Turners Falls Power & Elec. Co. v. Commissioner

TURNERS FALLS POWER & ELECTRIC CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Turners Falls Power & Elec. Co. v. Commissioner Docket No. 26306. United States Board of Tax Appeals 15 B.T.A. 983; 1929 BTA LEXIS 2759; March 20, 1929, Promulgated *2759 1. LOSS OR GAIN - EXCHANGE OF NOTES FOR PROPERTY AND STOCK. - As a result of a reorganization of the John Russell Cutlery Co. effected on December 15, 1923, the petitioner, then being the owner and holder of promissory notes issued by the cutlery company in the amount of $297,500 and another note of $100,000 secured by stock of the cutlery company and all representing a cost to the petitioner in the amount of $397,500, and also being then the original payee and holder of a note in the amount of $120,000, issued and representing a scrip dividend declared by the cutlery company in February, 1920, but which represented no element of cost to the petitioner, exchanged all of these notes and surrendered the collateral and received therefor 1,200 shares of the newly issued stock of the cutlery company at an agreed value of $102,000 and a conveyance of the real estate and factory equipment of said company at an agreed valuation of $300,000. Held, that the petitioner in exchange for notes representing a cost of $397,500 received stock and property at a valuation of $402,000 and then realized a gain in the amount of $4,500. 2. SCRIP DIVIDEND NOTE. - The note representing a scrip dividend*2760 declared in February, 1920, and in the hands of the original payee and under the facts as shown in this record, represents no element of cost and can not be a basis for either a bad debt or loss deduction. 3. INTEREST INCOME. - Although the petitioner kept its accounts and made its tax returns upon the accrual basis, the $42,016.67 interest item involved in this action was not a properly or legally accruable item in the ordinary course of petitioner's business, as there existed no reason for believing that the said interest was likely to be paid or could be collected. Following Great Northern Railway Co.,8 B.T.A. 225. Howard W. Brown, Esq., for the petitioner. Philip M. Clark, Esq., for the respondent. SMITH *983 The petitioner asks for a redetermination of a deficiency in income tax for the calendar year 1923, asserted in the respondent's deficiency notice dated February 10, 1927, in the amount of $22,015.06. The petitioner alleges error in the refusal of respondent to allow the deduction of an alleged loss in the amount of $115,500, and in not further reducing gross income by the elimination of an alleged interest*2761 item of $42,016.67. FINDINGS OF FACT. Since 1907 petitioner has been a Massachusetts corporation, engaged in the operation of hydro-electric plants at Turners Falls, and will be hereinafter referred to as the power company. *984 Some years prior to 1923 the John Russell Cutlery Co., which will be hereinafter referred to as the cutlery company, had been and then was a corporation carrying on a manufacturing business at Turners Falls. During the years 1918 to 1923, inclusive, the power company had, at various dates, advanced sums of money to the cutlery company. On December 15, 1923, these advances were represented by eight promissory notes, aggregating $180,000, all bearing interest and all payable on demand. Seven of these notes had been made prior to June 30, 1921, and upon all of said seven notes accruable interest from and after June 30, 1921, had remained unpaid. On February 3, 1920, the then outstanding capital stock of the cutlery company consisted of 2,000 shares of the par value of $100, and of these shares the power company was the owner of record of 1,985 shares and was the beneficial owner of the remaining 15 shares which then stood of record in the*2762 name of Charles E. Hazelton. These 2,000 shares of cutlery company stock had cost the power company $200,000. On February 3, 1920, the cutlery company had invested $120,000 or more of earnings in plant equipment, material, etc., but was without cash with which dividends might have been paid and on that date the board of directors of the cutlery company held a formal meeting and adopted a resolution in words and figures as follows: Whereas: this Company has hitherto expended of its earnings for the purpose of carrying on and developing its business, and in the purchase of materials, merchandise and other properties, with a view of increase of its business, moneys in excess of sixty per centum (60%) of the total par value of the capital stock of the company, and Whereas: the several stockholders of the Company are entitled to reimbursement of the same by a dividend of Sixty Dollars ( $60) per share payable at some definite future period, Now, therefore, be it RESOLVED: that a dividend of Sixty Dollars ( $60) per share is hereby declared to stockholders of record at the close of business this day, payable by a certificate signed by the Treasurer