*198 Decision will be entered for respondent.
Petitioner, on the accrual basis of reporting income and on the reserve system of accounting for bad debts, filed claim for refund of its 1941 tax payments on the basis that it was entitled to deduct the amount of $ 475,000, covering an open loan account, as an addition to its reserve for bad debts in this year. The Commissioner disallowed the claim in full. The Commissioner also included in petitioner's income for 1941, 1942, and 1943 unpaid interest due on the same open loan account in these years. On the facts, held, that petitioner is not entitled to the deduction of $ 475,000 or any part thereof as an addition to its bad debt reserve in 1941; held, further, that petitioner must accrue and include in its income for the years 1941, 1942, and 1943 the unpaid interest due on its open loan account in these years.
*780 In this proceeding petitioner seeks a redetermination of deficiencies determined by the Commissioner in its income tax for the years 1941, 1942, and 1943 in the respective amounts of $ 5,139.67, $ 7,305.83, and $ 7,313.42, and in its declared value excess profits tax for 1943 in the amount of $ 106.81, and it seeks a refund of alleged overpayments of income tax for the years 1941 and 1942 in the respective sums of $ 84,166.75 and $ 78,071.77. Of the issues included by petitioner in its petition, only three were prosecuted at the hearing and remain for our consideration. The first question is whether petitioner was entitled to deduct as an addition to its reserve for bad debts in 1941 the amount of $ 475,000 or any lesser sum to cover its open loan account with South Bay Consolidated Water Co. The second question is whether petitioner was required to accrue and report as income for the years 1941, 1942, and 1943 unpaid interest due on its open loan account with South Bay Consolidated Water Co. in the respective sums of $ 8,829.57, $ 14,249.60, *200 and $ 14,250.40. Assuming that petitioner is entitled to a deduction of $ 475,000 as an addition to its bad debt reserve in 1941, *781 the final question is whether this results in a net operating loss of $ 197,937.92 which petitioner is entitled to carry over to 1942.
Petitioner filed its returns for the years 1941, 1942, and 1943 with the collector of internal revenue for the second district of New York.
FINDINGS OF FACT.
Some of the facts were stipulated and are so found.
The petitioner is a corporation, duly organized under the laws of the State of New York on February 28, 1888, under the name of Woodhaven Water Supply Co., the name of which was changed to New York Water Service Corporation on December 21, 1926. During all years here in question petitioner kept its books and filed its income tax returns on the accrual basis and used the reserve system for bad debts. South Bay Consolidated Water Co. (hereinafter called South Bay) is a corporation duly organized under the laws of the State of New York in 1902 under the name of Quantuck Water Works Co., the name of which was changed to South Bay Consolidated Water Co. in 1925. During the years in question it reported its*201 income on the accrual basis. Both petitioner and South Bay are public utility corporations, engaged in supplying water to consumers in various areas located upon Long Island, New York.
On or about July 1, 1930, Federal Water Service Corporation acquired control of South Bay by purchasing 7,250 out of 7,500 shares of $ 100 par value common stock outstanding, for $ 1,155,360.40. The price paid was based in part upon an appraisal of the South Bay properties by the engineering firm of Stone & Webster, which valued them as of April 1, 1930, at $ 5,876,770 on the basis of reproduction cost new, less depreciation. On or about June 25, 1931, petitioner purchased the 7,250 shares of common stock of South Bay held by Federal Water Service Corporation for the same price of $ 1,155,360.40. Petitioner also on the same date bought 192 shares out of the 10,444 shares of $ 100 par value cumulative preferred stock of South Bay outstanding at a cost of $ 16,424, both of which stocks petitioner has held at all times since June 25, 1931. At the time of petitioner's stock purchases South Bay had approximately $ 3,000,000 in bonds outstanding.
By the corporate bylaws the voting power of South Bay *202 was placed in its common stock, except that the holders of the preferred had the right to elect a majority of the board of directors whenever two consecutive semiannual or four consecutive quarterly preferred dividends were passed and remained unpaid. No dividends were ever paid on the common stock of South Bay, and the last dividend on the preferred stock occurred on February 15, 1932. In 1933 the preferred stockholders exercised their right to elect a majority of the board of directors *782 of South Bay. They continued to exercise this right throughout all the years relevant to this case. Petitioner, notwithstanding it owned only a minority interest in the company's preferred stock, was able after 1932 to elect a majority of the board of directors of South Bay by solicitation of proxies.
After June 1931 petitioner and South Bay had interlocking directors and officers and formed a part of the Federal Water Service group controlled by the Federal Water Service Corporation.
On April 24, 1931, the Public Service Law of the State of New York was amended so that for the first time jurisdiction over water companies was acquired by the Public Service Commission. The year following*203 the extension of the jurisdiction of the Public Service Commission to water companies, a rate case involving charges of South Bay was begun and hearings held. On April 7, 1936, the Commission fixed the value of South Bay's properties for rate-making purposes at $ 2,991,100 1 as of December 31, 1934. The rates to be charged the company's customers were not to exceed a return of 6 per cent upon this valuation. This decision was never reviewed.
