*3123 1. Penalties paid by a railroad corporation to the United States for violation of certain regulatory statutes are not deductible as ordinary and necessary expenses.
2. Amounts deducted by a railroad corporation from its gross income for the operation of its regular service trains carrying men and equipment should, on the facts presented, be restored to gross income.
3. Amounts received by a railroad corporation from passengers in excess of its tariff rates, the said excess being the result of an error in making change, and which can not be refunded because the name and address of the person overcharged is unknown, constitute taxable income.
4. Petitioner issued pay checks, vouchers and other checks in payment of valid claims, which were allowed as deductions by respondent for the year in which issued. If checks remained uncashed after two years from date of issuance they were charged to profit and loss. Held, that such obligations when charged back to profit and loss constituted taxable income.
5. Where petitioner in the year 1915 charged off*3124 a debt, then worthless, of a corporation which was then insolvent, and where the worthless debt was taken as a deduction in 1915 and where, during said year, certain stockholders brought action against part of the directors charging fraud with respect to the debt, and where in 1917 and before trial the directors compromised the suit for less than one-eleventh of the principal of the debt, held that the debt was properly charged off and deducted in 1915.
6. Under the evidence, held that certain interest received by a reorganization committee was taxable income of petitioner.
7. Interest rentals and compensation earned by a railroad corporation which was on an accrual basis, during Federal control, held to be taxable income in the years earned.
8. When petitioner purchased the bonds of another corporation at less than par and thereafter became affiliated with such corporation and where, during the period of affiliation the bonds were retired, held that the affiliated group made no taxable income.
9. Where a corporation keeping its books on an accrual basis sells its own bonds at a discount, held that the discount is in the nature of deferred interest*3125 which may be amortized over the life of the bonds and the portion allocable to each year may be deducted from gross income for such year.
10. Proper method of amortizing discount on bonds which matured serially set forth.
11. Expenses incurred prior to March 1, 1913, in the sale of bonds should not be amortized over the life of the bonds. Expenses incurred subsequent to February 28, 1913, should be treated in the same manner as discount.
12. Where bonds which were sold at a discount were afterwards exchanged for stock, held that the amount paid in for the stock was precisely the amount paid in for the bonds but that there should be restored to surplus the amount, if any, by which surplus had been reduced by the amortization of discount.
*989 The above proceedings were by agreement consolidated for the purpose of hearing and decision and involve deficiencies in income tax for the calendar year 1916 of $10,281.15; and in income and profits taxes*3126 for the calendar year 1917 of $382,530.34; for the calendar year 1918 of $53,717.76; and for the calendar year 1919 of $36,275.28. Petitioner alleges the following errors:
(1) Respondent has failed to allow as a deduction from gross income in each of the years 1916 to 1919, inclusive, sums paid by *990 petitioner to the United States as penalties for the violation of Federal statutes relating to railroad operation.
(2) Respondent has erroneously credited petitioner's operating expenses for the years 1916 and 1917 in amounts representing petitioner's expenses for Transportation for Investment.
(3) Respondent's failure to allow as a deduction from petitioner's gross income for each of the years 1916, 1917, 1918, and 1919, any portion of the discount and expenses in connection with the sale of petitioner's First and Refunding Bonds sold by it during the years 1904 to 1908, inclusive.
(4) Respondent has erroneously computed for the years 1916, 1917, 1918, and 1919 amortization of discount on petitioner's Equipment Bonds, series "C," "D," "F," "G," and "H," maturing serially.
(5) Respondent has erroneously computed for the years 1916, 1917, and 1918 amortization of*3127 discount on petitioner's Collateral Trust Bonds issued May 1, 1902, which matured serially.
(6) Respondent has erroneously considered as part of petitioner's gross income for each of the years 1916 and 1917 amounts representing overcharges collected during said years for transportation of passengers and not refundable by petitioner.
(7) Respondent has erroneously considered as part of petitioner's income for the years 1916, 1917, 1918, and 1919 sums representing the amounts of checks or vouchers outstanding during the two years previous to the year for which the return is made, representing amounts for wages, overcharges, loss and damage claims, which checks or vouchers were either not called for or not cashed by the respective payees.
(8) Respondent erroneously failed to allow as a deduction from the petitioner's income for the years and in the amounts below stated sums representing loss on property retired and not replaced.
| 1916 | $325.92 |
| 1918 | 988.27 |
| 1919 | 20,658.89 |
(9) Respondent erred in failing to allow petitioner to deduct from its gross income for 1917 the sum of $871,921.26, representing unamortized discount on Debenture Bonds issued by petitioner*3128 in 1912 and retired on July 2, 1917.
(10) Respondent has failed to allow as a deduction from petitioner's gross income for 1917 the sum of $5,960,960.08, being the net loss sustained by petitioner on funds advanced to the Chicago, Rock Island & Pacific Railroad Co. (an Iowa corporation) in December, 1909, the transactions relating to which were not finally closed and the net loss ascertained until 1917.
*991 (11) Respondent has erred in considering as part of petitioner's gross income for the year 1917 the sum of $68,583.27, representing interest allowed by the depositary bank on certain funds of the Reorganization Committee, raised by assessment upon petitioner's stockholders.
(12) Respondent has erred in connection with the adjustment of land grant sales (timber sales) in arriving at the total allowable deduction by taking the "Loss as Corrected" for the year 1917 in the sum of $33,680.83, whereas such loss should be $37,432.76, making the total allowable deduction $174,931.64.
(13) Respondent has erred in including as part of taxpayer's income for the year 1918, the sum of $66,368.07 on account of profit on land grant sales during 1918, whereas the correct amount*3129 to be added to petitioner's income by way of adjustment for that year is $13,219.07.
(14) Respondent has failed to include as part of taxpayer's income for the years 1918 and 1919, respectively, sums representing interest rental allowed by the Director General of Railroads on additions and betterments completed and put in service during said years, respectively; but has erroneously included said amounts as part of petitioner's income for the year 1922.
(15) Respondent has failed to include as part of petitioner's income for the years 1918 and 1919, respectively, sums representing compensation (interest) paid by the Director General of Railroads on 30 locomotives purchased and paid for in 1918 out of petitioner's funds; but has erroneously included said amounts as part of petitioner's income for the year 1922.
(16) Respondent had erred in failing to include as part of the taxable income of the Chicago, Rock Island & Gulf Railway Co. for the years 1918 and 1919, respectively, sums representing interest rental allowed by and received from the Director General on additions and betterments completed during said years; but has erroneously included said amounts as income for the*3130 year 1922.
(17) Respondent has erred in considering as income of the Consolidated Indiana Coal Co. for the year 1918 the sum of $313,988.15, being the difference between $2,336,000 par value of the Coal Company's First Mortgage bonds, dated May 29, 1905, maturing May 29, 1935, and the sum of $2,022,011.85, the price at which said bonds were purchased prior to December 31, 1917, and thereafter retired.
(18) Respondent has failed to allow as a deduction from petitioner's gross income for the year 1919, the sum of $4,038.30, representing state, county, city and school taxes levied and assessed against certain property belonging to petitioner at Galveston, Tex., and paid during 1919.
*992 (19) Respondent has erred in including as income of the Chicago, Rock Island & Gulf Railway Co. for the year 1918 the sum of $3,209.85, representing an over-accrual of said company's standard return during Federal control.
(20) Respondent has failed to allow as a deduction from income of Choctaw, Oklahoma & Gulf Railroad Co. for the year 1919 the sum of $6,097.21 on account of depletion for coal mined during the year 1919.
(21) Respondent has erroneously computed petitioner's invested*3131 capital for 1917 in respect to the issuance by petitioner of $54,422,160 par value of its capital stock on July 2, 1917; petitioner claimed that said capital stock was outstanding for 183/365 of the year 1917, whereas respondent has computed invested capital by assuming that said capital stock was outstanding for 185/372 of the year.
(22) Respondent has failed to allow as invested capital for 1917 the unamortized portion of discount, commission and expense, amounting to $5,995,438.40, sustained or incurred in connection with the sale of petitioner's First and Refunding mortgage bonds during the years 1904 to 1908, both inclusive.
(23) Respondent has failed to allow as invested capital for the year 1917 discount, commission and expense in connection with the sale of Equipment Bonds, series "G," amounting to $181,235.98, and in connection with Equipment Bonds, series "H," amounting to $240,345. Series "G" bonds were sold in 1912 and series "H" bonds in 1913.
(24) Respondent erred in using a wrong method of amortizing discount on various issues of securities, with the result that he has failed to allow, on account of unamortized discount as of January 1, 1917, the sum of $153,963.22.
*3132 (25) Respondent has erred in reducing taxpayer's invested capital in the sum of $871,921.26, being the unallocated portion of the unamortized discount on taxpayer's $20,000,000 of the Debenture Bonds sold in 1912 at a discount of $1,200,000, whereas the said entire $1,200,000 of discount was charged by taxpayer to profit and loss in the year 1912.
(26) Respondent erred in reducing petitioner's invested capital in the sum of $871,921.26, as representing an alleged discount on $54,422,160 par value of stock issued by petitioner on July 2, 1917, whereas said stock was issued at par.
(27) Respondent has erred in disallowing as part of invested capital, $1,597,800.49 expended for additions and betterments to equipment during the period 1871 to March 31, 1902; said amount was originally charged to operating expenses and thereafter charged to investment in Road and Equipment in December, 1917, and credited at the same time to Profit and Loss.
*993 (28) Respondent erred in deducting from invested capital the sum of $172,242.80, being an alleged overpayment in division of profits of the Joint Land Department from its inception to December 31, 1916, said profits being equally*3133 divided between the Duluth & Iron Range Company and the petitioner.
(29) Respondent has failed to allow as part of petitioner's invested capital for 1917 the sum of $421,924.38, representing the balance (after giving effect to $30,544.49 allowed by respondent) of 183/365 of the total unamortized discount on petitioner's Debenture Bonds of 1912 as of December 31, 1916, amounting to $902,465.75; said bonds having been issued on July 15, 1912, and retired on July 2, 1917.
(30) Respondent erred in holding that income accruing to the Choctaw, Oklahoma & Gulf Railway Co. from sales of coal produced from lands leased from Indians for the year 1918 is subject to tax.
(31) Respondent has failed to allow as part of petitioner's invested capital for 1917 the sum of $700,000 carried by petitioner as an insurance and casualty reserve under I.C.C. General Balance Sheet Account No. 773; the amount of said reserve on December 31, 1916, was $716,204.43, of which amount $700,000 remained in said reserve at all times during the year 1917.
(32) Respondent has failed to allow as part of petitioner's invested capital for 1917 the sum of $111,345.75, representing an amount carried in a reserve*3134 account on December 31, 1916, and at all times during the year 1917, covering freight claims (which had been paid but not yet adjusted with participating carriers) on account of transactions prior to July 1, 1914.
By affirmative plea respondent alleged that in November, 1919, petitioner paid to the Association of Railway Executives the sum of $15,883.89, of which $9,927.43 was for advertising and publicity in connection with pending legislation and at the hearing he amended his answer and alleged (a) that he erred in so far as he allowed deductions in each or any of the years 1916 to 1919, inclusive, on account of allocating to said years or any of them, a part of the expenses, as distinguished from bond discount, incurred by the issuance of bonds by the petitioner at the dates when the bonds were issued, and asserts that all such expenses allowed by him should now be disallowed and that any portion of said expenses which have been allowed as invested capital should now be disallowed; and (b) he now asserts with respect to discount sustained by petitioner when it sold bonds in prior years that no part of such discount should be allocated to the years 1916 to 1919, inclusive; that*3135 any deductions heretofore allowed on account of such allocation of bond discount should now be disallowed; that no portion of such discount remaining *994 unamortized or otherwise determined should be allowed to remain in or be restored to invested capital for any of the years aforesaid and that all such allowances in or restoration to invested capital that have been allowed should now be disallowed and that any premiums received by petitioner on the sale of its bonds should receive similar treatment.
By stipulation between the parties petitioner withdrew errors 12, 25 and 30, and respondent confessed errors 8, 13, 18, 19, 20, 31 and 32. In the brief filed in its behalf, petitioner waived errors 21 and 27 and respondent in the brief filed in his behalf conceded error 28. Respondent introduced no evidence on its contention as to the payments made to the Association of Railway Executives and has apparently abandoned this contention.
FINDINGS OF FACT.
1.
Petitioner is a consolidated corporation organized and existing under the laws of the States of Illinois and Iowa, with its principal office at La Salle Street Station, 139 West Van Buren Street, Chicago, Ill.; is*3136 a common carrier engaged in the transportation of freight and passengers by steam railroad, and as such is subject to the provisions of the Interstate CommerceAct; and its accounts for the years 1916 to 1919, inclusive, were kept in accordance with the uniform system of accounts prescribed by the Interstate Commerce Commission, which system is upon the accrual basis.
Petitioner's capital stock prior to the receivership, hereinafter referred to, consisted of one class of stock and the par value of the amount thereof outstanding prior to said receivership was $74,359,722.50. Petitioner became financially embarrassed in 1914 and on April 20, 1915, receivers for the railroads and properties of petitioner were appointed in a proceeding pending in the District Court of the United States for the Northern District of Illinois. On November 14, 1916, an "Agreement of Reorganization" was entered into between certain committees representing the stockholders and creditors of petitioner. The pertinent parts of said agreement read:
AN AGREEMENT entered into as of the 14th day of November, 1916, by and between SEWARD PROSSER, NATHAN L. AMSTER, EMLIE K. BOISOT, CHARLES HAYDEN, JAMES SPEYER*3137 and S. DAVIES WARFIELD (hereinafter collectively termed the "Committee"), parties of the first part; and such of the holders of Stock of The Chicago, Rock Island and Pacific Railway Company (hereinafter called the "Railway Company"), as shall become parties hereto in the manner herein provided (who are hereinafter collectively termed "Depositing Stockholders"), and such of the holders of Twenty-Year Five Per Cent. Gold Debentures of the Railway Company (hereinafter termed the "Debentures") and such of *995 the Holders of Certificates of Deposit issued by Bankers Trust Company for Debentures deposited under the Deposit Agreement dated July 19, 1915, as shall become parties hereto in the manner herein provided (who are hereinafter collectively termed "Depositing Debenture holders"), parties of the second part (all the parties of the second part being hereinafter sometimes called "Depositors").
The Railway Company has outstanding $20,000,000 face amount of the Debentures, whereon the interest matured January 15 and July 15, 1916, has not been paid, and the Railway Company has defaulted upon the Debentures and under the Indenture dated January 17, 1912, whereunder the same were*3138 issued.
