*1948 1. On March 1, 1920, the petitioner's properties were turned back to it by the Director General of Railroads in an undermaintained condition. It filed a claim for undermaintenance in 1920, which was disputed by the Director General of Railroads, who contended that the United States did not owe the petitioner any amount for undermaintenance during the period of Federal control, but, on the contrary, that the petitioner's properties had been overmaintained and that the petitioner owed the United States an amount for overmaintenance. There was a lump-sum settlement of the claim in 1920 by which the Government allowed the petitioner $8,191,905.37 for undermaintenance of its properties. By reason of this settlement the Commissioner, in an audit of petitioner's return for 1920, disallowed as a deduction from gross income $8,191,905.37 of its maintenance expenditures for that year. The amount of overexpenditure for maintenance from March 1 to December 31, 1920, as compared with a 10-month period of the test period (July 1, 1914, to June 30, 1917), amounted to $3,263,523. Held, that only $3,263,523 of the maintenance expenditures for 1920 should be disallowed on this account.
*1949 2. The petitioner claims the deduction from gross income of 1920 for loss of approximately $25,000 sustained by it in 1920 upon the return to it of its properties on March 1, 1920, in an undermaintained condition, which undermaintenance was not made good by the lump-sum settlement in 1921. Held, that the petitioner sustained no deductible loss in 1920 when it received back its properties in an undermaintained condition.
3. The correct amount of the reduction of ordinary and necessary expenses for 1920 by reason of an increase in the book value of its inventory at March 1, 1920, over that at December 31, 1917, determined.
4. Amortization of premium on bonds issued subsequent to March 1, 1913, shown by petitioner's books of account as an accrual of 1920, held to constitute taxable income of 1920.
5. Compensation received in 1920 for guaranty period held to constitute taxable income.
*1408 This is a proceeding for the redetermination of a deficiency in income tax for the calendar year 1920 of $1,080,720.81. *1950 A number of the issues raised by the petition have been settled by stipulation of the parties. The allegations of error contained in the petition not settled by stipulation are as follows:
(1) The inclusion in taxable income of 1920 of the sum of $8,191,905.37, under the head "Undermaintenance," which sum represents the amount shown on the books of the Director General of Railroads as having been allowed for undermaintenance to the taxpayer in connection with the so-called Federal control settlement, made after the return of taxpayer's properties to it by the Railroad Administration in 1920.
(2) The failure of the Commissioner to reduce taxable income by the sum of $25,000,000, which sum represents the loss suffered by petitioner by reason of the deterioration of its properties during the period of Federal control, which loss was suffered by petitioner when it received its properties back from the United States.
(3) The failure of the Commissioner to reduce taxable income by the sum of $16,533,520.55, which sum represents the amount of the so-called Federal guaranty for a period from March 1, 1920, to September 1, 1920.
(4) The failure of the Commissioner to reduce taxable*1951 income by the sum of $2,236,938, which sum represents the amount of shortage in materials and supplies taken over by the Director General of Railroads at the beginning of Federal control, when said Director General returned the properties of petitioner to it at the end of Federal control, on March 1, 1920.
(5) The action of the Commissioner in allowing under the head of "Material and Supplies Adjustment," on account of materials and supplies used in additions and betterments, the sum of $203,461.94 instead of $516,404.50.
(6) The action of the Commissioner in reducing deductions for the year 1920, in correspondingly increasing income for the said year in the sum of $1,752,471.52 upon the ground that this sum represents the increase in inventory value of materials and supplies charged out in excess of the cost of such materials and supplies.
(7) The action of the Commissioner in including the sum of $24,191.95 as taxable profit, under the head of "Profit on Retirement of Funded Debt."
(8) The inclusion by the Commissioner in taxable income of the sum of $2,860.80, which sum represents amortized premium allocated to 1920 received upon the issuance in 1892 of certain bonds*1952 of petitioner.
*1409 (9) The action of the Commissioner in including the sum of $10,069.94 in income, which sum represents amortized premium upon bonds of the taxpayer issued in 1916.
(10) The failure of the Commissioner to reduce taxable income by the sum of $8,457, which represents adjusted amortization of discount upon bonds purchased for retirement.
(11) The failure of the Commissioner to include as a deduction the sum of $8,295.68, which sum represents amortization of discount and expense on bonds applicable to 1920.
(12) The inclusion by the Commissioner in taxable income of the sum of $14,602.50, said amount being the amount of assessment by the Association of Railway Executives.
(13) The inclusion by the Commissioner in income for 1920 of the sum of $7,450 under the head of "Donations to Y.M.C.A., etc."
(14) The failure of the Commissioner to reduce taxable income by the sum of $317,943.78, which sum represents unrefundable overcharges written off the books.
(15) The failure of the Commissioner to reduce taxable income by the sum of $37,592.17, which sum represents accounts payable written off the books.
FINDINGS OF FACT.
1. Petitioner is a*1953 corporation organized under special charter acts by virtue of the laws of the States of Illinois, Wisconsin, and Michigan, with its principal office at Chicago, Ill. It is engaged in the business of common carrier of freight and passengers for hire, both interestate and intrastate, and operates in the States of Illinois, Wisconsin, Michigan, Iowa, Minnesota, Nebraska, North Dakota, South Dakota, and Wyoming. Its system of accounting is upon the basis of accruals and is that prescribed by the Interstate Commerce Commission. The petitioner is subject to the act of Congress known as the "Act to Regulate Commerce," and acts amendatory thereof and supplemental thereto.
2. By proclamation dated December 26, 1917, the President of the United States, acting under the powers conferred on him by the Constitution and laws of the United States, by joint resolution of the Senate and House of Representatives, bearing dates of April 6 and December 7, 1917, respectively (said resolutions being respectively the resolutions declaring that a state of war existed between the United States and Germany, and between the United States and Austria-Hungary), and particularly under the powers conferred*1954 by section (1) of the act of Congress approved August 29, 1916, entitled "An Act Making appropriations for the support of the Army for the fiscal year ending June thirtieth, nineteen hundred and seventeen, and for other purposes," took possession and assumed *1410 control December 28, 1917, and for accounting purposes, as of December 31, 1917, of certain railroads and systems of transportion, including the railroad and transportation system of the petitioner. The principal railroads in the United States were so taken over, and a central and administrative board was, by direction of the President of the United States, set up and known as the United States Railroad Administration, at the head of which was an officer appointed by the President, and known as the Director General of Railroads.
3. On March 21, 1918, there was approved the so-called "Federal Control Act" under which the President was authorized to enter into agreements with the several carriers with reference to the just compensation to be paid them for the use of their several properties during Federal control. This statute included, among other things, the following provision:
Every such agreement shall also*1955 contain adequate and appropriate rovisions for the maintenance, repair, renewals and depreciation of the property, for the creation of any reserves or reserve funds found necessary in connection therewith, and for such accounting and adjustments of charges and payments, both during and at the end of Federal control, as may be requisite in order that the property of each carrier may be returned to it in substantially as good repair and in substantially as complete equipment as it was in at the beginning of Federal control, and also that the United States may, by deductions from the just compensations or by other proper means and charges, be reimbursed for the cost of any additions, repairs, renewals and betterments to such property not justly chargeable to the United States; in making such accounting and adjustments, due consideration shall be given to the amounts expended or reserved by each carrier for maintenance, repairs, renewals and depreciation during the three years ended June 30, 1917, to the condition of the property at the beginning and at the end of Federal control and to any other pertinent facts and circumstances.
4. Pursuant to this act, negotiations were entered*1956 into between the Director General, representing the President, and representatives of the several carriers, and, as a result, the so-called "standard contract" was evolved, which a majority of the railroad companies of the country, including the petitioner, accepted. This contract between the Director General and the petitioner was dated September 10, 1918.
