*1024 1. Held, the managing and operating of petitioner's property by trustees appointed under the provisions of the Public Control Act of Massachusetts (1918) did not create the relationship of lessor and lessee so as to make applicable the provisions of article 70 of Regulations 74, providing for the return of "income to lessor from leased property."
2. Held, where petitioner was under an obligation to repay a sum paid for its benefit by another, the sum so paid constituted a loan or advance and in the instant situation was not income to petitioner.
*494 These proceedings were brought to redetermine deficiencies in the income taxes of the petitioner for the years 1931 and 1932 in the sums of $286,920.28 and $186,744.37, respectively.
The parties stipulated the correct amount of the petitioner's income tax for the calendar years 1931 and 1932 and for the periods from January 1 to June 30, and from July 1 to December 31, 1931, contingent upon the determination*1025 of the several issues either for or against the petitioner.
The issues are:
(1) Whether or not the payment of dividends to the petitioner's stockholders under the Public Control Act of Massachusetts constituted rental and thus became the measure of petitioner's taxable income as provided in article 70 of Regulations 74.
*495 (2) Whether the payment of $1,775,338.80 made by the Commonwealth of Massachusetts to the petitioner in 1932 to reimburse it for deficits in the cost of service should be included in its taxable income.
(3) As an alternative issue, if the payment of $1,775,338.80 is held to be taxable income, whether or not the repayment of $1,409,253.35 made in 1931 by the petitioner to the commonwealth to offset amounts theretofore paid to the petitioner as reimbursements for deficits in operating costs, is an allowable deduction.
(4) Whether the sum of $156,206.11 paid as interest on preferred stock surrendered pursuant to the provisions of section 9 of the 1931 Act, amending the Public Control Act (Mass.), was deductible or was a part of the cost of the retirement of such stock.
(5) Whether or not the petitioner realized a profit of $823,753.95 from*1026 the final disposition of a special trust fund established under the provisions of chapter 740, Statutes of 1911 (Mass.).
(6) Whether the petitioner's income should be determined on a calendar year basis or on the basis of a fiscal year ending June 30. This issue was raised by the respondent's second amended answer.
FINDINGS OF FACT.
The petitioner is a corporation organized July 2, 1894, under the laws of the Commonwealth of Massachusetts, having its principal office in Boston, Massachusetts.
Chapter 740, Statutes 1911, effective in September 1911, authorized the purchase by the petitioner of all the properties of the West End Street Railway Co., hereinafter called West End, to take effect on June 10, 1922. The purchase price was the petitioner's first and second preferred stock equivalent to the outstanding preferred and common stock of West End. Upon the completion of the sale, West End was to distribute the petitioner's first preferred stock to its own preferred stockholders and the petitioner's second preferred stock to its own common stockholders.
The act provided that prior to June 10, 1922, any stockholder of West End might exchange his stock for an equal amount*1027 of the petitioner's common stock and that, after that date, any holder of the petitioner's first or second preferred stock might exchange it for an equal amount of the petitioner's common stock, but that all stock so exchanged should be canceled.
Section 9 of chapter 740 further provided that the petitioner should "forthwith" purchase, at a price to be agreed upon, all West End real estate not required in the conduct of the business of either company and also that:
The proceeds of said sale to an amount not exceeding one million five hundred thousand dollars shall be held as a special trust fund by the Boston Elevated Railway Company and be invested by it and allowed to accumulate until *496 the tenth day of June, nineteen hundred and twenty-two. Thereafter the Boston Elevated Railway Company shall continue to invest said fund with its accumulations to that date, and shall apply the annual income thereof to the purchase and retirement of second preferred stock of the Boston Elevated Railway Company issued under, and to carry into effect the purposes of this act. Such stock shall be purchased by the Boston Elevated Railway Company as cheaply as possible after tenders have*1028 publicly been invited. No part of said fund or its income shall be used for any other purpose except for the retirement of the aforesaid second preferred stock of the Boston Elevated Railway Company, in case said purchase and sale are effected.
Any second preferred stock so purchased shall be cancelled and no other second preferred stock shall be issued in its place. When all the second preferred stock has either been converted into common stock of the Boston Elevated Railway Company or has been retired as hereinbefore provided, or otherwise, said fund, with its accumulations, shall be applied by the Boston Elevated Railway Company to any purpose for which its stock and bonds can legally be issued.
The act further provided that upon the consummation of the purchase on June 10, 1922, the petitioner should assume and be responsible for all the indebtedness and liabilities of West End and should succeed to all its rights and powers but subject to all its duties, obligations, and restrictions.
Pursuant to section 9, the real estate not required for railway purposes was purchased by the petitioner for cash, amounting to approximately $1,500,000. This amount was set up as a special*1029 trust fund. The fund was so held by the petitioner until June 10, 1922, when it was taken over as the property of the petitioner. The accumulations to the fund from July 18, 1913, to June 10, 1922, were $707,342.17. On the latter date the special trust fund of $1,500,000 was entered on the petitioner's books under the heading "Insurance and Other Funds." On December 31, 1922, the item of $707,342.17 was entered on the petitioner's books as a debit to the "Insurance and Other Funds" account and a corresponding entry was made crediting that amount to profit and loss.
