*834 Petitioner made a final payment in 1934 of $157,529.90 on indebtedness of $315,057.22 incurred during the period of 1929 to 1931, inclusive, which indebtedness had been reduced to judgment in July 1931. Held, that the amount was properly deductible in computing undistributed net income as an amount used to retire indebtedness incurred prior to January 1, 1934, within the meaning of section 351 of the Revenue Act of 1934.
*542 The Commissioner determined a surtax against the petitioner as a personal holding company, under section 351 of the Revenue Act of 1934, in the amount of $42,176.95 for the year 1934. This is the amount of the deficiency. The determination results from the disallowance of a deduction of $157,529.90 claimed by the petitioner to represent the amount paid in 1934 on indebtedness incurred prior to January 1, 1934. Petitioner claims that this amount is deductible in computing its undistributed adjusted net income under subsection (b)(2)(B) of section 351.
FINDINGS OF FACT.
Petitioner is a corporation, *835 incorporated under the laws of Nevada in June 1927 to acquire, develop, and operate mines, with capital stock consisting of 100,000 shares of no par value. The company acquired certain property including a mine known as the Murchie Mine, near Nevada City, California, which had been under water *543 about 22 years until 1927. The old working were 1,150 feet deep on the incline of the vein. In 1928 and 1929 the mine was dewatered, buildings and machinery were rebuilt and renewed, and ore bodies were located and developed. Milling was started in 1929.
In the fall of 1927, M. C. C. Van Loben Sels made a loan to the operators of the Murchie mine, who controlled the stock of petitioner, which was to be used in the rehabilitation and development of the mine. The loan was in the amount of $50,000 and it was secured by 50,000 shares of petitioner's stock. It was orally agreed that Van Loben Sels, at his pleasure, could exchange or take the stock in payment of the loan.
Beginning April 4, 1928, and ending February 1, 1931, Van Loben Sels loaned to the petitioner numerous and various amounts from time to time as money was needed for the rehabilitation, development, and operation*836 of the mine, as follows: During 1928, $42,580.69; during 1929, $106,801.41; during 1930, $133,364.79; and during 1931, $7,310.33, or a total of $290,057.22.
In the spring of 1929 Van Loben Sels and his wife acquired 21,000 shares of petitioner's stock for $25,000. In March 1929 Van Loben Sels exercised the option under the agreement made in 1927 with the operators of the mine and acquired the 50,000 shares of petitioner's stock in payment of his loan of $50,000. Thereafter from time to time Van Loben Sels acquired additional stock, so that in April 1931 he and his wife owned a total of 88,000 shares, and at the beginning of 1934 they owned a total of 99,400 shares. Subsequent to 1934, they acquired and owned all of the outstanding 100,000 shares of petitioner's stock.
In the early part of 1931 Van Loben Sels was informed by his attorney that the early loans made to petitioner would soon be outlawed and advised collection thereof by suit. Consequently, to safeguard his loans, Van Loben Sels commenced an action against the petitioner in the Superior Court of the State of California in and for the County of Nevada for the recovery of a total amount of $315,057.22, which consisted*837 of the loans made to the petitioner by him in the amount of $290,057.22 and a note of $25,000 dated November 30, 1928, covering a loan made by one Bradford Ellsworth to petitioner which had been assigned on March 21, 1931, to Van Loben Sels. In order to avoid extended litigation on the part of the other creditors, to whom petitioner owed approximately $30,000 to $40,000, and on the part of minority stockholders, about 20 in number, one of whom had threatened to have a receiver appointed for the petitioner, Van Loben Sels notified creditors and stockholders that his only purpose in bringing the action was to protect his loans made to the petitioner, that he would not claim priority over any claims they might *544 have against the petitioner, and that he had no intention of freezing out minority stockholders by levying execution. By order of the court minority stockholders were permitted to, and three of them did, intervene in the above action. However, on July 16, 1931, judgment was entered in favor of Van Loben Sels in the amount of $315,057.22, plus attorney's fees of $6,758.