5. Undermaintenance. - Section 1(d) of the standard contract provided:
Wherever in this agreement the words "Federal control" are used to indicate a period of time, they shall be understood as meaning the period from 12 o'clock midnight of December 31, 1917, to and including the day and hour on which said control shall cease.
Section 1(e) of the standard contract provided:
Wherever in this agreement the words "test period" are used, they shall be understood as meaning the period between July 1, 1914, and June 30, 1917, both inclusive.
*1411 6. Section 5 of the standard contract provided:
(a) During the period of Federal control the Director General shall, annually, as nearly as practicable, expend and charge to railway operating expenses, either in payments for labor and materials or by payments into*1957 funds, such sums for the maintenance, repair, renewal, retirement, and depreciation of the property described in paragraph (a) of Section 2 hereof as may be requisite in order that such property may be returned to the Companies at the end of Federal control in substantially as good repair and in substantially as complete equipment as it was on January 1, 1918; Provided, however, That the annual expenditure and charges for such purposes during the period of Federal control on such property and the fair distribution thereof over the same, or the payment into funds of an amount equal in the aggregate (subject to the adjustments provided in paragraph (c) and to the provisions of paragraph (e) of this section) to the average annual expenditure and charges for such purposes included under the accounting rules of the Commission in railway operating expenses during the test period, less the cost of fire insurance included therein, shall be taken as a full compliance with the foregoing covenant.
(b) The Director General may expend such sums, if any, in addition to those expended and charged under paragraph (a) of this section (subject to the adjustments provided in paragraph (c) of this*1958 section) as may be requisite for the safe operation of the property described in paragraph (a) of section 2 hereof, assuming a use similar to the use during the test period and not substantially enhancing the cost of maintenance over the normal standard of maintenance of railroads of like character and business during said period; and the amount, if any, of such excess expenditures during Federal control shall be made good by the Company as provided in paragraph (b) of section 7 hereof.
(c) In comparing the amounts expended and charged under the provisions of paragraphs (a) and (b) of this section with the amounts expended and charged during the test period, due allowance shall be made for any difference that may exist between the cost of labor and materials and between the amount of property taken over and the average for the test period, and, as to paragraph (a), for any difference in use between that of the test period and during Federal control which in the opinion of the Commission is substantial enough to be considered, so that the result shall be, as nearly as practicable, the same relative amount, character, and durability of physical reparation.
(d) At the request of*1959 the Director General or the Company there shall be an accounting of the amounts due by or to any of the parties under paragraphs (a) and (b) of this section at the end of each year of Federal control and at the end of Federal control.
7. The Congress of the United States, by an act approved February 28, 1920, entitled the "Transportation Act of 1920," directed that Federal control "shall terminate at 12.01 a.m., March 1, 1920; and the President shall then relinquish possession and control of all railroads and systems of transportation then under Federal control and cease the use and operation thereof." This statute also authorized the President to make settlement of all matters arising out of Federal control.
8. In accordance with the terms of the act of Congress dated February 28, 1920, and referred to as the "Transportation Act of *1412 1920," the President, on March 1, 1920, relinquished possession of the railroad systems of the country, including that of the petitioner, and turned back to the petitioner all the properties comprising its said system.
9. The property which was so returned to the petitioner by the Director General was not in substantially as good*1960 repair and in substantially as complete equipment as when taken over. Maintenance, both of ways and structures, and equipment, had been greatly reduced during the period of Federal control, and as to many important items neglected altogether. The Director General had expended in maintenance a larger sum in dollars than had been expended by the petitioner during a corresponding length of time in the so-called "test period"; but by reason of the greatly increased prices, both of material and labor, during Federal control over the prices of the test period, and by reason further of the greatly increased cost of labor due to factors other than mere increased wages per hour (including such factors as important changes in rating of numerous classes of employees, and changes in working rules and conditions), the amount expended by the Director General during Federal control was materially less than the amount which should have been expended by him in order, during the Federal control period, to maintain the property up to the standard of the test period.
10. At the end of Federal control the petitioner prepared and filed a claim against the Director General for the amount by which the*1961 petitioner asserted the Director General had failed to make good his obligation under the standard contract. The proper method of arriving at an appropriate equation factor to be used in comparing test period expenditures for maintenance with the corresponding expenditures during Federal control was the subject of much difference in opinion between the Director General and the carriers, including the petitioner. The Director General computed the measure of his obligation so as to arrive at a result materially different from that reached by the petitioner. Prior to the end of Federal control the Director General had issued certain accounting instructions (commonly known and referred to as "Accounting Circulars Nos. 101 and 109") in which he called for the compilation of certain data to be used as a basis of comparison between the test period expenditures and the Federal control expenditures for labor and materials, so that unit prices for different items of labor and materials might be obtained for each of the respective periods, and appropriate equation factors developed therefrom. The data called for by these two circulars related to the maintenance of ways and structures, and*1962 to equipment. The method of computation contemplated by these accounting circulars and the method used by the Director General limited the comparison of differences in wages of the different classes *1413 of employees to a comparison of costs due to differences in wage rates per hour of the various classes of labor, and gave no effect to increased costs due to other factors such as inefficiency of labor, changes in rating, and the like. The Director General took the position that the words "cost of labor" as used in the standard contract meant "price of labor"; and that he was not obligated to expend a sum sufficient to include, in addition to the increased price of labor, the additional cost of labor due to any inefficiency or ineffectiveness of labor. He took the position that if he expended for maintenance such an amount as equalled the test period expenditures equated to give effect to the changed "price of labor" he had fulfilled the measure of his obligation. The data contained in the returns to these accounting circulars, and the computations made therefrom, not alone failed to give any effect to any inefficiency of labor in the sense of slackness, if such there was, *1963 but also failed to give effect to the changed ratings for different classes of labor and changed working conditions that went into effect during Federal control. Such changes in ratings and in working rules were quite extensive and resulted in very large increases in labor costs as compared with the test period.
11. Upon the return of its properties the petitioner prepared and presented to the Director General, in September or October of 1920, its claim for compensation for the taking and use of its properties, said claim comprising numerous items totaling $34,918,823.30. The principal item of the claim was that of undermaintenance, for which the petitioner claimed $33,889,023. Petitioner's claim in general was based upon its interpretation of its contract with the Director General; and as to the item of undermaintenance its claim was based upon its returns to Accounting Circulars 101, as to ways and structures and 109 as to equipment, with the exception, however, that this claim reflected certain additional factors, to wit, the so-called "inefficiency of labor," changes in rating of employees and working conditions, and the equation of depreciation and retirements, all of which*1964 the petitioner contended were comprehended by its contract. The element of "inefficiency of labor" was based upon changes in the rating and classification of employees, during Federal control, which petitioner had contended had resulted in the increase in the cost of labor with no corresponding increase in efficiency.
12. The Director General took petitioner's claim under consideration for several months. The Director General had made and sent out a report showing how he had arrived at the equation status with reference to particular items. During the year 1921, a representative of the Director General made an inspection of a considerable portion of the railroad and properties of the petitioner, but this representative did not communicate to the petitioner his conclusions as a result of this inspection.
*1414 The Director General never informed the petitioner until several years subsequent to the final settlement what his position was with respect to maintenance, but shortly after the claim was filed, responsible officers of the Railroad Administration informed representatives of the petitioner that no great amount was due on account of undermaintenance of ways and*1965 structures, and that equipment had been overmaintained.
13. Early in the summer of 1921, petitioner was notified that the Director General was ready to discuss the petitioner's claim and in July, 1921, a series of conferences was held in Washington, D.C., at which representatives of the petitioner and the Director General met and considered the various items of the claim.
