*2598 1. Determination of proper adjustment of invested capital incident to the exchange of certain assets of petitioner for other property.
2. Cost of mining lease and equipment and amount of coal reserve determined.
*378 For the year 1918 respondent determined a deficiency in income and profits taxes in the amount of $11,239.41. Errors alleged by petitioner are: (a) Reduction of invested capital as the result of *379 an exchange of property; (b) computation of depreciation and depletion; (c) computation of invested capital by treating certain marginal accounts as inadmissible assets; (d) selection of comparatives in computing profits taxes; (e) reduction of amounts available for dividends on account of current year's taxes; (f) failure to adjust invested capital on account of a refund of taxes for the year 1917.
Errors (c) and (e) were waived at the hearing. Hearing upon error (d) was, upon motion duly filed, postponed until after disposition of the other questions involved.
FINDINGS OF FACT.
*2599 Petitioner is a Virginia corporation, having its principal office At Richmond, and during the taxable year was engaged in the business of jobbing and distributing coal.
In October, 1917, it acquired all the capital stock of the Elmo Mining Co., consisting of 500 shares, issuing in exchange therefor 1,250 shares of its capital stock. The Elmo Mining Co. was engaged in mining under a lease dated March 31, 1917, which provided for royalties of 10 cents per ton for the first 20 years and 15 cents per ton for the next 20 years. The lease covered a tract of about 1,100 acres in the New River fields in Fayette County, West Virginia, on the main line of the Chesapeake & Ohio Railroad. The coal seam was clean and approximately 3 feet in thickness. The coal, which was mined by the drift method, was high grade, and because of its low ash content and high units of heat value was particularly well suited for export. During the year ended June 30, 1917, the coal extracted from the Elmo mine amounted to 25,583 gross tons. The estimated coal recoverable at the time the Elmo stock was acquired by petitioner was 2,621,847 tons. The indebtedness of the Elmo Mining Co. was about $40,000.
*2600 The acquisition of the Elmo Mining Co. stock was recorded on petitioner's books by the following journal entry (Journal page 242, Oct. 31, 1917):
| DR. | CR |
| $125,000.00 investment a/c capital stock | $125,000.00 |
| 1,417. 1,250 shares of Capital Stock of W Va. Coal Co. issued in exch. for 500 shares (being the entire issue capital stock) of the Elmo Mining Co. as authorized by Board of Directors at meeting held Oct. 30, 1917. |
Petitioner by check dated December 17, 1917, paid $35,000 of the indebtedness of the Elmo Mining Co.
The actual cash value of the Elmo Mining Co. stock when acquired by petitioner was $125,000.
*380 During the year 1917 petitioner carried on negotiations with one Thomas C. Beury with the view of obtaining the lease on the Stone Cliff mine which the Stone Cliff Coal & Coke Co. then held and under which it operated. This property was in Fayette County, W. Va. The coal seam, known as the Fire Creek seam, was 3 1/2 feet in thickness, and, like that of the Elmo mine, was of high quality and suitable for export. In the year ended June 30, 1917, coal production from this property amounted to 42,964 gross tons. The lease held by the Stone*2601 Cliff Coal & Coke Co. required the payment of royalties at the rate of 10 cents per gross ton, with minimum annual royalties of $4,000.
Beury in 1917 was president of the Stone Cliff Coal & Coke Co. and owned 477 shares of a total issue of 600 shares of its stock. The company had authorized the issuance of bonds in the face amount of $50,000, which bonds in the year 1917 were in the hands of a bank as collateral for a note of Beury's. Beury was also indebted in 1917 to the petitioner.
In November, 1917, petitioner and Beury came to terms and it was agreed that petitioner was to deliver to Beury the 500 shares of Elmo Mining Co. stock and to give Beury a credit of $37,500 against his indebtedness, and Beury was to procure an assignment to petitioner of the Stone Cliff lease and to deliver to petitioner the Stone Cliff bonds. This agreement was carried out by the parties. Funds to secure the release of the bonds from the bank then holding them were furnished to Beury by petitioner. The petitioner took over the Stone Cliff lease with the improvements on the premises, which were included in the assignment of the lease, in December, 1917, and operated the property throughout*2602 the year 1918. Petitioner recorded the transaction whereby it acquired the Stone Cliff properties on its journal by the following entry (Journal, p. 267, Dec. 22, 1917):
| DR. | CR. |
| $125,000.00 T. C. Beury investment a/c | $125,000.00 |
| 1568. Sale of entire Cap. Stock of Elmo Min. Co. | |
| $162,500.00 Investment a/c T. C. Beury | 162,500.00 |
| 1569. Purchase of Stone Cliff C. & C. Co. Lease of property. | |
| $5,000.00 Elmo Mining Co., T. C. Beury | 5,000.00 |
| 1570. Note of E.M. Co. assumed by T. C. B. |
The $5,000 item in the above entries represents a credit to Beury for a note of the Elmo Mining Co. which he assumed.