All the moneys loaned by Van Loben Sels to the petitioner, as well as the $50,000 loaned by him*838 to the operators of the mine in 1927, were expended for the rehabilitation, development, exploring, and operation of the Murchie mine. The mine had been filled with water for over 20 years. To dewater the mine it was necessary to construct a drain tunnel through about 700 feet of solid rock. The water was drained from the mine in the latter part of 1928. It was necessary, among other things, to retimber the mine, rebuild the mill and other buildings, construct a trestle from the shaft head to the mill for the conveyance of ore, and explore and search for an ore body. This was finally found in the latter part of 1928 and milling was commenced in the early part of 1929. This proved unsuccessful and the mill was again closed for about three months, during which time changes were made in the process of milling. Thereafter milling was resumed and proved successful.
Under date of December 15, 1931, the petitioner, together with Van Loben Sels and wife, as sellers, entered into an agreement with the Empire Star Mines Co., Ltd., a Delaware corporation, as purchaser, for the sale and conveyance by the sellers to the purchaser of certain mining property therein more particularly described*839 including the Murchie mine, subject to certain enumerated liens and indebtedness, not in excess of $150,000, including the so-called Humphrey mortgage, not in excess of $114,000, for the following consideration: $180,000 cash ($60,000 to be paid upon delivery of deed and the remainder, $120,000, in monthly installments of $5,000 commencing February 1, 1932, until paid); 15,000 shares of the capital stock of the Empire Star Mines Co., Ltd., in the name of the petitioner, valued at $20 a share for the purpose of the sale, $300,000; liabilities assumed, $26,000; mortgage assumed, $113,330.76; total, $619,330.76.
The possession of the property was to be turned over to the purchaser at midnight December 31, 1931. This was done. After such transfer, the petitioner had no assets other than the contract of sale, i.e., 24 monthly payments of $5,000, the $60,000 in cash, 15,000 shares of stock of the Empire Star Mines Co., Ltd., and some concentrates. The balance due on the Humphrey mortgage at the time of the transfer was $113,330.76.
Early in 1932 the petitioner had paid all its obligations except its obligation to Van Loben Sels. Payments to him were made whenever the corporation*840 had the cash to make payments.
*545 In January 1934 the petitioner sold 3,000 shares of the Empire Star Mines Co., Ltd., at $40 a share and in October 1934, 2,000 shares thereof at $37.50 a share, and realized a profit of $95,000 thereon. It received dividends of $90,000 during 1934 from the Empire Star Mines Co., Ltd.
Payments on the principal of the Van Loben Sels judgment were made as follows: 1931, $3,000; 1932, $130,188.09; 1933, $28,160.29; and 1934, $157,529.90.
The petitioner filed a personal holding company return (form 1120H) for 1934, showing the following:
| Net income (as defined in Title I of the Revenue Act of 1934) | $86,219.04 | |
| Dividends received on stock of domestic corporations | 90,000.00 | |
| $176,219.04 | ||
| Less: | ||
| Federal income and excess-profits taxes | 13,166.07 | |
| Adjusted Net Income | $163,052.97 | |
| Less: | ||
| 20% of $163,052.97 | $32,610.59 | |
| Amount used or set aside to retire indebtedness | 157,529.90 | |
| 190,140.49 | ||
| Undistributed Adjusted Net Income | None |
In auditing the return the respondent disallowed the deduction of $157,529.90, leaving undistributed adjusted net income of $130,442.38.
The indebtedness of the petitioner*841 to Van Loben Sels, herein involved, was incurred before January 1, 1934, and the amounts paid thereon in 1934 were reasonable with reference to the size and terms of the indebtedness.
OPINION.
HARRON: In computing its "undistributed adjusted net income" under section 351 of the Revenue Act of 1934, 1 for the purpose of determining its surtax liability as a personal holding company, the petitioner deducted the amount of $157,529.90, being the total of payments made during 1934 on an indebtedness which had been reduced to judgment on July 16, 1931, as "Amounts used or set *546 aside to retire indebtedness incurred prior to January 1, 1934" pursuant to subsection (b)(2)(B) of section 351.