14. At these conferences it developed that the Director General and the petitioner were in substantial agreement as to the method of equating the changes in cost of materials. With reference to labor, however, petitioner contended that under the standard contract the measure of the Director General's obligation for labor was to expend such an amount as was necessary in order to apply during the Federal control period an amount of material corresponding to the quantity of material applied during the test period. The petitioner also contended that in determining the extent of the Director General's obligation to return the property in substantially as good repair and substantially as complete equipment as when taken over, depreciation and retirements during the period of Federal control should be equated to*1966 Federal control prices, since, it was contended, a proper measure of physical reparation could not otherwise be secured. The formula upon which the petitioner's claim for undermaintenance was computed reflected the difference in cost of labor as distinguished from mere difference in price of labor, and also reflected the equation of depreciation and retirements. The method used in petitioner's formulae to arrive at its equation factors was as follows: The measure of the Director General's obligation with reference to material was determined by using the equation factors developed in accordance with the accounting circulars referred to above. There was then determined the cost of the labor necessary during the Federal control period to apply one dollar's worth of material. From these data was computed the amount of labor necessary to apply the quantity of material which the carrier contended should have been applied. Adjustments were made for the increased amount and use of property and for other items entering into maintenance. From these several computations a composite equation factor was arrived at to be applied to the average annual test period expenditures for maintenance, *1967 including depreciation and retirements.
On the other hand, the Director General took the position that the standard contract prescribed his obligations to the carrier, that it did *1415 not provide for or contemplate the so-called "inefficiency of labor" which made up the larger part of the carrier's claim for undermaintenance, nor for the equation of depreciation and retirements. The Director General took the position that the carrier's equation factors, upon analysis, had proved to be economically unsound, that the socalled "inefficiency of labor" was an element existing in the cost of labor at all times and something which could not be determined or measured in terms of economics, and therefore, the Director General had evolved certain equation factors which he had applied to the data submitted by the carrier and arrived at a different resultant allowance. The Director General, therefore, reduced the petitioner's claim for undermaintenance by eliminating its claim for "inefficiency of labor," for depreciation and retirements, for the increased amount and use of property by the amount which the same factor of "inefficiency of labor" had been applied thereto, and, finally, *1968 for the equation of gross material charges instead of net charges. These results appear in Exhibit 9 filed with the Board and indicate an admitted undermaintenance of ways and structures of $4,565,865, and claimed overmaintenance of equipment in the sum of $3,525,747, or a net undermaintenance of $1,040,118.
Under the Transportation Act of 1920 it was provided among other things that the United States should guarantee that the railway operating income for the six months immediately following Federal control (known as the Guaranty period) should not be less than one-half of the amount of actual compensation paid by the United States during the period of Federal control. It was provided that for purposes of computing this guaranty there should not be included in operating expenses, maintenance of ways and structures, or maintenance of equipment, more than the amount fixed by the Commission, and that in fixing such amount, the Commission should, so far as practicable, apply the rule set forth in the proviso in subsection (a) or Section 5 of the standard contract (quoted above). In carrying out the direction of Congress with reference to the so-called "Guaranty" during the six months*1969 immediately following Federal control, the Interstate Commerce Commission had occasion to consider the question of the comparison of maintenance expenditures between the test period and the Guaranty period. The Bureau of Finance of the Commission, together with representatives of the carriers, evolved a formula to be used in making this comparison. The formula used by the petitioner in computing its claim against the Director General was substantially the same as that worked out in connection with the so-called "Guaranty" by the Bureau of Finance of the Interstate Commerce Commission with the several carriers, except that the formula so worked out for purposes of the guaranty did not reflect the equation of depreciation and retirements, while that used as the basis of *1416 petitioner's claim did reflect the equation of these items. The question of the interpretation of the contract was considered by the Commission itself in connection with the guaranty period; and the Interstate Commerce Commission, by a divided membership, sustained the view of the Director General, and held that for purposes of the guaranty, the phrase "cost of labor" means "price of labor." By reason*1970 of this decision, the formula evolved by the carriers and the Bureau of Finance was not employed in determining the Government's obligation under the guaranty. No court has ever passed upon the meaning of the phrase "cost of labor" as used in the standard contract.
The claim of petitioner for undermaintenance during Federal control, prepared in accordance with this formula and filed with the Director General, amounted (including the equation of depreciation and retirements) to the sum of $33,889,023. This sum represented the amount by which the petitioner contended the Director General had undermaintained its property during Federal control, and represented the amount by which the amounts spent for maintenance by the Director General were less than the amounts which petitioner claimed should have been spent. This claim was filed shortly after the return of the property after Federal control. No part of this claim was ever accrued on petitioner's books prior to the final settlement.
15. The following tabulation shows in column one, the amount of the corporate claim; in column two, the amount on the Administration's books; and column three, the difference:
| Corporate claim as of May 31, 1921 | Administration books as of May 31, 1921 | Difference | |
| DUE TO CORPORATION | |||
| Compensation | $50,482,422.70 | $50,482,422.70 | |
| Less advances, loans, etc., to July 18, 1921 | 41,089,770.00 | 41,089,770.00 | |
| 9,392,652.70 | 9,392,652.70 | ||
| Rental interest on completed A & B | 567,859.12 | 567,859.12 | |
| Cash on hand Dec. 31, 1917 | 5,722,051.43 | 5,722,051.43 | |
| Agts. & Contrs. bal. Dec. 31, 1917 | 3,655,142.27 | 3,655,142.27 | |
| Assets Dec. 31, 1917, collected | 3,939,517.30 | 3,939,517.30 | |
| Revenue prior to Jan. 1, 1918 | 788,469.28 | 788,469.28 | |
| Cash payments a/c A & B | 807,070.00 | 807,070.00 | |
| Total | 24,872,762.10 | 24,872,762.10 | |
| Additions and betterments | 12,577,137.90 | 12,577,137.90 | |
| Liabilities, Dec. 31, 1917, paid | 13,509,831.24 | 13,509,831.24 | |
| Corporate transactions | 2,965,803.61 | 2,965,803.61 | |
| Expense prior to Jan. 1, 1918 | 5,801,048.15 | 5,801,048.15 | |
| Adjustment in open accounts by field section approved by corporation | 362,894.83 | 362,894.83 | |
| 35,216,715.73 | 35,216,715.73 | ||
| Balance due from corporation | 10,343,953.63 | 10,343,953.63 | |
| OTHER ITEMS DUE TO CORPORATION | |||
| Material and supplies (shortage) | $2,236,938.00 | $2,236,938.00 | |
| Equipment retired | 1,265,546.04 | #1,281,207.74 | 1 15,661.70 |
| Road property retired and not replaced | 472,758.32 | 212,520.43 | 260,237.89 |
| Rental interest allocated equipment | 79,263.98 | 79,263.98 | |
| Interest other than rental interest | 21,842.19 | 21,842.19 | |
| Interest on balance of depreciation and equipment retired applied as credit to open accounts | 574,862.75 | 574,862.75 | |
| Total | 4,651,211.28 | 1,515,570.36 | 3,135,640.92 |
| OTHER ITEMS DUE FROM CORPORATION | |||
| Material and supplies (excess) | 492,053.90 | 492,053.90 | |
| Salvages for A & B for war purposes | 1,342.39 | 1,342.39 | |
| Allocated equipment adjustment | 61,006.09 | 61,006.09 | |
| Interest on "Adjustments to open accounts by field section approved by corporation" | 49,535.39 | 49,535.39 | |
| Total | 49,535.39 | 603.937.77 | 554,402.38 |
| Balance due to corporation on other items | 4,601,675.89 | 911,632.59 | 3,690,043.30 |
| Balance due from corporation | 5,742,277.74 | 9,432,321.04 | 3,690,043.30 |
| DEPRECIATION OBLIGATION | |||
| Equipment | 7,029,002.71 | 6,617,708.00 | 411,294.71 |
| Road property | 83,633.33 | 83,633.33 | |
| Total due to corporation on depreciation | 7,112,636.04 | 6,617,708.00 | 494,928.04 |
| Balance due to corporation | 1,370,358.30 | 4,184,971.34 | |
| Balance due from corporation | 2,814,613.04 | ||
| MAINTENANCE | |||
| Ways and structures (under) | 13,165,898.00 | 4,565,865.00 | 8,600,033.00 |
| Equipment (under) | 20,382,567.00 | 23,908,314.00 | |
| Equipment (over) | 3,525,747.00 | ||
| Balance due to corporation on maintenance | 33,548,465.00 | 1,040,118.00 | 32,508,347.00 |
| Net balance due from corporation | 1,774,495.04 | ||
| Net balance due to corporation | 34,918,823.30 | 36,693,318.34 |
*1417 16. The contentions of the petitioner on the item of undermaintenance as to the element of "inefficiency of labor," changes in labor classification and ratings, depreciation and retirements, and the equation of gross material charges instead of net charges were not made known to the Director General until the petitioner's claim was presented in October, 1920, and could not have been ascertained even then until the petitioner's claim was completely analyzed, and the foregoing elements discovered. The Director General at no time denied his liability to the petitioner under the contract, and it was not until after the carrier's claim was presented and analyzed by his accounting officers and tentative allowances made thereon, which was in July, 1921, that the Director General disputed that the petitioner's claim for the full amount of the undermaintenance claimed was proper.
