*2135 1. In making loans upon real estate security the petitioner charged and deducted from the face of the loans a commission which was entered upon its books of account and returned as taxable income of the year in which the loan was made. At the close of each year the petitioner had on hand a large amount of mortgage notes and bonds which it had not sold to its clients. The petitioner kept its books of account and made its income-tax returns upon the accrual basis. Held that the commissions shown as income upon its books of account and in its returns constituted taxable income of the year in which the loans were made.
2, Petitioner had an extraordinarily large amount of income in 1920 representing gains on remittances to Poland. These gains resulted largely from a contract which the petitioner entered into in 1919 with the Polish National Loan Bank, which represented no investment of capital by the petitioner. Held that the petitioner is not entitled to special assessment for 1920 under section 328 of the Revenue Act of 1918.
*365 This proceeding is brought for the redetermination of a deficiency in income and profits tax for 1920 in the amount of $83,697.38. The points in issue are (1) whether the respondent erroneously included in taxable income commissions upon bonds and mortgages purchased during 1920, a part of which were not sold during that year; and *366 (2) whether the petitioner is entitled to have its excess-profits tax computed under the provisions of section 328 of the Revenue Act of 1918.
FINDINGS OF FACT.
The petitioner is an Illinois corporation organized in July, 1906, with a paid-in capital of $200,000, since which time it has been engaged in the banking business in Chicago. Its business was carried on in the northwestern section of the city, which was largely inhabited by people of Polish extraction. Prior to and during 1920 about 95 per cent of petitioner's depositors and customers, as well as officers and employees, were Poles. The petitioner was known and referred to as the Polish Bank.
Shortly after the termination of the World War, people of Polish extraction in the United States were sending money through the petitioner's foreign exchange*2137 department to Poland to help relatives and others there to rehabilitate themselves, their farms, and their businesses, which had suffered to a great extent due to the war. Remittances to Poland had been largely cut off during the war period. The business of making remittances to Poland increased to such an extent that great confusion in executing the remittances occurred in Poland, due to the volume of the business and to the lack of sufficient competent employees. In 1919 John F. Smulski, president of the petitioner, went to Europe to obtain a contract with the Polish National Loan Bank (Polska Kravjowa Kasa Pozyczkowa), hereinafter referred to as the P.K.K.P., for the purpose of executing petitioner's remittances to Poland. An oral contract was entered into in August, 1919, with the P.K.K.P., which was later confirmed in writing under date of May 18, 1920. Under the terms of this agreement the petitioner was to issue all of its money orders to Poland on the P.K.K.P., which latter bank was to execute such money orders on behalf of petitioner in an efficient and expeditious manner, and to supply the petitioner with a receipt for each remittance. The amount of all money orders*2138 was to be credited to the account of the P.K.K.P. Interest was to be paid and credited to the account at the rate of 2 1/2 per cent per annum. The P.K.K.P. was to pay the petitioner a commission on the total amount of money credited to the P.K.K.P. account with the petitioner. The P.K.K.P. was to issue a communique to the Polish press in Europe and America that arrangements had been made whereby money orders could be transmitted through the petitioner and payable through the P.K.K.P. in Poland.
To carry on the business of making remittances to Poland the petitioner established agencies throughout the United States which received money to be transmitted through it. The foreign exchange business transacted with the P.K.K.P. alone from August until *367 the end of the year 1919 amounted to $864,748.37, and for the year 1920 to $5,642,102.69. This business came not only from the petitioner's depositors, but from all over the United States. Under the contract the P.K.K.P. was required to keep the remittances to Poland on deposit with the petitioner for a period of 30 days. The average balances in this account during the year 1920 were as follows:
| January | $760,000 |
| February | 1,100,000 |
| March | 1,650,000 |
| April | 2,200,000 |
| May | $1,850,000 |
| June | 1,650,000 |
| July | 1,800,000 |
| August | 1,750,000 |
| September | $1,600,000 |
| October | 925,000 |
| November | 700,000 |
| December | 500,000 |
*2139 The large volume of foreign exchange business in 1920 made it necessary for the petitioner to obtain additional quarters for the foreign-exchange department in Chicago and to hire additional employees. This volume of business, as well as the disturbances caused in Poland by the advance of the Bolsheviki on Warsaw, made it difficult to obtain receipts from Poland for remittances made. In July, 1920, the petitioner sent a representative to Poland and an office was opened in quarters furnished by the P.K.K.P. Claims for approximately 25,000 unacknowledged remittances were filed with the P.K.K.P. This office was maintained until July, 1925, for the settlement and adjustment of claims arising from the 1920 business. The petitioner was under considerable expense subsequent to 1920 for the straightening out of its affairs relating to the 1920 business.
