Hemlock Hollow Coal & Coke Co. v. Commissioner

HEMLOCK HOLLOW COAL & COKE CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Hemlock Hollow Coal & Coke Co. v. Commissioner Docket No. 8837. United States Board of Tax Appeals 10 B.T.A. 1176; 1928 BTA LEXIS 3939; March 6, 1928, Promulgated *3939 Under the facts of this case, the petitioner is not entitled to a paid-in surplus with respect to leases. John Enrietto, Esq., and R. S. Doyle, Esq., for the petitioner. M. E. McDowell, Esq., for the respondent. TRAMMELL *1176 This is a proceeding for the redetermination of a deficiency in income and profits taxes for the fiscal years ended June 30, 1920, and June 30, 1921, in the amounts of $2,080.90 and $3,491.68, respectively. After certain stipulations between the parties, the only *1177 questions for decision are: (1) Whether the petitioner may include in invested capital a paid-in surplus arising out of the acquisition of two certain leases, and if so, the amount thereof; and (2) whether the amount of earnings available for dividend purposes should be reduced by a tentative tax in the computation of invested capital. The respondent in his answer admitted that he had made a clerical error against the petitioner in the amount of $100 in the computation of the petitioner's tax liability for the fiscal year ended June 30, 1921, as alleged in the petition. FINDINGS OF FACT. The petitioner is a corporation organized under*3940 the laws of the State of West Virginia on December 9, 1901, having its principal office at Lawton. It was organized for the purpose of mining and shipping coal, manufacturing, selling and shipping coke, to purchase, sell and lease land, to construct, rent and build tenements, and to do a general merchandise business. After its organization, the petitioner acquired two leases of coal lands known, respectively, as Lease No. 1, acquired December 19, 1901, and Lease No. 2, acquired in August, 1903, in Fayette County, W. Va., in what is known as the Quinnimont District of the New River Smokeless Coal Field of West Virginia. These leaseholds are located at the head of Laurel Creek and lie between the right and left forks of said creek. Lease No. 1 contained 600.22 acres and Lease No. 2 contained 411.73 acres. Lease No. 1 was acquired by H. W. Huntzinger from J. L. Beury, J. E. Beury and William Beury. Under this lease the lessees acquired the right to mine, coke and ship all the coal from the land included in the lease and use so much of the surface of the land, timber, water and stone necessary therefor, except a certain class of timber, and to remove all structures and buildings*3941 at the termination of the lease. The lessees were to pay 10 cents per gross ton royalty on all coal mined and a minimum royalty of $3,000 per annum from April 1, 1902, but the lease further provided that the lessees would "have the right of mining during the next succeeding year free from royalty a sufficient amount of coal above the minimum rental of that year to reimburse the deficiency of the next preceding year, provided that in the event of strikes by the employees or the failure of the railroad company to arrange transportation for the products of the mines without fault on the part of the lessees, then in either such event, the lessees shall be released from an equitable proportion of the said minimum rental." On December 19, 1901, Huntzinger assigned the said lease to the petitioner, which was formed to take over and operate the property, *1178 in consideration of one-fourth of the total authorized capital stock "as now capitalized or as same shall hereafter be increased." At the first stockholders' meeting of the petitioner on December 19, 1901, all of the stockholders being present or represented, the assignment was accepted on the terms offered and the directors*3942 were authorized to issue and did issue 25 per cent of the authorized capital stock of $25,000, which was represented by 500 shares of the par value of $50 each, to Huntzinger. The capital stock was later increased to $50,000, whereupon, in accordance with the terms of the assignment, 125 additional shares were issued to Huntzinger. Along both forks of Laurel Creek and on the eastern end of the leasehold there were many outcroppings of coal, and the indications were that the coal and conditions compared favorably with adjoining mines which were being profitably operated. The American Coal & Coke Co. Big Q Mine was directly across the right-hand fork of the creek from Hemlock Hollow. The Greenwood Coal Co. is opposite across the left fork of Laurel Creek. These leaseholds were in operation at the time of the assignment by Huntzinger to the petitioner of Lease No. 1 and were generally known to be profitable operations. They were operating in the same seam of coal as that covered by Lease No. 1. The construction of an extension of a railroad from Greenwood to Hemlock Hollow was begun in 1901. When completed this afforded facilities for the shipment of coal from the petitioner's*3943 mines. From the time petitioner acquired Lease No. 1 it expended all of the money which had been paid in for capital stock for improvements and general development, consisting of the opening of entries to the property, the construction of one-half mile dirt road, a timber incline, dead house and tipple, several tenement houses, some mining cars, mining rails and other development customary in opening