*1050 Petitioner, in consideration for the surrender of its outstanding 2-year 8 percent notes in the amount of $50,121,787.72 principal and accrued interest, issued 1,499,000 shares of its stock and $60,000,000 15-year 6 percent bonds. The agreement pursuant to which the exchange was made contemplated that $2,900,000 of notes and interest would be paid for stock and $56,221,787.72 for bonds. Petitioner claimed $3,778,212.28, being the difference between the face amount of the bonds and the amount of notes plus interest exchanged therefor, as bond discount. Respondent determined the bond discount to be $923,152.71, being the difference between the face amount of the bonds and the aggregate amount due on the notes plus certain expenses in connection therewith. Held, the amount of bond discount to be amortized is $3,778,212.28.
*939 Respondent determined income tax deficiencies against the petitioner for the calendar years 1935, 1936, and 1937 aggregating $167,694.52, and an excess profits tax deficiency for 1937*1051 of $14,304.83. The deficiencies determined and the approximate amount thereof challenged by petitioner are as follows:
| Deficiency | Amount challenged | |
| 1935 income tax | $39,532.74 | $38,208.02 |
| 1936 income tax | 81,210.92 | 68,044.68 |
| 1937 income tax | 46,950.86 | 46,366.75 |
| 1937 excess profits tax | 14,304.83 | 14,126.87 |
*940 The issue is the amount of bond discount petitioner is entitled to deduct each year in computing its taxable net income. All other adjustments made by respondent in determining the deficiencies were waived by petitioner.
FINDINGS OF FACT.
The principal facts have been stipulated and we adopt the stipulated facts as a part of our findings of fact.
Petitioner is a Delaware corporation, with its principal office and place of business in Chicago, Illinois. It filed its income and excess profits tax returns with the collector of internal revenue for the first district of Illinois. It kept its books and filed its tax returns on the accrual basis.
During the fore part of 1930 several corporations in the oil and gas business became interested in the possibility of selling natural gas produced in the Panhandle area of Texas in the*1052 markets of Chicago and its environs. To assist in the accomplishment of that purpose the corporations, on May 26, 1930, caused the Natural Gas Co. of America to be incorporated under the laws of Delaware. The full authorized capital stock of this corporation, consisting of 5,000 shares without par value, was issued for $500,000 in cash to the several corporations. Thereafter the interests of the Phillips Petroleum co. and the Skelly Oil .co. were acquired by the other participating companies, so that on or about August 31, 1931, the proportionate interests of the participating companies in the Natural Gas Co. of America were as follows:
| Shares | Percent | |
| Cities Service Co | 1,331.45155 | 26,6290310 |
| Natural Gas Investment Co. 1 | 1,331.45155 | 26.6290310 |
| Standard Oil Co. (New Jersey) | 665.725775 | 13.3145155 |
| Southwestern Development Co | 665.725775 | 13.3145155 |
| Texas Corporation | 879.15745 | 17.583149 |
| Columbian Carbon Co | 126.4879 | 2.529758 |
| Total | 5,000.000000 | 100.000000 |
The only business transacted by the Natural Gas Co. of America was the purchase of 1,000 shares of stock of the petitioner and the*1053 making of a $400,000 loan to petitioner. The stock and the 8 percent notes evidencing the loan were held only for the period from March 16, 1931, to December 30, 1931.
On April 25, 1930, petitioner was incorporated as the Continental Construction Co. and was authorized to issue 500,000 shares without par value. It issued 1,000 shares to the Natural Gas Co. of America for $100,000 in cash, and borrowed $400,000 from the latter company. *941 These amounts, together with other amounts borrowed, were used in the acquisition of facilities and the construction of a pipeline system from Oklahoma to Illinois. Active construction began in June 1930. From time to time petitioner borrowed money directly from the shareholders of the Natural Gas Co. of America. Each borrowing was in direct proportion to the interest of said shareholders in the Natural Gas Co. of America.
