*1090 In refinancing operations the petitioner delivered its first mortgage bonds of the face value of $1,000,000, together with its common stock of the par value of $250,000, to a brokerage concern and received $1,000,000 in cash. The brokerage concern charged a commission of 2 1/2 percent for its services, which was paid by the petitioner by issuing to the brokerage concern $25,000 par value of second mortgage bonds and $5,000 par value of stock. As a part of such operations it also sold its second mortgage bonds of the face value of $698,850, together with its common stock in 20 percent of such amount to its stockholders, and received therefor $698,850 in cash. The discount at which the first mortgage bonds and the second mortgage bonds were sold is determined. Held, that the commission paid the brokerage concern and the discount at which the first mortgage bonds were sold is amortizable over the life of those bonds and the discount on the issuance of the second mortgage bonds is amortizable over the life of those bonds.
*451 *1091 The respondent has determined deficiencies in income tax for the years 1927 and 1928 in the respective amounts of $16,290.36 and $335.58. The petitioner alleges as errors:
(a) Disallowance of net loss of 1926 brought forward to 1927, (1) by disallowance as a loss in 1926 that year's proportion of bond expenses, and (2) failure to allow sufficient depreciation for 1926 on physical properties; and (3) failure to apply provisions of Section 240(f) of the Revenue Act of 1926.
(b) Disallowance of bond expenses for the two taxable years -
| 1927 | $68,803.33 |
| 1928 | 50,970.00 |
FINDINGS OF FACT.
The petitioner is a Virginia corporation engaged in the business of manufacturing wood pulp and other related products, with its principal office and plants located at Hopewell, Virginia. It was organized in 1920, with an authorized capital stock of $5,000,000, of which $3,000,000 was common and $2,000,000 7 percent cumulative preferred. There was issued and outstanding on December 21, 1923, $1,770,600 par value common stock and $728,100 par value preferred stock, all of which had been subscribed and paid for in cash at par.
The petitioner began the construction of its pulp*1092 mill in 1921 and completed it in 1922. In 1923 it began the construction of a paper mill and beaver board mill which were completed in the latter part of 1923.
*452 The petitioner had a subsidiary company, the Hopewell Chemical Co., organized in 1920, which was the owner of a deposit of niter cake containing sulphate of soda, an essential chemical in the manufacture of wood pulp. During the period 1925 to 1928 practically all of the subsidiary's sales of niter cake were made to the petitioner.
In financing the construction of the paper mill and board mill the petitioner, in 1922, issued $1,000,000 par value of 7 percent three-year mortgage bonds, which matured September 1, 1925. The issue was underwritten by the First Wisconsin Co. of Milwaukee in conjunction with two other finance companies, of Richmond, Virginia.
During the last four months of 1924 and after the paper and board mills had gone into production the petitioner began to earn profits. It continued to earn substantial profits during 1925 except for one month during which a part of the plant was shut down.
On December 31, 1924, the petitioner was in a prosperous condition, but it had an aggregate current*1093 indebtedness of approximately $1,094,000, together with its $1,000,000 bond issue which was maturing in September 1925.
At an annual directors' meeting held in February 1925 a resolution was passed authorizing the petitioner's officers to take immediate steps towards refinancing the outstanding bond indebtedness. The resolution called for the valuntary surrender by the stockholders of 30 percent of the petitioner's common and all of its outstanding preferred stock. This was done some time during February 1925, as of December 31, 1924. The outstanding capital stock of the company at that time was $2,445,700. Thirty percent of that amount, or stock of the par value of $733,710, was surrendered to the petitioner. Of that amount, $111,697.79 was applied against an operating deficit of like amount, and $134,945 was used to pay the accumulated dividends on the preferred stock to January 1, 1925. This left a balance of $487,067.21, which was carried to surplus. During the period from January 1 to September 1, 1925, the petitioner had net earnings in the amount of $127,705.33, so that its surplus and undistributed earnings on September 1, 1925, amounted to $614,772.54. The book*1094 value of its stock on that date was $133.28 per share.
