Kansas City S. Ry. v. Commissioner

KANSAS CITY SOUTHERN RAILWAY CO. AND AFFILIATED COMPANIES, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Kansas City S. Ry. v. Commissioner

Docket No. 12054.

United States Board of Tax Appeals

16 B.T.A. 665; 1929 BTA LEXIS 2542;

May 24, 1929, Promulgated

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1. The total amount of compensation received by the petitioner from the United States Government for the use of its properties during the period of Federal control, as finally agreed upon, was income for each of the accounting periods for which said compensation was allowed.

2. Interest received from the United States Government on additions and betterments is taxable income and should be included in the computation of gross income for the years in which it accrued.

3. Depreciation or obsolescence claimed as a deduction by the petitioner for the taxable years on properties abandoned many years prior thereto is not an allowable deduction.

4. The petitioner derived a profit from the sale of stock of the Mena Land & Improvement Co., measured by the difference between the cost and the sale price thereof less commission as herein determined.

5. The petitioner is entitled to deduct in each of the taxable years that portion of the bond discount obtained by dividing the total discount by the number of years the bonds are to run.

6. Contributions or donations for the construction of spur tracks and other facilities along the petitioner's right of way do not constitute taxable income.

7. Interest due from the United States Government during the period of Federal control is not interest upon "obligations of the United States" within the meaning of section 213 of the Revenue Act of 1918, and is, therefore, not exempt from taxation, and should be included in the computation of gross income for the years in which it accrued.

8. Interest due from the petitioner to the United States Government is a proper deduction from gross income for the years in which it accrued.

9. Additional compensation awarded the petitioner in 1919 for service rendered in transporting United States mails for the period November 1, 1916, to December 31, 1917, is not taxable income for the year 1919.

10. Net income for 1918 should be increased by $800.46 erroneously eliminated therefrom by the respondent.

Fred R. Angevine, Esq., for the petitioner.

P. M. Clark, Esq., for the respondent.

Robert N. Miller, Esq., and John E. McClure, Esq., as amici curiae.

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MORRIS

This proceeding is for the redetermination of a deficiency in income taxes for 1918 and 1919 amounting to $123,846.26. The errors alleged to have been committed are:

(1) The respondent's finding that the petitioner's income from Federal compensation for 1918 was $3,274,837.64, instead of $3,800,000; and

(2) In finding that its income from Federal compensation for 1919 was $3,274,837.64 instead of $3,800,000; and

(3) His action in including in petitioner's taxable income for the years 1918 and 1919, or for any taxable year whatsoever, interest received from the United States Government on additions and betterments; and

(4) His denial of a deduction of $89,181.72 in the computation of net income for the year 1918, charged to depreciation; and

(5) In denying a deduction in the computation of net income of $89,993.40 for the year 1919, charged to depreciation; and

(6) In refusing to deduct in the computation of net income for the year 1919, $87,942.89 for loss on account of investment in stock of the Mena Land & Improvement Co.; and

(7) His failure to make an additional deduction of $26,158 in the computation of net income for 1918 on account of amortization of bond discount; and

(8) His failure to make an additional deduction in the computation of net income for 1919 of $26,158 on account of amortization of bond discount; and

(9) His action in adding to imcome for the year 1918, $14,741.06 on account of donations; and

(10) His action in adding to income for the year 1919, $12,878.54 on account of donations; and

(11) In his failure to exempt from taxable income for the year 1918, $199,883.92, being interest due from the United States Government; and

(12) In his failure to exempt from taxable income for the year 1919, $327,721.74, being interest due from the United States Government; and

(13) His refusal to deduct in the computation of net income for the year 1919, $26,290.32, for interest on unfunded debt; and

(14) In denying a deduction in the computation of net income for 1918 of $174,165.98, being the amount of interest due to the United States Government from the petitioner; and

(15) In denying a deduction in the computation of net income for 1919 of $326,315.12, being the amount of interest due to the United States Government from the petitioner; and

(16) His action in denying a deduction in the computation of net income for 1918 of $298,300.22 for state, county, and city taxes paid during the year 1918; and

(17) His action in increasing the petitioner's net income for the year 1919 by $53,103.29, representing additional compensation paid by the Post Office Department to it in the year 1921 for services rendered for the period November 1, 1916, to December 31, 1917; and

The respondent alleges affirmatively that errors were committed in that:

(18) For the year 1918 the petitioner reported as taxable income $800.46 under the caption "Income from Lease of Road"; that respondent in adjusting said income erroneously eliminated that amount and he now avers that the said net income should be increased by that amount; and

(19) That as to the issue raised by the petitioner in allegation of error numbered 6, hereinabove, the respondent avers that of this amount $36,065.07 has been allowed as a deduction, and, furthermore, that error was committed in said allowance of $36,065.07 and that no deduction of any amount should be allowed for loss on account of transactions between the petitioner and the Mena Land & Improvement Co., and, furthermore, that he committed error in his failure to include in taxable income for the year 1919 the profit derived by the petitioner in the sale of stock of the Mena Land & Improvement Co. for $40,000, said stock having been acquired during the years 1910 and 1911 at a total cost of $25,000; and

(20) That for each of the years 1918 and 1919 discount in the amount of $46,577.57 has been allowed as a deduction from the income of each of said years on account of amortization of bond discount, and he now avers that error was committed in said allowance and that no deduction should be allowed on account of said amortization of bond discount for either of said years.

FINDINGS OF FACT.

The petitioner, Kansas City Southern Railway Co., is a Missouri corporation, and its subsidiaries are incorporated under the laws of the following states: Texarkana & Fort Smith Railway Co., Texas; Arkansas Western Railway Co., Arkansas; Kansas City, Shreveport & Gulf Terminal Co., Louisiana; Poteau Valley Railroad Co., Oklahoma; Port Arthur Canal & Dock Co., Texas; K. C. S. Elevator Co., Missouri. All of said companies have their offices in Kansas City, Mo.

The petitioner and its subsidiary companies, during the whole of the years 1918 and 1919 and for a number of years prior thereto, constituted a railway system doing an interstate business, and filed operating returns with the Interstate Commerce Commission annually. During the said years in question the petitioner kept its books and records of account on the accrual basis, using the calendar year as an annual accounting period.

Under a provision contained in the Army Appropriation Act of August 29, 1916, the President, on behalf of the United States Government, on January 1, 1918, took possession and assumed control of the properties of the petitioner and certain of its said affiliated companies, viz, Texarkana & Fort Smith Railway Co., Arkansas Western Railway Co., Kansas City, Shreveport & Gulf Terminal Co., Poteau Valley Railroad Co., and Port Arthur Canal & Dock Co., and, through the Director General of Railroads, used and operated said properties during the 26-month period from January 1, 1918, to February 29, 1920, both dates inclusive.

Federal Compensation

The petitioner and its subsidiary and affiliated companies were entitled to just compensation for the use of their facilities under the provisions of the Federal Control Act as amended March 21, 1918 (40 Stat. 451).

The petitioner and its said affiliated companies and the Director General of Railroads did not enter into either an agreement or the standard form of contract for the use of their properties by the Federal Government.

The petitioner, subsequent to September 30, 1921, filed a claim with the Director General of Railroads for compensation during the 26-month period of Federal control in the amount of $9,518,125.87.

The petitioner and its affiliated companies set up on their books of account an accrued income, as just compensation from the Director General for the use of their properties, an amount of $3,495,584.85 for each of the years 1918 and 1919, this amount being based on the original certification of the Interstate Commerce Commission as well as the petitioner's calculation of their average railway operating income for the three years ended June 30, 1917.

In making its consolidated corporation income and profits-tax return for the year 1918, the petitioner stated its income from Federal compensation to be the said amount of $3,495,584.85, on which basis the tax was paid.

In making its consolidated corporation income and profits-tax return for the year 1919, the petitioner stated its income from Federal compensation to be the said amount of $3,495,584.85, but paid its tax on the basis of the Federal compensation actually received in cash from the Director General of Railroads, to wit: $2,463,000.

In its final certification to the President, the Interstate Commerce Commission ascertained the average annual railway operating income of the petitioner and its affiliated companies to be $3,274,837.64.

The petitioner did not accept the amounts ascertained and certified by the Interstate Commerce Commission. Negotiations were had with the Director General, and on November 14, 1923, a final settlement agreement covering the 26-month period of Federal control was effected. By the terms of this agreement all claims of the Director General against the petitioner, and all claims of the petitioner against the Director General arising out of the operation of the properties of the petitioner and its affiliated companies by the Director General during the Federal control period, were liquidated and settled.

