*136 Decision will be entered for the petitioner
Petitioner is a transferee of the Koppers Products Co., of which it was the sole stockholder, having received its assets and assumed its liabilities upon its final liquidation in 1936. In 1935 petitioner had determined to liquidate the subsidiary, which had a large bond issue outstanding in the hands of the public. The subsidiary had neither the funds nor the credit necessary to purchase its outstanding bonds, but petitioner's credit was sufficient and it borrowed the necessary funds in 1935 and purchased bonds from the individual holders at a figure slightly below par. These bonds, with all others, were thereupon called for redemption and petitioner as the owner thereof received payment at 102, plus accrued interest, as provided by the bond indenture. Petitioner reported as income to it the excess of this amount over its cost of the bonds. Respondent determined that the transaction constituted a shifting of profit by a fictitious sale to a controlled corporation and, under section 45 of the Revenue Act of 1934, treated it as a purchase by the subsidiary of its bonds from the public on which it realized a gain and disallowed the*137 deduction taken by the subsidiary on its return for that year of the premium and accrued interest paid on redemption. The resulting deficiency was determined as a liability of petitioner as transferee. Held, that the purchase of its subsidiary's bonds by petitioner with its own funds was a legitimate transaction by petitioner and the amount received by it on redemption of the bonds, being no more than its subsidiary would have been required to pay to any holder of the bonds under such conditions, the transaction was not a fictitious sale to a controlled corporation and the deficiency determined as to the subsidiary and the liability asserted therefor against the petitioner are erroneous.
*153 Respondent has determined a liability against petitioner as transferee of the Koppers Products Co. for an unpaid income tax deficiency in the sum of $ 67,757.53 determined against that company for the calendar year 1935.
FINDINGS OF FACT.
We include by reference the stipulation of facts filed by the parties. Facts hereinafter*138 set forth, in addition to those stipulated, are found upon evidence adduced at the hearing.
The petitioner is a corporation, with its principal office and place of business at Pittsburgh, Pennsylvania. It filed its Federal income tax return for 1935 with the collector of internal revenue for the twenty-third district of Pennsylvania. During 1935, at which time the petitioner was known as the Koppers Gas & Coke Co., it was the owner of all of the outstanding capital stock of the Koppers Product Co., a Delaware corporation, hereinafter referred to as the taxpayer.
On July 1, 1930, the taxpayer issued and sold to the public $ 6,650,000 in 5 percent debenture serial gold bonds under a bond indenture providing for the payment of $ 562,500 in principal amount of the bonds on July 1 of each year beginning July 1, 1934. The indenture permitted the calling of the bonds prior to maturity on any interest date at 102 plus accrued interest.
In 1933, due to the business depression, the taxpayer found itself without earnings sufficient to meet the interest on its bond issue and was forced to negotiate an extension agreement with its bondholders. Under this agreement the date of maturity of the*139 bonds was extended and a certain percentage of the interest was deferred for several years, subject to a provision that, if the earnings increased and were in excess of the interest to be paid, such excess would be applied toward payment of the difference between the lower rate of interest and the original rate of 5 percent and, furthermore, that any excess in earnings above 5 percent should be retained for the payment of the interest in succeeding years.
In 1934 the taxpayer's business improved and its earnings exceeded 5 percent, but, due to the provisions of the extension agreement, the excess above the amount required to pay bond interest could not be distributed in dividends to petitioner, its sole stockholder. Petitioner was thus placed in the position that it was forced to forego the receipt *154 of income from its investment in the taxpayer. In addition, it was no longer permitted under existing law to file a consolidated return with its subsidiary and in 1935, the year in which the events giving rise to the present deficiency transpired, it had planned to liquidate the taxpayer and take over its assets and business. Petitioner thereupon conceived a plan of going into*140 the open market and acquiring the taxpayer's outstanding bonds. The taxpayer at this time, although it had accumulated a cash surplus of $ 1,500,000, had neither the cash nor the credit sufficient to finance the purchase of its bonds. The resources and credit of petitioner, however, were sufficient to undertake the purchase. It then secured bank loans of nearly $ 4,000,000 and also borrowed from the taxpayer $ 1,500,000, representing the cash surplus held by it. With these funds the petitioner purchased $ 4,077,500 of the taxpayer's outstanding bonds in the hands of the public at 94 1/2, aggregating $ 3,853,237.50, plus unpaid interest for 1935 of $ 100,238.45, or a total cost of $ 3,953,475.95. Following this and within the same year petitioner purchased $ 1,197,500 of the taxpayer's bonds at various prices ranging from 94 1/2 to 102 3/4, or an average of 98 2/5. The amount paid for these bonds was $ 1,183,372.09 plus unpaid accrued interest for 1935 of $ 26,659.14, or a total cost of $ 1,210,031.23. The total price paid by petitioner for all of the $ 5,275,000 of outstanding bonds of the taxpayer was $ 5,163,507.18, which included $ 126,897.59 of accrued interest for 1935.