On November 15, 1939, petitioner applied for a refund of its Federal income tax payments for the year 1936 on the basis that its 7,250 shares of common stock in South Bay had become worthless in 1936. In the case of New York Water Service Corporationv. Hoey, U. S. Dist. Ct., So. Dist. N. Y., Civil 13-221, Apr. 6, 1943, the court held that such stock was not worthless in 1936.
During*204 the years from 1936-1943, though South Bay faced many financial difficulties, it remained a going concern, with no imminent threat of insolvency or receivership. Its operating revenue and expenses and its net gain or net loss in these years were as follows:
| Operating | Operating | Net gain or | |
| Year | revenue | expense | (loss) |
| 1936 | $ 462,551.71 | $ 260,803.50 | ($ 23,552.61) |
| 1937 | 474,043.11 | 262,037.64 | 946.62 |
| 1938 | 481,130.57 | 303,862.87 | (37,218.07) |
| 1939 | 510,150.11 | 323,789.01 | (29,188.74) |
| 1940 | 499,716.18 | 326,432.50 | (42,172.97) |
| 1941 | 511,351.95 | 324,094.40 | (12,999.91) |
| 1942 | 498,569.80 | 334,775.51 | (34,829.36) |
| 1943 | 511,802.66 | 344,456.25 | (30,378.97) |
The biggest factors in producing a net loss in South Bay's operations after 1937 were depreciation charges, taxes, and interest accrued on long and short term debts. During the year 1938 the company changed its general accounting procedure to conform to the Uniform System of Accounts prescribed by the Public Service Commission. The practice theretofore followed of making a charge against income *783 to provide a reserve for retirements and replacements was discontinued during 1938. In lieu thereof the company *205 adopted a 4 per cent sinking fund method of providing for accruing depreciation. The charge against income for 1938 as a result of this change was approximately $ 40,000 greater than would have been required on the old basis, and this difference continued to be approximately the same over the ensuing years through 1943. This change in accounting procedure was a large factor in the net losses sustained after 1937.
The earned surplus or deficit of South Bay during the years 1936-1943 is set forth in the table below:
| Year | Surplus | Deficit |
| 1936 | $ 163,535.68 | |
| 1937 | 165,237.06 | |
| 1938 | $ 117,921.01 | |
| 1939 | 142,001.05 | |
| 1940 | 230,416.47 | |
| 1941 | 243,516.38 | |
| 1942 | 276,777.71 | |
| 1943 | 305,719.30 |
While the aggregate of net losses in each year after 1937 contributed materially to reduce the earned surplus of South Bay by $ 407,052.06 from 1937-1941, yet $ 302,616.51 out of this sum resulted from changes in South Bay's accounting in 1938 and 1940. In 1938, to be consistent with the changed policy of providing for accruing depreciation as required by the Uniform System of Accounts, $ 250,311.55 was added to the reserve account to state the amount of accrued depreciation in conformity*206 with the 4 per cent sinking fund method of computation. This amount credited to the depreciation reserve account was charged against earned surplus. In 1940 the deficit was increased by the addition of $ 52,304.96, which constituted legal fees, etc., transferred from capital surplus, where they had been charged in 1930 and 1931.
In 1936 South Bay's bonded indebtedness stood at $ 3,157,500. At that time it had outstanding $ 2,898,000 of first and refunding mortgage 25-year 5 per cent gold bonds, series A, due May 1, 1950, secured by property and income of South Bay, subject to the prior lien of $ 236,500 face amount of first refunding mortgage 5 per cent gold bonds, due November 1, 1938, of the Great South Bay Water Co. then outstanding, and $ 23,000 face amount of first mortgage 6 per cent gold bonds, due January 1, 1938, of Port Jefferson Water Co., which latter two bond issues had been assumed by South Bay. The Port Jefferson mortgage was paid off in full by 1937. By 1941 South Bay retired a total of $ 15,500 of the first refunding mortgage 5 per cent gold bonds, the maturity date of which had been extended to November 1, 1949. Thus at the close of 1941 South Bay's bonded *207 indebtedness had been reduced to $ 3,119,000. In 1942 and 1943 South Bay retired a total of $ 12,000 of the first refunding mortgage 5 per cent gold bonds due November 1, 1949. Over the same years it also retired a total of $ 16,000 of the first and refunding mortgage 25-year 5 per *784 cent gold bonds. In all years from 1937-1943 South Bay met the interest payments due on all bonds.