of this Company, declaring*2763 that such stockholder is entitled to an amount equal to Sixty Dollars ( $60) per share for each share of the capital stock held by such stockholder, payable on the thirtieth day of December 1920, with interest thereon from this date at the rate of six per centum (6%) per annum. In pursuance of said resolution the directors on the same day caused to be issued two scrip dividend certificates. One of such certificates issued and delivered to the power company was in words and figures as follows: *985 JOHN RUSSELL CUTLERY COMPANY TURNERS FALLS, MASS., February 3, 1920. INTEREST CERTIFICATE, constituting scrip dividend No. 1, under a Resolution of the Board of Directors of this Company passed February 3, 1920, a copy whereof is hereto annexed. The JOHN RUSSELL CUTLERY COMPANY hereby certifies that Turners Falls Power & Electric Company being the holder of 1985 shares of the capital stock of said Company is entitled to One Hundred and Nineteen Thousand One Hundred 100/00 Dollars, payable ratably with the other certificates issued under said Resolution on the thirtieth day of December 1920, with interest thereon from February 3, 1920, at the rate of six per centum*2764 (6%) per annum. This certificate may be transferred on the books of the Company on the surrender of this certificate. In witness whereof, the said Company has caused this certificate to be signed by its Treasurer this seventeenth day of February 1920. C. E. HAZELTON, Treasurer. The other of such certificates, in like language but in the amount of $900 allocable to 15 shares of stock, was at the same time issued to Charles E. Hazelton, and immediately transferred and reissued to the power company. According to their terms these scrip dividend certificates were payable on December 30, 1920, with interest at the rate of 6 per cent per annum. On December 30, 1920, the cutlery company was unable to redeem these certificates in cash, and, in lieu thereof, the power company turned in said certificates and received in exchange therefor the cutlery company's promissory note in the amount of $120,000, in words and figures as follows: $120,000. TURNERS FALLS, MASS., December 30, 1920. On Demand We promise to Pay To the Order of Turners Falls Power & Electrical Company ONE HUNDRED TWENTY THOUSAND DOLLARS Payable at Office of John Russell Cutlery Co., Turners*2765 Falls, Mass. Value Received. With interest at 7% per annum. No. 228. Due On Demand. JOHN RUSSELL CUTLERY COMPANY, By (Signed) C. E. HAZELTON, Treasurer. [Countersigned] Lewis D. Bement, Pres. This note was still held by the power company on December 15, 1923, and no interest had been paid thereon subsequent to June 30, 1921. On or about October 26, 1921, the power company, being then the owner of the 2,000 shares of issued and outstanding stock of the cutlery company, by virtue of certain understandings and trust agreements, sold the said 2,000 shares of cutlery company stock to Lewis D. Bement, Charles E. Hazelton, and Lawrence Ewing, and then received *986 from the said purchasers $100,000 in cash, together with a contract note for $100,000, the same being in words and figures as follows: MONTAGUE, MASS., October 26, 1921. FOR VALUE RECEIVED, I, FRED C. ABERCROMBIE, Trustee under a certain Agreement and Declaration of Trust dated October 26, 1921, by and between said Fred C. Abercrombie, party of the first part, Lewis D. Bement, Charles E. Hazelton, and Lawrence Ewing, parties of the second part, and Turners Falls Power & Electric Company, *2766 party of the third part, promise to pay to TURNERS FALLS POWER & ELECTRIC COMPANY, or order, on demand, the sum of One Hundred Thousand ($100,000) Dollars, with interest thereon at the rate of Six and One-half (6 1/2) Per Centum per annum, having deposited with this obligation as collateral security therefor a certificate or certificates representing Nineteen Hundred Forty-Five (1945) shares of the common stock of the John Russell Cutlery Company, with authority to sell, assign, transfer, and deliver the same, or any collaterals substituted for or added to the above, either at public or private sale, at the option of the holder or holders hereof, on the non-performance of this agreement, the holder or holders hereof giving to the makers hereof at least Thirty (30) Days' notice in writing of intention to sell said collateral, and, in case of public sale, giving at least Seven (7) Days' notice in writing of the time and place of public sale; said holder or holders applying the proceeds, after deducting all proper charges and expenses, to the payment of this note, and accounting to me, as Trustee as aforesaid, for the surplus, if any; and it is hereby agreed that the holder or holders*2767 of this note, or any person or persons in behalf of such holder or holders, may purchase at any such public sale; and it is hereby stipulated that neither the Trustee nor the beneficiaries under said trust shall be held to any