Certain of the Debentures are represented by the Committee named in the Deposit Agreement dated July 19, 1915, above referred to, and such committee is hereinafter referred to as the "Debenture Committee." Certain of the holders of Stock of the Railway Company are represented by a committee consisting of Messrs. Charles Hayden and others, which committee is hereinafter referred to as the "Hayden Committee." Certain other of said stockholders are represented by a committee of which Messrs. Nathan L. Amster and others are members, which committee is hereinafter termed the "Amster Committee."
The Depositors desire that a Plan of Reorganization substantially as hereinbefore set forth be carried into effect, and have authorized the Committee in its discretion to consummate such Plan.
In consideration of the premises and of the advantages which will result to the Depositors, and of the conditions and promises hereinafter contained and of other good and valuable consideration, and for the purpose of carrying out said Plan in whole or in part, and whether modified or amended, the parties hereto have agreed and do hereby severally, agree, and each Depositing Stockholder and*3139 each Depositing Debenture-holder has agreed and does hereby agree with each of the other Depositing Stockholders and Depositing Debenture-holders and with the Committee, as follows:
FIRST. The Depositing Stockholders and the Depositing Debenture-holders jointly and severally hereby assent to and accept all the provisions of said Plan and of this Agreement. Said Plan is hereby adopted and approved and shall be deemed a part of this Agreement with the same force and effect as though embodied herein. Said Plan and this Agreement shall be read as parts of one and the same instrument, and every Depositor shall be bound by both.
SECOND. Holders of Stock of the Railway Company may participate in said Plan and in this Agreement, and will become parties thereto, by depositing the certificates representing the shares of Stock held by them, accompanied by instruments of transfer duly executed in blank and by all requisite tax stamps, with either of the Depositaries under this Agreement, or with any agent or agents appointed by either of said Depositaries with the consent and approval of the Committee to receive such deposits of Stock for such Depositary, and by making to either of said*3140 Depositaries the payments required by said Plan from time to time and as called for. Upon making each such payment, each Depositing Stockholder shall present his Certificate of Deposit (issued as hereinafter provided) to the Depositary for the notation thereon by the Depositary of the making of such payment.
THIRD. Holders of Debentures not heretofore deposited with the Debenture Committee may participate in said Plan and in this Agreement, and will become parties thereto, by depositing their Debentures, accompanied by all coupons maturing January 15, 1916 and thereafter, with either of the Depositaries hereunder or with any agent or agents appointed by either of said Depositaries with the consent and approval of the Committee to receive such deposits of Debentures *996 for such Depositary. * * * Upon such deposit under the Plan, by the Debenture Committee, of Debentures, the Committee shall become responsible for and shall assume each and every the responsibilities and indebtedness of the Debenture Committee, and the Debenture Committee, except as provided in Article SEVENTH hereof, shall be under no further duty or obligation in respect of Debentures so deposited.
*3141 FOURTH, Bankers Trust Company, of New York, N.Y., and First Trust and Savings Bank of Chicago, Illinois, are hereby severally appointed Depositaries under said Plan and this Agreement. The Depositaries will issue to Depositing Stockholders (and, if the Committee shall so direct, to Depositing Debenture-holders and to the holders of Certificates of Deposit of Bankers Trust Company in respect of Debentures) Certificates of Deposit, issued subject to the terms of this Agreement. The holders of such Certificates of Deposit and all persons claiming by, through or under the persons named in such Certificates of Deposit, shall be held to have assented to this Agreement as if they had severally subscribed to, acknowledged and delivered the same. Said Certificates of Deposit shall be transferable in such manner as the Committee shall approve, and upon such transfer all rights and obligations of the Depositors in respect of the securities represented by such Certificates of Deposit shall pass to the transferee, who shall be substituted in place of the prior holders and be subject to this Agreement. All such transferees, as well as the original holders of Certificates of Deposit hereunder, *3142 and all persons claiming by, through or under siad holders or transferees (and all holders of Certificates of Deposit of Bankers Trust Company, subject to the said Plan and this Agreement), shall be included within the terms "Depositing Stockholders," "Depositing Debenture-holders" and "Depositors" when used herein. Each such Certificate of Deposit not at the time registered in a name may be treated by the Committee and the Depositaries as a negotiable instrument, and the holder thereof for the time being and the registered holders of registered Certificates may be considered and treated as the absolute owner thereof and of all the rights of the original Depositor of every character, and neither the Committee nor either of the Depositaries shall be affected by any notice to the contrary. The Committee may take such action as it may deem proper for the listing upon the New York Stock Exchange or any other Exchange of Certificates of Deposit.
FIFTH. The Committee is hereby vested under the terms of this Agreement with the legal title to all the Stock, Debentures and Coupons which may at any time be deposited hereunder, and the Depositors agree that the deposit of the said Stock, *3143 Debentures and Coupons, transfers and assigns to and vests in the Committee complete and absolute title to the said Stock, Debentures and Coupons, with the same force and effect as if the Committee were the absolute owner thereof. They further agree, at any time upon request of the Committee, to execute any and all instruments of transfer, assignments or writings requisite or required by the Committee further to evidence the vesting in the Committee or its nominees of the legal title to the said Stock, Debentures and Coupons deposited hereunder.
SIXTH. In addition to vesting in the Committee the complete and absolute title to the Stock, Debentures and Coupons deposited hereunder, the Depositors hereby further constitute and appoint the Committee their only and exclusive attorneys in fact, and hereby authorize and empower the Committee, in the name of the Depositing Stockholders or in the name of the Depositing Debenture-holders, or both, or in the name of the Committee or in the name of any other person or persons, firm or firms, or corporation or corporations, as *997 the Committee may deem proper, to institute, maintain or take, or cause to be instituted, maintained or*3144 taken, or to intervene in or become party to such actions or proceedings at law or in equity or otherwise, and in all matters or proceedings to give such directions, make such requests and demands, file such protests and execute such papers, authorizations, consents, powers of attorney, or other instruments, all as will, in the judgment of the Committee, tend to protect the interests of the Depositors and to enforce the rights and the security belonging to or provided by said Stock, Debentures and Coupons and the said indenture under which the Debentures were issued. The Committee is hereby given full power to substitute or to revoke any or all such powers of attorney or other instruments which it may execute, and to adjust, compromise, settle and discontinue any or all such actions or proceedings, or to institute others, and to adjust, compromise, settle and discontinue the same; and the Depositing Stockholders and the Depositing Debenture-holders further give and grant unto the Committee full power and authority to do and perform every act and thing requisite and necessary to be done in its judgment in and about the premises, as fully to all intents and purposes as the Depositing*3145 Stockholders or the Depositing Debenture-holders might or could do individually, jointly or otherwise, and to exercise each and every right, power and privilege belonging to, conferred upon or vested in the Depositing Stockholders or the Depositing Debenture-holders by the Stock, Debentues and Coupons deposited hereunder or by the indenture under which the Debentures were issued, or otherwise as the case may be, and to represent the Depositors in respect thereof as fully as though the Depositing Stockholders and the Depositing Debenture-holders, respectively, were acting in person; the Depositors all hereby ratifying and confirming all that the Committee or its appointees or substitutes may lawfully do or cause to be done by virtue hereof.
* * *
SEVENTH. The Committee shall be the sole and final judge as to whether and when sufficient assents and deposits shall have been received, and whether other conditions warrant it in declaring said Plan operative, and, in attempting to carry the same or any part thereof into effect, the Committee may supply any defect or omission or reconcile any inconsistency in said Plan and in this Agreement, in such manner and to such extent as shall*3146 be deemed by it necessary or expedient to carry out the same properly and effectively, and it shall be the sole judge of such necessity or expediency.
Before declaring the Plan operative, the Committee may exercise the powers and authority upon it conferred by this Agreement, in whole or in part, if it shall deem it advisable to do so; it shall have power, whenever it shall deem it proper, to alter, amend, modify, depart from, or abandon said Plan and this Agreement or any part thereof in any respect, or it may substitute a new plan or a new agreement or both; it may at any time or times after any such partial abandonment or, after any modification, restore to said Plan and this Agreement any abandoned part or parts theretofore by it discarded and reject any such modification or substitution or any part thereof, and it may seek to carry the said Plan and this Agreement into effect as fully as if such part or parts had not been abandoned or such modifications made; it may also attempt to carry said Plan and this Agreement into effect rather than to abandon or modify the same, even though it be manifest or probable that, if consummated, said Plan and this Agreement must depart from*3147 the original Plan or this Agreement or from some part thereof; any change or modification when made by the Committee shall thereupon become and be a part of said Plan and this Agreement. In case, however, of intentional change or modification of, or departure from, or substitution of another plan for, said Plan and this Agreement, which other *998 plan, in the judgment of the Committee, shall materially and adversely affect the Depositors or any thereof, such proposed material change, modification, departure or substitution shall be forthwith submitted to the Debenture Committee, the Amster Committee and the Hayden Committee. * * *
EIGHTH. Any action contemplated in said Plan or authorized by this Agreement may be taken or performed whenever and as often as the Committee, in its uncontrolled discretion, shall deem advisable. Any such action may be taken by the Committee or by any one approved by it at any time when it shall deem the reorganization advanced sufficiently to justify such course, and as it may be necessary or expedient the Committee may defer or permit to be deferred the performance of any provisions of said Plan or of this Agreement, or it may devolve such*3148 performance on the New Company and may cause the New Company to pay any indebtedness authorized or incurred by the Committee or otherwise in furtherance of the Plan or to make or assume any obligations or liabilities which, in the judgment of the Committee, may be necessary or expedient to carry out said Plan or this Agreement.
The Committee may, in its discretion, set apart and hold in trust, or permit to be set apart and to be held in trust, or may place in trust or permit to be placed in trust, any part of the new securities to be issued and any cash which may be received from sales of new securities or otherwise, as it may deem suitable for the purpose of securing the application thereof for any of the purposes of said Plan or of this Agreement.
The Committee may employ depositaries, sub-depositaries, counsel, agents and all necessary assistants, and may incur and discharge any and all expenses by it deemed reasonable for the purposes of said Plan or for carrying out or attempting to carry out the same, including the compensation and expenses of counsel and engineering, accounting and other experts, whether employed by it or not, and all compensation and expenses in any way*3149 connected with the receivership; also all compensations and expenses of the Depositaries, subdepositaries and agents, and all expenses in connection with the preparation of said Plan and this Agreement, the issue and governmental approval of securities, the incorporation of any companies, and all legal and other expenses in any manner connected with said Plan or this Agreement or which it may deem expedient to incur in undertaking to promote any of the purposes thereof. The Committee shall be the sole judge of the propriety and expediency of any and all compensation and expenses and of the amount thereof.
* * *
TENTH. The Committee undertakes to endeavor to carry out said Plan either in its original form or as modified, altered or departed from, but neither the Committee nor the members thereof nor the Depositaries assume any personal responsibility for carrying out said Plan and this Agreement or any part of either, nor for the results of any steps taken or acts done for that purpose, nor shall the Committee or the members thereof or the Depositaries hereunder be personally liable for any act or omission of said Committee, or of said Depositaries or of any agent or employee*3150 selected by them or either of them, nor for any error of judgment or mistake of fact or law, nor for any acts except for its or their own individual wilful malfeasance, nor shall any member of the Committee be personally liable for acts or defaults of any other member thereof or of any depositary.
ELEVENTH. The members of the Committee shall not be considered or taken, as between themselves, as partners, nor shall the Committee or any of its members be taken or considered as partners with the Depositors or any of them, nor shall the Depositing Stockholders or Depositing Debenture-holders be taken or considered as partners with each other or with the Committee or *999 with any of the members thereof, either as between themselves or as to third parties. All acts performed, and obligations and liabilities incurred by the Committee, both as to the Depositors and as to any person or persons, firm or firms, corporation or corporations, dealing or contracting with the Committee, shall be deemed and considered to be acts of said Committee as a committee, and all or any person or persons, firm or firms, corporation or corporations, dealing or contracting with said Committee shall*3151 look alone to the securities deposited hereunder for the satisfaction and discharge of all obligations and liabilities so contracted or incurred by the Committee, and shall not hold or attempt to hold the Committee or any member thereof, personally or individually, liable or responsible therefor.
TWELFTH. The Committee shall be entitled to compensation for its services, the same to be fixed by it. * * *
The compensation, expenses, disbursements and liabilities of the Committee shall be paid as a part of the expenses of reorganization, and the compensation of such Committee shall be conclusively deemed to be a part of the expenses of the reorganization for all the purposes of said Plan and this Agreement. The accounts of the Committee shall be filed within six months after the reorganization shall be determined by the Committee to have been completed, with the board of directors of the New Company, or the company which, in accordance with the provisions of said Plan, shall issue the securities in said Plan provided for, unless a longer time be granted by said board of directors. Such accounts, when approved by such board of directors, shall be final, binding and conclusive*3152 upon the Depositors and upon all other parties having any interest therein, and upon such approval, whenever and however given, the Committee shall be discharged, and all liability shall cease. The Committee, or any subcommittee, may advise with counsel, and the opinion of counsel, acted upon in good faith, shall be full protection to the Committee, or to such sub-committee, for anything done or suffered to be done in accordance with such opinion.
* * *
FOURTEENTH. All moneys paid under or in respect to said Plan and this Agreement shall be paid to the Depositaries hereunder, or, if the Committee shall so determine, the same may be paid to such sub-depositary or sub-depositaries, agent or agents, as the Committee shall designate. Said Depositaries, and any such sub-depositary or agent, severally and respectively, shall hold all such moneys, subject to the check or order of the Committee, and the Committee is hereby expressly authorized to use the same or any part thereof, or to cause or permit the same or any part thereof to be used for any of the purposes of said Plan or of this Agreement, at such time as in its discretion Committee, its determination as to the propriety and*3153 purpose of any such application to be final and binding upon all of the Depositors; and nothing in said Plan or in this Agreement shall be understood as limiting or requiring the application of any specific moneys for any specific purpose.
FIFTEENTH. All calls for the deposit of securities and payments to be made as provided by said Plan or by this Agreement, or for the presentation or surrender of Certificates of Deposit and all notices fixing or limiting any period for the deposit of securities or for such payments, or declaring said Plan operative, and all other calls or notices hereunder, except when herein otherwise expressly provided, shall be published by the Committee at least twice in each week for two successive weeks in one newspaper of general circulation published in the Borough of Manhattan, in the City of New York, and in one newspaper of general circulation published in the City of Chicago, Illinois. Any *1000 call or notice whatsoever, when so published by the Committee, shall be taken and shall be considered as though personally served on all parties hereto and upon all parties to bound thereby as of the date of the first insertion thereof, and such publication*3154 shall be the only notice required to be given under any provision of said Plan or of this Agreement and shall be sufficient for all purposes whether or not actually brought to the notice of the Depositors.
