*137 Decision will be entered under Rule 50.
1. Held, in computing gain or loss on properties destroyed by fire in 1943 and 1946, taxpayer railroad which, as of January 1, 1943, changed from retirement accounting to depreciation accounting, is not required to deduct from its basis any amount for depreciation allegedly sustained prior to 1943.
2. Held, the expenditures made by petitioner in 1946 incident to the polling of its bondholders to obtain the consents thereof necessary to make possible its merger with its parent company pursuant to the reorganization plan of the latter, constituted reorganization expenses and as such were nondeductible capital expenditures.
*709 Respondent determined deficiencies in income taxes of the Denver & Salt Lake Railway Company for years and in amounts, as follows: *710
| 1943 | $ 13,762.02 |
| 1946 | 23,803.12 |
The Denver and Rio Grande Western Railroad Company is involved herein only as transferee of the Denver & Salt Lake Railway Company, which transferee liability is admitted.
There are two issues: (1) Was respondent justified in reducing petitioner's basis for computing gain or loss by the amount of alleged depreciation accrued from 1909 to 1943, and (2) were certain expenses deductible from gross income.
FINDINGS OF FACT.
The Denver & Salt Lake Railway Company (herein referred to as petitioner) was, during the years here involved, a railroad corporation with its principal office at Denver, Colorado. Petitioner was merged with the Denver and Rio Grande Western Railroad Company (hereinafter called the Denver and Rio Grande) on April 11, 1947, and lost its separate existence at that time.
Prior to the year 1943, petitioner kept its books and filed its tax returns, with respect to its depreciable roadway property, upon the so-called*139 retirement method of accounting. Under that method, no depreciation was charged upon petitioner's books nor deducted upon its tax returns, during the life of a depreciable item. Nor was any such deduction for depreciation allowable to petitioner. At the time a depreciable item was retired from use, for any reason, the entire cost of the asset, less salvage and insurance collected, was charged to operating expenses and was claimed as a deduction from gross income in petitioner's tax return. Petitioner, with other railroads, had followed this retirement accounting system for many years, with the permission of the Interstate Commerce Commission and with the approval of the respondent. It was estimated that the expense deductions, upon the retirement of various roadway properties, would equal or approximate the amounts to be deducted year by year as depreciation upon such properties under the straight-line depreciation method.
By order entered June 8, 1942, and effective January 1, 1943, the Interstate Commerce Commission required all steam roads, including petitioner, to change from the retirement method to the depreciation method with respect to its depreciable roadway properties. *140 Among the roadway asset accounts which petitioner was required to convert to the depreciation method were: Account 5, "Tunnels and Subways," and Account 18, "Water Stations." By order dated October 6, 1944, and effective January 1, 1945, the Interstate Commerce Commission added certain other road accounts to those as to which depreciation accounting would in the future be required.
*711 On March 26, 1943, in accordance with regulations prescribed by respondent, petitioner applied for permission to change from the retirement method to the depreciation method with respect to its depreciable road properties, which were embraced in certain designated primary accounts. Among such accounts were: Account 5, Tunnels and Subways, and Account 18, Water Stations. As a prerequisite to granting permission to petitioner to change from the retirement to the depreciation method of accounting, respondent imposed certain conditions requiring petitioner to set up a depreciation reserve for each of the depreciable roadway accounts, in accordance with one of three optional methods specified by him. Petitioner elected the method which required it to set up a reserve equal to 30 per cent of cost*141 of the total depreciable road accounts at December 31, 1942, such reserve to be allocated, in a manner acceptable to the Commissioner, among the depreciable road accounts involved. Petitioner was required to submit to respondent information showing its investment, its estimated net salvage, the expired life, and its proposed average normal useful life for each group of the properties involved.
