*2639 Actual cash value of limestone and shale deposits paid in to a corporation in exchange for stock determined upon the basis of tonnage in place, the fair royalty price per ton upon the tonnage extracted during the year which the corporation would have been required to pay if it had acquired the deposits on a royalty basis, and the period of years for which the deposits would last.
*181 This is a proceeding for the redetermination of deficiencies in income and profits tax for the years 1919 and 1920 in the respective amounts of $18,996.05 and $71,599.81. The appeals were not heard together but it was stipulated between counsel for the Commissioner and counsel for the petitioner that the record, testimony, and proofs in the earlier appeal (Docket No. 3334) should be received in evidence in the later appeal. The only question in issue is the actual cash value, for the purpose of computing invested capital, of the limestone and shale deposits of the petitioner company paid in for $1,200,000 capital stock.
FINDINGS OF FACT.
In 1906, H. J. Paxton, who had*2640 been in the employ of the Wyandotte Portland Cement Co. of Wyandotte, Mich., for approximately five years, conceived the idea of establishing another cement factory. He investigated the situation as to raw materials, first in Wisconsin and Minnesota, and then at various points in Michigan. In this investigation he made an examination of different deposits and had analyses made. In his search for limestone it was necessary also to locate a deposit of shale or clay that had silica, iron, and aluminum in the proper proportions.
At this time there was a Portland cement company operating at Alpena, Mich. Paxton negotiated for the purchase of this plant but without success. He located a tract of 120 acres of the same limestone deposit from which the Alpena Portland Cement Co. was obtaining its limestone. There were a number of small cement mills operating in the vicinity, many of which for lack of capital were not financially able to operate. Paxton found that the owner of the tract of 120 acres which he had inspected was willing to sell at a reasonable price. Adjoining this tract the Michigan Alkali Co., a $25,000,000 corporation, owned limestone lands from which it was quarrying*2641 stone. A well had been drilled on the land showing *182 that the limestone went down to a depth of about 150 feet. The limestone was better adapted for the manufacture of cement than that which Paxton had found in Minnesota, Wisconsin, and elsewhere He estimated that there were about 150,000,000 tons of limestone in the 120 acres and that it would furnish limestone for a large cement factory for 50 or 60 years.
He secured an option for the purchase of the 120 acres in June, 1906, at a price of $20,000. At the time of securing the option he desired to make further tests as to the extent of the deposit and as to the availability of the limestone for the manufacture of cement. Then, too, it was necessary for him to locate, if possible, a deposit of shale or clay nearby which could be used in connection with the limestone in the manufacture of Portland cement. There was no clay near Alpena that could be used. Paxton spent several months surveying and drilling for clay or shale. During a part of the time he had 8 or 10 men working under his direction and supervision. In all, several thousand holes were drilled for the purpose of locating such a deposit. He finally discovered*2642 a deposit of shale suitable for the manufacture of cement, at least 33 feet in depth, about 12 miles from Alpena. His tests went down 15 to 18 feet but there was a 33 foot well on the tract which showed the extent of the deposit. Paxton secured an option for the purchase of this deposit, which covered an area of 120 acres, at a price of $5,000. He then prevailed upon the Detroit & Mackinac Railroad Co. to run a railroad from the factory site on the limestone deposit to the shale deposit at the railroad's own expense, provided a large cement factory should be built at Alpena. The cost of the railroad would be between $150,000 and $200,000.
The deposit of limestone was very advantageously situated. It was within the city limits of Alpena where there was an available labor supply. It was located almost at the water's edge. There was a small harbor at Alpena that had been available for the use of the lumber mills. The lumber mills had dredged a channel about 12 feet deep. This channel could be deepened at no great expense. The cement manufactured at Alpena could be shipped to all ports upon the Great Lakes at a cost of only one-third or one-fourth of the cost of shipping by*2643 rail.
The use of cement was rapidly increasing and, in 1906, a large part of the cement that was being used in Detroit and other lake ports was being brought from the Lehigh Valley in the east.
