*732 Where a corporation acquired its own bonds at a price less than the issuing price, the amount of the excess of issuing price over purchasing price constituted taxable gain or income.
*333 The Commissioner determined a deficiency of $1,950.72 in petitioner's income tax for 1932, of which petitioner assails so much as results from the addition to income of the difference between par value and the lower price paid by it for some of its own bonds.
FINDINGS OF FACT.
Petitioner, a North Carolina corporation with principal office at Brevard, North Carolina, is owner of a railroad, approximately forty-two miles in length; approximately one-half of which lies between Hendersonville and Brevard, and the other half between Brevard and Lake Toxaway, all in that state.
Under date of January 1, 1906, it executed a lease of its railroad, rights of way, buildings, franchises, equipment, and all other real and personal property, for a period of 50 years, to the Southern Railway - Carolina Division, and the Southern Railway Co., and has not since been active as*733 an operating company.
The lease provided for an annual rental of $25,000 for each of the first 10 years and $30,000 for each of the succeeding 40 years. Out of these respective amounts the lessee bound itself to pay $3,300 for each of the first 10 years, and $8,300 for each of the succeeding 40 years, directly to petitioner.
After reciting petitioner's intention to issue first mortgage bonds of $434,000 (of an authorized issue of $500,000), bearing annual interest of 5 percent, or $21,700, and falling due January 1, 1956, the lease provided that the lessee:
* * * shall, on account of said rent, pay the said sum of twenty-one thousand seven hundred dollars ($21,700) in each year during said term to *334 the Trustee of the First Mortgage of the Transylvania Company in such amounts and at such times as will suffice to meet the interest as it accrues and becomes due on the said First Mortgage Bonds * * *.
The lessee further agreed:
Eighth. That it will pay and discharge all such taxes, duties and assessments whatsoever as shall or may during the said term or any renewals thereof be lawfully charged or assessed or imposed upon said leased railroad and property.
*734 Ninth. That it will at all times during the life of this agreement so preserve, renew and maintain the railroad of the Transylvania Company and the volume and character of its rolling stock and equipment, and all its property of whatever name and nature, and all alterations, additions, amendments and improvements heretofore made thereto by the Transylvania Company, itself paying all expenses, salaries, wages, liabilities and other outgoings incident thereto, so that if and when the said railroad shall in any manner revert to the possession of the Transylvania Company the said railroad and its appurtenances shall be in all respects in such complete and good condition, and as well provided for the operating and carrying on of its business as on the day of the delivery thereof hereunder unto the Southern Company, and said rolling stock and all other movable property shall be of the value and a condition of efficiency fully equal to the value and condition of the same on said date of delivery.
Tenth. That it will at all times during its possession of said railroad under this lease discharge all the duties and obligations which are or may be lawfully imposed by the State of North*735 Carolina or other authorities upon or assumed by the Transylvania Company, in respect of its duties as a common carrier of freight and passengers, or as owner or lessor of the said demised railroad, and to that end specifically agrees to operate the same as a railroad at all times during said term and any and all renewals thereof and to pay all expenses, salaries, wages, liabilities and other outgoings incident to such operation, and that it will defend at its own cost and expense all suits which may be brought against the Transylvania Company for any violation or neglect of its duty in respect to the operation of said railroad, accruing during said term and possession and any and all renewals thereof; and will pay and satisfy all claims and judgments of every kind whatsoever against said Transylvania Company, accruing by reason of the negligence of the Southern Company, its servants and employees in the operation of the said demised line of railroad, and will not permit or suffer any claim or demand to be created by the act or neglect of the Southern Company against the Transylvania Company which may or might be adjudged to be a lien upon the property of the Transylvania Company.
*736 Eleventh. That throughout the term hereby created and any and all renewals thereof it will keep all such usual accounts, books and vouchers for the purpose of showing the income, expenditures, debts, and liabilities of the property of the Transylvania Company as administered by the Southern Company, and furthermore will furnish annually throughout said term to the Transylvania Company at its office in the town of Brevard, North Carolina, a report in customary form showing the results of operation of the leased property during the last preceding fiscal year ended June 30.
