*20 Decision will be entered under Rule 50.
1. The taxpayer corporation's two principal stockholders each took out a $ 50,000 insurance policy on his life, designating his estate as beneficiary, and they immediately assigned the policies to the issuing insurance company as security for a loan which the company made to the taxpayer. In the assignment it was specified that proceeds be applied to liquidation of the loan; the taxpayer paid the policy premiums and carried the policies on its books as an asset at cash surrender value. Application for and assignment of the policies were conditions prescribed by the insurance company for making the loan. The insurance proceeds applied to the loan upon a stockholder's death, held, not includible in equity invested capital as defined in section 718 (a), Internal Revenue Code, since under the wording of the assignment the stockholder's estate had no right of subrogation against the taxpayer. Walker v. Penick's Executor, 122 Va. 664">122 Va. 664; 95 S.E. 428">95 S. E. 428.
2. The depreciable life of slip covers and reupholstered hotel furnishings, held, on the evidence to be four years.
*902 The Commissioner determined deficiencies of $ 665.32 and $ 355.87 in petitioner's income and declared value excess profits taxes, respectively, for the fiscal year ended May 31, 1944, and a deficiency of $ 10,201.73 in excess profits tax for the fiscal year ended May 31, 1945. As to fiscal 1944 petitioner assigns error in the disallowance as a deduction of amounts expended for new slip covers and the reupholstering of its hotel furniture. As to fiscal 1945, it claims the right to include in equity invested capital the proceeds of an insurance policy taken out on the life of a large stockholder and assigned as security*22 for petitioner's loan from the insurance company, the proceeds on the stockholder's death being applied directly in payment of the loan.
FINDINGS OF FACT.
Petitioner, a Virginia corporation with principal office at Luray, Virginia, filed its income tax, declared value excess profits tax, and excess profits tax returns for the fiscal years ended May 31, 1944 and 1945, with the collector of internal revenue for the district of Virginia. Its books are kept and its returns prepared on an accrual basis of accounting.
Petitioner was engaged during the taxable years in the operation of a tourist hotel, known as the Mimslyn, located at Luray. It was organized in 1930 by John W. and Ralph E. Mims, brothers, to each of whom it issued 500 shares of its stock of a par value of $ 100 a share in consideration of $ 25,000 cash and their transfer to it of property having an agreed value of $ 75,000. This property consisted of 5 parcels of land in Luray and some personalty. Petitioner also issued 127 shares to 20 other individuals, including 15 shares to Henry T. Mims, a brother of John W. and Ralph E. Mims, who was engaged in the operation of hotels in Pittsburgh, Pennsylvania.
Pursuant to an*23 understanding reached prior to the issuance of the shares, petitioner procured a $ 150,000 loan from the Shenandoah Life Insurance Co. (hereinafter called Shenandoah), of Roanoke, Virginia, with which to erect a new hotel on part of the land transferred to it. This loan was evidenced by eight 6 per cent bonds for $ 10,000 each, dated October 21, 1930, of which one was to mature on October 21, *903 1932, and one on October 21 of each succeeding year, and by one 6 per cent bond for $ 70,000, dated October 21, 1930, which was to mature on October 21, 1940. On May 19, 1931, petitioner borrowed from Shenandoah an additional $ 15,000 and gave an additional bond in that amount which was to mature on May 19, 1941. These bonds, evidencing an aggregate indebtedness of $ 165,000, were endorsed by John W. and Ralph E. Mims and were further secured by a first deed of trust on all petitioner's property. In agreeing to make the loan Shenandoah also required that John W. and Ralph E. Mims:
* * * each take out $ 50,000.00 of ordinary life insurance (first premium to be taken out of loan), which is to be kept in force unencumbered during the life of the loan, and to be assigned to us as further*24 security for the loan; proceeds of either policy, in the event of the death of insured, to be applied to the liquidation of the loan, that is, assuming that you are both insurable.
Each brother made application to Shenandoah on July 30, 1930, for a policy of insurance on his life, and on October 3, 1930, Shenandoah issued a policy to each, promising to pay $ 50,000 to the insured's executors or administrators on receipt of due proofs of death. Each insured reserved the right to change the beneficiary, and on October 31, 1930, each assigned his policy to Shenandoah "for value received and in further consideration of a mortgage loan made by the Shenandoah Life Ins. Co. to the Mims Hotel Corporation." The assignments of the policies expressly conveyed:
* * * all right, title and interest therein, together with all moneys which may be now due or hereafter payable thereunder, and all dividends, benefits, options and advantages to be derived therefrom, including the right to surrender said Policy and to receive the surrender value thereof; * * *
The annual premium on the policy insuring John W. Mims was $ 1,332; on that insuring Ralph E. Mims, $ 1,191. On petitioner's books annual debits*25 of $ 2,523, the sum of these figures, described as "Life Ins. Prem.," indicate their payment by petitioner. In the surplus account there is a credit of $ 5,000 in 1936 "To set up cash value Life Ins.," and credits in subsequent years "To adj. cash val. of Life Ins."