Chapter 159 of the Special Acts of the General Court of the Commonwealth of Massachusetts for the year 1918, hereinafter called the Public Control Act, provided for the management and operation of the petitioner's property by a board of trustees to be appointed by the Governor with the advice and consent of the council. Subsequent pertinent amendatory acts are chapters 244 and 245 of the Special Acts of 1919, effective December 29, 1919; chapter 108 of the Acts of 1921, effective March 12, 1921; chapter 333 of the Acts of 1931, effective July 1, 1931, except as to sections 8 and 22 thereof, which became effective*1030 May 19 and May 21, 1931, respectively; and chapter 99 of the Acts of 1935, effective April 1, 1935.
Since July 1, 1918, the board of trustees created by the Public Control Act, to the extent provided by that act, as amended, has managed and operated the Boston Elevated Railway Co. and the *497 properties owned, leased, or operated by it, under and in accordance with the provisions of the Public Control Act, and acts in amendment thereof, from and after the respective effective dates of the said amendatory acts. The business conducted under the provisions of those acts is the transportation of passengers by means of elevated, subway, and surface railway and bus lines in the city of Boston and suburban cities and towns.
Section 2 of the Public Control Act is as follows:
Section 2. Said board of trustees, hereinafter called the trustees, shall manage and operate the Boston Elevated Railway Company hereinafter called the company, and the properties owned, leased or operated by it, for a period of ten years, commencing on the first day of the month next after their appointment and qualification, and subject to the provisions of this act shall take and have possession of*1031 said properties in behalf of the commonwealth during the period of public operation and, for the purposes of this act, shall, except as is otherwise provided in this act have and may exercise all the rights and powers of said company and its directors, and, upon behalf of said company, shall receive and disburse its income and funds. They shall have the right to appoint and remove in their discretion the president, treasurer and clerk of the corporation, and all officers of the company other than the board of directors. They shall have the right to regulate and fix fares, including the issue, granting and withdrawal of transfers and the imposition of charges therefor, and shall determine the character and extent of the service and facilities to be furnished, and in those respects their authority shall be exclusive and shall not be subject to the approval, control or direction of any other state board or commission.
In the management and operation of the said company and of the properties owned, leased or operated by it, as authorized by this act, the trustees and their agents, servants and employees shall be deemed to be acting as agents of the company and not of the commonwealth, *1032 and the company shall be liable for their acts and negligence in such management and operation to the same extent as if they were in the immediate employ of the company, but said trustees shall not be personally liable. A majority of the board shall constitute a quorum for the transaction of business, and the action of a majority of those present at any meeting shall be deemed the action of the trustees.
Nothing herein contained shall be held to affect the right of the commonwealth or any subdivision thereof to tax the company or its stockholders in the same manner and to the same extent as if the company had continued to manage and operate its own property.
Section 3 provides that the trustees shall make contracts in the name and on behalf of the petitioner, issue stocks, bonds, and other company indebtedness, pay its debts, and declare and pay dividends on its stock.
Section 4 provides that the stockholders, through the board of directors, shall have no control over the management and operation of the street railway system, but that the petitioner's corporate organization shall be continued and its interests be protected.
Section 5 requires the trustees to raise $3,000,000*1033 by the sale of preferred stock, $1,000,000 of which shall be constituted a reserve fund to be used only to make good any deficiency in income (section 8).
*498 Section 6 is as follows:
Section 6. The trustees shall from time to time, in the manner hereinafter provided, fix such rates of fare as will reasonably insure sufficient income to meet the cost of the service, which shall include operating expenses, taxes, rentals, interest on all indebtedness, such allowance as they may deem necessary or advisable, for depreciation of property and for obsolescence and losses in respect to property sold, destroyed, or abandoned, all other expenditures and charges which under the laws of the commonwealth now or hereafter in effect may be properly chargeable against income or surplus, fixed dividends on all preferred stock of the company from time to time outstanding, and dividends on the common stock of the company from time to time outstanding at the rate of five per cent per annum on the par value thereof during the first two years, five and one half per cent per annum on the par value thereof during the next two years and six per cent per annum on the par value thereof during*1034 the balance of the period of public operation. Dividends upon the common shares shall be payable quarterly, but no dividends shall be paid upon such common shares in excess of the rates herein specified. The first payment shall be made at the expiration of six months from the commencement of public operation, and the total of the first three quarterly dividend payments shall be five per cent on the par value of the common stock.
Sections 7 and 10 relate to changes of rates to equate income with the cost of service.
