*74 Decision will be entered under Rule 50.
1. Petitioner's assets found to be less than its liabilities both before and after it purchased its obligations at less than face value, minus unamortized discount, during the years 1940, 1941, and 1943. Held, no income was realized from the purchase of these obligations.
2. Notes were surrendered to the debtor pursuant to a plan and returned to the petitioner with a change of interest rate and maturity date. Held, that the transaction was a recapitalization and the notes retain their original basis in the petitioner's hands.
*507 This proceeding was instituted to test the correctness of respondent's determination*75 of deficiencies in the amounts of $ 11,727.15, $ 44,850.29, and $ 883.85 in petitioner's income taxes for the taxable years 1942, 1943, and 1944, respectively. The major issue relates to the purchase by petitioner of its bonds in the years 1940, 1941, and 1943 and raises the question whether or not petitioner realized taxable income from such transactions. The determination of this question will affect the amount of petitioner's net operating loss carry-over to be applied in computing income for other years. A second issue relates to petitioner's basis for gain or loss on notes of another corporation that were redeemed by the debtor in the year 1944. Petitioner has abandoned its claim that no income was realized upon the purchase of its own bonds in 1944.
FINDINGS OF FACT.
Petitioner is a corporation organized under the laws of the State of Pennsylvania, on December 4, 1931, and has its principal place of business in Lancaster, Pennsylvania. The returns for the years involved were filed with the collector of internal revenue for the first district of Pennsylvania, at Philadelphia, Pennsylvania. Petitioner kept its books and filed its returns on the accrual basis of accounting.
*76 In 1931, eleven leased line corporations merged with the lessor corporation, Conestoga Traction Company, and formed a new corporation known as Conestoga Transportation Company, the petitioner herein. The merger was a tax free reorganization under section 112 of the Revenue Act of 1928. Since its incorporation and during the years in question, petitioner has engaged in the transportation of passengers by electric railway and buses in Lancaster City and Lancaster County, Pennsylvania. On January 1, 1900, the Conestoga Traction Company had issued $ 2,000,000, face value of 50-year 4 per cent general mortgage bonds, which were a first mortgage lien on all properties of that company. There was an unconditional obligation to pay the face amount of the bonds when due. There was no sinking fund provision for the bonds. Petitioner assumed the entire liability for the $ 2,000,000 bond issue.
In 1931, petitioner operated trolleys only, on single track lines. In 1932, it began converting to buses. In 1940, petitioner had about 29 *508 miles of track and 141 miles of bus lines in operation. In 1941, it had prepared and filed with the Pennsylvania Public Utility Commission applications*77 for the right to abandon practically all of its remaining rail lines and had ordered the additional buses necessary to service these routes. As a result of the war, these applications were withdrawn. After the war and as motor vehicle equipment became available, petitioner resumed abandonment of rail operations and extension of bus lines. The last trolley was abandoned in 1947 and since that date petitioner has operated only motor buses. By the end of 1943, it had 120 miles of bus lines and 28 miles of rail in use.
The cost incident to the removal of rail facilities has always been considerably greater than the amount received as salvage for the particular railway property used in operating a given route. Petitioner's initial balance sheet dated December 1, 1931, included a reserve for contingencies in the amount of $ 3,510,845.40, which was the sum of reserves for abandonment on the balance sheets of the 11 leased line companies, aggregating $ 3,251,233.98, and a reserve for contingencies on the books of the Conestoga Traction Company of $ 259,611.42. The petitioner continued in its initial balance sheet these combined reserves as a reserve for contingencies. As electric railway*78 lines and other assets were abandoned, the book value less depreciation on the books was charged to the reserve for contingencies.
As a result of a physical inventory taken as of December 31, 1933, and a subsequent re-check of that inventory, petitioner discovered that the sum representing railway property as carried on its books of account exceeded the purchase price and/or the actual cost of construction of the property by $ 981,101.21. This sum, representing nothing of value, was segregated and carried as an asset under the title "Undistributed Railway Items." The books were not otherwise adjusted for this item.
For the calendar years 1940, 1941, and 1943, the actual depreciation and obsolescence of railway property was in excess of the reserve for depreciation of railway property by the amounts of $ 924,648.26, $ 974,018.11, and $ 1,061,396.55, respectively.