Petitioner issued its first mortgage bonds of $434,000 on January 1, 1906, using the proceeds to refund a prior issue of $350,000 and for *335 expense of improvements. Its entire capital stock of a par value of $370,000 was issued free to purchasers of its bonds with the exception of a block of $25,000, for which petitioner received $16,000. Petitioner agreed further that, upon the lessee's request, it would issue additional bonds, authorized to the amount of $66,000, for making improvements on the road, the lessee undertaking in such event to pay "a further rental in an amount sufficient to meet and*737 discharge the interest * * *." Petitioner bound itself so to maintain its corporate organization during the term of the lease that its franchises might be available for the use of the lessee.
The Standard Trust Co., and its successor, the Guaranty Trust Co., have acted as trustee under the mortgage, paying the interest to the bondholders, who are numerous and scattered. The trust instrument makes no provision for a sinking fund.
In October 1932 petitioner purchased $19,000 par value of its bonds for $4,750. It has since held the bonds in its treasury, so that it would be able to collect interest on the bonds' coupons. Such interest has been collected by petitioner since October 1932 and has been reported as income in its income tax returns. The difference, $14,250, between cost and the amount of the bonds' obligation was credited to its profit and loss account and charged to bonds held in the treasury. This treatment is prescribed by the Interstate Commerce Commission's rules in respect of bonds reacquired by the issuer "under circumstances which require that they shall not be treated as cancelled or retired * * *."
The assets of the petitioner in 1932 consisted of $10,000*738 in its banking account, $77,000 worth of its recovered bonds, and physical property as to which no attempt was made by petitioner to compute its value for 1932. The books of the company showed a valuation of its physical properties at approximately $419,130 in June 1905. No entries appeared in the books showing either acquisitions, improvements, obsolescence, or depreciation since that time.
The liabilities of the petitioner as of October 1932 were approximately $500 accounts payable and $434,000 of bonds issued, of which $77,000 had been recovered and were held in its treasury.
The lessee has paid each year the rent specified in the lease, i.e., $25,000 a year for the first 10 years and $30,000 a year thereafter. There has never been any evidence of dissatisfaction on the part of the lessee concerning the lease. No bondholders' committee has been in existence. There have been no allegations of fraud made by bondholders, no claims that the assets of the company were below $434,000, and no evidence of dissatisfaction upon their part concerning their investment, except as dissatisfaction may have been shown by those who offered to sell their bonds at less than par.
*336 *739 The petitioner purchased that portion of the railroad which runs from Hendersonville to Brevard and constructed the other half of the road which runs from Brevard to Lake Toxaway.
The construction of that half of the railroad which lies between Brevard and Lake Toxaway was promoted by men who expected a timber industry, mineral deposits, and a tourist trade to be developed in the area served by it. During and after 1906 the timber business was flourishing, a hotel was built at Lake Toxaway, and two daily passenger trains with Pullman cars were operated in each direction, and a daily freight service of 10 or 15 cars. No minerals, however, have been found, the lake dried up, and the hotel was closed in 1916, and part of the timber was cut off. One lumber company was operating to sell off cut timber on hand. This lumber company and two acid plants were the only industries located on the route in 1932, and they provided very little freight revenue. Highways have been built in the section, and few passengers were carried by rail between Lake Toxaway and Brevard. A mixed passenger and freight train a day was still operated over the line because required.
OPINION.
MILLER: The*740 petitioner in 1932 bought $19,000 par value of its outstanding bonds for $4,750. The respondent held that the difference of $14,250 was a taxable gain and determined a deficiency. This determination the petitioner assails on the theory, first, that it did not retire the bonds and, second, that the value of its entire assets in 1932 was less than the amount of outstanding bonds and that consequently no assets were freed by the purchase.