up a mine. No additional money was used for the purpose. In May, 1903, the sole assets of the petitioner consisted of Lease No. 1 and the developments made thereon. No coal had been shipped or mined except one car which was loaded in 1902. In the latter part of May, 1903, A. D. Lawton and his associates, who were engaged in mining operations on a lease contiguous to the leaseholds of the petitioner, made an offer to Huntzinger, who then owned 440 shares of petitioner's stock, to purchase the entire capital stock of the petitioner then consisting of 1,000 shares for $150,000. When this offer was brought to the attention of Guthrie, another stockholder of the petitioner, he offered to purchase the stock for $160,000, at the rate of $160 per share, which offer was accepted and*3944 the stock was sold and transferred to Guthrie and his associates. From 1908 to 1918, $220,000 in cash dividends were paid, or an average *1179 of $20,000 per annum, and the operating profits from 1907 to 1916 were $260,749.18, or an average of $26,074.96 for each year. On August 18, 1903, the petitioner acquired the lease herein designated as Lease No. 2, from Julia A. Beury, widow of Joseph L. Beury, deceased, Thomas C. Beury, Joseph E. Beury, H. A. Beury, and Daisy E. Beury, children and heirs at law of Joseph L. Beury, deceased, and Joseph E. Beury in his own right. The corporation issued no stock and paid no consideration for the lease other than the royalties therein provided. The lessors were not stockholders in the corporation and had no connection therewith. It was recited in the lease that whereas J. L. Beury in his lifetime, J. E. Beury and William Beury, on the 5th day of Spetember, 1901, had entered into a contract of lease with Huntzinger, which is Lease No. 1 herein, the lease between these parties, that is, the lease between the parties above stated, will be upon the same terms, stipulations, conditions, and reservations set out and described in the said*3945 lease of September 5, 1901. This lease contained 411.73 acres and adjoined the property described in the first lease. Prior to the death of J. L. Beury in June, 1903, A. S. Guthrie had been in his employ for a number of years at a small compensation, and Beury had promised to give a lease to Guthrie on some coal land. He had persuaded Guthrie to continue in his employ upon the strength of this promise. At the time of his death Beury owned over 60,000 acres of coal land. The heirs at law, whose names are set out above, felt obligated to carry out what they considered to be Beury's wishes with respect to the lease of the coal land to Guthrie and were ready to make a lease to him for the property embraced in Lease No. 2. At the direction of Guthrie, however, this lease was made to the petitioner corporation direct instead of to him and was accepted by the corporation. William Beury, who owned a one-half interest in 178.80 acres which was included in Lease No. 2, and to whom the heirs of J. L. Beury had made the lease for the other half interest, orally authorized the manager of the petitioner corporation to mine and remove coal from his undivided half interest, and stated that*3946 later he would execute a formal lease. Pursuant to this authorization and oral lease with respect to the half interest in 178.80 acres included in Lease No. 2, the petitioner established boundary lines, erected monuments around Lease No. 2, and in 1904 began to remove coal from said tract. In 1908 the heirs of J. L. Beury and William Beury conveyed their interest in this 178.80 acres to the Laurel Creek Land Co., a corporation formed to take over the ownership of property owned in common by the transferors. Said corporation, under date of June 9, 1910, executed a lease in writing with respect to the undivided one-half interest from which the petitioner had been *1180 authorized to mine and remove coal by the verbal authorization of William Beury. The coal in Lease No. 2 was of exactly the same character as that in Lease No. 1 and formed a contiguous seam. The top was in good condition and indicated a high percentage of recoverable coal. Lease No. 2 could have been independently and profitably operated, either by use of an easement reserved in Lease No. 1, or by development along the right fork of Laurel Creek. The expense of operating Lease No. 2 was considerably lessened*3947 by using the development on Lease No. 1. The respondent allowed a value, for invested capital purposes, of $12,500 on Lease No. 1, that being the par value of stock issued therefor, and allowed no value, for invested capital purposes, on Lease No. 2. The royalty rate of 10 cents per ton, provided in both of the leases, was the prevailing royalty rate in that vicinity. One lease in the neighborhood carried a rate as low as 6 cents per ton. Beury, who had extensive holdings through this section, made leases for his other coal lands upon the same royalty basis and the same general provisions as are contained in the leases herein referred to, and no consideration or bonus was paid to the lessors on leases which were contiguous to those acquired by the petitioner or in that vicinity. It was stipulated as follows: That the petitioner is entitled to deductions for gross income for depletion of its coal leaseholds in the following amounts: Calendar year 1917 $1,228.40 Six-month period ending June 30, 1918 902.80 Fiscal year ending June 30, 1919 987,43 Fiscal