The depreciation of bus property as reported on petitioner's income tax returns was the same as that carried on its books of account which was on the basis of a 10-year life. Petitioner's buses had an estimated life of 8 years and depreciation should have been computed on that basis. There was also carried in petitioner's*79 accounts as of December 31, 1943, items in the approximate amount of $ 80,000 representing the cost of land and of rights-of-way for tracks, title to which had reverted to the original owners when the tracks were removed or the property no longer used for railway purposes.
*509 The book value of the railway and bus properties at the end of 1940, 1941, and 1943, after giving effect to certain of the adjustments heretofore set forth in our findings, is as follows:
| Dec. 31, 1940 | Dec. 31, 1941 | Dec. 31, 1943 | |
| Shown by books: | |||
| Railway property, less | |||
| reserve for depreciation | $ 2,369,951.96 | $ 2,309,421.59 | $ 2,195,382.15 |
| Bus property, less | |||
| reserve for depreciation | 427,297.51 | 540,768.84 | 645,303.81 |
| Total | $ 2,797,249.47 | $ 2,850,190.43 | $ 2,840,685.96 |
| Less: | |||
| 1. Undistributed railway item | 981,101.21 | 981,101.21 | 981,101.21 |
| 2. Abandoned land and | |||
| rights-of-way | 80,000.00 | ||
| 3. Additional depreciation | |||
| railway property | 924,648.26 | 974,018.11 | 1,061,396.55 |
| $ 1,905,749.47 | $ 1,955,119.32 | $ 2,122,497.76 | |
| Adjusted book value | $ 891,500.00 | $ 895,071.11 | $ 718,188.20 |
The market value of petitioner's assets other than railway property*80 and bus property for the respective years is as follows:
| Dec. 31, 1940 | Dec. 31, 1941 | Dec. 31, 1943 | |
| Current assets | $ 149,915.90 | $ 161,804.75 | $ 223,670.02 |
| Stocks and bonds | 145,336.25 | 127,867.75 | 507,452.00 |
| Special deposits | 64,864.83 | 22,163.42 | 73,344.27 |
| Prepaid and deferred items | 19,116.35 | 24,402.13 | 25,520.31 |
| Total | $ 379,233.33 | $ 336,238.05 | $ 829,986.60 |
The liabilities of petitioner for the respective years are as follows:
| Dec. 31, 1940 | Dec. 31, 1941 | Dec. 31, 1943 | |
| Current liabilities | $ 91,648.15 | $ 101,466.15 | * $ 342,085.38 |
| Bonds outstanding | 1,669,900.00 | 1,632,400.00 | 1,258,500.00 |
| Reserve for retroactive wages | 20,000.00 | ||
| Reserve for injuries and damage | |||
| claims | 15,000.00 | 15,000.00 | |
| Total | $ 1,776,548.15 | $ 1,748,866.15 | $ 1,620,585.38 |
Giving effect to the adjustments shown in the paragraphs preceding, the excess, per books, of petitioner's liabilities over its assets can be shown as follows:
| December 31, 1940 | |
| Assets: | |
| Railway property, net, adjusted | $ 464,202.49 |
| Bus property, net | 427,297.51 |
| Other assets, market value | 379,233.33 |
| Total assets | $ 1,270,733.33 |
| Total liabilities | 1,776,548.15 |
| Excess liabilities over assets | $ 505.814,82 |
| December 31, 1941 | |
| Assets: | |
| Railway property, net, adjusted | $ 354,302.27 |
| Bus property, net | 540,768.84 |
| Other assets, market value | 336,238.05 |
| Total assets | $ 1,231,309.16 |
| Total liabilities | 1,748,866.15 |
| Excess liabilities over assets | $ 517,556.99 |
| December 31, 1943 | |
| Assets: | |
| Railway property, net, adjusted | $ 72,884.39 |
| Bus property, net | * 645,303.81 |
| Other assets, market value | 829,986.60 |
| Total assets | $ 1,548,174.80 |
| Total liabilities | 1,620,585.38 |
| Excess liabilities over assets | $ 72,410.58 |
*510 The total number of shares of stock of petitioner outstanding was 77,786, all common and with no par value. The maximum selling price of this stock for the respective years was as follows:
| 1933 | $ 0.10 |
| 1934 | .10 |
| 1940 | .10 |
| 1941 | 0.25 |
| 1942 | .80 |
| 1943 | 1.25 |
During the period from 1934 through 1944, petitioner purchased Conestoga Traction Company bonds as follows:
| Face value of | Cost of bonds | |
| Year | bonds purchased | purchased |
| 1934 | $ 48,800 | $ 10,988.00 |
| 1935 | 30,300 | 7,876.75 |
| 1936 | 5,000 | 2,637.50 |