personal liability under or by reason of this note, but the holder or holders of this note shall look only to the trust property for payment of the said note. FRED C. ABERCROMBIE, Trustee under an Agreement and Declaration of Trust dated October 26, 1929, but not individually. This contract note, together with 1,945 shares of cutlery company stock as collateral, was still held by the power company on December 15, 1923, and no interest had been paid upon the note up to that date. Shortly before December 15, 1923, the power company was still holding cutlery company obligations represented by the scrip dividend note of $120,000, loan notes aggregating $180,000, and the $100,000 note last above described secured by 1,945 shares of cutlery company stock deposited as collateral. The cutlery company was also indebted to banks for moneys borrowed in the amount of $117,500. It was without funds to meet its current obligations and was unable to borrow further*2768 amounts. Facing this situation the power company submitted to the cutlery company a proposed plan of reorganization and refinancing of the cutlery company. This proposed plan of reorganization and refinancing, after due consideration, was accepted by the cutlery company stockholders as evidenced by a writing dated November 30, 1923, and in words and words and figures as follows: *987 GEORGE W. LAWRENCE, President, Turners Falls Power & Electric Co., Greenfield, Mass. DEAR SIR: We have carefully examined and thoroughly considered a memorandum for the reorganization of the John Russell Cutlery Company which has been prepared by representatives of your company in collaboration with Mr. Hazelton, of the John Russell Cutlery Company. Briefly the plan proposed is as follows - (1) The Turners Falls Power & Electric Co. will surrender the following items: Scrip dividend note of John Russell Cutlery Co. now held by Turners Falls Power & Electric Co $120,000 Subordinated notes of John Russell Cutlery Co. now held by Turners Falls Power & Electric Co 180,000 Trustees' note now held by Turners Falls Power & Electric Co., secured by common stock of John Russell Cutlery Co 100,000 Accrued interest on above notes (approximately) 35,000 Outstanding notes of John Russell Cutlery Co. now held by banks (to be purchased by Turners Falls Power & Electric Co. for this purpose) 117,500 Total (approximately) 552,500 *2769 (2) In exchange for the above Turners Falls Power & Electric Company will receive - (a) A deed in fee simple of the land and buildings and machinery, equipment and apparatus attached to buildings now owned by the John Russell Cutlery Company. (b) 1,200 shares of the class B stock of the John Russell Cutlery Company to be issued in accordance with the plan of recapitalization set forth below. (3) The land, buildings, machinery, apparatus, and equipment, conveyed as above stated, are to be leased by the Turners Falls Power & Electric Company to the John Russell Cutlery Company by a lease containing the provisions set forth below, including an option to the lessee to repurchase the property on or before December 31, 1931, for $300,000. (4) We as individuals are to have the option to purchase at $85 per share on or before December 31, 1931, the 1,200 shares of Class B stock above referred to. (5) The lease above referred to shall be for the term beginning at the date of the conveyance of the property to the lessor and ending December 31, 1943, and shall provide that the lessee shall pay during the term of the lease all taxes on the leased property (including the taxes for*2770 1923 which are to be advanced by the lessor at the time of the conveyance) and all insurance, and will make all necessary repairs, renewals, and replacements so that the leased property shall be kept at all times according to the judgment of and decision of an engineer to be selected by the lessor in as good repair, condition and working order as the same are in at the commencement of the lease. Said lease shall also provide for a rent of nothing for the period up to December 31, 1924, of $12,000 for the year 1925, of $13,000 for the year 1926, of $14,000 for the year 1927, of $15,000 for the year 1928, of $21,000 for the year 1929, of $22,000 for the year 1930, of $23,000 for the year 1931, and of $25,000 a year thereafter for each and every year during the remainder of the term. Said lease shall also provide for the option above referred to in paragraph (3). (6) The John Russell Cutlery Company is to be recapitalized by the retirement of all outstanding capital stock consisting of 1390 shares of preferred stock and 2,700 shares of common stock and by issuing in place thereof 1,390 *988 shares of Class A stock without par value and 3,550 shares of Class B stock without*2771 par value. The 1,390 shares of new Class A stock are to be issued share for share to the present holders of the existing preferred stock. Of the 3,550 shares of new Class B stock, 2,700 shares are to be issued share