With the information furnished by petitioner, respondent recomputed and determined the amount of net salvage value and the total service lives of the various classes and subclasses of petitioner's assets included in the primary depreciable road accounts. With the figures so supplied by respondent, and at his specific direction, petitioner prepared revised schedules of its depreciable road accounts subdivided as to primary accounts, and subaccounts, showing:
(1) Nature of asset
(2) Cost at December 31, 1942
(3) Net salvage value (respondent's figure)
(4) Service value at December 31, 1942 (item 2 less item 3)
(5) Expired life years
(6) Total service life years (respondent's figure)
(7) Amount of annual depreciation (item 4 divided by item 6)
(8) Depreciation rate (which is item 7 expressed *142 in terms of a percentage of item 4)
(9) Expired dollar years (item 5 multiplied by item 7)
(10) Past depreciation to December 31, 1942. (Although the total of column 9 is supposed to be the Commissioner's computation of accrued depreciation to December 31, 1942, the total thereof, $ 986,221.65, exceeded the Commissioner's predetermined aggregate amount of 30 per cent of column 2, namely $ 735,505.94, hence an arbitrary adjustment of the figures in column 9 was necessary. Since $ 735,505.94 was the predetermined total of column 10, the detailed figures in column 10 were arrived at by taking 73.5 per cent (735,505.94/986,221.65) of the figures in column 9.)
*712 Such schedules, which also showed petitioner's amortization of certain improvements to leased property, not here in issue, were submitted to respondent along with a covering letter dated August 17, 1944. The schedules labeled "Depreciation Study of Road Accounts" and attached thereto contained the following information with respect to the accounts for tunnels and water stations:
| Asset | Past depreciation to 12/31/42 |
| Totals -- Account No. 5 | |
| Tunnels and subways | $ 174,727.83 |
| Totals -- Account No. 18 | |
| Water stations | 38,266.25 |
*143 Under date of September 2, 1944, respondent addressed to petitioner a letter (hereinafter referred to as the "terms letter") wherein respondent informed petitioner that it would be permitted to change from the retirement to the depreciation method with respect to its depreciable road property, effective January 1, 1943, only if petitioner would irrevocably agree to the following conditions:
(1) That a reserve for depreciation shall be computed as of December 31, 1942, on all the depreciable property included in these accounts in accordance with the summary tabulation set forth below;
(2) That the remaining sum to be recovered through depreciation allowances shall be limited to the cost or other basis less the depreciation so accrued;
(3) That neither the change of method nor the amount of depreciation so accrued shall have any effect on taxable net income for any year ending prior to January 1, 1943;
(4) That the depreciation rates agreed to are subject to modification if subsequent experience indicates that revision is necessary in order to spread the cost of the assets over their remaining useful lives; such revision, however, is not to be made retroactive;
(5) That complete depreciation*144 accounting in accordance with all the applicable sections of the Internal Revenue Code and regulations shall be adopted for these accounts;
(6) That the reserve for depreciation accrued to the date of the change from retirement to depreciation accounting shall reduce accumulated earnings and profits in the determination of invested capital for excess profits tax purposes.
The foregoing letter also contained a tabulation regarding various accounts of the petitioner wherein the above figures with respect to tunnels and subways, and water stations were adopted by respondent and set forth in a column captioned "Accrued Depreciation at 12/31/42." Petitioner was also informed that permission (as of January 1, 1943) for the requested change of accounting method would become effective only upon receipt of a letter agreeing to all the terms and conditions above imposed, signed in ink by the president, vice *713 president, or other principal officer of petitioner, over his official title, and submitted in duplicate.
Petitioner signified its acceptance of these terms by letter of September 8, 1944, reserving only the right to claim the benefits of any subsequent modifications of the above*145 conditions as might be extended to railroads generally. Respondent acknowledged this letter and informed petitioner that permission to make the change was granted.
The entire agreement between petitioner and respondent on the subject of petitioner's change of accounting method is embodied in the terms letter.
On September 20, 1943, the timber lining in petitioner's Tunnel No. 10 was destroyed by fire. Petitioner claimed a loss in its tax return for that year on account of this casualty. The total cost of such timber lining at the date it was destroyed was $ 26,952.15. Petitioner collected insurance on account of the casualty in the amount of $ 18,478.42, and there was no other salvage recovery.