| 1937 | 19,500 | 10,790.48 |
| 1938 | 36,700 | 14,238.75 |
| 1939 | 79,800 | 29,775.50 |
| 1940 | 110,000 | 45,725.00 |
| 1941 | 37,500 | 16,042.75 |
| 1942 | None | None |
| 1943 | 373,900 | 247,921.26 |
| 1944 | 131,900 | 102,203.12 |
| Total | $ 873,400 | $ 488,199.11 |
The sales price of the Conestoga Transportation Company * bonds for the period 1939 to 1944, inclusive, is as follows: *511
| Average | |||
| price paid | |||
| Year | High | Low | by petitioner |
| 1939 | 42 1/2 | 33 | 36.11 |
| 1940 | 41 1/2 | 35 | 41.57 |
| 1941 | 46 | 40 | 44.38 |
| 1942 | 56 | 43 | |
| 1943 | 69 1/2 | 54 1/2 | 66.31 |
| 1944 | 89 1/2 | 67 1/2 | 77.48 |
Of the Conestoga Traction Company bonds purchased by petitioner in the years 1940, 1941, and 1943, the differences between the purchase price and face value, less unamortized discount, were $ 59,731.12, $ 20,063.07, and $ 115,167.05, respectively. Petitioner included the differences for 1940 and 1941 in its income tax returns for those years as income.
The petitioner's net income before provision for income tax for the years 1932 through 1943 as shown on its reports filed with the Public Utility Commission of Pennsylvania and on its Federal income tax returns is as follows:
| P. U. C. reports | Federal income | |
| Year | tax returns | |
| 1932 | ($ 29,567.54) | ($ 153,282.53) |
| 1933 | (3,003.89) | (107,025.25) |
| 1934 | 9,722.49 | (92,526.21) |
| 1935 | 35,788.86 | (23,086.84) |
| 1936 | 27,215.97 | (34,334.19) |
| 1937 | 30,888.25 | (8,432.99) |
| 1938 | (31,475.51) | (87,159.34) |
| 1939 | (13,864.47) | (55,010.92) |
| 1940 | (3,830.67) | (68,810.59) |
| 1941 | 20,040.33 | (47,572.39) |
| 1942 | 211,593.46 | 150,806.31 |
| 1943 | 522,167.64 | 470,188.42 |
*83 The sums given above as reported on the income tax returns do not reflect income from purchase of bonds, and no net operating losses were carried forward or back in arriving at these sums.
During the war years, the traffic of petitioner increased greatly over what it formerly had been. In 1943, the petitioner's level of traffic was 135 per cent more than it had been in 1940. This compared with an increase in traffic for the country as a whole of only 70 per cent.
The petitioner paid interest on its funded debt during the years 1940 through 1944 in the following amounts:
| 1940 | $ 69,217.71 |
| 1941 | 65,698.36 |
| 1942 | 65,296.00 |
| 1943 | 60,913.63 |
| 1944 | 47,606.66 |
The petitioner has never failed to pay interest when due on its indebtedness. It has never been in receivership nor has there been a *512 threat of receivership since 1931. The petitioner declared a dividend of $ 0.25 per share in 1937 and in the same amount in 1938.
The petitioner filed a claim for refund of income taxes for 1942 and amended returns for 1940, 1941, and 1942 on January 26, 1944. The basis of the claim was that it had erroneously included in income for the years 1940 and 1941 the sums of $ 59,731.12*84 and $ 20,063.07, respectively, which represented the difference between the par value (less unamortized discount) and purchase price of petitioner's bonds.
In each of the taxable years 1940, 1941, and 1943 in which petitioner purchased its own bonds, its liabilities exceeded its assets both before and after the purchases. No assets of petitioner were freed as a result of these purchases and no income was realized therefrom.
The going concern value of the petitioner's business was an amount not in excess of $ 100,000 in each of the taxable years.
In 1936, petitioner purchased notes of the Baltimore & Ohio Railroad Company for $ 15,231.85. In February 1940, pursuant to a court decree and in accordance with a supplemental indenture, petitioner surrendered its notes to the issuing company and there were annexed thereto extension agreements and new coupons. The fair market value of the Baltimore & Ohio notes owned by the petitioner on February 20, 1940, after they were modified was $ 8,550. Petitioner did not deduct any amount as a loss in the year 1940 when the notes were surrendered.
