*659 1. The petitioner by merger acquired the assets and assumed the liabilities of a second corporation, subject, however, to the rights of special noteholders to be reimbursed for advances made to the corporation so merged, the petitioner to have no right to any income or gains until such reimbursement. At the end of the taxable year assets of the merged corporation having a book value in excess of $2,000,000 were still unliquidated, even though there was indication of considerable shrinkage in actual value. The special noteholders had refused to accede to the representations of petitioner that their claims were worthless. Held, that there was no completed or closed transaction in the taxable year with respect to the assets of the merged corporation and that the petitioner is not required to report income or gain received or realized in respect of those assets and is not entitled to deduct losses in respect thereto in determining its own net income. Corn Exchange National Bank & Trust Co.,46 B.T.A. 1107">46 B.T.A. 1107.
2. In the course of operating its trust department, the petitioner had purchased for certain trusts and estates for which it acted as fiduciary bonds of*660 a corporation in which it had a direct proprietary interest, being the owner of its common stock. The bonds had so shrunk in value as to indicate that the estates and trusts holding them would eventually sustain substantial losses. The petitioner acquired the said bonds from the trusts and estates at par and immediately sold them at the current market price to prevent further losses to itself by reason of further shrinkage. Held, that the petitioner is entitled to the deductions claimed in respect of the losses sustained. Sec. 23(a) and (f), Revenue Act of 1934.
*738 The Commissioner determined a deficiency in income tax against the petitioner for 1934 in the amount of $19,152.67. The issues involved are whether the respondent erred (1) in disallowing a loss deduction claimed in respect of the partial liquidation of the assets of an insolvent corporation which had been merged with petitioner, certain third parties still having a contingent interest in the results of complete liquidation of the said assets, and (2) in disallowing a deduction claimed*661 by reason of a loss sustained on the sale of certain bonds purchased by it from certain trust and guardianship estates for which it acted as fiduciary.
FINDINGS OF FACT.
The petitioner, an Hawaiian corporation, was organized in 1906 and has its principal office in Honolulu. At all times subsequent to its incorporation it has conducted a trust and agency business in the Territory of Hawaii. Its income tax return for 1934 was made from books kept on the accrual basis and was filed with the collector of internal revenue at Honolulu.
During 1931, 1932, and 1933 the petitioner was affiliated with a number of other corporations, among which was the Henry Waterhouse Trust Co., Ltd., sometimes hereinafter referred to as Waterhouse. Waterhouse was an Hawaiian corporation organized in 1902, with its principal office in Honolulu, and carried on a trust and agency business in the Territory of Hawaii. In 1925 the petitioner's manager proposed to the secretary of Waterhouse that its stockholders, who were few in number, sell their stock to the petitioner. Because of failure to agree upon a price, no sale resulted, but the petitioner was promised that if a sale should be contemplated*662 later the petitioner would be given the first opportunity to buy.
In October 1930 Waterhouse increased its capital stock of $200,000 to $400,000, consisting of 4,000 shares of a par valne of $100 each. *739 The new shares were all taken by the old stockholders, who paid for them in cash at par value. In November the effects of the general business depression were being felt in Hawaii. Since a large part of the assets of Waterhouse consisted of real estate and mortgages, its secretary became apprehensive as to whether its financial condition would be sufficiently liquid to meet its cash requirements if many calls were made on the demand accounts. After discussing the situation with the treasurer and auditor, he advised petitioner's management that a sale of the Waterhouse stock might be arranged and suggested a price of $100 or more per share. At that time Waterhouse was conducting business as usual. The book value of its assets was $4,820,090.92, and its liabilities, exclusive of capital and surplus, were $4,149,437.06. The petitioner made an investigation of the assets and affairs of Waterhouse and estimated that the total probable realization from the assets would*663 be $3,739,287.77, which, applied against liabilities, would leave an estimated deficit of $410,149.29. The petitioner thereupon suggested that Waterhouse raise sufficient funds to assure its liquidity.
Shortly after February 1, 1931, petitioner advised the stockholders of Waterhouse that it would not pay cash for the Waterhouse shares, but it would acquire the shares under an arrangement or plan whereby the petitioner would guarantee the payment of that company's obligations. The plan provided in the main as follows:
(1) That the petitioner would acquire all of the Waterhouse stock without cost.