In determining the deficiency herein for 1943 respondent has computed a gain to petitioner in the amount of $ 8,237.86 by computing "past accrued depreciation" on such timber lining from 1909 to December 31, 1942, inclusive, in the amount of $ 16,374.69. Petitioner had never accrued or deducted depreciation, as such, in its tax returns, nor had the respondent allowed any portion thereof as a deduction, in the years prior to 1943. Neither would any portion thereof have been "allowable" *146 under the retirement method used by petitioner for 1942 and prior years. In addition, respondent computed depreciation for the period since January 1, 1943, as to which petitioner was entitled to claim depreciation, in the amount of $ 336.90, which amount is not in dispute. Respondent then used the total of these two amounts, or $ 16,711.59, to reduce petitioner's basis from $ 26,952.15 to $ 10,240.56. The latter figure was less than the insurance recovered by petitioner, and respondent therefore determined a gain on the casualty in the amount of $ 8,237.86. Petitioner's computation herein is the same as respondent's, except that petitioner has not reduced its cost basis ($ 26,952.15) by any "accrued depreciation" for the period 1909 to January 1, 1943, when it was not entitled to any deduction for depreciation and had claimed none. Petitioner thus computes a loss of $ 8,136.83 on the casualty.
On February 19, 1946, petitioner's water tank at Radium, Colorado, was destroyed by fire. Petitioner, through oversight, did not claim any loss in its 1946 tax return on account of this casualty. The total cost of such water tank was $ 3,161.94, at the date of its destruction. Petitioner*147 collected insurance on account of the casualty in the amount of $ 1,000, and there was no other salvage recovery.
In determining the deficiency herein for 1946, respondent has computed a gain to petitioner on account of this casualty in the amount *714 of $ 431.67, by reducing petitioner's basis ($ 3,161.94) by so-called past accrued depreciation for the period 1908 to 1942, inclusive, in the amount of $ 2,273.60. Petitioner had never accrued or deducted any depreciation on this water tank, nor had the respondent allowed any depreciation, as such, on such tank, in years prior to 1943. Respondent further computed petitioner's allowable depreciation on the water tank from January 1, 1943, to the date of destruction in the amount of $ 320.01, which amount is not in dispute. Respondent used the total of these two computed figures, or $ 2,593.61, to reduce petitioner's cost basis to $ 568.33. Since this figure was less than petitioner's insurance recovery by $ 431.67, respondent determined a gain to petitioner in that amount. Petitioner's computation herein is the same as respondent's except that petitioner has not reduced its cost basis ($ 3,161.94) by any so-called accrued *148 depreciation for the period prior to January 1, 1943, when it was not entitled to any deduction for depreciation and had claimed none. Petitioner thus computes a loss of $ 1,841.93 on the casualty.
In the year 1935, the Denver and Rio Grande (the transferee-petitioner herein), being unable to pay its debts, filed a petition with the United States District Court for the District of Colorado for a reorganization under the terms of section 77 of the Bankruptcy Act of 1898, as amended. That petition resulted in a reorganization proceeding, under the supervision of the District Court, which lasted until 1947, the debtor company being operated by two court-appointed trustees in the meanwhile. In the course of the reorganization, several proposed plans were submitted to the court with the approval of the Interstate Commerce Commission. As finally approved by the court in its opinion entered in 1943 and its confirmation order entered in 1944, the plan which was adopted for the Denver and Rio Grande included, among other things, the merger into it of certain of its subsidiaries, including petitioner, about 95 per cent of the stock of which was owned by the Denver and Rio Grande. As it *149 related to petitioner, the final plan was in the alternative. It was provided that the reorganization should include the merger of petitioner into the Denver and Rio Grande, and it was also provided that the reorganization should be carried through without the participation of petitioner in any way. Whether or not petitioner would become a party to the reorganization depended (a) upon securing the consent (to modifications of the trust indenture) of holders of at least 90 per cent face value of the outstanding income mortgage bonds of petitioner, within a period of 90 days from the time the reorganization plan was submitted to them, and (b) formal action by petitioner becoming a party to the proposed reorganization.