* * *
The "Plan of Reorganization" above referred to provides in part:
On April 20, 1915, receivers of the railroads and properties of The Chicago, Rock Island and Pacific Railway Company (hereinafter referred to as the Railway Company) were appointed and the receivership still continues. The interest on the Twenty-Year Five Per Cent. Gold Debentures (hereinafter referred to as the Debentures), which matured January 15, 1916 and July 15, 1916, has not been paid, and such interest has continued in default beyond the sixty-day period of grace provided in the indenture under which the Debentures were issued. No defaults have occurred in the payment of interest upon any of the obligations of the Railway Company secured by lien upon its property or the property of its subsidiary railroad corporations. A committee representing certain holders of the Railway Company's First and Refunding Bonds has, however, commenced suit by leave of Court for the foreclosure of the First and*3155 Refunding Mortgage, alleging various defaults other than nonpayment of interest. This litigation is being contested by the Railway Company and by the Joint Reorganization Committee. Representatives of the Joint Reorganization Committee have been holding informal conferences with members of the said committee representing First and Refunding bondholders of the Railway Company.
Under the provisions of the accompanying Agreement the Joint Reorganization Committee is empowered to make any settlement, compromise or arrangement that may, in its discretion, be deemed advisable with respect to the First and Refunding Bonds or with respect to any other secured or unsecured obligations of or claims against the Railway Company.
The Railway Company has outstanding in the hands of the public $20,000,000 face amount of Debentures and $74,359,722.50 par value of capital stock all of one class.
Negotiations between members of the Debenture Committee, the Amster Committee and the Hayden Committee have resulted in concerted action looking to early reorganization of the Railway Company. As a result of these negotiations, and upon the understanding that approximately $30,000,000 new cash capital*3156 would be provided in reorganization, the Debenture Committee has consented that the Plan shall provide for the delivery to Debenture holders of 6% preferred stock of the New Company (cumulative up to 5% per annum) in lieu of the fixed charge obligations now hold by them. Investigations have been made of the physical condition, operations, earning power and accounts of the Railway Company by experts, based upon which the Joint Reorganization Committee has prepared the following:
PLAN.
The railroads and properties of the Railway Company are either to be retained in the present company, subject to a readjustment of securities as hereinafter provided, or are to be vested in a new company or the Railway Company otherwise reorganized, as may be determined by the Joint Reorganization Committee, subject to all liens of record by way of mortgage or deed of trust and to such *1001 liens as may be substituted for any thereof. The company in which the railroads and properties of the Railway Company shall be so vested or retained is hereinafter called the New Company.
NEW SECURITIES.
The New Company will have capital stock presently issuable of $125,000,000 par value, consisting*3157 of shares of the par value of $100 each, whereof
$30,000,000 par value will be 7% preferred stock;
$20,000,000 par value will be 6% preferred stock; and
$75,000,000 par value will be common stock.
The Joint Reorganization Committee may in its discretion determine that the authorized amounts of the 6% preferred stock or of the 7% preferred stock, or both, shall exceed the amounts above specified by not more than $15,000,000 in par amount for both; and any part of such preferred stock not required for the purposes of the Plan may be placed in the treasury of the New Company for its general corporate purposes. The authorized amounts of the preferred stocks may not be increased after reorganization except by vote of a majority of each class of stock of the New Company outstanding, each class voting separately.
The preferred stocks of both classes shall share pari passu in the distribution of assets upon insolvency or dissolution of the New Company, and shall, in such event, be preferred over the common stock in the payment of the entire par value of the preferred stocks, plus any unpaid dividends then accumulated thereon, before any payment or distribution shall be made*3158 upon the common stock.
The 7% preferred stock shall have preference and priority over the 6% preferred stock as to dividends to the extent of one per cent in any fiscal year, which shall be first declared and paid or set aside for payment before any dividends shall be declared upon the 6% preferred stock; but, after the declaration and payment or setting aside of such one per cent in any fiscal year on the 7% preferred stock, the shares of both classes of preferred stock shall rank pari passu as to further dividends declared and paid thereon. Dividends upon the 7% preferred stock presently to be issued hereunder shall be cumulative up to but not exceeding 5% per annum from and after such date as may be fixed by the Joint Reorganization Committee having regard to the amounts of the several instalments and the respective dates fixed for the payment thereof by Depositing Stockholders. Dividends upon the 6% preferred stock to be issued in exchange for Debentures as hereinafter provided shall be cumulative up to but not exceeding 5% per annum from and after July 15, 1916. The Joint Reorganization Committee may, in its discretion, by unanimous vote of the members of said Committee, *3159 upon or after the consummation of the Plan, pay in cash, either out of the funds provided for under the Plan or otherwise, all or any part of the amount that would otherwise then have accumulated by way of dividend on said 6% preferred stock issuable in respect of Debentures, or on said 7% preferred stock, or on both, without any modification whatsoever of the Plan or of the accompanying Agreement;and thereupon the dates from which dividends shall accumulate on such 6% preferred stock or on such 7% preferred stock, or both, as the case may be, shall be changed accordingly.
The charter of the New Company shall provide that the whole, but not a part, of the 7% preferred stock outstanding may at any time be purchased or redeemed on any dividend payment date by the New Company at $105 per share plus the amount of all cumulative dividends accrued thereon; and that, either independently or contemporaneously, the whole, but not a part, of the 6% preferred *1002 stock outstanding may be likewise purchased or redeemed by the New Company at any time on any dividend payment date at $102 per share plus the amount of all cumulative dividends accrued thereon. The charter shall also provide, *3160 in such form as the Joint Reorganization Committee shall approve, for the notice to be given of any such redemption and all the other conditions and provisions for such redemption.
The right of cumulative voting upon shares of stock at all elections for Directors of the New Company shall be provided for by the charter of the New Company, and all Directors shall be elected annually.
In lieu of the 7% preferred stock and 6% preferred stock, if in the judgment of the Joint Reorganization Committee it shall be more expedient so to do, there may be issued income debentures of the New Company which shall have substantially the same priorities, substantially the same rights as to distribution of earnings and assets and, if practicable, substantially the same voting privileges, including cumulative voting for directors as above stipulated in respect of the proposed 7% and 6% preferred stocks.
DISTRIBUTION OF NEW SECURITIES
For the purposes of the cash requirements of the Plan, estimated at $29,743,889, a Purchase Agreement has been entered into by the Joint Reorganization Committee with Messrs. Speyer & Co. and Messrs. Hayden, Stone & Co., therein and herein referred to as the Bankers, *3161 whereby the latter have agreed to purchase, for the sum of $29,743,889, less a commission of 3%, the $29,743,889 par value of 7% preferred stock and the $74,359,722.50 par value of common stock of the New Company to be presently issued.
The Bankers have authorized the Joint Reorganization Committee to offer for account of the Bankers, the 7% preferred stock and the common stock of the New Company so to be acquired by them to holders of Certificates of Deposit for stock of the Railway Company to the extent below stated. Such holders of Certificates of Deposit for stock of the Railway Company as shall avail themselves of such offer and as shall participate in the Plan will receive, upon the consummation of the Plan and the surrender of their respective Certificates of Deposit and upon payment therefor as herein provided, in respect of each share of stock of the Railway Company represented by such Certificates of Deposit:
$100 in par value of common stock of the New Company, and
$40 in par value (being identical with the amount of the cash payment) of 7% preferred stock of the New Company;
or interim certificates or receipts representing same.
Upon the consummation of the*3162 Plan and the surrender of their respective Certificates of Deposit depositing Debenture holders will be entitled to receive in cash the 5% arrears of interest on their Debentures to July 15, 1916, and, in respect of each $1,000 Debenture, $1,000 in par value of 6% preferred stock of the New Company or interim certificates or receipts representing same.
| Share capitalization of new company | ||
| New securities | Authorized | To be presently issued |
| 7 per cent preferred stock | $30,000,000.00 | $29,743,889.00 |
| 6 per cent preferred stock | 20,000,000.00 | |
| To be issued in exchange for | ||
| debentures, say | 20,000,000.00 | |
| Common stock | 75,000,000.00 | 74,359,722.50 |
| Total | 125,000,000.00 | 124,103,611.50 |
*1003 DEPOSITS OF EXISTING SECURITIES.
Such of the holders of stock of the Railway Company as may desire to participate in the Plan must deposit their shares, on or before such date as may be prescribed by the Joint Reorganization Committee, subject to the terms and provisions of the Plan and the accompanying Agreement, with either of the Depositaries named below, and must promptly make, in current New York or Chicago funds, according to the place of deposit, the*3163 following cash payments in respect of each share of stock so deposited, viz.:
| 30 days after the first publication of notice requiring the payment | |
| thereof | $10 |
| 15 days after the first publication of notice requiring the payment | |
| thereof (not sooner, however, than 30 days after the plan shall have | |
| been declared operative | 10 |
| 15 days after the first publication of notice requiring the payment | |
| thereof (not sooner, however, than ninety days after the plan shall | |
| have been declared operative | 20 |
| Total | 40 |
The nonpayment of any instalment upon or prior to the date specified therefor will render the deposited stock and any prior payments liable to forfeiture.
* * *
DECLARING PLAN OPERATIVE.
The Plan is to become operative only when the Joint Reorganization Committee, in its absolute discretion, shall determine that sufficient amounts of Debentures and stock have been deposited or have assented thereto. In such case, the Joint Reorganization Committee will declare the plan operative and will publish notice simultaneously in New York and Chicago to that effect. The Plan will become operative upon the date of the first publication of such notice.
APPLICATION*3164 OF FUNDS.
It is proposed that the $29,743,889 cash to be provided under the Plan shall be applied as follows:
| To the payment or acquisition of: | |
| 2-year collateral trust gold notes | $7,500,000 |
| Loan, Central Trust Co., secured by collateral | 2,500,000 |
| Loan, Hayden, Stone & Co., secured by collateral | 1,600,000 |
| Receiver's certificates, series A | 5,488,000 |
| Receiver's certificates, series B | 1,100,000 |
| 18,188,000 | |
| To pay or acquire claims against and liabilities of the | |
| receiver, to pay interest and other debts of the new | |
| company, and to pay the expenses of the reorganization | |
| (including compensation and allowances, counsel fees, | |
| court costs, services of engineering, accounting and other | |
| exports, etc.), and other incorporation and reorganization | |
| disbursements, syndicate commissions, and miscellaneous | |
| requirements and to provide additional working capital for | |
| the general corporate purposes of the new company | 11,555,889 |
| 29,743,889 |
*1004 The Plan will leave unaffected various claims against the Railway Company incurred in the conduct of operations by it or by the Receiver, which will have to be met, contested or otherwise disposed of by the New Company. *3165 The more important of these claims are set forth in the Appendix annexed to the Plan, to which attention is hereby directed. As against these claims the Receiver will, upon the consummation of the Plan, turn over to the New Company all moneys then remaining undisposed of in his hands. On November 2, 1916, the moneys so in the hands of the Receiver amounted to $4,821,589, a part of which represented accumulations made by him in anticipation of payments then presently to become due.
* * *
The "Plan" left undisturbed equipment bonds, notes and other funded obligations of petitioner and its subsidiaries in the amount of $257,758,383. The following is a statement of the funded debt and other obligations of petitioner that were intended to be displaced, exchanged or liquidated in the reorganization:
| Description | When due | Amount outstanding |
| 20-year gold debentures, 5 per cent | 1932 | $20,000,000 |
| 2-year collateral trust gold notes, 6 per cent | 1917 | 7,500,000 |
| Loan, Central Trust Co., secured by collateral, | ||
| 5 per cent | 1917 | 2,500,000 |
| Loan, Hayden, Stone & Co., secured by collateral, | ||
| 4 per cent | 1916 | 1,600,000 |
| Receiver's certificates, series A, 5 per cent | 1917 | 5,488,000 |
| Receiver's certificates, series B, 6 per cent | 1917 | 1,100,000 |
| Total | 38,188,000 |
*3166 On June 12, 1917, a final decree was entered in the cause in which the receivers were appointed. In said decree it was, among other things, found and adjudged:
* * *
2. That heretofore and on or about April 20, 1915, the defendant Railway Company became and was financially embarrassed and thereupon such proceedings were had in this court that Receivers of its railroads and properties were duly appointed herein who thereupon took possession of all the railroads and properties of every name and nature wherever situated of the defendant Railway Company and of the rents, issues, income and profits thereof, and this court through its Receivers or Receiver has ever since continued to possess, hold and operate the same and to receive the earnings and income thereof. That on or about September 28, 1915, H. U. Mudge, one of said Receivers, resigned and his resignation was accepted. That since September 28, 1915, Jacob M. Dickinson, the other of said Receivers, has acted and is still acting as sole Receiver of the defendant Railway Company. * * *
3. That the defendant Railway Company failed to pay the interest aggregating Five Hundred Thousand Dollars ($500,000) due January 15, 1916, upon*3167 its Twenty Million Dollars ($20,000,000) face amount of Twenty-Year Five Per Cent Gold Debentures outstanding issued under a certain Indenture, dated January 17, 1912, made and executed by and between the defendant Railway Company and Bankers Trust Company, as Trustee, and that no interest accruing on said Debentures on January 15, 1916, or thereafter has been paid, and that all of said interest, to wit, the semiannual installments each aggregating Five *1005 Hundred Thousand Dollars ($500,000) due, respectively, January 15, 1916, and July 15, 1916, remained past due and were never paid; that, on or about December 4, 1916, Bankers Trust Company, as trustee under said Indenture, declared due and payable then forthwith the entire principal of said Debentures, and that the whole principal amount of Twenty Million Dollars ($20,000,000) thereof has been ever since said December 4, 1916, and now is due and unpaid; that on January 23, 1917, the complainant Bankers Trust Company, as trustee, obtained in this court in an action at law brought against the defendant Railway Company a judgment against the defendant Railway Company under said Indenture and upon said Debentures in the sum*3168 of $21,560,513.70, whereon execution was duly issued but was and still is wholly unsatisfied; that upon the rendition of said judgment, the entire indebtedness secured by said Debentures and all right of action thereon were merged in said judgment and vested in said Bankers Trust Company, as Trustee; that Bankers Trust Company, as Trustee, brought suit in equity in this Court, "No. 824 in Equity," as the holder of said judgment whereon execution had been returned unsatisfied, such suit being one of the above-entitled constituent causes of this consolidated cause; that the defendant Railway Company or its said Receiver is further indebted for large amounts upon loans and other indebtedness, and that since the appointment of said Receivers they have, or the said sole Receiver has, under authority of this court, issued Receivers' or Receiver's certificates to large amounts, secured by liens upon the property and earnings of the defendant Railway Company, whereof $4,482,000 Series A and $1,100,000 Series B, a total principal amount of $5,582,000, remain outstanding, and said Receivers have, or said Receiver has, contracted additional obligations for car trusts and equipment trusts, all*3169 as more particularly appears upon the records of this court. That on February 10, 1917, an order was made herein permitting and directing all creditors and claimants to file their claims with Herbert A. Lundahl, Special Master appointed for that purpose, within a period limited by said order and thereafter extended, and that due notice was given of such appointment and of the requirements that such creditors and claimants should file their said claims, all as appears by the interim report of said Special Master filed herein and hereby approved and adopted.