1. It is not necessary that reacquired bonds be retired in order that gain accrue from the purchase. This question has been decided by the Board, adversely to the petitioner, in Garland Coal & Mining Co.,28 B.T.A. 348">28 B.T.A. 348; affd., Garland Coal & Mining Co. v. Helvering, 75 Fed.(2d) 663; Virginia Iron, Coal & Coke Co.,29 B.T.A. 1087">29 B.T.A. 1087; and Montana, Wyoming & Southern Railroad Co.,31 B.T.A. 62">31 B.T.A. 62; affd., 77 Fed.(2d) 1007; certiorari denied, 296 U.S. 604">296 U.S. 604; applying the decisions of the Supreme Court in United States v. Kirby Lumber Co.,284 U.S. 1">284 U.S. 1, and *741 Helvering v. American Chicle Co.,291 U.S. 426">291 U.S. 426.
The petitioner says that it did not and would not retire these bonds because by keeping them alive it got the interest from the Southern Railway. This may be a good reason between the parties for recognizing the continuing obligation of the Southern to pay - whether as interest or rent would be unimportant between them. But it does not serve petitioner in the present controversy. When it acquired its own bonds it became in form both debtor and creditor *337 and thus it wiped out its obligation qua obligation, irrespective of its continuing right to rent. To be sure, it could have revitalized its obligation by selling these bonds, cf. Garland Coal & Mining Co. v. Helvering, supra, or pledging them as collateral security, Washington Loan & Trust Co. v. Blair, 75 Fed.(2d) 671, but this would give a new interest against petitioner which is properly to be recognized when it becomes actual. As we said in Garland Coal & Mining Co., supra: "The purchase of the bonds by the petitioner constituted such a closed transaction as gives rise to recognizable gain or loss under the*742 revenue act. The fact that the petitioner had such bonds available for resale is not controlling. Such a resale would be an entirely new transaction."
The petitioner relies upon the use of the word "retires" in article 68(1)(c) of Treasury Regulations 77 and upon statements contained in Garland Coal & Mining Co. v. Helvering, supra, concerning the intention of the taxpayer to retire repurchased bonds. It is sufficient in this regard to quote from that case as follows:
To say, as the regulation does say, that when bonds are purchased and retired at less than the selling price, the excess is income, is by no means to say that when they are purchased, but not retired, it is not income; and if the regulation must be so construed, the question whether it violates the terms of the statute (Revenue Act 1928, § 22(a), 26 U.S.C.A., § 2022) would at least be arguable, but we have no need to pass upon that question here.
2. It is true that a prima facie showing of gain, from the repurchase of bonds at a price less than issuing price, may be rebutted by evidence that the entire business in which the borrowing was a factor resulted finally in a loss, *743 Bowers v. Kerbaugh-Empire Co.,271 U.S. 170">271 U.S. 170, and by evidence that the original bond issue brought nothing to the taxpayer's treasury which was freed by the reacquisition of the bonds, Commissioner v. Rail Joint Co., 61 Fed.(2d) 751.
On the other hand, a showing of shrinkage in value, alone, is not sufficient to rebut a prima facie case. Consolidated Gas Co. of the City of Pittsburgh,24 B.T.A. 901">24 B.T.A. 901. In the case last cited it appeared that there was a shrinkage or loss in value of the company's properties, used for manufacturing gas, resulting from the development of natural gas; which shrinkage was the primary cause for decrease in the value of the bonds repurchased. See also Commissioner v. Coastwise Transportation Corporation, 71 Fed.(2d) 104; certiorari denied, 293 U.S. 595">293 U.S. 595.
In the instant case petitioner has failed to sustain its burden of proving either that the entire business in which the borrowing was a factor resulted finally in a loss or that the original bond issue brought nothing to the taxpayer's treasury which was freed by the reacquisition of the bonds. Petitioner's sole*744 witness was obviously little *338 acquainted with the physical properties of the railroad. The books of the petitioner apparently contained no information concerning those properties since 1905. The witness admitted on cross-examination that he had no information on the subject except what was in the books. He stated that he had made no attempt to compute the value of the properties for 1932. Presumably full information was available to the petitioner, upon the subject, because its lease agreement with the Southern Railway Co. required the lessee to keep a full record and account concerning the same. Obviously petitioner has failed to show a failure of assets, or loss of the money originally borrowed. On the contrary, the evidence showed that the property of petitioner was still valued on its books at the same price as when the bonds were issued; and that the Southern Railway has paid each year the amount specified in the lease, which includes both interest on the bonds and several thousand dollars in addition. There was no evidence of dissatisfaction upon the part of the lessee; nor upon the part of the bondholders, except those few who, in the depression year of 1932, *745 offered to sell the bonds which were purchased by the petitioner. The lease still had 24 years to run, and there was not an iota of evidence that the lessee would fail to perform as it was required to do. Its present performance - up to the time of the hearing in 1936 - was all that could have been expected or hoped for at the time of the execution of the lease, when, presumably, the petitioner's prospects were brightest.