On December 13, 1906, Paxton took conveyance of the limestone land from the owners. He paid $20,000 or thereabouts cash for the property, borrowing the money from a bank or banks. At about the same time he acquired the shale lands at a price of $5,000.
*183 The proposition had now been assembled and Paxton took up the matter of forming a company to erect a factory. He estimated that a large factory with a capacity of 1,200,000 barrels per year would cost $800,000 to build. He wanted to build a large plant since it was more economical to operate than a small one. Working capital would also be needed. To secure these funds he approached J. B. Ford, at that time president of the Michigan Alkali Co., and S. T. Crapo, and their associates. Ford was familiar with the deposit of limestone at Alpena. It had been carefully inspected by the officers of the Michigan Alkali Co. before that company had acquired its deposit. He foresaw the possibilities of a Portland cement factory*2644 located on Paxton's deposit. The Michigan Alkali Co. had in its employ one H. R. Brown, who had made analyses and who had investigated the extent of the Alpena limestone deposit. Ford directed Brown to make an investigation of the limestone and shale lands upon which Paxton at that time had options, with a view of determining the extent of the quarryable deposits and their chemical qualities as materials for the manufacture of Portland cement. He reported to Ford that the limestone was of a very excellent character for the manufacture of cement; that the deposit could be quarried to an average depth of 100 feet, and he placed the value upon it at $15,000 per acre, or a total value upon the 120 acres of limestone of $1,800,000. The basis of Brown's estimate was that there were 300,000 tons or more of stone per acre and that its value in place was 5 cents per ton.
Ford and his associates were agreeable to the proposition made to them by Paxton, which was that a corporation should be organized; that Paxton should turn over to the corporation the limestone and shale lands which he owned in exchange for one-tenth of the capital stock of the corporation, provided Ford and his associates*2645 would reimburse him to the extent of nine-tenths of the cost of the land; that the balance of the capital stock of the corporation should be issued to Ford and his associates upon their undertaking to finance the corporation and erect a modern Portland cement factory. It was agreed that the money for the erection of such a factory and for needed working capital should be raised by the issuance of preferred stock and bonds.
The next problem before Paxton and his associates was the determination of the value of the lands and factory site to be paid in to the new corporation in exchange for its capital stock. Among the factors to be taken into consideration were the arrangement for a railroad to be constructed by the railroad company at its own expense to transport the shale to the cement factory and the location of the limestone deposit on the lake front convenient to the harbor, making it possible for coal to come in by water and for the *184 cement to be shipped at a low cost to all points on the Great Lakes. The final determination as to the value of the 120-acre tract was made by Ford. He thought that Brown's estimate of 5 cents a ton for the limestone in the ground*2646 was a little high. He estimated 313,000 tons per acre of quarryable limestone and a total content of 40,000,000 tons. He considered that a fair royalty for the limestone was 3 cents per ton. Upon a royalty basis of 3 cents per ton he computed the value at the date paid into the corporation at $1,200,000. He knew also that the selling price of cement was then from $1.15 to $1.20 per barrel and he believed that the new company could manufacture at a profit of 10 cents a barrel. On the basis of about 575 pounds of limestone to each barrel of cement, this meant about 30 cents profit for each ton of stone manufactured into cement.
The petitioner corporation was then organized and the minutes of the first stockholder's meeting read in part as follows:
The first meeting of the stockholders of the corporation Huron Portland Cement Company was held this day in accordance with the written waiver of all the stockholders duly entered upon the record of the 22nd day of January, 1907, in office No. 814 Majestic Building, Detroit, Michigan, at ten A.M.
Present: Messrs. B. F. Berry, J. B. Ford, H. J. Paxton and S. T. Crapo.
Mr. J. B. Ford was elected as President and Mr. S. T. Crapo*2647 as Secretary.