The trust indenture under which South Bay's first and refunding mortgage 25-year 5 per cent gold bonds, series A, were issued provided for a sinking and an improvement fund payment to the trustee in each year in cash or by delivery in whole or in part of previously authenticated bonds for cancellation, amounting to $ 100,155 per year, being equal to 3 per cent of the largest principal amount of such bonds at any time outstanding. The sinking fund provision permitted withdrawal of such cash as might be in the fund by the substitution and pledge of expenditures for improvements to plant and property of equal value. All cash deposited in such fund, including the amount deposited for the May 1, 1941, requirement, was repaid to the company to reimburse it for like amounts of expenditures for additions*208 and betterments to plant and property. At December 31, 1941, South Bay had available unpledged expenditures for additions and betterments amounting to $ 49,265.13. South Bay met the sinking and improvement fund requirement in each year through 1941, but in its financial statement for 1941 it stated that it would probably have to default on the payments due in 1942. In 1942 and 1943 South Bay did in fact default on the sinking fund payments.
The hydrants in use and services connected by South Bay gradually expanded over the period 1936-1943, as shown in the table below:
| Year ended Dec. 31 -- | Hydrants | Services |
| in use | connected | |
| 1936 | 2,877 | 15,784 |
| 1937 | 2,942 | 16,145 |
| 1938 | 2,945 | 16,251 |
| 1939 | 2,973 | 16,562 |
| 1940 | 2,998 | 16,902 |
| 1941 | 3,008 | 17,186 |
| 1942 | 2,996 | 17,520 |
| 1943 | 3,001 | 17,637 |
For the period 1936-1943 additions and improvements to the properties of South Bay as compared to retirements of property from service stood as follows:
| Additions | ||
| Year | and improvements | Retirements |
| 1936 | $ 67,901.67 | $ 17,467.95 |
| 1937 | 91,776.94 | 22,746.26 |
| 1938 | 60,972.03 | 51,469.43 |
| 1939 | 73,084.62 | 26,653.78 |
| 1940 | 78,163.93 | 37,246.28 |
| 1941 | 64,361.97 | 23,540.34 |
| 1942 | 46,900.56 | 28,327.70 |
| 1943 | 38,670.00 | 13,181.00 |
*209 The book valuation of South Bay's properties, less reserve for depreciation, as compared to its long term debts and its current assets as compared with its current liabilities in the years 1941, 1942, and 1943, as they appeared on its financial statements, which were in turn incorporated in petitioner's financial statements, were as follows: *785
| Utility plant, | ||||
| Year | less reserve for | Long term | Current assets | Current liabilities |
| depreciation | debts | |||
| 1941 | $ 6,131,727.90 | $ 3,975,245.94 | $ 164,217.16 | $ 166,076.21 |
| 1942 | 6,107,870.46 | 3,991,173.14 | 171,583.47 | 156,179.84 |
| 1943 | 6,076,765.78 | 4,003,101.14 | 190,973.56 | 138,672.60 |
In 1941 Federal Water Service Corporation held a demand note of South Bay in the amount of $ 227,960. Interest payments on the unsecured note were subordinated to the payment of dividends on South Bay's cumulative preferred stock, and as a consequence in 1941 South Bay owed accrued and unpaid interest of $ 144,456.37 on the note. Before it could secure the approval of the Securities Exchange Commission for a proposed recapitalization, it was necessary for Federal Water Service Corporation to revalue its investments, including this demand*210 note. After the company marked down the value of its investments, including revaluation of the South Bay note at $ 1,000 as of June 30, 1941, the Securities Exchange Commission approved the recapitalization plan.
Over the period from 1936-1943, as in the past, it was necessary for South Bay to borrow money continually from petitioner in order to meet the interest payments upon its bonds. Petitioner carried these advances on its books as an open loan account and credited South Bay with repayments thereon as they were made from time to time. When the Public Service Commission fixed the value of South Bay's properties for rate-making purposes in April 1936, South Bay owed a balance of $ 475,000 on its open account with petitioner. The aggregate advances and repayments in each year from 1936-1943 are set forth below:
| Year | Advances | Repayments | Balance |
| 1936 | $ 201,200 | $ 168,200 | $ 411,000 |
| 1937 | 222,000 | 128,000 | 505,000 |
| 1938 | 185,000 | 180,000 | 510,000 |
| 1939 | 115,000 | 155,000 | 470,000 |
| 1940 | 210,000 | 170,000 | 510,000 |
| 1941 | 161,900 | 161,900 | 510,000 |
| 1942 | 120,000 | 135,000 | 495,000 |
| 1943 | 20,000 | 475,000 |
The open loan account of petitioner for South Bay bore interest at the*211 rate of 6 per cent per annum until January 1, 1941, when the interest rate was reduced to 3 per cent per annum. The interest was paid regularly by South Bay in all years prior to 1941, but it ceased to pay the reduced amount of interest after May 1941. The interest due for the remaining seven months of 1941 and in 1942 and 1943 in the respective amounts of $ 8,829.37, $ 11,249.60, and $ 14,250.40 was not paid. South Bay accrued such unpaid interest on its books as an expense and deducted it, but petitioner accrued no interest after payments ceased in May 1941 and did not report such unpaid interest as income.