In furtherance of the petitioner's plans to refinance its bonded indebtedness, investment bankers in Richmond, New York, and Chicago were approached, but they were unwilling to handle the matter because of the petitioner's comparatively short record of earnings. Finally the First Wisconsin Co. of Milwaukee, which had assisted in underwriting the outstanding issue of bonds, agreed to underwrite the new $1,000,000 issue upon condition that the petitioner would furnish $250,000 par value of common stock to be sold as a bonus with the $1,000,000 par value of bonds, and that the stockholders *453 would raise sufficient funds for liquidating the petitioner's floating indebtedness by subscribing for $698,850 par value of second mortgage 10-year 8 percent bonds. The second mortgage bonds were to carry a bonus of 20 percent of their par value in common stock. In furtherance of this agreement the petitioner issued second mortgage bonds of a par value of $723,850, with a bonus of 20 percent of their par value in petitioner's common stock. The petitioner's stockholders subscribed for and paid cash in the amount of $698,850 and*1095 the remaining $25,000, plus $5,000 par value of common stock, was paid to the First Wisconsin Co. as its commission of 2 1/2 percent for underwriting the $1,000,000 bond issue. For the $1,000,000 face value of first mortgage 5-year 7 percent bonds and the $250,000 par value of stock, the petitioner received $1,000,000 cash, $900,000 of which represents the portion of the cash allocable to the bonds and $100,000 the amount allocable to the stock. The petitioner paid the First Wisconsin Co. a fee in the form of $25,000 second mortgage bonds and $5,000 par value of stock, which had a cash equivalent of $25,000.
For the $698,850 10-year 8 percent second mortgage bonds and $139,770 par value of stock sold to its stockholders, the petitioner received $698,850 cash, $642,942 of which represents the portion of the cash allocable to the bonds and $55,908, the portion allocable to the stock.
On September 1, 1925, and after the issuance of the bonus stock sold with its first and second bond issues, the book value of the common stock here involved was $111.35 per share. The petitioner's business was prosperous, its financial situation was strong, and its net earnings for the year up to*1096 that time amounted to $127,705.33. Its buildings and equipment were all constructed or purchased new after its incorporation, were in good condition, and at such date their depreciated cost was $3,465,499.36. The only write-up on petitioner's books was an increase in book value of a deposit of niter cake, which had $2cost per ton to $4 per ton, to reflect the market increase in the price thereof. This represented appreciation in the amount of $293,006.35. Petitioner's stock was not listed on any securities market and, except for $250,000 par value sold with the 5-year bond issue, was closely held and no sales thereof sufficient to establish market value were made at or near September 1, 1925. Some time in the early part of 1926 petitioner's president offered $100 a share for 1,000 shares of the stock and found that none were procurable for less than $125 per share. On September 8, 1926, he bought 250 shares for cash at $98 per share.
Following the rehabilitation of its financial situation and the reduction of its stock liabilities, the petitioner retired its first mortgage *454 bonds in 1926, 1927, and 1928, in the respective amounts of $300,000, $145,000, and $105,000. *1097 At the end of 1928, which is the last taxable year under review, none of the second mortgage bonds had been retired.
In its income tax returns for 1926, 1927, and 1928, respectively, petitioner deducted from its gross income the several amounts of $105,000, $54,333.33, and $36,500, representing amortization of the costs of its two bond issues, which it claimed was $144,700 for its 10-year second mortgage and $250,000 for its 5-year first mortgage any allocation of receipts from the sale of the two different types each bond issue had been sold at par for cash, disallowed all the deductions of all amounts claimed as amortization, made other adjustments, and determined no deficiency for 1926 and deficiencies for 1927 and 1928 as above set out.
In its income tax return for 1927 the petitioner claimed a net loss carried forward from 1926 in the amount of $97,208.11, which, upon audit of the return, was disallowed by the respondent, who based his determination largely on his disallowance of any deduction representing amortization of cost of the petitioner's two bond issues made in 1925. At the hearing counsel for respondent conceded that petitioner's deductible allowance for depreciation*1098 should be increased in the amount of $38,859.54 for 1926, and agreed that finding of the Board that petitioner was entitled to ratable annual deductions representing amortization of the cost of the bond issues would require the application of the proper amount thereof in the computation of net loss for 1926.
The petitioner kept its books of account and made its tax returns upon the accrual basis.
OPINION.
SMITH: In this proceeding only the deficiencies for 1927 and 1928 are before us, but the true tax liability for 1927 depends upon the amount of a statutory net loss sustained in 1926, which the petitioner is entitled to carry forward in the computation of its taxable income for 1927. Accordingly, it is necessary to pass upon cartain deductions from petitioner's income in 1926, which have been disallowed by the respondent. As authorized by section 274(g) of the Revenue Act of 1926, 1 we therefore determine the ratable annual deductions representing amortization of the discount on the bond issues to which the petitioner was entitled in that year, as a condition precedent to redetermination of the deficiency for 1927.
