*5 Decision will be entered under Rule 50.
1. Interest paid on debentures issued by wholly owned subsidiary corporation to its parent corporation, along with new shares, in exchange for the outstanding shares, such debentures having a definite maturity date and the interest obligation being unconditional, held, deductible by the subsidiary corporation.
2. Amortization deductions of the alleged cost of a restrictive covenant in a contract for the acquisition of all the intangible assets of a rival newspaper disallowed where the contract was not divisible as between the covenant and the other assets, which are not amortizable.
*1079 This proceeding involves deficiencies for the years 1938 to 1942, inclusive, as follows:
| Declared | |||
| Year | Income tax | value excess | Excess profits |
| profits tax | tax | ||
| 1938 | $ 43,166.04 | ||
| 1939 | 57,100.73 | $ 9,457.80 | |
| 1940 | 69,649.36 | 9,578.77 | $ 9,008.42 |
| 1941 | 79,961.88 | 16,751.43 | 7,274.94 |
| 1942 | 90,320.78 | 14,566.09 | 10,170.37 |
| Total | 340,198.79 | 50,354.09 | 26,453.73 |
*6 *1080 The questions in issue are whether the petitioner is entitled (1) to interest deductions on its debenture bonds and (2) amortization deductions on account of a payment made to a competitor as consideration for a ten-year restrictive covenant.
Some of the facts have been stipulated and are incorporated herein by reference.
FINDINGS OF FACT.
The petitioner is an Ohio corporation, with its principal office located in Toledo, Ohio. It filed its returns for the years 1938 to 1942, inclusive, with the collector of internal revenue for the tenth district of Ohio. The returns were made on an accrual basis and for a calendar year.
The petitioner is, and for many years has been, the owner and publisher of an evening newspaper, the Toledo Blade, in Toledo, Ohio.
On June 9, 1926, the petitioner's stockholders entered into an agreement to sell all of the petitioner's common stock, consisting of 1,500 shares of a par value of $ 100 each to Paul Block for $ 4,000,000. The contract called for a cash payment of $ 500,000, which the purchaser paid, and the balance on or before October 1, 1926, with interest at 6 per cent until the due date and 8 per cent thereafter until paid.
On July*7 31, 1926, Block assigned his interest in the contract to Consolidated Publishers, Inc., a Delaware corporation, organized in July 1926. The assignee paid Block $ 500,000 cash and assumed all of his obligations under the contract of June 9, 1926.
Consolidated Publishers, Inc., hereinafter referred to as Consolidated, also owned all of the capital stock of the following publications:
The Herald Co. (Minn.)
Newark Star Publishing Co. (N. J.)
The New Era Publishing Corporation (Pa.)
Paul Block, Inc. (N. Y.)
On August 20, 1926, Consolidated sold $ 4,300,000 of its own 6 3/4 per cent gold notes to Lehman Brothers of New York for $ 4,039,056.25, of which $ 39,056.25 represented accrued interest from July 1 to August 20, 1926. These notes were issued under a trust indenture dated July 1, 1926, with the Chemical National Bank of New York, as trustee. The collateral pledged under the trust indenture consisted of all the common stock of the petitioner and the other above named affiliates of the Consolidated group. The notes were payable July 1, 1936, but were redeemable earlier upon certain specified conditions. The trust indenture provided for a sinking fund for redemption of certain*8 of the notes on specified dates.
Consolidated paid the balance due on the purchase price of the petitioner's stock, as provided for in the agreement of June 9, 1926.
Preliminary to offering the notes of Consolidated for sale to the *1081 public, Lehman Brothers had an appraisal made of the petitioner's assets by Palmer, DeWitt & Palmer, which showed a total asset value, as of April 30, 1926, of $ 5,005,946.41, including a value of $ 4,452,909.71 for petitioner's circulation, good will, and press franchises.
