*216 Decision will be entered under Rule 50.
In 1941, the State of Arkansas redeemed some of its refunding bonds which were received by petitioner in 1934 in substitution for some defaulted bonds which petitioner had acquired in prior years. Held, that a refunding of outstanding defaulted bonds of the State of Arkansas pursuant to a refunding state statute with provisions for the same face value of bonds and the same interest rate did not create a new debt but resulted in a continuation of the existing indebtedness. Motor Products Corporation, 47 B. T. A. 983, affirmed per curiam 142 F. 2d 449. Held, further, that petitioner's surrender of defaulted bonds and receipt of refunding bonds in lieu thereof as evidence of the state's continuing indebtedness to it was not an exchange of property giving rise to gain or loss. Hence, petitioner's basis of cost for its old bonds became the cost basis for its refunding bonds. That basis should be used in computing gain or loss upon redemption of the refunding bonds at par in 1941.
*105 Respondent determined deficiencies in petitioner's income taxes, personal holding company surtaxes, and delinquency penalty for the calendar years and in the amounts as follows:
| Personal holding company | |||
| surtax | |||
| Year | Income tax | ||
| deficiency | |||
| Deficiency | 25% penalty | ||
| 1941 | $ 9,147.43 | ||
| 1944 | 126.94 | $ 4,255.85 | $ 1,063.96 |
| Total | $ 9,274.37 | $ 4,255.85 | $ 1,063.96 |
*218 Petitioner concedes the adjustment of $ 126.94 for 1944 income taxes.
By stipulation the parties agree that petitioner sustained a long term capital loss in 1941 in the amount of $ 14,687.50 in a taxable exchange of bonds of Republic of Colombia, which loss was not claimed on petitioner's return nor allowed as a deduction in the notice of deficiency. This loss will be allowed in a computation under Rule 50.
The undistributed personal holding company income for 1944 arises from a change in net income for 1941, which affects the dividend paid credit carry-over to 1944. By stipulation this issue is no longer in controversy. Petitioner concedes any deficiency in personal holding company surtax and delinquency penalty not exceeding $ 137.57 and $ 34.39, respectively, for the taxable year 1944, which may be determined in a computation under Rule 50, depending on the outcome of *106 this case. There remains no contested adjustments to petitioner's 1944 taxes.
The only remaining issue relates to one adjustment by respondent to petitioner's 1941 net income which is explained in the deficiency notice as follows:
(a) It is held that the loss claimed in your return on the redemption*219 of bonds of the State of Arkansas should be disallowed and taxable income increased by the amount of gain realized on this transaction computed as follows:
| Face | ||
| Date acquired | Description | value |
| November 1934 | Arkansas Highway Series A | $ 50,000 |
| 4 1/2s of Jan. 1, 1934. | ||
| November 1934 | Arkansas Highway Series A 5s | 25,000 |
| of Jan. 1, 1934. | ||
| November 1934 | Arkansas Toll Bridge Series A | 10,000 |
| 4 3/4s of Jan. 1, 1934. | ||
| $ 85,000 | ||
| Net loss claimed in return | ||
| Addition to taxable income |
| Market value | ||||
| when acquired | ||||
| Redemption | ||||
| Date acquired | value | Gain | ||
| Quotation | Amount | |||
| November 1934 | 74 | $ 37,000 | $ 50,000 | $ 13,000.00 |
| November 1934 | 74 | 18,500 | 25,000 | 6,500.00 |
| November 1934 | 74 | 7,400 | 10,000 | 2,600.00 |
| $ 62,900 | $ 85,000 | $ 22,100.00 | ||
| Net loss claimed in return | 1,345.25 | |||
| Addition to taxable income | $ 23,445.25 |
By appropriate assignments of error petitioner contests the above adjustment which respondent has made.
FINDINGS OF FACT.
The facts have been stipulated and are found accordingly.
Petitioner is a corporation organized under the laws of the State of Missouri, with its principal office at Warrensburg, Missouri. *220 It keeps its books and files its returns on the accrual basis of accounting. Petitioner filed its income tax return for the calendar year 1941 with the collector for the sixth district of Missouri.
During the taxable year 1941, petitioner held various securities as investments and also owned and operated a hydroelectric dam.