In a schedule prepared by the Director General of Railroads supporting the final settlement agreement, it is disclosed that the petitioner and its affiliated companies were allowed as compensation for the use of their properties during the 26 months of Federal control the amount of $8,222,950.82. This latter amount, when prorated over the period of Federal control, is the equivalent of $3,800,000 annually.

The respondent in his deficiency letter of December 18, 1925, sets up as "Income from lease of Road" for each of the years 1918 and 1919, the amount of $3,274,837.64, being the amount finally certified by the Interstate Commerce Commission as the average annual railway-operating income for each of those years, as set forth above, and proposes to tax said amounts in lieu of the amounts as returned by the petitioner as aforesaid.

The respondent inadvertently eliminated from taxable income in the year 1918 the amount of $800.46, due to the fact that respondent assumed that the entire amount reported in the tax return as "Income from lease of road, $3,496,385.31" was received from the Director General of Railroads, whereas $800.46 of said amount was received from the Central Coal & Coke Co.

Interest on Additions and Betterments

For the years 1918 and 1919 neither the petitioner nor any of its affiliated companies accrued any amount whatever as income receivable from the Director General on account of additions and betterments completed during the period of Federal control. An amount was accrued in later years, and a claim was filed subsequent to September 30, 1921, with the Director General for an allowance of $151,370.56, allocated by the petitioner over the period of Federal control as follows:

Calendar year 1918	$ 29,621.86
Calendar year 1919	101,561.92
January and February 1920	20,186.78

The petitioner's computation of the above amount was upon an interest basis of 6 per cent per annum, whereas the total amount, when computed upon an interest rate of 4 per cent for additions and betterments - road, and 6 per cent for additions and betterments - equipment, results as follows:

Calendar year 1918	$ 27,472.39
Calendar year 1919	85,752.33
January and February 1920	16,586.17
Total	129,810.89

In the final settlement with the Director General of Railroads on said November 14, 1923, the petitioner was allowed as rental interest, on account of additions and betterments - road, and additions and betterments - equipment, the amount of $128,676.17, which amount, as computed by the Director General, when allocated over the period of Federal control, is as follows:

Calendar year 1918	$ 27,022.22
Calendar year 1919	85,202.49
January and February 1920	16,451.46

Deductions for Abandoned Property

Prior to the year 1909 the petitioner was engaged in interestate commerce. Its line was about 786 miles in length and extended from Kansas City, Mo., to Port Arthur, Tex. The road was built years before 1909, when the country was heavily timbered and sparsely settled and the traffic was correspondingly small. The traffic at that time would not support, nor could capital be obtained for, an expensively constructed road, and, in consequence of the general practice in the development of the country, the road was built with rather heavy ruling grades.

Due to a heavy increase in traffic and brisk competition, the petitioner was confronted with the problem of increasing the capacity of the road. Two methods were presented - one, by double-tracking; the other, by lowering the grades and permitting traffic to be moved more rapidly. Two methods of reducing the grades at various points along the line were presented - one, by raising or lowering the roadbed on the existing right of way; the other, by the construction of sections of new road in substitution for portions of the road in instances where the same result could be obtained at less cost. The program of improvement contemplated not only many changes on the original right of way, but also a number of changes by the substitution of short sections of road on new ground, where that method was more economical. Work on the program was commenced in 1909 and completed in 1912 and involved about 41 per cent of the entire line, and the expenditure of several million dollars. The road at each of the several and many points where new locations were utilized was in no way worn out, was fully maintained, and was capable of performing for an indefinite time the function for which it was originally constructed. All of the changes were made for the purpose of increasing the capacity of the line, securing economic operation, and rendering improved service to the public. The grade revisions were completed by removing the tracks to adjacent parcels of ground, which were procured and substituted for the original parcels; the use of the latter parcels was discontinued.

In addition to the revision of the grade above described, petitioner owned in 1909 a shop and terminal plant at Shreveport, La. The shop, with its equipment, was not worn out or obsolete, and was capable, with ordinary running repairs, of performing for an indefinite term the functions for which it was orginally constructed. Petitioner constructed in 1909 - 1912 a new and enlarged shop and terminal plant at Shreveport on a new and different location from that of the shop and terminal plant first above mentioned and upon the completion of the new shop and terminal plant, the old shop and terminal plant were abandoned.

The orders and classification of the Interstate Commerce Commission applicable to steam roads provided that the petitioner should charge to current expenses of operation the estimated cost, less salvage, of replacing the discontinued portions of the road as well as the estimated replacement value, less salvage, of said old shop and terminal plant, provided, however, that upon application by the petitioner to the Commission, such charge to operating expense account might be charged in monthly installments distributed over a period of time to be designated by the Commission.

After prolonged litigation (See case of Kansas City Southern Ry. Co. v. United States (Interstate Commerce Commission Intervener), 204 Fed.Rep. 641, and Kansas City Southern Ry. Co., App. v. United States of America and the Interstate Commerce Commission,231 U.S. 423">231 U.S. 423; 34 Sup.Ct. 125) and upon application to the Interstate Commerce Commission after the decision of the Supreme Court of the United States was rendered, permission was granted the petitioner in the Commission's supplemental order of February 3, 1914, to spread the estimated cost, less salvage, of replacing the discontinued portion of the road as aforesaid and the estimated replacement value, less salvage, of said shop and terminal plant, in annual installments over a period of years ending December 31, 1925.

The following is a letter from the Interstate Commerce Commission authorizing the petitioner to spread those amounts over a period of not to exceed 15 years from the date of the expenditures:

FEBRUARY 3, 1914.

Mr. R. J. MCCARTY,

Vice President, Kansas City Southern Railway Co., kansas City, Mo.

Dear Sir: -

Your letter of January 26, replying to my letter of January 22, relative to the disposition of amounts now carried in suspense by your company on account of the abandonment and replacement of portions of its line, has been received, and due consideration has been given to your request that your company be permitted to charge the amounts in question to Operating Expenses in equal monthly installments to April 6, 1950.

It is the view of the Commission that these amounts should be disposed of in a much shorter period. The period of disposition of an amount representing the cost of replacing in kind abandoned property has no apparent relation to the period of life of the bonds issued to finance the undertaking. Considering the possibility that your company will desire to accumulate through Operating Expenses reserves for the abandonment and replacement of other property, it seems desirable to dispose of the amount you are now carrying in the shortest possible period without unduly burdening the operating expense accounts. It is our opinion that the period should not exceed fifteen years from the date of the expenditures.

* * *

I should be glad to have you give these suggestions and inquiries your prompt consideration and advise me further.

Respectfully,

(Signed) JAS. S. HARLAN,

Commissioner.

The amounts charged monthly to operating expenses on said account during the calendar years 1918 and 1919, aggregated $89,181.72 and $89,993.40, respectively, which said amounts were claimed and taken as deductions from taxable income in petitioner's consolidated corporation income and profits-tax returns for the years 1918 and 1919, respectively.

For the purpose of determining the income for the "test period" under Federal control, those deductions were considered as a deduction from income, and the income was decreased thereby, and the amount of net income so arrived at was the basis of the certification by the Interstate Commerce Commission of the "test period" income used as the basis for fixing compensation during Federal control. The so-called "guaranty period" was also effected by this deduction. The net income guaranteed to the Kansas City Southern under the guarantee provision of the Transportation Act was arrived at and paid by taking the difference between the actual net income in the six months following the end of Federal control and the average compensation allowed during the Federal control period.

The respondent has disallowed each of the above mentioned amounts as a deduction from income in each of said years to wit: $89,181.72 in 1918 and $89,993.40 in 1919.

In the event it is finally decided that the deductions hereinabove described are properly allocable to years subsequent to 1912, including the years 1918 and 1919, then the proper amounts of deductions for said years in arriving at the net income are:

1918	$89,181.72
1919	$89,993.40

Mena Land and Improvement Company

On July 12, 1910, the petitioner caused the Mena Land & Improvement Co. to be organized under the laws of the State of Arkansas, with an authorized capital of $25,000. All of the stock was owned by the petitioner herin, the qualifying shares for the most part being held by officers or employees of the petitioner.