In October 1931, when the pipeline project was completed, the petitioner had borrowed from, and had given its 8 percent 2-year notes to, the Natural Gas Co. of America and its shareholders in the following amounts:
| Principal amount of notes | Accrued interest | |
| Cities Service co | $14,911,027.60 | $718,836.52 |
| Natural Gas Investment Co. (Insull) | 14,911,027.60 | 718,836.52 |
| Standard Oil Co. (New Jersey) | 7,518,013.82 | 363,377.16 |
| Southwestern Development Co | 7,393,013.82 | 355,459.35 |
| Texas Corporation | 9,854,296.55 | 461,758.08 |
| Columbian Carbon Co | 1,424,857.49 | 65,946.22 |
| Natural Gas Co. of America | 400,000.00 | 25,336.99 |
| Total | 56,412,236.88 | 2,709,550.84 |
| Total principal and interest | 59,121,787.72 |
*1054 On December 8, 1931, the corporate name of the Continental Construction Co. was duly changed to "Natural Gas Pipeline Company of America" and its authorized capital stock was increased from 500,000 to 1,500,000 shares without par value. The board of directors was authorized to issue and sell the capital stock for such consideration and upon such terms as the directors should fix, such issued shares to be fully paid and nonassessable. The stockholders of record at the time additional stock was issued were given a prior right to subscribe for and take such additional shares.
In December 1931 the holders of the petitioner's 8 percent 2-year notes made an offer to the petitioner to surrender them (with accrued interest) for cancellation in exchange and consideration for the issuance to them by the petitioner of 1,499,000 shares of its no par value stock on a basis of $2 per share and $60,000,000 principal amount of its 15-year first mortgage 6 percent bonds. The offer was accepted by petitioner and the following resolutions were unanimously adopted by its board of directors and by its stockholders at meetings held on December 30, 1931:
WHEREAS: this Company has outstanding notes*1055 bearing interest at the rate of 8% per annum in an aggregate principal amount of $56,412,236.88, plus accrued interest thereon to December 15, 1931, amounting to $2,718,202.40 (2,709,550.84*), being a total of $59,130,439.28 (59,121,787.72*), principal and interest to said date; and
*942 WHEREAS: this Company has outstanding one thousand shares of its capital stock without par value; and
WHEREAS: the holders of the notes above mentioned have offered to accept and receive, in full payment for said notes and interest the following:
(a) $60,000.000 principal amount of the First Mortgage Pipeline and Collateral six per cent Bonds, Series A, of the Company due December 15, 1946, bearing interest from December 15, 1931; and
(b) 1,499,000 shares of the capital stock without par value of this company;
NOW, THEREFORE, be it
RESOLVED, That the Board of Directors of this Company hereby determine that the property so to be received by this Company is of the value at least equal to the consideration asked therefor, and that the officers of this Company be, and they hereby are, authorized and directed to accept said offer and in payment for said notes to issue and deliver the*1056 said bonds in the face amount of $60,000,000 and 1,499,000 shares of the capital stock without par value, for and upon receipt of the notes of this Company as above mentioned;
FURTHER RESOLVED, That the stock so to be issued is hereby declared and shall be taken to be full paid stock and not liable to any further call, nor shall the holder thereof be liable for any further payments thereon; and
FURTHER RESOLVED, That the sum of Two Million Nine Hundred Thousand Dollars ($2,900,000) of the consideration to be received by the Company for said stock, is hereby determined to be capital, so that the capital of the Company after the issuance thereof shall be Three Million Dollars ($3,000,000).
[*These figures were not included in the original resolutions but are corrected figures to reflect the actual accrual of interest.]