*786 Over a period of many years petitioner had set up on its books a reserve for bad debts on its customers' accounts, made additions thereto annually, and deducted them on its Federal tax returns. By resolution of the board of directors dated January 27, 1939, petitioner established on its books as of December 31, 1938, a separate reserve of $ 2,000,000 against possible losses in investments in its subsidiary companies, South Bay and Western New York Water Co. Included in this figure were $ 1,171,784.40 representing the book value of its stockholdings in South Bay*212 and $ 475,000 representing the open loan account with South Bay. Its financial statement for 1938 explained the reserve by stating that little income had ever been received from these investments and no income could be anticipated for some years. No deduction was ever claimed for any part of this reserve.
By resolution of the board of directors dated February 27, 1942, petitioner restated the aforesaid investment reserve, as of December 31, 1941, at $ 1,646,784.40, to cover only its stockholdings in South Bay and its open loan account with that company.
In its 1941 Federal income tax return petitioner did not claim a deduction for any part of its investment reserve as an addition to its bad debt reserve. However, petitioner did claim as an addition to its bad debt reserve a deduction of $ 4,100, which it had added to its reserve against customers' accounts receivable. Respondent disallowed this deduction in full as an unreasonable addition to its bad debt reserve.
On or about February 15, 1945, petitioner filed a claim for refund on its 1941 Federal tax payments in the amount of $ 84,166.75, based on the deduction of the $ 475,000 in its investment reserve which covered its open*213 loan account with South Bay. It claimed the $ 475,000 deduction as an addition to its bad debt reserve.
Petitioner also filed a claim for refund on its 1942 Federal tax payments in the amount of $ 78,071.77, based upon the allowance of a net operating loss carry-over of $ 197,437.92 from 1941. The net operating loss in 1941 resulted from deducting the $ 475,000.
In the statement attached to its notice of deficiency respondent said in part:
Your contention that you are entitled to deduct as a bad debt or as an addition to a reserve for bad debt the debt of South Bay Consolidated Water Co. Inc., in the amount of $ 475,000 or some portion thereof, is disallowed under the provisions of Section 23 (k) of the Internal Revenue Code.
Your contention that you are entitled to a net operating loss carry-over of $ 197,437.92 from 1941 to the year 1942 is disallowed for the reason that you did not sustain a net operating loss for the year 1941 within the purview of Section 122 of the Revenue Code.
Under his "Explanation of Adjustments" attached to the notice of deficiency, respondent stated regarding the unpaid interest on the open loan account of petitioner:
*787 (a) It is held that interest*214 of $ 8,829.57, $ 14,249.60 and $ 14,250.40 due on the obligation of South Bay Consolidated Water Co. Inc., constitutes taxable income for the respective years 1941, 1942 and 1943.
The open account indebtedness of South Bay to petitioner was not worthless at the close of the year 1941.
There was a reasonable probability that the unpaid interest of $ 8,829.57 in 1941, $ 14,249.60 in 1942, and $ 14,250.40 in 1943 owing to petitioner on the open account indebtedness would be paid at the times the right to receive those sums arose.
OPINION.
There are two principal questions for our determination in this case. First, we must decide whether petitioner was entitled under section 23 (k) (1) of the Internal Revenue Code, 2 as amended, to deduct as a reasonable addition to its reserve for bad debts for the year 1941 the sum of $ 475,000 or any lesser amount to cover the open account indebtedness of South Bay to petitioner. Secondly, we must consider whether petitioner was required to accrue and report as income for the taxable years 1941, 1942, and 1943 unpaid interest due on its open account with South Bay in the respective sums of $ 8,829.57, $ 14,249.60, and $ 14,250.40. If it should *215 be held that petitioner is entitled to a deduction of $ 475,000 in 1941, then we must examine its contention that this results in a net operating loss of $ 197,437.92 which it is entitled to carry over to the year 1942.
What constitutes a reasonable addition to a reserve for bad debts must be decided in the light of the particular facts of each case. The burden of proof is on petitioner to show the $ 475,000 addition to its reserve in 1941 was reasonable, since allowance of the addition as a deduction for bad*216 debts is by the language of the statute left within the discretion of the Commissioner, and he has disallowed the deduction of the $ 475,000 in full. As we said in Walter H. Goodrich & Co., 40 B. T. A. 960, 961-962:
* * * Unless his [the Commissioner's] refusal to permit such a deduction is capricious or arbitrary, or otherwise an abuse of discretion, the Board should be slow to override it. Certainly it may not merely substitute its judgment for that of the Commissioner as if the statute contained no such condition and the Board were simply to decide de novo whether the claimed addition to the reserve were reasonable. * * *
*788 See C. P. Ford & Co., 28 B. T. A. 156, and Art Metal Const. Co. v. United States, 17 Fed. Supp. 854.