*141 Upon so acquiring all the outstanding bonds of the taxpayer except $ 247,000 par value thereof the petitioner, as a step in bringing about the liquidation of its subsidiary, the taxpayer, had it call these bonds for redemption. As a result the petitioner received therefor a total of $ 5,716,781.25, or at the rate of 102 plus accrued interest for each bond, as provided in the bond indenture. The taxpayer effected this payment by transferring to petitioner notes receivable in the face amount of $ 1,250,000, notes and trade accounts receivable in the face amount of $ 997,416.85, loans receivable in the face amount of $ 100,000, inventories at book cost in the amount of $ 1,869,364.40, and canceling a debt of $ 1,500,000 owed to the taxpayer by petitioner. The taxpayer redeemed its bonds in the par value of $ 247,000, outstanding in the hands of the public, by paying therefor 102 plus accrued interest -- the same price paid to petitioner.
The amounts so received in excess of its cost of the bonds redeemed, the petitioner entered on its books as profit on the sale of its subsidiary's bonds and reported as income on its return for 1935, which return showed no tax liability and no deficiency*142 was determined.
The taxpayer, in making its return for 1935, deducted $ 105,500 representing the 2 percent premium over and above the issuing price of the bonds and paid by it to petitioner when the bonds were redeemed. It also deducted upon its return for that year $ 178,031.25 as interest *155 on the bonds for that year. In the notice of deficiency the respondent allowed the latter amount plus $ 1,345.98 as a deduction to the taxpayer, thus making the total amount allowed as 1935 interest, the sum of $ 179,377.23. Respondent disallowed the deduction of $ 105,500 for bond premium. He also disallowed a deduction by the taxpayer of $ 158,250, the amount reflecting the difference between interest at 5 percent for 1933 and the interest at 2 percent which was paid in that year. This amount was carried forward by the taxpayer as its obligation for accrued interest required to be paid and which was paid upon the redemption of the bonds.
In determining the deficiency respondent held that the amount of $ 238,390.41, the difference between the face amount of the bonds, or $ 5,275,000, and $ 5,036,609.59, the price at which the bonds, exclusive of interest, were purchased in the open*143 market, constituted taxable income to the taxpayer for the year 1935. The adjustments made by respondent in his contested determination were explained in the notice of deficiency as follows:
| (c) An adjustment for purchase of bonds has been made as follows: | ||
| Profit on purchase of bonds | $ 238,390.41 | |
| Alleged premium payment disallowed | 105,500.00 | |
| Alleged 1933 interest payment disallowed | 158,250.00 | |
| Total | 502,140.41 | |
| Adjustment for 1935 accrued interest on bonds purchased | 1,345.98 | |
| Net adjustment | 500,794.43 |
It has been held that the difference between $ 5,275,000.00, the issuing price of these bonds, and $ 5,036,609.59, the price at which they were acquired from the bondholders by the parent company for resale to your Company, resulted in a profit taxable to you. It has been held that the alleged premium of 2% paid to the parent Company in the purchase of these bonds does not represent a part of the true cost of the bonds and is, therefore, disallowed as a deduction from your gross income. It has been further held that the alleged additional accrued interest for 1933 paid by your Company to the parent Company, but which was not payable or paid to the *144 bondholders under the extension agreement of July 3, 1933, does not represent an allowable deduction from your gross income. The difference between $ 179,377.23, the accrued 1935 interest paid to the bondholders by the parent Company and $ 178,031.25, the amount allocated to this accrued interest in the total consideration paid to the parent Company by your Company, has been allowed as a deduction from your gross income.
On October 31, 1936, the taxpayer distributed its entire assets to petitioner, as its sole stockholder, in complete liquidation and on December 31, 1936, a certificate of dissolution of the taxpayer was issued by state authority.
OPINION.
Petitioner admits that it is a transferee of the Koppers Products Co. and liable as such for any tax deficiency of that company. It denies, however, that there is any deficiency. The deficiency *156 results from respondent's treating the transaction, under which petitioner acquired certain bonds of its subsidiary at a price below par in the open market and then brought about their redemption by the subsidiary, as in reality a transaction of the subsidiary and the gain accruing as taxable to it.
In the notice of deficiency *145 respondent makes no mention of any specific statutory provision upon which his action was predicated. At the hearing and upon brief his counsel takes the position that this action was authorized by section 45 of the Revenue Act of 1934. 1 It is argued that the facts here show that the petitioner has dealt with its controlled subsidiary in a way which constitutes a so-called "milking" of the controlled corporation to the extent of a profit which it could not have obtained in a transaction at arm's length with a corporation not so controlled.
*146 The parties appear to be in agreement as to the purpose and effect of section 45, supra. Respondent on brief calls attention to Senate Report No. 960, 70th Cong., 1st sess., explaining the purpose of the section as follows:
Section 45 is based upon section 240 (f) of the 1926 Act, broadened considerably in order to afford adequate protection to the Government. The section of the new bill provides that the Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, in such manner as may be necessary in order to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of "milking"), and in order to arrive at their true tax liability.
