*16 Decision will be entered for the respondent.
In 1939 the petitioner made a loan of $ 600,000 to a wholly owned subsidiary to enable it to acquire from the petitioner $ 600,000 par value of its stock. The subsidiary gave the petitioner a demand note for the loan, payment of which was to be subordinated to all debts outstanding at the date thereof, with interest payable, if earned, at the rate of 3 percent per annum. Upon order of a bank examiner the petitioner in 1939 charged off $ 200,000 of the indebtedness of the subsidiary to itself and claimed the amount as a deduction from gross income in its income tax return. This deduction was disallowed by the respondent in the determination of the deficiency. Held, that the amount is not a legal deduction from gross income under section 23 (k) of the Revenue Act of 1938, as amended by section 124 of the Revenue Act of 1942.
*244 This is a proceeding for the redetermination of deficiencies in income tax and excess profits tax for 1939 in the respective amounts of $ 35,500.58 and $ 71.01. The question in issue is*17 whether the petitioner is entitled to deduct from gross income $ 200,001 charged off as a bad debt and claimed by the petitioner as a deduction from gross income in its tax return.
FINDINGS OF FACT.
1. The petitioner is a national bank, organized under the laws of the United States in 1911, with its principal place of business in Richmond, Virginia. It files its income tax returns with the collector of internal revenue for the district of Virginia.
2. The Central National Bank Building Corporation (hereinafter referred to as the building corporation) was organized under the laws of the State of Virginia in 1928 with an authorized capital stock of $ 750,000, divided into 7,500 shares of a par value of $ 100 each, all of which were acquired by the petitioner for a cash consideration of $ 750,000.
3. The building corporation acquired land in the heart of the shopping district of Richmond on which it erected a 22-story office building at a cost of about $ 1,800,000. Necessary funds were acquired from the sale of its capital stock, from an $ 850,000 first mortgage on its property and from moneys borrowed from the petitioner on its notes, payable on demand. Upon completion of the building*18 the first story, mezzanine, and basement, or parts thereof, were rented to the petitioner. The remaining space was rented to many different tenants.
*245 4. In 1932 a bank examiner ordered the petitioner to write off its entire investment of $ 750,000 in the stock of the building corporation. Upon appeal to the Comptroller of the Currency the order of the bank examiner was reversed. The Comptroller ordered it, however, to write off $ 10,000 of its investment in 1932 and $ 40,000 in 1933. In 1933 the building corporation amended its charter to provide for a reduction in its capital stock to $ 700,000. The petitioner surrendered 500 shares of its stock to the building corporation and treated the par value thereof, $ 50,000, as a contribution by it of capital to that corporation. The petitioner was required to write off an additional $ 50,000 of its investment in each of the next four years and $ 25,000 in 1938. At the close of 1938 the petitioners' investment was carried on its books at a value of $ 475,000.
5. The petitioner's deposits nearly doubled from 1932 to 1938. The ratio of capital to deposits during this period declined. Petitioner had never received any dividends*19 upon its shares of stock in the building corporation, nor had it ever deducted or been allowed to deduct from gross income in its tax returns the amounts which it had been required to charge off in respect of the book value of its investment in the stock of the corporation. The petitioner's executive vice president was delegated to make a study of the situation and to make a recommendation to the petitioner's executive committee. He conceived the idea of the petitioner making a loan of $ 600,000 to the building corporation which it would immediately pay back to the petitioner in retirement of 6,000 shares of its capital stock and give the petitioner a demand note for $ 600,000, payment of which would be subordinated to all of the outstanding debts of the building corporation, with interest payable at 3 percent per annum only, if earned. The Comptroller of the Currency offered no objection to the plan. The first mortgagee agreed to it, provided it did not impair its security.
6. The petitioner's executive vice president made the following report with respect to the proposed $ 600,000 loan:
January 3, 1939
Central National Bank Building Corporation
$ 600,000 loan
Purpose*20 : To provide the building corporation with funds with which to buy 6,000 shares of its stock at $ 100 per share in accordance with negotiations which have been going on between the building corporation and the bank during the last 11 months.