That, as also appears by the statement of the Comptroller for the Receiver, being "Exhibit B" to said Petition and Offer, the financial embarrassment of the defendant Railway Company by reason whereof Receivers were appointed of its railroads and properties April 20, 1915, still continues, and will continue unless the financial condition of the Railway Company shall be bettered and its financial embarrassments removed by the contribution of a large sum of new cash money and by the conversion of said Debentures into stock, all as contemplated by said Plan and Agreement of Reorganization.
4. That the holders of most of the*3170 Debentures (approximately 95 per cent thereof) and of nearly all the stock (approximately 99 per cent thereof) of the defendant Railway Company united in a Plan and Agreement of Reorganization under which it was contemplated that the railroads and properties of the defendant Railway Company should either be acquired by a new company or be reorganized under, by or through the present defendant Railway Company for the benefit of all of its creditors and stockholders, and that such new or reorganized company should own and operate said railroads and properties after such reorganization. Exhibit A filed with said petition is a copy of said Plan and Agreement of Reorganization.
* * *
6. *1006 That the holders of more than 99 per cent in amount of the stock and of more than 95 per cent in amount of the Debentures (deposited under said Plan and Agreement of Reorganization as aforesaid) have agreed to the terms of said Plan and have complied therewith. That the said stockholders, in order to comply with said Plan, have made, or are obligated to make, payments in cash at the rate of $40 per share in respect of each share of stock held by them, in return for which they are to*3171 receive new 7 per cent preferred stock of the defendant Railway Company, and have agreed that the said stock of the defendant Railway Company deposited by them shall be subjected and subordinated not only to said 7 per cent preferred stock by them thus agreed to be purchased, but also to an amount of not exceeding $35,000,000 of 6 per cent preferred stock. That the said holders of Debentures have surrendered their claims for the payment of money in respect of the principal of said Debentures, and have agreed to accept as of July 1, 1917, cash representing interest unpaid upon their Debentures and to accept said new 6 per cent preferred stock of the defendant Railway Company in lieu of the principal of their said Debentures at the rate of par for par.
7. That the defendant Railway Company and the Joint Reorganization Committee under said Plan and Agreement of Reorganization, Exhibit A, have made the written offer set forth in said petition, in and by which the Railway Company and the Committee offer to make provision for all indebtedness of the defendant Railway Company and of the said Receiver, matured or to mature in the near future, including provision for the amounts of cash*3172 immediately required for retiring Receivers' or Receiver's certificates, secured floating debt and other obligations, upon the conditions and to the extent set forth in said offer. That the said offer includes as a term and condition thereof the granting to each and every holder of a Debenture of the defendant Railway Company not deposited under said Plan, or of a valid claim duly allowed against the defendant Railway Company or its Receiver as described in said offer, the same treatment and terms as are accorded to the holders of said Debentures subjected as aforesaid to said Plan and Agreement, namely: the payment in cash, at the rate of 5 per cent per annum, of any interest accrued and unpaid upon said undeposited Debentures and said claims to and including June 30, 1917, and the is suance and delivery, on July 1, 1917, or upon due demand made as soon as practicable thereafter, to each holder of such a Debenture or claim, of said new 6 per cent preferred stock par for par in respect of the principal of such Debenture or claim, upon surrender and assignment of such Debenture or claim. That the only unpaid indebtedness of the defendant Railway Company and its Receiver, matured or*3173 to mature in the near future (other than obligations to be paid pursuant to said offer, mortgage indebtedness and unliquidated claims in litigation), are the judgment upon said Twenty Million Dollars ($20,000,000) of Debentures and the interest due thereon, and the amount that may be determined to be due upon the claims filed with said Special Master, together with interest, if any, due thereon. That where the holders of so great a preponderance of the claims against, and stock in, the defendant Railway Company have assented to exchange their claims for stock, or to make a cash contribution and subordinate their stock to preferred stocks, as the case may be, it is fair and equitable that creditors who have not subordinated their claims to the terms of the Reorganization Plan should, nevertheless, be limited so that, out of the assets and funds of the defendant Railway Company in the custody and under the control of this court, they should in no event receive treatment different from or better than the creditors, in such vast preponderance, are to receive; that in the absence of such a plan as formulated for the reorganization of the defendant Railway Company, it would be necessary*3174 to sell the property of the defendant *1007 Railway Company to pay the said judgment recovered by the Bankers Trust Company, as Trustee, the said Receiver's certificates and the other indebtedness due from the defendant Railway Company; that not only would the expense attendant upon such sale be great, but the amount realized by holders of debentures and other claims out of the proceeds of any such sale would be less than the market value of the preferred stock offered under said Plan and Agreement of Reorganization to the holders of said debentures and other claims; that such a sale, if made, would involve great expense, loss and waste which can be saved to said holders of said debentures and other claims through the carrying out of said Reorganization Plan and under the terms of this decree.
8. That the offer of the defendant Railway Company and the JointReorganization Committee was duly submitted to a meeting of the Board of Directors of the defendant Railway Company duly called and held with the permission of this court, and the making thereof was approved and authorized by said Board; that the said offer and the said plan of reorganization are fair and just to, and*3175 for the benefit of, all concerned, and in order to enable said defendant Railway Company properly to perform its paramount duty to the public ought to be approved by the Court and made effective forthwith by the parties thereto.
IT IS, THEREFORE, FURTHER ORDERED, ADJUDGED AND DECREED:
9. That the said objections of Robert Abeles and others joined with him, intervening petitioners herein, filed herein on June 11, 1917, be and the same are hereby disallowed and overruled; that the said offer made by the defendant Railway Company and the Joint Reorganization Committee and said Plan and Agreement of Reorganization are both hereby approved; that said offer and the acceptance thereof by and on behalf of the parties interested in the defendant Railway Company be and the same are hereby approved; and that the defendant Railway Company, its directors, officers, employees and servants and the Joint Reorganization Committee, be and they are hereby authorized and directed to consummate and carry out the same; that said action of the defendant Railway Company's Board of Directors be and the same is hereby allowed, confirmed and approved; and that the creation, issuance and disposal by the*3176 defendant Railway Company of its new preferred stocks, fully paid and nonassessable, for the considerations, at the times and in the manner mentioned in said offer and said Plan, up to but not exceeding authorized amounts as follows, viz:
$30,000,000 par value of 7 per cent preferred stock, and $35,000,000 par value of 6 per cent preferred stock, with such preferences, priorities, rights and other terms and conditions as are set forth in said offer and in said Plan and Agreement of Reorganization, and as may be determined pursuant thereto by the Joint Reorganization Committee and the defendant Railway Company, or by either of them, are all hereby approved, and that the defendant Railway Company be and it is hereby authorized and empowered to take any and all such further action as may be necessary to complete the acceptance of said offer and consummate and carry out the arrangements therein contemplated.
That the defendant Railway Company be and it is hereby authorized and required, but upon the conditions and reservations therein prescribed, to make the several payments described in subdivision A of said offer, to the extent that they have not been paid or shall not have been*3177 paid out of moneys in the possession of the Receiver. That this decree is made upon the express condition that the defendant Railway Company shall make (except to the extent aforesaid) all the payments, assume all the obligations and liabilities, take over and assume the prosecution and defense of all litigations and make all *1008 agreements of indemnity, in the manner and upon are conditions and reservations in said subdivision A expressed, and shall also pay any and all proper court costs and disbursements in this consolidated cause, in the constituent causes thereof, and in any causes ancillary thereto, and shall also pay in cash (subject to its right of appeal from any allowance or order) any claim for which a preference or priority over its mortgage indebtedness has been, or shall be, allowed or adjudged herein. * * *
10. That, upon delivery on or prior to July 1, 1917, to Bankers Trust Company, as Trustee, either by the defendant Railway Company or by the Joint Reorganization Committee, of certificates for the 6 per cent preferred stock to be issued by the defendant Railway Company under said Plan and Agreement of Reorganization in the aggregate par amount of $20,000,000, *3178 together with the sum of $1,958,333.33, in cash, being a sum equivalent to the interest which has accrued upon said Debentures from July 15, 1915, to and including June 30, 1917, Bankers Trust Company, as Trustee, shall execute or cause to be executed and delivered to said Railway Company a satisfaction in such form as may be required by law, fully to satisfy and discharge the judgment entered in this court on January 23, 1917, in favor of Bankers Trust Company, as Trustee, against the defendant Railway Company, in the sum of $21,560,513.70, and that thereafter the said Bankers Trust Company, as Trustee, shall forthwith cause to be delivered and paid, respectively, (A) to the holders of certificates of deposit of such Debentures from time to time upon surrender and cancellation thereof, certificates for the shares of such preferred stock to which such holders may be entitled at the rate of $1,000 par value of stock for each $1,000 of principal of Debentures represented by such certificates of deposit, and the amounts in cash, at the rate of $97.91 2/3 per each $1,000 of principal of Debentures represented by such certificates of deposit to which they are or may be, respectively entitled*3179 under said Plan and Agreement of Reorganization and under said offer filed herein May 29, 1917, less the proper deduction in the case of Debentures which have received an advance respecting the coupon matured January 15, 1916; and also (B) to the holders of such Debentures who shall not have heretofore deposited the same under said Plan and Agreement, new 6 per cent preferred stock and cash in the proportions and in the amounts above stated, such deliveries and payments to be made by Bankers Trust Company, as Trustee, only upon surrender and cancellation of such undeposited Debentures accompanied by the coupons due January 15, 1916, and all subsequent coupons thereto appertaining. That Bankers Trust Company, complainant in the above-entitled constituent cause of this consolidated cause, upon receipt of said stock and cash and upon due satisfaction of said judgment pursuant to this paragraph 10 of this decree, may thereafter at any time apply to this Court to be discharged from all trusts under said Indenture dated January 17, 1912, and from all duties in respect thereof excepting only the due distribution and delivery of said stock and cash as herein decreed.
* * *
12. That*3180 at midnight of June 24, 1917, the Receiver transfer and surrender to the defendant Railway Company each and all of the railroads, franchises, leaseholds, trackage rights, real estate, moneys, accounts, choses in action, books of account, records, files, documents and all other property of every name and nature whatsoever and wherever situated then in the possession of said Receiver or under his control, and that for further assurance he execute and deliver to the defendant Railway Company all such deeds, bills of sale and other instruments of transfer as may be necessary, desirable, or advisable to effect or confirm such retransfer; that, upon such surrender and *1009 transfer the Receiver shall be and he is hereby discharged from the control and management thereof; and that thenceforth the defendant Railway Company shall enjoy, control and manage the same and each and all thereof, subject, however, to the reservations contained in this decree. That all contracts made by the Receivers or Receiver, under any order or orders of this court, for the purchase of rolling stock or other equipment or of rail and rail fittings or of other railroad supplies, for the construction or acquisition*3181 of additions to or betterments or improvements of the railroads and properties in their or his charge herein, or with other common carriers, telephone companies, terminal companies, depot companies or bridge companies, are hereby ratified and authorized and, as to any unperformed parts of any thereof, are hereby continued in full force and effect as against the defendant Railway Company and shall be deemed assumed by it and the retransfer to the defendant Railway Company of its railroads and properties is expressly decreed to be subject to such contracts and the assumption thereof by the Railway Company. That the retransfer to the defendant Railway Company of its railroads and properties is expressly decreed to be subject to the rights of sureties under order No. 26 herein.
13. That the defendant Railway Company shall take over and assume the defense of all actions and suits at law or in equity against the defendant Railway Company and the Receivers or Receiver herein, or against either or any of them, or in which they, or any of them, are or is a party defendant, pending and undetermined at the date of the entry of this decree in any court or tribunal; that the property and assets*3182 of the defendant Railway Company are to be liable for the amounts of any judgments eventually obtained in any of such actions and suits, but the payment of any judgment pending or which hereafter may be rendered against the Railway Company or any cause of action accruing prior to June 25, 1917, shall be subject, however, to such order as this court shall make in the premises, either by way of reference tosaid Special Master or otherwise, and subject to the rights of the defendant Railway Company as specified in Paragraph 11 of this decree.
* * *
2.
The following penalties were assessed against petitioner during the following years under the following statutes and in the following amounts:
| 1916 | 1917 | 1918 | 1919 | |
| Hours of service law | $973.73 | $1,030.68 | $520.50 | $100.00 |
| Safety appliance law | 449.14 | 2,371.41 | 538.93 | 111.00 |
| 28-hour law (livestock) | 2,239.72 | 10,169.25 | 168.95 | 1,378.92 |
| Quarantine law | 1,100.53 | 820.86 | 398.25 | 676.81 |
| 36-hour law | 5.00 | |||
| Total | 4,763.12 | 14,392.20 | 1,631.63 | 2,266.73 |
There was also assessed against the Chicago, Rock Island & Gulf Railway Co. during the year 1919 penalties under the above statutes in the amount*3183 of $160.75. Respondent did not allow any of the penalties above referred to in the determination of the deficiencies for the year 1916, 1917, 1918, and 1919.
*1010 3.
Men and material in connection with additions and betterments were transported by petitioner during the years 1916 and 1917 in its regular revenue trains and the amounts charged therefor to construction account by petitioner and credited to operating expenses by respondent for the years 1916 and 1917 were $153,394.54 and $292,079.67, respectively.
4.
