Mississippi River & Bonne Terre Ry. v. Commissioner

MISSISSIPPI RIVER AND BONNE TERRE RAILWAY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Mississippi River & Bonne Terre Ry. v. Commissioner Docket No. 84282. United States Board of Tax Appeals 39 B.T.A. 995; 1939 BTA LEXIS 941; May 24, 1939, Promulgated *941 1. Petitioner, which had no taxable net income for the year in question, but filed form 1122 in connection with a consolidated return of its parent, held liable on a deficiency in parent's income. Regulations 78, art. 15(a). 2. Loss on the sale of a building owned by petitioner, but leased on a long term general lease to its parent, under which it received only the proceeds of the sale, held deductible by petitioner. 3. Where petitioner leased all of its railroad property under a 99-year lease which obligated its parent lessee at the termination of the lease to return the property in substantially as good condition as when received, held, neither petitioner nor its lessee is entitled to deduction for depreciation on the property. James M. Chaney, Esq., for the petitioner. W. H. Schwatka, Esq., and J. Y. Porter, Esq., for the respondent. OPPER *995 This proceeding was brought for a redetermination of deficiencies in petitioner's income tax liability of the sums of $11,545.05 and $1,572.02 for the taxable years 1932 and 1933, respectively. The questions presented are (1) whether petitioner, a subsidiary, with no taxable*942 net income, can be held for a deficiency due to additional taxable income received by its parent corporation; (2) whether petitioner, lessor, is entitled to a loss deduction on the sale and retirement during the term of the lease of certain leased property; and (3) whether depreciation deductions on leased equipment for the years in question are allowable to either the lessor or the lessee, where the lease provides for the return of the property at the termination of the lease in substantially as good condition as when received. FINDINGS OF FACT. The case was submitted on a stipulation of facts and the introduction in evidence of the notice of deficiency and its attached schedules as petitioner's exhibit 1. The stipulated facts are found, as are the facts appearing in the above mentioned exhibit. For present purposes we make the following summary: The Missouri-Illinois Railroad Co. is a corporation organized under the laws of the State of Missouri, with outstanding capital stock consisting of 22,500 shares of the par value of $100 each. Petitioner is a corporation organized under the laws of the State of Missouri with capital stock authorized and outstanding in the sum*943 of $3,000,000, consisting of 30,000 shares of par value of $100 each. Of this 30,000 shares 29,992 shares are owned and issued in the name *996 of Missouri-Illinois Railroad Co. and 7 of the remaining shares are qualifying shares issued to directors. On January 1, 1929, petitioner leased all its railway and other property to the Missouri-Illinois Railroad Co. for a term of 99 years beginning January 1, 1929. The lease, so far as here pertinent, contains the following provisions: In the habendum: Provided always, however, that nothing herein contained shall operate to grant or demise the franchise to be a corporation possessed by the Lessor, or any other right, privilege or franchise which is or may be necessary to fully preserve the corporate existence or organization of the Lessor; * * * In article two, section 1, the lessee covenanted to pay to the lessor the sums requisite "for the maintenance of its corporate organization, including the salaries of any necessary officers or compensation of its Board of Directors and for other expenses of administration, including the expense of the issue, registration and transfer of its securities." By section 5 of the*944 same article the lessee further covenanted with the lessor: SECTION 5. In the manner and as and when the same become due and payable, to pay all interest and sinking fund requirements, if any, on all bonds, notes and other obligations and indebtedness of the Lessor, issued or incurred after the effective date of this lease with the consent of the Lessee and in accordance with the provisions of this lease; provided that such payment may be made as to any and all bonds, notes and other obligations and indebtedness of the Lessor, at the time owned or held by the Lessee or for its benefit, by the surrender of any coupons representing such interest, or by the due endorsement upon such bonds, notes or other obligations of the payment of such interest, or by the execution and delivery to the Lessor of proper acknowledgments of the payment of such interest. The Lessee shall also pay or cause to be paid all charges of any paying agent or agents, and all other expenses in connection with the payment of said interest and sinking fund requirements. To the extent that the obligors of any such bonds, notes or other obligations and indebtedness may be liable so to do, the Lessee shall pay*945 or retain all sums which may be required to be paid or retained from the