(2) That two of the stockholders of Waterhouse, who were indebted to it in the amount of $733,914.08, pay to Waterhouse $535,000 in cash and convey to it certain properties for a credit of $100,000; that the remainder of the indebtedness, $98,914.08, be written off; that said properties be sold for $87,000; and that the petitioner contribute $13,000 in cash to Waterhouse to make up the deficiency from the sale of the properties at less than the credit of $100,000 allowed therefor, thus bringing to a total of $635,000 the amount of cash received by Waterhouse from certain indebtedness.
*664 (3) That Waterhouse raise $400,000 in cash by loans on notes, bearing simple interest at the rate of 4 percent per annum, the principal and interest to be payable only after repayment of contributions of petitioner referred to in (4), infra.
(4) That petitioner contribute such amount, if any, over $1,035,000 (the $635,000 plus the $400,000) as would be required to liquidate the liabilities, other than the notes of Waterhouse mentioned in (3), supra.
(5) That the petitioner, without other cost, take over the business of Waterhouse, inclusive of trusts, executorships, agencies, safe *740 deposit business, etc., with the necessary furniture, equipment, supplies, etc., but exclusive of other assets and liabilities, and own and operate the same at its own expense and for its own benefit.
(6) That the assets of Waterhouse, except as provided in (5), supra, and consisting of cash, bank deposits, notes and accounts receivable, stocks and bonds, stock exchange seat, furniture, equipment, and supplies, be gradually liquidated and its liabilities paid, the petitioner to be entitled to $1,000 a month for supervision.
(7) That if upon final settlement there should*665 be an excess of assets over liabilities, the excess should be applied, first, to the reimbursement of the petitioner for such amount, if any, without interest, as it might advance pursuant to (4), supra; second, to pay pro rata the principal of and the interest on the notes mentioned in (3), supra, and the balance, if any, to be paid to the petitioner.
As stated by petitioner's president to its board of directors, the objects of the plan were: (1) to prevent the failure of Waterhouse and consequent general disastrous effects; (2) to prevent loss on the part of many who had intrusted their money to Waterhouse for investment and who could ill afford to lose; and (3) to enable the petitioner to acquire new business.
The plan was accepted by the stockholders of Waterhouse and on or about February 14, 1931, they transferred their 4,000 shares of stock to petitioner. From and after that time petitioner owned directly all of the stock in Waterhouse. Its acquisition of the stock was unqualified and complete and it did not hold the stock in trust or as agent. Liquidation was not the sole and primary purpose of the petitioner in acquiring the stock, nor was tax reduction a motive.
*666 The two stockholders who were indebted to Waterhouse made the cash payment and transferred the certain properties as provided by the plan. The properties were sold for $87,000, and the petitioner paid $13,000 cash to Waterhouse. Eight individuals and corporations, two of whom were banks, contributed to Waterhouse, under the plan, amounts ranging from $25,000 to $100,000 and totaling $400,000. For these amounts they received notes, sometimes hereinafter after referred to as special notes. The principal of and interest on the notes were payable only after all other liabilities of Waterhouse, including contributions by petitioner other than the $13,000, had been paid. The parties making these contributions were moved to do so either by long personal interest in Waterhouse or because of their interest in avoiding the serious effect that the collapse of Waterhouse would have upon general financial conditions in Hawaii.
On February 16, 1931, a new board of directors and new officers of Waterhouse were elected. Most of them were officers of petitioner. A committee of three members, appointed by and representing the lenders on the special notes, was created to assist in an advisory*667 *741 capacity but with no power of control, and it was at times consulted. Waterhouse continued to do business at its old office at first, and later at offices in the petitioner's building. At all times after February 14, 1931, it was able to meet all of its obligations by reason of the loans made to it and by reason of the fact that its liabilities were guaranteed by petitioner.
On May 29, 1931, the vice president of Waterhouse, who was also its manager and one of its directors, told petitioner's board of directors that the operation of the Waterhouse business was causing a monthly loss "as it is in the nature of a receivership." He also expressed the belief that "the bulk of the work in straightening out the affairs of Waterhouse will be accomplished in a year or two." On June 26, 1931, he recommended to the petitioner's board of directors that all of the work of Waterhouse, with the exception of the collection end of the business, be transferred directly to the petitioner. He expressed the belief that the petitioner would suffer no loss if business would become normal again and suggested that, by filing a consolidated income tax return including the Waterhouse losses, *668 the petitioner could effect a substantial saving in tax.