In 1944, these notes were called by the Baltimore & Ohio Railroad Company at face value and petitioner*85 received $ 14,992.55 therefor. In its 1944 tax return, petitioner reported as income $ 6,442.55, which represented the difference between the fair market value of the notes as of the date of recapitalization ($ 8,550) and the amount received ($ 14,992.55).
In April 1946, petitioner filed a claim for refund of 1944 income taxes based on the fact that the transaction in 1940, pursuant to which petitioner exchanged its notes for other notes of the same company, was nontaxable under section 112 of the Internal Revenue Code and that petitioner's basis in computing gain or loss was the original cost of the notes of $ 15,231.85. Respondent determined that the basis was $ 8,550.
Petitioner's basis for computing gain or loss on the Baltimore & Ohio Railroad Company notes is $ 15,231.85, the original cost of the notes.
OPINION.
The major issue is whether the petitioner realized income upon the purchase of its obligations at less than face value, minus unamortized discount, during the years 1940, 1941, and 1943. *513 The years 1940 and 1941 are before us only in connection with the determination of net losses as they affect the years 1942 and 1943.
Since the Supreme Court decision in*86 United States v. Kirby Lumber Co., 284 U.S. 1">284 U.S. 1, it is now well settled that a solvent corporation realizes income upon the discharge of its indebtedness at less than face value since "it [the transaction] made available * * * assets previously offset by the obligation." Subsequent to the Kirby decision, we held in Porte F. Quinn, 31 B. T. A. 142, that such a transaction did not give rise to the realization of income if the taxpayer was insolvent both before and after the transaction, as the discharge of the indebtedness in such a case did not free or make available any assets to the taxpayer. In Porte F. Quinn, supra, we stated:
But he [the taxpayer] has not realized income by being relieved from paying that which he in fact is unable to pay. "Gain or profit is essential to the existence of taxable income. A transaction whereby nothing of exchangeable value goes to or is received by a taxpayer does not give rise to or create taxable income." [Cases]
In Lakeland Grocery Co., 36 B. T. A. 289, we again had occasion to consider United States v. Kirby Lumber Co., supra,*87 and cases subsequently decided, and we there held that since the taxpayer's assets exceeded its liabilities immediately after the discharge of the indebtedness, it realized income to the extent of the value of the assets which were freed from the claims of creditors as a result of that transaction, even though the assets were not in excess of liabilities prior to the transaction. In these cases we referred to the financial condition in which liabilities exceeded assets as "insolvency."
Both parties cite the above cases and recognize that they lay down the principles under which this proceeding is to be decided. Their principal difference is as to whether the petitioner was solvent or insolvent both before and after redemption of its bonds. The petitioner claims that it was insolvent. In reaching this conclusion, it compares the values of its tangible assets with the amount of its liabilities. The respondent does not seriously dispute the figures that are used by the petitioner but reaches a conclusion of solvency based largely on the petitioner's history and its potential earning power. The respondent also takes into consideration what may be termed a "going value."
The existence*88 of a going value has been recognized and taken into consideration by the courts for a variety of purposes. In the case of Los Angeles Gas & Electric Corp. v. Railroad Commission of California, 289 U.S. 287">289 U.S. 287, the Supreme Court considered such a value as inhering in an operating business for rate making purposes. The Court said, in part:
This Court has declared it to be self-evident "that there is an element of value in an assembled and established plant, doing business and earning money, over *514 one not thus advanced," and that this element of value is "a property right" which should be considered "in determining the value of the property upon which the owner has a right to make a fair return." * * * The going value thus recognized is not to be confused with good will, in the sense of that "element of value which inheres in the fixed and favorable consideration of customers, arising from an established and well-known and well-conducted business," which, as the Court has repeatedly said, is not to be considered in determining whether rates fixed for public service corporations are confiscatory. * * * The concept of going value is not to *89 be used to escape the just exercise of the regulatory power in fixing rates, and, on the other hand, that authority is not entitled to treat a living organism as nothing more than bare bones.
The principle as thus recognized and limited is obviously difficult of application. * * * It does not give license to mere speculation; it calls for consideration of the history and circumstances of the particular enterprise, and attempts at precise definition have been avoided. * * *
The going value of a business has also been taken into consideration under the Federal Bankruptcy Act, In re Nathanson Bros. Co., 64 F. 2d 912, and under state insolvency statutes, Pacific States Savings & Loan Co. v. Hise, 25 Cal. 2d 822">25 Cal. 2d 822, 155 Pac. 2d 809. See also the annotation at 158 A. L. R. 968. In the Nathanson Bros. case, the court defined going concern value as follows:
Doubtless the underlying principle of going concern value is that an additional element of value attaches to property, considered in the aggregate, by reason of its having been assembled for the conduct of the given business *90 and its fitness for such use.