In 1927 and 1931, petitioner purchased for cash the following bonds issued by the State of Arkansas:
| Principal amount | Cost | |
| State of Arkansas Highway Bonds, 4 1/2%, | ||
| due 1943, Dated June 1, 1927, acquired | ||
| August 6, 1927 | $ 50,000.00 | $ 51,305.00 |
| State of Arkansas Highway Bonds, 5%, | ||
| due 1951, Dated January 15, 1931, acquired | ||
| July 27, 1931 | 25,000.00 | 24,906.25 |
| State of Arkansas Toll Bridge Bonds, 4 3/4%, | ||
| due 1945, Dated November 1, 1930, acquired | ||
| January 22, 1931 | 10,000.00 | 10,134.00 |
| $ 85,000.00 | $ 86,345.25 |
The foregoing State of Arkansas Highway Bonds were issued under the provisions of Act 11, Acts of Arkansas, 1927, pages 17 to 32, approved February 4, 1927 (sometimes called the Martineau Road Act), *107 and acts amendatory thereof. The foregoing State of Arkansas Toll Bridge Bonds were issued under Act 5, Acts of Arkansas, 1928, *221 pages 11 to 21, approved October 3, 1928, and acts amendatory thereof. (The two issues of State of Arkansas Highway Bonds and the issue of State of Arkansas Toll Bridge Bonds held by petitioner, and other similar bonds of those issues will hereinafter sometimes be referred to as the "old bonds.")
On March 1, 1933, the State of Arkansas defaulted in payment of interest on the "old bonds" held by petitioner and other similarly issued bonds. The General Assembly enacted the Ellis Refunding Act 1 in 1933, but the holders of the "old bonds" were dissatisfied with its provisions and organized a bondholders' protective committee. On June 20, 1933, petitioner deposited its "old bonds" with the bondholders' committee.
The General Assembly of the State of Arkansas enacted Act 11, Acts of Arkansas, Special Session, 1934, pages 28 to 79, which was approved February 12, 1934, hereinafter referred to as the "refunding statute." On November 13, 1934, petitioner received from*222 the bondholders' committee the following described bonds issued pursuant to the "refunding statute":
| Principal amount | |
| State of Arkansas Highway Refunding 4 1/2% Bonds, Series A | |
| Dated January 1, 1934, due April 1, 1953 | $ 50,000.00 |
| State of Arkansas Highway Refunding 5% Bonds, Series A | |
| Dated January 1, 1934, due April 1, 1961 | 25,000.00 |
| State of Arkansas Toll Bridge Refunding 4 3/4% Bonds, Series A | |
| Dated January 1, 1934, due October 1, 1955 | 10,000.00 |
| State of Arkansas Highway Refunding Bonds, Series B | |
| Dated January 1, 1934, due October 1, 1953 | 3,583.25 |
| State of Arkansas Toll Bridge Refunding Bonds, Series B | |
| Dated January 1, 1934, due October 1, 1953 | 554.10 |
(The foregoing bonds held by petitioner and other similar bonds of the same issues will sometimes hereinafter be referred to as the "refunding bonds.")
There is no issue in this proceeding regarding the Series B bonds. Both the "old bonds" and the "refunding bonds" were general obligations of Arkansas with the full faith and credit of the state pledged for the payment of interest and principal. The "refunding statute" contained specific provisions to this effect in sections 3 and 4, while the principle *223 was settled to the same effect in litigation involving the "old bonds." Bush v. Martineau, 174 Ark. 214">174 Ark. 214, 295 S.W. 9">295 S. W. 9.
The old highway bonds were secured by a pledge of the revenues from gasoline, motor oil, and automobile taxes, while the old bridge bonds were secured by revenues from toll bridges to be supplemented, if necessary, by excess highway revenues from the old highway bonds. *108 Under section 2 of the "refunding statute" similar taxes and tolls were to be paid into a single State Highway Fund. Instead of the taxes being specifically pledged for each kind of "old bonds," certain percentages of the central fund were to be used to make payments on the "refunding bonds." The "old bonds" bore interest at varying rates, namely, 4 1/2 per cent, 5 per cent, and 4 3/4 per cent. The "refunding statute" provided that they should bear the same interest rates, but added the following provisions in sections 3 and 4:
* * * that until April 1, 1937, such interest shall be paid at the rate of 3 1/2% per annum in cash and the balance in State Highway [or Toll Bridge] Refunding Bonds, Series B, issued under the provisions of Section*224 7 hereof, and thereafter until April 1, 1939, such interest shall be paid at the rate of 4% per annum in cash and the balance in such State Highway [or Toll Bridge] Refunding Bonds, Series B, and, thereafter, until maturity, such interest shall be paid solely in cash.
Series B bonds were also issued in an amount equal to the interest accrued and unpaid to January 1, 1934 (section 7). These B bonds bore interest at 3 1/2 per cent. The maturity dates of the bonds were extended approximately 10 years for the specific bonds refunded. A provision was added for calling the "refunding bonds" for redemption at par plus accrued interest on any interest payment date.