Between February 14, 1931, and December 30, 1933, Waterhouse continued to operate as a separate entity. While the petitioner took over some of the business of Waterhouse, the latter continued to carry on some business until December 30, 1933, and its operating and liquidating losses were included in the consolidated returns of the petitioner for the years 1931 through 1933.
In accordance with the plan whereby the petitioner acquired the stock of Waterhouse, it made advances from time to time to liquidate the liabilities of that company. The advances made by the petitioner to liquidate the said liabilities totaled $585,000 by December 31, 1932, and $1,476,460.82 by December 31, 1933. This was in addition to the $13,000 previously paid in to make up for the loss sustained on the sale of real estate.
On July 18, 1932, Waterhouse sent a letter to each of the holders of the special notes advising them that an exhaustive reappraisal of its assets made early in the year disclosed that its liabilities, other than to the holders of the special notes and to stockholders, exceeded the value of the assets by a considerable amount*669 and stated that market conditions had since become worse. It stated that it regarded the special notes as worthless and asked the holders to concede worthlessness so as to dispense with the continuance of the advisory committee and to permit Waterhouse to eliminate the notes from the liabilities carried on its books. It was stated that by so doing the noteholders could claim the amount of the notes as bad debts in their 1932 income tax returns provided they wrote them off their books. So far as disclosed, none of the noteholders complied with the request.
*742 On December 30, 1932, the petitioner's directors adopted a resolution providing that $500,000 be set aside from surplus to provide for loss on Waterhouse. Pursuant to that action, a reserve of $500,000 was set up on the books of the petitioner under an account headed "Reserve for H. Waterhouse Trust Company losses." This reserve was carried on the books of the petitioner until the merger of the two companies, as hereinafter set out, when the balance of the amount remaining on the books was added to the petitioner's general reserve.
Both the petitioner and Waterhouse, when they filed their income tax returns for*670 1921, exercised their option to take deduction for bad debts upon the basis of debts ascertained to be worthless in whole or in part and charged off within the taxable year. This basis has been used by them in their returns for all subsequent taxable periods. Neither of them has requested nor been granted permission to change to the reserve method.
The following is a statement of book value of the Waterhouse assets, exclusive of cash, on the indicated dates, actual losses sustained on liquidation to the indicated dates, and the estimated losses on liquidation arrived at by a group of petitioner's officers and set up on its books:
| Book value of assets exclusive of cash | Actual losses sustained on liquidation | Estimated loss on liquidation | |
| Feb. 14, 1931 | $4,275,543.05 | $1,080,803.15 | |
| Dec. 31, 1931 | 3,697,746.38 | $324,913.77 | |
| 1932 | 2,993,234.31 | 410,345.80 | |
| 1933 | 2,965,675.99 | 571,482.80 | * 936,352.98 |
| 1934 | 2,182,864.44 | 629,807.10 | * 891,809.29 |
| 1935 | 1,835,938.85 | 775,168.66 | |
| 1936 | 1,614.111.82 | 832.785.18 | |
| 1937 | 967,778.02 | 1,209,403.09 | |
| 1938 | 791,266.95 | 1,267,352.15 | |
| 1939 | 613,244.14 | 1,309,192.19 | |
| 1940 | 570,409.52 | 1,311,108.99 |
*671 During 1933 the petitioner decided to effect a merger for the purpose of simplifying its financial structure and effecting economies. ,0n December 19, 1933, it sent a letter to each of the holders of the special notes advising them of its plan to merge Waterhouse and two other trust companies into itself and stating that it appeared certain that upon completion of the liquidation of the affairs of Waterhouse there would be nothing remaining for payment on the notes. The petitioner requested that it be informed whether the noteholders desired that after the merger (1) the petitioner keep earmarked the assets and liabilities of Waterhouse as well as accurate accounts of all amounts the petitioner had theretofore contributed, advanced, or loaned to Waterhouse or might thereafter contribute or advance toward meeting the liabilities of that company, so as to protect the rights of the *743 noteholders in the event there ultimately should be something for payment on the notes, or (2) the petitioner make no such earmarking and keep no special accounts on the theory that the notes, having become worthless, such course would avoid needless expense to petitioner. On December 21, 1933, a*672 meeting of the noteholders was held, at which the holders of $300,000 of the $400,000 of outstanding notes were represented, and it was decided that the procedure outlined in proposal (1) should be followed by the petitioner.