The following statement sets forth the several issues of bonds of petitioner outstanding during the yers 1916, 1917, 1918, and 1919 or any of them, together with their respective dates of maturity, dates of sale, par value sold during each year, discount and expenses in connection with each such sale, the annual amortization of discount amortized to December 31, 1916, and amount unamortized to December 31, 1916:
| PRIOR TO JANUARY, 1, 1909 | |||||
| Class of obligation | Maturity | Date of Sale | Par value sold | Discount (charged to profit and loss on date of sale) | Expense (charged to profit and loss on date of sale) |
| First and refunding mortgage bonds | Apr. 1, 1934 | 1904 | $14,704,000 | $1,470,400.00 | $50,827.01 |
| Do | do | 1905 | 17,404,000 | 1,550,534.96 | 60,160.03 |
| Do | do | 1906 | 11,784,000 | 1,038,303.59 | 40,733.50 |
| Do | do | 1907 | 17,250,000 | 2,794,722.21 | 59,627.73 |
| Do | do | 1908 | 13,116,000 | 2,490,206.67 | 45,337.81 |
| 74,258,000 | 9,344,167.43 | 256,686.08 | |||
| General mortgage bonds | Jan. 1, 1988 | 1898 | 47,471,000 | 356,032.50 | 173,222.91 |
| Do | do | 1899 | 5,000,000 | 37,500.00 | 18,245.10 |
| Do | do | 1902 | 7,110,000 | 1 720,173.35 | 25,944.53 |
| Do | do | 1903 | 2,000,000 | 80,000.00 | 7,298.04 |
| 61,581,000 | 406,640.85 | 224,710.58 | |||
| SUBSEQUENT TO JANUARY 1, 1909 | |||||
| First and refunding mortgage bonds | Apr. 1, 1934 | 1909 | $5,214,000 | $470,325.00 | |
| Do | do | 1910 | 6,196,000 | 780,300.00 | |
| Do | do | 1911 | 5,324,000 | 737,890.00 | |
| Do | do | 1912 | 3,500,000 | 437,500.00 | |
| 20-year gold debentures | Jan. 15, 1932 | Jan. 15, 1912 | 20,000,000 | 1,200,000.00 | |
| 40,234,000 | 3,626,015.00 | ||||
| PRIOR TO JANUARY 1, 1909 | |||||
| Class of obligation | Total | Annual amortization of discount and expense | Amount amortized to Dec. 31, 1916 | Amount unamortized at Dec. 31, 1916 | Changes during 1917 |
| First and refunding mortgage bonds | $1,521,227.01 | $50,707.57 | $646,521.52 | $874,705.49 | |
| Do | 1,610,694.99 | 53,689.83 | 644,277.96 | 966,417.03 | |
| Do | 1,079,037.09 | 37,208.18 | 409,289.98 | 669,747.11 | |
| Do | 2,854,349.94 | 101,941.07 | 1,019,410.70 | 1,834,939.24 | |
| Do | 2,535,544.48 | 93,909.05 | 845,181.45 | 1,690,363.03 | |
| 9,600,853.51 | 337,455.70 | 3,564,681.61 | 6,036,171.90 | ||
| General mortgage bonds | 529,255.41 | 5,880.62 | 111,731.78 | 417,523.63 | |
| Do | 55,745.10 | 619.39 | 11,149.02 | 44,596.08 | |
| Do | n1 694,228.82 | n1 7,979.64 | n1 119,694.60 | n1 574,534.22 | |
| Do | n1 72,701.96 | n1 845.37 | n1 11,835.18 | n1 60,866.78 | |
| n1 181,930.27 | n1 2,325.00 | n1 8,648.98 | n1 173,281.29 | ||
| SUBSEQUENT TO JANUARY 1, 1909 | |||||
| First and refunding mortgage bonds | $470,325.00 | $18,838.82 | $146,620.17 | $324,004.83 | |
| Do | 780,300.00 | 32,405.31 | 221,490.00 | 558,810.00 | |
| Do | 737,890.00 | 31,872.22 | 188,126.09 | 549,763.91 | |
| Do | 437,500.00 | 19,662.92 | 98,206.86 | 339,293.14 | |
| 20-year gold debentures | 1,200,000.00 | 60,000.00 | 297,534.25 | 902,465.75 | $449,996.63 |
| 3,626,015.00 | 163,779.27 | 951,977.37 | 2,674,337.63 | 449,996.63 | |
| 4,508,010.00 | 8,537,228.24 | 449,996.63 | |||
| PRIOR TO JANUARY 1, 1909 | |||
| Class of obligation | Amounts of unamortized discount and expense which should be credited to surplus (if petitioner's contentions are sustained), for purpose of invested capital, year 1917 | Unamortized discount allowed by bureau as invested capital | Difference |
| First and refunding mortgage bonds | $6,036,171.90 | 2 $6,036,171.90 | |
| General mortgage bonds | 1 173,281.29 | 173,281.29 | |
| SUBSEQUENT TO JANUARY 1, 1909 | |||
| First and refunding mortgage bonds | $324,004.83 | $324,004.83 | |
| Do | 558,810.00 | 558,810.00 | |
| Do | 549,763.91 | 549,763.91 | |
| Do | 339,293.14 | 339,293.14 | |
| 20-year gold debentures | 3 452,469.12 | 30,544.49 | 4 $421,924.63 |
| 2,224,341.00 | |||
| 8,087,231.61 | 1,802,416.37 | 6,284,815.24 | |
*1011 *3186 Respondent has not allowed any of the above discount and expense prior to January 1, 1909. He has allowed all such discount and expense subsequent to January 1, 1909, except as explained in footnote 4.
*1012 5.
The following statement sets forth petitioner's various issues of the Equipment bonds or notes and petitioner's Collateral Trust Bonds (serial) of 1902, which were outstanding during any or all of the years 1916, 1917, 1918, and 1919; the dates of issue or sale; the various final serial maturities thereof; and the discount incurred in connection with each such issue. The several amounts of discount amortized and unamortized shown in columns 7, 8, and 10 were obtained and used bu respondent pursuant to his method of computation. The several amounts of this discount shown in columns 11, 12, and 14 represent the amount thereof obtained according to petitioner's method of computation. The figures set forth in column 7, 8 and 10, 11, 12, and 14 are mathematically correct:
| PRIOR TO JANUARY 1, 1909 | |||||
| Class of obligation | Date of sale | Date of maturity | Par value sold | Discount | Annual amortization of discount |
| 1Collateral trust bonds of 1902 | May 1, 1902 | May 1, 1918 | $23,883,000 | $823,200.00 | Various. |
| SUBSEQUENT TO JANUARY 1, 1909 | |||||
| Equipment notes, series C | Apr. 1, 1909 | Oct. 1, 1919 | $5,300,000 | $39,750.00 | Various. |
| Equipment gold notes: | |||||
| Series D | May 1, 1910 | May 1, 1925 | 6,750,000 | 303,750.00 | Various. |
| Series F | Aug. 1, 1911 | Aug. 1, 1926 | 360,000 | 15,144.59 | Various. |
| 2 Series G | July 1, 1912 | July 1, 1927 | 4,590,000 | 181,235.98 | Various. |
| Series H | July 1, 1913 | July 1, 1923 | 4,510,000 | 240,345.00 | Various. |
| 21,510,000 | 780,225.57 | ||||
| 45,393,000 | 1,603,425.57 | ||||
| PRIOR TO JANUARY 1, 1909 | ||||
| Class of obligation | Amount amortized to Dec. 31, 1916 (respondent's figures) | Amount unamortized at Dec. 31, 1916 (respondent's figures) | Changes during 1917 | Amount of unamortized discount which should be credited to surplus (if any amounts should be so credited) for purpose of invested capital, year 1917 (respondent's figures) |
| Collateral trust bonds of 1902 | $817,769.16 | $5,30.84 | ||
| SUBSEQUENT TO JANUARY 1, 1909 | ||||
| Equipment notes, series C | $37,902.64 | $1,847.36 | ||
| Equipment gold notes: | ||||
| Series D | 241,630.24 | 62,119.76 | ||
| Series F | 10,878.14 | 4,266.45 | ||
| Series G | 117,768.14 | 63,467.84 | $63,467.84 | |
| Series H | 164,269.14 | 76,075.86 | 76,075.86 | |
| 572,448.30 | 207,777.27 | 139,543.70 | ||
| 1,390,217.46 | 213,208.11 | 139,543.70 | ||
| PRIOR TO JANUARY 1, 1909 | ||||
| Class of obligation | Amount amortized to Dec. 31, 1916 (petitioner's figures) | Amount unamortized at Dec. 31, 1916 (petitioner's figures) | Changes during 1917 | Amount of unamortized discount which should be credited to surplus (if any amounts should be so credited) for purpose of invested capital, year 1917 (petitioner's figures) |
| 1Collateral trust bonds of 1902 | $809,041.56 | $14,158.44 | ||
| SUBSEQUENT TO JANUARY 1, 1909 | ||||
| Equipment notes: Series C | $36,639.13 | $3,110.87 | ||
| Equipment gold notes: | ||||
| Series D | 207,508.07 | 96,241.93 | ||
| Series F | 8,847.91 | 6,296.68 | ||
| 2 Series G | 73,654.31 | 107,581.67 | $107,581.67 | |
| Series H | 100,563.26 | 139,781.74 | 139,781.74 | |
| 427,212.68 | 353,012.89 | 247,363.41 | ||
| 1,236,254.24 | 367,171.33 | 247,363.41 | ||
*1013 Series "C" Equipment Notes issued as of April 1, 1909, were issued in 20 series of $265,000 each, the first series maturing April 1, 1910, and one series maturing each 6 months thereafter, the final series maturing October 1, 1919.
Series "D" Equipment Notes issued as of May 1, 1910, were issued in 30 series of $225,000 each, the first series maturing November 1, 1910, and one series maturing each 6 months thereafter, the final series maturing May 1, 1925.
Series "F" Equipment Notes issued as of August 1, 1911, were issued in 30 series of $12,000, the first series maturing February 1, 1912, and one series maturing each 6 months thereafter, the final series maturing August 1, 1926.
Series "G" Equipment Notes issued as of July 1, 1912, were issued in 30 series of $170,000 each, the first series maturing January 1, 1913, and one series maturing each 6 months thereafter, the final series maturing July 1, 1927.
Series "H" Equipment Notes issued as of July 1, 1913, were issued in 10 series of $441,000 each, the first series maturing July 1, 1914, and*3189 one series maturing each year thereafter, the final series maturing July 1, 1923.
The Collateral Trust Bonds issued as of May 1, 1902, were issued in 16 series, the first series amounting to $1,473,000, maturing May 1, 1903, and the remaining 15 series in the amount of $1,494,000 each, one series maturing each year thereafter, the final series maturing May 1, 1918.
*1014 6.
During the years 1916 and 1917 petitioner collected $4,480.33 and $8,360.22, respectively, in excess of passenger fares provided by its tariffs. These overcharges resulted from various causes, principally from the agent's error in computing the correct fare for a particular ticket; the error is discovered when the agent's accounts are audited, the name and address of the passenger are unknown and petitioner is unable to make any refund. The amount of such overcharge is held in Suspense Account and credited to Profit and Loss at the end of the year. Respondent included the aforesaid amounts in determining taxable income for the years 1916 and 1917.
7.
In the regular course of its business petitioner issues pay-checks, checks or vouchers in payment of loss and damage claims, and for various*3190 other disbursements. Many of these pay-checks are never called for by the employe entitled thereto; likewise, some of the checks and vouchers for loss and damage claims and other disbursements, which are delivered to the various payees, are never cashed. These checks and vouchers are directly charged out to operating expenses on petitioner's books, and are deducted on petitioner's income. tax returns for the year in which so charged. At the end of two years, such as have not been cashed are credited to Profit and Loss; in the event that any payee thereafter demands the sum due him, on account of such check or voucher, payment is made by petitioner accordingly, and the amount is charged to Profit and Loss. During each of the following years, the following sums were so credited by petitioner:
| 1916 | $26,070.72 |
| 1917 | 16,395.93 |
| 1918 | 19,091.53 |
| 1919 | 24,473.93 |
Respondent has considered as part of petitioner's Consolidated Income for each of said years, the respective amounts so stated. Any sums that have been charged to profits and loss as aforesaid have been allowed as deductions by respondent in computing net income of the year in which the charges were made.
*3191 8.
On January 15, 1912, petitioner sold $20,000,000 of its Debenture Bonds, maturing January 15, 1932, for the sum of $18,800,000. The discount of $1,200,000 was charged to profit and loss account in 1912, and a pro rata amount thereof was amortized by petitioner in each of *1015 the years 1912 to 1916, inclusive, the annual amount being $60,000, leaving $902,465.75 remaining unamortized at December 31, 1916. Said bonds were retired on July 2, 1917, and the discount remaining unamortized on that date amounted to $871,921.26.
The respondent allowed as a deduction from income for the year 1917 the sum of $30,544.49, being the aliquot portion (as computed by respondent) of the aforesaid annual portion for the period January 1, 1917, to July 2, 1917. The respondent also restored to invested capital the aforesaid sum of $30,544.49, being the average of the annual portion of $60,000 for the period January 1, 1917, to July 2, 1917.
The bonds were retired on July 2, 1917, by exchanging with the holders thereof petitioner's 6 per cent preferred stock, which is entitled to preferential dividends at the rate of 6 per cent annually, and also to accumulation of dividends remaining*3192 unpaid up to 5 per cent per annum, and likewise preferred both as to par value and accumulated unpaid dividends in any distribution of assets upon insolvency or dissolution of the corporation. Said exchange was made at the rate of $100 par value of stock for each $100 principal amount of said debenture bonds.
In an order made and entered by the State Public Utilities Commission of the State of Illinois on June 20, 1917, it was ordered:
2. That the six per cent preferred stock in the aggregate amount of $30,000,000 shall be sold or disposed of at not less than par and the proceeds thereof applied to the following purposes:
| (a) For the discharge or lawful refunding of obligations incurred for the construction, extension or improvement of or addition to its facilities, namely, the twenty-year debentures of The Chicago, Rock Island and Pacific Railway Company issued under the trust indenture of January 17, 1912, between said Company and Bankers Trust Company | $20,000,000 |
| (b) For the payment of claims allowed by the special master and approved by the United States District Court for the Northern District of Illinois in the receivership proceedings, pursuant to the final decree entered in said cause June 12, 1917, to be issued from time to time in such amounts as shall be allowed and approved, not to exceed | $10,000,000 |
| Total | $30,000,000 |
*3193 Petitioner has regularly paid semiannually the full 6 per cent annual dividends on said preferred stock from the date of its issuance to the present time.
The respondent did not allow as invested capital the effective average of the par value of the aforesaid preferred stock for the period July 2, 1917, to the end of the year, but deducted from the $20,000,000 par value of the stock issued the sum of $871,921.26, being the amount of the unamortized discount on the aforesaid debenture bonds at *1016 July 2, 1917, and allowed the effective average of the remainder in invested capital for the year.
9.