On January 7, 1921, the United States Attorney for the Southern District of West Virginia, acting in behalf of the United States, filed a bill in the United States District Court against the Stone Cliff Coal & Coke Co., and Beury and others as directors and stockholders of the company for the recovery of taxes alleged to be owing by that company. The bill as subsequently amended alleges inter alia that *381 Beury and his codefendants acting for the company did "sell all of the assets of every nature belonging to the said Stone Cliff Coal & Coke Company, *2603 for the sum of $162,500 in cash or property received by said company of a substantially equivalent value * * *." The defendants, in their answer, deny this allegation.
In a valuation schedule for the year 1918, executed by officers of the petitioner in 1921, the following valuations were assigned to the Stone Cliff Coal & Coke Co. property as of the date acquired:
| Leasehold | $120,000.00 |
| Plant and equipment | 34,101.24 |
| Store merchandise | 8,398.78 |
| 162,500.00 |
These amounts represent the actual cash values of the properties at the date they were acquired by petitioner.
At the time the Stone Cliff properties were acquired the coal recoverable from the leased premises was estimated at 1,000,000 tons. The part of the property then being worked, which contained 280,000 tons estimated recoverable, was separated from the remainder by a fault, and at December 1, 1917, an entry had penetrated to the fault. As other operators working beyond the fault on property adjacent to the Stone Cliff property were in good coal, it was believed by petitioner that if an opening could be driven through the fault the coal underlying the remainder of the property would be recoverable. *2604 During the greater part of 1918 petitioner did endeavor to drive through the fault and penetrated it several hundred feet without reaching coal. By the end of 1918, the demand for coal having decreased, petitioner abandoned its efforts to drive an entry through the fault. Allowing for the fault, the estimated coal recoverable at the close of 1918 amounted to 600,000 tons.
In its valuation schedule for the year 1918, above mentioned, petitioner set forth the unexhausted coal in the Stone Cliff properties at 300,000 tons.
The production from the Stone Cliff mine in 1918 was as follows:
| Net tons | |
| January | 2,941.40 |
| February | 2,933.30 |
| March | 3,593.01 |
| April | 2,469.45 |
| May | 3,453.95 |
| June | 687.80 |
| July | 2,442.85 |
| August | 1,461.55 |
| September | 1,202.85 |
| October | 709.70 |
| November | 1,214.25 |
| December | 862.35 |
| Total | 23,972.46 |
Respondent determined that the 500 shares of the Elmo Mining Co. had no value at the time they were paid in for 1,250 shares of petitioner's stock, and, accordingly, allowed no value for the stock in computing petitioner's invested capital. Respondent allowed in *382 the computation of invested capital the sum of $35,000 determined*2605 by him to be the cost of the 500 shares of Elmo stock, which amount represented the amount of indebtedness due by the Elmo Mining Co. which was discharged by petitioner. Respondent also included in his computation of invested capital the accounts receivable of $37,500 due petitioner by Beury.
OPINION.
ARUNDELL: One of the allegations of error is that respondent failed to adjust invested capital as the result of a refund of income and profits taxes for 1917 in the amount of $3,642.54. No facts were alleged or proved with respect to this item. The respondent's determination in this particular must therefore be sustained.
There remains for disposition the question of the proper adjustments to be made in invested capital as the result of the acquisition of the Elmo Mining Co. stock and the subsequent exchange of that stock and of other assets for the Stone Cliff Coal & Coke properties, and the amount of depletion and depreciation to which petitioner is entitled because of its ownership of the lease and operation of these properties in 1918.
Petitioner, in October, 1917, acquired for 1,250 shares of its capital stock all the capital stock of the Elmo Mining Co. This stock, *2606 the evidence establishes, had a value of $125,000. After acquiring the stock petitioner paid off an indebtedness of the Elmo Mining Co. in the amount of $35,000. In the same year, 1917, petitioner acquired from the Stone Cliff Coal & Coke Co. the coal lease under which that company was then operating, together with the plant and equipment on the leased property. What was paid for this lease is a question on which there is a conflict of testimony. Under date of November 20, 1917, petitioner entered into an agreement with Thomas C. Beury whereby it agreed to sell to Beury the Elmo Mining Co. stock for $125,000 cash. On the same date the petitioner entered into an agreement with the Stone Cliff Coal & Coke Co., of which Beury was president and majority stockholder, whereby petitioner agreed to buy from the Stone Cliff Co. all of the latter's assets for $162,500 cash. These agreements, it was testified by officers of petitioner and by Beury, were never carried out and for that reason we have not incorporated them in our findings of fact. Beury's testimony as to how the transaction was carried out is that petitioner issued a check to the Stone Cliff Coal & Coke Co. in the amount*2607 of $37,500 in full payment for the lease, which check he, as president of the company, endorsed and handed back and the amount was credited to his personal indebtedness on petitioner's books; that petitioner advanced funds to him to secure the release of the $50,000 face value of Stone *383 Cliff Coal & Coke Co. bonds which were then held by a bank as security for a note of Beury's, and that upon his obtaining the release of the bonds he turned them over to petitioner in exchange for the 500 shares of Elmo Mining Co. stock.