Prior to 1910 the petitioner had maintained one of its division points at Mena, Ark. On September 15, 1910, for economical and lawful reasons, it changed the Mena division point to other points. This rearrangement required a number of its employees having homes in Mena to move to such other division points. In order to save those employees from hardship, the petitioner arranged to acquire their homes for the amount of money which such employees had invested therein. For this purpose said Mena Land & Improvement Co. was organized.

The first 12 shares were issued to 12 individuals as incorporators and were endorsed in blank to the petitioner. In November, 1910, the petitioner acquired the remaining 238 shares of the capital stock of said corporation, the transaction being set up on the books of account of the petitioner by journal entry No. 139, under date of November 30, reading as follows:

Capital Stock Mena Land and Improvement Co.

To

Mena Land and Improvement Co.

For par value of 238 shares of the capital stock of The Mena Land and Improvement Co. purchased by the Kansas City Southern Ry. Co., and in payment therefor, giving The Mena Land and Improvement Co. credit in open account as against a portion of advances heretofore made to The Mena Land and Improvement Co. See File #14712.

238 shares at $100 per share --- $23,800.00

In January, 1911, the petitioner took upon its books the remaining 12 outstanding shares of the capital stock, and recorded the transaction on its books by journal entry No. 137 of January 31, 1911, which reads as follows:

Capital Stock, Mena Land and Improvement Co.

To

Mena Land and Improvement Co. $1,200.00

To transfer from the open A/c Mena Land & Improvement Co. to the debit of Capital Stock, M.L. & I. Co., the amount of K.C.S. Vo. #225, June 1910 made to cover draft of J. B. McDonough to cover incorporation expenses M.L. & I. Co. which amount was credited by the Mena Land & Improvement Co. to Subscribers to Capital Stock in payment of the subscriptions of the original 12 subscribers. The 12 shares of stock in question having been endorsed in blank and are held by H. Visscher, Trea., subject to the order of proper officer of The K.C. Sou. Ry. Co --- $1,200.00

The Mena Land & Improvement Co. began immediately in 1910 to acquire the property of the employees situated at Mena at cost price to such employees, and the petitioner advanced to the Mena Land & Improvement Co. various sums of money aggregating $236,200 over and above the $25,000 which was transferred to the capital stock account of the Mena Land & Improvement Co. These advances were between September, 1910, and April, 1918. They were carried on the books of the petitioner "in open account" as advances to the Mena Company and were carried on its balance sheet as an asset. Whenever the Mena Land & Improvement Co. sold real estate and was not in need of the cash proceeds therefrom they would be paid over to the petitioner to apply on the advances so made. During this period the Mena Land & Improvement Co. sold from time to time different buildings acquired from the employees, which money in the amount of $28,340 was paid over to the petitioner herein, leaving a balance due and owing petitioner, at the date of the sale hereinafter mentioned, in the amount of $107,860.

Under date of May 28, 1919, petitioner, by a written contract, sold to outside interests, the entire capital stock of the Mena Land & Improvement Co. for the sum of $40,000. That agreement provided for the sale to the petitioner of the entire outstanding capital stock of that company, to wit, 250 shares, par value $100, and for the payment therefor of $10,000 cash, to be paid upon conveyance of said stock, and the remainder of $30,000 to be evidenced by three promissory notes of $10,000 each, payable on or before March 15 of the three succeeding years. In addition to the security provisions of that agreement, and among other things, section 9 thereof provided that there should be assigned to the seller any and all rentals due upon the property of the Mena Company at the date of that agreement which had accrued to March 15, 1919, and, furthermore, that there should be paid over to the seller at the time of the delivery of said stock "such sum as represents the total cash which shall be ascertained to have been in the treasury of the Mena Company or in the hands of its officers or agent on March 15, 1919, together with such rentals which had accrued up to March 15, 1919, and have been collected since that date * * *," and, furthermore, "the assignment of such unpaid rentals and the payment of said sum shall be so accepted by the Seller and shall operate as a full settlement and discharge of any and all amounts due and owing from the Mena Company to the Seller on March 15, 1919."

The negotiations incident to the execution and consummation of the above-mentioned sale were carried on through the office of Kelley, Stratton & Co. of Mena, Ark., and said company was paid by the petitioner a commission and other items as follows:

Commission	$ 1,629.34
K.C.S.R.R. - Recording deed	1.50
U.S. capital stock tax	3.00
Total	1,633.84

Under the provisions of section 9 of the agreement above referred to, the petitioner received a total of $3,646.30.

Payments for the stock of the Mena Land & Improvement Co. were made as follows:

June 12, 1919	$ 10,000.00
July and August, 1919	2,772.66
Oct. 13, 1919	2,628.61
February, 1920	4,522.72
Apr. 21, 1920	20,076.01
Total	40,000.00

For the year 1918 the operations of the Mena Land & Improvement Co. resulted in a net loss of $2,904.65, which loss was claimed and used as a deduction from taxable income in petitioner's consolidated corporation income and profits-tax return for the calendar year 1918.

For the purpose of showing their relationship to the $87,942.89 urged as a deduction, the above items are recapitulated and summarized as follows:

Cash advances, Sept. 1910 to Apr., 1918, to Mena
Land & Improvement Co	$ 136,200.00
Cost of capital stock, Mena Land & Improvement Co	25,000.00
Commission paid to Kelly-Stratton & Co.;
recording deed and capital stock tax	1,633.84
Total		$162,833.84
Cash received from Mena Land & Improvement Co.
Dec. 1911 to Dec. 1917	28,340.00
Cash received from sale of stock of Mena Land &
Improvement Co	40,000.00
Cash received under section 9 of agreement dated
May 28, 1919	3,646.30
Deficit of Mena Land & Improvement Co. taken as
a loss in 1918 tax return	2,904.65
Total		74,890.95
Difference - Amount shown in allegation of error
numbered six		87,942.89

Another instrument, dated May 28, 1919, respecting the sale of the capital stock of the Mena Land & Improvement Co., provided that:

The Kansas City Southern Railway Company hereby certifies that it has received from the parties of the second part [purchasers] the full amount of the said consideration, and all interest thereon, and that it will deliver the said stock to the said parties of the second part, said stock having been held by it as collateral to secure the performance of the terms of said agreement.

The Kansas City Southern Railway Company further certifies that for the said consideration, the receipt of which is acknowledged by it as set forth, it hereby also releases and acknowledges full satisfaction of any claim it may have on account of moneys advanced by it to the said The Mena Land & Improvement Company, being approximately One hundred eight thousand dollars ($108,000.00) Dollars, and has no claim against the parties of the second part or The Mena Land & Improvement Company on account thereof.

Although M. A. Stratton, one of the syndicate purchasing the capital stock of the Mena Land & Improvement Co., had for some years represented that company as an agent, his former employment had nothing whatsoever to do with the purchase.

The properties of the Mena Land & Improvement Co. were wholly residential, ranging from 2 rooms to 10 or 12 rooms of frame construction. There were some solid, some pier and some block foundations. The houses in Mena were ceiled, canvassed, and papered; most of them were painted and, without exception, they had shingled roofs, but very few were plastered.

The values of the land and improvements thereon of the Mena Land & Improvement Co. were segregated, and the estimated cost of improvements to that company after said segregation was $113,195.56.

There was no depreciation in the land during the period 1910 to 1919. The rate of depreciation to be applied to buildings of the character just described should be 2 1/2 per cent.

Amortization of Bond Discount

In the month of November, 1900, the said petitioner sold a total par value of $3,000,000 of its first mortgage bonds, due April 1, 1950, and realized therefrom the sum of $1,692,100, or at a sacrifice or loss of $1,307,900, which amount consists of $1,080,000 discount and $227,900 commission on account of the sale of bonds, which commission was withheld by the bankers at the time of the sale. The said discount and commission apportioned in equal annual installments, from the date of the sale to the date of the maturity of the bonds, amount to $21,600 discount and $4,558 commission annually.

In the month of June, 1902, said petitioner sold a total par value of $3,802,000 of its first mortgage bonds, due April 1, 1950, and realized therefrom the sum of $2,528,330, or at a sacrifice or loss of $1,273,670, which said amount consists of $1,235,650 discount and $38,020 commission on account of the sale of the bonds, which commission was withheld by the bankers at the time of the sale. The said discount and commission apportioned in equal annual installments from the date of the sale to the date of the maturity of the bonds amount to $25,877.49 discount and $796.23 commission annually.

