak the July 30, 1941, transactions as a sale of its new bonds for cash and a purchase of its old bonds with a portion of such cash proceeds. However, we may not ignore the fact that the indenture of mortgage is the basic instrument governing the legal inter-relationship existing between the old bonds and the new and also governing the construction to be placed on the July 16, 1941, agreement. That agreement specifically refers to and is bottomed on the indenture of mortgage and despite the use of words of purchase and sale in the agreement it specifically provides that "$ 387,000 principal amount of the Series B Bonds will be issued under Article Four of the Original Indenture against the cancellation and retirement of an equal principal amount of the said outstanding Series A Bonds and the remaining $ 213,000 principal amount of the Series B Bonds will be issued under Article Six of the Original Indenture against the deposit with the Trustee thereunder of $ 213,000*293 cash. The cash so deposited will be withdrawn by the company in accordance with the provisions of Section 6.02 of the Original Indenture," that is, for the purpose of redeeming outstanding bonds or for physical property additions. In short, the essence of the July 30, 1941, transactions was that upon the completion thereof petitioner was in the position of having cash made available through the sale of $ 213,000 principal amount of new series B bonds and of having exchanged or substituted $ 387,000 principal amount of new series B bonds for an equal principal amount of old series A bonds simultaneously canceled and retired. Furthermore, the indisputable facts are that, to the extent of $ 387,000 principal amount, the issuance of the new bonds was entirely dependent upon the simultaneous surrender of the outstanding old bonds; that the old and the new bonds were not independent obligations existing at the same time, but instead evidenced the same indebtedness between the same parties continuing without interruption, by virtue of the simultaneous exchange or substitution; and that the only material change effected as to such continuing indebtedness was in the rate of interest thereon, *294 the date of maturity thereof, and the form of the bond representing the debt. We hold that the premium paid and unamortized discount and expense upon the retirement of petitioner's first mortgage series A bonds in 1941 are not deductible in full in that year, but should be amortized annually over the life of the bonds issued in exchange for those retired. Great Western Power Co. v. Commissioner, supra. On the first issue we sustain the respondent's determination. Decision will be entered under Rule 50. Footnotes 1. Helvering v. California Oregon Power Co., 75 Fed. (2d) 644; Helvering v. Union Public Service Co., 75 Fed. (2d) 723; Helvering v. Central States Electric Corporation, 76 Fed. (2d) 1011; Southern California Edison Co., Ltd., 4 T. C. 294; Congress Square Hotel Co., 4 T. C. 775; Illinois Power & Light Corporation, 33 B. T. A. 1189; American Gas & Electric Co., 33 B. T. A. 471 (see first issue, pertinent here, not involved on appeal 85 Fed. (2d) 527); East Ninth Euclid Co., 26 B. T. A. 32; reaffirmed, 27 B. T. A. 1289; and T. D. 4603, XIV-2 C. B. 58↩. 2. Great Western Power Co. v. Commissioner, 297 U.S. 543, affirming 79 Fed. (2d) 94. Also see T. D. 4603, supra; and Virginia Electric & Power Co. v. Early (Dist. Ct. Va.), 52 Fed. Supp. 835↩.