We conclude, therefore, that assets of the petitioner were released by the purchase of its own bonds at a price less than issuing price; that taxable gain was realized thereby; and that the Commissioner's determination was correct.
Reviewed by the Board.
Judgment will be entered for the respondent.
LEECH, dissenting: The majority holds that petitioner, a corporation, realized taxable gain in the purchase of its own bonds at less than the issuing price, in spite of what I think is the conclusively established fact that it did not then intend nor has it since intended to cancel or retire these purchased bonds.
This conclusion is said to be supported by *746 Garland Coal & Mining Co. v. Helvering,28 B.T.A. 348">28 B.T.A. 348; affd., 75 Fed.(2d) 663, which is the only court or Board case cited, touching the point. Instead of supporting that conclusion, in my judgment, the opinion of the court in that case definitely and convincingly opposes it.
The taxpayer there purchased its own bonds in 1928 for less than their issuing price, and retired them in the following year. The *339 only question presented was in which of those years petitioner's admitted gain was taxable. The answer to this inquiry was dependent on whether, in view of the respondent's applicable regulation (Regulations 74, art. 68(1)(c)), retirement of the purchased bonds was necessary to establish the transaction as "closed", and thus give rise to gain.
Without doing more than doubting the validity of that regulation, the court recognized the existence of the superficially anomalous but nevertheless widely adopted rule that, whether the purchase of its bonds by a corporate obligor constitutes payment of the purchaser's debt evidenced by the bonds, and thus is a "closed" transaction for tax purposes, depends upon the intention of the purchaser*747 when it purchased the bonds. Thus, the court in that case, after stating this rule and citing a few of the many authorities therefor, says in the following paragraph of its opinion:
And so, in this case the question is, the intention of petitioner when it redeemed its bonds.
The court then decided that the mere purchase of the bonds in 1928 was a closed transaction, and that a taxable gain resulted then and not in 1929 when the bonds were actually retired, solely because the evidence established the fact that when petitioner purchased the bonds it then intended to retire them and so pay its debt thus evidenced. The actual retirement of the bonds was only corroborative of petitioner's book entries during the year of purchase, which indicated its then intention to retire the bonds. And, of course, the fact that the bonds were not actually retired until the next year could not and did not change the decisive fact that the bonds were purchased with the intention of retiring them. It seems to me this interpretation of the meaning of the court in its opinion in the Garland case is confirmed rather than disputed from the excerpt of that opinion appearing here*748 in the majority opinion.
If that intention of the purchaser of the bonds be controlling, it would be difficult to conceive a stronger case than this, proving that such intention was not to buy and retire the bonds, but was to keep them alive, as an investment. The Southern Railway Co., not the obligor, purchaser of the bonds, was obligated to pay the interest on them. That fact distinguishes the situation here from that in the Garland case and is convincing to me that the petitioner purchased its bonds here with the intention, not of retiring them, but of keeping the obligation they reflected, alive.
It seems to me that the rationale of the majority opinion faces the dilemma of either violating the elementary rule that a debt once paid is thereby extinguished and can not be revived thereafter, or *340 recognizing the rule of intention for which I contend, in that the sale or pledge of such purchased bonds legally continues the obligation they evidence. I think the sale or pledge of such bonds, after their purchase, merely establishes the necessary fact to their continuing validity that the intention of the purchaser was not to retire the bonds but to keep them alive. *749 Cf. Garland Coal & Mining Co. v. Helvering, supra; R. J. Reynolds Tobacco Co.,35 B.T.A. 949">35 B.T.A. 949. Therefore, I do not think the petitioner realized taxable income by its purchase of its own bonds for less than the issuing price, and, accordingly, dissent.