Consolidated was unable to meet the payments due under its sinking fund agreement. In anticipation of default in the payment due July 1, 1932, an extension agreement was entered into on June 30, 1932, providing for redemption of $ 500,000 of notes on July 1, 1934, $ 700,000 on July 1, 1935, and the balance, $ 1,146,000, on July 1, 1936. As consideration for the extension, the interest rate was increased from 6 3/4 per cent to 7 1/4 per cent. A further extension agreement was entered into on May 28, 1934, which provided for redemption of notes in percentages ranging from 10 per cent to 14 per cent on July 1 of each of the years 1934 to 1938, inclusive, and the balance on*9 July 1, 1939.
The holders of the face amount of $ 336,000 of the outstanding notes failed to agree to the extension and refused to deposit their notes with the trustee. These notes were all to become due in 1936.
Consolidated became apprehensive about its ability to meet the payments on these notes in addition to the sinking fund payments due under the extension agreement. Default on such payments might have resulted in a loss to Consolidated of petitioner's capital stock which was pledged as security on the notes. This stock was among Consolidated's most valuable assets. The directors of Consolidated decided that it would be to the company's best interest to have the petitioner recapitalized. The proposed recapitalization contemplated the issuance by the petitioner of new common stock of a par value of $ 500,000, consisting of 10,000 shares, par value of $ 50 each, and $ 3,000,000 of 7 per cent debentures. These new shares and debentures were to be exchanged for petitioner's outstanding common stock, consisting of 6,000 shares of a par value of $ 100 each. The petitioner's outstanding preferred stock, consisting of 6 shares of a par value of $ 100 each was to be retired.
This*10 plan was approved by the board of directors of Consolidated at a meeting held December 24, 1934, and at a meeting of the petitioner's board of directors held December 27, 1934. The resolution adopted by Consolidated's board of directors reads, in part, as follows:
6. That this corporation should be placed in a creditor position with respect to its interest in one or more of its subsidiary corporations so that the payment of any installment of principal or the anticipation at any time prior to such extended maturity of the balance of said notes then outstanding or the final instalment [sic] of said notes, due July 1, 1939, might be financed. That it was the opinion that this corporation could more readily secure the necessary funds for any such financing by pledge, hypothecation or otherwise, of evidences of indebtedness of subsidiary corporations, than by virtue solely of the ownership of stock of the subsidiary corporations. Such evidences of indebtedness of subsidiary corporations *1082 should mature at least one year after the maturity of the said balance of such collateral trust notes. The obligation of Toledo Blade Company was most desirable for this purpose and *11 steps should be taken to authorize the issuance by said corporation of a debenture note issue in the principal sum of $ 3,000,000 with interest at the rate of 7% per annum, due not later than January 1, 1941.
The recapitalization and exchange of petitioner's securities were carried out in accordance with the plan agreed upon. The $ 3,000,000 of 7 per cent debentures were issued under a trust indenture dated December 31, 1934, with the Toledo Trust Co. of Toledo, Ohio, as trustee, and, together with the newly issued common stock, were deposited with the Chemical Bank & Trust Co. as collateral security in lieu of the petitioner's old shares which were pledged under the trust indenture of July 1, 1926.
In 1936 the debentures were pledged to secure a loan to Consolidated from Chemical Bank & Trust Co. of $ 2,200,000, of which $ 1,348,375 was used to make the final payment in redemption of the gold notes issued by Consolidated July 1, 1926.
The petitioner paid interest on its $ 3,000,000 of debentures during the years 1938 to 1942, inclusive, as follows:
| 1938 | $ 210,000 |
| 1939 | 210,000 |
| 1940 | 206,500 |
| 1941 | 182,000 |
| 1942 | 182,000 |
These interest payments were all made to Paul Block*12 And Associates, Inc. (Del.), the holder of the debentures, or its nominee, the Chemical Bank & Trust Co. There were redemptions of $ 200,000 face amount of the debentures in each of the years 1940, 1941, and 1945.