*1418 17. After extensive conferences had been held and the several items of the petitioner's claim discussed, a lump sum offer of settlement was made by representatives of the Director General to pay the petitioner $6,000,000 in full settlement of all claims of whatever*1972 kind. At these conferences the Director General did not state what disposition he proposed to make with reference to the particular items discussed. This offer was rejected. Two days later a further conference was held, and an agreement reached that nothing was to be paid to the petitioner on account of materials and supplies, but that in final settlement of all other items the Director General should pay the carrier in cash $6,500,000, which amount was paid in full, and a release signed by petitioner dated September 15, 1921. This release recites among other things:
The purpose and effect of this instrument is to evidence a complete and final settlement of all demands of every kind and character as between the parties hereto growing out of the federal control of railroads, including all balances due on the purchase price of allocated equipment except time obligations therefor, save and except * * *.
18. The Director General made a breakdown of this settlement, which indicates that after giving effect to the various debits and credits in a mutual account between the parties, the allowance for undermaintenance of ways and structures was fixed at $5,000,000 and for equipment*1973 at $3,191,905.37, making a total undermaintenance allowance of $8,191,905.37. The respondent obtained, but not in the presence of any representative of the petitioner, the figures showing this breakdown made by the Director General, and eliminated from operating expenses for 1920, this sum of $8,191,905.37, upon the ground that expenditures for maintenance made in 1920 and included in operating expenses for that year had, to this extent, been reimbursed by the Director General.
19. The petitioner closed out on its books as of 1921 all of the several accounts showing balances either due to or from the Director General and wrote off such balances to profit and loss. This was done pursuant to a special order of the Interstate Commerce Commission dated January 25, 1922. Said order provided, however, as follows:
That the use of profit and loss in clearing said balances should not operate to relieve the carriers of the observance of classification rules applied to additions and to retirement of physical property and the maintenance of adequate depreciation reserves for equipment.
The effect of this order was to permit the carrier to close out to profit and loss all unadjusted*1974 balances arising out of Federal control *1419 in so far as such unadjusted balances did not affect the carrier's capital account or depreciation reserves.
20. A physical inspection of the petitioner's properties made by officers of the petitioner as soon as its properties were turned back to it at the end of Federal control showed marked evidences of undermaintenance. The Director General had during Federal control failed to apply the proper number of ties and a large number of those installed were deficient in size and quality. He had allowed the ballast to become neglected and sloughed at the shoulders; he failed to apply the appropriate amount of rock and gravel ballast and, in some instances, applied cinder ballast where rock or gravel ballast should have been applied; he failed to keep the track free of weeds; he failed to keep the ditches free of debris; and, as a result of this neglect, the drainage of the right of way was materially interfered with; the proper amount of new rails was not applied to keep up former maintenance; the rail ends showed evidence of being battered and worn and some track became rough and in poor shape. There was also a substantial undermaintenance*1975 in the case of equipment. Repairs to locomotives were neglected so that at the end of Federal control there were approximately 65 per cent fewer tractive miles available than at the beginning of Federal control. The number of locomotives and cars in bad order at the end of Federal control exceeded the corresponding number at the beginning of Federal control. Items normally going into maintenance of equipment were greatly reduced. Much of the deterioration suffered on account of this neglect was progressive.
21. The petitioner's operating expenses for the year 1920 aggregated in excess of $55,000,000. The Interstate Commerce Commission, in determining the amount of the guaranty for the six-month period following Federal control (March 1 to August 31, 1920), disallowed $3,075,985 of petitioner's maintenance expenses for the six months of the guaranty period. In arriving at this amount, the Commission did not take into account any difference in the cost of labor other than the difference in the wage rate per hour as between the test period and the guaranty period. Upon the disallowance of this sum by the Interstate Commerce Commission, and using the equation factor which the*1976 Interstate Commerce Commission used, but taking the comparison of the 10 months from March 1, 1920, to December 31, 1920, with the corresponding 10 months of the test period year, the amount of overexpenditure for maintenance as compared with the test period (July 1, 1914, to June 30, 1917), *1420 amounted to $3,263,523 for the 10 months from March 1, 1920, to December 31, 1920.
22. In the case of the petitioner, the Interstate Commerce Commission found as a proper equation factor for purposes of computing the guaranty, the factor of 2.43. The petitioner contended for a factor of 2.50. If the equation factor of 2.50 were adopted, the amount of such excess expenditures for maintenance for the 10 months from March 1, 1920, to December 31, 1920, amounts to $1,665.914.
23. Although the petitioner kept its books of account upon the accrual basis, it kept them in accordance with the rules and instructions furnished by the Interstate Commerce Commission. It did not accrue upon its books of account any portion of its claim against the Director General of Railroads for undermaintenance of its properties during the period of Federal control. Its claim for undermaintenance*1977 was disputed and unliquidated during the year 1920.
24. Compensation for quaranty period. - By the terms of section 209 of the Transportation Act of 1920 railroad corporations which accepted the provisions of the act were guaranteed an operating income of not less than one-half the amount named as just compensation in their contract with the Director General; or if a noncontract carrier, not less than one-half of the amount estimated by the President as just compensation under the Federal Control Act. If the carrier's operating income for the guaranty period exceeded the amount of operating income guaranteed, the carrier should remit the excess into the Treasury of the United States.
Upon the terms of the Transportation Act, railroad corporations which duly accepted the provisions thereof were guaranteed "railway operating income" during the six-month period from March 1, 1920, to August 31, 1920, equal to one-half of the annual compensation received from the Director General of Railroads for the use of their properties during the Federal control period. If the "railway operating income" received from patrons of the respective railroads for the six-month period was more*1978 than the amount guaranteed, the respective railroad companies which accepted the provisions of section 209 were required to pay the excess into the Treasury of the United States. If the amount of "railway operating income" received from patrons of railroads was less than this amount, the Government agreed to pay to such railroads a sum sufficient to make the total "railway operating income" received from the patrons and from the Government equal to the amount guaranteed by section 209.
Under the provisions of section 209, the Interstate Commerce Commission determined that the petitioner was entitled to the sum of *1421 $16,533.520.55 as compensation applicable to the six months immediately following Federal control as the fulfillment of the obligation of the United States to make good this guaranty, which sum was duly paid to the petitioner. The respondent has included this sum in petitioner's taxable income for the year 1920.
25. Materials and supplies. - Section 2(a) of the standard contract provided:
The railroads and systems of transportation of the Company and of its said affiliated Companies of which the President has taken over possession, use, control, *1979 and operation shall be considered as including:
* * *
(b) All materials and supplies of the Companies on hand at midnight December 31, 1917.