This loan provides us with a more desirable asset which is more readily salable or rediscountable and therefore more liquid. Should we elect to sell the note we can do so without losing control of the corporation owning our banking quarters. Moreover, should the building corporation prosper in the future it can partially liquidate this note in lieu of amending its charter from time to time, which would be necessary were it to retire stock.
*246 This transaction gives us a much better asset and provides a more practicable financial arrangement for the building corporation than that which has existed heretofore.
7. This report was approved by the executive committee and by the petitioner's board of directors on the same day, January 3, 1939, and the proposed loan was made. A check of $ 600,000 was drawn by the petitioner payable to the building corporation and a similar check was drawn by the building corporation payable to the petitioner*21 on the same date and put through the clearing. The building corporation gave its demand note to the petitioner dated January 3, 1939, for the amount of $ 600,000. On the face of the note it is stated: "This note is subject to the terms and conditions set forth on the reverse hereof." On the reverse side of the note is the following:
This note is payable with interest at the rate of 3 per cent per annum. Such interest shall be payable only from the earned income of the maker after payment in full in each calendar year of all interest and principal payments heretofore agreed by maker to be made on its first mortgage obligations now outstanding, and on any renewals or extensions thereof, and also after payment in full in each calendar year of all interest and principal payments on other indebtedness of maker or renewals or extensions thereof, heretofore agreed by maker to be made; payment of both principal and interest of this note being subordinate to the payments of principal and interest on maker's present outstanding mortgage indebtedness, including extensions and renewals thereof, and also subordinate to payments of principal and interest on all other indebtedness of maker at*22 present outstanding, together with extensions and renewals thereof.
The petitioner delivered 6,000 shares of the building corporation's stock to that corporation. A certificate for amendment to the charter of the building corporation was filed in the office of the Virginia State Corporation Commission on June 15, 1939. It was therein provided that the number of shares of the building corporation should be reduced from 7,000 shares to 1,000 shares and the par value reduced from $ 100 per share to $ 50 per share.
8. As a result of the above stated transactions the petitioner's investment in the building corporation was represented by 1,000 shares of that corporation. At or prior to June 15, 1939, the book value of the shares on the petitioner's books of account was written down to $ 1. On and after January 3, 1939, the demand note given to it by the building corporation was carried upon the petitioner's books of account at a value of $ 600,000.
9. In a report of the bank examiner dated February 13, 1939, petitioner was required to write down the value of its $ 600,000 note to $ 425,000 and in a later report dated September 20, 1939, to write off an additional amount of $ 25,000. *23 In the last named report the examiner found the building corporation's note carried as an asset by the petitioner at a value of $ 424,999. With regard to that entry the bank examiner reported:
*247 * * * The note of $ 424,999 was taken for the sale of stock of the corporation sold to it for $ 600M, the difference being previously charged to profit and loss. This note bears interest at 4% [should be 3%] if and when made. None has been paid. It is also subordinated to all other debts of the corporation. In view of this situation a further charge-off of $ 25M was requested. It was made during the examination.
10. By reason of vacancies and reduced rentals during some of the years from 1931 to 1936 the building corporation had fallen behind in required interest payments on its first mortgage note and had not made the curtails on the principal which it was required to make by the mortgage indenture. Its financial situation had greatly improved by the close of 1938. It had paid off all arrearages in interest on its mortgage note and had reduced the principal to $ 759,500. It still owed the petitioner $ 85,000 on a demand note which had been outstanding since 1929 but upon*24 which interest was being paid currently. By reason of brightening business prospects the petitioner's officers in January 1939 were of the opinion that the loan of $ 600,000 made to the building corporation during that month was a good loan.
In years subsequent to 1938 the building corporation has further curtailed the principal of its first mortgage. At June 10, 1942, the principal of the first mortgage had been paid down to $ 592,000.
11. As above indicated, the petitioner charged off on its books of account the $ 200,000 ordered by the bank examiner in 1939 and $ 1 additional. The reason for the write-off of $ 1 is not shown by the evidence. The petitioner's officers have never ascertained the worthlessness or partial worthlessness of any part of the $ 600,000 note. They have always maintained and still maintain that it is worth its face value.