From July, 1909, to December, 1912, the said petitioner sold a total par value of $16,000,000 of its refunding and improvement mortgage bonds, due April 1, 1950, and realized therefrom the sum of $15,359,696.57, or at a sacrifice or loss of $640,303.43, which amount consists of $612,500 discount and $27,803.43 expenses of various kinds, exclusive of commissions, on account of the sale of the bonds. The said discount and expenses apportioned in equal annual installments, from the dates of sale to the date of the maturity of the bonds, amount to $15,359.52 discount and $714.56 expenses per annum.

From April, 1913, to December, 1915, the said petitioner sold a total par value of $2,000,000 of its refunding and improvement mortgage bonds, due April 1, 1950, and realized therefrom the sum of $1,866,994.95, or at a sacrifice or loss of $133,005.05, which said amount consists of $130,000 discount and $3,005.05 expenses of various kinds, exclusive of commissions, on account of the sale of said bonds. The said discount and expenses apportioned in equal installments, from the dates of sale to the date of the maturity of the bonds, amount to $3,742.13 discount and $87.44 expenses annually.

In returning its income-tax returns for the years 1918 and 1919 the petitioner deducted $19,903.65 on account of amortization of bond discount for each year. In support of the deduction the petitioner showed that during the period July, 1909, to December, 1915, it sold a total par value of $18,000,000 of its refunding and improvement mortgage bonds, due April 1, 1950, for the sum of $17,226.691.52, or at a discount or loss of $773,308.48, which latter amount included all expenses incident to the sale of said bonds, and which discount or loss when prorated or amortized over the life of the bonds from the date of their respective sales amounts to the said sum of $19,903.65 annually. Subsequently, upon audit of said returns by the respondent, a further and additional amount of $26,673.72 was allowed as a deduction from taxable net income for each of said years on account of the sale in June, 1902.

The discount or loss on the first mortgage bonds sold in 1900 and 1902 was charged to property account and not profit and loss.

In the reorganization of the properties, $30,000,000 par value of 3 per cent mortgage bonds were issued, a large part of which were in exchange for securities of predecessor companies. The issues of $3,000,000 and $3,802,000 hereinabove were sold for cash. The discount on the bonds issued in exchange for securities, as well as the discount sustained on those two sales for cash, was charged to the investment account, and the proceeds of the bonds were expended for property, and the cost thereof charged to investment account. As the transaction now stands on the petitioner's books, the discount is made up when the bonds are redeemed at maturity. Although the discount has not been written off to operating revenues, it has been taken as a deduction for income-tax purposes.

No bonds of said above-mentioned issues were retired or canceled during either of the years 1918 or 1919.

Donations

During the years 1918 and 1919 certain individuals and corporations made contributions to the petitioner toward the cost of constructing spur tracks or other facilities desired by the contributors. In some instances, instead of contributing cash they furnished the labor or material used in the construction of such spur tracks or other facilities. The amount of such contributions, including the estimated value of the labor and material furnished by such persons or corporations, was $14,741.06 in 1918 and $12,878.54 in 1919.

The spur tracks or other facilities, for which such contributions were made, were constructed under contracts which provided that the title to the property constructed on right of way of petitioner would remain in the petitioner, although a part or all of its cost would be paid by the person applying for the same.

The classification of Investment in Road and Equipment, prescribed by the Interstate Commerce Commission, provided as follows:

2. ITEMS TO BE CHARGED - To these accounts (accounts for investment in Road and Equipment) shall be charged the cost of original road, original equipment, road extensions, additions and betterments; also the estimated values at time of acquisition of right of way and other road and equipment property donated to the carrier --- ---

Costs shall be actual money costs to the carrier where a portion of the funds expended by the carrier has been obtained through donations by states, municipalities, individuals, or others, no deductions on account of such donations shall be made in stating the costs --- ---

The Classification of Income, Profit and Loss and General Balance Sheet Accounts, prescribed by the Interstate Commerce Commission, effective July 1, 1914, contained the following rules:

606. - Donations - This account shall include amounts creditable to surplus of cash or its equivalent in estimated money value at the time of acquisition of lands or other properties donated by individuals or companies for the construction or acquisition of property. It shall include donations made by individuals and companies in connection with the construction of new lines for the purpose of compensating the carrier for loss anticipated during the early period of operations. Any advances made by individuals or companies with absolute or conditional provisions or partial or complete reimbursement shall not be considered a donation prior to the fulfillment of all conditions, and then only to the extent to which the liability for reimbursement is nullified or negatived. Prior to such determination the amounts received shall be credited to balance sheet account No. 778 "other unadjusted credits."

Note: Donations made by States, municipalities and other public corporations as their contributions toward the construction or acquisition of property, shall be included in balance sheet account No. 754, grants in aid of construction:

615. Surplus Appropriated for Investment in Physical Property.

This account shall include amounts definitely appropriated from surplus, to be applied for the construction or acquisition of new lines and extensions or additions to and betterments of property, the cost of which is includable in balance sheet No. 705, "Miscellaneous Physical Property," and also the amount of donations in aid of construction, made by individuals and companies, not subject to distribution as dividends.

In compliance with the foregoing rule of the Interstate Commerce Commission, the petitioner charged to its Investment Account the entire cost of spur tracks or other facilities built at the request of individuals or corporations where the title to such spur tracks or other facilities remained in the petitioner. Included in such cost was the estimated value of labor and material furnished by such individuals and corporations. The amount contributed by such individuals and corporations, including the estimated value of labor and material furnished by them, was credited to the account under "Profit and Loss" styled "606, Donations," and at the same time an entry was made transferring the amount so credited to "Donations" from "Profit and Loss" to "Appropriated Surplus."

The individuals or corporations that contributed to the construction of such spur tracks or other facilities paid the same lawful tariff rates for shipments of freight as did other shippers who had not contributed toward the cost of constructing spur tracks or other facilities.

The respondent included the amounts contributed by such individuals and corporations, as well as the estimated amount of labor and material furnished by such individuals and corporations toward the construction of such spur tracks or other facilities, in computing the taxable income of the petitioner, and, in the determination of the proposed deficiency, added to the income of petitioner for the years 1918 and 1919 the sum of $14,741.06 and $12,878.54, respectively.

In some cases the railroad company will refund to coal companies a certain amount, which is the cost of the recoverable material at the rate of $3 per car upon all cars of freight hauled to and from the coal company's plant upon which the revenue to the railroad company shall amount to $15 or more per car, and any amount remaining unrefunded at the end of three years is to be forfeited to the railroad company.

Interest due from the United States Government

There was due the petitioner from the United States Government for the years 1918 and 1919, under the provisions of the Federal Control Act, enacted March 21, 1918, certain items of interest, aggregating $199,883.92 and $327,721.74, respectively, made up of the items enumerated below:

	1918	1919
Interest on the amount of cash which petitioner had
on hand at Dec. 31, 1917, taken over by Director
General at the time he took over the railroad	$74,217.26	$98,506.55
Interest on balances carried on the books of
account at Dec. 31, 1917, at the time the Director
General took over the properties of the railroad,
which represented uncollected accounts for freight
charges due from agents. Such collections were
carried as an asset by the petitioner at that time
and were later collected in cash by the Director
General	12,771.12	16,950.76
Interest on various assets which the corporation
had at Dec. 31, 1917, which were taken over by the
Director General and collected and retained by him,
that is, such items as bills collected at Dec. 31,
1917, which were later collected by the Director
General	40,422.71	60,627.25
Interest, on revenue earned by the petitioner prior
to Jan. 1, 1918, not collected until after that
date, at which time the Director General had
possession of the railroad properties	7,497.40	9,365.13
Interest computed on compensation of $ 3,800,000 a
year due from the Director General, less interest
on payments that the Director General made on
account of compensation, that is each year the
Director General advanced certain sums of money to
apply against said compensation	64,809.98	2,823.43
Interest on the cost of additions and betterments
to property coming into service after the beginning
of Federal control	165.45	2,823.43
Total	199,883.92	327,721.74

Interest due to the United States Government

Interest due and payable from the petitioner to the United States Government for 1918 and 1919 amounted to $174,165.98 and $326,315.12, composed of the following amounts:

	1918	1919
Interest due the Director General on liabilities of
the petitioner at Dec. 31, 1917 and paid by said
Director General, namely, wages, material and
supplies or any obligations or liabilities set up on
the books at the beginning of Federal control paid
out of the Director General's funds	$98,042.23	$139,341.72
Interest on payments made by the Director General,
which could not have, or might not have, been set up
as a liability on the corporate books at the
beginning of Federal control	49,283.44	91,723.00
Interest on expenses which had been incurred by the
petitioner prior to Jan. 1, 1918, that is, expenses
incurred in 1917 for example, not audited and paid
until 1918, at which time they were paid by the
Director General	11,467.25	31,091.38
Interest on completed betterments and additions.
During the period of Federal control, the Director
General, in most cases, advanced the money for
improvements to the properties, that is, additions
and betterments which under the classification of the
commission are chargeable to investment account.
Interest was calculated on the cost of such additions
and betterments from the date of their completion and
coming into service	15,373.06	64,159.02
Total	174,165.98	326,315.12

State, County and City Taxes

By stipulation the petitioner admits that the respondent's refusal to allow $298,300.22 as a deduction from taxable net income in 1918 is correct.