Neither party has cited any case, nor have we found any, which passes on the question of what weight is to be given to going concern value for the purpose of determining whether a taxable gain is realized by a taxpayer on the redemption of its securities at less than the issue price. Under the circumstances of this case, and in view of the nature of the evidence offered by the parties, it is our view that in determining the solvency or insolvency of the petitioner, the going concern value that attached to its property is a proper subject of inquiry.
The petitioner, in our opinion, has not given due weight to the value of its properties as they constituted parts of "an assembled and established plant, doing business and earning money." Los Angeles Gas & Electric Corp. v. Railroad Commission of California, supra. As to the respondent's contention, we think it is proper to take into consideration the going concern value and in doing so it is not error to consider the petitioner's history. "Whether there is going concern value in any case depends upon the financial history of the business." Federal Power Commission v. Natural Gas Pipeline Co., 315 U.S. 575">315 U.S. 575, 591.*91 However, it seems to us that the respondent places undue emphasis on the reports that were filed with the Pennsylvania Public Utility Commission which are shown by the evidence not to represent *515 an accurate reflection of the petitioner's history. Also, it appears from the evidence that the respondent minimized the difficulties that were facing the petitioner, including the conversion from trolleys to buses, and its obligations to meet interest on its bonds and to prepare for their maturity.
We have examined and analyzed the testimony and the numerous exhibits offered by both parties and it is our conclusion that the petitioner had some going concern value which should be taken into consideration in resolving the question of solvency, but that that value did not exceed the amount of $ 100,000 in any of the years before us.
In the years 1940 and 1941, the petitioner's liabilities so far exceeded the value of its assets that the addition of $ 100,000 to assets will not result in solvency for those years. For the year 1943, the balance sheet adjusted for the major items that were stipulated shows an excess of liabilities over assets in the amount of $ 72,410.58. However, the*92 balance sheet as so adjusted does not take into consideration the correct amount of depreciation sustained on buses. The evidence is that in 1943 and in prior years depreciation on buses was computed on the basis of a 10-year life rather than on a correct 8-year life. Correction of this error will lower the value of the buses by at least $ 100,000 and will offset any amount attributed to going concern value. With these adjustments the petitioner was still insolvent at the close of 1943.
It follows, and we so hold, that the purchase by the petitioner of Conestoga Traction Company bonds in the years 1940, 1941, and 1943 did not result in the realization of income.
The remaining issue concerns the basis of notes of the Baltimore & Ohio Railroad Company that were called and redeemed by that company in 1944. The petitioner contends for a basis of cost at the time of acquisition by it in 1936, whereas the respondent's position is that the basis is fair market value in 1940 when the original notes were modified by extension of the maturity date and reduction of interest rate. The case of Mutual Fire, Marine & Inland Ins. Co., 1057">12 T. C. 1057, involved the*93 question of basis of another issue of bonds of the Baltimore & Ohio Railroad Company, the maturity date of which was extended and the fixed interest rate was reduced in 1940 pursuant to a plan proposed by the company on August 15, 1938, which date is the same as the date of the proposal as to the notes involved in this proceeding. We held for the petitioner in that case and said:
It has been held that a recapitalization, and hence a reorganization, within the meaning of section 112 (g) results under circumstances similar to those which took place in 1940 in connection with the Baltimore & Ohio Railroad Co. plan. Sigmund Neustadt Trust, 43 B. T. A. 848; affd., 131 Fed. (2d) 528; Commissioner v. Edmonds' Estate, 165 Fed. (2d) 715, affirming a memorandum opinion of the Tax Court.
*516 We see no valid factual distinction between the Mutual Fire case and the present one, and decision on this point will be for the petitioner.
Decision will be entered under Rule 50.
Footnotes
*. Included in the current liabilities for the year 1943 are taxes payable in the amount of $ 248,370.44. This is the amount of taxes payable as shown on petitioner's original tax returns for the years 1941 to 1943, inclusive.↩
*. This figure does not give effect to our finding that the life of the buses was 8 years rather than 10 years with the increase of allowable depreciation. Depreciation computed at the proper rate would reduce the value of buses by not less than $ 100,000.↩
*. The name of the company is so stipulated. Presumably the correct name is Conestoga Traction Company.↩