In 1902 a corporation was formed under the laws of Iowa, under the name "Chicago, Rock Island and Pacific Company." This Iowa corporation acquired $71,353,500 par value of petitioner's common stock in payment for which it issued, among other securities, $71,353,500 par value of its 4 per cent Collateral Bonds of 2002, for which said stock was deposited as security with a trustee. Said Iowa corporation also acquired and owned capital stock of the St. Louis & San Francisco Railroad Co. in payment of which it issued its Ten Year 5 Per Cent Collateral Bonds. In December, *3194 1909, the Iowa corporation desired to sell its St. Louis and San Francisco Railroad Co. stock, and in connection with this sale it was necessary to retire said 5 per cent collateral bonds. For such retirement said corporation had to raise $7,314,660.83 in cash. To provide this amount, petitioner advanced said sum to the Iowa corporation as a loan, and received therefor $7,500,000 par value of the Iowa company's 5 per cent Debenture Bonds, maturing September 1, 1913. At Maturity, these bonds were not paid, but were exchanged by the petitioner for an equal par value of the Iowa corporation's 5 per cent Debenture Bonds, maturing September 1, 1917. In November, 1914, the petitioner delivered bank $1,388,000 par value of these debenture bonds to the Iowa company, and received in lieu thereof $1,353,699.75, leaving a balance due to petitioner of $5,960,961.08. Petitioner ceased paying dividends on its capital stock early in 1914; for this reason the Iowa corpoation defaulted in the payment of interest on its outstanding Collateral Bonds of 2002. On December 31, 1914, the United States Court for the Southern District of New York authorized the sale of petitioner's stock, deposited as*3195 collateral security for said Collateral Bonds, to the representative of the Bondholders' Protective Committee. In June, 1915, the book value of the Debenture Bonds of the Iowa corporation owned by petitioner was written down $1to, and the balance, $5,960,960.08, was written off to Profit and Loss by petitioner's receivers. Said Debenture Bonds themselves were worthless in June 1915. On or about February 1, 1915, ten of petitioner's stockholders commenced an action in the Supreme Court of the State of New York, County of New York, against petitioner and 13 of its directors. The action was brought in behalf of said stockholders and all other stockholders of petitioner and for the benefit of petitioner. In the complaint it was charged that the Chicago, Rock Island & Pacific Railroad Co. had from the date of its organization been in full control of petitioner and its board of directors through the ownership of a majority of its *1017 stock; that the transactions above set forth were ultra vires and constituted a fraud on petitioner. In that action service of summons and complaint was made on petitioner and eight of its directors. The directors served and petitioner*3196 interposed answers denying the allegations of the complaint. Thereafter many proceedings were had in said action, including an appeal to the Appellate Division of the Supreme Court of New York, First Department, and an attempted appeal to the Court of Appeals of New York. No final judgment was entered in said action but the following offer was made by some of the dfendant directors:
That if the Railway Company and the receiver would release the individual defendants from all claims in favor of the railway Company and of the receiver against them or any of them, that the individual defendants would on their part, and in consideration thereof, do and perform the following:
(a) That they would purchase from the Joint Reorganization Committee of the Railway Company, or from any other persons or body, corporate or otherwise, entitled to dispose of the same on behalf of the Railway Company, $5,000,000, par value of the Six Per Cent preferred stock of the Railway Company, or of a new company which would succeed to the assets of the Railway Company; such $5,000,000 of such Six Per Cent Preferred Stock was to be issued in addition to the $20,000,000 thereof which would be offered in exchange*3197 to the holders of $20,000,000 of debentures of the Railway Company as hereinbefore described, and that such individual defendants would pay therefor the par value thereof, to wit, $5,000,000.
(b) That in addition to the foregoing purchase and payment, the individual defendants would pay to the Railway Company, or to its successor and successors, or to the Joint Reorganization Committee for the corporate purposes of the Railway Company or its successor and successors, the sum of $500,000.00 in cash, and
(c) That the individual defendants would pay to your petitioner the total amount of their expenses and disbursements incurred in the institution and carrying on of the action brought by your petitioners in the Supreme Court of the State of New York hereinbefore referred to, together with the fees, expenses and disbusements of the counsel for your petitioners in that action, the aggregate amount thereof to be agreed upon between counsel representing the said defendants and counsel representing your petitioners, and in the event of their failure so to agree, that the amount thereof should be fixed and determined by this Court.
Said offer was presented to the District Court of the*3198 United States for the northern district of Illinois in the action in which the receivership proceedings were then pending and was on January 29, 1917, approved by that court, conditional upon the event that the "Plan of Organization" heretofore referred to should become operative and carried into effect. Thereafter the amounts agreed to be due by said defendant directors were paid for the purposes set forth in the offer. Petitioner filed with the Collector of Internal Revenue at Chicago, Ill., on or about January 21, 1928, its amended tax return for the year 1915 wherein it took no deduction of $5,960,960.08 as a loss in *1018 that year. Said amount appeared as a deduction in petitioner's original return for 1915. No deduction was allowed by respondent in determining taxable income for the year 1917.
10.
On April 20, 1915, receivers of the railway and properties of petitioner were appointed and said receivership continued until June 24, 1917, inclusive. During the receivership various committees were formed and in November, 1916, a General Reorganization Committee was formed as heretofore set forth. Said committee issued the "Plan and Agreement of Reorganization" *3199 on November 14, 1916, as heretofore set forth. Petitioner was not a party to the agreement. All funds received by the Reorganization Committee were provided to be held and disbursed by it for the purpose of the "Plan and Agreement." The committee came into possession of funds from assessment on stockholders and from other sources and said funds were deposited by the committee with the Bankers Trust Co., New York City, in a special account known as "Assessment Account (Common Stock)." The bank allowed interest at the rate of 2 per cent per annum on daily balances on said account. The following statement shows amounts received and disbursed by said committee as of close of business on July 25, 1917:
| AMOUNTS RECEIVED | |
| Installments received from holders of common stock | $29,303,960,00 |
| Advanced by Bankers Trust Co. to pay the unpaid installments of $29,743,889 | 118,200.00 |
| Paid by underwriters against unassented stock | 321,729.00 |
| Funds transferred from Chicago (by the C.R.I. & P. Ry. Co.) | 838,194.44 |
| Settlement of suit against directors | 5,500,000.00 |
| Interest allowed by bankers on deposits | 66,747.74 |
| Additional interest received | 1,835.53 |
| 36,150,666.71 | |
| AMOUNTS DISBURSED | |
| Retirement of First Mortgage Bonds with interest | $12,875,000.00 |
| Retirement of Receivers Certificates | 5,552,000.00 |
| Payment of Collateral Trust Notes | 7,500,000.00 |
| Payment of Hayden, Stone & Co. Loan, with interest | 1,601,600.00 |
| Payment of Central Trust Co. Loan, with interest | 2,538,194.44 |
| Funds paid to Bankers Trust Co. to cover cash payment of outstanding debentures | 1,958,400.00 |
| To acquire Consolidated Indiana Coal Co. bonds with interest | 1,728,597.55 |
| Funds deposited with Bankers Trust Co. to pay $1 per share on 7 per cent preferred stock | 297,439.00 |
| Organization expenses by Reorganization Committee | 316,584.22 |
| Reorganization expense disbursements by B. W. Jones | 1,750,000.00 |
| Cash on hand | 32,851.50 |
| 36,150,666.71 | |
*3200 *1019 The amount of $5,500,000 which was received in settlement of the suit by a part of the stockholders against the directors was paid to said committee on July 2, 1917. The first of the payments on which interest was received was received by the committee on February 2, 1917. The amount of $32,851.50 shown above was also expended by the committee with the exception of a small sum, less than $1,000, which was returned to petitioner. The respondent included in taxable income the interest aforesaid for the year 1917.
11.
During the year 1918 petitioner acquired all of the capital stock of the Consolidated Indiana Coal Co., and for that part of said year during which said 100 per cent stock ownership existed, petitioner included the Coal Company in its consolidated return. On May 29, 1905, said Coal Company issued first mortgage bonds of the face value of $2,336,000 in payment for coal lands and mining properties. As part of the reorganization of petitioner incident to its receivership during the period April 19, 1915, to June 24, 1917, the reorganization committee purchased said first mortgage bonds of the Coal Company which were then outstanding in the lands of*3201 the public; the funds for said purchase were furnished by petitioner. The total purchase price paid to obtain said bonds was $2,022,011.85, being $313,988.15 less than the par value thereof. Respondent, in its 30-day letter dated January 7, 1924, has included said last named sum as part of petitioner's consolidated income for the year 1918, the year during which said bonds were canceled and retired by the Coal Company.
The aforementioned adjustment was also reflected in the 60-day letter. The accounts with said coal company were kept and its Federal income and profits-tax returns were regularly rendered on an accrual basis. The aforementioned bonds were retired during that portion of the year 1918 during which the coal company and petitioner were affiliated.
12.
On January 26, 1920, petitioner and the Chicago, Rock Island & Gulf Railway Co. entered into a single contract with the Director General for compensation for the use of their properties during Federal control.
Section 7(d) of said contract provides:
Upon the cost of additions and betterments, less retirements in connection therewith, and upon the cost of road extensions, made to the property of the Companies*3202 during Federal control, the Director General, shall, from the completion of the work, pay the Company a reasonable rate of interest, to be fixed by him on each occasion. In fixing such rate or rates he may take into account *1020 not merely the value of money but all partinent facts and circumstances, whether the money used was derived from loans or otherwise, provided that to the extent that the money is advanced by the Director General or is obained by the Companies from loans or from the proceeds of securities the rate or rates shall be the same as that charged by the Director General for loans to the Companies or to other companies of similar credit.
The last named company owns and operates that portion of the Rock Island's system situated in Texas, and all of its capital stock is owned by the Chicago, Rock Island & Pacific Railway Co. The Director General allowed said companies $100,256.06 as interest rental on completed additions and betterments made during the year 1918. The director General did not allocate this sum as between the two companies, but petitioner allocated $96,115.49 to itself and $4,140.57 to the Chicago, Rock Island & Gulf Railway Co. Petitioner*3203 included said $100,256.06 in its amended consolidated income-tax return for the year 1918; but respondent has refused to allow said sum as income for the year 1918, but has treated said amount as income for the year 1922.
The Director General allowed said companies $325,885.64 as interest renal on completed additions and betterments made during the year 1919. Of this sum, petitioner allocated $312,426.56 to itself, and $13,459.08 to the Chicago, Rock Island & Gulf Railway Co. Petitioner included said $325,885.64 in its amended consolidated income-tax return for the year 1919; respondent has refused to allow said sum as income for that year, but has treated said amount as income for the year 1922.
Petitioner purchased and received delivery of 30 locomotives in the year 1918, and paid for the same from its corporate funds. The Director General allowed petitioner as interest rental for the year 1918 on said locomotives, the sum of $62,111.86, and for the year 1919, the sum of $94,461.76. Petitioner included these sums as income in its amended income-tax returns for the years 1918 and 1919, respectively, but respondent thereafter excluded said amounts as part of petitioner's*3204 income for 1918 and 1919, respectively, and has treated said amounts as income to petitioner for the year 1922.
By section 7 of the aforementioned contract the Director General guaranteed petitioners as annual compensation the amount of $15,880,681.22 during each year and pro rata for each fractional part of a year of Federal control, subject to certain findings by the Interstate Commerce Commission. Subsequent to January 26, 1920, the Interstate Commerce Commission determined such annual compensation to be at the rate of $15,710,405.93.
13.
Respondent has reduced petitioner's invested capital for 1917 by the amount of $421,580.98, representing the discount sustained or *1021 incurred by petitioner in connection with the sale of its Equipment Bonds, Series "G," sold July 1, 1912, and Series "H," sold July 1, 1913. Said $421,580.98 was charged by the petitioner to Profit and Loss Account at the time such discounts were sustained, and was not charged by petitioner to Investment Account. As of December 31, 1916, the amount of discount theretofore amortized, according to respondent's method of calculating such amortization, was as follows:
| Series G | $117,768.14 |
| Series H | 164,269.14 |
*3205 The amount remaining unamortized was -
| Series G | $63,467.84 |
| Series H | 76,075.86 |
Respondent has deducted said $282,037.28 from petitioner's Profit and Loss Account, and has not added back to Profit and Loss Account said $139,543.70. The total of these two figures is $421,580.98.
OPINION.
MILLIKEN: The facts of these proceedings were either stipulated or consist of admissions made by respondent in his pleadings.
These proceedings involve two distinct classes of issues: those which relate to taxable income, and those which relate to invested capital. We will first dispose of the issues relating to taxable income.
Issue 1. Respondent refused to permit petitioner to deduct from gross income amounts paid by it to the United States as penalties for the violation of certain Federal statutes which are referred to in the findings of fact. This question was before us in
Issue 2. Petitioner complains that respondent credited its operating expenses for the years 1916 and 1917 in amounts representing expenses of transportation for investment. The facts, with reference to this contention, were not stipulated. Respondent in his answer denied the allegations of the petitions and followed his denials with an admission which we have incorporated in our findings of fact. The facts as found are quite meagre and are not sufficient to bring before us the contention vigorously urged by petitioner in the brief filed in its behalf. However, the contentions urged were considered by us in
Issue 6. During the years 1916 and 1917, petitioner collected $4,480.33 and $8,360.22, respectively, in excess of passenger*3207 fares as fixed by its tariffs. These amounts resulted from the agent's errors in computing the correct fares for passengers. Since the names and addresses of the passengers so overcharged were not known, it was impossible to make refunds. The amounts received by petitioner were paid for the right to travel over its road. They were income unless the fact that the overcharges were unlawful takes these items out of that category. That such is not the case see
Issue 7. During each of the years in question petitioner credited to profit and loss pay checks, checks or vouchers in payment of loss and damage claims, pay rolls, and for various other ordinary and necessary expenses which had in previous years been issued and had not for a period of two years been presented for payment. The checks when issued were charged out to operating expenses, deducted and allowed as a deduction by respondent in the determination of taxable income. Petitioner allowed two years to intervene and if the checks had not been presented for payment it credited the same to profit and loss. Respondent in auditing the returns added such sums to income.
Petitioner does not claim that the deductions theretofore allowed by reason of these checks should be restored to taxable net income for the earlier years, but desires to retain the benefit of the same. Neither has petitioner advanced any suggestion as to when, if ever, any adjustment should be made for the checks uncashed. We assume it to be the position of petitioner that such adjustment would never be made. Section 13(d) of the Revenue Act of 1916 and section 212 of the Revenue*3209 Act of 1918 provide a latitude as to the manner in which books of account may be kept in order to reflect taxable income. The books of petitioner were kept and maintained on the accrual basis during all of the years in question and pursuant to the sections *1023 of the statutes aforesaid. It was permitted to deduct expenses for which checks were issued regardless of the date of the cashing of the checks by the parties to whom issued. After two years had elapsed the checks were credited to a profit and loss account. Petitioner followed this course in order that its books of account might reflect a true and accurate state of affairs. The Interstate Commerce Commission authorized and required such procedure. So far as we are advised this has been the uniform and consistent practice of petitioner in treating such items. If subsequent events, due to the failure to cash the checks show such charges to have been in error, petitioner restored the same to income, thus correcting what had been theretofore eliminated therefrom. We should be very cautious in disturbing such a consistent practice pursued by petitioner and one having the sanction of the Interstate Commerce Commission. *3210 Any large business enterprise, especially a common carrier, should adjust its income accounts so as to be an accurate reflection of income.