Prior to the war the profits of the foreign exchange department of the petitioner were approximately $5,000 or $6,000 per year. During the war practically no business was transacted in the foreign exchange department. After obtaining the contract with the P.K.K.P., and for the years 1919 to 1922, inclusive, the earnings of the foreign*2140 exchange department were as follows:
| 1919 | $148,721.49 |
| 1920 | 399,594.52 |
| 1921 | 53,185.29 |
| 1922 | 32,350,35 |
The main revenue or profit to petitioner from its foreign exchange department in 1920 is attributable to the difference in exchange rates as follows: When a person desired to purchase marks, the rate of exchange would be quoted and the P.K.K.P. would be advised by mail of the remittance. The P.K.K.P. was not advised every day of these remittances as such advice was dependent upon the departure of steamers for Europe, and sometimes it would be several days before the advice would finally go forward. If there occurred a drop in the exchange rate, the petitioner profited to the extent of the drop, *368 as the P.K.K.P. was credited with the exchange rate as of the date it was advised of the remittance. During this period the value of the mark was dropping rapidly. The source of income to the petitioner from its foreign exchange department was from commissions paid by the P.K.K.P. and the remitter and from the differential in the rates of exchange.
In addition to operating a foreign exchange department, the petitioner during 1920 and for some years prior*2141 thereto operated a real estate loan department in which real estate mortgages and mortgage bonds were purchased and sold. There was a material increase in the activities of this department during 1920. In the case of real estate mortgage bonds the procedure followed by the petitioner was as follows: Upon receipt of an application for a loan the property was appraised and the title examined, and if found to be acceptable a mortgage was executed and bonds issued, secured by the mortgage. The bonds were set up on the petitioner's books at their face value, commissions account was credited with the petitioner's commission, as agreed upon, usually 2 or 3 per cent, and the balance made available to the mortgagor. No adjustment of the commissions account was made at the end of the year on account of bonds acquired and not sold during the year. The same accounting procedure was employed with real estate mortgages handled by this department. So far as accounting for the commissions earned in the real estate loan department, the books of account were kept upon the accrual basis and the returns were made upon the same basis. In the commercial department the books were adjusted each month*2142 to show the amount of accrued earnings from loans discounted, as well as the unearned discount.
At the beginning of 1920 the petitioner had on hand $141,000 face value of real estate mortgage bonds. During 1920, $46,200 of these bonds were sold, on which the petitioner's commission of $1,750 had been reported in 1919. In 1920, petitioner loaned $1,019,900 upon the security of mortgages against which bonds were issued of which $579,500 remained on hand unsold at the end of the year. The petitioner's commission on these $579,500 of unsold bonds reported as income in 1920 was $25,016.50.
On January 1, 1920, the petitioner had on hand real estate mortgages having a face value of $771,915, of which $300,180 were sold during 1920, on which the petitioner's commission of $1,008 had been reported as income in 1919. During the year the petitioner loaned $1,407,160 on the security of land mortgaged to it, against which mortgage notes were issued. Of this amount, $1,076,390 of mortgage notes remained unsold at the end of the year, on which the petitioner's commission of $18,949.89 was included in income for 1920.
*369 In the determination of the deficiency here involved the*2143 respondent made no change in the basis adopted by the petitioner in reporting commissions earned by its real estate loan department.
OPINION.
SMITH: At the hearing of this proceeding the petitioner abandoned certain issues raised by the pleadings. The issues not abandoned are (1) whether the respondent erroneously included in taxable income commissions upon bonds and mortgages purchased in 1920, a part of which were not sold during that year; and (2) whether the petitioner is entitled to have its excess-profits tax computed under the provisions of section 328 of the Revenue Act of 1918.
The argument of petitioner upon the first point is that the petitioner in effect purchased mortgages from its clients who desired to borrow money from it upon real estate security at amounts representing the difference between the face of the mortgage and the amount advanced to the mortgagor by the petitioner, and that the commission which is charged upon its books of account to income as of the date of the loan was not in reality income until the mortgage note or bonds secured by the mortgage had been sold or had been paid off by the mortgagor. It is submitted that one realizes no income*2144 from the ordinary purchase of property; that a merchant realizes no income or profit from the purchase of merchandise; that a sale is required before a profit or loss is realized; that petitioner was a merchant in real estate mortgage bonds and real estate mortgages and that no income was realized by the mere purchase of a mortgage or a bond issue underwritten. In support of this contention it cites S.M. 3820, C.B. IV-2, pp. 32-34, which deals with a number of questions arising in connection with the reporting of income by banks. It reads in part:
3. The third situation is where the bank purchases, at a discount, mortgages as securities for the purpose of resale. Such mortgage loans usually bear interest, and in the case of such loans no income from such discount is to be reported under either the cash or accrual systems until the payment of all or a portion of the loan, or a resale. * * *
Section 212 of the Revenue Act of 1918 provides in part as follows:
(b) The net income shall be computed upon the basis of the taxpayer's annual accounting period * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such*2145 method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. * * *
At *370 the hearing of this proceeding the petitioner's secretary was asked:
Q. Do you know about [upon] what basis the books of the Northwestern Savings & Trust Company were kept, that is, the accrual basis or the cash receipts and disbursements basis?