The petitioner had net tangible assets of a value at January 1, 1934, of $ 1,221,695.28. Its net earnings for the period 1930 to 1934, inclusive, were as follows:
| 1930 | $ 490,100.18 |
| 1931 | 438,686.49 |
| 1932 | 269,581.27 |
| 1933 | 259,930.14 |
| 1934 | 397,813.26 |
The following table shows the petitioner's stipulated "net revenues" from advertising and circulation for the period 1930 to 1943, inclusive:
| Year | Advertising | Circulation |
| 1930 | $ 2,523,804.53 | $ 497,866.15 |
| 1931 | 2,152,259.38 | 483,319.23 |
| 1932 | 1,733,282.24 | 473,149.11 |
| 1933 | 1,508,417.47 | 479,259.94 |
| 1934 | 1,733,323.94 | 519,314.02 |
| 1935 * | 1,835,631.72 | 549,028.78 |
| 1936 | 2,112,756.68 | 748,681.35 |
| 1937 | 2,065,439.16 | 779,934.28 |
| 1938 | 1,833,497.50 | 828,689.81 |
| 1939 | 2,229,245.39 | 924,972.33 |
| 1940 | 2,338,951.87 | 949,684.43 |
| 1941 | 2,473,560.01 | 973,674.61 |
| 1942 | 2,261,508.87 | 1,024,132.66 |
| 1943 | 2,399,320.10 | 1,150,732.01 |
*1083 The petitioner's books showed a*13 surplus at December 31, 1933, of $ 861,737.28.
The petitioner paid substantial dividends on its common stock in each of the years 1926 to 1942, inclusive, except in 1927, when none was paid. The largest of these dividends was $ 900,000 in 1934 and the smallest, $ 175,000 in 1935.
As a going concern the petitioner had a value at December 31, 1934, free of all obligations, of not less than $ 4,000,000.
The Toledo News-Bee was an evening newspaper and a competitor of the Toledo Blade. It was owned and published prior to August 1, 1938, by the Toledo Newspaper Co. The petitioner desired to have the publication of the Toledo News-Bee discontinued and for that purpose it entered into a contract on August 1, 1938, with the Toledo Newspaper Co. and the E. W. Scripps Co., the owner of a majority of its voting stock, under the terms of which the petitioner agreed, for a consideration of $ 100,000, to purchase the name "The Toledo News-Bee" and "the circulation, route, subscription, dealer and carrier lists and other assets," excluding, however, the plant and equipment. The Toledo Newspaper Co. agreed for a stated consideration of $ 780,000, to discontinue publication of the Toledo News-Bee*14 for a period of ten years. The contract reads, in part, as follows:
I-(a) For and in consideration of the payment by First Party to Second Party of the sum of Seven Hundred and Eighty Thousand ($ 780,000) Dollars as hereinafter set forth, Second Party agrees that for the period of ten (10) years from and after the closing date hereinafter named, it will discontinue publication of The Toledo News-Bee from and after the publication of its regular editions on Tuesday, August 2, 1938 (hereinafter referred to as the closing date), and Second Party further agrees that it will not resume publication of any newspaper in the City of Toledo, Ohio, during the period of ten (10) years from and after said closing date; and Second Party further agrees that it will not, without the written consent of First Party, permit its plant or equipment to be used for the publication of any newspaper in the City of Toledo, Ohio, during the said ten (10) year period.
* * * *
III-(a) First Party hereby agrees to and does hereby purchase from Second Party, and Second Party hereby agrees to and does hereby sell, assign and transfer to First Party, the name and title of the newspaper "The Toledo News-Bee" now *15 owned by Second Party, together with all rights and privileges necessarily connected therewith, including any and all trademarks or copyrights of said name, provided however that it is understood and agreed that the name and/or emblem of Scripps-Howard are not included hereunder; and also all circulation, route, subscription, dealer and carrier lists, copies of all statements of account and copies of all records relating to or concerned with the sale, distribution, delivery and returns of said newspaper "The Toledo News-Bee" in the territory in which it circulates on the closing date, it being expressly understood that no other assets of Second Party are sold or transferred to First Party hereunder. Second Party agrees that the assets to be sold to First Party shall be free and clear of all liens and encumbrances.