*842 The respondent determined that the amount involved did not constitute an allowable deduction under section 351, and in particular under article 351-4 of Regulations 86, 2 upon the ground that it represented payment of a "commercial loan." In article 351-4 of Regulations 86, the term "indebtedness" as used in subsection (b)(2)(B) of section 351 of the Revenue Act of 1934, was restricted in meaning to "bonds, debentures, or similar obligations * * * for the purpose of raising capital." No such restriction or limitation in connotation of the term is contained in the statutory provision involved. That it was not the intention of Congress to so limit the term appears from Report No. 558 of the Committee on Finance, 73d Cong., 2d sess., p. 15, wherein it is stated:
* * * Considerable hardship has been avoided by permitting the deduction from the adjusted net income of a reasonable amount used or set aside to retire indebtedness incurred prior to January 1, 1934. This will substantially and properly relieve personally owned corporations which have outstanding bonds or other indebtedness that must be met from current earnings before distributions can be made. [Emphasis supplied. *843 ]
*844 Although section 351(b)(2)(B) of the Revenue Act of 1936 remained the same as the corresponding section of the 1934 Act, *547 Congress in the Revenue Act of 1937 changed the corresponding section of that act (section 355(b)) to read as follows:
(b) Amounts used or irrevocably set aside to pay or to retire indebtedness of any kind incurred prior to January 1, 1934, if such amounts are reasonable with reference to the size and terms of such indebtedness. [Emphasis supplied.]
Both the Committee on Ways and Means and the Committee on Finance refused to carry out the recommendation of the Joint Committee on Tax Evasion and Avoidance to eliminate in the 1937 Act the deduction allowed in section 351(b)(2)(B) of the 1934 Act in arriving at undistributed adjusted net income of a personal holding company, for the following reasons:
* * * While recognizing the reasons which impelled the joint committee to make this recommendation, your committee feels, from further study of the question, that the denial of this deduction would cause hardship in numerous cases where due to the particular circumstances of the corporation, a dividend distribution cannot be made because of a*845 necessity for legal reasons of using the earnings and profits to discharge the debts. Moreover, any loss of revenue caused by the continued allowance of this deduction cannot increase, since indebtedness incurred after 1933 cannot be used as a basis for the deduction. * * * 3
In November 1937, article 351-4 of Regulations 86 (footnote No. 2, supra ) was amended in Treasury Decision No. 4777, C.B. 1937-2, p. 197. Therein the term "indebtedness" was defined as "an obligation, absolute and not contingent, to pay, on demand or within a given time, in cash or other medium, a fixed amount."
The authority given to the Secretary of the Treasury to make rules and regulations for the administration of the revenue laws does not include the power to alter or amend such laws. . A regulation to be valid must be consistent with the statute and also reasonable. A regulation, which "operates to create a rule out of harmony with the statute, is a mere nullity." *846 . Where a regulation does not carry into effect the will of Congress as expressed in a statute, a subsequent amended regulation, which does so, becomes "the primary and controlling rule in respect to the situation presented."
On brief the respondent admits that the change made by Congress in the 1937 Act and the explanation of such change as contained in Report No. 1242, of the Committee on Finance, supra, indicate strongly the disapproval of Congress of the administrative construction of section 351(b)(2)(B) of the Revenue Act of 1934 contained *548 in article 351-4 of Regulations 86, and that consequently it is probable that the restrictions in such regulation, limiting the deduction to bonds or debentures, is subject to revision. He contends, however, that an indebtedness to be deductible under section 351(b)(2)(B), supra, must be "reasonable with reference to the size and terms of such indebtedness."
The purpose of section 351, enacted for the first time in the Revenue Act of 1934, was to prevent tax avoidance*847 by means of an "incorporated pocket book", i.e., the formation of a personal holding company by an individual for the purpose of turning over to it, in exchange for its stock, his personal holdings in stock, bonds and other income-producing property. By so doing individuals had theretofore escaped payment of surtax on income which without the intervention of such corporations would have been payable by them individually. (See footnote No. 3, supra. )
The evidence discloses that the petitioner was organized to acquire, rehabilitate, and operate the Murchie mine and other property. It was not until about the latter part of 1929 that the mine was in condition to operate with any degree of success. Up to that time it had not been able to accumulate any surplus income. How successful the operations were thereafter, the record fails to disclose. However, the testimony is that the income from the mine was never enough at any time to cover the amounts expended for its development and operation. In any event it was deemed advisable to sell all of the assets of the petitioner in December 1931, at which time there was outstanding, in addition to other indebtedness, the indebtedness*848 herein involved of over $315,000, plus interest and costs, which it was required to pay. In 1932 the evidence discloses that the petitioner had income of $73,089.25, including dividends from the Empire Star Mines Co., Ltd., of $25,750, and also received $60,000 under the contract of sale. In 1933 it received dividends from the Empire Star Mines Co., Ltd., of $20,395 and $44,707.53 on its contract of sale. In 1934 it received dividends of $90,000 and realized a profit of $95,000 on the sale of 5,000 shares of stock of the Empire Star Mines Co., Ltd., received under the contract of sale. The balance sheet in its 1934 return shows a deficit of $975,654.74 as of December 31, 1934. So far as the record shows it had no surplus available for dividends in 1934 or prior thereto.