26. Section 9(b) of the standard contract provided:
At the end of Federal control the Director General shall return to the Companies all uncollected accounts received by him from them and also materials and supplies equal in quantity, quality, and relative usefulness to that of the materials and supplies which he received, and to the extent that the Director General does not return such materials and supplies he shall account for the same at prices prevailing at the end of Federal control. To the extent that the Companies receive materials and supplies in excess of those delivered by them to the Director General the Company shall account for the same at the prices prevailing at the end of Federal control, and the balance shall be adjusted in cash.
27. The recorded inventory value of materials and supplies of petitioner on hand as at January 1, 1918, was $10,344,410.40. The recorded inventory value of materials and supplies turned back to the petitioner as of March 1, 1920, was $12,096,881.92. The entire increase in the recorded*1980 inventory value amounting to $1,752,471.52 was at first eliminated by the Commissioner from petitioner's operating expenses for 1920 upon the ground that petitioner's operating expenses for that year had been inflated and overstated by the amount of the increase in inventory value. Subsequently the respondent reduced this amount by $203,461.94, which represented the amount of such increase in inventory value which was applicable to additions and betterments during 1920.
The Commissioner now concedes that before ascertaining the proportion of the increased inventory value applicable to additions and betterments during 1920, there should be eliminated from the aforesaid increase in inventory value or base figure the sum of $174,490.68, representing "leased rails and fixtures," and $24,389.30, representing "material in temporary tracks," both of which are capital items and not technically unapplied materials and supplies. Eliminating these capital items the balance of said increase in inventory value amounts to $1,553,591.54. To this sum the Commissioner contends there should be applied the percentage of the increased inventory value *1422 applicable to additions and betterments*1981 which has been conceded by the Commissioner to be 11.73 per cent, leaving the net corrected adjustment for materials and supplies $1,371,397.91.
28. Profit on retirement of funded debt. - During the year 1920 petitioner purchased in the open market and retired certain of its own bonds which had been previously issued by it. These purchases were made at prices less than the par value of the bonds. The difference between the par value of the bonds so purchased and retired and the amount paid in the acquisition of the bonds was $47,511.60, of which amount the respondent has added the sum of $24,191.95 to petitioner's taxable income upon the ground that said amount was a profit arising out of said transaction.
29. Amortized premiums on bonds. - During the year 1892 petitioner issued $4,000,000 par value of thirty-year debenture bonds and realized therefrom the sum of $4,082,287.50 or a premium of $82,287.50. Petitioner amortized the amount of this premium on its books and allocated the sum of $2,860.80 as applicable to the year 1920. The petitioner claimed as a deduction from its gross income as interest the amount which it paid on the said bonds during the year 1920*1982 as the interest obligation provided therein, which amount exceeded the premium amortized in said year. In auditing the petitioner's income tax return for 1920 the respondent made no adjustment with respect to said interest deduction so claimed, except by increasing the petitioner's taxable income for the year by including therein the sum of $2,860.80, which is the amortized portion for the year 1920 of the premiums received by the petitioner upon the sale of said bonds.
During the year 1916 petitioner sold at a premium certain of its own bonds. Of the premium so received, the amount amortized and applicable to 1920 is $10,069.94. Petitioner claimed as a deduction from its gross income as interest the amount which it paid on said bonds during the year 1920 as the interest obligation provided therein, which amount exceeded the premium amortized in said year. In auditing the petitioner's income tax return for 1920 the respondent made no adjustment with respect to said interest deduction so claimed except by increasing the petitioner's taxable income for the year by including therein the sum of $10,069.94, which is the amortized portion for the year 1920 of the premiums received*1983 by the petitioner upon the sale of said bonds.
30. Amortization of discount upon the bonds purchased for retirement and retired. - During the year 1920 the petitioner purchased for retirement certain of its sinking fund bonds, series 1929 and 1933, which were issued at a discount. Petitioner treated such discount *1423 as amortizable and allocated the amount thereof over the life of the bonds. The proportion of the discount allocable to the year 1920 was $29,685.84. The respondent allowed only the sum of $21,228.84 as the amortized discount upon said bonds purchased for retirement during the year 1920 and disallowed the balance of $8,457.
31. Computation of amortized discount and expense on bonds. - Between 1897 and 1902 petitioner issued at various times its general mortgage gold bonds, series of 1987, in the amount of $9,756,000 par value. From the sale of these bonds petitioner realized only $9,414,540. The discount, amounting to $341,460, has been regularly amortized by petitioner. The amount of such discount applicable to the year 1920 was $3,856.44. No expense of issuance was included in the amount amortized.
Between 1916 and 1920 petitioner issued*1984 and sold at various times a total of $10,500,000 par value of its general mortgage gold bonds, series of 1987, and received therefor $10,237,500. The discount, amounting to $262,500, has been regularly amortized by petitioner and the amount applicable to the year 1920 was $4,439.24. The difference in the par value and sale price of the aforesaid bonds included both discount and expense of issuance, although none of such expense was incurred prior to or applicable to the period March 1, 1913.
The respondent has included both said sum of $3,856.44, representing amortized discount on bonds issued prior to March 1, 1913, and the said sum of $4,439.24, representing both the amortized discount and expense of said bonds issued subsequent to March 1, 1913, in taxpayer's taxable income for the year 1920.
32. Assessments paid to Association of Railway Executives. - During the year 1920, and for a number of years prior thereto, there was an organization known as the Association of Railway Executives, which was an association of railroad corporations, through their chief executives, owning the greater part of the railroad mileage of the United States. Its functions were conferences*1985 and cooperation with respect to matters of common interest to the railroads. The railroads were represented generally in such matters by committees or agents. The petitioner was a member of the association. The activities of the association were all in the interest of the railroads and their stockholders. The amount of the assessments paid by the petitioner in 1920 to the association was all expended in the maintenance of the association.
33. Contributions to railroad Y.M.C.A.'s and Travelers' Aid Society. - During the year 1920 the petitioner contributed $6,550 to various Y.M.C.A.'s. Of this amount $250 was contributed to the *1424 Y.M.C.A. as a general contribution and $6,300 to the following railroad Y.M.C.A.'s:
| Baraboo, Wis. | Boone, Iowa. |
| Janesville, Wis. | Chicago, Ill. |
| South Kaukauna, Wis. | Chadron, Nebr. |
The payments to the above railroad Y.M.C.A.'s were made in connection with work done by those institutions among employees of the company so that the employees might be more contented and the company's business operations be better carried on. These Y.M.C.A.'s were at important division or terminal points of the petitioner. The contribution*1986 of $250 to the Y.M.C.A. as a general contribution was to enable the supervisory organization to direct the efforts of the railroad Y.M.C.A.'s.
In 1920 the petitioner contributed $750 to the Travelers' Aid Society. That society maintains an organization for looking after a certain class of travelers, usually of helpless character, who need assistance, and in that connection the society relieves the petitioner from the duty of caring for helpless persons who arrive at its terminals - especially its Chicago terminal. The society has a desk there in the terminal and looks after this class of people that come into the city. To the extent that this society functions, the work of the company's regular passenger agents is lessened, and, were it not for the activity of the society, the petitioner would be obliged to look after the making of arrangements to take care of such persons.
34. Unrefundable overcharges and unpaid pay rolls and vouchers. - During the year 1920 petitioner collected $317,943.78 unrefundable overcharges in excess of its rates and fares provided by its tariffs. These overcharges resulted from various causes, principally from the agent's error in computing*1987 the correct rate for a particular shipment or the correct fare for a particular ticket; the error is discovered when the agent's accounts are audited; the name and address of the shipper or passenger and unknown; and petitioner is unable to make any refund. The amount of such overcharge is held in suspense account and credited to profit and loss at the end of three years. Respondent included the aforesaid amount in determining taxable income for the year 1920.
