*234 Decision will be entered under Rule 50.
Cancellation of common stock and exchange of bonds, preferred stock, and demand note for securities of new corporation in 77B proceeding, held to result in tax-free exchange and consequent carry-over of old basis of the bonds and preferred stock but not of the common stock and demand note.
*742 This proceeding was brought for a redetermination of a deficiency in petitioner's income tax for the year 1940 in the amount of $ 7,343.21. Petitioner claims an overpayment of tax for that year in the amount of $ 30,488.15.
A claimed additional deduction of $ 873.40 for capital stock tax is conceded by respondent.
The question presented relates to the basis of securities sold by petitioner in the taxable year which had been obtained pursuant to a reorganization under section 77B of the Bankruptcy Act.
The case was presented upon stipulation, supplemental stipulation, and testimony adduced at the hearing. Those facts hereinafter appearing which are not from the stipulation*235 are otherwise found from the record.
FINDINGS OF FACT.
The stipulated facts are hereby found accordingly.
Petitioner is a corporation organized under the laws of the State of California, with its principal office in San Francisco. Its income tax return for the year 1940 was filed with the collector of internal revenue for the first California district.
On September 25, 1940, and on October 7, 1940, petitioner sold to Turner Poindexter & Co. of Los Angeles all of its bonds and shares of stock in California Consumers Corporation for amounts aggregating $ 19,654.85. The sales were arm's-length transactions between a willing buyer and a willing seller.
The amounts received for each, the cost basis claimed, and the loss claimed by petitioner on its return for the taxable year were as follows:
| Cost basis | |||
| Amount | claimed on | Loss claimed | |
| Item | received | return | on return |
| $ 75,000 principal amount of bonds with | |||
| participating certificates for 600 | |||
| shares of stock held by voting trustees | $ 18,750.00 | * $ 54,877.66 | $ 36,181.38 |
| 1,353 shares stock | 263.82 | 51,001.75 | 50,737.93 |
| 3,287.5 shares stock | 641.03 | 6,246.25 | 5,605.22 |
| Total | 19,654.85 | 112,125.66 | 92,524.53 |
*743 In arriving at the cost basis of the 3,287.5 shares on the return petitioner used a value of $ 1.90 per share.
In the petition, petitioner claims a cost basis of $ 478,270 (the amount of the note hereinafter referred to) for the 3,287.5 shares above referred to.
California Consumers Co. (hereinafter sometimes called Consumers), a Delaware corporation, was organized on March 20, 1928. It operated both directly and indirectly, through various subsidiary companies, an extensive ice and cold storage business in southern California. Operations by Consumers during the years 1932 and 1933 resulted in losses. On October 1, 1933, Consumers defaulted in the payment of the semiannual interest due on its first mortgage series A bonds and on December 1, 1933, it was insolvent. Accordingly, on December 3, 1933, the trustee under the indenture securing the bonds filed a bill of complaint for the foreclosure of the indenture in the United States District Court at Los Angeles and requested the appointment of a receiver of the properties ancillary to and pending the outcome of the foreclosure action. On that date the court appointed a receiver, *237 and thereafter and until the consummation of the March 1, 1935, agreement the properties were operated by the receiver.
The plan of reorganization set forth in the agreement dated March 1, 1935, was formulated and composed by committees representing the bondholders, the preferred stockholders, and petitioner as unsecured creditor of Consumers. The plan, provisions, and terms of this agreement were confirmed by the United States District Court for the Second District of California, Second Division, on September 30, 1935, and carried out and consummated in 1935, under the provisions of section 77B of the Federal Bankruptcy Act.
In 1928 petitioner acquired 15,000 shares of common stock of Consumers, which constituted at that time all the issued and outstanding shares of common stock. On June 10, 1930, petitioner acquired 10,000 additional shares of common stock by reason of a declaration of a dividend of 10,000 shares on the 15,000 shares. Petitioner thereafter, until the time of the transaction covered by the agreement dated March 1, 1935, held all the issued and outstanding common stock of Consumers, consisting of 25,000 shares. The basis for these 25,000 shares was $ 6,000.
At*238 intervals between April 1931 and July 1933 petitioner acquired a total of 902 shares of preferred stock of Consumers at a cost of $ 51,001.75 and bonds of the company in the principal amount of $ 75,000 at a cost of $ 54,877.66. These purchases were made on the open market and the stock and bonds were held by petitioner up to the time of the transaction covered by the March 1, 1935, agreement.
Prior to May 31, 1933, petitioner had made cash advances to Consumers which totaled $ 478,270. On that date Consumers made a promissory *744 note, payable on demand and bearing interest at 5 percent per annum, in the amount of $ 478,270 in favor of petitioner, evidencing an indebtedness of that amount. Prior to March 1, 1935, petitioner had not received any payment on account of this indebtedness.
