*998 A lease of land, together with water privileged, ran for a term of 15 years with a right of renewal by the lessee indefinitely for consecutive terms of 15 years, subject to the right of the lessor to demand an increased rent at each renewal and an obligation, upon termination, to pay the lessee for improvements. The lease was renewed in 1908 for 15 years and the petitioner, who had acquired it in 1910, again renewed it in 1923 for another 15 years. In 1928 the lease was canceled and the petitioner received payments for cancellation of the lease and for the value of the improvements. Held, that the property or property rights surrendered by petitioner in consideration of the amount paid for cancellation of the lease were not in existence on March 1, 1913, but were acquired at the time of renewal in 1928, and that, since the renewal admittedly cost the petitioner nothing, there is no cost basis to be applied against the payment in determining the taxable gain; and that this conclusion renders it unnecessary to consider evidence of the March 1, 1913, value of the petitioner's rights under the renewal in effect on that date.
*109 The Commissioner determined a deficiency of $5,635.07 in the petitioner's income tax for the year 1928. The error assigned by the petitioner is that the Commissioner determined the value of a leasehold and water rights as of March 1, 1913, to be $15,000, whereas the actual value was much greater. The Commissioner claims an increased deficiency on the ground that he erred in allowing any amount to be used as a March 1, 1913, value in the reduction of the amount received by the petitioner in 1928 from the sale of its water rights. He seeks to include in taxable income the entire amount ($58,000) received by the petitioner for the water rights.
FINDINGS OF FACT.
On December 4, 1865, the trustees of the town of Manchester (later a part of the city of Richmond, Virginia), leased certain land and water rights to a partnership doing business as the Manchester Paper Mill Co. The land was a strip of the town common, 125 feet wide, extending from the James River to a street bordering a canal, which belonged to the town. The lease ran from October 1, 1863, for 15 years at an annual rental of $1,200. *1000 The lessee agreed to pay all public taxes on the leased premises, to keep up a bridge over the canal, to set up a pump and pump water for the town reservoir, and not to underlet. The lease provided in part as follows:
The said parties of the second part [the partner], having by virtue of an agreement made in contemplation of this lease, erected on the land hereby demised, buildings, machinery and fixtures suitable for the manufacture of paper, the said machinery being so constructed as to be propelled by the water power hereinafter mentioned, the said parties of the first part covenant to supply the said parties of the second part with three hundred square inches of water, appurtenant to and to be used on the land hereby demised, to be drawn from the aforesaid canal at a pressure of three feet above the centre of the aperture through which the water is taken, or a quantity equivalent thereto, under a greater or less head, according to the principles of hydraulics. It is understood that the water power hereby demised, embraces a head and fall together of eighteen feet (18) six (6) inches, and it is agreed that any increased power in head or fall which the parties of the first*1001 part may hereafter secure and furnish by any alteration or improvement of their works, shall demand a corresponding diminution of the size of the aperture, upon the principles of hydraulics, as to give a power only equivalent to that hereinbefore contracted for.
The lease provided also that it should be renewed at the end of each 15-year period for a like term, but at each renewal period "the said Trustees may fix upon and demand an increased rate of rent, which the lessees shall pay, or otherwise surrender the lease and improvements to said Trustees, who shall pay the actual valuation *110 for the improvements erected by the parties of the second part in pursuance of this lease, and at the time existing, no regard being had in making such valuation to the advantages of the site or to the privileges and appurtenances thereto belonging." An additional quantity of 25 square feet of water was allowed the partners for operating the pump for the town reservoir.
The Manchester Paper Twine Co. later succeeded to the rights of the original lessee. The property of the latter was sold, pursuant to court orders, at public sale for $25,000, the highest bid, and was thus acquired*1002 by the petitioner, which had just been incorporated under the laws of the State of Virginia. A special commissioner of the court made the deed to the petitioner. It was dated March 31, 1910. The petitioner has since been engaged in the manufacture of paper products at Richmond, virginia. This deed conveyed to the petitioner "the said paper manufacturing plant of the said Manchester Paper Twine Company in the City of Manchester in the state of Virginia, that is to say, that certain lease, dated December 4, 1865, for the term of fifteen years beginning on the 1st day of October 1863, with the right of renewal at the end of each term perpetually except as therein provided * * *; said lease, to which special reference is here made for an accurate description of the premises so demised and the terms covenants and conditions thereof, having by successive assignments become the property of the said Manchester Paper Twine Company; * * * and all the water rights of every kind and nature by said lease granted or demised; and all the right title and interest of the said Manchester Paper Twine Company any and the other parties to the said suit * * * under said lease or otherwise, in and to*1003 that certain brick and stone paper mill building erected on said leased premises, * * * together with the machinery and fixtures at present contained in said mill building * * *."
The Virginia Railway and Power Co., in the meanwhile, had succeeded to all of the rights and obligations of the original lessor. On April 2, 1910, the petitioner and this power company entered into an agreement in which the lessor recognized the petitioner as lessee and agreed to a renewal of the original lease from October 1, 1908, to October 1, 1923, without change in terms.
In 1923 the lessor notified the lessee that it would demand an annual rental of $4,000 and if the lessee did not accept it would take over the property at the appraised value in accordance with the terms of the lease. The lessee agreed to pay the $4,000 rental and a renewal agreement was entered into under date of October 1, 1923, for a term of 15 years, with no other change. Thereafter, the petitioner and the lessor became involved in litigation concerning the interpretation of the lease on the amount of water involved. Their differences were settled by arbitration. The lease was canceled and *111 the petitioner received*1004 $58,000 on account of the cancellation. The settlement was made as of June 15, 1924, when the differences arose. The board of arbitration, in its findings dated October 17, 1927, stated, inter alia, that the settlement of the contract should "be on a basis of a perpetual rather than a 15 year lease; that a fair compensation for the cancellation of the lease is a payment by the Power Company to the Paper Company of the sum of Seventy Thousand Dollars ($70,000) of which Twelve Thousand Dollars ($12,000) is determined to be the value of the hydro plant of the Paper Company and which shall become the property of the Power Company * * *." Interest was also allowed.