On December 30, 1933 (the last business day of 1933), Waterhouse and two other trust companies were formally merged into petitioner, pursuant to the provisions of Act 169 of the 1931 Session Laws of the Territory of Hawaii.
Following the merger and for the purpose of accounting to the special noteholders, the petitioner kept separate accounting records, sometimes referred to as the "Waterhouse Section," of the Waterhouse assets acquired and the liabilities assumed in respect thereto. Among the records so kept, a special account designated "Notes Payable - Underwriters H W T - New" was set up to cover the $400,000 paid in by the special noteholders and the charges against it. This account at December 31, 1934, the end of the taxable year, disclosed a credit balance of $147,513.69.
During 1934 the petitioner's operations or transactions relating to and in respect of the Waterhouse assets and liabilities resulted in the realization of income, all of which*673 petitioner reported in its income tax return for that year, as follows:
| Interest | $44,636.14 |
| Rents, and sundry income from rental property (net) | 15,937.02 |
| Gains, dealings in property | 13,296.31 |
| Dividends | 2,797.39 |
| Other income | 8,948.57 |
| Total | 85,615.43 |
During 1934 the following expenses and losses resulting from operations or transactions in the Waterhouse assets were deducted by petitioner in its income tax return for said year:
| Salaries | $14,097.50 |
| Rent | 90.00 |
| Interest | 27,992.61 |
| Taxes | 3.63 |
| Losses, dealings in property * | 46,995.22 |
| Bad Debts | 18,466.73 |
| Dividends from corporations subject to income tax | 2,187.39 |
| Other deductions | 5,798.06 |
| Total | 115,631.14 |
*744 In the records showing the transactions in or operations relating to the Waterhouse assets, the petitioner charged these assets with $81,295.97 as interest and $315 as rent and on its regular books credited itself with like amounts. Neither of these amounts was reported as income, nor taken as a deduction by the petitioner in its income tax return.
In determining*674 the deficiency, the respondent increased income under the heading "Unallowable deductions and additional income" by $111,626.68, described as "Losses of Henry Waterhouse Trust Company." The explanation was as follows:
(a) In your 1934 return you have deducted $111,626.68 of losses arising from the assets and business acquired by you in your merger with Henry Waterhouse Trust Company. This deduction is being disallowed for the reason that it is held that you did not suffer the loss, but that the amount thereof should be applied to reduce the contingent liability of $400,000.00 which was created at the time you took over the business of Henry Waterhouse Trust Company.
Regardless of explanation, the effect of the change was to add to petitioner's income an amount equal to the interest and rent charged by petitioner on its books against the Waterhouse assets and to disallow deductions totaling $30,015.71, which amount is equal to the excess of the total deductions claimed by petitioner on its return in respect of the liquidation of the Waterhouse assets over the income reported by petitioner in respect of or from those same assets.
The Honolulu Bond & Mortgage Co., Ltd., sometimes*675 hereinafter referred to as the Bond Co., was organized under the laws of Hawaii in 1926. During 1931 through 1934, all of its outstanding common stock of a par value of $300,000 was owned by petitioner. The Bond Co. also had outstanding certain preferred stock of a par value of $300,000, but this was without voting rights except on resolutions to amend the articles of incorporation.
In June 1927 an indenture of trust was executed providing for the issuance by the Bond Co. of 6 percent collateral trust first mortgage bonds. The petitioner was appointed trustee for the bondholders under the indenture. The indenture provided for the assignment to the trustee, as security for said bonds, of first mortgages having a value of not less than 110 percent of the par value of the bonds issued thereunder, and authorized the issuance of $300,000 par value of series A bonds. Later in 1927 the issuance of an additional $200,000 par value of said bonds was authorized. By the end of 1928 all of these bonds ($500,000) had been issued and were outstanding. In 1929 the issuance of $500,000 par value of series B bonds, bearing interest at the rate of 6 percent, was authorized under the indenture, *676 and by the end of 1930 all of these bonds had been issued and were outstanding.