By stipulation the respondent admits that the petitioner accrued, during the year 1918, on account of Federal income and excess-profits taxes the amount of $119,456.70; that petitioner restored to taxable income for said year, on account of Federal income and excess-profits taxes, the amount of $179,185.09, thereby restoring an excessive amount of $59,728.30 to taxable net income for said year, and therefore that the taxable net income for the year 1918 should be reduced in the amount of $59,728.30.

Compensation for Transporting Mail

On December 23, 1919, the Interstate Commerce Commission, pursuant to the Act of July 28, 1916 (Post Office Appropriation, 39 Stat., pp. 412-425) awarded the petitioner additional compensation for services rendered during the period November 1, 1916, to December 31, 1917, in transporting United States mails; the total amount of said award, to wit, $53,103.29, was received by the petitioner during the year 1921 and returned as taxable income of that year. The respondent eliminated that item from 1921 and allocated to and included the same amount in taxable income of 1919.

OPINION.

MORRIS: Substantially all of the facts herein are founded upon stipulations entered into between the parties.

The question raised by the first two allegations of error, that is, the proper basis for taxing compensation due and payable to railroads during the period of Governmental operation and control, has been presented to this Board in several cases involving facts similar in all material respects to these here, Illinois Terminal Co.,5 B.T.A. 15">5 B.T.A. 15; New Orleans, Texas & Mexico Railway Co.,6 B.T.A. 436">6 B.T.A. 436; Great Northern Railway Co.,8 B.T.A. 225">8 B.T.A. 225; Chicago, Rock Island & Pacific Railway Co.,13 B.T.A. 988">13 B.T.A. 988, all of which have been reviewed from time to time and in some, distinctions have been made, but the general principles enunciated in Illinois Terminal Co., supra, have been strictly adhered to, and while the respondent has presented a lengthy argument in an attempt to distinguish the facts in the instant proceeding, we have been unable to find any sound reason in law or in fact why these principles should not be applied here. We, therefore, conclude that the amount finally determined as compensation should be prorated over the period of Federal control.

Interest earned by the petitioner, referred to in allegation numbered 3 herein, from the United States Government on additions and betterments is taxable income (see discussion hereinafter with respect to other interest received from the United States Government) and should be included in the computation of gross income for the years 1918, 1919, and 1920, in which it accrued. Texas & Pacific Railway Co.,9 B.T.A. 365">9 B.T.A. 365.

The fourth and fifth allegations of error are with respect to deductions of certain amounts in the computation of net income for the years 1918 and 1919 which were charged to depreciation. Section 234(a), and subsection (7), of the Revenue Act of 1918, provide:

(a) That in computing the net income of a corporation subject to the tax imposed by section 230, there shall be allowed as deductions:

* * *

(7) A reasonable allowance for the exhaustion, wear, and tear of property used in the trade or business, including a reasonable allowance for obsolescence.

It appears from the stipulated facts, and from the testimony offered by the petitioner, that because of changing conditions and increasing traffic and competition in the railroad business, extensive improvements were necessitated over its line, contemplating not only many changes on the original right of way, but also a number of changes by way of substitution of short sections of road on new ground, where that method was found to be more economical; that the program of improvements was commenced in 1909, and completed in 1912, involving about 41 per cent of the entire line and expenditure of several millions of dollars; and, further, that the road at each of the several points where new locations were utilized was in no way worn out, was fully maintained, and capable of performing, for an indefinite time, the function for which it was originally constructed; that the changes were made for the purpose of increasing the capacity of the line to secure economical operation and to render improved service; that grade revisions were completed by removing the tracks to adjacent parcels of ground, procured and substituted for the original parcels, the use of the latter being discontinued. The evidence reveals also that in addition to the grade revisions the petitioner constructed in 1909-1912 a new and enlarged shop terminal plant at Shreveport on a new and different location from that of another terminal plant which it owned in 1909, and which was also located at Shreveport, having equipment which was not worn out or obsolete, and which was capable, with ordinary running repairs, of performing for an indefinite term the functions for which it was originally constructed; and that upon completion of the new plant the old terminal was abandoned. Under date of February 3, 1914, the petitioner was authorized by the Interstate Commerce Commission to spread the amounts of estimated cost, less salvage, of replacing the discontinued portion of the road, and the estimated replacement value, less salvage, of the terminal plant, over a period of 15 years from the date of the expenditures. Accordingly, the petitioner charged to its monthly operating expenses, during the years 1918 and 1919, amounts aggregating $89,181.72 and $89,993.40, respectively, which amounts were claimed as deductions in the computation of its net income for these years.

Petitioner admits in its brief that the instant question presents a rather unusual phase of depreciation and in this we must heartily concur, but it points to the fact that the Supreme Court of the United States, in Kansas City Southern Railway Co. v. United States of America and Interstate Commerce Commission,231 U.S. 423">231 U.S. 423, has defined the subject matter as depreciation or obsolescence, in support of its contention. We have examined the report of that case, rendered during the October term of 1913, and we find that the court, speaking through Mr. Justice Pitney, said:

A more complete depreciation than that which is represented by a part of the original plant that through destruction or obsolescence has actually perished as useful property, it will be difficult to imagine.

The court states further in that case:

* * * The other kind of depreciation is the result of changes attributable to the inadequacy of the existing property to meet the demands of the future. The road or the structures have to be replaced with stronger or more efficient instrumentalities. Abandonments occasioned by changes of this character are therefore chargeable to future earnings, for the reason that the improved condition of the road is not only designed to meet the demands of the future, but presumably will result in economies of operation, and so the resulting benefits will be reaped by those who hold the stock of the company in the present and in the future. The railroad company may, if it sees fit, anticipate general depreciations, and make provision for them by establishing a reserve for the purpose; but if no such provision has been made the abandonments should be taken care of by charging them to present or future operating expense. In case, however, the amount is so large that its inclusion in a carrier's operating expenses for a single year would unduly burden the operating expense account for that year, the carrier may, if so authorized by the Commission, distribute the cost throughout a series of years.

A statement of the theory is sufficient to show that the regulation is not arbitrary in the sense of being without reasonable basis. And there is evidence to show that the Commission was warranted in adopting it, as sustained by expert opinion and approved by experience.

Although the Supreme Court held that these amounts represented depreciation or obsolescence and that they should be charged to future earnings, the court was not considering or interpreting the statutory provision for the deduction from gross income under the revenue acts of exhaustion, wear and tear of property used in the trade or business, nor did it attempt to determine how far into the future the amounts should be spread. It is true that the Interstate Commerce Commission permitted 15 years as the proper basis for allocation, but this we consider was purely arbitrary, and was only for the purpose of relieving the financial statements during the earlier years of these extremely burdensome charges, and not for the purpose of allocating to future years expenses or operating costs incident to the earnings for those years.

The allowance for exhaustion, wear and tear of property or obsolesence thereof as provided for in section 234(a)(7), supra, is an annual deduction and is based upon the exhaustion sustained during the taxable year in question. Morris & Bailey Steel Co.,9 B.T.A. 205">9 B.T.A. 205. Clearly, there is no exhaustion sustained during the taxable year on an asset which was abandoned or scrapped long prior thereto. The revenue acts provide for a deduction in the year in which the asset was discarded. Evanston National Bank,1 B.T.A. 9">1 B.T.A. 9; Winter Garden, Inc.,10 B.T.A. 71">10 B.T.A. 71; Dilling Cotton Mills,2 B.T.A. 127">2 B.T.A. 127. The respondent's determination in this particular must, therefore, be sustained.