The "old bonds" were retained as collateral for the "refunding bonds." The fair market value of the "refunding bonds" at the time of the exchange was $ 74 per $ 100 par value. The fair market value of the "old bonds" at that time is not shown in the stipulation. On its books petitioner carried its "refunding bonds" at the original cost of its "old bonds." No loss was claimed by petitioner in respect to these bonds in its income tax return for the year 1934, and no loss thereon has been allowed petitioner.
In 1941, the State*225 of Arkansas called the "refunding bonds" for payment at par. Petitioner's "refunding bonds" were redeemed by the State of Arkansas in April 1941, at par, petitioner thereby receiving an aggregate amount of $ 85,000. The basis for the "refunding bonds" was $ 86,345.25, the cost of the "old bonds." Petitioner realized a long term capital loss of $ 1,345.25 in the redemption of the "refunding bonds" in 1941.
OPINION.
This proceeding raises the question whether petitioner sustained a loss in 1941 upon the redemption of its Arkansas "refunding bonds" as it claims, or realized a capital gain thereon as determined by the Commissioner. This question calls for a determination of petitioner's basis for the "refunding bonds." Petitioner maintains in two independent arguments that the basis is the cost to petitioner of the "old bonds," while respondent determined it to be the fair market value of the "refunding bonds" on the date of exchange *109 of the "old bonds" for the "refunding bonds." Alternatively petitioner raises the third issue by contending that it received tax exempt income when the bonds were redeemed.
The initial question is whether the exchange of petitioner's "old bonds" *226 for the "refunding bonds" in 1934 was an exchange of property within the meaning of section 112 (a), I. R. C.Section 112 (a) provides that "upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized" for determining capital gains or losses. Generally there will be a gain or loss realized on the exchange of property. Petitioner contends here that the 1934 transaction whereby it received the "refunding bonds" did not constitute a section 112 (a) exchange.
Petitioner relies primarily on Motor Products Corporation, 47 B. T. A. 983, affirmed per curiam, 142 F. 2d 449. In holding that a municipal bond refunding plan was not a section 112 (a) exchange, the Board emphasized the following factors:
[p. 996] In our opinion, the refunding agreement to which this petitioner was a party presented a plan whereby the city of Detroit merely issued new bonds in substitution for and in continuation of outstanding evidences of its former bonded indebtedness and the result of the transaction was merely to effectuate an extension of time for payment*227 of that portion of the former bonded indebtedness originally maturing on or before June 30, 1943 (and also an extension for payment of a certain portion of the interest accruing thereon through the issuance of series B and C bonds), such extension being coupled with an option to the city of paying off the indebtedness represented by the refunding bonds, series A, at par with accrued interest on any interest payment date. The city assumed no additional obligation under the refunding agreement or upon the refunding bonds, series A, since upon the consummation of the refunding agreement through the issuance of such series A bonds there existed the same debtor, the same principal amount of indebtedness, the same rate of interest thereon, the same provision for a sinking fund, and the same creditors. Certainly, from the standpoint of the city of Detroit the essence of the 1934 transaction was an exchange constituting merely a substitution of the evidence of the same continuing debt. * * *
[p. 997] * * * Furthermore, the 1931 bonds and the series A bonds had the same fair market value on the date of the exchange.
See also City Bank Farmers Trust Co. v. Hoey, 52 F. Supp. 665">52 F. Supp. 665 (1942),*228 affirmed per curiam 138 F. 2d 1023, in which the only differences between the old and new bonds mentioned in the opinion were the right to prepayment and market values. The District Judge said:
* * * Regulation 86, promulgated under the 1934 Revenue Act, Article III-1 reads: "The Act regards as income or as loss sustained the gain or loss realized from the conversion of property into cash or from the exchange of property for other property differing materially either in kind or extent." We do not believe the taxpayer effected any exchange whatever. When the refunding operation was completed he held precisely the obligation he had held before. The regulation defines the statute to include income derived from an exchange of property for other property differing materially either in kind or extent. The *110 obligation in the new bond does not differ either in kind or extent from that expressed in the old; it is the same. * * *
We think that substantially the same thing may be said of the bond substitution which petitioner made here in 1934 with the State of Arkansas. Here petitioner owned State of Arkansas Highway Bonds, 4 1/2 per cent, due 1943, *229 dated June 1, 1927, $ 50,000. In the place of these it received $ 50,000 State of Arkansas Highway Refunding 4 1/2 per cent Bonds, Series A, dated January 1, 1934, due April 1, 1953. It owned $ 25,000 State of Arkansas Highway Bonds, 5 per cent, due 1951, dated January 15, 1931. In the place of these it received $ 25,000 State of Arkansas Highway Refunding 5 per cent Series A Bonds, dated January 1, 1934, due April 1, 1961. It owned $ 10,000 State of Arkansas Toll Bridge Bonds 4 3/4 per cent, due 1945, dated November 1, 1930. In the place of these it received $ 10,000 State of Arkansas Toll Bridge Refunding 4 3/4 per cent Bonds, Series A, dated January 1, 1934, due October 1, 1955.