*745 Prior to 1934, the petitioner, acting as fiduciary for certain trust and guardianship estates, invested a part of the funds of the said estates in series A and series B bonds of the Bond Co. These investments, totaling $67,655, were made when the market value of the bonds was par or above. At the time the petitioner made said investments the bonds were legal investments for trust funds under the laws of Hawaii.
Beginning in 1933 the Bond Co. made public offerings to repurchase its outstanding bonds at $65 per $100 par value and during the year it purchased $23,000 par value of its bonds for $17,195. Although the Bond Co. was not in default in payment of either principal or interest on its bonds in 1934, the market value of the bonds declined to $65 per $100 par value during that year.
During 1933 the petitioner applied to the Reconstruction Finance Corporation for a loan and that corporation sent one of its appraisers, Harry S. Hossack, to investigate the affairs and condition of the petitioner and its subsidiary corporations. After making certain investigations in 1933, Hossack*677 found that the petitioner was the owner of the common capital stock of the Bond Co. and that it had invested funds of certain trust and guardianship estates, for which it was fiduciary, in the bonds of that company. He informed the petitioner that this was a disturbing situation. While not stating it as a condition to a favorable recommendation on petitioner's application for a loan, he requested and in June 1934 obtained from petitioner an oral understanding that it would repay to its trust and guardianship estates the amount of money which it had invested for them in the bonds of the Bond Co.
In the early part of 1934 the petitioner consulted counsel concerning its liability to its trust and guardianship estates with respect to investments it had made for them in the bonds of Bond Co. Upon investigation counsel found that in practically every case where the Bond Co. had pledged a first mortgage with petitioner, as trustee under the indenture, it had retained a second mortgage on the same property; that in many cases both the first and second mortgages were past due and unpaid; and that, instead of instituting foreclosures, the petitioner had permitted the Bond Co. to accept*678 payments from the mortgagors and to apply a portion of the payments on the first mortgages and a portion on the second mortgages, whereas the entire payments should have been applied on the first mortgages. This being the situation, and since the petitioner was the owner of the common capital stock of the Bond Co. and thereby had an indirect interest in the second mortgages, counsel concluded, and so advised the petitioner, that it had committed a breach of trust with respect to its trust and guardianship estates and that it was *746 legally liable to make good the amount of funds which it had invested for them in the bonds of the Bond Co.
During 1934 the petitioner purchased at par the $67,500 par value of series A and series B bonds of the Bond Co. owned by petitioner's trust and guardianship estates and immediately sold said bonds to the Bond Co. for their then market value of $43,875, or $65 per $100 par value. The Bond Co. immediately retired the bonds so acquired and in its income tax return for 1934 reported a profit of $23,625 from the transaction; however, the return of the Bond Co. disclosed no tax liability. In addition to the foregoing $67,500 par value of*679 bonds purchased from the petitioner, the Bond Co. during 1934 purchased from other owners $196,000 par value of its bonds for $139,026.
In its income tax return for 1934, the petitioner took a deduction of $23,625 as a loss sustained on the bonds purchased from its trust and guardianship estates and sold to the Bond Co. The respondent disallowed the deduction on the ground that the loss did not arise from a transaction entered into for profit.
OPINION.
TURNER: We have for determination two questions: (1) Whether the petitioner should report the income and gain received or realized and deduct the losses sustained in transactions in and operations relating to the Waterhouse assets, and (2) whether it is entitled to deduct the losses sustained by it in removing from the portfolios of certain trusts and estates bonds of the Honolulu Bond & Mortgage Co. The petitioner has filed no brief and its contentions are disclosed only in its petition and statements made by counsel at the time of the hearing.