A. The books were kept on an accrual basis at that time.The evidence is conclusive that the petitioner charged to income at the time the loan was made the commission charged the mortgagor upon the loan; in other words, the petitioner agreed to loan the mortgagor the face amount of the loan but deducted therefrom for its own compensation the amount of the commission agreed upon. The books of account in 1920 were not kept differently from the way they were kept in prior years. The return for 1920 was made upon the same basis as the returns for prior years. The petitioner now proposes, however, to impugn the correctness of its books of account for the purpose of reflecting*2146 its true income and contends that the books of account and the returns made thereon do not reflect the true income.
A question analogous to this was before the Supreme Court in the case of . The facts in that case were that under the plaintiff's usual course of business the borrower, upon the making of a loan, executed to the order of the company his note for the amount of the loan, due in five years, with interest at 5 per cent per annum, payable semi-annually, with the privilege of paying $100 or any multiple thereof on the principal, on or after two years, at the maturity of any interest payment. At the same time the borrower executed to the company another note due in two years, without interest, for 10 per cent of the total amount of the loan, as the company's commission or compensation for making and negotiating the loan. From these commission notes the company derived its income. In 1917, in accordance with the usual practice, the company accrued and set up on its books as a liability and charged to expense the aggregate amount of the payments called for in the bonus contracts given investors during*2147 that year. It made its tax return for that year upon the basis upon which the accounts were kept, claiming as an expense the aggregate amount of these bonus contracts as set up on its books. In the course of its opinion the court said:
* * * We think that the amount of the bonus contracts was "an expense incurred and propery attributable" to the Company's process of earning income during the year 1917. * * * The Company's net income for the year could not have been rightly determined without deducting from the gross income represented by the commission notes, the obligations which it incurred under the bonus contracts, and would not have been accurately shown by keeping its books or making its return on the basis of actual receipts and disbursements. The method which it adopted clearly reflected the true income. And, just as the aggregate amount of the commission note was properly included in *371 its gross income for the year - although not due and payable until the expiration of two years - so, under the doctrine of the Anderson case, the total amount of the bonus contracts was deductible as an expense incurred within the year, although it did not "accrue" in that*2148 year in the sense of becoming then due and payable.
The contention of the petitioner that it has realized no income from commissions charged on its loans to real estate owners until the mortgage note or bond issued against the mortgage is sold appears not to be well founded. Its contention would undoubtedly be well founded if the petitioner's books of account and returns had been made upon the basis of cash receipts and disbursements. But this was not the case. The books of account were kept and the returns were made upon the accrual basis and we have no doubt that the income accrued to the petitioner in the sense of the law from these commissions at the time the loan was made. The petitioner was then protected in respect of the amount of the commission by the mortgage which it had upon the property of the borrower.
The proceeding at bar seems to us to be controlled by the decision of the Board in ; affirmed by Circuit Court of Appeals for the Seventh Circuit, June 10, 1930. In that case it appeared that the petitioner made real estate or mortgage loans during 1921 and 1922, bearing interest at a specified rate. *2149 In addition to the interest a commission was charged and deducted from the face of each loan. Petitioner kept its books of account upon an accrual basis. We held that the total amount of commissions on loans so made in the respective years constituted taxable income for such years. Cf. ; ; ; ; .
The petitioner bases its right to special assessment for 1921, to use the words of the president of the corporation, on:
* * * The very favorable contract we had with the P.K.K.P., through which were able to obtain this large number of correspondents throughout the country, the great confidence that the Poles of the United States had in Mr. Smulski and his institution, the fact that during the War through deprivation and starvation the relatives and friends of Americans here wrote for help and asked them to send money to rehabilitate their farms and help them in a general way. There had been no money sent during this entire period, during the last War, to Poland, *2150 by any relatives, to their relatives in Poland, and the rapid drop in the value of the mark, which had no backing, created a favorable position for the bank in that we were able to make a very nice margin of profit on these remittances.
The pertinent portion of section 327 of the Revenue Act of 1918 provides:
That in the following cases the tax shall be determined as provided in section 328:
* * *
(d) *372 Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative, corporations specified in section 328. This subdivision shall not apply to any case (1) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital * * *.
We find no abnormality in the invested capital of the petitioner. *2151 The petitioner undoubtedly had a favorable contract with the P.K.K.P., but that contract cost it nothing and there was no basis for including any value for it in the computation of invested capital.
Petitioner during 1920 had a foreign exchange department which it had had for a number of years prior to the war. Postwar conditions resulted in a large amount of business for its foreign exchange department. This favorable situation is not in our opinion an abnormality of income within the provisions of section 327(d) quoted above. Cf. . Nor do we consider that the expense (estimated to be $70,000) paid in succeeding years in straightening out its remittances in 1920 constitutes such an abnormality of income in 1920 as warrants special assessment. Those expenses were legal deductions from income of the year in which paid. Taking the agreement with the P.K.K.P. as a whole in conjunction with the operations of the petitioner in 1920, it appears that the income from the foreign exchange department was largely attributable to speculation in Polish marks resulting from the petitioner's favorable position in being able to profit by the drop*2152 in exchange rates. The income earned by the petitioner in 1920 was in the ordinary course of business and the tax for the year is high principally because the petitioner had a high rate of profit upon a normal invested capital.
Judgment will be entered for the respondent.