It has been stipulated that "On its books petitioner carried its 'new Arkansas refunding bonds' at the original cost of its 'old Arkansas bonds.' No loss was claimed by petitioner in respect to these bonds in its income tax return for the year 1934 and no loss thereon has been allowed petitioner." While it is true, of course, that the mere fact that petitioner took no loss in 1934 as resulting from the substitution of bonds in the refunding transaction with the State of Arkansas would not be conclusive*230 of the issue which we have here, nevertheless, we think that the petitioner's action in taking no loss as a result of the refunding operation was correct under the applicable law and the facts. We think, to use the language of District Judge Clancy in City Bank Farmers Trust Co. v. Hoey, supra, "The obligation in the new bond does not differ either in kind or extent from that expressed in the old; it is the same." We see no material difference in the bonds which petitioner received from those which it surrendered in the refunding operation except as to the dates of maturity. This latter factor, we think, is not material. That factor was present in Motor Products Corporation, supra, but we attached no importance to it, pointing out "such extension being coupled with an option to the city of paying off the indebtedness represented by the refunding bonds, series A, at par with accrued interest on any interest payment date."
A similar provision was contained in the "refunding bonds" which are involved here and, as a matter of fact, the State of Arkansas did redeem them on an interest payment date in 1941, at par plus*231 accrued interest. As has already been pointed out, petitioner received upon the redemption of these bonds $ 85,000, and it seems unrealistic under the facts and circumstances which have been stipulated to say that petitioner realized a capital gain of $ 22,100 upon the redemption *111 of these bonds, notwithstanding the "old bonds" for which the "refunding bonds" were substituted cost petitioner $ 86,345.25. We hold that petitioner had a capital loss of $ 1,345.25 as it claims, instead of a capital gain of $ 22,100 as the Commissioner has determined.
We think the instant case is distinguishable on its facts from Girard Trust Co. v. United States, 166 F. 2d 773, and Thomas Emery, 8 T. C. 979, affd. 166 F. 2d 27, upon which the Commissioner strongly relies. Those cases involved a bond refunding operation of the city of Philadelphia of bonds not in default but refunded because it was felt that the bonds could be refunded by offering a method of voluntary exchange which would, in the long run, be advantageous to the finances of the city of Philadelphia. Up to a certain date the new bonds*232 carried the same rate of interest as the old bonds and after that date the interest rate of the bonds was substantially lower. This fact we emphasized in our opinion in the Emery case, supra, in the following language: "The interest rate of the refunding bonds, fixed to equal the rate of the old bonds until the latters' first call date, was substantially less thereafter." Again we said in that case:
Of material bearing on the issue, furthermore, is the city's inferable purpose in adopting the refunding plan and the method chosen to carry it into effect. The outstanding bonds bore a higher rate of interest than the current money market demanded; it would have been to the city's advantage to call the old bonds at the earliest call date, and to issue new bonds at lower rates. In effect it accomplished this result in an anticipatory manner by paying the old rate on the new bonds until the old bonds' first call date and the lower rate thereafter. The refunding bonds, so viewed, are thus clothed with the character of a new obligation, having different terms and conditions. * * * [Emphasis added.]
In the instant case, no change in interest rate was made in the "refunding*233 bonds" from that which was carried in the "old bonds." It is true that for a period of time the interest on the "refunding bonds" was to be paid part in cash and part in series B bonds. But, as we have already emphasized, the interest rate was to be the same throughout the life of the bonds, and the fact that part of this interest for a few years was to be paid in cash and part in series B bonds does not make such a substantial difference between the "old bonds" and the "refunding bonds" as to make the exchange a taxable one. That factor was present in Motor Products Corporation, supra, and we attached no importance to it.
On this issue we hold in favor of the petitioner. Having held in petitioner's favor as to this issue, it becomes unnecessary to pass upon Issues 2 and 3 which petitioner raises in the alternative.
Decision will be entered under Rule 50.
Footnotes
1. Act 167, Acts of Arkansas, 1933, pages 496 to 500.↩