It is undisputed that in a strict legal sense, petitioner has not derived income.
Petitioner also submits that if, after two years, the person to whom the checks were issued submits them for payment, they are honored. The system of accounting employed by petitioner will logically take care of this situation and the respondent agrees that there would thus arise a deduction from income on account thereof. It is also significant to note that in the years before us none of the*3211 checks of the character above referred to are in question. In reaching our conclusion, we have not failed to take into consideration the fact that bookkeeping entries do not constitute income.
Petitioner cites in support of its position the decision of the United States Supreme Court in
*1024 Issue 10. Petitioner in its amended answer filed June 12, 1928, seeks to transfer from the year 1915 to the year 1917 a loss of $5,960,960.08 arising from its transactions*3212 with the Chicago, Rock Island & Pacific Railroad, an Iowa corporation. It is stipulated that in December, 1909, the Iowa corporation needed $7,314,660.83 to retire certain of its outstanding bonds, and that "To provide this amount petitioner advanced said sum to the Iowa corporation as a loan and received therefor $7,500,000 par value of the Iowa company's 5 per cent Debenture Bonds maturing September 1, 1913." In November, 1914, peitioner delivered back $1,388,000 par value of these debenture bonds to the Iowa company and received in lieu thereof $1,353,699.75, leaving a balance due to petitioner of $5,960,961.08. In June, 1915, the book value of the debenture bonds of the Iowa corporation owned by petitioner was written down to $1 and the balance, $5,960,960.08, was written off to Profit and Loss by petitioner's receivers. Said debenture bonds themselves were worthless in June, 1915. It is further stipulated that petitioner's receivers deducted said loss on their tax return on behalf of petitioner for the year 1915, but that on or about January 21, 1928, petitioner filed an amended return for 1915, in which said deductions was not taken.
Section II G (b) of the Act of October 3, 1913, grants*3213 to corporations the right to deduct from gross income "all losses actually sustained within the taxable year and not compensated by insurance or otherwise, * * *." The question presented is, Did petitioner actually sustain a loss in 1915 in respect to its loan to the Iowa company? In this connection it is pertinent to point out that the deduction was taken in a tax return made after the end of 1915, and that the stockholders' proceeding against the directors and petitioner was begun in February, 1915. The receivers, with knowledge of that proceeding, deliberately charged off of petitioner's books a debt of nearly $6,000,000, and deducted the same loss in their income-tax return. The reasons for this procedure are obvious - the Iowa company, which owed the debt, was insolvent; its bonds were worthless; the debt was worthless. The fact that a few stockholders were pursuing some of petitioner's directors, charging fraud, does not militate against the fact that petitioner sustained an actual loss in the year 1915. Whether such fraud would be established was entirely problematical. In fact, to this day, no such fraud has been found or decreed by any court; nor has such fraud been*3214 confessed. The directors offered to pay to petitioner or to its receivers less than one-eleventh of the principal amount involved, to say nothing of interest for over 7 years. There is nothing in the record which indicates that the directors were not financially able to pay the whole amount. It seems evident that this comparatively small amount was paid, not as a confession of wrongdoing, but to procure the dismissal of an annoying *1025 proceeding. If the court had thought the claim valid, it certainly would not have approved the acceptance by its receivers of this offer. If the receivers had thought that there was any merit in the claim they would not have written the debt off in 1915. They were not required to be "incorrigible optimists."
Issue 11. The sum of $68,583.27 received by the reorganization committee as interest on its daily bank balance was undoubtedly taxable income. The question is, To whom was such income taxable? We may at once eliminate the individual members of the committee and the committee as an organization. Neither was entitled to*3215 the interest. The committee received the amounts paid by the stockholders and other depositors for specified purposes. This leaves only the various depositors which included the subscribing stockholders and petitioner. Under the "Plan of Reorganization," the stockholders were to subscribe and pay for the 7 per cent preferred stock at par, the payments to be made through the committee. Whenever a stockholder made a deposit his only specified right was to receive the stock for which he had subscribed. It seems conceded that such stockholders had no right to the interest. There is nothing either in the agreement or the plan of reorganization which makes any provision for them in this respect. No part of the interest was paid to them. This was the construction placed on the plan and the agreement by the parties themselves. Petitioner points out that it is stipulated that petitioner was not a party to the agreement. This does not conflict with the fact that the agreement was made for its benefit, that it was the sole beneficiary thereof, nor with the fact that other agreements may have been entered into between petitioner and the committee. In fact, it was first stipulated that*3216 "the railway company was not a party to the agreement in any manner," and by a subsequent stipulation the words underscored were eliminated. The record discloses that petitioner contributed to the committee $838,194.44 from its own funds and that there was paid to the committee $5,500,000, which was received from the directors as the result of the stockholders' suit, and which clearly belonged to petitioner. It is stipulated that the committee purchased bonds of the consolidated Indiana Coal Co. and paid therefor $2,022,011.85, and that "the funds for said purchase were furnished by petitioner." Finally, it is stipulated that after all expenditures had been made by the committee a small sum, less than $1,000, was returned to petitioner. Since provision was not specifically made in the plan or the agreement of reorganization for any of these transactions, there must have been other agreements between the committee and petitioner or petitioner's receivers not provided for in the plan. What these agreements *1026 were is not disclosed. It is sufficient to point out that every expenditure made by the committee redounded to the benefit of petitioner. The amounts which were*3217 paid by the committee for services and expenses were just as much for petitioner's benefit as though expended by petitioner itself. Under all the facts of the record, we are of the opinion that since petitioner was the sole beneficiary of the funds held by the committee, the interest on these funds constituted taxable income to it. Cf.
Issues 14, 15, and 16. These issues relate to interest, rentals and compensation earned by petitioner during Federal control during the years 1918 and 1919, but which were paid by the Director General in a subsequent year. Since petitioner was on an accrual basis these amounts constitute taxable income in the year earned and its contentions must be resolved in its favor on the authority of
Point 17. During the period April, 1915, to June, 1917, petitioner, through the reorganization committee, purchased from the public the outstanding bonds of the Consolidated Indiana Coal Co. of the face value of $2,336,000, for which it paid the sum of $2,022,011.85. During the year 1918 petitioner acquired all the capital stock of the Coal Company and for that part of 1918 during which such ownership existed it included the Coal Company in its consolidated return. The Coal Company retired said bonds during the period of affiliation whether by cancellation or payment and, if by payment, at what amount does not appear. On these facts respondent has determined that the affiliated group was in receipt of income to the extent of $313,988.15, which was the difference between the par value of the bonds and the amount paid for them by petitioner during the period 1915-1917.
It is clear petitioner made no gain at the time it purchased bonds at a discount; neither did the Coal Company lose anything by reason of the transaction. No funds of either company were used during the period of affiliation to purchase the outstanding obligations*3219 of the Coal Company. It appears that there was no affiliated group in existence at the dates of the purchases to which the purchases might be attributed. Petitioner, as a distinct taxable entity, purchased the bonds and subsequently brought them into the affiliation, at which time they became intercompany obligations, the payment or collection of which produced neither income nor loss. Cf.
Issues 3, 4, and 5. We have reserved the question of deduction of amortized discount and expenses for the reason that it is so intimately connected with invested capital that both issues should be discussed together and in the older in which they arise.
Petitioner complains that respondent erred in refusing to permit the deduction from its gross income of any part of the discount and expense incurred in connection with the sale of its First and Refunding Bonds sold during the period 1904-1908; and further, that although respondent allowed as a deduction an amortized part of the discount on its Equipment Bonds which matured serially and on its Collateral Trust Bonds issued in 1902, which also matured serially, he erred in his method of computing such amortization.
Respondent in the instance of the First and Refunding Mortgage 4% Gold Bonds which were issued and sold during the years 1904 to 1908 refused to allow any part of the discount and expenses applicable thereto for the reason that on the books of account of petitioner the discount and expenses were charged to profit and loss or surplus account prior to January 1, 1909. If, however, petitioner had charged*3221 the discount and expenses on its books to a reserve for "unamortized discounts and expenses on bonds" he would, pursuant to his regulations promulgated on the subject, have allowed the deductions now claimed for the years in question and also if the bonds had been issued at a discount subsequent to January 1, 1909, a deduction would have been allowed notwithstanding the manner in which it was reflected on the books of account. Apparently, therefore, the controlling factor is the manner in which the discount was reflected upon the books of account. We can see no merit in the respondent's action in so far as it is dependent upon the manner in which the account is reflected upon the books. Bookkeeping entries can not control over the actual facts, and if necessary they should be corrected to correspond with the true facts. If the bond discount is to be disallowed as a deduction the denial must rest on more substantial grounds.
Both parties refer to
On
Article 544 of Regulations 45, based upon the Revenue Act of 1918, provides:
(2) (a) If bonds are issued by a corporation at a premium, the net*3223 amount of such premium is gain or income which should be prorated or amortized over the life of the bonds.
(3) (a) If bonds are issued by a corporation at a discount, the net amount of such discount is deductible and should be prorated or amortized over the life of the bonds.
It is to be borne in mind that the premiums here in question were received by the Old Colony not later than 1904 and during a period of time when there was no Federal statute authorizing the laying and collection of taxes on incomes, and several years prior to adoption of the
The question then is whether the premiums that were received by the taxpayer not later than 1904, are income of the taxpayer that may be amortized over the life of the bonds and the sum or part of the premiums apportioned to the year 1920 be taxed in 1920 to the taxpayer as a part of its income in that year under Sec. 213(a) and 212(b) of the Revenue Act of 1918.
If it be*3224 assumed that the premiums received in 1904 and prior thereto were income, can they be said to be taxable income "for the taxable year in which received by the taxpayer" (Sec. 213(a)), "which should be prorated or amortized over the life of the bonds" (Art. 544, Reg. 45, 2(a)). It seems to us that the answer to this question disposes of the case, and that the answer must be in the negative. The premiums, when received, were treated and used as capital. They were not received in 1920, the tax year in question, but some 16 or more years prior thereto. At that time there was no Federal statute imposing a tax upon incomes and no provision of the Constitution giving Congress power to lay or collect taxes on incomes without apportionment, which the Revenue Act of 1918 unquestionably does. It is not to be presumed that Congress by the Act of 1918 intended to tax the whole or any part of the premiums on bonds received prior to February 25, 1913, whether the life of the *1029 bonds extended into a taxable year subsequent to February 25, 1913, or not, as it was beyond its power to do so at the time they were received. See *3225
This question, as we understand it, has not heretofore been passed upon by any court. A somewhat analogous question was decided by the Court of Claims, in the case of
The decision of the Board of Tax Appeals is affirmed.
It will be observed that the court had before it for decision the sole question whether any part of premiums received prior to March 1, 1913, was taxable in the year 1920. This issue the court decided in the negative. Whether discount incurred in the sale of bonds prior to March 1, 1913, should receive like treatment was not before the court. Neither was it before us when we decided the case. What was said by the court and what was said by us in respect of this issue was merely dicta. The Circuit Court of Appeals in affirming the decision of the Board primarily based its decision on the fact that the bond premium was received prior to February 25, 1913, and that it was beyond the power of Congress to tax the whole or any part of the premiums so received, regardless of whether the life of the bonds extended into a taxable year subsequent*3227 to the enactment of the
What is income is controlled by the Constitution, while deductions are a statutory concept. In the years before us, the petitioner was on an accrual basis for the reporting of income, not only because that was the system necessary to reflect true income, but because the Interstate Commerce Commission required such a basis. Income realized before the adoption of the
Respondent's regulation, beginning with articles 149 and 150 of Regulations 33 (Revised), (with an exception which we will refer to later) have consistently provided that discount on bonds issued by a taxpayer should be prorated over the life of the bonds and an aliquot part thereof be deducted from gross income each year. See article 544, Regulations 45, and article 545 of Regulations 62, Regulations 65 and Regulations 69. These regulations have been in effect for over 10 years and have been applied by respondent in all cases of discount on bonds sold except as provided in article 149, Regulations 33, which will be noticed later. Under these circumstances these regulations should not be lightly disregarded unless they are in conflict with the provisions of the statute. It is significant that they are in harmony*3231 with general accounting practice, which treats discount as deferred interest to be spread over the life of the obligation. Further, they coincide with general business usage. Whenever a corporation contemplates issuing longterm securities, three methods present themselves: Shall the bonds carry the market rate of interest and be issued at par, or shall they carry a greater rate than the market rate and be sold at a premium, or shall they carry a rate less than the market rate and be sold at a discount? Which of these methods should be pursued is determined by the present needs and the future prospects of the company, but it matters not which plan is adopted, other things being equal, the rate of interest finally paid will be the market and not the contract rate. The true income of the company can be reflected only when the discount is spread over the life of the bonds. The most material element in determining the contract rate of interest, that is, whether the bonds shall be sold at par or at a premium or discount, is time. Thus no one would consider the proposition that he pay a premium for bonds payable at once nor would one issue bonds at a discount which are due and collectible*3232 the day they are issued. Since time is such a vital element in determining premium and discount, it is difficult to perceive why this element should not be taken into consideration in determining taxable income - why time should not be used as a divisor in order to allocate to each period of time that part of the discount which is greater or less by reason of time.
The question remains, Is this method, which is in harmony with general accounting practice and with business usage, in conflict with the Revenue Acts of 1916 and 1918? Section 13(d) of the Revenue Act of 1916 provides:
(d) A corporation * * *, keeping accounts upon any basis other than that of actual receipts and disbursements, unless such other basis does not *1032 clearly reflect its income, may, subject to regulations made by the Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury make its return upon the basis upon which its accounts are kept, in which case the tax shall be computed upon its income as so returned.
Section 212(b) of the Revenue Act of 1918, which is made applicable to corporations by section 232, provides in part:
(b) The net income shall be computed*3233 * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. * * *
Section 200 of the Revenue Act provides that the term "paid" includes "paid or accrued." In
will be permissible for corporations which accrue on their books monthly or at other stated periods amounts sufficient to meet fixed annual or other charges to deduct from their gross income the amounts so accrued, provided such accruals approximate as nearly as possible the actual liabilities for which the accruals are made, and provided that in cases wherein deductions are made on the accrual basis as hereinbefore indicated, income from fixed and determinable sources accruing*3234 to the corporations must be returned, for the purpose of the tax, on the same basis.