The proposal was not presented to the income mortgage bondholders until July 1946. Petitioner was not at that time a party to *715 the proceedings in the District Court, nor had it ever been. At the time the bondholders were polled, petitioner had not formally committed itself in any way to entering the reorganization plan, nor, under the terms of the plan, could it have done so.
At the time the polling took place, there were $ 11,000,000 face amount of petitioner's*150 income mortgage bonds outstanding. The bonds were widely held, but there were large concentrations of ownership in Colorado and in the Atlantic seaboard area. The proposed merger, to which the bondholders were asked to agree, involved the surrender by them of their bonds, maturing in 1960 and paying interest up to 6 per cent if earned, and the receipt in exchange of new bonds maturing in 1993 and bearing fixed interest of only 3 per cent, with an additional 1 per cent payable if earned. These new bonds were not to be issued by petitioner but by its successor by merger, the Denver and Rio Grande. The plan also involved the surrender and cancellation of the income bonds owned by the Denver and Rio Grande, amounting to $ 1,266,000. The proposed plan was thus financially advantageous to petitioner.
In collaboration with the reorganization committee of the Denver and Rio Grande, petitioner undertook to procure the consent of holders of 90 per cent of its outstanding income bonds to its merger with the parent company on the basis proposed in the reorganization plan of the latter. In furtherance of this undertaking there were sent to petitioner's income bondholders (a) a descriptive*151 circular signed by the aforementioned reorganization committee and (b) a ballot for voting on "the proposal in the Plan of Reorganization of The Denver and Rio Grande Western Railroad Company * * * relative to the modification of rights of the holders of said bonds" of the petitioner. Both the circular and the ballot bore the caption of the District Court reorganization proceeding of the parent company. Petitioner discovered that it would be a difficult task to secure the agreement of holders of 90 per cent of the income bonds. Feeling that it was to its advantage to join the reorganization, petitioner employed a New York stockholder-relations firm, Georgeson & Co., to canvass all bondholders in the East and secure affirmative ballots if possible. This involved direct contact with every bondholder in the East by mail, telephone, and frequently by personal visits, within the allotted 90 days. A brokerage firm in Denver was also employed to contact those bondholders in the Colorado area. As a result of these efforts, petitioner was successful in obtaining the consent of the required amount of the outstanding bond interests to a modification of their mortgage indenture and the *152 participation of petitioner in the Denver and Rio Grande reorganization. The number of assenting bondholders was 90.28 per cent of the total. In connection with polling the bondholders, petitioner incurred expense of $ 11,366.21, of which $ 10,000 was in fees *716 to brokers for services, as outlined above, and the remainder was miscellaneous expense for printing, postage, and the like.
The sum of $ 11,366.21 was expended by the petitioner to make possible its merger with its parent corporation, the Denver and Rio Grande, pursuant to a reorganization plan approved for the latter under section 77 of the Bankruptcy Act, as amended. Petitioner claimed this amount as an ordinary and necessary expense of doing business and deducted it from gross income in its return for 1946. Conceding that petitioner was not a party to the reorganization at the time these expenses were incurred, respondent nevertheless disallowed the deduction for 1946 on the ground that the expenditures were capital in nature and connected with a corporate reorganization.
OPINION.
The first question is whether petitioner's bases in certain properties for determining gain or loss on their destruction by fire are*153 to be reduced by amounts representing depreciation allegedly accrued during the period 1908 to 1943 as to the water tank, and from 1909 to 1943 as to the tunnel lining, taxpayer having changed from retirement accounting to depreciation accounting as of January 1, 1943. The portions of the statutes claimed to be applicable are found in sections 23 (i) and 113 (b), Internal Revenue Code of 1939. 1
*154 Briefly summarized, the pertinent facts are these. Following an order by the Interstate Commerce Commission for petitioner to change from the retirement method of accounting, which method it had traditionally *717 used with respect to its depreciable roadway property, to the depreciation method, petitioner applied to respondent for permission to make such change for tax purposes. Respondent granted such request, effective January 1, 1943, subject to petitioner's irrevocable acceptance of certain terms and conditions dealing with depreciation set forth in his so-called terms letter, the germane portions of which are set forth in the above findings. Thereafter, certain items of petitioner's roadway property, i. e., a wooden tunnel lining and a water tower, were destroyed by fire in 1943 and 1946, respectively. In each instance there was no salvage and petitioner collected insurance on account of the casualty. Petitioner claims to have suffered a deductible loss on each casualty, whereas respondent has determined, and here contends, that petitioner realized taxable gains thereon. The treatment accorded to depreciable property under retirement accounting and the exact procedure*155 employed in making the respective computations are set out in our Findings of Fact.