Operations by Consumers resulted in losses and in December 1933 it was insolvent. Excepting liabilities to the subsidiaries and affiliated companies, its liabilities (exclusive of capital stock) at that time were as follows:
$ 3,496,500 principal amount First Mortgage Series "A" bonds dated April 2, 1928, of which petitioner held $ 75,000 principal amount;
$ 478,270 unsecured promissory*239 note held by petitioner.
As of December 2, 1933, Consumers had stock outstanding as follows:
15,343 shares $ 7 cumulative preferred stock, no par value, of which petitioner held 902 shares;
25,000 shares of no par common stock, held by petitioner.
All the interested parties accepted the plan of reorganization set forth in the agreement dated March 1, 1935. In accordance with the provisions of the plan requiring a new corporation, California Consumers Corporation (hereinafter sometimes called the new company) was organized in 1935, under the laws of the State of California, and in that year acquired the properties referred to in the plan, which constituted all or substantially all of the properties which had been owned and operated by Consumers, and issued $ 3,496,500 principal amount of bonds and 54,274 shares of stock as provided in article III of the plan. The parties who prior to the plan held bonds, stock, and the note of the company, received pursuant to the plan the following interests in the new company:
| Holdings in Consumers | Interests in new company received |
| $ 3,496,500 principal amount of bonds | $ 3,496,500 principal amount of bonds |
| (of which $ 75,000 principal amount | and 27,972 participating certificates |
| was held by petitioner) | for 27,972 * shares of stock |
| 15,343 shares no par value preferred | 23,014.5 shares |
| stock (of which 902 shares were held | |
| by petitioner) | |
| $ 478,270 unsecured demand note (held | 3,287.5 shares |
| by petitioner) | |
| 25,000 shares common stock (held by | Nothing |
| petitioner) | |
| Total | $ 3,496,500 bonds; 54,274 shares |
By reason of its respective holdings of bonds and stock and the note of Consumers, petitioner, as a result of the consummation of the plan, received the following: *745
| Holdings in Consumers | Interests in new company received |
| $ 75,000 principal amount of bonds | $ 75,000 principal amount of bonds with |
| participating certificates for 600 | |
| shares of common stock held by | |
| voting trustees | |
| 902 shares preferred stock | 1,353 shares of common stock |
| $ 478,270 note -- unsecured | 3,287.5 shares of common stock |
| 25,000 shares common stock | Nothing |
The bonds and stock of the new company which petitioner received were the bonds and stock which petitioner sold in the taxable year.
The bonds of Consumers had been first mortgage bonds, dated April 1, 1928, maturing in twenty years, but subject to earlier redemption upon payment of principal and accrued interest, computed on a specified formula according to the date of redemption.
The bonds of the new company were to be dated as of such date as the bondholders' committee should designate and, subject to certain provisions allowing earlier redemption, matured twenty years from*241 their date. They bore an interest rate of 5 percent, of which 3 percent was designated "fixed interest" (i. e., unconditionally due), payable in semiannual installments, and the remaining 2 percent designated as "income interest" payable in annual installments only if and to the extent that the net income of the new company and its subsidiaries on a consolidated basis for the twelve-month period ended two months prior to the interest date was available for the payment of interest. The bonds further provided that "Net income shall be deemed to be available for the payment of income interest only if the payment thereof will not reduce the net working capital of the new corporation and its subsidiaries * * *, to an amount insufficient for the needs of the business as determined from time to time by the board of directors and, so long as the voting trust agreement is in existence, approved by at least a majority of the voting trustees."
Income interest not earned and available in any annual period did not accumulate. The new bonds also contained provisions for establishment of a sinking fund. Such bonds were, according to the plan, secured by a new trust indenture upon all of the *242 properties acquired. The bondholders' committee was given the right to select the trustee under the new indenture.
Paragraph 7 of article IV of the plan contains the following:
The new trust indenture shall provide that with the consent of the holders of seventy-five per cent (75%) in principal amount of new bonds then outstanding:
(a) The new trust indenture may be released and the new bonds satisfied (but only with the written consent of the Commissioner of Corporations of the State of California so long as there is such a commissioner) upon payment or delivery to the trustee for the benefit of the holders of all the new bonds then *746 outstanding, of a consideration (which may be money, securities or any other consideration), which consideration may be less than the principal amount of the new bonds then outstanding;
(b) With the consent of the new corporation and the trustee, any of the terms and provisions of the new trust indenture or the new bonds may be altered, eliminated or supplemented; or
(c) The new trust indenture may be subordinated to a new mortgage or trust deed or other encumbrance for such purposes and in such amount as such percentage of the holders of the*243 new bonds then outstanding shall approve.