Section 9 is as follows:
Section 9. Whenever the income of the company is insufficient to meet the cost of the service as herein defined, the reserve fund shall be used as far as necessary to make up such deficiency, and whenever, on the other hand, such income is more than sufficient to meet the cost of the service, the excess shall be transferred to and become a part of the reserve fund.
Section 11 is as follows:
Section 11. (As amended by Sp. Acts of 1919, c. 244.) If as of the last day of June in the year nineteen hundred and nineteen, or the last day of any June thereafter, the amount remaining in the reserve fund shall be insufficient to meet the deficiency*1035 mentioned in section nine, it shall be the duty of the trustees to notify the treasurer and receiver general of the commonwealth of the amount of such deficiency, less the amount, if any, in the reserve fund applicable thereto, and the commonwealth shall thereupon pay over to the company the amount so ascertained. Pending such payment it shall be the duty of the trustees to borrow such amount of money as may be necessary to enable them to make all payments, including dividend payments, as they become due. If as of the last day of any June thereafter during the period of public operation, the reserve fund shall exceed the amount originally established, the trustees shall apply the excess, so far as necessary, to reimbursing the commonwealth for any amounts which it may have paid to the company under the provisions hereof, and the commonwealth shall thereupon distribute the amount so received among the cities and towns in which the company operates, in proportion to the amounts which they have respectively been assessed as provided in section fourteen.
In order to meet any payment required of the commonwealth under the provisions of this section the transurer and receiver general*1036 may borrow at any time, in anticipation of the assessments to be levied upon the cities and *499 towns, such sums of money as may be necessary to make said payments, and he shall repay any sums so borrowed as soon after said assessments are paid as is expedient. [The amendment to section 11 was accepted by the directors December 29, 1919.]
Section 12 extends the period of public management until the commonwealth shall elect to discontinue it.
Section 13 requires the trustees to maintain the petitioner's property in good condition and so to return it to the petitioner.
Section 14 provides that the amounts of deficiency payments made to the petitioner shall be assessed against the cities and towns served by the petitioner's lines.
Changes in the time of making the deficiency payments, of altering rates of fare and of making annual reports are determined by chapters 244 and 245, Special Acts of 1919, and by chapter 108, Acts of 1921, respectively.
Chapter 333, Special Acts of 1931, revises and extends the terms of the public management and control of the petitioner's property. Section 4 of that chapter authorizes the issuance of 6 percent bonds, aggregating no*1037 more than $30,000,000, to be sold only to the metropolitan transit district. The proceeds from the sale of such bonds "shall be used for the retirement of the existing preferred stocks of the company as provided in this act * * *." The company, through its stockholders, was required to accept the terms of the act.
Section 9 is as follows:
Section 9. Dividends upon all classes of preferred stocks of the company shall cease when this act takes effect, and all "assenting stockholders" shall be entitled on or after such date not more than seven months thereafter as may be fixed by the trustees of the company to present their certificates of such stock to the treasurer of the company, or to such bank or trust company as may be designated by the said trustees, for the purpose of surrender and cancellation and shall be respectively entitled to receive payment for their said stock, duly endorsed to the company, on the following basis: for each share of first preferred stock, one hundred and ten dollars; for each share of second preferred stock, one hundred and two dollars; for each share of the preferred stock, one hundred dollars, together with the accrued dividends at the rate fixed*1038 for each of said classes from the last dividend date thereof to and including the day on which this act takes effect and with interest at the rate of five per cent per annum from the date dividends cease as hereinbefore provided to the date so fixed for presentation. * * *
Section 17 gives to the commonwealth the option to purchase the petitioner's properties under specified conditions. Provisions are made to protect "nonassenting" stockholders and to govern the procedure relating to evaluating the company's stock, the issuance of its securities, evidences of indebtedness, etc.
Sections 22 and 23 are as follows:
Section 22. Until the period of ninety days within which this act must be accepted as provided in section eight has expired, the operation of sections ten *500 and eleven of said chapter one hundred and fifty-nine which authorize an increase in fares and payment of deficits by the commonwealth shall be suspended and no such payment shall be required in the current year. This section shall take effect upon its acceptance by vote of the board of directors of the company.
Section 23. When all the second preferred stock of the company has been retired, the*1039 special trust fund established under the provisions of section nine of chapter seven hundred and forty of the acts of nineteen hundred and eleven shall, to the extent necessary therefor, be converted by the trustees of the company into cash and the same shall thereupon be applied to repay to the commonwealth all amounts which, prior to the effective date of this act, have been assessed under the provisions of chapter one hundred and fifty-nine of the Special Acts of nineteen hundred and eighteen upon the cities and towns served by the company and which have not been previously repaid to the commonwealth, and the treasurer and receiver general of the commonwealth shall thereupon distribute the same to such cities and towns as provided in said chapter. Any balance remaining in said fund shall be applied as provided in said chapter seven hundred and forty.
Chapter 99, acts of 1932, changes the date of making deficiency payments by the commonwealth from the last day of June to the last day of March.