12. In its income tax return for 1939 the petitioner claimed the deduction from gross income of $ 200,001 representing the write-down of the note of the building corporation from $ 600,000 to $ 399,999. This deduction has been disallowed by the respondent in the determination of the deficiency.
OPINION.
The question presented is whether*25 the petitioner is entitled to deduct from its gross income of 1939, $ 200,001 representing claimed indebtedness of the building corporation to it which was charged off on its books of account pursuant to an order of a bank examiner to the extent of $ 200,000. The petitioner maintains that it has never ascertained any part of the debt to be worthless, that the note evidencing the debt has always been worth its face value, and that it will eventually be paid in full, together with interest at the rate of 3 percent per annum.
The petitioner claims the deduction of the $ 200,001 referred to above under section 23 (k) of the Revenue Act of 1938 as interpreted by *248 Regulations 101, article 23 (k)-1, as amended by Treasury Decision 4978, providing in part as follows:
(c) Where banks or other corporations which are subject to supervision by Federal authorities (or by State authorities maintaining substantially equivalent standards) in obedience to the specific orders of such supervisory officers charge off debts in whole or in part, such debts shall be conclusively presumed, for income tax purposes, to be worthless or recoverable only in part, as the case may be, but in order that*26 any amount of the charge-off may be allowed as a deduction for any taxable year it must be shown that the charge-off took place within such taxable year. But no such debt shall be so conclusively presumed to be worthless or recoverable only in part, as the case may be, if the amount so charged off is not claimed as a deduction for the taxable year in which such charge-off takes place. * * *
Section 23 (k) of the Revenue Act of 1938 and of the Internal Revenue Code was amended by section 124 of the Revenue Act of 1942. As amended, the section permits the deduction from gross income of:
* * * Debts which become worthless within the taxable year; or (in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part which becomes worthless within the taxable year, as a deduction. * * *
By subdivision (d) of section 124 the amendment as above quoted is declared to "be effective with respect to taxable years beginning after December 31, 1938."
Were it not for the change in section 23 (k) effected by the amendment of section 124*27 of the Revenue Act of 1942, adverted to above, we think there might be a serious question as to whether the petitioner is entitled to the deduction from gross income of 1939 of at least $ 200,000. The bank examiner required the petitioner to charge that amount off in 1939 and it was charged off pursuant to his order. It is to be observed, however, that under section 23 (k) of the Revenue Act of 1938 debts may not be deducted from gross income except where they are ascertained to be worthless and charged off within the taxable year. There was no ascertainment of worthlessness by the petitioner in 1939 of any part of the $ 600,000 note given to it by the building corporation. Must the Commissioner's regulation be given effect where there is no ascertainment of worthlessness by the taxpayer?
There is a further question presented as to whether the $ 600,000 indebtedness to the petitioner of the building corporation is such a debt as was contemplated by article 23 (k)-1 of Regulations 101, as amended by Treasury Decision 4978. Quite clearly in this case the petitioner's investment in the stock of the building corporation was changed into a note indebtedness without the petitioner *28 lending the building corporation any cash. The building corporation was a completely owned subsidiary of the petitioner. In the circumstances of the case, should the Government look through the form of this proceeding *249 to actualities as was done in the case of Higgins v. Smith, 308 U.S. 473">308 U.S. 473? In that case it was held that an individual who owned all the shares of stock of a corporation was not entitled to deduct a loss representing the difference between the cost of shares to him and the sale price of those shares to his own corporation. The Supreme Court said:
* * * The Government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute. * * *
The regulation of the Commissioner solely relied upon by the petitioner in this case was based upon section 23 (k) of the Revenue Act of 1938, which was incorporated in the Internal Revenue Code under the same section number. Since that provision of the law has now been amended by section 124 of the Revenue *29 Act of 1942, it must be held that article 23 (k)-1 of Regulations 101 has been abrogated. We think that the respondent properly disallowed the claimed deduction.
Decision will be entered for the respondent.