The plan also provided for the dismissal, with prejudice to all parties plaintiff, of a dividend suit filed December 29, 1933, in the Superior Court of California against petitioner, seeking the recovery of the amount of certain dividends alleged to have been illegally declared and paid on both preferred and common stock of Consumers, in the sum of approximately $ 1,000,000.
Petitioner has never claimed any portion of the unsecured indebtedness of Consumers as partially or wholly worthless in any of its income tax returns, nor has petitioner received any tax benefit through bad debt deductions with respect thereto. No part of petitioner's cost of preferred stock and bonds of Consumers or of its common stock and bonds of the new company has been claimed or allowed as a deduction or otherwise in any tax return filed by petitioner prior to 1940.
Petitioner reported a net loss on its Federal income tax returns for 1933, 1934, and 1935, and no tax has been paid by petitioner for those years.
As of December 31, 1933, petitioner wrote down its investment in the bonds of Consumers to $ 15,000, petitioner's estimate of their fair market value as of*244 that date, and wrote down the balance of its investments and note to $ 1.
OPINION.
In order to compute the deductible loss sustained by petitioner upon a sale in the instant tax year it becomes necessary to fix a basis for the securities which it sold. This in turn involves the question whether the transaction by which petitioner received the stock through a 77B reorganization in exchange for certain interests in a predecessor company was such that petitioner's loss was then recognizable and a new basis acquired, or whether, as petitioner contends, it retained its original basis. This is the sole issue.
The nonrecognition is claimed under three theories -- first, that it was an exchange of property for stock under section 112 (b) (5); second, that it was an exchange of stock or securities for stock or securities in a reorganization; and, third, that it is in any event covered *747 by the new provisions, 1 particularly section 112 (1), added by the Revenue Act of 1943.
*245 It seems clear at the outset that this could not have been an exchange under 112 (b) (5). That section requires an identity of interest before and after the exchange, as well as an ownership or control of 80 percent in the same persons. It is stipulated that prior to the 77B reorganization the old company was insolvent. It might follow from this that the creditors would then step into the shoes of the stockholders and at least upon the institution of the receivership would so far succeed to the entire proprietary interest in the debtor that a delivery to them of all of the stock of the reorganized corporation would satisfy the requirements of identity of interest established by 112 (b) (5). . But here the creditors, who on that theory would be entitled to all of the proprietary interest in the new corporation and its assets, and certainly at least to a controlling interest, acquired but 48 percent of the new stock and the secured creditors but 42 percent, petitioner as holder of an unsecured demand note obtaining the other 6. The preferred shareholders, who on the insolvency theory would be regarded*246 as wiped out, obtained a majority interest. And it will not do to say that the insolvency theory might be disregarded, for that is the sole reason advanced for the complete elimination of the common shareholders.
By the same token, of course, the requirement that the owners of the property transferred shall retain a control of not less than 80 percent likewise acts as a bar to the application of 112 (b) (5). Not only did the creditors of the insolvent old corporation, the presumptive owners of all of its property, acquire less than an 80 percent interest in the transferee; they received, as has been pointed out, less than a 50 percent interest. If the financial condition of the old company *748 was such that the interests in its assets were properly allocated as between creditors and preferred shareholders -- a finding which incidentally would contradict the stipulated fact of insolvency 2 -- that conclusion would have to appear from evidence of the assets and liabilities involved. In the absence of such evidence, it can not be assumed that the exchange in question was nontaxable under 112 (b) (5). .*247
Consideration of section 112 (b) (3) requires a separation of the various interests involved. Petitioner acted in four capacities. It was the owner of all of the common stock of the old company, as well as some of the preferred. It held its unsecured demand note for almost half a million dollars. And it owned some of the bonds. Under the plan of reorganization petitioner received blocks of common stock of the new company, the only class issued, in exchange for its bonds and preferred stock, and an additional common stock interest in exchange for the demand note. It received nothing for its common stock. This we think completely eliminates the*248 latter as a part of petitioner's retained basis. Section 112 (b) (3) relates exclusively to exchanges. Since the common stock was exchanged for nothing, the loss was complete at that time. No part of petitioner's original basis for the common stock may hence be included as any part of its retained basis for the stock of the new company.
As to the exchange of bonds for bonds and common stock and of preferred stock for common, no question arises concerning the existence of an exchange and, since the old bonds and preferred stock were clearly securities of the old company, that portion of the requirements of section 112 (b) (3) is met. There might have been some doubt whether the exchange was the result of a statutory reorganization under the principle of , and But, as will subsequently appear, this factor has been eliminated by the 1943 amendment. The consequence is that the claimed loss on that part of the new stock and bonds acquired in exchange for the bonds and for the preferred stock may be allowed.