The Secretary thereupon read the Articles of Association as executed by the incorporators, and stated that Mr. H. J. Paxton offered to convey to the corporation the real estate described below, for the sum of Twelve Hundred Thousand ($1,200,000.00) Dollars, to be paid by the issue of full paid shares of stock to the following persons:
| Shares | |
| J. B. Ford | 3,005 |
| E. L. Ford | 2,995 |
| B. F. Berry | 2,400 |
| S. T. Crapo | 2,400 |
| H. J. Paxton | 1,200 |
Mr. J. B. Ford stated that he had investigated the lands proposed to be conveyed, that they were suitable for the purposes of a Cement Plant, and for that the stone contained therein was peculiarly fit for the manufacture of Portland Cement. Taking all things into consideration, he considered said lands worth to the Company the sum of Twelve Hundred Thousand Dollars ($1,200,000.00).
Thereupon the following resolution was unanimously adopted:
Resolved: That in our opinion the lands proposed to be conveyed to this corporation by H. J. Paxton are worth the sum of Twelve Hundred Thousand Dollars ($1,200,000.00) and that this Company accept a conveyance of them at said sum, in return for which paid non-assessable*2648 stock shall be issued in the aggregate sum of Twelve Hundred Thousand Dollars par value to be issued to the parties named by Mr. Paxton.
The opening entries on the books of the Huron Portland Cement Co. under date of January 22, 1907, show capital stock credited with $1,200,000 and subscription account debited as follows:
| J. B. Ford | $299,500 |
| G. R. Ford | 1,000 |
| G. B. Morley | 120,000 |
| H. J. Paxton | 120,000 |
| E. L. Ford | $299,500 |
| B. F. Berry | 240,000 |
| S. T. Crapo | 120,000 |
*185 The second entry shows the real estate account debited $1,200,000 and subscription account credited with like amount. Then follow the description of the limestone and shale lands described as mill site and clay lands, each description being set out in detail.
During the year 1908 the construction and equipment of the cement-manufacturing plant had progressed to such a state of completion that manufacturing operations were begun. By December 31, 1908, preferred stock had been issued and paid in at par to the amount of $573,400, indebtedness for construction purposes incurred to the amount of $315,138.72. The company's balance sheet at December 31, 1908, was as follows:
| Balance Sheet as of January 1, 1909. | |
| LIABILITIES | |
| Common stock | $1,200,000.00 |
| Preferred stock | 573,400.00 |
| Bills payable | 315,138.72 |
| Pay roll | 3,220.33 |
| Accounts payable | 74,686.30 |
| 2,166,445.35 | |
| ASSETS | |
| Real estate | $1,200,000.00 |
| Construction: Plant, equipment, preliminary | 820,329.01 |
| Supplies | 47,847.78 |
| Cement | 35,798.46 |
| Accounts receivable | 50,484.81 |
| Cash | 5,885.31 |
| Profit and loss | 6,100.08 |
| 2,166,445.35 |
*2649 During the 13 years from 1908 to 1921, inclusive, the company manufactured and sold 16,865,429 barrels of cement and used in the manufacture of this cement approximately 4,818,700 tons of limestone and the necessary proportion of shale. The total sales aggregated $21,762,992.08, and the operating profits before making provision for depreciation of plant and depletion of limestone and shale used were $5,081,514.15, or an average per barrel of cement manufactured and sold of 30.13 cents per barrel. Deducting reserves for income and profits taxes, interest on current loans, but not interest on bonded indebtedness, and making provision for depreciation of plant and equipment and depletion of limestone and shale used, there is left a net operating income of $3,048,914.25, and during these years the company received income from investments and other sources *186 aggregating $419,602.12, making a total income subject to the payment of interest upon long-term bonds, dividends upon preferred stock, and applicable to the payment of dividends upon common stock, or additions to surplus and undivided profits in the amount of $3,325,616.59.