In order that consideration of the issue raised by allegation of error numbered 6 herein may not become confused because of the several angles from which the question has been argued by counsel for the petitioner and the respondent, it is well to have before us, at the very outset, the issue as it has been presented in the petition, which is, that the respondent erred in refusing to deduct, in the computation of net income for the year 1919, $87,942.89 for loss on account of investment in stock of the Mena Land & Improvement Co. Therefore, it is only necessary for us to determine what the investment in the stock of that company was and whether a loss on account of said investment was actually sustained as alleged.

The respondent has, by affirmative allegation numbered 19 herein, averred that of the foregoing amount, to wit, $87,942.89, $36,065.07 has been allowed as a deduction and that error was committed in said allowance; that no deduction of any amount should be allowed because of this transaction, and, furthermore, that he committed error in failing to include in the taxable income for 1919 the profit derived by the petitioner in the sale of said stock. Therefore, if we determine that no loss was sustained in this transaction it is incumbent upon us to determine whether a profit was actually derived as alleged by the respondent.

A brief review of the facts here may aid in the solutions of the questions at issue. To begin with it is clear that the petitioner caused the Mena Land & Improvement Co. to be organized in July of 1910 for the purpose of acquiring the homes of certain of its employees at Mena, so that they might be saved from hardship due to the removal of the Mena division point to other points, and, furthermore, that in 1910 it acquired the entire capitalization of the Mena Land & Improvement Co. for $25,000, which it recorded in its books of account as an asset in November of 1910 and January of 1911. Thus it will be seen that the petitioner's initial investment was $25,000.

The petitioner in effect contends, however, that the sum of $25,000 was not the entire investment in the Mena Land & Improvement Co., but that certain advances made by it to that company for the acquisition of properties, less certain amounts received and applied against these advances, should be added to that amount in determining the investment. Let us proceed further with the facts and circumstances surrounding these advances and the ultimate sale of the stock which is alleged to have resulted in the loss here in dispute.

It appears that the Mena Land & Improvement Co. began immediately in 1910 to carry out the purpose for which it was organized, and to purchase the properties of employees situated at Mena, at cost to them, and that the petitioner advanced sums of money to that company aggregating $136,200, over and above the $25,000, the amount of the capital stock; that said advances were made between September, 1910, and April, 1918; that they were carried on the books of the petitioner "in open account" as advances to the Mena Company and were carried on the petitioner's balance sheet as an asset. As the Mena Land & Improvement Co. sold real estate, if it was not in need of the cash proceeds from said sale or sales, they would be paid over to the petitioner to apply on the advances so made, and the petitioner received during that period $28,340 from the sales of such real estate, leaving a balance due at the date of the sale, hereinafter discussed, of $107,860. It further appears that on May 28, 1919, the petitioner sold the capital stock of the Mena Land & Improvement Co. to certain individuals for $40,000, under an agreement by which it reserved to itself all rentals due upon the properties at the date of that agreement which had accrued to March 15, 1919, and the cash on hand on said date, together with the accrued rentals to March 15, 1919, collected since that date. Under that provision of the agreement the petitioner received $3,646.30. The petitioner paid out commissions and other expenses incident to the aforesaid sale, aggregating $1,633.84.

Another agreement was entered into with respect to the sale aforesaid on May 28, 1919, by which the petitioner released the purchasers of the capital stock, under the agreement hereinbefore discussed, of any and all claims it may have on account of advances to the Mena Land & Improvement Co., in the approximate amount of $108,000.

There is nothing in the record to indicate, or even to intimate, that the advances made by the petitioner to the Mena Land & Improvement Co. ever became, or were ever intended to become, payments on account of the subscription or purchase of that company's capital stock. On the other hand, it appears very clearly from the manner in which these advances were recorded in the petitioner's books of account that they were intended, certainly at the time they were made, to be collected in full from that company. In fact, certain payments were made from time to time and applied against that indebtedness. How, then, can it be said that the investment in the capital stock upon which the loss is predicated should be enhanced by the amount of these advances? We are of the opinion that it should not be. It is quite clear, therefore, from what we have said that the petitioner's investment in stock of the Mena Land & Improvement Co. was $25,000, and no more.

Having determined the amount of the petitioner's investment in the transaction aforesaid, and bearing in mind the exact issue raised by the pleadings, the inescapable conclusion is that the petitioner sold its capital stock for $40,000 and realized a profit therefrom of the difference between $25,000 and $40,000, or $15,000, less the expenses incident to the sale.

The seventh and eighth allegations of error urged by the petitioner pertain to additional deductions on account of amortization of bond discount in the computation of net income for 1918 and 1919.

The respondent, by way of affirmative allegation in his answer, numbered twenty herein, states that for 1918 and 1919 discount in the amount of $46,577.57 has been allowed as a deduction in the computation of net income, and having been so allowed, he avers that error was committed in said allowance and, furthermore, that no deduction should be allowed on account of amortization of bond discount for either of said years.

Following Chicago, Rock Island & Pacific Railway Co.,13 B.T.A. 988">13 B.T.A. 988, we hold that the petitioner is entitled to deduct, in each of the taxable years here in controversy, that portion of the bond discount obtained by dividing the total discount by the number of years the bonds are to run.

Respondent concedes error with respect to "donations" for the construction of spur tracks and facilities on the right of way of the petitioner. We have previously held that such amounts received by a railroad company are not taxable income. Great Northern Railway Co., supra.

Errors numbered 11 and 12, urged by the petitioner, are the failure of the respondent to exempt from taxable income for the years 1918 and 1919, $199,883.92 and $327,721.74, respectively, being interest due the petitioner from the United States Government. The petitioner contends that these items of interest are upon "obligations of the United States" and therefore exempt from taxation. The respondent contends that those amounts were not upon obligations of the United States within the meaning of the statute, and, furthermore, in discussing the amounts due to the Director General, he contends that they have been allowed as deductions from gross income for the years in question.

What the respondent actually did in computing the deficiency here in controversy, as he points out in his brief, was to take the difference between $199,883.92 and $327,721.74, interest due the petitioner from the United States Government and $174,165.98 and $326,315.12, the interest due from the petitioner to the United States Government, a difference of $27,124.56 in favor of the petitioner, which he added to the petitioner's net income for the two years in question.

Since the question of the deductibility of interest due from the petitioner to the United States Government has been separately placed in issue in assignments of error numbered 14 and 15, and the taxability of interest due the petitioner from the United States Government has been raised in the assignments of error here being considered, and, furthermore, since the principles to be applied in disposing of these separate issues are different, because separate and distinct sections of the Revenue Act are involved, we shall consider here the taxability of the interest due the petitioner, and hereafter, under assignments of error numbered 14 and 15, the deductibility of interest due from the petitioner to the United States Government.

Section 213 of the Revenue Act of 1918 provides that "gross income,"

* * *

(b) Does not include the following items, which shall be exempt from taxation under this title:

* * *

(4) Interest upon * * * (b) securities issued under the provisions of the Federal Farm Loan Act of July 17, 1916; or (c) the obligations of the United States or its possessions; or (d) bonds issued by the War Finance Corporation: * * *. In the case of obligations of the United States issued after September 1, 1917, and in the case of bonds issued by the War Finance Corporation, the interest shall be exempt only if and to the extent provided in the respective Acts authorizing the issue thereof as amended and supplemented * * *.

The exact language here under consideration, that is, "obligations of the United States," was first read into the Act of October 3, 1913, and has since been included in each succeeding revenue act. In addition to the exemption granted to taxpayers holding "obligations of the United States," the Act of September 8, 1916, first provided for exemption of interest upon "securities issued under the provisions of the Federal Farm Loan Act." That Act, as amended by the Act of October 3, 1917, granted the exemption theretofore provided for on obligations issued after September 1, 1917, to the extent of the amount provided "in the Act authorizing the issue thereof." The Revenue Act of 1918, which is the one here under consideration, granted an additional exemption on interest upon "bonds issued by the War Finance Corporation."