Since July 1, 1918, the board of trustees, in accordance with the provisions of the Public Control Act, as amended, has notified the treasurer and receiver-general of the Commonwealth*1040 of Massachusetts of deficiencies as defined by the provisions of the said act, as amended, and payments thereof have been made by the commonwealth, as follows:
| Date of notice | Date of payment | Amount |
| July 1, 1919 | July 24, 1919 | 3,980,151.67 |
| July 1, 1932 | July 15, 1932 | 1,775,338.80 |
| July 1, 1933 | July 14, 1933 | 2,753,124.14 |
| July 2, 1934 | July 20, 1934 | $1,551,631.97 |
| Apr. 15, 1935 | Apr. 26, 1935 | 1,396,388.83 |
| Apr. 17, 1936 | Apr. 26, 1936 | 2,086.202.37 |
In pursuance of section 11 of the Public Control Act, as amended by chapter 244 of the Special Acts of 1919, the following payments have been made to the Commonwealth of Massachusetts:
| July 14, 1922 | $517,196.45 |
| July 18, 1923 | 1,114,557.82 |
| July 27, 1925 | 20,581.33 |
| July 21, 1926 | 22,304.46 |
| July 25, 1927 | $60,660.25 |
| July 18, 1928 | 895,518.01 |
| 2,630,818.32 |
On petitioner's books appears the following notation:
The income for the 12 months ended June 30, 1932 was insufficient to provide for the Cost of Service for the period by the sum of $1,775,338.80.
This deficit was advanced by the Comm. of Massachusetts as provided for by Section 11, Chapter 159, Special Acts of 1918 on July 15, 1932.
*1041 Similar entries and notations on various vouchers issued by the petitioner show that the amount was advanced and corresponding reimbursements from the petitioner to the commonwealth are designated "repayments."
*501 Pursuant to chapter 333, Acts of 1931, all classes of preferred stock were retired by August 14, 1931. Under the requirements contained in section 23 there was paid on August 19, 1931, from the special trust fund (established under the provisions of section 9 of chapter 740 of the Acts of 1911) to the Commonwealth of Massachusetts the sum of $1,409,253.35, the amount which, prior to the effective date of chapter 333 of the Acts of 1931, had been assessed under the provisions of the Public Control Act upon the cities and towns referred to therein and for which the Commonwealth of Massachusetts had not been theretofore reimbursed.
After the payment of $1,409,253.35, the sum of $21,937.68 was transferred to the petitioner's "Miscellaneous physical property" account, $568,280.27 to its "Bond Account", and $233,536 to its "Notes from sale of Real Estate" account. The special trust fund account was closed by an appropriate entry as of December 31, 1931.
During*1042 the entire period of public management and operation, all of the income and receipts from such management and operation and moneys in connection therewith have been deposited and kept in bank accounts carried in the name of the Boston Elevated Railway Co. Checks on such bank accounts have been signed by officers of the company appointed by the board of trustees pursuant to section 2 of the Public Control Act. No bank account has been maintained or kept in the name of said board of trustees; all contracts have been made and all business conducted in the name of Boston Elevated Railway Co., all payments and disbursements, including payments to stockholders of the petitioner, as provided in section 6 of the Public Control Act, as amended, have been made from the above mentioned bank accounts carried in the name of the Boston Elevated Railway Co.
As of June 30, 1931, there was a deficiency, as defined in the Public Control Act, in the amount of $1,969,473.12. The amount of the reserve fund provided by that act applicable thereto was $1,000,000. Pursuant to section 22 of chapter 333 of the Acts of 1931, no notificatin of the deficiency was given by the board of trustees to the treasurer*1043 and receiver-general of the commonwealth under the provisions of section 11 of the Public Control Act, and no payment therefor has been made by the commonwealth under the Public Control Act, as amended.
Under the provisions of section 9 of chapter 333 of the Acts of 1931, the board of trustees fixed August 18, 1931, as the date for assenting holders of preferred stock to present their stock to the treasurer of the company for the purpose of surrender and cancellation.
There was paid in the year 1931 to such preferred stockholders the sum of $156,206.11, an amount computed at the rate of 5 percent per *502 annum upon the amount due the stockholders from the date dividends upon said stock ceased, to August 18, 1931, as provided hereinbefore.
Payments received by stockholders of the petitioner under the provisions of the Public Control Act, as amended, for the years 1930 to 1935, inclusive, are as follows:
| 1930 | $3,081,309.37 |
| 1931 | 2,134,823.50 |
| 1932 | 1,193,970.00 |
| 1933 | 1,193,970.00 |
| 1934 | 1,193,970.00 |
| 1935 | 1,193,970.00 |
All income tax returns of the petitioner have been filed upon a calendar year basis.