for share to the present holders of the existing common stock, (and of these 2,700 shares, 1,200 are to be transferred to the Turners Falls Power & Electric Company) and 850 shares are to be issued to us, and for these 850 shares we are to surrender to the John Russell Cutlery Company its notes for $35,000 now held by us and to pay to it also the sum of $45,000 in cash. (7) The provisions applicable to the Class A stock and the Class B stock shall be in substance that both classes shall vote share for share and shall have equal rights share for share in the event of liquidation; that no dividends shall be paid before July 1, 1925, that after July 1, 1925, in each fiscal year dividends up to but not exceeding Six (6) Dollars per share may be paid if declared by the directors to the Class A stock alone before any payment to Class B; that unless in any fiscal year the full amount of Six (6) Dollars per share has been paid to Class A no dividends shall be paid in that*2772 year to Class B; that after Six (6) Dollars per share has been paid in any year to Class A such dividends as the directors may declare may then be paid in the same year to Class B without further payment to Class A; that Class A shares may be converted at any time into an equal number of Class B shares; and that Class A may be called and redeemed at any time at $110 per share by the vote of 3/4 of Class B (Class A not voting), the privilege of conversion, however, to continue after the call and down to the date fixed for redemption. In our opinion the plan of reorganization above referred to, under the circumstances existing, is eminently just and fair to the John Russell Cutlery Company and all persons interested therein, and is one which will give to the Company an excellent opportunity of doing from now on a profitable business. With a full knowledge and understanding of the plan, we heartily approve of it. Yours very truly, (Signed) LEWIS D. BEMENT. C. E. HAZELTON. LAWRENCE EWING I hereby concur in the above approval. (Signed) C. W. HAZELTON. TURNERS FALLS, MASS., November 30, 1923. Immediately upon the acceptance of the proposed reorganization plan*2773 the petitioner acquired the outstanding notes of the cutlery company held by several banks at a cost of $117,500, and on December 15, 1923, the terms of the reorganization agreement were carried out in exact accord with the language and figures of said agreement except that the item of interest on the notes held by the petitioner was on that day found to be $42,016.67. The petitioner received a deed of conveyance transferring to it all the plant property of the cutlery company subject, however, to reservations as follows: To have and to hold the above described premises to it the said Turners Falls Power and Electric Company, its successors and assigns to its and their own use forever; subject, however, to this reservation in favor of said John Russell Cutlery Company, its said successors and assigns, namely that it is hereby reserved to it and them, an estate for years in all the property hereby conveyed, as more fully set forth in a lease which has been executed by the parties *989 herein contemporaneously with this deed and part of the same transaction, and which is to be recorded herewith, and also the right to purchase the property within the time and upon the terms*2774 set forth in said lease, which lease is made part hereof. At the same time, by an instrument of lease dated December 15, 1923, the Turners Falls Power Co. did lease back to the John Russell Cutlery Co. the property which had been conveyed by the latter to the former, for the term beginning December 15, 1923, and ending December 31, 1943, and this lease contains a provision under which the lessee, the John Russell Cutlery Co., had the right to repurchase the property for the sum of $300,000 at any time on or before December 31, 1931, in accordance with the reorganization agreement hereinabove set forth. There was also then issued and delivered to the petitioner 1,200 shares of the new Class B stock of the cutlery company, in accordance with and subject to the terms of a written instrument made on that date and in words and figures as follows: THIS AGREEMENT made this fifteenth day of December, 1923, by and between FRED C. ABERCROMBIE of Turners Falls, Massachusetts, as trustee under an agreement and declaration of trust between the parties hereto dated October 26, 1921, party of the first part, CHARLES E. HAZELTON, of Montague, Massachusetts, LEWIS D. BEMENT of Deerfield, Massachusetts, *2775 and LAWRENCE EWING of Greenfield, Massachusetts, parties of the second part, and TURNERS FALLS POWER & ELECTRIC COMPANY, a corporation of Massachusetts having its principal place of business at said Turners Falls, party of the third part, said parties being all of the parties to the aforesaid agreement and declaration of trust and the only parties interested in said agreement and declaration of trust and in the stock