year ending June 30, 1920 973.35 Fiscal year ending June 30, 1921 1,117.00 That subject to the*3948 provisions of paragraph numbered three following, the invested capital of the petitioner for the years 1917 to 1921 both inclusive, shall be considered as follows: Calendar year 1917 $163,339.18 Six-month period ended June 30, 1918 155,090.16 Fiscal year ended June 30, 1919 131,357.66 Fiscal year ended June 30, 1920 125,261.38 Fiscal year ended June 30, 1921 116.335.55 That the foregoing invested capital figures may, and shall be adjusted in accordance with the Board's disposition of the issues relating to the value of property paid in and the tentative tax computation. The purpose of this stipulation is to dispose of all issues with the exception of the value, for invested capital, of property paid in and the reduction of invested capital by the tentative tax computation. Petitioner's invested capital was reduced for the fiscal years ended June 30, 1920, and June 30, 1921, by amounts representing a pro rata *1181 of dividends alleged to have been paid in excess of earnings in each year. In making such adjustment the respondent reduced the amount of net earnings for each year available for dividends by a tentative income and profits tax theoretically*3949 set aside out of such earnings pro rata over each year. OPINION. TRAMMELL: The issues presented are: (1) Whether the invested capital of petitioner for the fiscal years ended June 30, 1920, and June 30, 1921, should be increased by a paid-in surplus arising through the acquisition by petitioner of Lease No. 1; (2) whether invested capital should be increased for the years in question by a paid-in surplus arising through the acquisition of Lease No. 2; (3) whether the reduction in the amount of current earnings available for dividends in each of said fiscal years by a tentative income and profits tax theoretically set aside out of such earnings pro rata over each year is a proper reduction in the determination of petitioner's invested capital. We must decide the last issue adversely to the respondent upon the authority of many previous decisions of the Board. ; ; ; *3950 ; ; All . With respect to the question as to whether the petitioner is entitled to paid-in surplus arising through the acquisition of Lease No. 1, it is well established that if the lease paid in for stock had a value in excess of the par value of the stock issued therefor, the excess constitutes paid-in surplus and may be included in invested capital. In order, however, that there may be a paid-in surplus, the actual cash value of such property must be shown to have been "clearly and substantially" in excess of the par value of the stock. Section 326(a)(2) of the Revenue Acts of 1918 and 1921 provides as follows: That as used in this title the term "invested capital" for any year means (except as provided in subdivisions (b) and (c) of this section): * * * (2) Actual cash value of tangible property, other than cash, bona fide paid in for stock or shares, at the time of such payment, but in no case to exceed the par value of the original stock or*3951 shares specifically issued therefor, unless the actual cash value of such tangible property at the time paid in is shown to the satisfaction of the Commissioner to have been clearly and substantially in excess of such par value, in which case such excess shall be treated as paid-in surplus. *1182 The fact that Huntzinger did not pay a lump sum or bonus in acquiring the lease does not prevent the inclusion in invested capital of the actual cash value thereof at the time of its acquisition by the petitioner. The real question is did the lease have an actual value at the time Huntzinger turned it over to the corporation for stock in excess of the royalty or other payments required to be made to the lessor, and in excess of the par value of the stock issued therefor. The evidence is that Lease No. 1 provided for a 10 cent royalty rate and that this was the prevailing rate in that vicinity. There is evidence that one lease in that vicinity provided for a rate as low as 6 cents a ton. The territory in which this land was situated was developed coal land. Other leases were being successfully operated near-by when Huntzinger acquired the lease from the lessors. Both Huntzinger*3952 and the lessors were familiar with these facts and with the regular and usual royalty rate in that vicinity. The lessors and lessees appear, from all the facts, to have arrived at the royalty rate to be paid upon a consideration of what other leases had been made for and of the prevailing rate of royalty in that vicinity. There is nothing to indicate that any favor was given or received by Huntzinger in acquiring the lease, or that the lessees and lessors were not dealing at arm's length. This lease was acquired by Huntzinger in September, 1901, and turned over to a corporation which was organized to take it over, the organization of which was completed in December, 1901, when the transfer to it was made. While the lease cost Huntzinger nothing, he turned it over to the corporation for 25 per cent of its stock, receiving in the aggregate $12,500 par value of stock. We think that these circumstances, indicating dealings between a willing lessor and a willing lessee at arm's length, having knowledge of all the circumstances and a knowledge of the prevailing rate of royalty in that immediate vicinity, and the