The Mimslyn Hotel was opened in 1932, but its operation for the next six years was not profitable. Petitioner defaulted in payment of three of the $ 10,000 bonds at maturity, and by April 5, 1939, it had reduced the indebtedness only to $ 125,000. On that date Shenandoah advised it by letter:
* * * that if these loans are reduced to the sum of $ 100,000.00 by October 21, 1940, we will renew this balance of $ 100,000.00 for a period of ten years, with interest at the rate of 5% per annum, payable semi-annually, to be repaid in principal curtailments during each year in the aggregate sum of $ 10,000.00.
This extension will be based upon the same terms and conditions as set out in the original deed of trust as to your maintaining fire insurance, payment of *904 taxes, etc., and the maintenance of the two life insurance policies of $ 50,000.00 each on the life of each of you gentlemen, which are now assigned, and are*26 to continue to be assigned to us as additional protection in connection with this mortgage.
By September 1939 petitioner had made further payments of $ 4,000, reducing the indebtedness to $ 121,000. On September 24, 1939, John W. Mims died, and on October 5, Shenandoah advised petitioner that it was crediting on the indebtedness the $ 50,000 payable under the insurance policy on his life:
* * * this policy being assigned to this Company as collateral security for the re-payment of the above mortgage on which the said John Wright Mims was personal endorser.
At petitioner's request Shenandoah returned the four remaining $ 10,000 bonds, with interest coupons marked paid, and acknowledged credits reducing the principal due on the two outstanding bonds to $ 71,000. On its journal petitioner debited $ 50,000 to "Bonded Debt" and credited surplus with a like amount, explained as:
Life Insurance policy carried on Jno. W. Mims, dec'd. by the Corp. for the benefit of the holders of the first mortgage bonds applied. See letter from Shenandoah Life Ins. Co. dated Nov. 21st, 1939.
By this credit of $ 50,000, entered November 22, 1939, a book deficit of $ 38,162.93 in the surplus*27 account was converted into a surplus of $ 11,837.07. On its tax return for the fiscal year 1939 petitioner reported the $ 50,000 as nontaxable income from a life insurance policy.By instrument dated October 21, 1940, Shenandoah agreed to payment of the remaining $ 71,000 due on the bonds in annual installments of $ 5,000, reduced interest to 5 per cent, and released Ralph E. Mims and the estate of John W. Mims from any liability by reason of their individual endorsements. But it specified that the $ 50,000 policy on the life of Ralph E. Mims "* * * be kept in full force and shall continue to be assigned to the first party as additional security for the payment of the balances due as aforesaid."
When John W. Mims died, he owed his mother $ 10,000 and Ralph E. Mims owed her $ 16,000 on the purchase price of some of the lands which they transferred to petitioner for its shares. She originally held a first mortgage on the lands securing payment of this indebtedness, but, to enable petitioner to procure the loan from Shenandoah in 1930, she released her mortgage, and each brother gave to her as security his 500 shares of petitioner's stock. After John W. Mims' death and on December*28 15, 1939, the third brother, Henry T. Mims, purchased his deceased brother's 500 shares from the estate for $ 30,000. He discharged $ 10,000 of the price by assuming the debt due to the mother. In the sale contract it was agreed that the estate had no interest in or claim against petitioner, and that, if any claim should later *905 appear to exist, the estate would assign it without consideration to the vendee.
By instrument dated December 17, 1943, Shenandoah agreed to reduce the bond interest to 4 per cent and granted a time extension for payment of principal. The indebtedness was paid off in full on February 20, 1946. On May 31, 1944, petitioner's operating deficit was in excess of $ 50,000, the amount of the insurance proceeds applied to payment of bonds in 1939, and its surplus account so indicated.