*1084 (b) For and in consideration of the sale and transfer of the aforesaid assets to First Party by Second Party, First Party further agrees to pay Second Party the total sum of One Hundred Thousand ($ 100,000) Dollars * * *.
The contract further provided, in substance, that the petitioner and the Toledo Newspaper Co. would share equally in any tax savings that might*16 result to the petitioner from deductions taken in its returns on account of the $ 780,000 payment.
In payment of the consideration mentioned in the contract the petitioner issued to the Toledo Newspaper Co. its promissory notes, series A and B, in the principal amount of $ 880,000. The notes were without interest and were payable in quarterly installments, beginning in 1939, of $ 12,500 each until 1944 and $ 26,500 thereafter as to the $ 780,000 principal and in quarterly payments of $ 2,500 each as to the $ 100,000 principal.
In its returns for the taxable years involved the petitioner claimed amortization deductions on account of the alleged cost of the restrictive covenant contained in the agreement with the Toledo Newspaper Co. amounting to $ 32,500 in 1938 and $ 78,000 for each of the years 1939 to 1942, inclusive. The respondent determined that these deductions were not allowable.
OPINION.
As to the interest deductions, the respondent takes the position that the so-called debentures issued by the petitioner in the recapitalization did not evidence a valid indebtedness of the petitioner, but were in actuality certificates of preferred stock; and that consequently the alleged*17 interest payments thereon were not interest payments, but were dividend distributions. He submits in his brief that "the whole transaction was a sham so that the Tax Court is not now called upon to interpret the Bazley and Adams decisions in relation to this case."
In the cases referred to by the respondent, Bazley v., the Supreme Court held that the issuance of new shares of stock and debentures in exchange for old shares constituted taxable distributions and not tax-free reorganizations. That is not the question before us here.
The facts, we think, do not support the respondent's contention that the transaction by which the petitioner's debentures were issued was a "sham." Whatever may be said of the reasons underlying the transaction, there can be no question but that the debentures themselves were genuine and evidenced legal obligations of the petitioner. Under their terms, the debentures were absolute as to the payment of both principal and interest. Had they been issued to a nonproprietary purchaser for value there could have been no question as to their genuineness. *18 The fact that they were issued to the petitioner's sole *1085 stockholder in exchange for a portion of the interest represented by its stockholdings in the petitioner does not affect their validity. That factor was present in ; affd., , reversing ; ; affd., , and ; affirmed in part and reversed in part, . In all of those cases the interest payments on the debentures were held deductible by the issuing corporations.
In 1432 , and , the interest deductions were disallowed because the interest was payable conditionally, out of earnings or at the pleasure of the debtor. Here both principal and interest on the debentures were payable in all*19 events and at definite times.
While the evidence indicates that the issuance of the debentures may not have served any business purpose of the petitioner, the respondent recognizes in his brief that the business purpose test, as applied to the issuance of debentures, has not been regarded by this Court as determinative of the question of the deductibility of the interest payments.
We said in , that "stockholders have the right to change to the creditor-debtor basis, though the reason may be purely personal to the parties concerned." Citing , affirming .
On the facts here we think that this case follows the pattern of the John Kelley Co. and the Cleveland Adolph Mayer Realty Corporation cases and we hold accordingly that the petitioner is entitled to the deductions claimed for interest paid on the debentures in the taxable years.
We think the respondent correctly disallowed the amortization deductions claimed by the petitioner in each of the taxable years on account of the $ 780,000 payment to the*20 Toledo Newspaper Co. under the contract of August 1, 1938.
The respondent's position is that under this contract the petitioner acquired the business and good will of the Toledo Newspaper Co., including that company's agreement not to compete for a period of ten years, in a single transaction for the lump sum of $ 880,000, and that this did not result in petitioner's acquisition of any property subject to amortization or depreciation.