During the years 1909 to 1921 the company*2650 increased its manufacturing plant and equipment and acquired warehouses at Cleveland, Detroit, and Duluth, and made investments in shipping facilities and other properties. By December 31, 1921, the preferred stock issued and paid in amounted to $800,000, and the company's indebtedness had increased and been funded into long-term bonds in the amount of $500,000. The bonds drew interest at the rate of 6 per cent and the preferred stock was issued on a basis of a 7 per cent dividend. On December 31, 1921, the company's balance sheet stood as follows:
| Balance Sheet as of January 1, 1922. | ||
| LIABILITIES | ||
| Common stock | $1,200,000.00 | |
| Preferred stock | 800,000.00 | |
| Bond issue | 500,000.00 | |
| Pay roll | 29,597.26 | |
| Accrued expense | 70,269.91 | |
| Reserve for income tax | 67,396.24 | |
| Accounts payable | 354,249.80 | |
| Surplus | 2,104,149.85 | |
| 5,125,663.06 | ||
| ASSETS | ||
| Real estate | $1,201,200.00 | |
| Alpena | 27,574.79 | |
| Detroit | 12,000.00 | |
| Cleveland | 10,000.00 | |
| Construction: | ||
| Alpena | $2,768,238.48 | |
| Less depreciation | 975,067.10 | |
| 1,793,171.38 | ||
| Detroit | 150,166.87 | |
| Less depreciation | 21,285.86 | |
| 128,881.01 | ||
| Cleveland | 104,995.57 | |
| Less depreciation | 20,420.28 | |
| 84,575.29 | ||
| Duluth | 163,269.58 | |
| Less depreciation | 22,251.60 | |
| 141,017.96 | ||
| Investments | 434,756.65 | |
| Huron Trans. Co. advance | 88,697.64 | |
| Supplies | 551,796.72 | |
| Unaccrued expense | 9,522.94 | |
| Cement | 260,168.16 | |
| Accounts receivable | 95,476.99 | |
| Bills receivable | 200.00 | |
| Cash | 286,623.53 | |
| 5,125,663.06 |
*2651 *187 No dividends were paid upon the common stock from the date of incorporation until 1916. A 2 per cent dividend was paid in each of the years 1916, 1917, and 1918, a 6 per cent dividend in 1919, a 7 per cent dividend in 1920, and a 6 per cent dividend in 1921.
In the year 1907 concrete was rapidly becoming an important building material. Concrete was also being used both for foundations and surface of public roads and highways, and portland cement was an essential element to the manufacturers of concrete. The then present demand for cement was very large and the future of the cement business could be predicated with a reasonable degree of certainty.
The recoverable limestone content of the 120 acres of limestone land was 40,000,000 tons. The limestone and shale lands paid in to the petitioner corporation for stock had an actual cash value at the time paid in in the amount of $237,600.
OPINION.
SMITH: The question at issue in this case is the actual cash value, for the purpose of computing invested capital, of the limestone and shale deposits paid in to the petitioner corporation in exchange for $1,200,000 par value of its common capital stock. It is the*2652 contention of the petitioner that such actual cash value was $1,200,000. The respondent has allowed an actual cash value for the property of only $25,000.
The limestone and shale deposits paid in to the corporation were acquired by H. J. Paxton at a cost of $25,000 plus a certain amount not shown by the record for expenses paid in determining the value of the deposits. He entered into an agreement with J. B. Ford and associates that if they would repay him nine-tenths of the cost of the property and build a cement mill, for which they should receive preferred stock and bonds of the corporation, and give him one-tenth of the common capital stock of such corporation, he would turn the lands over to the corporation. This agreement was acceptable to Ford and his associates. Paxton believed that the limestone deposit would last for a period of at least 50 or 60 years for the operation of a large mill and Ford testified that with the mill that was built in 1907 the deposit would probably last 100 years. Paxton estimated that the deposit contained 50,000,000 tons of limestone. Ford was a little more conservative and estimated that the quarryable content of the limestone deposit was*2653 approximately 40,000,000 tons. For purposes of the organization of the corporation he estimated the value of the deposits at $1,200,000. When asked as to the basis of his estimate he replied:
A. We arrived at that figure in this way: That Mr. Paxton at that time was very anxious to erect a cement plant and it was largely through his solicitation *188 to Mr. Berry that the matter came to me that Mr. Paxton wanted to build a cement plant, and he wanted the few of us at that time to go in with Mr. Paxton. Mr. Paxton had seen a few other people at that time about the proposition, and probably would have put the proposition over, as he was pretty anxious to build the mill.