On December 30, 1931, the Natural Gas Co. of America transferred to its shareholders its 1,000 shares of stock and its $400,000 of 8 percent 2-year notes of petitioner (with accrued interest). All of petitioner's 8 percent notes (with accrued interest) were thereupon surrenderd by said shareholders for 1,499,000 shares without par value and $60,000,000 first*1057 martgage 6 percent bonds in the petitioner. At the time petitioner issued its remaining unissued capital stock, the 1,000 shares which it had previously issued to the Natural Gas Co., and which were then owned by the shareholders of that corporation, were surrendered, and petitioner issued to the new shareholders certificates of stock representing in all 1,500,000 shares without par value and $60,000,000 first mortgage 6 percent bonds as follows:
| Shares | Percentage | Amount of bonds | Percentage | |
| Cities Service | 399,435.465 | 26.6290310 | $15,977,500 | 26.6291666 |
| Natural Gas | 399,435.465 | 26.6290310 | 15,977,500 | 26.6291667 |
| Standard Oil | 199,717.7325 | 13.3145155 | 7,988,500 | 13.3141666 |
| Southwestern Dev | 199,717.7325 | 13.3145155 | 7,988,500 | 13.3141667 |
| Texas Corp | 263,747.235 | 17.583149 | 10,549,500 | 17.5825000 |
| Columbian Carbon | 37,946.37 | 2.529758 | 1,517,500 | 2.5291667 |
| Treasury | 1,000 | 0.0016667 | ||
| Total | 1,500,000.0000 | 100,0000000 | 60,000,000 | 100.0000000 |
*943 Cash adjustments were made between petitioner and its shareholders in order to equalize the issuance of bonds in even $500 minimum denominations in direct proportion to stock ownership, as*1058 a result of which petitioner acquired its unissued $1,000 bond for a net consideration of $1,000.
The issuance of the remaining unissued stock and of the $60,000,000 of bonds was reflected by petitioner on its books of account in the following entry:
| Notes Payable | $56,421,236.88 | |
| Interest Payable accrued | 2,709,550.84 | |
| Bond Discount | 3,778,212.28 | |
| Bonds Outstanding | $60,000,000.00 | |
| Capital Stock Outstanding | 2,900,000.00 |
Entry to record the issuance of 1,499,000 shares of the capital stock of this company and $60,000,000.00, principal amount of the six per cent Pipeline and Collateral Bonds of the Company and Accrued Interest thereon, to December 15, 1931.
Of the $3,778,212.28 treated by petitioner as bond discount the respondent has amortized $878,212.28 over the life of the bonds and allowed an allocable portion thereof as a deduction for each of the taxable years, but has refused to amortize and allow as a deduction any portion of the balance ($2,900,000) of said amount.
Prior to December 30, 1931, and on July 25, 1931, the petitioner had entered into a contract with the Chicago District Pipeline Co. whereby that corporation agreed to purchase*1059 all of its natural gas requirements from petitioner and pay a certain minimum capacity charge therefor. Performance of the contract by the Chicago District Pipeline Co. was guaranteed by the Peoples Gas Light & Coke Co., Public Service Co. of Northern Illinois, and Western United Gas & Electric Co. This contract was amended by a contract dated December 31, 1935.
The guarantors of the contract of July 25, 1931, were distributors of gas to the consuming public in and near Chicago. They created the Chicago District Pipeline Co. to connect their plants with the terminus of petitioner's pipeline at Joliet, Illinois, where delivery was made. Petitioner's pipeline had a total capacity of 210,000,000 cubic feet of gas daily and the guarantors agreed to pay, on and after January 1, 1935, for not less than 130,000,000 cubic feet daily. The rates specified in the contract of July 25, 1931, assured petitioner of an annual revenue after January 1, 1935, of $11,207,200. Petitioner's estimated annual cash requirements for expenses, bond retirement, and interest were $10,300,000.
Also prior to December 30, 1931, and on October 15, 1931, petitioner had entered into contracts with the Texoma*1060 Natural Gas Co. and Colorado*944 Interstate Gas Co. assuring itself of an adequate supply of gas from the Texas Panhandle area with which to meet the requirements of the Chicago District Pipeline Co. and other purchasers of gas.
The Texoma Natural Gas Co. was created to construct and hold title to the pipelines from the Panhandle area to Gray, Oklahoma. It constructed a gathering system from the wells in the field to a central pumping station in Hutchinson County, Texas, from which point a 24-inch pipeline was constructed to Gray, Oklahoma. The costs of the gathering system and the pipeline were advanced by petitioner. By the end of 1931 these advances plus accrued interest amounted to $23,100,000, and petitioner was obligated for additional construction amounting to $1,900,000, which was evidenced by a note maturing within one year. During December 1931 the Texoma Natural Gas Co. issued $25,000,000 of its bonds to petitioner to satisfy the advances made or to be made plus accrued interest. The bonds so issued were reflected upon petitioner's books at their face value. Subsequent to December 30, 1931, petitioner advanced cash to Texoma for construction in excess of*1061 $1,900,000.