The question presented is novel, notwithstanding that we have already considered several cases involving interest paid to railroads on the use of their property by the Government during Federal control. Illinois Terminal Co., supra;Great Northern Railway Co., supral Texas & Pacific Railway, supra;Indiana Harbor Belt Railroad Co.,16 B.T.A. 279">16 B.T.A. 279. No question was raised by those petitioners as to the taxability of the interest, but merely the year in which such interest should be included in gross income. A concurrence in the present petitioner's contention results in the conclusion that the so-called interest is exempt from tax while the obligatin upon which the interest is paid is taxable. The petitioner contends that the obligation to pay just compensation on account of the taking over of the railroad by the Federal Government, and to pay interest on such compensation until the same was paid in full, is an obligation of the United States. Several questions are bound up in the contention: What is an obligation?; what is the basis or authority for the payment of the amount in question in this proceeding?; was it the payment of interest on an "obligation of the United States" as that expression is used in section 213(b)(4) of the Revenue Act of 1918?

The word obligation "is in its general and most extensive sense, synonymous with duty"; it has been defined "to be 'the constraining power or authoritative character of a duty, a moral precept, a civil law, or a promise or contract voluntarily made; that at which one is bound; that which one is obliged or bound to do, especially by moral or legal claim; a duty.'" The word as used in a will reciting, "Whereas, I now hold obligations against certain of my friends, I direct my executor not to urge the payment of any such obligations before the space of two full years after my decease" has been defined to mean "a written instrument like a note or bond"; in a strictly technical sense is has been defined to mean a "bond." See Words and Phrases, First Series, vol. 6, pp. 4878-79.

Thus it will be seen that the word obligation may include, in the broader sense, a mere duty, or it may mean a contract, either express or implied, and in a stricter sense, it may be confined to bonds or other similar evidences of indebtedness.

The Act entitled "An Act To provide for the operation of transportation systems while under Federal control, for the just compensation of their owners, and for other purposes," 40 Stat. 451, called the "Federal Control" Act, approved March 21, 1918, authorized the President to agree with and to guarantee to carriers just compensation during the period of Federal control "not exceeding a sum equivalent as nearly as may be to its average annual railway operating income for the three years ended June thirtieth, nineteen hundred and seventeen." That Act provided that:

Every such agreement shall also contain adequate and appropriate provisions for the maintenance, repair, renewals, and depreciation of the property, * * * and for such accounting and adjustments of charges and payments, both during the 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; * * *

Section 4 of that Act with respect to additions and betterments provided:

That the just compensation that may be determined as hereinbefore provided by agreement or that may be adjudicated by the Court of Claims, shall be increased by an amount reckoned at a reasonable rate per centum to be fixed by the President upon the cost of any additions and betterments, less retirements, and upon the cost of road extensions to the property of such carrier made by such carrier with the approval of or by order of the President while such property is under Federal control.

Section 2 of that Act provided:

That if no such agreement is made, or pending the execution of an agreement, the President may nevertheless pay to any carrier while under Federal control an annual amount, payable in reasonable installments, not exceeding ninety per centum of the estimated annual amount of just compensation, remitting such carrier, in case where no agreement is made, to its legal rights for any balance claimed to the remedies provided in section three hereof. Any amount thereafter found due such carrier above the amount paid shall bear interest at the rate of six per centum per annum. The acceptance of any benefits under this section shall constitute an acceptance by the carrier of all the provisions of this Act and shall obligate the carrier to pay to the United States, with interest at the rate of six per centum per annum from a date or dates fixed in proceedings under section three, the amount by which the sums received under this section exceed the sum found due in such proceedings.

The taking over of the petitioner's property was an exercise by the Government of its sovereign power of eminent domain. North Carolina R. Co. v. Lee,260 U.S. 16">260 U.S. 16; Phelps v. United States,274 U.S. 341">274 U.S. 341; Illinois Terminal Co., supra.Such act immediately set in motion the petitioner's constitutional right to just compensation for the use of its properties. The Government's obligation, and it was undoubtedly that in the broad sense of the word, was to pay just compensation. What just compensation is, has already been determined by the Supreme Court of the United States in Phelps v. United States, supra.The facts in that case are that the Secretary of War by direction of the President, pursuant to an Act of August 29, 1916, 39 Stat. 619, and an Act of August 10, 1917, 40 Stat. 276, requisitioned a pier which the plaintiffs leased. The plaintiffs continued to pay rent to the lessor, and in accordance with the findings of a board of appraisers created for the purpose of ascertaining fair compensation for the temporary use of the property, the amount of such payments, $79,890.42, was repaid the plaintiffs by the United States. The board also found the value per month of the use of the plaintiffs' property, less the monthly rents paid. That amount was not satisfactory to plaintiffs; they elected to take 75 per cent of award and sued to recover an amount to make up just compensation. The court found the value per day of the use of their property, and the difference between that amount and the amount already paid was included in the judgment entered March 8, 1926. The plaintiffs contended that there should be added such sums as would produce the equivalent of the value of the use of the leased property paid contemporaneously; and that interest at a reasonable rate from the date of the use to the time of payment was a good measure of the amount to be added in order to make just compensation. The action was brought under section 145 of the Judicial Code. That section gives to the Court of Claims jurisdiction to hear and determine "all claims (except for pensions) founded upon the Constitution of the United States or * * * upon any contract, express or implied, with the Government of the United States * * *." Section 177 provides "that no interest shall be allowed on any claim up to the time of the rendition of judgment unless upon a contract expressly stipulating for its payment." In the course of its opinion the court used the following language:

* * * Under the Fifth Amendment plaintiffs were entitled to just compensation; and, within the meaning of § 145 the claim is one founded on the Constitution. Moreover, it has long been established that, where pursuant to an Act of Congress private property is taken for public use by officers or agents of the United States, the Government is under an implied obligation to make just compensation. That implication being consistent with the constitutional duty of the Government as well as with common justice, the owner's claim is one arising out of implied contract. United States v. Great Falls Manufacturing Co.,112 U.S. 645">112 U.S. 645; 656; Duckett v. United States,266 U.S. 149">266 U.S. 149, 151; Campbell v. United States,266 U.S. 368">266 U.S. 368, 370 * * *. Plaintiffs' property was taken before its value was ascertained or paid. Judgment in 1926 for the value of the use of the property in 1918 and 1919, without more, is not sufficient to constitute just compensation. Section 177 does not prohibit the inclusion of the additional amount for which petitioner contends. It is not a claim for interest within the purpose or intention of that section. Acts of Congress are to be construed and applied in harmony with and not to thwart the purpose of the Constitution. The Government's obligation is to put the owners in as good position pecuniarily as if the use of their property had not been taken. They are entitled to have the full equivalent of the value of such use at the time of the taking paid contemporaneously with the taking. As such payment has not been made, petitioner is entitled to the additional amount claimed.

The situation with respect to the payment of the part of the amount in question in the instant proceeding is parallel. Although this payment was designated interest, it was in effect not interest within the purpose or intention of the statute, but merely the satisfaction of the obligation itself, namely to pay just compensation. It was the return to the petitioner of the "full equivalent of the value of such use at the time of the taking paid contemporaneously with the taking." Section 4 of the Federal Control Act designates part of the amount in question as compensation reckoned at a reasonable rate per centum.

There are further considerations which lead us to the conclusion that the petitioner's contention is fallacious. Although the word "obligation" is broad enough to cover the duty resting upon the Government to pay just compensation, we are of the opinion that its application is more restricted under section 213(b)(4) of the Revenue Act of 1918. We have examined the Congressional record so far as practicable with respect to all the acts containing these exemption clauses, but unfortunately we find no expressions upon the part of the legislators which would aid in determining precisely what should be treated as an obligation under the statute. The apparent purpose for exempting from taxation the interest upon obligations of the United States was to facilitate the flotation of low-interest-bearing Government securities, thus partially compensating for the higher interest rates of competitive private issues. The reason for the exemption does not apply to interest on obligations, construing that word in the broad sense for which the petitioner contends.

The revenue acts throw additional light upon the Congressional intent. It way early recognized that if interest was not to be taxed, interest paid on money borrowed to purchase nontaxable, interest-bearing securities should not be deducted. In the Revenue Act of 1916, as amended by the Revenue Act of 1917, the following provision appears (Section 1201(a)(2)):

All interest paid within the year on his indebtedness except on indebtedness incurred for the purchase of obligations or securities the interest upon which is exempt from taxation as income under this title.

The Revenue Act of 1918, sections 214 and 234, contains a similar exception on interest on indebtedness "incurred or continued to purchase or carry obligations or securities," etc. Section 213(a) of the 1918 Act makes special provision for "obligations issued" after September 1, 1917. The words "purchased" and "issued" used in connection with obligations connotes a more restricted use of the word "obligation" than that contended for by the petitioner.