However, after looking into the matter for some time, and knowing at that time that the value of that proposition lay in the amount of limestone, which I knew was there, and knowing about the harbor that we had there, and knowing the low cost of fixing up that harbor, which had been used previously and would only require some dredging, and the market condition I thought the best way to do to get at the value of the property would be to value it on what might be called a royalty basis. I have seen that*2654 basis used in a number [of] plant [a] where they had had anywhere from five feet to twenty-two feet, and found that the geologists give an average depth of the limestone in the United States, now in use for cement purposes at something like 22 feet, and they usually establish the value of the stone on a royalty basis. These royalties ran from two cents to five cents a ton, and I have been offered, in some places a price on that basis, and it was on the royalty basis that I fixed the value on that limestone at $1,200,000; that is as the value of the property.
Q. You had before you the suggestion of Mr. Brown?A. I had before me the suggestion of Mr. Brown, making it 5 cents a ton, which made something like $15,000 an acre on a certain depth which he took.
Q. Yes.A. And I made my computation on the basis of three cents which was the average of the rates that I had [paid] for the price of limestone lands.
Q. And you arrived at the value by using the index for limestone properties?
A. I did.Q. Did you have anything in mind as to a possible profit that you would have to make on the cement manufactured out of that limestone?
A. Yes, sir.Q. What*2655 was that?
A. We felt that we would have to make ten cents a barrel on the cement to come out.
Upon the basis of operating results the petitioner has had a certified public accountant prepare elaborate tables as to the value of the deposit upon the basis of Hoskold's tables. The computations are made upon the basis that in 1907 there were 42,417,600 tons of quarryable limestone in the deposit and that the deposit would last for a period of 40, 50, 60, or 70 years. It is also assumed that 8 per cent is the fair rate for remuneration of capital invested and that 4 per cent is the proper discount figure to be used. It is also figured that inasmuch as Ford estimated that the company could calculate on a profit of 10 cents per barrel of manufactured cement, and that 1 ton of limestone would produce approximately 3 barrels of cement, the company should compute a profit of 30 cents per ton upon the manufacture of the limestone into cement.
We are of the opinion that the basis for a value of 30 cents per ton for the limestone deposit in 1907 is not warranted by any evidence given by Ford. Ford testified that in purchasing limestone upon the royalty basis a fair royalty was from*2656 2 to 5 cents a ton and that *189 he had figured that 3 cents was the average of the rates that he had paid for limestone lands. He also figured that they would have to calculate on a profit of 10 cents per barrel to come out whole. It seems to us that this is far from saying that the actual cash value of the limestone in place in 1907 is to be computed upon the basis advanced by the petitioner. We can not determine how much of the manufacturing profit is to be attributed to skill in management and how much to the raw materials.
We think that the actual cash value of the limestone and shale deposits in 1907 is best determined from the following factors: That there were approximately 40,000,000 tons of limestone in place; that if the company were acquiring the deposit upon a royalty basis 3 cents per ton payable annually upon the tonnage mined during the year was a fair royalty price; that the deposit would last 60 years. In our opinion the evidence does not warrant a finding that the actual cash value of the deposits which Paxton transferred to the corporation for $120,000 par value of common stock plus $22,500 cash was in excess of $237,600, and we think that this amount*2657 should be used as the value of the deposits in the computation of invested capital.
Reviewed by the Board.
Judgment will be entered on 15 days' notice, under Rule 50.
LANSDON and TRUSSELL dissent.