held in trust thereunder: WITNESSETH as follows: (1) Said agreement and declaration of trust is hereby terminated. (2) The note of the said Abercrombie as trustee for the amount of One Hundred Thousand (100,000) Dollars now held by Turners Falls Power & Electric Company shall be forthwith surrendered by said Turners Falls Power & Electric Company to said Abercrombie for cancellation. (3) The Nineteen Hundred and Forty-five (1,945) shares of the common stock of John Russell Cutlery Company now held by said Abercrombie as trustee as aforesaid shall be exchanged by him forthwith for Nineteen Hundred and forty-five (1,945) shares of the Class B stock without par value of said John Russell Cutlery Company in accordance with the reorganization of said company recently*2776 carried into effect, and he shall then transfer Twelve Hundred (1,200) shares of said Class B stock without par value to Turners Falls Power & Electric Company, Two hundred and forty-eight (248) of said shares to said Charles E. Hazelton, Two Hundred and forty-eight (248) of said shares to said Lewis D. Bement, Two Hundred and Forty-eight (248) of said shares to said Lawrence Ewing, and the remaining One (1) share to such person or persons as may be determined by said Hazelton, Bement and Ewing. (4) Said Turners Falls Power & Electric Company further agrees that said Charles E. Hazelton, Lewis D. Bement, and Lawrence Ewing shall have the right to purchase said Twelve Hundred (1,200) shares at the price of Eighty-five (85) Dollars per share at any time not later than December 31, 1931, and that upon *990 payment and tender of said purchase price within said time by Charles E. Hazelton, Lewis D. Bement and Lawrence Ewing said Turners Falls Power & Electric Company will transfer said shares to them or upon their order. In the event of the death of any one or two of said Hazelton, Bement and Ewing prior to the exercise of the aforesaid option, said option may thereafter be exercised*2777 by the survivors or survivor of them. Nothing herein contained shall prevent the sale of said shares by said Turners Falls Power & Electric Company at any time to any person or corporation at such price as it sees fit, provided that such purchaser shall be notified of this option agreement and shall agree to be bound thereby. IN WITNESS WHEREOF, the parties have hereto set their hands and seals, on the day and year first above written, this being one of five original copies of the same agreement all executed as aforesaid. (Signed) FRED C. ABERCROMBIE, Trustee. (Signed) LEWIS D. BEMENT. (Signed) C. E. HAZELTON. (Signed) LAWRENCE EWING. TURNERS FALLS POWER & ELECTRIC COMPANY. By (Signed) GEORGE W. LAWRENCE, Pres. The above said transactions having been completed, the petitioner recorded same upon its books in journal entries as follows: Credit entries. Notes receivable $517,500.00 Interest account 42,016.67 Total 559,516.67 Debit entries. Property accounts $439.516.67 Surplus a/c bad debt written off 120,000.00 Total 559,516.67 In its income-tax return for the calendar year 1923, the petitioner claimed a deduction*2778 from gross income as "note of John Russell Cutlery charged off, $120,000." This claimed deduction, together with others not here in controversy, was disallowed by the respondent. The petitioner now reasserts its claim to a loss growing out of the transactions herein detailed in the amount of $115,500, and further claims at this time that its net taxable income as adjusted by the respondent should be further reduced by the elimination of the interest item of $42,016.67. OPINION. SMITH: This case has been tried and argued upon the theory that its decision would turn upon the question of an exchange of property for other property, and that the loss or gain would be the difference between the cost of the notes held by the petitioner, and which represented cost plus the value of the scrip dividend note, and the *991 market value of the stock and property received in exchange. In support of this theory two witnesses, one of them representing the petitioner, and the other representing the stockholding interests of the cutlery company, have given opinion testimony as to the fair market value of the new cutlery company stock and of the plant and equipment. We have no doubt of*2779 the competency of these witnesses to testify as to the values of these properties, and in view of the fact that all parties in interest have agreed that for the purposes of the transactions then taking place the value of the real estate and factory equipment was $300,000 and the value of the 1,200 shares of stock received by the petitioner was $102,000, we accept those figures as representing a true value of the properties received by the petitioner in exchange for the notes surrendered. The statutory provisions of the Revenue Act of 1921 which require special consideration are the following: SEC. 202. (a) That the basis for ascertaining the gain derived or loss sustained