Various phases of the general question of retirement accounting by railroads and the difficulties that were encountered when the railroads changed to depreciation accounting have been before the courts. 2 We know of no case, however, which involved as a fact or a factor the narrow question presently before us, which is, the effect and applicability of what is here called the terms letter, in determining gain or loss on property destroyed by fire. It is agreed that the terms letter embodies the entire contract or agreement between the railroad and the Commissioner in the matter of depreciation accounting, and, as we understand counsel for the parties, a decision on this question is dispositive of the entire issue.
*156 The respondent contends that, by necessary implication, the terms letter authorizes his action in deducting depreciation from petitioner's cost basis and points to section 113 (b) (1) (B) and (C). Petitioner maintains that the provisions and meaning of the terms letter are clear and that the action of the respondent cannot be justified by any provision of the agreement. We agree with the petitioner.
The terms letter does not deal with gain or loss. It refers exclusively to the matter of depreciation. Such an important matter as the calculation of gain or loss, had the parties intended its inclusion, would not have been left to implication or interpretation. It would have been made the subject of specific provision. The terms letter seems clear and unambiguous. To hold as respondent suggests, would extend the effect of the agreement far beyond its apparent scope.
*718 Petitioner has adjusted its depreciation practice to conform to the straight-line method, within the limitations set by the respondent and does not here challenge respondent's action in respect to the period after December 31, 1942. It has fixed the cost basis of depreciable property at an agreed figure, *157 has set up the 30 per cent reserve with its arbitrary write-down of book cost, and has, so far as we are informed, kept strictly within the provisions and spirit of the agreement embraced in the terms letter.
As to respondent's reliance on section 113 (b) (1) (B) and (C), in the Akron and Canton case this Court considered many phases of the basic question (except the applicability of the terms letter above disposed of and not there present) holding on the authority of a long line of cases that where a taxpayer changed from retirement accounting used by a predecessor corporation to depreciation accounting used by the new corporation, no adjustment to the predecessor's basis or substituted basis in petitioner's hands was proper under section 113 (b) (1) (B) and (C).
We hold that respondent erred in reducing petitioner's basis for computing gain or loss by the deduction of depreciation allegedly allowed or allowable during the period prior to January 1, 1943.
One further issue remains to be considered. Prior to the year here involved, petitioner's parent company, the Denver and Rio Grande, was undergoing a reorganization under the terms of section 77 of the Bankruptcy Act. The plan*158 of reorganization, as adopted, proposed the merger of petitioner into the Denver and Rio Grande, provided the holders of a requisite proportion of petitioner's income bonds consented thereto. Otherwise, the reorganization would proceed without the participation of petitioner. The plan to which petitioner's bondholders were asked to agree called for the surrender by them of petitioner's bonds in exchange for those of the reorganized parent. The bonds to be issued by a different obligor would have an extended maturity date and a lower rate of interest than those surrendered. Petitioner undertook, in collaboration with the reorganization committee of the Denver and Rio Grande, to poll its bondholders and to procure the requisite consent thereof. In such undertaking petitioner was successful. Petitioner incurred and paid expenses in connection therewith in the amount of $ 11,366.21 during 1946, and here seeks our approval of the deduction thereof in 1946.