interest upon any such bonds, notes or other obligations and indebtedness under state or federal laws or under the terms of any such securities or of the instruments securing the same, and shall pay or refund to the holders of any such securities any and all taxes which by the terms thereof or of any instruments securing the same may be required to be so repaid or refunded. Anything herein contained to the contrary notwithstanding, any payments made by the Lessee under this Section 5 to meet sinking fund requirements shall be deemed to be advances made by the Lessee to the Lessor, and such advances shall bear interest at the rate of six per cent. per annum. And in sections 11 and 12: SECTION 11. At its own cost and expense to keep and maintain the physical properties of the Lessor hereby demised, except such parts thereof as may be *997 sold or otherwise disposed of, abandoned or retired as herein provided, in as good order, repair and condition as when received at the beginning of this lease, retiring, replacing or renewing, to the extent deemed expedient by the Lessee in the efficient operation*946 of the demised property, whatever becomes obsolete, defective or worn out from time to time; and to comply with all valid orders of public authorities in connection with the operation and maintenance of the demised property. SECTION 12. Subject to the right of the Lessee to be reimbursed as provided in Section 9 of Article Three hereof, to return to the Lessor at the expiration or other termination of this lease the demised property, except such portions of said property as during the term hereof may have been sold, abandoned, retired or otherwise disposed of pursuant to the provisions hereof, in substantially as good condition for the uses and purposes of the Lessor as when the Lessee received the same. In article three, sections 3, 5, 6, 8, and 9, the lessor covenanted with the lessee as follows: SECTION 3. The Lessor, at the expense of the Lessee, shall and will during the continuance of this lease, subject to the provisions of Section 7 of Article Five hereof, maintain, and, if necessary, from time to time renew, its existence and organization as a body corporate, in due form of law, and as such body corporate shall and will from time to time and at all times when thereto*947 required by the Lessee, do and perform, at the expense of the Lessee, all such acts, matters and things consistent with the rights of the Lessee under this lease, as shall be necessary in the opinion and judgment of the Lessee, or its officers or counsel, to the due preservation and protection of all estates, property, rights, franchises and interests herein demised to the Lessee, and to carry into full effect the true intent and meaning of this lease, and in default thereof the same may be done by the Lessee, its successors or assigns, or its lawful agents, in the name and as the act of the Lessor. * * * SECTION 5. The Lessor shall and will from time to time, if requested by the Lessee and at the expense of the Lessee, proceed to appropriate and condemn by exercising the right of eminent domain such real estate, either as an addition to the main lines, branches or extensions already built, or for any branch that the Lessee hereafter may desire to have built, or for any other lawful railway purpose for which such right of eminent domain may be available, as the convenient exercise of the demised franchises or the operation of the demised property, or the lawful orders of any*948 public authority, may in the opinion of the Lessee render necessary or desirable. SECTION 6. Upon the written request and at the expense of the Lessee, from time to time, the Lessor will institute and prosecute in its own or other proper name or will permit the Lessee to institute and prosecute in the name of the Lessor, any and all proper proceedings for the purpose of acquiring the right to cross, intersect or connect with any and all other lines of railway, rivers, canals, other waters, or public highways or properties, which it shall or may become necessary or desirable to cross, intersect or connect with, in connection with the operation by the Lessee of the Lessor's transportation system, or the improvement or extension thereof. * * * SECTION 8. At any time during the continuance of this lease the Lessee shall have the right, subject to the provisions of any mortgages or trust instruments from time to time in force upon or with respect of any of the demised property, and to regulation by the proper governmental authorities, * * * *998 (c) to sell, lease or otherwise dispose of any part of the demised property or to exchange any part thereof for other property*949 or to abandon or retire any part thereof; provided in every case that the exercise of any of the rights above set forth in the judgment of the Lessee shall not decrease the value of the demised property as a whole for railway purposes; and provided further that * * * the proceeds of any sale, lease or other disposition of any part of the demised property shall be applied by the Lessee at its