It is clear that where a specific account of a taxpayer becomes worthless during the taxable year, the full amount of it may be included in its addition to reserve for bad debts and deducted if the aggregate addition to the bad debt reserve is reasonable. Rhode Island Hospital Trust Co. v. Commissioner, 29 Fed. (2d) 339;*217 First National Bank of Omaha v. Commissioner, 49 Fed. (2d) 70; Abraham Sultan, 22 B. T. A. 889; Houston Chronicle Publishing Co., 3 T.C. 1233">3 T. C. 1233; William Purvin, 6 T. C. 21. Thus the question for our determination becomes whether the open account indebtedness of South Bay to petitioner was worthless in 1941.
Both parties agree that on the basis of New York Water Service Corporationv. Hoey, U. S. Dist. Ct., So. Dist. N. Y., Civil 13-221, Apr. 6, 1943, which held that petitioner's common stock in South Bay was not worthless in 1936, the open account indebtedness of South Bay to petitioner also was not worthless in 1936. But petitioner contends that circumstances after 1936 were such that there was no reasonable probability of payment in 1941. In examining the points upon which petitioner relies to prove the debt to be worthless, we are limited to facts known at the close of the year 1941; subsequent facts may be used only to evaluate the soundness of petitioner's decision that the debt was worthless in 1941 and not as evidence of the fact of worthlessness. *218 Peyton Du-Pont Securities Co. v. Commissioner, 66 Fed. (2d) 718; Farmville Oil & Fertilizer Co. v. Commissioner, 78 Fed. (2d) 83; Apex Brewing Co., 40 B. T. A. 1110; Shield Co., 2 T.C. 763">2 T. C. 763.
In support of its position petitioner lays great stress on the general financial deterioration of South Bay during the years from 1937-1941. Specifically it points out that South Bay suffered a net loss in each of these years except 1937, and that, despite the increase in operating revenue, its expenses and debts grew correspondingly. Petitioner contrasts the earned surplus of $ 163,535.68 in the financial statement of South Bay for 1936 with the deficit of $ 243,516.38 on its books in 1941, a difference of over $ 400,000. Furthermore, petitioner shows that South Bay ceased to pay interest on the balance of advances in petitioner's open account after May 1941 even at the reduced rate of 3 per cent. Petitioner contends it was known in 1941 that South Bay would be unable to meet the sinking fund payments on its first and refunding mortgage 25-year 5 per cent gold*219 bonds and that the $ 2,898,000 mortgage exceeded the value of South Bay's properties. The fact that, before the Securities Exchange Commission approved a proposed recapitalization of Federal Water Service Corporation it was necessary for the latter in June 1941 to mark down the value of a $ 227,960 demand note of *789 South Bay to $ 1,000 as a part of a general revaluation, is emphasized by petitioner as corroborating evidence that the open account indebtedness of South Bay was worthless in the same year.
While the specific points outlined above were important elements in South Bay's financial history from 1937-1941, yet when they are weighed in their true light and when factors which point to the economic soundness of South Bay during this period are also included in the evaluation of South Bay's economic position, the conclusion is inevitable that South Bay was far from insolvency or receivership at the close of 1941.
In analyzing the net losses suffered by South Bay in the period 1938-1941, we note that they were never large and in 1941 the net loss was barely over one-half the loss suffered in 1936, when petitioner admits its advances to South Bay were not worthless. South*220 Bay's operating revenue, always large, showed a steady rise except in 1940, and was always substantially in excess of operating expenses, but depreciation, taxes, and interest accrued on long and short term obligations kept South Bay from showing a profit in these years. One big factor in causing the net losses after 1937 resulted from a change in the accounting system employed by South Bay in 1938 in conformity with the Uniform System of Accounts prescribed by the Public Service Commission of New York. As a result of this change the charge against income for depreciation in 1938 was approximately $ 40,000 greater than would have been required on the old basis, and this difference continued in substantially the same amount during the ensuing years. Such a circumstance does not affect the possible future earning capacity of South Bay. We conclude therefore that in no year were the net losses so severe as to support the view that South Bay was in any immediate financial danger, and that the continued margin of operating revenue over operating expense gave hope in 1941 of eventual financial recovery.
Petitioner emphasized the change from South Bay's earned surplus of $ 163,535.68*221 in 1936 to a deficit of $ 243,516.38 in 1941. While the aggregate of net losses in the years 1938-1941 accounted for a sizeable portion of this decrease in the surplus account, yet $ 302,616.51 out of the $ 407,052.06 total amount of decrease arose from changes in South Bay's accounting, as outlined in the findings of fact, and is not indicative of the future earning capacity of South Bay.
