*2599 1. Amounts donated to petitioners by private individuals and corporations for construction of spur tracks and facilities do not constitute taxable income.
2. Petitioner paid an assessment to the Association of Railway Executives in 1919 which sum respondent in his answer affirmatively alleges is not an ordinary and necessary expense of doing business, and therefore not an allowable deduction within the meaning of the statute. Respondent not having adduced sufficient evidence to sustain his allegation that the amount paid was not an ordinary and necessary business expense the net income should not be increased by the amount in controversy.
3. Petitioner's properties were taken over by the Director General of Railroads and operated by the said Director General during the period of so-called "Federal Control." On July 21, 1919, an agreement was entered into between the petitioner and the Director General with respect to compensation for the use and operation of its properties, which agreement contained a provision for the payment of interest on the cost of additions and betterments during the period of Federal control. Held, such interest is a part of the "just compensation" *2600 sought to be paid and should be included in the computation of gross income in the years 1918 and 1919 when it accrued.
*366 This is a proceeding for the redetermination of deficiencies in income taxes of $11,436.44 and $43,410.52 for the years 1918 and 1919 respectively. There are four issues raised by the pleadings:
1. Whether respondent erred in increasing net income in 1918 and 1919 by the amounts of donations to the petitioner by private persons and corporations for the construction of spur tracks.
2. Whether the respondent erred in failing to disallow a deduction taken by the petitioner for 1919, representing an assessment paid to the Association of Railway Executives.
3. Whether respondent erred in failing to increase the petitioner's income for 1918 by the amounts of overaccrued interest.
4. Whether respondent erred in including in income for the years 1918 and 1919 interest on completed additions and betterments or whether those amounts should be included in income in the year of final settlement with the Director General of Railroads.
*2601 Of the four issues above, the first was raised by the petitioner and the remaining three were raised by the affirmative allegations set forth in the respondent's answer.
FINDINGS OF FACT.
Petitioner is a railroad corporation organized and incorporated under an Act of Congress dated March 3, 1871, with its principal place of business at Dallas, Tex.
Petitioner operates under the supervision of the Interstate Commerce Commission and keeps its books and accounts on the accrual basis in accordance with the rules prescribed by that Commission. Although petitioner was actually operated under the control of the Director General of Railroads during the years here under consideration, it was in the hands of operating receivers, from which receivership it was discharged on May 14, 1924.
In 1918 and 1919 the petitioner agreed in writing to erect, and did erect, certain spur tracks and other facilities along its right of way, the cost of which was borne by private individuals and corporations. The agreements entered into between the petitioner and the said private individuals and corporations contained the following typical provisions:
That, whereas, the party of the second*2602 part [private persons or corporations] has requested the party of the first part [petitioner] to build and construct side tracks or spur tracks at a point on the line of road of the party of the first part, said point being near mile post 333.66 on the Ft. Worth Division of the Texas & Pacific Railroad, and in the County of Eastland, State of *367 Texas, and runs thence in the direction and for a distance, and to the point hereinafter set forth as follows:
* * *
It is agreed that the party of the first part shall build said side or spur tracks upon the following conditions, to-wit:
1-a. Party of the second part shall pay for, own and maintain track No. 1 from right of way line, at letter "E", survey station 4 plus 90 to the end, at letter "G", survey station 13 plus 00; and all of track No. 2 from the right of way line, from letter "E" to end, letter "F".
b. The party of the second part shall pay for and maintain and the party of the first part shall own all of track No. 3.
The spur tracks and other facilities so erected for private interests, in so far as they were actually located on the right of way of the petitioner, became its property upon completion. *2603 During the years 1918 and 1919 the petitioner credited to Profit and Loss Account No. 606, $1,912.34 and $46,514.13, representing "donations" by private interests for materials and labor used by the petitioner for the construction and erection of these facilities. These amounts represent that portion of the cost of said spur tracks and facilities located on petitioner's right of way borne by private interests.
Two accounting entries recording these amounts were made in the books of account of the petitioner, in accordance with the "Classification of Income, Profit and Loss, and General Balance Sheet Accounts for Steam Roads" prescribed by the Interstate Commerce Commission: (1) Debit to General Balance Sheet Account No. 701, Investment and Road and Equipment and credit to Profit and Loss Account No. 606, "Donations," and (2) debit to Profit and Loss Account No. 615, "Surplus Appropriated for Investment in Physical Property" and credit to General Balance Sheet Account No. 779, "Additions to property through Income and Surplus." The net effect of those entries is, therefore, a debit to General Balance Sheet Account No. 701, "Investment In Road and Equipment" and a credit to General*2604 Balance Sheet Account No. 779, "Additions to property through Income and Surplus."