option either to the reduction of any outstanding obligations or indebtedness of the Lessor or to betterments or improvements upon or to additions to the demised property * * *. SECTION 9. The Lessee shall have the right and is hereby authorized from time to time, for the account of the Lessor, during the term of this lease (a) to make or cause to be made all such additions, betterments, improvements and extensions upon and to the demised property as the Lessee shall deem to be necessary and proper; (b) to acquire or construct new or additional lines of railway and any and all other property, real and personal, of any nature whatsoever which may in the judgment of the Lessee be necessary, useful or desirable in connection with the demised property or the operation or maintenance thereof; *950 and (c) to acquire the capital stock and/or bonds or other obligations of any corporation in so far as the Lessee may deem necessary or desirable in connection with the possession or use of the demised property. For all capital expenditures made by the Lessee with respect to the demised property for any of the purposes heretofore enumerated in this Section 9 or in Sections 5, 6 or 8 of this Article Three or in Section 5 of Article Two or in Section 4 of Article Five hereof and/or other expenditures properly chargeable to capital account under the then effective regulations or classifications of the Interstate Commerce Commission or its successor in authority, the Lessee shall be entitled to be reimbursed at its option (and not in excess of the total amount of such expenditures) in the following ways: (a) by the issue by the Lessor to the Lessee or upon its order of shares of stock and/or bonds or other obligations of the Lessor secured or unsecured, provided that in the case of unsecured obligations such obligations, if not already due and payable upon the termination of this Lease, shall become due and payable, at the option of the Lessee, upon such termination; and/or (b) *951 by a credit against or offset to any indebtedness of the Lessee to the Lessor at the termination of this lease; and/or (c) by the payment of cash to the Lessee upon the termination of this lease. Article five is entitled "Miscellaneous Provisions" and section 4 thereof provides: SECTION 4. The Lessee shall have the right, from time to time, to perfect and complete the Lessor's title in fee-simple to any and all real estate now held or used by the Lessor, to which real estate up to the effective date of this lease the Lessor does not have full and complete title in fee-simple; and the Lessee shall be entitled to reimbursement for all capital expenditures made in this connection, in the manner provided in Section 10 of Article Three hereof. * * * Section 7 provides: SECTION 7. Nothing contained in this indenture shall prevent the consolidation or merger of the Lessor with or into the Lessee, or the sale to the Lessee of the *999 lines of railway and property of the Lessor, or any consolidation or merger of the Lessee, or, subject to this indenture, of the Lessor, with or into any other corporation, or any conveyance or transfer by the Lessor, subject to this indenture, *952 of its property or any thereof, or any conveyance, transfer or lease by the Lessee of its property, including its leasehold interest in the demised property. Subject to the terms of any applicable mortgage or trust instrument, the Lessee shall have the right to sublet the demised property and to assign this lease. For each of the taxable years in question the Missouri-Illinois Railroad Co., as the parent company, and petitioner, as the subsidiary company, filed affiliated or consolidated income tax returns with the collector of internal revenue at St. Louis, Missouri, petitioner filing form 1122 and thereby unqualifiedly consenting to respondent's regulations governing such consolidated returns. Petitioner in each year sustained a loss. During the year 1932 petitioner owned an office building at Bonne Terre, Missouri, which had not been used since August 1931 and for which no use was contemplated thereafter. The building was a part of the property covered in the above-mentioned lease and its book value or cost was $11,101.08. The building was sold in 1932 by the Missouri-Illinois Railroad Co. under the provisions of the lease for the sum of $6,000, and an expense of $55.97*953 was incurred in making the sale. In the tax returns for the affiliated corporations for 1932 the net amount realized by the Missouri-Illinois Railroad Co. upon the sale of the property ($5,944.03) was included by that company as a credit to profit and loss, and its taxable income increased to that extent. The entire book value of the building, or $11,101.08, was claimed by petitioner as a loss on the retirement of the property. Respondent disallowed entirely the deduction of $11,101.08 to petitioner, but made no change in respect to the inclusion by the Missouri-Illinois Railroad Co. (the parent company) of the net amount realized for the building ($5,944.03) as taxable income. Respondent now concedes