After pointing out that the Corporation Tax Act of 1909 and the Revenue Act of 1913 provided "in terms that net income should be ascertained by deducting from gross income received, interest, expenses and taxes actually paid and losses actually sustained," and after stating that the difficulty in administering these Acts resulted in the promulgation of certain regulations which permitted to a limited extent the return of income on an accrual basis and that section 13(d) went much further than these regulations, the court said:
A consideration of the difficulties involved in the preparation of*3235 an income account on a strict basis of receipts and disbursements for a business of any complexity, which had been experienced in the application of the Acts of 1909 and 1913 and which made it necessary to authorize by departmental regulations, a method of preparing returns not in terms provided for by those statutes, indicates with no uncertainty the purpose of sections 12(a) and 13(d) of the Act of 1916. It was to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income *1033 earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period; and indeed, to require the tax return to be made on that basis, if the taxpayer failed or was unable to make the return on a strict receipts and disbursements basis.
We are of opinion that in an economic and accounting sense, the discounts, herein involved, are in the nature of deferred interest, that they may be accrued and that the proper proportionate part applicable to each taxable year involved may be taken as a deduction from gross income in such year, and that this concept is not*3236 in conflict but rather in harmony with the provisions of the Revenue Acts of 1916 and 1918. This view is not in conflict with
The company owned many bonds, etc., payable at future dates, purchased at prices above their par values, and to amortize these premiums a fund was set up. It claimed that an addition to this fund should be deducted from gross receipts. The District Court thought the claim well founded, *3237 but the Circuit Court of Appeals took another view. Unless the addition amounted to a loss "actually sustained within the year" no deduction could be made therefor. Obviously, no actual ascertainable loss occurred. All of the securities might have been sold thereafter above cost. The result of the venture could not be known until they were either sold or paid off.
In that case the insurance company could shift the loss or perhaps make a profit. Here petitioner was bound to pay the discount. It is true the possibility existed that petitioner might become insolvent and obtain relief in paying its bonds at less than par, but we have no more right to anticipate such a situation here than to hold that no income or loss occurred in the taxable year because loss or income was made in the succeeding year. If we indulged in such prognostications in all cases the accrual system of accounting would be set at naught.
It is pertinent at this period to state that respondent has denied petitioner the right to deduct amortized discount on all bonds sold prior to the year 1909. This is in accord with article 149 of Regulations 33 (Revised). This regulation was based on what we conceive*3238 *1034 to be an erroneous interpretation of the decision in
This brings us to the question whether respondent used the proper method in computing the amortization of discount on petitioner's bonds which matured serially. Respondent computed the discount on these bonds under the formula laid down by him in
Where bonds mature serially a proper proportion of the total expense of floating the bonds should be allocated to each*3239 series and each series then treated as a separate unit. The deduction applicable to each series should be prorated equally over the life of the bonds constituting the series, provided, however, that if the corporation retired any of the bonds before maturity, the deduction for that year should be increased by an amount equivalent to the amount which would ordinarily be deducted duing the succeeding years on account of those particular bonds if they had not been prematurely retired.
Petitioner contends for the method prescribed by the Interstate Commerce Commission and which respondent has now adopted (see
* * *
The amount of each series of bonds should be multiplied by the number of years it has to run, the product representing an amount equivalent to the series as though outstanding for one year.
To any series of bonds should be allocated that proportion of the total discount (or premium) which the product for such series bears to the sum of the products for all the series.
The portion of the discount (or premium) thus applicable to any series of bonds should then be prorated equally over*3240 the life of the bonds constituting such series.
* * *
Since we are treating discount as deferred interest, the formula contended for by petitioner and now adopted by respondent, in our opinion, coincides with such concept.
The next question under these three issues is whether respondent erred in refusing to deduct an amortized part of the expense incurred in issuing its First and Refunding Bonds, the last of which were sold in 1908. Here we have no question of deferred liability, but the *1035 payment of an expense made prior to March 1, 1913. Waiving for the moment the question how such expenses should be treated if made subsequent to such date, we are of opinion that since the Circuit Court of Appeals has held in the Old Colony Railroad Co. case, supra, that premiums actually received prior to March 1, 1913, are not taxable income, by the same token, expenses actually paid prior to said date are not deductible from gross income of taxable years. Respondent did not err in refusing this latter deduction.
At this point respondent affirmatively pleads that he erred in allowing the deduction of any amortized part of the expense paid in connection with any*3241 of the issues of bonds by petitioner. With the exception of bonds issued prior to March 1, 1913, the facts as stipulated, do not show that there was any expense incurred in selling any other bonds. However, it is stated in the briefs filed in behalf of both petitioner and respondent that petitioner incurred bond expenses in 1917 and 1919 in the respective amounts of $48,260.50 and $53,610.25 and that respondent has allowed as deduction an amortized part of such expense. Since respondent has by his amended answer opened this phase of the case and since the parties are agreed upon the facts, we will now determine whether respondent's action in this respect was proper. Respondent draws a distinction between discount and such expenses and contends that unlike discount, such expenses do not partake of the nature of interest since they were paid to persons other than the lenders of the money. We are not impressed by this contention. While such expenses do not so nearly coincide with the concept of interest, they are, nevertheless, intimately connected with the loan and in fact constitute a part of the cost of the money borrowed. We see no reason for divorcing them from the loan and*3242 holding them annual expenses. In
* * * Further, it is clear to us that the revenue of a day or a year should not be burdened with the cost of acquiring additional capital, the benefits from which will inure to the corporation over a long period of years. This is the doctrine generally recognized and adopted in the treatment of expenses incident to the procuring of temporary capital through the flotation of bonds and other term securities, and in such cases the expenses are written off over the life of the indebtedness.
Respondent did not err in respect of the deduction of amortized expenses in connection with the bonds sold in 1917 and 1919.
Issue 9. The facts with reference to this issue are that on July 15, 1912, petitioner sold $20,000,000 par value of its Debenture Bonds for *1036 the sum of $18,800,000, or at a discount of $1,200,000. On July 2, 1917, it exchanged for those debentures*3243 its second preferred stock of the same par value. On this latter date the unamortized discount on the debentures amounted to $871,921.26. Petitioner asserts that by this transaction it lost the latter amount and should be permitted to deduct it from its gross income for 1917.
We are aware of the fact that, in accounting, unamortized discount appears on the asset side of the balance sheet as a deferred expense, but it does not follow that such treatment can give value to what in fact is a liability. Without value there can be no deductible loss. Unamortized discount represents that part of the total discount for which no provision has been made in the way of reduction of surplus or otherwise. It represents not value but liability, the extinction of which, under the facts of the transaction, did not result in deductible loss. Petitioner did not sell its bonds for cash, and with this or money from any other source, pay off the bonds. It exchanged its stock for its bonded liability. This was a purely capital transaction, which did not result in deductible loss or taxable gain. Cf. *3244
Issue 22. During the period 1904-1908, petitioner sold its First and Refunding Mortgage bonds at a total discount of $9,344,167.43 and at a total expense of $256,686.08. The unamortized amount of both discount and expense on December 31, 1916, was $6,036,171.90. The latter amount respondent excluded from invested capital for the year 1917 on the same ground that he had disallowed it as a deduction. For the reasons heretofore given, we are of opinion that respondent did not err in so far as the expenses were concerned. They were actually paid prior to March 1, 1913, and can not be carried beyond that date either for the purpose of deduction or for the purposes of invested capital. In both cases they should be treated alike.
As we have pointed out, discount is in fact a deferred interest charge which is not paid by one on a cash basis until the debt is paid and which may be accrued*3245 by one on an accrual basis. Since it appears that the whole discount was charged to profit and loss, at the date of the sale of the bonds, and since this discount should not have been so charged but should have been treated as deferred interest and as such accrued over the life of the bonds, it follows that this charge should be removed with its attendant effect upon surplus. Profit and loss should then be reduced each year by the amortized part of the discount with the final result that surplus instead of being reduced at the outset is reduced in the end by precisely the same *1037 amount. Since the total discount was deducted when the bonds were issued, the true surplus at the beginning of any year is computed by restoring to surplus the unamortized discount. This is the theory and this theory assumes the existence of a surplus. For the purpose of this discussion, we include undivided profits in the term "surplus." In
Both these terms as commonly employed in corporate accounting denote an excess in the*3246 aggregate value of all the assets of a corporation over the sum of all its liabilities including capital stock.
The surplus which may be included in invested capital is an actual, not a paper surplus. Until such a surplus exists, no charge against profit and loss can be reflected in surplus and since nothing is taken from surplus there is nothing to restore. This general rule is, of course, subject to exceptions, one of which is that subsequently a surplus may be paid in or earned in which might be reflected the charge against profit and loss.
In the instant case we are not informed whether petitioner had a surplus, and if so, in what amount, when the bonds were sold. Neither are we informed what effect the period of financial stringency through which it had just passed and the receivership had on its surplus. For all we know, petitioner's capital may have been impaired, in which case such impairment must have been made good before there could be a surplus.
Issues 23 and 24. The first of these issues involves the reduction of petitioner's invested capital for the year 1917 by the amount of the discount incurred in connection with the sale of its Equipment Bonds, Series "G," issued July 1, 1912, and Series "H," issued July 1, 1913. Respondent appears to have assumed that the discounts on these bonds had been charged to Investment Account, when in fact they were charged to Profit and Loss Account. The second of these issues involves the contention that respondent erred in computing the amortized discount on Series "C," "D," "F," "G," and "H" of its Equipment Bonds issued respectively on April 1, *1038 1909, May 1, 1910, August 1, 1911, July 1, 1912, and July 1, 1913, and on its Collateral Trust Bonds issued May 1, 1902.
Irrespective of the character*3248 of entry made when Series "G" and "H" were issued but subject to the limitation laid down under issue 22, we are of opinion that the unamortized discount on all the abovementioned bonds should be restored to surplus and that the discount on all the bonds which matured serially should be computed under the formula set forth under issues 4 and 5.
Issues 26 and 29. Under the first of these issues, petitioner contends that respondent erred in reducing its invested capital by the sum of $871,921.26 "as representing an alleged discount on $54,422,160 par value of stock issued by the taxpayer on July 2, 1917, whereas said stock was issued at par."
The issue of stock in the amount of $54,422,160 included an issue of second preferred 6 per cent stock in the amount of $20,000,000. This issue petitioner on July 2, 1917, exchanged at par for $20,000,000 (the whole issue) of its Debenture Bonds issued in 1902 and for which it had received $18,800,000. On the date of the exchange, the unamortized discount on these debentures amounted to $871,921.26. This amount respondent deducted from the $20,000,000 par value of the second preferred stock and allowed the effective average of the remainder*3249 in invested capital for the remainder of the year. Petitioner contends that the effective average of the par value of the stock issued on July 2, 1917, should be included in invested capital for that year.
Under issue 29 petitioner asserts, apparently as an alternative, that it is entitled to include in invested capital for 1917 the sum of $421,924.38, representing the balance (after giving effect to $30,544.49 allowed by respondent) of 183/365 of the total unamortized discount on said Debenture Bonds as of December 31, 1916.
Invested capital consists, broadly speaking, of money or property paid in for capital stock and paid in and earned surplus. Petitioner insists that since its debentures were received in exchange for its stock, we should hold that they were paid in for capital stock and since as it asserts, there is no evidence in the record to the effect that these debentures were worth less than par, the result is that $20,000,000 in debentures was paid in for $20,000,000 stock, and, further, that we can not go behind the finding of the Public Utilities Commission of Illinois.
The facts as stipulated show that this exchange was made just after petitioner had emerged*3250 from a receivership caused by great financial stress and that it had defaulted in the payment of interest on these very obligations. It is of interest to note that in the copy of the petition for advice with respect to the acceptance of the offer *1039 of compromise made by the directors, filed with the agreed statement of facts, it is stated that these debentures were selling on the market in June, 1916, at approximately $580 for each $1,000 debenture. Further, the "Plan of Reorganization" discloses that petitioner's 7 per cent first preferred stock was to be sold at par for cash. It is reasonable to suppose that its 6 per cent second preferred stock was worth less than its 7 per cent first preferred, and therefore less was paid for the former. Aside from this, we are of opinion that all that was paid in for this stock was precisely the amount paid for the debentures, which was, $18,800,000. An illustration will suffice. If petitioner had issued its debentures on July 1, 1917, instead of in 1902, could it be successfully contended that the amortized discount for the whole life of the debentures except one day was paid in for the stock? The question answers itself. We*3251 are, therefore, of opinion that all that was paid in for the second preferred stock was $18,800,000, the amount paid in for the debentures.
We have yet before us the effect of these transactions on surplus. Petitioner has the right to have restored to surplus the unamortized part of the discount, subject to the limitations set forth under issue 22.
Respondent has, by affirmative plea, raised the questions of the taxation of unamortized premiums and the effect of such amortized premiums on invested capital. All bonds which were sold at a premium were issued prior to March 1, 1913, and such premiums should not be amortized either for the purpose of taxation or invested capital. See
Reviewed by the Board.
Judgment will be entered under Rule 50.
TRAMMELL dissents on the questions of bond discounts and penalties.
MURDOCK, concurring: Under issue 29 in the foregoing opinion I concur in the result only. The petitioner contended that its invested capital should be increased over that allowed by the Commissioner for the reason that its debentures of the face value of $20,000,000 originally issued for*3252 $18,800,000, were exchanged for stock, and thus $20,000,000 was paid in for stock. The fair market value of the debentures at the time they were exchanged for stock would be the determining factor for invested capital purposes. The Commissioner made no claim for a decrease in investd capital from the amount allowed by him in his determination of the deficiency. The petitioner, on the other hand, has not offered evidenceto convince me that the debentures were worth more at the time exchanged for stock than the Commissioner has determined, consequently the parties should be left as we found them.
Footnotes
1. Denotes red figure. ↩
2. Prior to Jan. 1, 1909. ↩
1. Denotes red figure. ↩
3. Amount unamortized at Dec. 31, 1916, $902,465.75 retired July 2, 1917, therefore addition to surplus claimed by petitioner is 183/365 of $902,465.75, or $452,469.12, in lieu of $30,544.49 allowed by respondent. ↩
4. Commissioner allows only that proportion of the annual amount of amortization as the period Jan. 1, 1917, to July 2, 1917, bears to the entire year, i.e., $30,544.49. ↩
1. Discount originally charged to property account. ↩
2. Discount originally charged to profit and loss. ↩
1. Discount originally charged to property account. ↩
2. Discount originally charged to profit and loss. ↩