*1099 *455 The petitioner contends that the value of its common stock delivered to the First Wisconsin Co. and to its shareholders in connection with its refinancing operations should be regarded as the cost of selling its first and second mortgage bond issues, and seeks to deduct such alleged costs ratably over the terms of the respective issues. The respondent has based his determination on his finding that in each instance the bonds were sold at par for cash. In his brief he argues that even if it is not true, each transaction was a mixed sale of bonds and stock and there is no evidence of record upon which any allocation of receipts from the sale of the two different types of securities can be made.
The law is well established that a corporation which keeps its books of account and makes its income tax returns on the accrual basis is entitled to deduct from the gross income of each year a pro rata part of the expenses incurred and discount allowed upon the sale of bonds. ; *1100 ; ; ; .
The real question before us is the amount of the discount at which the petitioner's first mortgage bonds were sold in 1925. The respondent, on the one hand, contends that they were not sold at a discount, but were sold at par, and that the shares of stock of the petitioner were issued without any cash consideration. The petitioner, on the other hand, contends that the fair market value of the shares of its capital stock on September 1, 1925, was $100 per share and that therefore the discount at which the $1,000,000 5-year 7 percent first mortgage bonds were sold was $250,000 and the discount at which the $698,850 second mortgage bonds were sold was $139,770. Substantially all of the evidence submitted by the petitioner is directed to the fair market value of its shares on September 1, 1925. No evidence was submitted with respect to the amount of cash realized by the petitioner from the sale of its bonds alone.
The contention of the respondent*1101 that the bonds were sold at par cannot be sustained. The evidence conclusively shows that the petitioner was unsuccessful in its efforts to sell its bonds at par. The First Wisconsin Co. was willing to underwrite the issue only upon condition that the petitioner rid itself of its floating indebtedness and issue to it certain shares of stock which it could sell to its customers in connection with the sale of the bonds.
In this connection the president of the First Wisconsin Co. testified:
The common stock that we received of the corporation [petitioner] we sold in units to the bondholders, and six or eight months later we were able to sell *456 some of the bonds, the tail end of the issue, without the stock. It was not a part of our plan, but it happened that eight months later we were able to sell the bonds without the common stock.
The position of the petitioner is that its shares of common stock were sold at par. The corollary of this is that the first mortgage bonds were sold at $75. There is nothing in the evidence that warrants such a contention. The first mortgage bonds in the amount of $1,000,000 were secured by property that had cost the petitioner $3,000,000, *1102 bore 7 percent interest, and matured in 1930. We reject the contention that $750,000 of the cash received should be allocated to the $1,000,000 bonds and $250,000 to the $250,000 par value of stock issued.
From the a consideration of all of the evidence, we reach the conclusion that the first mortgage bonds were sold for $900,000, or at a total discount of $100,000, and that the common stock issued in connection therewith was sold at $40 per share. Upon this basis the petitioner is entitled to the amortization of the discount of $100,000 over the life of the first mortgage bonds.
Upon the same basis, namely, that the shares of stock issued in connection with the second mortgage bonds were sold at $40 per share, the total discount at which the $698,850 par value of second mortgage bonds were sold was $55,908. The petitioner is entitled to amortize such discount over the life of the second mortgage bonds.
At the hearing counsel for respondent admitted error in the computation of petitioner's deductible allowances for depreciation in 1926, in the amount of $38,859.54, which he now concedes should be added to petitioner's allowable deductions for that year, and that the effect*1103 of such inclusion is to increase any statutory net loss sustained in 1926 in the amount of $16,597.65. He also admits that "in the event an additional deduction was allowed for 1926 of the bond discount, of course, the net loss would be increased by whatever amount the petitioner is entitled to." The effect of these admissions will be taken into account in the recomputation under Rule 50.
Reviewed by the Board.
Judgment will be entered under Rule 50.
MURDOCK, dissenting: I think the determination of the Commissioner that the bonds were sold at par and nothing was received for the stock should be approved because the petitioner has failed to introduce evidence from which the Board can determine how much was paid for the bonds and how much was paid for the stock. Where a guess is the only alternative to an affirmance of the Commissioner's determination, the determination should be approved.
Footnotes
1. SEC. 274. (g). The Board in redetermining a deficiency in respect of any taxable year shall consider such facts with relation to the taxes for other taxable years as may be necessary correctly to redetermine the amount of such deficiency, but in so doing shall have no jurisdiction to determine whether or not the tax for any other taxable year has been overpaid or underpaid. ↩