Petitioner reported net taxable income on its returns for the calendar years 1931 to 1939, inclusive, and paid dividends out of earnings and profits for said years in the following amounts:
| Net income | Dividends | |
| 1931 | (Loss) $404,706.01 | |
| 1932 | (Loss) 1,859,125.16 | |
| 1933 | (Loss) 1,495,583.66 | |
| 1934 | (Loss) 406,469.55 | |
| 1935 | 1,845,477.58 | |
| 1936 | $3,356,068.39 | $2,775,000.00 |
| 1937 | 4,985,122.43 | 4,125,000.00 |
| 1938 | 3,696,150.02 | 2,250,000.00 |
| 1939 | 4,022,168.02 | 3,675,000.00 |
Petitioner, on December 30, 1931, issued $60,000,000 pay value of 15-year first mortgage 6 percent bonds at a discount. The amount of the discount was $3,778,212.28.
In computing the deficiencies respondent determined the amount of bond discount and expenses to be amortized as $878,212.28 and $44,940.33, respectively, or a total of $923,152.71, being the difference between the amount due on the notes and the par value of the bonds plus certain other expenses in connection therewith.
OPINION.
ARNOLD: The rule is established that, where bonds are issued for less than their face value by a corporation on the accrual basis, the difference between the amount realized and the*1062 face value of the issue will be recognized as bond discount. ; ; *945 affd., . A concise statement of the discount concept is contained in , which was quoted with approval in . The applicable regulations provide for the amortization of bond discount over the life of the bonds. Art. 22(a)-18, Regulations 86 and 94, Revenue Acts of 1934 and 1936. Both parties have applied the rule to the transaction of December 30, 1931, but with different results. Since the principle of amortizing bond discount over the life of the bonds is recognized by the parties, we need determine only the correct amount to be prorated.
An analysis of the conflicting claims shows that different amounts were determined as bond discount because of the variance in treatment of the consideration for the 1,499,000 shares of stock issued on December 30, 1931. Petitioner, in reliance on the offer*1063 made by its creditors and accepted by its directors and stockholders, allocated $2,900,000 of the notes with accrued interest to the 1,499,000 shares of no par capital stock issued. Respondent refused to accept the allocation and determined the bond discount to be the difference between the aggregate notes with accrued interest and the par value of the bond issue, i.e., $878,212.28, plus $44,940.33, representing costs of printing the bonds, stamps, fees, etc., or a total bond discount of $923,152.61.
Respondent contends that the amortization of bond discount is only a concept which should not be extended to cover transactions in which the substance of what was done fails to disclose that the bonds were actually issued under circumstances equivalent to a "discount" as the term is used in the regulations. He argues that the notes were exchanged for bonds, and that stock (1,000 shares) was exchanged for new stock (1,500,000 shares) as integral parts of a single or entire transaction, citing He insists that if his first contention is rejected, nevertheless, the Board should not find that the stock had a fair market value*1064 on December 30, 1931, of $3,000,000, or any market value whatsoever, citing . Finally he points out that the evidence discloses that petitioner had no dividend record at December 30, 1931, or for several years thereafter, that the face value of its bonded indebtedness exceeded the capital invested, and that, because of market conditions and the speculative nature of petitioner's enterprise, no purchaser could have been found for its stock.
We can not agree with respondent's contentions. In our opinion he properly recognized petitioner's right to amortize bond discount under the particular facts of this case. As to his second contention, respondent has stipulated that petitioner's creditors offered to surrender *946 all of its outstanding 8 percent notes with accrued interest "for cancellation in exchange and consideration for the issuance to them" of 1,499,000 shares of stock and $60,000,000 par value of bonds. This offer was verbal. It was submitted as the result of an agreement reached after numerous conferences between 15 to 20 representatives of petitioner's creditors. The uncontradicted*1065 testimony of the witnesses shows that the creditors collectively agreed to accept as payment for their notes and interest sufficient shares of petitioner's common stock which, with stock then outstanding, would equal 1,500,000 shares at $2 per share and $60,000,000 face value of bonds at a discount price of approximately 93 1/2.