The petitioner received a communication from the chairman of the Association of Railway Executives under date of October 16, 1919, together with a "Report on National Advertising for the Association of Railway Executives," which report reads in part as follows:
At the suggestion of the Chairman, a meeting was held last Tuesday for the purpose of discussing the general publicity policy of the Association in view of the legislative situation.
* * *
It was the consensus of opinion of the meeting that the Association of Railway Executives should now go before the country in an intensive advertising campaign to state the railroads' case to the people.
*368 At the suggestion of the Chairman, a formal report on the subject has been prepared by Mr. Fayant, Mr. Dunn, Mr. Sissen, and Mr. Lee. The report is as follows:
The time has now arrived when intensive effort must be made to bring to bear on Congress the strong pressure of public opinion throughout the country to speed up railroad legislation and put on the statute books a sound law that will protect and encourage the transportation*2605 industry.
There can be no doubt that the vast majority of the people of this country want to see the railroads returned now to private management under liberal legislation that will enable the railroads to continue doing their full part in upbuilding the country. The country wants to see a good job done in Congress and Congress is plainly anxious to do a good job.
What is needed now is definitely to crystallize public opinion.
There is only one way to do this and that is on the foundation of national advertising that will reach into every nook and corner of the country. The intelligent use of advertising space, especially in the newspapers, has come to be the accepted and approved method of crystallizing American public opinion on any great national issue.
The long struggle of the railroads for national legislation to insure the future solvency and prosperity of the carriers is about to be won, but to make sure that the fight will be won a direct appeal to the country is now vitally necessary.
We therefore unhesitatingly recommend that the Association of Railway Executives authorize the expenditure for national advertising detailed in the attached exhibit.
We also*2606 recommend that the national advertising thus begun by the railways as a whole be continued as a permanent program with the return to private operation. We believe that such a settled policy of continuous good will advertising for the general education of the public on railroad problems will be a certain means of retaining public good will, of working out the perplexing problems that will arise under private operation, and of insuring the continuance of private operation in the future.
The daily newspapers of this country, for example, have a total circulation of 30,000,000. A column of space in every one of these papers can be purchased for less than $25,000.
To spend too large an amount on such a campaign as this would be a waste of money, but not to spend enough would be an even greater waste, because the desired result would not be attained.
We recommend the authorization of a total expenditure of $1,000,000.
In the tentative estimates attached to this memorandum we have included as the publications to be used in this campaign
First, all English daily newspapers. This covers 2,300 publications, reaching from the great metropolitan dailies to the smallest dailies*2607 in the interior, with a total circulation of 30,000,000 copies.
Second, a selected list of country weekly newspapers, reaching the rural communities in every congressional district.
Third, a selected list of the best agricultural journals, by means of which we will reach the great body of farmers, especially those that do not happen to be reached by the daily and weekly newspapers.
Fourth, a selected list of the leading national journals of opinion, reaching the great body of the most intelligent and most influential people of the country.
*369 The copy to be used in the advertising, the typographical form in which it is to be presented, the frequency of publication, and other similar details of the campaign, would of course be determined by a conference between the publicity staff of the Association and advertising experts, and all these details would be subject to the approval of the Association or such committee of the Association as is delegated to supervise the work.
Under date of November 1, 1919, the chairman of the Association of Railway Executives sent another communication to the petitioner, containing an enclosure entitled "Item in Proposed (Seventh) *2608 Annual Assessment" which communication and proposal read as follows:
On October 16th I wrote you of the action of the Standing Committee on October 14th in levying an assessment at the rate of $2.00 per Thousand Dollars of "standard return", and enclosing therewith a statement showing how the funds were to be spent.
Your company's share of this assessment is $8,286.56. One-half of this is due and payable immediately; one-quarter is due February 1, 1920, and the final quarter is due May 1, 1920.
In arriving at your assessment we credited you with a "standard return" amounting to $4,143,283.51, which includes your subsidiaries as noted at the bottom of this letter.
Please make your first check for the amount of $4,143.28 payable to the Association of Railway Executives, and mail to this office. An early response will be appreciated, as the advertising campaign should be started immediately, for which funds must be promptly available.
| 1. Advertising and publicity in connection with pending legislation and the return of the roads to private operation (see special report) | $1,000,000 |
| 2. Bureau of Railway Economics (1920) | 90,000 |
| 3. Railway Corporate Engineers Association (1920) | 10,000 |
| 4. Railroad Corporate Accounting Conference (1920) | 10,000 |
| 5. Presidents' Conference Committee on Federal Valuation (1920) | 200,000 |
| 6. Association of Railway Executives for general and legal expenses (1920) | 290,000 |
| Total | $1,600,000 |
*2609 BASIS OF ASSESSMENT to be the "standard return". Where no contract has been executed, the figure certified by the Interstate Commerce Commission to be used.