from a sale or other disposition of property, real, personal, or mixed, acquired after February 28, 1913, shall be the cost of such property; * * * * * * (c) For the purposes of this title, on an exchange of property, real, personal or mixed, for any other such property, no gain or loss shall be recognized unless the property received in exchange has a readily realizable market value; but even if the property received in exchange has a readily realizable market value, no gain or loss shall be recognized - *2780 * * * (2) When in the reorganization of one or more corporations a person receives in place of any stock or securities owned by him, stock or securities in a corporation a party to or resulting from such reorganization. The word "reorganization," as used in this paragraph, includes a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or of substantially all the properties of another corporation), recapitalization, or mere change in identity, form, or place of organization of a corporation, (however effected); * * * Even though it be granted that there was a reorganization of the John Russell Cutlery Co., the petitioner did not in place of stock or securities of the old company receive stock or securities in the new corporation. In exchange for the notes of the old company it received a certain number of shares of stock of the new corporation and real estate and factory equipment of a determined value of $300,000. If the property received in exchange had a fair market value in excess of the cost to the petitioner*2781 of the notes sold by the petitioner, such excess value is taxable income within the meaning of the statute. The record establishes that all of the notes surrendered by the petitioner, except the scrip dividend note, represented cost in the *992 total amount of $397,500. The note representing the scrip dividend was still held by the original payee and represented no element of cost to it. We are, therefore, of the opinion that this note can not be used as a basis of any value in connection with the exchange of notes for properties which took place as a result of the reorganization of the cutlery company. We are thus brought to the conclusion that the petitioner surrendered notes representing a cost to it of $397,500 and received in exchange stock and property of a then agreed value of $402,000, and that the transaction thus resulted in the petitioner then realizing a gain in the amount of $4,500. As to the matter of the interest item of $42,016.67, the record establishes the fact that all of petitioner's business transactions and relations with the cutlery company were outside the realm of its regular business; that they represented investments in stock and loans to*2782 a separate business organization; that the loans were made largely to protect stock investments; that the cutlery company, at least from 1918 to 1923, was chronically suffering from financial embarrassment; that during these years petitioner was in imminent danger, not only of not collecting interest upon its loans but of actually losing much of the value of such loans; and that at no time, at least between the first of January, 1921, and December 15, 1923, could the petitioner have anticipated the collection of interest upon the notes representing its advances. We are therefore of the opinion that in spite of the fact that petitioner's business accounts were kept on the accrual basis, interest upon these notes was not a properly accruable item and that when such interest was computed as a part of the transactions involved in the refinancing of the cutlery company it should not have been reflected as accrued interest in the income accounts of the petitioner. Cf. , where we said: * * * The company [the debtor] was not earning any interest on its obligations and had not been for many years. The petitioner derived no income*2783 from the interest accruable upon bonds of this [debtor] company during the taxable years and the addition to the reported income of the petitioner of any amount for interest upon these obligations was in error. We are therefore of the opinion that this item of $42,016.67 should not be included or reflected in the taxable income of the petitioner for the year 1923. Reviewed by the Board. Judgment will be entered under Rule 50. TRUSSELL (Dissenting in part) TRUSSELL, dissenting in part: I am not in accord with that part of the views of the majority of the Board respecting the matter of loss or gain resulting from the exchanges made according to the facts in *993 this case. The most conspicuous fact disclosed by this record is that a reorganization of the cutlery company was brought about on December 15, 1923, and a complete recapitalization of the company resulted. I am of the opinion that this reorganization and recapitalization was of such a character as is contemplated by section 202(c)(2) of the Revenue Act of 1921 and that no gain or loss should be predicated upon these transactions.