*2152 Payments made by coal companies to a railroad company in compromise of suits at law growing out of the building of a railroad by the latter company to the mines of the coal companies held, under the facts, to constitute capital expenditures amortizable over the life of the coal properties, and not business expenses deductible in the year paid.
*327 These consolidated appeals seek a redetermination of deficiencies in income and profits taxes asserted by the Commissioner against these petitioners as follows:
| Colony Coal & Coke Corporation, Docket No. 37973, | |
| For 1923 | $1,162.83 |
| For 1924 | 2,534.43 |
| For 1925 | 1,358.65 |
| Hazard Coal Corporation, Docket No. 42263: | |
| For 1925 | 702.95 |
The alleged errors are that the Commissioner improperly treated payments of $22,666.67 made by each of the petitioners to the Louisville & Nashville Railroad Co. in 1923 as parts of a sum paid to that corporation in consideration for the building of 6.2 miles of railroad to their coal mines, and, therefore, *2153 capital charges not deductible in full for the year paid. A second issue involving allowances for depletion was disposed of by stipulation at the hearing.
FINDINGS OF FACT.
Both petitioners are coal corporations engaged in the owning and leasing of coal properties. In 1917 and during the years involved the Hazard Coal Corporation, the Virginia Iron, Coal & Coke Co., and the Montgomery Coal Corporation were all owners of adjacent coal lands in Perry County, Kentucky, lying along a subtributary to the Kentucky River known as "Carrs Fork." This stream was about 25 miles in length and emptied into a branch of the Kentucky River, known as "North Fork" at a junction point near Hamdin Station, on a line of railroad owned and operated by the Louisville & Nashville Railroad Co.
These coal companies together owned approximately 10,800 acres of coal lands extending out and along Carrs Fork, which, except for the branch line of the Louisville & Nashville Railroad Co., as mentioned, the nearest point of which was Hamdin Station, 2 1/2 miles away, was without railroad facilities. To encourage prospective tenants in leasing their properties and otherwise aid in their development, these*2154 corporations decided among themselves to procure in some way the construction of a line of railroad connecting their properties with the branch line of the Louisville & Nashville Railroad Co. at Hamdin Station. With this object in mind they caused surveys to be made and cost estimates to be prepared for the building of a railroad 6.2 miles long extending from Hamdin Station up and along said Carrs Fork to their properties. These estimates showed that such a line could be built at an approximate cost of $150,000, exclusive of steel. Having jointly settled their future plans in reference to the procurement of additional railroad facilities, these companies then turned their attention to the procurement *328 of desirable tenants to develop their properties and in 1917 executed in all seven leases to responsible parties for portions of their properties, each lease containing, among other things, the following provisions:
Art. I. The Lessee shall begin work under this lease within four months from the time actual construction of the railroad up Carrs Fork, as provided in Article XXXII hereof, has been begun, and shall proceed with all diligence to the end that it may be ready*2155 to ship coal or coke or other products of coal as soon as practical; and shall at all times energetically open, develop and keep up its operations; and shall put in a strictly modern plant with a capacity of at least a thousand tons of coal per day.
Art. III. The lessee shall pay to the lessor as a minimum annual rental hereunder on account of coal mined or to be mined in equal monthly installments payable on or before the 25th day of each month for the preceding month, at least the sum of $4,000 for the second year of this lease after the completion of a standard gauge railroad up Carrs Fork to the mouth of George's Branch; at least the sum of $8,000 for the third year; and $12,000 for the fourth year and each succeeding year. There shall be no fixed minimum for the first year after such completion, but payment is to be made only for the coal actually gotten out in that year.
Art. XXXII. It is understood and agreed that in the event the construction of a standard gauge railroad from a connection with the Louisville & Nashville Railroad near Hamden up Carrs Fork to or near the mouth of Montgomery Fork is not begun within 12 months from the date hereof, the lessee may at its*2156 option cancel and terminate this lease by giving the lessor written notice of its intention so to do.
Having leased their properties to responsible tenants, these corporations took up among themselves plans for carrying into effect their building project. After several conferences, first among themselves and then with officials of the Louisville & Nashville Railroad Co., they proposed to the railroad company that it build a branch line of its railroad to their properties. The terms of their proposal were set forth in a letter reading as follows:
LOUISVILLE, KY., Nov. 5, 1917.
Mr. M. L. MAPOTHER,
1st V-Pres L & N RR Co.,
Louisville, Ky.
DEAR SIR: Confirming the interview that Major Brown and I had with you this afternoon regarding the construction of 6.2 miles of railroad up Carrs Fork in Perry County, Ky., I beg to say:
The Virginia Iron, Coal & Coke Co., the Hazard Coal Corporation and the Montgomery Coal Corporation, owners of coal land, have seven leases (The Virginia Iron, Coal & Coke Co., three, the Hazard Coal Corporation three, and the Montgomery Coal Corporation one) on Carrs Fork that will be developed by said 6.2 miles of railroad, that provide for a*2157 minimum output after the third year of 800,000 tons - the minimum during the first three years increasing gradually until after the third year it is 800,000 tons per year.
*329 Of the seven leases five are already in executed contract form, with strong solvent Lessees - these executed leases providing for an ultimate minimum tonnage of 580,000 tons. The remaining two leases, not yet executed, but which can be closed whenever the railroad is assured, providing for an ultimate minimum tonnage of 220,000 tons. Total minimum, 800,000 tons.