Early in 1944 petitioner expended $ 2,094.40 on furnishings of the Mimslyn Hotel. The greater part of this amount was spent on new slip covers for chairs in the hotel lobby and rooms; the lesser part on reupholstering, tightening, and repair of furniture. Most of the furniture had been acquired in 1932 and its cost had been fully recovered by prior depreciation deductions. *29 In 1948 petitioner sold all furnishings to a lessee of the hotel for $ 75,000. At that time the renovated furniture and slip covers were still in use, but very worn, and the purchaser replaced the covers in March 1948. The prospective useful life of the furnishings improved by the expenditure of $ 2,094.40 was four years.
Petitioner computed its excess profits tax credit for the fiscal year 1945 by the method prescribed in section 714, Internal Revenue Code. It reflected in its equity invested capital for the year $ 50,000 representing the proceeds of the insurance policy on John W. Mims' life which was applied on its bonded indebtedness in 1939. In determining the excess profits tax credit, the Commissioner did not include the $ 50,000 in equity invested capital. On its tax return for the fiscal year 1944 petitioner deducted the $ 2,094.40 expended on furnishings as a repair expense. In disallowing the deduction, the Commissioner determined the amount to be "a capital expenditure recoverable through depreciation."
OPINION.
Upon John W. Mims' death in 1939 Shenandoah applied to the payment of petitioner's bonded indebtedness the $ 50,000 payable under the policy of insurance*30 issued by it on his life. Petitioner charges error in the Commissioner's refusal to include the $ 50,000 in its equity invested capital for computation of the excess profits credit for the fiscal year 1945. By section 718 (a), Internal Revenue Code, equity invested capital is defined to comprise:
(1) Money paid in. -- Money previously paid in for stock, or as paid-in surplus, or as a contribution to capital;
(2) Property paid in. -- Property (other than money) previously paid in (regardless of the time paid in) for stock, or as paid-in surplus, or as a contribution to capital. * * *
*906 Petitioner contends that when Shenandoah applied the policy proceeds to its debt, it:
* * * received the benefit of the surety's (John W. Mims) property and became liable to the executors or administrators of John W. Mims for the proceeds of the policy so applied to its benefit. * * *
and, as the estate's claim against petitioner for reimbursement was relinquished without consideration, such relinquishment "constituted property paid in as donated or paid in surplus for the purpose of determining petitioner's equity invested capital under Section 718 * * *." In case no relinquishment or*31 forgiveness of the claim be found, petitioner argues in the alternative that the $ 50,000 was equity borrowed capital within the meaning of section 719.
If stockholders forgive a debt due them from their corporation under circumstances showing a purpose on their part to make an additional contribution to the corporation's capital and thereby increase their investment, the amount of the canceled debt has been recognized as an addition to invested capital. A. R. R. 678, 5 C. B. 290; The Parisian, 2 B. T. A. 415; Cohn-Goodman Co., 7 B. T. A. 475; Charles L. L'Hommedieu & Sons Co., 6 B. T. A. 41. This principle was more recently reiterated in Liberty Mirror Works, 3 T.C. 1018">3 T. C. 1018. Petitioner invokes it as here applicable on the theory that John W. Mims was the owner of the insurance policy during his lifetime; his estate was the designated beneficiary under the policy, and as such beneficiary, was entitled to the $ 50,000. Since the policy was held by Shenandoah merely as collateral for petitioner's debt, petitioner became liable to decedent's*32 estate for the amount of the proceeds used to discharge that debt.
In support of this view petitioner relies on Tate v. Commercial Bldg. Assn., 97 Va. 74">97 Va. 74; 33 S.E. 382">33 S. E. 382. There, as here, the stockholder of a corporation took out a policy of insurance on his life which he assigned as collateral to secure a loan of the corporation from the insurance company. Upon the insured's death the policy proceeds were applied in payment of the debt, and an assignee of the policy brought suit against the corporation for the amount of the proceeds. The assignee's claim was sustained on the ground that the corporation would "have become liable to Wrenn's [the insured's] estate for the amount of the policy, if he had not assigned it in his lifetime to Tate." But in so holding, the court took note that Tate:
* * * acquired the policy of Wrenn, subject to the rights of the insurance company to apply the proceeds of the policy to the debt of the association, but with the right, if so applied, to claim the amount from the association, less such sum as might be due to it for premiums paid for Wrenn on the policy. * * *
By the terms of the assignment*33 here considered Mims transferred to Shenandoah "all right, title and interest" in the policy, "including *907 the right to surrender," and did so under a written agreement that in the event of death the policy proceeds were "to be applied to the liquidation of the loan." While true, as petitioner contends, that an assignment, absolute upon its face, is still to be regarded as collateral security if the parties so intended, Eichelberger v. Mutual Life Ins. Co. of New York, 59 Fed. Supp. 852; First Nat. Bank of Roanoke v. Speece, 99 Va. 194">99 Va. 194; 37 S. E. 843, it is equally true that an insured's intentions are the controlling factor in determining whether or not the designated beneficiary of a pledged policy becomes the creditor's subrogee if the policy proceeds are used to satisfy the debt. In Smith v. Coleman, 184 Va. 259">184 Va. 259; 35 S. E. (2d) 107, it was found that the insured did not intend that proceeds of his pledged policy be used to pay the debt if there was no default, and accordingly the court held the designated beneficiary*34 entitled to recover from the insured's estate the amount of proceeds actually applied to the debt. The court, however, was careful to stress that the insured could have defeated the beneficiary's expectancy by surrendering the policy for cash value, by designating the pledgee bank as beneficiary pro tanto:
* * * or he could have made the proceeds of the insurance policy a primary fund out of which to discharge his indebtedness. The insured exercised none of these rights. He simply assigned the policy * * * as collateral security to pay an obligation * * *.