that the taxable net income of the Missouri-Illinois Railroad Co. for 1932 should be reduced by this amount. Deductions for depreciation on leased equipment consisting of steam locomotives, freight train cars, passenger train cars, and work equipment for 1932 in the sum of $11,933.30 and for 1933 in the sum of $9,645.35 were claimed in the tax returns of the Missouri-Illinois Railroad Co. (the parent company) for the respective years. Respondent disallowed these deductions on*954 the ground that the Missouri-Illinois Railroad Co. had no capital investment in the leased equipment. The equipment in question was owned by petitioner and covered by the above mentioned lease. Respondent denies the deduction of depreciation to either petitioner or to the Missouri-Illinois Railroad Co., the lessee. *1000 By the stipulation respondent concedes certain reductions in the taxable net income of the affiliated corporations. These adjustments will be reflected in the Rule 50 computation. OPINION. OPPER: Petitioner, an almost wholly owned subsidiary of the Missouri-Illinois Railroad Co., resists respondent's determination of a deficiency as to it, which is the result of certain adjustments made by respondent in the net income of petitioner's parent corporation. Petitioner and its affiliate filed consolidated returns. The issues are three: First, whether under the circumstances respondent was entitled to assert against this petitioner, which had, by itself, no taxable net income, a deficiency arising as a result of the net income of its parent; second, whether the loss on the sale of a building owned by petitioner but leased under a long term general*955 lease to its parent was deductible either by the parent or by petitioner; and, third, whether items of depreciation on the leased property generally may be deducted by either this petitioner or the parent lessee. For convenience of discussion the issues stated will be treated in inverse order. In our view the precise question raised as to depreciation has been ruled upon. In , both the lessor and lessee were before the Board in a consolidated proceeding. It was determined that the lessee there was not entitled to deduct for depreciation because it had no capital investment in the property or the lease, and that such deductions were not available to the lessor because the obligation of the lessee was to redeliver the property at the end of the lease in its original condition. The decision was affirmed at , certiorari being denied, . Petitioner objects to the result so reached on the ground that "from every principle of right and justice, allowance for this depreciation should be made to one or to the other member of the affiliated group. The cars and other units*956 of equipment are depreciating each year, exactly the same as are similar units of equipment owned by any other railroad where no lease is involved." A similar contention in , was characterized as "more apparent than real" and answered by a quotation from , as follows: "And the lessee, when it makes good the loss, is entitled to deduct the entire amount so expended either in the year in which made (if an ordinary repair), or (if a capital item), over the life of the property replaced or remaining term of the lease, whichever is shorter. In that manner the lessee will have returned to it its entire cost of maintaining the property which it is *1001 entitled to deduct, and the lessor, at the end of the term, will receive back its property or its equivalent in value in as good a condition and value as when leased." It is urged further that the cases cited are distinguishable on two grounds. First, because petitioner is almost wholly owned by the lessee; and, second, because the terms of the lease require that the lessor reimburse the*957 lessee for expenditures of maintaining the property. To support the first distinction petitioner cites . In our view, however, the doctrine of that case is inapplicable here. There, as the Supreme Court's opinion points out, "The Central Pacific and the Southern Pacific were in substance identical because of the complete ownership and control which the latter possessed over the former as stockholder and in other capacities. While the two companies were separate legal entities, yet in fact, and for all practical purposes they were merged, the former being but a part of the latter, acting merely as its agent and subject in all things to its proper direction and control. And, besides, the funds represented by the dividends [the ownership of which was the subject of dispute] were in the actual possession and control of the Southern Pacific as well before as after the declaration of the dividend." [Emphasis added.] Here the separate identity of the two corporations has been meticulously preserved, not only as to their separate existence, but as to their reciprocal rights and obligations. The indenture of lease*958 which gives rise to the present question is a printed document covering 27 pages and dwelling with repeated emphasis upon the several rights and liabilities of the parties. It