This offer was accepted by petitioner's directors and stockholders as made. The entries on petitioner's books of account and the resolutions adopted by its stockholders and directors clearly reflect the acceptance and the intention of the parties that 1,499,000 shares of additional stock would be issued to "the holders of the notes * * * in full payment" for $2,900,000 of the notes and interest, so that "after the issuance thereof" the capital of the petitioner "shall be Three Million Dollars ($3,000,000)." The creditors, therefore, subjected $2,900,000 to the risk of the business. No stock-for-stock exchange (1,500,000 shares for 1,000 shares) was established despite the vigorous cross-examination of petitioner's witnesses as to the mechanics of the transfer.
Respondent's final contention is that petitioner's stock had no value. Value or the lack*1066 of it is of importance in determining whether the allocation of consideration as made by the parties between the stock and the bonds was reasonable. The fact that petitioner was newly organized at December 30, 1931, and without any earnings or dividend record does not necessarily prove that the stock lacked value. Its assets, tangible and intangible, indicate that there was value behind the stock. Petitioner's tangible assets consisted of the bonds of the Texoma Natural Gas Co., and the pipeline and facilities necessary to transport natural gas from Oklahoma to Illinois. In addition, petitioner had intangible assets at December 30, 1931, which, in our opinion, were very valuable, namely, its contracts for the supply and sale of natural gas. By its supply contracts petitioner assured itself of natural gas of at least 210,000,000 cubic feet daily which was the total capacity of its pipeline. By its sales contract petitioner was assured of an annual profit of $900,000 from approximately 63 percent of its daily capacity. That the remaining 37 percent of its pipeline capacity was sold at a profit is established by petitioner's stipulated net income for the years 1935 to 1939, inclusive. *1067 These contracts must be considered corporate assets. Obviously the contracts were of *947 great value to petitioner and their value must be weighed and considered in determining whether the capital stock had value.
Expert testimony was offered by both parties regarding the value or lack of value of the capital stock on December 30, 1931. Respondent's expert witness, after testifying to the dismal condition of the security market in December 1931, expressed the opinion that the assets reflected on petitioner's 1931 return, which was not introduced in evidence, indicated that the stock was without value. He admitted on cross-examination that he gave no consideration to the contracts held by petitioner.
On the other hand petitioner's expert, whose qualifications are recognized by respondent, testified that in his opinion the shares could have been sold if placed on the market on or about December 30, 1931. He testified that the purchasers would have been parties seeking to double or treble their investment rather than investors seeking a reasonable return thereon, but he thought the nature of the business, the sponsors and management of the enterprise, the contracts*1068 held by petitioner, and the potential earning capacity of the capital stock would have secured purchasers for the stock at two dollars per share. This witness also testified that, had petitioner's bond issue been sold on the market, the bond discount would have been considerably in excess of $3,778,212.28. He supported his opinion by specific in stances of financing by public utilities late in 1931 and early in 1932 in which the percentage realized on bond issues by operating companies with established earning capacities was much less than that realized by petitioner.
After carefully weighing and considering the stipulated facts and the testimony, it is our opinion that the parties intended to and did fix the value of the petitioner's stock at $2 per share. We are further of the opinion that the amount so fixed is reasonable and is justified by the facts peculiar to this case. By accepting the offer of its creditors, petitioner reduced its interest rate from 8 percent to less than 6 1/2 percent, since $3,778,212.28 spread over the 15-year life of the bonds is less than 1/2 of 1 percent of the face amount of the bonds. If petitioner had been able to sell this bond issue on the*1069 market in December 1931, the testimony of the expert witnesses clearly establishes that the bond discount would have exceeded the amount of discount that will be paid to petitioner's creditors under the present facts. We hold, therefore, that the amount of bond discount to be amortized by petitioner over the life of its bonds is $3,778,212.28.
Reviewed by the Board.
Decision will be entered under Rule 50.
Footnotes
1. Organized to hold the interest of Insull, Son & Co. ↩