Petitioner stresses that South Bay ceased to pay interest on the open account advances from petitioner after May 1941 even at the reduced rate of 3 per cent. This fact is at least in part offset by the absence of any evidence that petitioner attempted to enforce collection of the interest in any manner, by the fact that repayments by South Bay in 1941 on the principal of petitioner's advances far exceeded the *790 amount of interest due, and by an unbroken record of interest payments on this obligation through May 1941.
The financial statement of South Bay for 1941 does state, as alleged by petitioner, that it probably would be unable to meet the sinking fund payment of $ 100,155 in cash or by delivery of canceled bonds in 1942, as required under the trust indenture for the first and refunding*222 mortgage 25-year 5 per cent gold bonds. While this is a sign of possible future financial weakness in South Bay, yet up to the close of 1941 South Bay had met the sinking fund payments regularly in every year. It is noteworthy that there is no suggestion in the South Bay financial statement for 1941 that it would not pay interest on these bonds in the future as it had in the past.
Petitioner raises the question of the proper valuation of South Bay's properties by asserting that at the close of 1941 the market value of the company's plant and property was exceeded by the $ 2,898,000 first and refunding mortgage 25-year 5 per cent gold bonds. Petitioner has failed to convince us that the properties of South Bay at the end of 1941 were insufficient to pay off the secured creditors and still cover the unsecured creditors, such as petitioner.
Petitioner has consistently contended that the South Bay properties were worth only $ 2,991,100 in 1934 as valued by the Public Service Commission of New York for rate-making purposes and that they have deteriorated since that time. We can not agree that this figure represents a correct valuation of the company's property for the purpose of determining*223 whether an unsecured creditor can collect on its debt. As the Supreme Court said in Group of Institutional Investors v. Chicago, Milwaukee, St. Paul & Pacific Railroad Co., 318 U.S. 523">318 U.S. 523, 540:
* * * Mr. Justice Brandeis once stated that "value is a word of many meanings." See Southwestern Bell Telephone Co. v. Public Service Comm'n., 262 U.S. 276">262 U.S. 276, 310, concurring opinion. It gathers its meaning in a particular situation from the purpose for which a valuation is being made. Thus the question in a valuation for a rate making is how much a utility will be allowed to earn. The basic question in a valuation for reorganization purposes is how much the enterprise in all probability can earn. * * *
For the purpose of determining the collectibility of unsecured debts, we too are concerned with future earning capacity and will not be guided by a valuation for the purpose of fixing rates.
The $ 2,991,100 valuation of the Public Service Commission espoused by petitioner was never reviewed and is inconsistent with every other valuation in the record. Considering the price petitioner paid for its stockholdings in South*224 Bay and the long term indebtedness of South Bay at the time of the purchase, petitioner itself valued the company at well over $ 4,000,000. Also, in contrast to the value of South Bay properties found by the Public Service Commission of New York is *791 the valuation of $ 5,876,770 made by the engineering firm of Stone & Webster in 1930. Finally, we note that the South Bay financial statement of 1941 which valued the utility plant, less reserve for depreciation, at $ 6,131,727.90 was incorporated in the financial statement of petitioner for the same year. The close affiliation between Federal Water Service Corporation, petitioner, and South Bay, with interlocking officers and directors, indicated an integrated group of utility companies. As between them the control and franchise of South Bay may well have had a potential value not reflected in a public market and account for this valuation. This sum exceeded the long term liabilities of South Bay at the close of 1941 by $ 2,156,481.96 and current liabilities exceeded current assets by only $ 1,859.05 in this year. Suffice it to say petitioner has not established to our satisfaction that South Bay's properties were not adequate*225 to cover the company's open account indebtedness to petitioner.
Petitioner stresses the fact a $ 227,960 demand note of South Bay was revalued by Federal Water Service Corporation at $ 1,000 in June 1941 as a part of a general mark down of its investments before the Securities Exchange Commission would approve its recapitalization. Due to the fact that the evidence does not contain any record of the Securities Exchange Commission proceedings, this fact loses its significance as corroborating evidence of the financial weakness of South Bay in 1941. Assuming that Securities Exchange Commission required a revaluation of this particular asset, we are not told the reasons therefor and are thus unable to judge their soundness. One possible explanation is the fact that interest payments on the note were subordinated to the payment of dividends on South Bay cumulative preferred stock. As a consequence, South Bay owed accrued and unpaid interest of $ 144,456.37. In the absence of any supporting evidence, we are not able to attach significance to this portion of petitioner's argument.
Other factors which were present at the close of 1941 point to the future financial soundness of South*226 Bay. Since payments of interest on corporate indebtednesses played such a big part in the company's yearly net losses, it is significant that during the years 1937-1941 the total of South Bay's fixed debt was reduced from $ 3,157,500 to $ 3,119,000. As evidence of the moderate expansion of South Bay's facilities during the 5-year period, the number of hydrants in use rose steadily from 2,877 in 1936 to 3,008 in 1941 and the number of services connected increased from 15,784 to 17,186 over the same years. As an indication of the way the properties of the company were maintained during this period, we find that the amounts expended on additions and improvements were over $ 60,000 each year and always far exceeded the value of property retired from service. At December 31, 1941, South Bay had available unpledged expenditures for additions and improvements in the amount of $ 49,265.13.