From July 1, 1918, to and including the calendar*1044 year 1929, the petitioner's income tax liability was determined and paid upon the basis that its taxable net income for these respective years consisted of the dividends received by its stockholders for each of the said years under the provisions of the Public Control Act, as amended, plus the total Federal income tax paid by the petitioner at the rates prescribed under the applicable revenue acts, as required by a ruling and determination made by the Commissioner of Internal Revenue.
For the taxable years petitioner filed returns showing gross income received and deductions claimed for expense of operation and other purposes.
The respondent determined:
* * * That the taking over of the properties of the Boston Elevated Railway Company was, in effect, a direct lease of these properties and assets to the Commonwealth of Massachusetts, in consideration for the payment of a fixed annual rental by the Boston Elevated Railway Company, Public Trustees, in the form of dividends on the capital stock of the former company and that the various acts of the Legislature of the Commonwealth of Massachusetts have created two separate and distinct entities: (1) The Boston Elevated Railway*1045 Company (the lessor) and (2) the Boston Elevated Railway Company, Public Trustees, (lessee). It is upon the former that the income tax liability is imposed, the latter being an instrumentality or agent of the Commonwealth of Massachusetts.
The respondent designated the amounts paid as dividends to the petitioner's stockholders as "rent income received" and stated that:
The above amount represents dividends, paid during the year 1932 direct to your stockholders, by the Boston Elevated Railway Company, Public Trustees, and is considered rent constructively received by and taxable to you under the authority of article 70 of Regulations 74. [Regulations 77, in the deficiency notice for 1932.]
OPINION.
VAN FOSSAN: The first and controlling issue is whether, under the above facts, petitioner should, as contended by it, return its income *503 in the normal way, usual to corporations, by listing all items of gross income and deducting therefrom the deductions allowed by statute, paying tax on the net income so determined, or should, as contended by respondent, return as gross income the amount of the dividends paid to its stockholders, plus the Federal tax thereon and*1046 minus certain deductions, paying tax on the net of such computation, as provided in article 70 of Regulations 74 1 and Regulations 77, entitled "Income to lessor corporation from leased property."
*1047 The basic predicate of article 70 of Regulations 74 and Regulations 77 is "where a corporation has leased its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor's capital stock * * * such payments shall be considered rental payments and shall be returned by the lessor corporation as income", etc. Here the Commissioner ruled that "the taking over of the properties of the Boston Elevated Railway Company was, in effect, a direct lease of these properties and assets to the Commonwealth of Massachusetts in consideration for the payment of a fixed annual rental * * * in the form of dividends on the capital stock * * *." Obviously petitioner had not leased its property to the commonwealth in the ordinary sense of that term. Was the Commissioner correct in holding that the relationship, "in effect", was that of lease?
The commonwealth, through its legislative body, established an elaborate system whereby the railway properties of petitioner were to be kept in operation for the benefit of the public. The Public Control Act, designed to carry out the plan, provided for the appointment of*1048 a board of trustees to assume that duty and take charge of petitioner's property. Their function was to "manage and operate" the petitioner's railway and other properties. The petitioner consented to the plan.
The board was given the broad and unusual powers to regulate and fix rates and also to cooperate with the treasurer and receiver-general *504 of the commonwealth in equalizing the cost of service with operating receipts, by means of assessments against the cities and towns served by the company's lines. Thus, it acted in a dual capacity - as a manager and as a rate-fixing board. But it is in relation to the former capacity that questions of income must be decided.
In so far as the taxable income received by petitioner is concerned, the board of trustees acted in the capacity of a managing agent. The board conducted the petitioner's affairs just as a corporation, individual, or any other entity designated for that purpose might have done. In this respect it served as a substitute to carry on the functions normally performed by the petitioner itself.
In section 2 of the Public Control Act the status of the board of trustees was specifically set forth. *1049 The trustees and their agents and employees were "deemed to be acting as the agents of the company and not of the Commonwealth." In its acts involved in the operation of the railway system and hence in the production of income, the board thus was designated as the agent of the petitioner. The issue is not confused nor is it controlled by the fact that the trustees also represented the people of the commonwealth and that in one sense the properties were operated by the commonwealth. See . The consideration of their undertaking and managing of the petitioner's affairs was the continuation of the operation of the railway as a public utility for the benefit of the citizens who were dependent on its lines for transportation, but, by the express terms of the act creating the board of trustees and defining their duties and powers, the corporate entity of the petitioner was preserved. The property remained in private ownership. All business transactions were carried on in the name of the corporation, including making contracts, paying bills, receiving and banking operating revenues, and*1050 all other acts normal to the conduct of its business. By specific provision of the act the compensation of the trustees was paid by the company.