Petitioner did not become a personal holding company as defined in section 351(b)(1) of the Revenue Act of 1934 until January 1, 1932, upon the sale of all its assets. Prior to that time the indebtedness involved had been reduced to judgment. The judgment did not provide any time for payment. The postponement of execution on a judgment is not unusual. Payments were made on the judgment *549 with reasonable*849 promptness whenever cash was available for that purpose.
Upon all the evidence it is held that the indebtedness of the petitioner to Van Loben Sels was an indebtedness incurred prior to January 1, 1934, and that the amount paid in 1934 was reasonable with reference to the size and terms of such indebtedness within the meaning of section 351, supra, and article 351-4 of Regulations 86, as amended by Treasury Decision No. 4777, supra. The petitioner is therefore entitled to the deduction claimed.
Decision will be entered for the petitioner.
Footnotes
1. SEC. 351. SURTAX ON PERSONAL HOLDING COMPANIES.
(a) IMPOSITION OF TAX. - There shall be levied, collected, and paid, for each taxable year, upon the undistributed adjusted net income of every personal holding company a surtax equal to the sum of the following:
* * *
(b) DEFINITIONS. - As used in this title -
* * *
(2) The term "undistributed adjusted net income" means the adjusted net income minus the sum of:
* * *
(B) Amounts used or set aside to retire indebtedness incurred prior to January 1, 1934, if such amounts are reasonable with reference to the size and terms of such indebtedness; * * * ↩
2. ART. 351-4. Amounts used or set aside to retire indebtedness incurred prior to January 1, 1934. - If, pursuant to a bona fide plan for the retirement of its bonds, debentures, or similar obligations representing indebtedness incurred prior to January 1, 1934, for the purpose of raising capital (or assumed prior to that date in connection with the acquisition of capital assets by which such indebtedness is secured) the taxpayer -
(1) retires during the taxable year an amount of such indebtedness, or
(2) establishes a sinking fund or reserve for the retirement of such indebtedness during the taxable year, and sets aside in such fund or reserve an amount for the retirement of such indebtedness -
in determining the undistributed adjusted net income for the taxable year, a deduction from the adjusted net income is allowable in a reasonable amount in respect of the amount so paid or set aside in such fund or reserve during the taxable year.
The amount allowable as a deduction in any case must be reasonable, considering the nature, purposes, scope, conditions, amount, maturity, and other terms of the indebtedness. No deduction is allowable unless it appears, either from the covenants of the obligations or from a recognized business and accounting practice respecting the retirement of such indebtedness, that provision for retirement must be made out of earnings for the taxable year before distribution of such earnings may be made. The reasonableness of the deduction shall be determined by existing conditions known at the close of the taxable year. The fact that amounts have not been used or set aside in prior years will not entitle the taxpayer to deduct in any taxable year a greater amount than would otherwise be allowable. Amounts paid or set aside to discharge current liabilities for expenses, salaries, wages, taxes, interest, the purchase of any property for resale, dividends, balances due brokers, bank or other commercial loans, or any other current liability (whether represented by negotiable instruments, balances on account, or otherwise) do not constitute allowable deductions. This is true as respects liabilities which are payable at the convenience of either the debtor or the creditor, or on the demand of either.
No deduction will be permitted under this article with respect to any item for which a deduction is otherwise allowable under Title IA or Title I of the Act or under any applicable prior income tax Act.
* * * ↩
3. Report No. 1546, Committee on Ways and Means, 75th Cong., 1st Sess., p. 11.
Report No. 1242, Committee on Finance, 75th Cong., 1st sess., p. 13. ↩