RATE OF ASSESSMENT to be $2.00 per $1,000 of "standard returns". If the Presidents' Conference Committee on Federal Valuation be not affiliated with the Association, then $200,000 may be omitted, and the rate reduced to $1.75 per $1,000 of "standard return."
ASSESSMENT TO BE PAYABLE, one-half by November 1, 1919, the third quarter by February 1, 1920, and the fourth quarter by May 1, 1920. It is necessary to call for the first half immediately, as it is proposed to spend the appropriation for advertising and special publicity immediately.
Pursuant to the aforementioned letter of November 1, 1919, petitioner paid to the Association of Railway Executives, before the end of the calendar year 1919, 50 per cent of its quota of the seventh *370 assessment amounting to $4,143.28. In computing its net income for the calendar year 1919 the petitioner deducted the amount so paid and the respondent disallowed ten-sixteenths thereof, or $2,589.55.
By proclamation, the President of the United States, acting under the*2610 powers conferred upon him by the Constitution, laws, and certain resolutions of the Senate and House of Representatives, took possession of, and assumed control of the operation of certain railroads, including the properties of the petitioner, on December 28, 1917. By an Act of Congress, approved March 21, 1918, known as the "Federal Control Act," the President was authorized to enter into agreements with the railroads thus taken over, providing for the maintenance and upkeep thereof during the period of Federal control and also for compensation for the use of those facilities. Section 4 of said Act provides:
That the just compensation that may be determined as hereinbefore provided by agreement or that may be adjudicated by the Court of Claims, shall be increased by an amount reckoned at a reasonable rate per centum to be fixed by the President upon the cost of any additions and betterments, less retirements, and upon the cost of road extensions to the property of such carrier made by such carrier with the approval of or by order of the President while such property is under Federal control.
The President, acting under the powers so granted, authorized the Director General*2611 of Railroads to agree with the carriers, including the petitioner, upon the amount of compensation to be paid, and on July 21, 1919, articles of agreement were entered into between the petitioner and the Director General of Railroads. Under section 7 of that agreement it was provided that the petitioner should receive $4,107,432.49, subject to certain adjustments, during each year and pro rata for each fractional part of a year of Federal control, to be paid in stipulated installments.
Subdivision (d) of section 7 of that agreement provided:
Upon the cost of additions and betterments, less retirements in connection therewith, and upon the cost of road extensions, made to the property of the company during Federal control, the Director General shall, from the completion of the work, pay the Company a reasonable rate of interest, to be fixed by him on each occasion. In fixing such rate or rates he may take into account not merely the value of money but all pertinent facts and circumstances, whether the money used was derived from loans or otherwise, provided that to the extent that the money is advanced by the Director General or is obtained by the Company from loans or from the*2612 proceeds of securities the rate or rates shall be the same as that charged by the Director General for loans to the Company or to other Companies of similar credit.
In determining the net income of the petitioner the respondent included therein for the years 1918 and 1919 the sums of $47,916.95 and $158,159.37, respectively, representing interest on the cost of *371 completed additions and betterments during those years, and while said properties were under Federal control.
OPINION.
MORRIS: The first assignment of error, the only one urged by petitioner, relates to the action of the respondent in increasing net income of the petitioner for the years 1918 and 1919 by $1,912.34 and $46,514.13, representing so-called donations made to the petitioner by private individuals and corporations located on its right of way for the building and installation of spur tracks and other facilities.
At the request of shippers located on property adjacent to the right of way of the petitioner, spur tracks and other facilities were installed under written agreements entered into between the parties requiring said persons or corporations to pay for and maintain said spur tracks and*2613 facilities, and providing further, that the title to that portion of said facilities installed on the right of way of the petitioner should be in the petitioner upon completion. During the years here under consideration, petitioner entered into such agreements and had entered upon its books of account $1,912.34 in 1918 and $46,514.13 in 1919, representing payments to the petitioner by private individuals and corporations for the cost of materials and labor expended by it or by such private individuals and corporations in building spur tracks under the agreements above mentioned. Appropriate book entries as required by the rules of the Interstate Commerce Commission were made to record these transactions, the net effect of which being to debit General Balance Sheet Account No. 701 and credit General Balance Sheet Account No. 779 "Additions to Property Through Income and Surplus." The respondent contends that the acquisition by petitioner of that portion of the spur tracks and facilities installed on its right of way without cost to it, was income derived by it from the furnishing of services such as it was organized to furnish. The petitioner contends, however, that such donations*2614 contained no element of gain and do not constitute taxable income within the meaning of the statute and the decided cases.