When, *249 however, we come to the exchange of the unsecured demand note for additional stock in the new company, we are met with the difficulty that the section requires an exchange of stock or securities for other stock or securities. It is clear that the demand note was not stock. It appears to be equally clear that it was not of sufficient dignity to be considered a security. ;. No case has been found where a tax-free exchange under section 112 (b) (3) was held to have resulted from the exchange of a demand note. The inclusion of such an exchange in the entire plan, like the payment of cash, might not prevent that section from applying to exchanges otherwise encompassed within the described class of transactions. See ; affd. (C. C. A., 3d Cir.), ; certiorari denied, . And long term notes, especially where a number of them*250 are outstanding, may represent such an interest as to be considered securities. Burnham v. Commissioner (C. C. A., 7th Cir.); ; certiorari denied, ; . But to hold that a short term or demand note is a security in the face of such cases as , construing the same word in the same section and holding that short term notes "were not securities within the intendment of the Act," seems to us unjustifiable.
, is not to the contrary. There the opinion on review observes:
* * * From what we have already pointed out, it seems clear that U. G. I.'s economic interest in Nashville continued uninterrupted throughout. After the reorganization, just as before, U. G. I. was the substantial owner of Nashville.
* * * *
* * * In substantial effect, the cancellation of the debt was but a contribution by the sole owner of the reorganized company to the capital*251 of the company * * * By just so much as U. G. I. thus contributed was its stock interest in the reorganized company benefited. * * *
Here petitioner may either be regarded as the sole stockholder prior to the reorganization, but that interest was wiped out by it, or it may be regarded as a creditor, in which event its interest was recognized to the extent of a minor share in the new company's common stock. Viewed from either standpoint, petitioner's release of its unsecured demand note is not comparable to the capital contribution of a sole shareholder such that the receipt of the stock at that time would prevent its deducting as a loss the uncollected portion of the debt. See , appeal dismissed (C. C. A., 4th Cir.); It follows that neither the basis for the common stock nor the amount represented by the demand note carried over as a part of petitioner's basis for the new stock.
The only change in the situation resulting from the 1943 amendment is, as has been suggested, that any doubt as to the tax-free character of the*252 transaction involving the bonds and preferred stock has been eliminated. That section still requires that there be an exchange of *750 stock or securities which would not include the demand note. It permits, it is true, the relinquishment of an interest, as well as its exchange, but that must be in consideration of the receipt of stock or securities. Thus, petitioner's relinquishment of its common stock without any consideration equally fails to come within the amendment.
There can, however, be little doubt that, whether or not the transaction in question was a reorganization under section 112 (g), it does comply with the requirements of section 112 (l), since there was a 77B proceeding and the new company was employed to carry out the terms of the reorganization there adopted. Respondent insists that the section is inapplicable because it does not appear that petitioner definitively and formally treated the transaction as nontaxable in its prior dealings. We think, however, that failure to deduct the loss on its original return, coupled with the fact that no question has been raised by respondent and no subsequent amendment has been attempted by petitioner, leaves the entire*253 matter in a state of as complete finality as could possibly have been achieved under the circumstances. We do not read respondent's regulations as calling for more. See .
Decision will be entered under Rule 50.
Footnotes
*. Expense of $ 53.72 was also claimed.↩
*. Stipulated, but apparently in error, as 29,972 shares.↩
1. Section 112 (1):
"(1) General rule. -- No gain or loss shall be recognized upon an exchange consisting of the relinquishment or extinguishment of stock or securities in a corporation the plan of reorganization of which is approved by the court in a proceeding described in subsection (b) (10) [under section 77B of the National Bankruptcy Act], in consideration of the acquisition solely of stock or securities in a corporation organized or made use of to effectuate such plan of reorganization.
"(2) Exchange occurring in taxable years beginning prior to January 1, 1943. -- If the exchange occurred in a taxable year of the person acquiring such stock or securities beginning prior to January 1, 1943, then, under regulations prescribed by the Commissioner with the approval of the Secretary, gain or loss shall be recognized or not recognized --
"(A) to the extent that it was recognized or not recognized in the final determination of the tax of such person for such taxable year, if such tax was finally determined prior to the ninetieth day after the date of the enactment of the Revenue Act of 1943; or
"(B) in cases to which subparagraph (A) is not applicable, to the extent that it would be recognized or not recognized under the latest treatment of such exchange by such person prior to December 15, 1943, in connection with his tax liability for such taxable year."↩
2. "* * * The full priority rule of * * * gives creditors, whether secured or unsecured, the right to exclude stockholders entirely from the reorganization plan when the debtor is insolvent. * * *" .↩