In Hibernia Savings & Loan System v. San Francisco,200 U.S. 310">200 U.S. 310, an action was begun in the State Superior Court to recover certain taxes paid under protest upon certain checks or orders signed by the Treasurer of the United States and addressed to the Treasurer or an Assistant Treasurer of the United States, for interest accrued upon certain registered bonds of the United States owned by the plaintiff. These checks were issued in compliance with Rev. Stat., sec. 3698, which requires that "the Secretary of the Treasury shall cause to be paid, out of any money in the Treasury not otherwise appropriated, any interest falling due, or accruing, on any portion of the public debt authorized by law." The checks, which were payable at the United States Treasury at San Francisco at any time within four months from their date, were not presented immediately for payment but were withheld by the plaintiff until the first Monday in March, 1899, the day when the status of property, for the purpose of taxation, was determined. Plaintiff did not list those checks for assessment; but the assessor in making up his roll for the ensuing year, included them, and, after fruitless effort to be relieved from the assessment, the plaintiff paid the amount of the tax and brought suit to recover. The question presented to the court there was whether the two checks or orders were exempt from State taxation under Rev. Stat., sec. 3701, which provided that "all stocks, bonds, treasury notes, and other obligations of the United States, shall be exempt from taxation by or under State or municipal or local authority." the court there said:

* * * The basis of this exemption is the fact that a tax upon the obligations of the United States is virtually a tax upon the credit of the Government, and upon its power to raise money for the purpose of carrying on its civil and military operations. The efficiency of the Government service cannot be impaired by a taxation of the agencies which it employs for such service, and, as one of the most valuable and best known of these agencies is the borrowing of money, a tax which diminishes in the slightest degree the value of the obligations issued by the Government for that purpose impairs pro tanto their market value.

* * *

The principle, however, upon which this exemption is claimed does not apply to obligations, such as checks and warrants intended for immediate use, and designed merely to stand in the place of money, until presented at the Treasury and the money actually drawn thereon. In such case the tax is virtually a tax upon the money which may be drawn immediately upon presentation of the checks.

* * *

Had the Government, in the absence of money for the immediate payment of interest upon its bonds, issued new obligations for the payment of its interest at a future day, it might well be claimed that these were not taxable, as the taxation of such notes would, to the extent of the tax, impair their value and negotiability in the hands of the holder.

* * *

* * * While the checks are obligations of the United States and within the letter of $3701, they are not within its spirit, and are proper subjects of taxation.

In Bank of Commerce v.Tennessee for the use of Memphis et al.,161 U.S. 134">161 U.S. 134, the court, in considering the question of exemption, said:

These cases [meaning New Orleans City & Lake Railroad v. New Orleans,143 U.S. 192">143 U.S. 192, 195; Vicksburg & Pacific Railroad v. Dennis,116 U.S. 665">116 U.S. 665, and many cases there cited; Farrington v. Tennessee,95 U.S. 679">95 U.S. 679, 686; West Wisconsin Railway v. Supervisors,93 U.S. 595">93 U.S. 595; Tucker v. Ferguson,22 Wall. 527">22 Wall. 527] show the principle upon which is founded the rule that a claim for exemption from taxation must be clearly made out. Taxes being the sole means by which sovereignties can maintain their existence, any claim on the part of any one to be exempt from the full payment of his share of taxes on any portion of his property must on that account be clearly defined and founded upon plain language. There must be no doubt or ambiguity in the language used upon which the claim to the exemption is founded. It has been said that a well founded doubt is fatal to the claim; no implication will be indulged in for the purpose of construing the language used as giving the claim for exemption, where such claim is not founded upon the plain and clearly expressed intention of the taxing power.

In Citizens Bank v. Parker,192 U.S. 73">192 U.S. 73, Mr. Justice Brewer, with whom the Chief Justice concurred, dissenting, cited the language used by that court in Phoenix Insurance Co. v. Tennessee,161 U.S. 174">161 U.S. 174, in which it said:

* * * It must alway be borne in mind in construing language of this nature that the claim for exemption must be made out wholly beyond doubt; for, as stated by Mr. Justice Harlan, in Chicago, Burlington & Kansas City Railroad v. Guffey,120 U.S. 569">120 U.S. 569, 575; "It is the settled doctrine of this court that an immunity from taxation by a State will not be recognized unless granted in terms too plain to be mistaken."

Mr. Justice Brewer then cited language which we have quoted from Bank of Commerce v.Tennessee et al., supra, and he said:

Only last term the same doctrine was reaffirmed in Theological Seminary v. Illinois,188 U.S. 662">188 U.S. 662, 672, in these words:

"The rule is that, in claims for exemption from taxation under legislative authority, the exemption must be plainly and unmistakably granted; it cannot exist by implication only; a doubt is fatal to the claim."

I make these quotations, which are in harmony with the many other decisions of this court, for even the most casual examination of them makes it apparent that the rule therein stated is plainly ignored in this case, and that a term, whose meaning is well understood, is stretched beyond its ordinary significance and to its utmost limits in order to include the alleged exemption.

The Congress first exempted obligations of the United States in general terms. It later saw fit to expressly exempt securities under the provisions of the Federal Farm Loan Act and bonds issued by the War Finance Corporation. We do not believe, however, that it intended to distinguish between bonds and securities, as such, and obligations of the United States, or to broaden the scope of that provision beyond the already understood and generally accepted meaning of that term. it merely sought to add to, by way of definiteness, the securities of the Federal Farm Loan Board and War Finance Corporation, leaving the term "obligations of the United States" to cover all other bonds or other similar evidences of indebtedness issued by the United States but not specifically mentioned in the Act.

It is not necessary that we attempt to detail in this opinion what the term "obligations of the United States" includes or to define the exact meaning thereof. It is only necessary for us to say that we believe the payment of interest under the circumstances of this case was not within the spirit and intendment of section 213 of the Revenue Act of 1918. Said interest should be included in the computation of gross income for the years in which it accrued. Texas & Pacific Railway Co., supra.

Allegation of error numbered 13 herein was expressly withdrawn by counsel for the petitioner at the hearing of this proceeding.

The question raised by allegations of error numbered 14 and 15 is the deductibility of interest due from the petitioner to the United States Government. As we have heretofore pointed out in discussing the taxability of interest due from the United States Government to the petitioner, the respondent, in the computation of the deficiency, treated these two classes of interest jointly, that is, he took the net difference between the interest due from the Government and the amount due the Government and added it to the petitioner's net income. The respondent states in his brief, as we have also pointed out, that the amounts of interest due the Government from the petitioner have been allowed as deductions, and this it appears is so, except that it has been done in such a manner as to require a segregation of the separate items and a separate discussion and consideration thereof.

Section 234(a) of the Revenue Act of 1918 and subsection 2 thereunder, in so far as applicable here, read:

(a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:

* * *

(2) All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917) the interest upon which is wholly exempt from taxation under this title as income to the taxpayer, * * *.

Since the respondent has admittedly allowed this deduction, as indicated hereinabove, and since it appears from the stipulated facts that the amounts claimed as deductions were due and payable to the United States for the years 1918 and 1919, we are satisfied that he deductions as claimed should be allowed, as such, in the redetermination of the deficiency here in controversy.

The petitioner, by stipulation with the respondent, admits that the action of the respondent complained of in allegation of error numbered 16, is correct.

The question raised by allegation of error numbered 17 has been fully considered and disposed of in accordance with the contention of the petitioner in Western Maryland Railway Co.,12 B.T.A. 889">12 B.T.A. 889.

In recomputing the amount of net income for 1918 there should be added thereto $800.46, erroneously eliminated therefrom in that year as alleged in error urged by the respondent numbered 18 herein.

The respondent admits, by stipulation with the petitioner, that the petitioner's taxable income for the year 1918 was overstated, and should be reduced by $59,728.30, due to the restoration by the petitioner to said net income of $179,185.09, instead of $119,456.70, amount of income and profits taxes accrued by the petitioner for that year. This admission has no bearing whatsoever upon the allegations of error set forth herein, but is for the purpose of correcting, upon redetermination, an error made in the former computation, in accordance with the agreed stipulation of the parties.

Reviewed by the Board.

Judgment will be entered under Rule 50.

STERNHAGEN and MURDOCK dissent in part.

MILLIKEN dissents concerning the loss claimed in connection with the Mena Land & Improvement Co. and concurs in the result concerning the claim that the interest due from the United States was exempt from taxation.