The petitioner relies upon the , and . The respondent's counsel attempts to distinguish the Cuba Railroad Co. case, supra, from the instant case in that the money and property was acquired from the Government as a subsidy. He also attempts to distinguish the Liberty Light & Power Co. case, supra, from the instant case by reason of the fact that the Board found that that company was under compulsion to accept properties offered to it by its patrons and by the further fact that the Board held that the additional cost of rendering services to certain country lines of *372 that company was recognized, and it was therefore entitled to charge higher rates for such services. Since the hearing of this case, the Board has promulgated its decision in , which renders it useless for us to consider the distinctions attempted to be drawn by the respondent's counsel. *2615 The facts in the instant case are practically identical with those in the , in which the Board, following the decisions in Liberty Light & Power Co. and , held that contributions received in the aid of construction during 1918 and 1919 did not constitute taxable income to the petitioner. Therefore, considering the merits of the instant case and under authority of , we are of the opinion that the respondent was in error in including the sums of $1,912.34 and $46,514.13 in the income of the petitioner for the years 1918 and 1919, respectively.
The second assignment of error affirmatively pleaded in respondent's answer is that he erred in failing to disallow a deduction in the amount of $2,589.55 taken by the petitioner for 1919 representing payment of a certain assessment to the Association of Railway Executives. During the year 1919 there was in existence an organization known as the Association of Railway Executives. Petitioner received a communication from that Association bearing date October 16, 1919, transmitting a report on a proposed*2616 plan of national advertising by the Association and for a special assessment of its members therefor. Petitioner received a further communication from that Association bearing date November 1, 1919, assessing it $2 per $1,000 of "standard return," or a total amount of $8,286.56, to be paid one-half immediately and the remainder in two installments during the year 1920. Petitioner paid the Association one-half of the above sum, or $4,143.28, in 1919, which it deducted in the computation of its net income for that year. The respondent now contends that ten-sixteenths of that amount, or $2,589.55, should be disallowed as a deduction on the ground that it was paid to the Association for the purpose of advertising and publicity in connection with pending legislation.
Although the evidence does not disclose when the Association of Railway Executives was organized, we understand that it was in operation some time prior to the taxable years and its purposes and policies were no doubt well established. We do not know, except in a very general way what the business of the Association is, nor for what purpose it was organized. Of course, we know that the $1,000,000 which was assessed*2617 was for the purpose of carrying on a certain advertising campaign, but we do not know, even in a general way, just how this money was expended if it was in fact expended. *373 We are not informed of how this expenditure was treated in the books of account of the petitioner for the year 1919. In order for us to determine whether this sum is an ordinary and necessary business expense within the meaning of the statute, we should know something about the organization to which this money is paid, what its purpose is, what it is in fact doing, its relationship with the petitioner, and we should know something about how this money was in fact spent. Under the authority of , we do not believe that the respondent has offered sufficient evidence to support the affirmative allegation set up in his answer that the amount deducted was not an ordinary and necessary business expense.
At the hearing of this proceeding petitioner's counsel conceded the correctness of respondent's contentions with respect to the third allegation of error affirmatively pleaded in the respondent's answer. Taxable income for the years 1918 and 1919 should*2618 therefore be increased by $27,549.38 and $40,113.93, respectively, amounts by which the petitioner over-accrued interest owing by it.
The fourth and last assignment of error, affirmatively pleaded by the respondent's answer, is that he erred in including in income of the petitioner for the years 1918 and 1919 the sums of $47,916.95 and $158,159.37, respectively, representing rental interest on additions and betterments completed during Federal control. The respondent contends that the rental interest on these completed additions and betterments was not accruable in the years 1918 and 1919 but was taxable income in the year 1923, the date of final settlement with the Director General of Railroads.
On July 21, 1919, the Director General of Railroads, acting on behalf of the United States and the President, under the powers conferred by the proclamations of the President, entered into an agreement with the petitioner with respect to the "possession, control, operation and utilization" of its properties, and the compensation therefor, during the period of Federal control. The preamble and recitals of that agreement contained the following provision:
Whereas by proclamation dated*2619 March 29, 1918, the President, acting under the Federal Control Act and all other powers him thereto enabling, authorized the Director General * * * to agree with the carriers, * * * upon the amount of compensation to be paid pursuant to law, and to sign, seal, and deliver in his own name or in the name of the President, or in the name of the United States such agreements as may be necessary and expedient with the several carriers * * * respecting compensation.