*792 A significant sign of South Bay's financial soundness during the years in question is the fact that there is no evidence petitioner took any step to reorganize its debtor's capital structure despite the adversities suffered. Petitioner answers that such a step was not taken because to have*227 demanded it would have resulted in participation only by the secured creditors to the exclusion of its unsecured claim. Whether this is true or not depends on the valuation placed on the company's properties. Valuation of South Bay's assets for purposes of recapitalization depends on its prospective earnings, Consolidated Rock Products Co. v. Du Bois, 312 U.S. 510">312 U.S. 510, 525, and petitioner has not shown that in 1941 South Bay's prospective earnings were such as to prevent participation in a reorganization by petitioner.
Thus we conclude that at the close of 1941 South Bay was still very much of a going concern, with expanding facilities, increasing operating revenue, and reduced funded indebtedness. While South Bay's prospects were not bright at the close of 1941 unless the company's affairs were readjusted and there was some unforseen change in the development of localities served by the company, yet it was in no imminent financial danger at this time.
Turning from the general financial condition of South Bay during the years 1937-1941, we find significant indications that petitioner's advances to South Bay were not worthless from the manner in which*228 the open account was treated by both debtor and creditor. Repayments on the loans totaling $ 795,100 after 1936 is impressive evidence of the collectibility of the advances. It is notable that $ 161,900 of this total was repaid in 1941, the year petitioner says the account was worthless. Surely this is not the sign of a worthless debt.
Another emphatic indication that petitioner's advances were not worthless in 1941 is the fact that petitioner continued to loan money on the open account during the years 1937-1941 in the total amount of $ 894,100, of which $ 161,900 was advanced in 1941. Where a creditor voluntarily advances further large sums to a debtor as petitioner did, it can hardly assert the worthlessness of the account on which the new advances were made. See Jones v. Commissioner, 38 Fed. (2d) 550; Squier v. Commissioner, 68 Fed. (2d) 25; Harris v. Commissioner, 140 Fed. (2d) 809; Powers Mfg. Co. v. Commissioner, 34 Fed. (2d) 255.
Furthermore, there is no evidence that petitioner made any effort to collect from South Bay the balance*229 of the open account in any year after 1936. Nor is there proper proof that such an effort would have been futile, that a suit for the amount of this balance in 1941 would have yielded only a nominal amount after the secured creditors had been paid off. Mere nonpayment does not prove worthlessness of a debt. It must be remembered that petitioner was in control of the board of directors of South Bay and in a position to control the *793 amount of the repayments as well as the amount of the advances. The answer may have been that it was to petitioner's ultimate advantage to safeguard the financial stability of the debtor by not demanding prompt repayment of the advances, especially in view of the fact that it was receiving 6 per cent interest on them until January 1, 1941, but such a ground for failing to demand payment would not be a valid reason for claiming the debt was uncollectible.
The explanation in the financial statement of petitioner for 1938 for setting up the $ 2,000,000 reserve for stockholdings and advances to South Bay and investments in Western New York Water Co. does not indicate in any way that the open loan account was worthless. It merely states that little*230 income had been received in the past and no income from these investments could be looked for in the nearby future. This is a far cry from saying there was no hope of recovery. No further explanation for retaining a reserve for the South Bay investments was given in petitioner's financial statement when the investment reserve was reduced as of December 31, 1941. We note also there is no evidence that the open account indebtedness was charged off against the $ 475,000 investment reserve set up for it either in 1941 or subsequently, indicating the error of petitioner's contention.
Finally, perhaps the most significant point concerning petitioner's treatment of its open loan account with South Bay is the fact that, while petitioner set up the reserve for it in 1938, it waited until 1945 to attempt to deduct it as a reasonable addition to the bad debt reserve in a claim for overpayment of taxes for 1941. No satisfactory explanation is given for not claiming this as a reasonable addition at the time petitioner's 1941 tax return was filed. Certainly if the chance for such a large tax deduction existed in 1941, we can not consider mere inadvertence as a sufficient explanation for not*231 taking advantage of it.
We conclude that, even if at the close of 1941 there were some indications pointing to the possible eventual uncollectibility of petitioner's advances to South Bay, yet in 1941 the open loan account indebtedness was not worthless. See Walter H. Goodrich, supra. Mere doubtfulness did not make the debt worthless, while reasonable probability of collection remained. We therefore uphold respondent's disallowance of the full amount of $ 475,000 as an unreasonable addition to petitioner's reserve for bad debts in 1941.