This identical contract was under consideration by this Court in a proceeding brought by the Toledo Newspaper Co., reported at . The question there under consideration was the gain on the transaction to the Toledo Newspaper Co. That company was contending, contrary to the petitioner's contentions here, that the contract *1086 was not divisible as between the intangible assets and the restrictive covenant; that it evidenced a sale of the business as a single transaction; and that the seller's gain or loss was to be computed by comparing the total consideration of $ 880,000 against the statutory bases of such intangible assets. The Commissioner had determined, and was contending before this Court, that the $ *21 780,000 was received as compensation for the covenant not to compete and was, therefore, taxable in its entirety as ordinary income.
On the evidence in this case we reach the same conclusion that we reached in the earlier case as to the nature of the contract, that it was not divisible, but that the total consideration of $ 880,000 was the price which the petitioner paid for the going business and intangible assets, including the good will and the covenant not to compete. We pointed out in our opinion in Toledo Newspaper Co., supra, that:
No deduction for depreciation, including obsolescence, is allowable to a taxpayer in respect of good will. See art. 23 (l) (3), Regulations 101. Likewise, it has been held that a newspaper subscription list, because it has no definite life, is not subject to depreciation or obsolescence allowances. . See also . Therefore, the March 1, 1913, value of petitioner's intangibles, including good will, which were sold in the contract of August 1, 1938, does not have to be adjusted for depreciation*22 or obsolescence, if any, occuring between March 1, 1913, and the date of sale, for no deductions with respect thereto were allowable to Toledo in the computation of its net income during such period.
On the evidence in the instant case we can not find that any of the assets which the petitioner acquired under the contract in question had a definite cost which the petitioner is entitled to recover through amortization or depreciation deductions.
Decision will be entered under Rule 50.
Murdock, J., dissenting: The general scheme of Federal income taxation has always been to allow a taxpayer to recover through deductions the cost of assets used in its business before taxing the excess as income. United States v. Ludey, 274 U.S. 295">274 U.S. 295. The principle has not been applied to good will, subscription lists, and some other assets, either because such assets are not actually exhausted through use in the business or because of the practical impossibility of telling when and to what extent they become exhausted in use. Danville Press, Inc., 1 B. T. A. 1171; Meredith Publishing Co. v. Commissioner, 64 Fed. (2d) 890.*23 Those cases are the exceptions in which some distortion of income can not be avoided. However, it has been held uniformly that the cost of a contract not to compete for a stated period may be recovered under section 23 (l) through deductions for exhaustion spread over the period. William Ziegler, Jr., 1 B. T. A. 186; Christensen *1087 ., 18 B. T. A. 256; Christensen Machine Co. v. United States, 50 Fed. (2d) 282; News Leader Co., 18 B. T. A. 1212. It was held in the latter case that the amount paid to a competing newspaper for an agreement that it would discontinue its paper for five years was recoverable through deductions for exhaustion spread ratably over the five years even though the agreement not to compete was necessarily closely associated with the good will of the discontinued paper. The Commissioner acquiesced in that case. IX-2 C. B. 44.
The agreement on the part of the Toledo Newspaper Co. and the E. W. Scripps Co., which owned a majority of its stock, to refrain from publishing a newspaper in the Toledo district for a period*24 of 10 years was obviously valuable to the petitioner. The petitioner paid a substantial portion of the total of $ 880,000 for that agreement. The parties to the agreement specified therein that $ 780,000 of the total was paid for that agreement. Thus, there is evidence before this Court of the cost of the agreement not to compete. The respondent offered no evidence to show that the cost of that agreement was less than $ 780,000. Perhaps other provisions of the contract itself might lead a fact finder to conclude that the true cost was something less than $ 780,000. But however that may be, something was paid for that agreement and it is incumbent upon this Court to determine what portion of the total consideration may properly be regarded as the cost of the agreement not to compete for the purpose of allowing deductions under section 23 (l). ; ; . Judge Learned Hand said in : "The one *25 sure way to do injustice in such cases is to allow nothing whatever upon the excuse that we cannot tell how much to allow." That comment is apposite here, where the majority opinion allows no deduction for the exhaustion of this contract not to compete, which contract obviously cost the petitioner a substantial amount of money.
Footnotes
*. No audit that year. These are company figures.↩