The amount of compensation guaranteed to the petitioner under the agreement of July 21, 1919, supra, is $4,107,432.49, over which amount there is no dispute in this proceeding. The amounts here in *374 controversy are the payments provided for in subdivision (d) of section 7 of that agreement, which reads:
Upon the cost of additions and betterments, less retirements in connection therewith, and upon the cost of road extensions, made to the property of the Company during Federal control, the Director General shall, from the completion of the work, pay the Company a reasonable rate of interest, to be fixed by him on each occasion. In fixing such rate or rates he may take into account not merely the value of money*2620 but all pertinent facts and circumstances * * *.
Section 212(b) of the Revenue Act of 1918 provides that:
The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer * * * or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income.
The books of the petitioner were kept on the accrual basis in accordance with the regulations promulgated by the Interstate Commerce Commission.
In , the United States took over the properties of that company under conditions similar to those in the instant case, except that in that case no agreement was entered into as was done here. After the close of the period of Federal control that company filed a claim for compensation, and in 1922 it was awarded a sum of $390,818.05, which amount was included in its tax return for 1922. The Commissioner, on the other hand, *2621 prorated that amount to the years 1918, 1919, and 1920, the period of Federal control, and assessed additional taxes for those years. The petitioner appealed to this Board from the findings of the Commissioner, and the Board held upon finding that the books were kept on the accrual basis that the amount of compensation received should be prorated to the years there in question.
In , that company did not sign a compensation agreement, but filed an application with the Director General of Railroads for compensation in excess of the "standard return." In 1921 it was finally agreed that the company should be paid compensation in the amount of $1,500,000, annually. That company included in its original return for 1918, $1,101,215.32, the amount of the so-called standard return as certified by the Interstate Commerce Commission, but subsequently to the agreement reached between that company and the Director General of Railroads, that company filed an amended return for that year and included the entire amount of $1,500,000. The Commissioner excluded the difference between those amounts from the return for*2622 1918, and added it to the income of the company for *375 1921. The Board, in that case, following , held that the taxpayer was correct in including the entire amount in the year 1918.
While the two preceding appeals do not involve the question of interest upon costs of additions and betterments, and differ in that respect from the facts of this case, we are convinced that the interest paid under the circumstances of this case should be governed by the same considerations - in fact the interest so provided for is, we believe, in fact and in law, nothing more nor less than a part of the "just compensation" sought to be paid under section 4 of the Federal Control Act as amended March 21, 1918 (40 Stat. 451).
Counsel for the respondent lays great stress upon the proposition that the interest on additions and betterments was a mere claim against the United States, unliquidated as to amount, and, therefore, could not be accrued as income until the amount was actually determined in 1923, but in view of the Appeals of Illinois Terminal Co. and *2623 , we are not impressed with his contentions. The amounts in controversy in those cases were undetermined until some time after the period of Federal control, and notwithstanding that fact, the Board held that they should be allocated to the years in which earned.
In , the contract between the petitioner in that case and the Director General provided:
SEC. 4. (a) * * * Balances of the above accounts shall be struck quarterly on the last days of March, June, September, and December of each year, and the cash balance found on such adjustments to be due either party shall be then payable and, if not paid, shall bear interest at the rate of 6 per cent, per annum, unless the parties shall agree upon a different rate. * * *.
No quarterly balances were struck between the Director General and the petitioner, and the only settlement of account made between them was the final settlement in April, 1921. The petitioner in that case accrued the sum of $1,570,199.75 for the year 1919, representing the estimated amount of interest due under the provision of the contract aforesaid, *2624 which amount it reported as taxable income for that year, but accrued nothing for 1918. The respondent in that case computed the amount of interest due the petitioner from the Director General for 1918 to be $693,005.39 and for 1919 to be $351,764.86 and in the determination of the proposed deficiency in that case, the respondent added $693,005.39 to the taxable income of the petitioner for the year 1918 and reduced the taxable income for the year 1919 in the sum of $1,218,434.89. The petitioner contended in that case that it should be permitted to report its income from this source in accordance with its books. The Board held in that case following , that the respondent was correct in allocating these amounts to the years in which earned.
*376 Under the facts and circumstances in this case and considering the cases herein cited, the sums of $47,916.95 and $158,159.37 were correctly included in the petitioner's income for the years 1918 and 1919, respectively, instead of the year of final settlement as contended by the respondent.
Judgment will be entered on 15 days' notice, under Rule 50.
Considered by MURDOCK*2625 and SIEFKIN.