With respect to the first question, it is the claim of the petitioner that by reason of the merger it acquired all of the assets of Waterhouse and succeeded to all of its liabilities*680 and obligations in a nontaxable transaction and that it should therefore in each year thereafter report as its own all of the income, gains, and losses therefrom in the same manner and on the same basis as Waterhouse would have done had it continued. The difficulty with that proposition is that it did not succeed to the unfettered ownership of the Waterhouse assets. It acquired those assets subject not only to the liabilities of Waterhouse generally but also to the rights of the special noteholders, after the satisfaction of which it was entitled to the gain, if any, that might be realized therefrom or thereon. Until the assets were liquidated, leaving nothing for the special noteholders, or until the special noteholders should be paid off, the petitioner had no right to appropriate or use the Waterhouse assets or proceeds therefrom for its own purposes. It is argued that the value of the Waterhouse*747 assets had shrunk to such an extent that it could not in good judgment be said that there was any reasonable hope or probability that anything could or would be realized for the special noteholders, and some evidence tending to support that argument was submitted at the*681 time of the hearing. The record shows, however, that a similar argument was made to the special noteholders prior to the beginning of the taxable year, with the request that they release the petitioner of any and all claims in respect of the Waterhouse assets and thereby eliminate needless administration expense. The noteholders refused to agree to the proposal and the petitioner, as it was obligated to do, retained the Waterhouse assets intact and accounted for all gains and losses thereon or in respect thereto separate and apart from the gains and losses from its other operations. At the end of 1934 the petitioner still held Waterhouse assets which had a book value of $2,282,864.44, and while the surveys which it had made indicated that a net loss probably would be sustained in the end, it still had a credit balance of $147,513.69 in the fund which had been set up from the proceeds of the special notes to be applied on the Waterhouse losses. We accordingly conclude and hold that with respect to the Waterhouse assets and operations there was no completed or closed transaction in the taxable year from which income should be reported or losses deducted by the petitioner. *682 . Shrinkage of assets does not supply the basis for a loss deduction in determining net income.
In determining the deficiency herein, the respondent not only disallowed as deductions the excess of sustained losses over the income and gain realized on the Waterhouse assets, but in addition added to petitioner's income a further sum of $81,620.97, representing interest and rent accrued on petitioner's books against said assets. These additions were not reported as income, nor claimed as deductions by petitioner in its income tax return, and such treatment of the items in question was obviously correct. The petitioner has no right, under its agreement with Waterhouse originally or with the special noteholders, to any such charges on the Waterhouse assets or operations.
With respect to the amounts expended by petitioner in removing the bonds of the Honolulu Bond & Mortgage Co. from the portfolios of certain estates and trusts for which it acted as fiduciary, the respondent argues that the petitioner is entitled to no deduction for losses sustained or for any of the amounts expended, on the ground that the acquisition*683 of the bonds from the trusts and estates and their subsequent disposition was not in the nature of a transaction or transactions entered into for profit. The statute grants to corporations the right to deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business; also losses sustained *748 during the taxable year and not compensated for by insurance or otherwise. Sec. 23(a) and (f), Revenue Act of 1934. In the case of individuals it permits the deduction of losses sustained during the taxable year and not compensated for by insurance or otherwise "if incurred in a trade or business" or "if incurred in any transaction entered into for profit." Sec. 23(e), Revenue Act of 1934. The respondent's argument appears to have been based upon the language of section 23(e), which applies to individuals, for certainly it may not be said that the losses sustained by the petitioner in the instant case do not fall literally within the provisions of section 23(f). But even though we assume that section 23(e) is applicable in the instant case, we find no merit in the respondent's contention. The petitioner, through its trust department, *684 acted as fiduciary for trusts and estates with a view to making a profit. In the course of its operations it had acquired for certain of the trusts and estates the bonds of a corporation in which it, as the owner of all the common stock, had a direct proprietary interest. The bonds had so shrunk in value that the estates and trusts holding them were faced with substantial losses. The petitioner in the course of its trust business took the necessary steps to rectify its own mistakes and in so doing was required to expend the sum here in question, without any basis for hope of recovery. We think therefore that the deduction claimed in respect of the losses sustained or the expenditures so made not only must be allowed, under section 23(f), as a loss not compensated for by insurance or otherwise but might reasonably be regarded as ordinary and necessary expenses incurred in the operation of the petitioner's business, under section 23(a), or as losses sustained in transactions entered into for profit, under section 23(e), if that provision of the statute were applicable to corporations. See also *685 .
Decision will be entered under Rule 50.