fact that the lessor had made numerous leases to others upon substantially*3953 the same terms and conditions as were included in this lease, have greater weight in determining the actual cash value of the leaserhoold greater weight in determining the actual cash value of the leasehold The facts relied upon by the petitioner occurred in 1903 and subsequent years. In 1903, when the stock was sold at $160 per share, the development work had been completed, some coal had already been sold and other conditions had occurred. The petitioner also relied, to some extent, upon the amount of dividends paid from 1908 to 1918, and the net operating profits from 1907 to 1916, which, to our mind, have substantially no weight in showing the value of the leasehold in 1901. It is to be observed that while witnesses testified who, on account of their long experience in the *1183 coal business in this vicinity and the making and securing of leases, would have been competent to testify as to the value of the leasehold in 1901 when acquired by the corporation, no such testimony was elicited from them. There was some evidence introduced with respect to a branch line the amount of the net profit, the respondent included this There is no testimony, however, that this railroad*3954 was begun after Huntzinger acquired the lease and before it was transferred to the corporation, nor are we convinced by the testimony that Lease No. 1 had any greater value at the time it was transferred to the corporation than when Huntzinger acquired it without any outlay. For the foregoing reasons it is our opinion that the petitioner is not entitled to any paid-in surplus with respect to Lease No. 1. With respect to Lease No. 2, it appears that the petitioner acquired this lease direct from the lessor without any consideration other than payment of the required royalties therein provided. It is true that the lessors felt under obligation to make a lease to Guthrie on account of the fact that their father had promised to make such a lease during his lifetime. Guthrie, however, did not have, and did not claim to have, any legal claim to the leasehold from the Beury heirs, or from Beury, and when the lease was made in 1903, it was made upon substantially the same terms and conditions and with the prevailing rate of royalty in that vicinity. It was based upon the same terms and conditions as were contained in Lease No. 1. Guthrie had no right, title or interest to assign*3955 to the corporation with respect to Lease No. 2, and, since the lease was made direct to the corporation without any consideration other than the royalty payments which were required, no basis is afforded for a paid-in surplus. The Beury heirs had no connection with or interest in the corporation and made the ordinary and usual lease upon the usual terms and conditions as they had made with others on some of the coal lands in that vicinity. There were approximately 178.80 acres of this land included in Lease No. 2 in which a partner of J. L. Beury owned an undivided one-half interest. The Beury heirs, in making Lease No. 2, leased all of the land which they owned absolutely, and included the 178.80 acres in which they only owned a one-half interest. William Beury, however, verbally authorized the manager of the petitioner corporation to enter upon and mine the coal from the land in which he owned a one-half interest and that he, William Beury, would later execute a lease. In 1904 the petitioner began to remove coal from this acreage, and without objection from any one continued to mine it as if it had been held under a formal lease and paid royalties on the coal mined. *3956 *1184 The petitioner cites the case of ; as authority for the proposition that the verbal lease, under the circumstances, was valid and binding. In the case cited, however, the lessee took actual possession and paid the royalties for many years. One of the owners treated him as a tenant for seven years, another for eight years, and another for eleven years. But here, in 1903, the date when Lease No. 2 is sought to be included as paid-in surplus, the petitioner had not entered into possession of the property, had mined no coal and paid no royalties with respect to which the owner of the one-half interest had authorized verbally the petitioner corporation to mine. The statutes of West Virginia, with respect to the verbal leasehold, are as follows: Code, ch. 71, sec. 1. No estate of inheritance or freehold, or for a term of more than five years, in lands, shall be conveyed, unless by deed or will; * * * Code, ch. 98, sec. 1. No. action shall be brought in any of the following cases: * * * (6) Upon any conract for the sale of real estate, or the lease thereof, for more than a year. *3957 In the case of an oral lease, the principles laid down by the Court of Appeals of West Virginia in the case of , have no application, because at the time in question the petitioner had received no cash and had acquired no right of property by having taken possession as was the situation in that case. On the other hand, if the petitioner did acquire a property right, it acquired it, not from Guthrie, but from the lessor direct, without any money or other consideration except the royalties required to be paid. Under the foregoing circumstances, the satute does not authorize the inclusion of a paid-in surplus. Judgment will be entered on 15 days' notice, under Rule 50.