In the regular course of its business petitioner issues pay checks, checks or vouchers in payment of payable items, loss and damage claims, and for other various disbursements. Many of these pay checks are never called for by the employee entitled thereto; likewise, some of the checks and vouchers for loss and damage claims and other disbursements, which are delivered to the various payees, are never cashed. These checks and vouchers are directly charged *1425 out to operating expenses on petitioner's books, and are deducted on petitioner's income tax returns for the year in which so charged. At the end of three years such checks and vouchers as have not been cashed are credited to profit and loss. In the event*1988 that any payee thereafter demands the sum due him, on account of such check or voucher, payment is made by petitioner accordingly. There have been frequent instances where such amounts so credited to profit and loss have subsequently been paid. Petitioner's practice is to disregard the bar of the statute of limitations and make payment in such cases irrespective of whether the statute has run. The sum so credited by petitioner for the year 1920 was $37,592.17. Respondent has considered as part of petitioner's income for the year 1920 the last mentioned amount.
OPINION.
SMITH: (1) The first question presented by this proceeding is whether $8,191,905.37 of the maintenance expenses of the petitioner for 1920 should be disallowed as a deduction from gross income in the determination of tax liability by reason of the fact that in 1921 the petitioner was allowed $8,191,905.37 in the lump-sum settlement of its claim against the United States for undermaintenance during the period of Federal control.
The respondent concedes that this amount would have been a legal deduction from gross income of 1920 had it not been for the allowance in 1921 of a like sum for undermaintenance in*1989 the lump-sum settlement of its claim. In his notice of deficiency, upon which this proceeding is based, the respondent stated:
The Unit eliminated the above item [$8,191,905.37] of undermaintenance allowed in the final settlement with the Director General from the 1921 return and included it in the 1920 taxable income on the basis that such undermaintenance was made good in the year 1920, and since you have not been able to disprove this contention, the action of the Unit in Bureau letter of February 23, 1927 is sustained and your contentions and your protest are denied.
The petitioner contends that it is entitled under the statute to deduct from gross income all of its ordinary and necessary expenses paid or incurred during the taxable year in carrying on its trade or business and that the amount deductible is not affected by the lumpsum settlement of its claim in 1921.
The evidence shows that the petitioner, in 1920, had no knowledge that any part of its claim, filed in the fall of 1920, for undermaintenance during the period of Federal control and amounting to $34,918,823.30, would be allowed. The Director General of Railroads not only declined to recognize any part*1990 of the carrier's claim but, on the other hand, asserted that the carrier owed him $1,774,495.04. *1426 It was not until the summer of 1921 that any progress was made in the adjustment of the claim for undermaintenance and in September, 1921, the claim was allowed to the extent of $8,191,905.37. The petitioner, keeping its books of account upon the accrual basis and in accordance with the requirements of the Interstate Commerce Commission and pursuant to certain instructions given to it in 1921, charged off to profit and loss in 1921 all of the balances of accounts with the Director General of Railroads.
The same issue presented by this assignment of error was before the Board in . We there held:
It may be conceded that whatever payment or allowance was made to the petitioner for undermaintenance does not constitute income to it; it represents no more than a return to it of its original capitial investment. * * * The position of the Commissioner may be simply stated. When the properties were returned on March 1, 1920, they were undermaintained; during the balance of that year over $1,000,000 was*1991 expended for maintenance; a part of this represented expenditures made to overcome the undermaintenance of the period of Federal control and to restore the properties to their normal condition and a part represented normal maintenance; to the extent that expenditures were made to overcome the undermaintenance of the period of Federal control and were paid for by the Director General of Railroads, they do not represent an ordinary and necessary expense of its business, incurred and paid by petitioner, which is deductible in computing its net income subject to tax, but rather an expense paid by the Director General. In other words, the payment claimed may have been made in the first instance by the petitioner, but petitioner was later reimbursed for such expense, so that in effect the expenses of maintenance, to the extent of such reimbursement, were not expenses incurred by it. Upon this basis the Commissioner has reduced the amount expended by petitioner during the year 1920 for maintenance by the amount which he asserts was later paid petitioner to recompense it for a part of such expenditure.
We are of the opinion that the Commissioner must prevail in his contention. The statute*1992 (sec. 214 [234], Revenue Act of 1918) provides that in computing net income of a taxpayer there shall be allowed as deductions all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. We do not understand that this would permit the deduction of expenses paid or incurred by the taxpayer for which he is reimbursed. In such a case the expenses are not his, nor are they paid or incurred by him within the meaning of the statute. The taxpayer is allowed the expenses of its business borne by it and is taxed only upon its net income after its expenses have been deducted.
We there held that, inasmuch as the petitioner did not establish before the Board that the undermaintenance during the period of Federal control was not made good by maintenance expenditures during the period March 1 to December 31, 1920, the disallowance of the deduction from gross income of maintenance expenditures made by the Commissioner was correct, and entered our decision accordingly.
*1427 The same question was before us in *1993 , and in . In those decisions we reversed the action of the Commissioner in disallowing a portion of the maintenance expenses, but solely upon the ground that the evidence adduced before the Board tended to show that the undermaintenance during the period of Federal control was not made good by maintenance expenditures within the taxable period. In , we held that, since the evidence showed that the maintenance expenditures for the period March 1 to December 31, 1920, equated to maintenance expenditures of a 10-month period during the test period were in excess of the maintenance expenditures of the test period by only a portion of the amount received from the Director General in the lump-sum settlement for undermaintenance, only such portion of the maintenance expenditures for 1920 should be disallowed as a deduction from gross income.
The above decisions of the Board are controlling upon the issue here presented. The petitioner is not entitled to deduct from gross income of 1920 maintenance expenditures*1994 which served to overcome the undermaintenance of the period of Federal control. Applying the rule to the case in hand which was applied in , we find that the overexpenditures for maintenance during the period March 1, 1920, to December 31, 1920, was only $3,263.523. The action of the respondent in disallowing the deduction from gross income of $8,191,905.37 is therefore sustained to the extent of $3,263.523.
(2) The second question for our consideration is whether the petitioner sustained a loss deductible from gross income in 1920 by reason of the return to it on March 1, 1920, of its railroad properties in a seriously undermaintained condition. The petitioner contends that the amount of this loss is approximately $25,000,000, or, more accurately, the difference between its claim for undermaintenance, filed with the Director General in 1920, of $34,918,823.30 and the $8,191,905.37 allowed in the lump-sum settlement of 1921, or $26,726,917.93.
The provision of law invoked in making this contention in section 234(a)(4) of the Revenue Act of 1918, which permits a corporate taxpayer to deduct from gross income "Losses sustained*1995 during the taxable year and not compensated for by insurance or otherwise." This provision of law was under consideration by the Supreme Court in , in which the Court stated:
The case turns upon the question whether the loss, concededly sustained by the respondent through the seizure of the assets of the German company, in 1918, was so evidenced by a closed transaction within the meaning of the *1428 quoted statute and treasury regulations as to authorize its deduction from gross income of that year. The statute obviously does not contemplate and the regulations (Art. 144) forbid the deduction of losses resulting from the mere fluctuation in value of property owned by the taxpayer. * * * But with equal certainty they do contemplate the deduction from gross income of losses, which are fixed by identifiable events, such as sale of property (Art. 141, 144), or caused by its destruction or physical injury (Art. 141, 142, 143) or, in the case of debts, by the occurrence of such events as prevent their collection (Art. 151).