Turning to the second question in this case, we must determine whether petitioner should have accrued and reported as income the unpaid interest due on its open account advances to South Bay in 1941, 1942, and 1943.
It is well settled that, before there is an obligation on a taxpayer to accrue and report unpaid interest on an obligation, there must be a reasonable probability of payment at the time the right to receive *794 it arises. Corn Exchange Bank v. United States, 37 Fed. (2d) 34; Atlantic Coast Line Railroad Co., 31 B. T. A. 730; Bettendorf Co., 34 B. T. A. 72;*232 and American Central Utilities Co., 36 B. T. A. 688. This doctrine is well stated in Atlantic Coast Line Railroad Co., supra, where we said:
* * * If the facts indicate that there was a reasonable expectancy of receipt of the interest involved or that the petitioner would probably be able to collect such interest, then the full amount should have been accrued on its books and reported as taxable income, notwithstanding the obligation afterwards became uncollectible or worthless, and even though this occurred within the same taxable year. On the other hand, if the facts show that there was a reasonable doubt as to the ability of the Steamship Co. to pay the interest, or if it was reasonably certain for any reason that the interest would never be received, petitioner was justified in reporting only such amounts as were actually paid by the Steamship Co. and received by it in each year.
Thus we must determine in the instant case whether in 1941, 1942, and 1943 there was a reasonable probability of payment of the interest owing on the open account by South Bay. To determine this matter we may examine all relevant circumstances*233 which existed before the close of the year 1943.
In support of its contention that there was no reasonable probability of collecting the interest, petitioner sets forth some of the same points made under the first issue regarding the general financial deterioration of South Bay, merely carrying them down to the close of 1943; that is, that South Bay operated at a loss in every year but 1937, that its deficit continued to grow year by year, that the fixed indebtedness of South Bay exceeded the value of its properties, that South Bay defaulted on its payments under the trust indenture for first and refunding mortgage 5 per cent gold bonds in 1942 and 1943, and that the principal amount of its indebtedness to petitioner on the open loan account was worthless.
We evaluated these points in detail in deciding the first issue, and feel that further discussion of them is not justified by any radical changes in 1942 and 1943. It is true that evidences of South Bay's financial unsoundness continued in 1942 and 1943, but at the close of 1943 the company was still very much of a going concern, its operating revenue remained large, its funded indebtedness was being reduced and interest payments*234 thereon continued, and such additions and betterments as were procurable during the war were being made to maintain the plant in proper running order. There was no hint of impending insolvency or a reorganization. We conclude that at the close of 1943, though South Bay's financial future was still subject to doubt, it was in no such straits as would support the conclusion that there was no reasonable probability that the interest due in 1941, 1942, and 1943 would be paid.
Turning from the general economic condition of South Bay during *795 the years 1941-1943 to circumstances directly connected with the interest payments on the open loan account of petitioner, we find it significant that there is no long history of default on the interest due. Nor is the amount of unpaid interest so large as to discourage hope of future payment. While petitioner had the right to apply the repayments of South Bay to the principal of its advances rather than to interest, yet the very fact that the repayments were far in excess of the interest owing in each of the years 1941, 1942, and 1943 greatly weakens petitioner's contention that the interest due in this period was uncollectible. See Bettendorf Co., supra.*235 In view of the close relationship between creditor and debtor, the fact that South Bay accrued the interest as an expense and deducted it, while not controlling on petitioner, is still a highly significant indication that petitioner ought to have accrued it and reported it as income. See Bettendorf Co., supra.Despite its control over South Bay, we note there is no evidence in the record that petitioner ever attempted in any manner to enforce collection of the overdue interest. We are not satisfied that to have instituted suit for the interest would have served no purpose on the ground that petitioner as an unsecured creditor would receive only a nominal sum. We may not assume that interest is uncollectible simply because there has been no effort to collect it.
We conclude petitioner has failed to sustain its burden of proof that in the years 1941, 1942, and 1943, when interest on the open account indebtedness of South Bay became due, there was no reasonable probability it would be paid. We therefore uphold respondent's determination that petitioner must accrue and report as income the respective amounts of interest which it was entitled to receive*236 in each of those years. If such interest subsequently becomes uncollectible, petitioner has its remedy in claiming a deduction therefor.
Based upon our earlier determination that petitioner was not entitled to a deduction of $ 475,000 in 1941, we hold petitioner had no net operating loss in 1941 to be carried forward to 1942.
Decision will be entered for respondent.
Footnotes
1. There is a discrepancy between this valuation as given in the financial statements of South Bay and in the stipulation of facts; we have adopted the figure in the stipulation of facts.↩
2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(k) Bad Debts. --
(1) General rule. -- Debts which become worthless within the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts; * * *
[By virtue of section 124 (d) of the Revenue Act of 1942 and section 113 (b) of the Revenue Act of 1943, the above portion of section 23 (k) (1)↩ was effective for taxable years beginning after December 31, 1938.]