In various cases, the Public Control Act has been construed by different courts on points directly related to the issue before us. In , the petitioner asked for a refund of capital stock tax on the ground that under the leased road theory it was not taxable. There, the court (in 1928) said:
The rather complicated arrangement under which the public took over the management and operation of the Boston Elevated Railway Company under Sp. Acts 1918, c. 159, has been fully and authoritatively described (see ; ; ; Opinion of the Attorneys General of Massachusetts 1919, *505 p. 20; , November 22, 1927; Boston Elevated Railway v. Malley, (*1051 ); and it is not necessary to restate it here. The gist of it is that the company, in return for payments and guaranties by the commonwealth, abdicated its right to manage its property and affairs in favor of public trustees appointed by the Governor. The business was still conducted in the name of the company, and all contracts for labor and supplies relating to the operation of its railway were made in its name. It continued to be liable in contract and in tort, as it had previously been. The special act expressly provided that the trustees "shall be deemed to be acting as agents of the company and not of the commonwealth."
The basic facts leave but slight ground for the plaintiff's contention. An elaborate and ingenious argument has been made on its behalf based largely upon the use of the words "lease" and "take over" by the Supreme Judicial Court in describing the relations between the company and the commonwealth. . See, too, Opinion of the Justices of November 22, 1927 . With respect to this terminology, Judge Peters observed: "It is not profitable to discuss whether*1052 the term 'lease' is properly descriptive of the legislative contract." . It is the essential character of the arrangement as gathered from the special act and the opinions and decisions above cited, rather than the expressions used to describe it, upon which the present question turns. * * *
In Boston Elevated Railway Co. v. White (not reported), the precise issue here presented was decided in favor of the petitioner by the United States District Court for the District of Massachusetts and no appeal was taken from that decision. In that case the petitioner sued for a refund of Federal income tax paid for the year 1930 on the leased road basis. There, the court (in 1934) said:
The defendant contends that the relation between the plaintiff and the Public Trustees of the Boston Elevated Railway Company was in effect that of lessor and lessee for the purpose of the Federal income tax. Assuming, for the purposes of this case, but by no means deciding that this is so, the tax was not legally collectable.
The Treasury Regulation providing that where a corporation leases its property in consideration*1053 that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor's capital stock, such payments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends are paid by the lessee directly to the stockholders of the lessor, is not applicable. The dividends received by the stockholders in the case at bar were in no sense received from the Public Trustees or from the Commonwealth. The amount of such dividends paid by the plaintiff cannot be regarded as income received by it.
We are of the opinion that respondent was in error in his holding that the taking over of these properties "was, in effect, a direct lease of these properties" to the Commonwealth.
It may be added that nothing has come to our attention that leads us to believe that the employment of the fiction that the relationship *506 between the petitioner and the commonwealth was that of lessor and lessee would more accurately reflect petitioner's income. In this respect the instant case bears some resemblance to *1054 ; affirmed in part, , albeit in that case the position of the parties and their respective contentions were exactly reversed.
In the Cleveland Railway Co. case, consequent on financial difficulties experienced by the railway system, a plan of operation known as the "Taylor plan" was adopted, under which transportation was to be furnished at cost of service. This cost of service included "operating and maintenance costs fixed by the City of Cleveland on a carmile basis, interest on bonded and floating indebtedness and a return to the stockholders of 6 per cent on the outstanding capital stock. In fixing a return of 6 per cent it was provided that this would be paid in quarterly amounts and would not be dependent upon the earnings of the petitioner, but regardless of the amount earned, the return to the stockholders could not exceed 6 per cent." A fund of $500,000 known as the "interest fund" was established by the company, into which all earnings in excess of certain stated expenses were to go, and out of which certain payments were to be made, the fund being calculated to serve as a barometer to*1055 determine when and how the rate of fare was to be changed.
For several years the Cleveland Co. filed returns in the form and manner normal to corporations but in the taxable years returned as its net income the amount of money paid as the 6 percent return to its stockholders plus the certain taxes of the previous year. The Commissioner treated the gross amount received from car riders, less the usual statutory deductions, as the taxable income of the company and determined deficiencies accordingly. At the hearing the Commissioner contended that the taxpayer's net income should be determined in the ordinary way, namely, by treating as receipts all gross income and deducting therefrom those deductions allowed by statute, and that the remainder should be taxed as income, irrespective of whether the net income so determined exceeded or was less than the 6 percent permitted and guaranteed to its stockholders.
Discussing petitioner's contention that the net income of a given year may not reflect the exact status of the taxpayer, the Board held that "when viewed in the light of the statute * * * the petitioner's position is untenable." We said further, the fact "that the petitioner*1056 would not object to being taxed on more income than is earned in the 'lean years' does not make taxable income that which is not taxable income under the statute." Specifically, we held "that the contentions of the petitioner for a limitation of its taxable income to a 6 per cent return on its outstanding capital stock, without regard to the income earned, as defined by statute, must be denied."
*507 In the case at bar the parties are in exactly the opposite positions. The taxpayer is contending for the right to return its income in the normal manner. The Commissioner is urging the unusual. Under the facts here present, we believe petitioner is right.