Assuming that the petitioner's properties were undermaintained during the period*1996 of Federal control to the extent contended for by the petitioner and that the undermaintenance was not made good in the lump-sum settlement to the amount of $26,726,917.93, what was the "identifiable event" of 1920 that fixed the loss as one sustained in that year? The petitioner contends that it was the return of the properties by the Director General to it in that year. But the fact is that under its contract with the Director General of Railroads of September 10, 1918, it was provided:
SEC. 5. (a) During the period of Federal control the Director General shall, annually, as nearly as practicable, expend and charge to railway operating expenses, either in payments for labor and materials or by payments into funds, such sums for the maintenance, repair, renewal, retirement, and depreciation of the property described in paragraph (a) of Section 2 hereof as may be requisite in order that such property may be returned to the Companies at the end of Federal control in substantially as good repair and in substantially as complete equipment as it was on January 1, 1918: * * *
Clearly, under the contract the petitioner had a right to recover from the United States any valid claim which*1997 it might have by reason of undermaintenance of its properties during the period of Federal control. The petitioner knew that it had such a right under its contract and filed its claim with the Director General of Railroads for undermaintenance upon the basis thereof. The Director General never denied liability under contract. The petitioner's claim was not settled in 1920. It was an outstanding claim at the close of 1920 and remained a live claim until it was finally settled by the closing agreement of 1921. The closing agreement provided in part:
The purpose and effect of this instrument is to evidence complete and final settlement of all demands, of every kind and character, as between the parties hereto growing out of the Federal control of railroads, * * *
If any loss was sustained upon the settlement it was a loss sustained as a result of the settlement in 1921, and not a loss that is allocable to the year 1920. There was no determinable loss until the claim against the United States for undermaintenance was acted upon.
*1429 The petitioner has submitted as mass of evidence in support of its claim that it sustained a loss in 1920 as a result of the undermaintenance*1998 of its properties during the period of Federal control which was not made good by the lump-sum settlement of 1921. It has argued before the Board the validity of its claim for undermaintenance filed with the Director General of Railroads in 1920. It contends that the Director General of Railroads did not give sufficient weight to its contention for the "inefficiency of labor" during the period of Federal control in the adjustment of its claim. It presses upon the Board the merits of numerous formulae by which it arrived at the amount of its claim for undermaintenance as contrasted with formulae used by the Director General of Railroads in arriving at the amount of undermaintenance. We are of the opinion that no useful purpose will be served by a discussion of this evidence. It may furthermore be pointed out that the claim for undermaintenance is largely predicated upon the cost of labor and cost of materials during and at then end of the Federal control period and not upon the cost of labor and materials at December 31, 1917. We think that any capital loss deductible from gross income must be predicated upon the fair market value of the lost or destroyed property on March 1, 1913, or*1999 its cost if acquired subsequent to that date. The evidence does not establish such value or cost. We are of the opinion that if any loss was sustained as a result of the lump-sum settlement that loss does not pertain to the year 1920, which is the only year before us with respect to which the respondent has determined a deficiency. The contentions of the petitioner upon this point are not sustained. Cf. .
(3) The petitioner predicates error upon the inclusion in taxable income of $16,533,520.55 received by it from the United States under the provisions of section 209 of the Transportation Act of 1920. By the terms of that section, railroad companies which accepted the provisions of the act were guaranteed an operating income for the six-month period following the Federal control period of not less than one-half of the amount named as annual compensation in their contract with the Director General, or, if a noncontract carrier, not less than one-half of the amount estimated by the President as annual compensation under the Federal Control Act. If the carrier's operating income for the guaranty period exceeded the amount*2000 of operating income guaranteed, the carrier was required to remit the excess into the Treasury of the United States.
The petitioner accepted the provisions of the Act. The amount received by it was income from the carrying on of the business and was properly taxed as a part of the petitioner's gross income for *1430 1920, the year in which it was received. .
(4), (5), and (6) In the audit of petitioner's return for 1920, the respondent disallowed the deduction from gross income of $1,752,471.52 operating expenses, upon the ground that that amount measured a write-up in its books of account for materials and supplies which were charged out to operation and maintenance in 1920.
The facts upon this point are that at the beginning of Federal control the petitioner turned over to the Director General materials and supplies, including fuel, having an inventory value of $10,344,410.40, which included materials and supplies of a great many different classes. At the end of Federal control the Director General turned back to the petitioner materials and supplies of various classes having an inventory value*2001 of $12,096,881.92. The difference between these two amounts is $1,752,471.52. Of this amount $198,879.98 represented "leased rails and fixtures" and "material in temporary tracks," concededly capital items. Exclusive of these two amounts the increase in the inventory between the beginning and end of Federal control was $1,553,591.54. At the time that the materials and supplies were returned to the petitioner by the Director General certain classes of material were in excess of similar classes at the beginning of Federal control, while other classes of materials and supplies did not contain as many units as existed at the beginning of Federal control. In the final settlement between the petitioner and the Director General on September 15, 1921, it was agreed that neither party should pay the other anything for the shortages or overages.
With respect to this issue the petitioner makes three contentions:
First: That it sustained a loss of $2,236,938, which represented the shortage of the physical units at prices prevailing in 1920, or a loss of $1,541,802 if the shortage in physical units be valued at 1917 prices.
Secondly: That the operating expenses of 1920 deductible from*2002 gross income should not be reduced by the inventory adjustment.
Thirdly: That the Commissioner is in error in determining the amount of the increase in the inventory chargeable to operating expenses in 1920.
With respect to the first contention, it is to be noted that the Director General of Railroads, under his contract with petitioner, was obligated to return to it materials and supplies equal in quantity, quality, and relative usefulness to those of the materials and supplies which he received. The Director General of Railroads never denied his liability under this contract. The contractual liability was settled in 1921 and not in 1920. There was no "identifiable event" *1431 which marked the loss in the inventory, assuming that there was one, as a loss occurring in 1920. When the contract was settled in 1921, the petitioner accepted the inventory turned over to it by the Director General in place of that received by the Director General from the petitioner on December 31, 1917. In the absence of any identifiable event to fix any loss as having been sustained in 1920, this contention of the petitioner is not sustained.
*2003 The second contention of the petitioner is decided adversely to it on the authority of .
The third contention relates to the determination of the amount of the increase in the inventory between December 31, 1917, and March 1, 1920, which went into additions and betterments. It is admitted that a percentage of the increase went into additions and betterments. The petitioner contends that the percentage is 11.61. The respondent, on the other hand, has found a figure more favorable to the petitioner, namely, 11.73. The question is to what base the percentage shall be applied in determining the amount which went into additions and betterments. The petitioner, after making extensive investigations, reaches the conclusion that the base should be $2,734,922.66, which represents the increase in the value of materials and supplies other than fuel between December 31, 1917, and February 29, 1920. The respondent, on the other hand, uses as a base the increase in the total inventory, which increase, excluding $198,879.98 for leased rails and fixtures and material in temporary tracks, was $1,553,591.54. The respondent's*2004 computation follows:
| Amount of materials and supplies applicable to additions and betterments (11.73 per cent of $1,553,591.54) | $182,193.63 |
| Leased rails and fixtures | 174,490.68 |
| Materials in temporary tracks | 24,389.30 |
| Total | 381,073.61 |
The respondent deducts this total of $381,073.61 from $1,752,471.52, the total increase in the book value of the inventory, and arrives at the sum of $1,371,397.91 as representing the increase in the value of materials and supplies which went into operating expenses in 1920 to be excluded from allowable deductions. The petitioner's method is as follows:
| Approximate amount of book increase of materials returned by Director General that was applied to additions and betterments (11.61 per cent of $2,734,922.66) | $317,524.52 |
| Leased rails and fixtures | 174,490.68 |
| Materials in temporary tracks | 24,389.30 |
| Total | 516,404.50 |
*1432 Deducting this amount from $1,752,471.52 it arrives at $1,236,067.02 as the amount of the operating expenses shown by its books of account which should be disallowed as a deduction from gross income on this point.
It should be stated, however, that this is not all of the petitioner's*2005 contention upon this point, since it also claims the right to deduct the amount of the shortage in materials and supplies returned. Counsel for the petitioner states that the net change, if such a deduction is made, is after giving effect to counterbalancing items to increase the amount of deductions by the further sum of (that is additional to $516,404.50) $180,896.03, if respondent is correct in not eliminating the fuel item, and by $51,544.25 if petitioner is correct in its contention that the fuel item should be eliminated.