Petitioner's officers testified differently. They say that no check for $37,500 was issued payable to either Beury or the Stone Cliff Coal & Coke Co. in either 1917 or 1918; that they acquired the Stone Cliff lease and plant for the Elmo Mining Co. stock plus the $37,500 credit to Beury; that they had been informed and believed that the Stone Cliff bonds had never been issued by the company and they insisted on the delivery of the bonds to prevent their falling into the hands of innocent purchasers.
We find it difficult to give full credence to Beury's version of the transaction. It does not seem likely that the petitioner would advance funds to secure*2608 the release of the $50,000 Stone Cliff bonds and then give in exchange for them the Elmo Mining stock, which was worth at least $125,000. And it hardly seems possible that Beury, a practical operator who knew the value of the Stone Cliff lease, would sell for a credit of $37,500 the lease and plant and equipment.
The gist of the transaction, as we gather it from the conflicting views of the witnesses, was this: Petitioner owned all the stock of the Elmo Mining Co., which at the time it was paid in to petitioner was worth $125,000. This stock, plus a credit of $37,500 against what Beury owed petitioner, was traded in 1917 for the lease and physical property of the Stone Cliff Coal & Coke Co., the property acquired having an actual cash value of $162,500.
How should petitioner's invested capital reflect this transaction which took place in December, 1917? We have found the value of the Elmo Mining Co. stock at the time paid for petitioner's stock to be $125,000. The substitution of some other item of property for that paid in for stock would not affect petitioner's invested capital, except as there might be an adjustment as to inadmissibles and of surplus because of gain or*2609 loss on the exchange. The Commissioner has allowed as an item to be included in invested capital after the exchange of properties, the amount of $35,000 which was paid upon the indebtedness of the Emlo Mining Co. after the petitioner acquired its stock, plus an amount of $37,500 credited to Beury upon the exchange of properties in December, 1917. He has disallowed any value for the Elmo stock as of the date of acquisition for petitioner's stock, which, as stated above, we have found to be $125,000. If there had been no exchange of property with the Stone Cliff Co., and disregarding for the time being any question of affiliation, then by reason of our findings petitioner's invested capital would be increased $125,000 over the amount allowed by respondent, subject *384 to any necessary adjustment for inadmissibles. Petitioner, however, has exchanged for properties of the Stone Cliff Co. having a fair market value of $162,500 at the time of the exchange 500 shares of Elmo Mining Co. stock, and has canceled an indebtedness due it by Beury in the amount of $37,500. It has therefore substituted for assets reflected in its invested capital at $197,500, assets of the value of $162,500. *2610 This transaction serves to reduce petitioner's earned surplus by $35,000. It follows that in the computation of petitioner's invested capital as of the beginning of 1918 the sum of $162,500 should be used in place of the $72,500 used by respondent in his determination.
We have found that the entire cost of the Stone Cliff properties was $162,500, and of this cost petitioner in its valuation schedule attributed $120,000 to the cost of the lease and $34,101.24 to the plant and equipment, the balance being assigned to store merchandise. We see no reason, on the evidence, for disturbing these allocations, and they should serve as a basis in determining petitioner's depletion and depreciation. There is no evidence to indicate that the plant and equipment had a period of useful life longer or shorter than the coal supply and it is accordingly our opinion that deductions for the exhaustion of this property should be computed on the same basis as those for depletion of the coal reserve. The cost for computations of depletion and depreciation, is, therefore, $154,101.24. The evidence is that at the time the Stone Cliff properties were acquired there was an estimated reserve of 1,000,000*2611 tons of coal. Efforts made during 1918 to drive through the fault to the reserve beyond it disclosed it to be of greater extent than it was originally believed to be, and upon the discovery being made the estimate of recoverable coal was reduced to 600,000 tons. Both of these estimates were made by an engineer of many years experience in that field, and it is our opinion that the "reasonable allowance" for depletion should be based on the revised estimated reserve of 600,000 tons.
In the valuation schedule filed the estimated recoverable coal was put at 300,000 tons, but this figure is not supported by the evidence. While the petitioner did not reach the coal beyond the fault, there is no evidence to show that it did not exist or that it could not be reached by an opening on some other part of the property. In fact, it appears that further efforts to reach the reserve beyond the fault were abandoned largely because of the drop in the demand for coal at the end of 1918.
Our finding of a cash value of $162,500 for certain assets, in lieu of a value of $72,500 determined by the Commissioner, may affect the matter of abnormalities under section 327 and computation of the petitioner's*2612 profits tax for the taxable year under the provisions *385 of section 328 of the Revenue Act of 1918 as was done by the Commissioner in his deficiency notice. In any event, the income and profits tax will be affected by a change in depreciation and depletion. It is directed, therefore, that prior to further consideration of the proceeding upon assignment of error (d) as to the proper rate of profits tax, the Commissioner give consideration to the determination of the Board herein and that he file with the Board a recomputation of the tax liability for the taxable year.
Further proceedings will be had under Rule 62(d).