The second issue presents the question whether the payment of $1,775,338.80 made to the petitioner by the commonwealth in 1932 was an advance or loan or was a part of the petitioner's gross income.
The Public Control Act provided that a reserve fund of $1,000,000 should be set up for the purpose of making good any deficiency in the petitioner's income and, conversely, if its income were more than sufficient to meet the cost of service, the excess should be added to the reserve fund. The act as amended also provided*1057 that if the reserve fund was insufficient to meet any deficiency the commonwealth would pay over to the company the necessary amount to meet it. On June 30, 1932, the cost of service exceeded the petitioner's income by $1,775,338.80. The reserve fund had been exhausted and on July 15, 1932, the commonwealth paid that amount to the petitioner. The petitioner contends that the amount so paid was an advance or loan to it which it was required to repay under section 11, which reads as follows:
If as of the last day of any June thereafter during the period of public operation the reserve fund shall exceed the amount originally established, the trustees shall apply the excess so far as necessary to reimbursing the commonwealth for any amounts which it may have paid to the company under the provisions hereof.
The respondent maintains that the sum so paid is properly includible in the petitioner's gross income.
The petitioner's books reflect its position that the payment by the commonwealth was an advance or loan and that payments to the commonwealth were designated and treated as "repayments."
The petitioner relies on the principle set forth in *1058 ; certiorari denied, ; affirming . In that case the petitioner paid to several corporations certain amounts which were to be repaid from the proceeds of the operation of those companies and which the petitioner would lose only if the operation were ultimately unsuccessful. Such payments were held to be loans. The court there said:
In the event of success it was to receive back the amount it had advanced plus its portion of the net profits. The advances were, therefore, loans which the Texas corporations would repay if successful. If they were unsuccessful, they would have nothing to pay with and the loss would fall upon petitioner.
It is immaterial that there was no express agreement on the part of the Texas corporations to repay the moneys advanced. Not only was such agreement implied in the agreement that only the net profits of the various enterprises were to be divided among the stockholders, but a promise to repay moneys laid out *508 and expended for the use and benefit of another and at his request is implied in law. * * * Here the expenditures*1059 were made for the use and benefit of the Texas corporations and upon an agreement made in their behalf. And it makes no difference in the result, if we construe the agreement as requiring repayment by the Texas corporations only in the event that their operations should prove successful. A loan is no less a loan because its repayment is made contingent.
It is well settled that when a taxpayer makes expenditures under an agreement that he will be reimbursed therefor, such expenditures are in the nature of advancements and are not deductible as business expenses. ; affd., ; ; ; ; affd., . By parity of reasoning payments so conditioned would not be income to the recipient.
The terms employed by the statute characterize definitely the nature of the payment and repayments to and from the commonwealth and the petitioner. When the reserve fund exceeds the $1,000,000 originally established, the excess shall be applied*1060 to "reimburse" the commonwealth, (sec. 11, Public Control Act) and the special trust fund remaining after the retirement of the second preferred stock shall be used to "repay" to the commonwealth all amounts previously assessed but not "repaid" under the Public Control Act (sec. 23, Acts 1921).
It is thus apparent that by the very language of the acts which form the agreement between the petitioner and the commonwealth both parties thereto understood and agreed that the payments back and forth through the reserve fund were advances and repayments as the profitable or unprofitable operation of the railway dictated. The sum of $1,775,338.80, therefore, was not income taxable to the petitioner in 1932.
The cases cited by the respondent involve no obligation of repayment and, therefore, are not in point.
The determination of the second issue automatically disposes of the third issue. No deduction of the item of $1,409,253.35 is allowable.
The fourth issue relates to the deductibility of an item paid by the petitioner to its preferred stockholders. The sum of $156,206.11 was paid as interest on the amounts due to stockholders in payment for their preferred stock, from July 1, 1931, the*1061 effective date of the act, to August 18, 1931, the date fixed by the trustees for the surrender and cancellation of the stock under section 9 of chapter 333, Acts 1931.
That section states unequivocally that after the effective date of the act "dividends upon all classes of preferred stock of the company shall cease." The act, in effect, changed the status of preferred stockholders *509 on July 1, 1931, from shareholders in the petitioner corporation to creditors of it. After that date they had the right only to surrender their stock and to receive therefor various amounts fixed by the statute, together with dividends on their stock to July 1, 1931. The trustees were given a reasonable time in which to redeem the stock certificates and pay the debt so created by the act.
In obvious recognition of the character of the payments so to be made, the act makes a sharp and clear distinction between the stock prior to July 1, 1931, and the right of the stockholders to payment therefor, by providing that "interest at the rate of 5 per cent per annum from the date dividends cease" shall be paid to the petitioner's former stockholders. It imposed upon the petitioner the*1062 definite corporate liability to pay a fixed rate of interest on such principal indebtedness remaining unpaid after that date. The conclusion is inescapable that the $156,206.11 paid as interest thereon is an allowable deduction for the year 1931.