is even provided (article three, section 3) that "The Lessor, at the expense of the Lessee, shall and will during the continuance of this lease, subject to the provisions of Section 7 of Article 5 hereof, maintain, and, if necessary, from time to time, renew, its existence and organization as a body corporate, in due form of law * * *." The section referred to (article five, section 7) permits the consolidation or merger of the lessor and the lessee. But the very presence of that provision negatives the intention of the parties that they be regarded as already merged for practical purposes. It is further stipulated in the "habendum" clause that the lease shall not operate to grant or demise "any other right, privilege or franchise which is or may be necessary to fully preserve the corporate existence or organization of the Lessor." And (section 1, article two) it is also provided that the lessee will pay the lessor the sums necessary "for the maintenance of its corporate organization, including the salaries*959 of any necessary officers or compensation of its Board of Directors and for other expenses of administration * * *." *1002 We can not disregard for the purposes of this proceeding the separate corporate organization of the parties which they themselves have so carefully preserved and emphasized. The income tax returns for the relevant years were not made as one organization but as two. For all that appears some advantage may have been anticipated in this respect by petitioner and its affiliate. In any event, these corporations have chosen to operate separately in so far as the relationship here material is concerned, and no assumption that in certain instances the existence of corporate entities may be disregarded seems to us to require that for the benefit of the corporation itself we overlook a separation upon which in their own relations both parties have been insistent. Nor are we able to concur in petitioner's contention that a construction of the lease places upon it the cost of upkeep of the property. The provisions are essentially similar to those appearing in *960 With reference to sections 11 and 12 of article two of the present lease, quoted at length in our findings of fact, petitioner itself concedes in its brief "* * * if the lessee should regard the replacement of the equipment as essential to the maintenance of the value of the property for lessor's purposes (as would appear most natural), and return the property at the expiration of the lease with equipment in as good condition as that found at the beginning of the lease, lessor would, under the provisions of the lease above quoted, sustain no damage by reason of the annual depreciation." Petitioner contends, however, that other provisions, particularly section 9 of article three, require that repairs and replacements be made at the expense of the lessor. We can not agree. Examination of the lease makes it apparent that the section last mentioned refers only to additions and extensions and not to maintenance or replacement of existing properties. In the earlier section the obligation of the lessee is spoken of as "retiring, replacing or renewing." No similar words are used in section 9, but the reference there is to "additions, *961 betterments, improvements and extensions" and to the acquisition or construction of "new or additional lines of railway." And it is only for the latter class of expenditures that the lessor is required to reimburse the lessee, presumably on the theory that such extensions and betterments become the lessor's property, as would appear to follow from the general statement at the beginning of section 9 that such action is "for the account of the Lessor." Most significant of all is the reimbursement provision itself, which states that the lessee is to be repaid "For all capital expenditures made by the Lessee with respect to the demised property for any of the purposes heretofore enumerated in this Section 9 or in Sections 5, 6 *1003 or 8 of this Article Three or in Section 5 of Article Two or in Section 4 of Article Five hereof * * *." There is no reference to sections 11 and 12 of article two, which are the sections requiring the lessor to maintain the demised property. Being unable to conclude that the lease requires the lessor to sustain the expense of maintaining the property in its original condition, we can not follow the petitioner to the conclusion that in this case*962 the economic loss resulting from depreciation falls on the lessor; and, that being so, we see no ground for distinguishing the cases cited above. It does not follow from what has been said, however, that petitioner is not entitled to a deduction for the loss occasioned upon the sale of its building. It is true this also was covered by the lease. But "no use was contemplated" for it and it was sold at an admitted loss. We think this issue is controlled by the principle of , affirming a memorandum decision of this Board. There (page 716), "Although the assignee is bound generally to maintain the leased property in good condition