Respondent disallowed such deduction and here argues on brief that the expenditures in controversy were not ordinary and necessary expenses of doing business; that they were reorganization expenses, and that, as such, they are *159 neither deductible nor amortizable by petitioner. It is petitioner's contention that at the time the polling of bondholders took place in 1946, it was not actually a party to any reorganization *719 and that such polling and the expenses incident thereto, were a necessary prerequisite to its participation therein. Petitioner further argues that such expenses were incurred in connection with a modification with respect to petitioner's outstanding bonds, which modification was advantageous to petitioner and that they are, therefore, deductible in full in 1946 or beginning in that year are amortizable over the life of the bonds, as extended. We disagree with petitioner on this point.
It is true that petitioner was not technically a party to a reorganization at the time it incurred the disputed expenses. It is also true that such amounts might possibly be said to have been expended to acquire a modification in petitioner's outstanding bond issue, which was advantageous to it. Nevertheless, the fact remains that petitioner made such expenditures in anticipation of and as an integral part of its proposed merger with the Denver and Rio Grande. Furthermore, what advantages there*160 were accruing to petitioner, in the modification sought by it, were contingent upon and did not accrue to it unless and until the actual merger occurred. We, therefore, are of the opinion that being so inextricably tied in with the proposed plan of reorganization and with petitioner's participation therein, the expenditures in question must necessarily be considered as part of the expenses thereof. This being true, they represent capital expenditures and as such, are not deductible. Bush Terminal Buildings Co., 17 T. C. 485, affd. 204 F.2d 575">204 F. 2d 575, following Bush Terminal Buildings Co., 7 T.C. 793">7 T. C. 793. See also Motion Picture Capital Corp. v. Commissioner, 80 F. 2d 872, affirming 32 B. T. A. 339. Gt. W. Power Co. v. Commissioner, 297 U.S. 543">297 U.S. 543, and other cases of like import relied upon by petitioner are distinguishable on their facts and the rationale thereof is not considered applicable. Respondent's determination is therefore approved.
Decision will be entered under Rule 50.
Murdock, *161 J., dissenting: The statute contemplates only one basis for all purposes, including gain and loss, and I think the parties had no other thought in mind when they agreed, as a condition to the change in accounting method for depreciation, that the basis should be reduced by a reserve equal to 30 per cent of cost. That was a reasonable thing for them to do in view of the fact that the deductions under the retirement method had approximated the deductions which would have been allowable under the straight-line depreciation method. The 30 per cent should be taken into account in computing gain or loss when the two properties burned.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(i) Basis for Determining Loss. -- The basis for determining the amount of deduction for losses sustained, to be allowed under subsection (e) or (f), and for bad debts, to be allowed under subsection (k), shall be the adjusted basis provided in section 113 (b) for determining the loss from the sale or other disposition of property.
SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.
(a) Basis (Unadjusted) of Property. -- The basis of property shall be the cost of such property; except that --
* * * *
(b) Adjusted Basis. -- The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under subsection (a), adjusted as hereinafter provided.
(1) General rule. -- Proper adjustment in respect of the property shall in all cases be made --
* * * *
(B) in respect of any period since February 28, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent of the amount --
(i) allowed as deductions in computing net income under this chapter or prior income tax laws, and
(ii) resulting (by reason of the deductions so allowed) in a reduction for any taxable year of the taxpayer's taxes under this chapter (other than subchapter E), subchapter E of chapter 2, or prior income, war-profits, or excess-profits tax laws, but not less than the amount allowable under this chapter or prior income tax laws. * * *
(C) in respect of any period prior to March 1, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent sustained;↩
2. Los Angeles & Salt Lake Railroad Co., 4 T. C. 634; Chicago & North Western Railway Co. v. Commissioner, 114 Fed. (2d) 882, affirming 39 B. T. A. 661, certiorari denied 312 U.S. 692">312 U.S. 692; Commissioner v. Union Pacific Railroad Co., 188 F. 2d 950, 952; Boston & M. R. R. v. Commissioner, 206 F. 2d 617, affirming in part 16 T. C. 1517; Kansas City Public Service Co. v. United States, 100 F. Supp. 105">100 F. Supp. 105; and Akron, Canton & Youngstown Railroad Co., 22 T. C. 648↩.