A brief resume of the facts relating to the establishment and treatment of the special trust fund is necessary for a clear understanding of the question raised by the fifth issue.
Under the provisions of chapter 740, Statutes 1911, the petitioner and West End were consolidated, to take effect June 10, 1922. The form of the acquisition of the West End assets by the petitioner was deemed a purchase and sale. The petitioner purchased the property, privileges, and franchises of West End in exchange for its own capital stock equal at par to the par value of the outstanding West End stock. West End thereupon distributed the petitioner's stock so received to its stockholders in accordance with their ownership of common and preferred stock.
In addition, the petitioner purchased the real estate of West End, not required in the railway business, for slightly over $1,500,000. The act required that the proceeds of the sale not to exceed*1063 $1,500,000 should be set aside by petitioner as a special trust fund the income of which should be used to retire the petitioner's second preferred stock issued to West End and distributed by it to its stockholders. The special trust fund was established to insure the redemption and retirement of such stock and after that should be accomplished (or its conversion into common stock, an alternative offered by the statute) the petitioner could use the fund and its accumulations for any purpose for which its stocks and bonds could legally be used. The act further provided that on June 10, 1922, the petitioner should assume all of West End liabilities and indebtedness and succeed to all of its rights.
Pursuant to the act, the nonbusiness real estate was purchased for $1,500,000 cash and the special trust fund was set up on July 18, *510 1913. The fund was held by the petitioner as trustee until June 10, 1922, when, with accumulations from income amounting to $707,342.17, it was taken over as property of the petitioner under the terms of the statute. Appropriate entries reflecting such acts were made on the petitioner's books.
Chapter 333, Acts 1931, changed the method of*1064 retirement of petitioner's second preferred stock held by former West End stockholders by authorizing the issuance of bonds, not exceeding $30,000,000 in amount, to cover the retirement of all existing preferred stocks of the petitioner. The only effect of this act in this respect was to release the special trust fund from the prior restriction and limitation of its use to the retirement of the second preferred stock.
Chapter 333 also voided, for the year 1931 only, the use of the reserve fund and payments from and to the commonwealth as established pursuant to sections 5, 8, and 9 of the Public Control Act. It likewise compelled the petitioner to repay to the commonwealth from the special trust fund the amount of $1,409,253.35 previously advanced by the commonwealth (secs. 22 and 23).
After the payment of the $1,409,253.35 on August 19, 1931, there remained in the special trust fund $823,753.95, which the respondent contends thereupon became income to the petitioner. That balance was divided and reassigned to the petitioner's other accounts to which the items properly related. Of the balance of $823,753.95 but $83,844.59 represented profit earned in the taxable year, *1065 which amount, it was stipulated, has already been considered in computing the petitioner's income on the "operating road" basis. In so far as the remainder of the fund represented accumulated profits of the fund they were earned in years prior to the taxable year, and accordingly should not be included in income for the taxable year. Earnings become income when they are received, not when they are distributed. . The removal of the restriction on the use of the fund in 1931 did not have the effect of converting accumulated profits from prior years, on which presumptively the tax had been paid, into income of the taxable year. Except as to the $83,844.59 earned in the taxable year, the fund represented a capital asset of petitioner. The sum of $83,844.59 representing profit derived from the use of the fund in 1931 was a proper item of income and has been so treated.
In the last issue respondent avers affirmatively that, in the event the Board determines that petitioner should report its income on the normal corporate basis as an operating company, such income should be returned on the basis of a fiscal*1066 year ended June 30 of each year. On this issue respondent has the burden of proof.
*511 We find no evidence that leads us to conclude that petitioner's income will not be accurately reflected if reported on a calendar year basis. Petitioner made its return on the basis of the calendar year. It may be called to attention that the parties have stipulated, without apparent difficulty, the precise amount of petitioner's income under both the "operating road" and "leased road" theories and both on the calendar year basis. In any event, the proof of record falls far short of sustaining respondent's contention. Such evidence as we have and all reasonable inferences tend to support petitioner on the issue.
Reviewed by the Board.
Decision will be entered under Rule 50.
LEECH, ARNOLD, and DISNEY concur only in the result.
Footnotes
1. ART. 70. Income to lessor corporation from leased property.↩ - Where a corporation has leased its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor's capital stock or the interest on the lessor's outstanding indebtedness, together with taxes, insurance, or other fixed charges, such payments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends and interest are paid by the lessee directly to the shareholders and bondholders of the lessor. The fact that a corporation has conveyed or let its property and has parted with its management and control, or has ceased to engage in the business for which it was originally organized, will not relieve it from liability to the tax. While the payments made by the lessee directly to the bondholders or shareholders of the lessor are rentals as to both the lessee and lessor (rentals paid in one case and rentals received in the other), to the bondholders and the shareholders such amounts are interest and dividend payments received as from the lessor and as such shall be accounted for in their returns. [Article 70 of Regulations 77 is identical.]