In reaching its decision, the court distinguished Walker v. Penick's Executor, 122 Va. 664">122 Va. 664; 95 S. E. 428, wherein the insured had pledged his policy with the issuing insurance company for a loan from it, with the stipulation that the amount of the insured's indebtedness be deducted from any sum payable under the policy. After the insured's death the company paid to his daughter, the designated beneficiary, only the amount due under the policy above the amount applied by it in satisfaction of the debt. The daughter sued the insured's estate, which was solvent, *35 for the amount so applied. The court rejected her claim, saying:
* * * the insured created the proceeds of the policy on his life the primary fund for the payment of the loan note secured by the policy * * *. Under this view of the case, no question of exoneration or subrogation can arise.
We are of opinion that John W. Mims likewise intended that policy proceeds constitute a "primary fund" for payment of petitioner's loan. From the attendant circumstances it is manifest that his motive in applying for the policy was to meet a condition which Shenandoah imposed as a prerequisite to making petitioner a loan. It was agreed in advance not merely that the policy would be pledged as security, but further that the proceeds would "be applied to the liquidation of the loan." The policies on the lives of both brothers were taken out for petitioner's benefit; petitioner paid the premiums; it carried the policies *908 on its books as assets at their cash surrender value; and when John W. Mims died, it constructively received $ 50,000 by application of the policy proceeds to its debt. During his lifetime John W. Mims paid nothing for the policy, and he had no rights over it inherent*36 in an owner. As a matter of form, his estate was designated beneficiary, but before the policy was even issued he was under contract to direct that its proceeds be applied to petitioner's loan, and immediately upon issuance be assigned "all right, title and interest therein" to Shenandoah as collateral. There was never a time when John W. Mims was free to treat the policy as his own property, he never paid anything for it, and upon his death his estate had no claim against Shenandoah, because the proceeds were expressly applicable to the loan -- not applicable when and if petitioner should be in default.
Petitioner suggests that the premiums which it paid were "either additional compensation to John W. Mims or a gift to him." We consider the attendant circumstances more consonant with the view that the policy was an asset of petitioner, as it was in fact recorded and recognized on petitioner's books, and that in paying the premiums petitioner acquired an asset from which it derived $ 50,000 upon John W. Mims' death. As insurance proceeds, the amount constituted tax-exempt income to petitioner, section 22 (b) (1), not money or property paid in by Mims or his estate as a contribution*37 to capital. We hold that the Commissioner correctly excluded it from petitioner's equity invested capital in computing the excess profits credit.
In a second assignment petitioner charges error in the disallowance of $ 2,094.40 claimed as an expense deduction for the fiscal year 1944. It is established that this amount was expended chiefly on the purchase of slip covers for hotel furniture and to some extent on reupholstering and repairs. There is testimony by Henry T. Mims that in the Pittsburgh hotels which he managed slip covers are usually replaced after two years of use and that petitioner's repaired furniture, already fully depreciated, was too worn in fiscal 1944 for more than four years' use. It appears that the covers and furniture were still in use, although much worn, when petitioner sold them in 1948, together with many other assets. As the witness refuted that prospective use of the improvements purchased by the $ 2,094.40 was less than one year, petitioner properly concedes that the amount is not deductible as an expense. It contends instead that a proper portion should be allowed for depreciation on the basis of a four-year life. We have found this term supported*38 by the evidence, and hold accordingly that petitioner is entitled to a depreciation deduction computed on that basis.
Decision will be entered under Rule 50.