Materials and supplies, other than fuel, were carried on petitioner's books of account in a separate account from the fuel account. Charges and credits to the account for fuel were handled independently of other supply charges. The fuel account can be checked up independently of the other items of materials and supplies at any time. Although the sum total of materials and supplies other than fuel charged to additions and betterments can be readily obtained, it is a practical impossibility to determine the particular items of materials and supplies, other than fuel, that are so charged.
The petitioner has made detailed studies upon this point and has*2006 introduced in evidence its detailed computations. From a careful study of them we are of the opinion that the item "fuel" should be eliminated from the inventory at the beginning and end of Federal control in arriving at the amount of the increase that went into additions and betterments. The item of fuel did not largely enter into additions and betterments. Of the increase of $2,734,922.66 in the book value of materials and supplies, 11.61 per cent, or $317,524.52, went into additions and betterments other than the capital accounts of "leased rails and fixtures" and "materials in temporary tracks." The petitioner's contentions upon this point are sustained and it is held that the operating and maintenance expenses of the petitioner for 1920 should be reduced only by the amount of $1,236,067.02 by reason of the increase in the book value of the inventory between the beginning and end of the Federal control period.
The further contentions of the petitioner that the amount of the increase in the inventory which went into additions and betterments was in excess of $516,404.50 is not supported by the evidence. There were shortages and overages in the different items on the inventory*2007 as it was turned back of the petitioner by the Director General. The petitioner admittedly has not evidence from which it can determine how much of any specific item of inventory went into additions and *1433 betterments and how much went into maintenance expenses. Its contention that more than $516,404.50 of the increase went into additions and betterments is not sustained.
(7) This issue relates to the question whether the petitioner realized a profit in 1920 upon the retirement of a portion of its funded debt. The respondent has included in the petitioner's taxable income of 1920, $24,191.95 as taxable profit from this source. The petitioner contends that no part of the difference between the par value of its outstanding bonds and the amount paid to retire them is taxable income. The petitioner's contention upon this point is sustained. .
(8) and (9) The question presented by this issue is whether amortized premiums on bonds issued by the petitioner in 1892 and in 1916, and shown upon the petitioner's books of account as accruals of 1920, were taxable income of that year. There is no question but*2008 that the premiums were received in the years 1892 and 1916, respectively. The respondent has, however, included in the gross income of 1920, $2,860.80 representing the amortized premiums allocable to 1920 upon the 1892 issue and $10,069.94 as amortized premiums allocable to 1920 upon bonds of the taxpayer issued in 1916.
The item of $2,860.80 did not constitute a part of the petitioner's gross income for 1920. ; affd., .
The question now before us for the first time is whether any part of the premium received by the petitioner upon the issuance of its bonds at a premium in 1916 is taxable income of the year 1920. This case is unlike the Old Colony Railroad Co. case in that here the bonds were issued subsequent to March 1, 1913.
The classification of accounts by the Interstate Commerce Commission requires the accrual of the premium to be taken up as income; in other words, a taxpayer keeping its books of account upon the accrual basis is required to spread the premium received over the life of the bond and report as income of each year an aliquot part of the amount received. The regulations*2009 of the Commissioner are to the same effect. Article 544, Regulations 45.
We are of the opinion that the petitioner's books of account accurately reflect the accrual of the premium upon the bonds issued in 1916 in the amount of $10,069.94 for 1920. We can not doubt that where a corporate taxpayer sells its bonds or other debt obligations at a price in excess of the amount which it will have to pay at the maturity of the bond or obligation in the redemption thereof derives income from the transaction. The action of borrowing money is incidental to the carrying on of the petitioner's business. If it makes a gain in such transaction there appears to be no provision *1434 of the statute which exempts that gain from income tax. There appears to be only the question as to whether it all should be reported as income in the year of its receipt or should be spread over the life of the bond. Where a taxpayer keeps its books of account on the accrual basis and spreads the income over the life of the bond, ascribing to each year an aliquot part of the income received, we can see no reason why, for income tax purposes, the books of account do not reflect to correct income. Article*2010 212(b) of the Revenue Act of 1918 provides:
The net income shall be computed upon the basis of the taxpayer's annual accounting period * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. * * *
Section 213(a) of the Act provides in part:
* * * The amount of all such items [gains, profits, and income] shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under subdivision (b) of section 212, any such amounts are to be properly accounted for as of a different period; * * *
In the instant proceeding the respondent makes no contention that the petitioner's books of account for 1920 do not reflect its true net income so far as the item under consideration is concerned. Neither does the petitioner make any such contention. In fact the petitioner in its beief states:
*2011 If such premium constitutes income, then, under the logic of the reasoning in , we see no escape from the proposition that such premium should be amortized. * * *
We may assume that the petitioner did not return as income for 1916 the full amount of the premiums which it received on bonds issued in that year. The regulations of the Interstate Commerce Commission upon this point have long been in force. Cf. . If it made its return for 1916 in accordance with its books of account, as we may presume it did, it returned as income in that year only an aliquot part of the premium received. We see no good reason why, for 1920, it should not likewise return as income an aliquot part of the premium received in 1916. The contention of the respondent upon this point is sustained.
(10) This issue is whether the deduction for amortization of discount upon bonds purchased for retirement and retired during 1920 *1435 was properly computed. The evidence shows that the interest which would have accrued*2012 upon certain issues of the petitioner's bonds in 1920, if the amount outstanding at the beginning of the year was likewise outstanding at the close of the year, was $29,685.84. This is the amount which the petitioner contends is the accrual of discount upon those bonds. The evidence is to the effect, however, that $496,000 par value of these bonds was retired and canceled during the year. In respect of such bonds the respondent has disallowed the deduction of all or a part of the accrual of discount claimed. The bonds were retired at different dates during the taxable year. We think it is not competent for the petitioner to contend that it is entitled to deduct discount upon the bonds after the date of their retirement. The respondent has determined that the amount of deductible discount upon the issues of bonds in question was $21,228.84. The evidence does not convince us that the petitioner is entitled to deduct any greater amount for the accrual of the discount upon such bonds. For lack of evidence showing error on the part of the respondent in making his computation of the deductible discount, the claim of the petitioner for the deduction of an additional amount of $8,457*2013 is not sustained.
(11) The issue raised by this assignment of error is that the petitioner failed to deduct from gross income, and that the respondent failed to allow the deduction from gross income in the computation of the deficiency, the discount which accrued in 1920 on certain bonds issued prior to 1913. The amount of the discount and expense on certain bonds applicable to 1920 which was not allowed as a deduction by the respondent is $8,295.68. This issue is determined in favor of the petitioner, upon the authority of ; affd., C.C.A., 7th Cir., March 26, 1931.
(12) In 1920, petitioner paid $14,602.50 representing assessments made against it by the Association of Railway Executives as its proportion of the expenses payable by it. The respondent admits in his brief that the facts in this issue are substantially the same as in the case of , in which we held that such contributions were proper deductions from the petitioner's income. The contention of the petitioner upon this point is sustained.
*2014 (13) In 1920, the petitioner paid $7,300 to certain Y.M.C.A.'s and the Travelers' Aid Society. It is admitted by the respondent that upon substantially the same state of facts the Board held in , that such payments are proper deductions as operating expenses. Upon the basis of our decision in that case the contention of the petitioner is sustained. The petitioner alleged in its petitioner that the amount paid was $7,450. *1436 But the petitioner has proved payments of only $7,300. The deduction of only $7,300 is allowed.
(14) and (15) In 1920, the petitioner charged to profit and loss $317,943.78 representing unrefundable overcharges written off petitioner's books in 1920 and $37,592.17 representing certain checks and vouchers issued in payment of accounts and wages which were never called for or cashed and which were written off to profit and loss at the end of three years. The contentions of the respondent upon these points are sustained.
Reviewed by the Board.
Judgment will be entered under Ruel 50.
Footnotes
1. Deficit. ↩