and to return equal value at the end of the term", there was an exception for "such portions and parcels of the real estate and property not required by the lessee for railroad purposes." Here also the lessee is given power "to sell, lease or otherwise dispose of any part of the demised property" with the proviso "in every case that the exercise of any of the rights above set forth in the judgment of the lessee shall not decreased the value of the demised property as a whole*963 for railway purposes." And in the event of a sale the proceeds "shall be applied by the lessee at its option either to a reduction of any outstanding obligations or indebtedness of the lessor or to betterments or improvements upon or additions to the demised property" for which under other provisions of the lease the lessor was obligated to pay. Speaking of the property sold in the Providence, W. & B.R. Co. case, supra, the court said: "When they were sold the only proceeds the respondent could ever receive were limited to the sale price and the only obligation of the assignee was to account to the respondent for that. The difference between that and the cost which the respondent had paid was an absolute loss." We think the same conclusions follows here. This is not inconsistent with our holding on the previous issue, but in effect follows logically from it. To quote again from : This loss occurred entirely in the year when the property was sold in accordance with the sixth paragraph of the lease. While the generators remained a part of the leased property, the assignee's obligation to return equal*964 value at the termination of the lease continued and prevented any deduction by *1004 the respondent for depreciation. . * * * During this time no lessening in the value of the generators became its financial burden. But, when the provisions of the sixth paragraph were invoked and the generators were sold in accordance with those provisions, the respondent was no longer protected by the obligation of the assignee of the lease to return their value in full, and the loss determined by the sale became the respondent's loss. It then was deductible. * * * Finally, there is the question of respondent's authority to collect from this petitioner a deficiency in tax for the affiliated group arising by reason of income of the parent and not of the subsidiary involved in this proceeding. This question was decided adversely to petitioner's contention in , in the following language: Finally, petitioners question the propriety of the respondent's action in asserting a deficiency against each of them. The deficiency, it appears from the pleadings, arises from adjustments*965 of income of the parent, Pacific Coast Biscuit Co. This action is in accordance with article 15 of Regulations 75, which provides that the parent and each subsidiary "shall be severally liable for the tax (including any deficiency in respect thereof) computed upon the consolidated net income of the group." The subsidiaries each executed and filed a Form 1122 in which they unqualifiedly consented to the regulations. * * * Here also this petitioner executed form 1122, 1 one effect of which was that of "consenting to these regulations." 2 Section 141, Revenue Act of 1932, provides, as did the comparable provision of the 1928 Act, for the assessment and collection of the tax due on a consolidated return in accordance with respondent's regulations. These regulations 3 require that "each subsidiary, a*966 member of the affiliated group during any part of a consolidated return period, shall be severally liable for the tax (including any deficiency in respect thereof) computed upon the consolidated net income of the group." "The making of the consolidated return constituted acceptance by petitioner and its subsidiaries of the regulations that had been prescribed." . Petitioner attacks the validity of the regulation. To this it may not only be answered that the filing of the consolidated return "was a voluntary act on their part and they will not be heard now to complain of the consequences", ; but in addition, Regulations 78, issued under the 1932 Act, was in the respect *1005 here material identical with Regulations 75 governing the years 1929 through 1931 under the 1928 Act. The reenactment in the Revenue Act of 1932 of the provisions appearing in the 1928 Act, with the intervening establishment by means of the regulation of the liability here contested, is a persuasive evidence of Congressional approval. *967 . The action of the respondent is sustained as to the depreciation issue and overruled on the question of loss to petitioner upon the sale of the building. Decision will be entered under Rule 50. Footnotes 1. The deficiency letter introduced by petitioner as proof of the facts therein contained includes among the "returns examined" the statement: Form Year "Subsidiary Company: Mississippi River & Bonne Terre Rwy., 210 North 13th Street, St. Louis, Mo [1122] 1932" A similar statement appears for the year 1933. ↩ 2. Regulations 78, art. 12(b). ↩ 3. Regulations 78, art. 15(a). ↩