The petitioner received the $58,000 in 1928. The Commissioner, in determining the deficiency, held that $48,000 of this amount was taxable income. He deducted $10,000 as the March 1, 1913, value of the water rights.
The petitioner used other power beside water power in its plant.
OPINION.
MURDOCK: The question in this case is to determine whether all, some part, or none of the $58,000 received by the petitioner in 1928 for the cancellation of its lease, was gain or profit and properly a part of gross income*1005 subject to tax. The Commissioner claims that the entire amount was gain, since there was no basis to be subtracted from the amount received. The petitioner contends that it is entitled to deduct from the proceeds as a basis the March 1, 1913, value of its rights under the renewal of the lease then in effect. There was opinion evidence of value on March 1, 1913, introduced by both parties and we know of the sale in 1910. But we agree with the respondent that that evidence is immaterial in the decision of the case. Consequently, we have made no finding of fact on the question of value.
Section 111 of the Revenue Act of 1928 provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis provided in section 113, and the loss shall be the excess of such basis over the amount realized. The parties agree that this section applies. Section 113 provides that the basis for determining gain or loss from the sale or other disposition of property acquired after February 28, 1913, shall be the cost of such property. It also provides that the basis for property acquired before March 1, 1913, shall be the cost, or*1006 fair market value of such property as of March 1, 1913, whichever is greater. The petitioner does not contend that the property for which it received $58,000 had any cost at any time. It argues only for the use of the March 1, 1913, value as a basis. Thus it becomes *112 important to determine whether the property disposed of was acquired before or after March 1, 1913.
The petitioner contends that the lease had a value to it on March 1, 1913, over and above the amount of the annual rental which it was required to pay. We will assume that this was true. It is also true that the lessor could never refuse to renew the lease. However, the evidence does not show the separate value of the renewal privilege nor of the right in the lessee to require the lessor to take and pay for its plant in case a renewal failed because of a demand for an increase in rent. , certiorari denied, . We do not know that these privileges had any value. They gave the lessee no undue advantage over the lessor in dealing for a renewal at an increased rental. They merely tended to prevent a demand for*1007 an excessive rental, not to restrict the lessor to less than a fair rental. Furthermore, the plant value was apparently not great enough to make this provision a very heavy restraint upon the lessor.
We do not agree with the petitioner that the award of the board of arbitration indicates value in the lease as of any other date. In our opinion the value of the lease to the lessee fluctuated, depending upon changing economic conditions and the unexpired portion of the current 15-year period. At times the lease may have been more favorable to the lessor than to the lessee. We are not bound by all of the findings of the board of arbitration, which, we are told by counsel for the petitioner, consisted of three engineers. We do not know what evidence was before that board, what prompted it to find as it did, nor what was the meaning, purpose, or effect of some of its findings. We have been told of the lease and the various renewals and must reach our own conclusions as to the effect of these agreements.
The March 1, 1913, value was due principally, if not entirely, to the then excess of present worth of the annual benefits to the lessee over the amount which it had to pay to*1008 the lessor. This value resulted from then existing economic conditions which made the rental, as fixed by the renewal agreement then in effect, favorable to the lessee. The value on March 1, 1913, which was due to these causes would have completely disappeared by October 1, 1923, the end of the period covered by the renewal agreement in effect on March 1, 1913, and would have been returned tax-free through annual deductions for exhaustion of the leasehold. Cf. ; 353 ; sec. 111(b)(2), Revenue Act of 1928. When the period of 15 years covered by the current renewal agreement had expired, the parties would either let the lease lapse or deal for a new lease. The lessor would be expected to demand what its property was worth as a *113 rental for the next period. Neither the original lease nor the renewal agreement which had just expired would have any noney value to either party at that time, so far as this record shows. Any valuable rights or property which the lessee had in the leased premises after October 1, 1923, did not carry over from the prior agreements. *1009 If the lessee had refused to renew on October 1, 1923, because of the lessor's demand for an increase in rent, there would have been a settlement under the agreement then in effect. The lessee would have received nothing for its lease and only the fair value of its plant. But there was a new agreement entered into on that date and the prior agreements became ineffective. This new agreement adopted most of the provisions of the original lease, but it was nevertheless a completely new contract resulting from arm's length dealing between the parties. The lessor was not under compulsion to lease for any less than a fair rental. If, as the settlement in 1928 may indicate, the petitioner, as lessee, had valuable property rights under the lease after October 1, 1923, that value was an incident of the renewal agreement. It must have been primarily due to an excess of value in the annual privileges of the lessee over the annual rental of $4,000. The value depended upon economic conditions existing at the time as of which it was determined. The value and the rights were also dependent upon and secured to the petitioner by the renewal agreement of October 1, 1923. They could not have*1010 been anticipated nor could they have antedated that agreement. We have not been shown that anything which was disposed of by the petitioner in 1928 for the $58,000 was in existence or valuable on March 1, 1913. The renewal cost the petitioner nothing. The $58,000 was clear gain. The petitioner's property under the renewal agreement had a basis of zero for gain or loss upon sale or disposition.
Decision will be entered under Rule 50.