The question to resolve, therefore, is whether the petitioner has in fact here brought about the evasion of tax by its subsidiary by causing a transaction, actually that of the subsidiary, to be carried out in petitioner's name and the profit thereon to be reflected as realized by it. Respondent contends for the affirmative. He argues that there*147 has been a "shifting of the profits" to petitioner through a "fictitious sale" and that the situation is, in its essence, the same as that revealed in ; affd., ; certiorari denied, ; rehearing denied, ; ; affirmed, per curiam, ; and ; affd., .
We can not agree. In the Asiatic Petroleum case, supra, the taxpayer owned a certain block of stock which had increased in value *157 some $ 3,000,000 over its cost, and had negotiated a sale at a figure realizing this gain. In order to evade the tax upon this profit the conveyance was not made direct to the purchaser but to a controlled foreign subsidiary for the amount of the cost of the stock to the parent. The parent then caused the subsidiary*148 to convey the stock to the ultimate purchaser for the real consideration and the gain was by this device shifted to the subsidiary. In the Pennsylvania Indemnity case the taxpayer caused certain of its controlled subsidiaries to convey to it, at their original cost, certain securities which had in fact depreciated greatly in market value. The taxpayer parent then sold these securities at market and sought to deduct the "loss" registered to it on the face of the transaction. A substantially similar transaction was presented in the Majestic Securities case. In these three cases upon which respondent relies the respective sales were to or by the controlled corporation and were each manifestly fictitious. This was there clearly demonstrated by the fact that the value of the consideration paid had no relation to the market value of the property involved but was an arbitrary amount fixed for the specific purpose of establishing for tax purposes a gain or loss or a false and fictitious basis for computing gain on resale. No such sales would have been made to outside interests.
Here the character of the deal is not unusual and could as probably have occurred with a stranger. *149 It is true that the taxpayer here was a controlled corporation. Nothing, however, was taken from it or conveyed to it over and above what would have passed between petitioner and an uncontrolled corporation in a similar transaction.
Here the taxpayer three years before had defaulted on its bonds and had been forced to obtain an extension agreement from the bondholders which precluded it from paying dividends while the bonds were outstanding. The existence of this condition subsequent to the improvement in its earnings which, except for this restriction, made possible the payment of dividends to its stockholder, the petitioner, was annoying to the latter. Because of that and other factors, not here involved, the liquidation of the taxpayer by petitioner became desirable. At this time the taxpayer had outstanding in the hands of the public a large amount in bonds. A primary requisite in its liquidation would be the redemption of these bonds. On the call for their redemption the taxpayer would be required to pay the bondholders 102 plus accrued interest, which interest included an amount for 1933 on which payment had been deferred under the extension agreement. The bonds were*150 selling slightly below par, but it is agreed by both parties that the taxpayer lacked both the necessary funds and credit to purchase its bonds. The petitioner, however, had sufficient credit to obtain such funds. It did so and purchased bonds from the public for a total amount of $ 5,163,507.18. This was a purchase which *158 petitioner had a perfect right to make. It used its own funds for the purchase. It bought the bonds on the market for itself. Thereupon, as owner of the taxpayer's bonds, it was entitled to all the rights of a bondholder, and those rights were not reduced by reason of the fact that it was also the owner of petitioner's stock.
Then followed the transaction under which these bonds were redeemed by the taxpayer and which respondent asserts resulted in a shifting of profits and was "fictitious." We find, however, nothing fictitious in the transaction. It was the same transaction, in so far as the consideration paid by the taxpayer for the redemption, as it would have been had it been carried out by the taxpayer with the public owners of the bonds prior to their acquisition by petitioner. The taxpayer was required to pay nothing more nor less than the*151 owner of the bonds was entitled to receive, under the terms of the bond indenture. The consideration was not affected by the fact that the obligor on the bonds was a controlled corporation. The amount payable by the taxpayer upon redemption of the bonds was $ 5,716,781.25. This amount was paid to and received by the petitioner since it had purchased the bonds and was the then owner thereof. The excess of this payment over its cost of the bonds petitioner reported as income realized by it. The fact that petitioner sustained losses in the same taxable year in excess of this amount and thus no tax liability resulted, has no bearing on the only pertinent question, which is whether the income derived from the transaction was that of petitioner or its subsidiary. Cf. ; ; ; ; ; .*152
Respondent's counsel, on brief, makes the rather naive argument that petitioner, after it obtained the necessary funds for purchase of the taxpayer's bonds on the market, could have loaned these funds to the taxpayer and allowed it to purchase its bonds direct. This is true, and had it voluntarily done so and been content to accept insufficient security for the loan, the taxpayer would have had an increased tax liability as a result in the exact amount of the deficiency here determined. The answer, however, to this argument is that petitioner did not do this. It was free to and did use its funds for its own purposes. It was under no obligation to so arrange its affairs and those of its subsidiary as to result in a maximum tax burden. On the other hand, it had a clear right by such a real transaction to reduce that burden. ; ; ; ; .*153
*159 The action of respondent in treating the transaction involved here as, in fact, that of the taxpayer, on which a gain to it was computed, and his disallowance of the deductions of the taxpayer for accrued interest and bond premium paid petitioner on the redemption of the bonds, were erroneous.
Decision will be entered for the petitioner.
Footnotes
1. SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income or deductions between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.↩