In addition to this tonnage, there will, sooner or later, be three or four additional leases that will be developed by the 6.2 miles of road, to say nothing of the very large tonnage that can be developed by an extension of said line further up Carrs Fork.
As explained to you in previous interviews by Mr. Newton, President of Virginia Iron, Coal & Coke Co., and by Major Brown, President of Hazard Coal Corporation, the five executed leases provide that the lease contracts shall not be binding on the Lessees unless the railroad construction on the Carrs Fork Line is begun by January 1st, 1918, and in order to secure and make certain to*2158 the Lessors the benefits of these leases, and of the other two leases that can now be made, the Directors of the three Companies referred to have concluded that said three Companies will, if necessary, themselves build said 6.2 miles of road, and already have secured contract on more than three-fourths of the rights-of-way required, and have made the preliminary survey and location of said lands (which said survey and location have been completed by our engineers after several conferences with Mr. H. C. Williams, Chief Engineer of the L. & N., and have been approved by Mr. Williams) and the final location thereof will be begun this week and pushed to early completion.
While the three Companies referred to have made their plans to proceed forthwith to form a separate Company to take title to the rights-of-way, and to let to contract the construction of said line, all of them would prefer that this road in the outset be built as an L&N branch, and to that end Major Brown, as President of the Hazard Coal Corporation, and I, as Vice-President of the Virginia Iron, Coal & Coke Co., are authorized to make the following proposition:
(1) The three Companies referred to will have conveyed*2159 to the L&N, according to the L&N's standard form, all necessary rights-of-way for said 6.2 miles of road free of cost to it.
(2) The L&N to promptly let to contract the construction of said 6.2 miles to road and begin work thereon before January 1st, 1918.
(3) The said three Companies to guarantee that the cost of said 6.2 miles of road, exclusive of steel, but including the cost of all survey and location work, will not exceed $200,000, if at once let to contract and pushed to completion.
(4) The said three Companies to take L&N 5% construction bonds and pay for same at par, in cash, in an amount sufficient to cover the said cost of construction.
(5) The Lessees of said three Companies to stand the cost of the spurs and sidings necessary to reach their plants respectively.
Speaking for the Virginia Iron, Coal & Coke Co., I will say that we own in round numbers 50,000 acres of coal land in Kentucky which is tributary to the L&N Division of the L&N, and we are anxious to get royalty returns from some of this property, and we wish especially to make effective the lease contracts which have been entered into and which we consider very favorable for us.
*330 I*2160 understand you will have this proposition acted upon by the L&N within the next few days and advise us promptly so that our further steps may be taken in accord with their decision.
Yours very truly,
(Signed) D. D. HULL, Jr.,
Vice-President, Virginia Iron, Coal & Coke Co., Roanoke, Virginia.
I have read the foregoing letter and in behalf of the Hazard Coal Corporation hereby concur therein.
(Signed) WM. J. BROWN,
President, Hazard Coal Corporation.
This proposal was accepted by the railroad company in a letter over the signature of its president as follows:
NOVEMBER 12, 1917.
Mr. D. D. HULL, JR.,
Vice President, Virginia Iron, Coal & Coke Co.,Roanoke, Va.
Mr. WM. J. BROWN,
President, Hazard Coal Corporation,Bristol, Tenn.
GENTLEMEN: Your favor of the 5th instant, to Mr. W. L. Mapother, First Vice-President, duly received and considered.
The proposition submitted by you for the Virginia Iron, Coal & Coke Company, the Hazard Coal Corporation and the Montgomery Coal Corporation, for the construction of 6.2 miles of road up Carrs Fork, is accepted.
You of course realize the importance of having deeds for rights of way, and*2161 other necessary data, in the hands of our Engineering Department as promptly as possible (say not later than December 1st) in order that contract may be let and work begun before January 1, 1918.
Also, it is understood that you will, before the work of construction is actually begun, take and pay for, at par, sufficient Lexington & Eastern bonds to cover the cost of such construction, as described in paragraph 4 of your proposition.
Yours truly,
(Signed) M. H. SMITH, President.
Pursuant to the agreement as set forth in paragraph (1) of their proposal, these three companies caused to be conveyed by deed direct to the railroad company all of the necessary rights of way for 6.2 miles of railroad. They also, in accordance with provisions of paragraph (4) of said proposal, purchased from the railroad company $200,000 par value of the first mortgage 5 per cent gold bonds of the Lexington & Eastern Railway Co., with accrued interest, paying therefor the sum of $202,500 in cash.
Immediately following, and within the time agreed, the railroad company let the contract for the building of 6.2 miles of railroad from Hamdin Station, on its line, up and along Carrs Forks as proposed, *2162 but owing to war conditions, it was unable to complete the same until some time in 1921; and then at a cost which exceeded the guaranteed estimate of $200,000 by $175,070.71. Because of this excess in cost *331 over the guaranteed maximum, the railroad company later made demand upon the three coal corporations for payment to it of the sum of $175,070.71. These companies refused to concede any liability under their guarantee, alleging that the railroad company had failed to comply with a condition precedent to such, in that it did not speedily "push to completion" the building of said railroad within the terms and conditions of their agreement. Upon the refusal of these corporations to concede such liability, the railroad company filed suits against each of them in the Circuit Court of Jefferson County, Kentucky, upon their contract. These suits were later dismissed without trial, following a settlement in which the coal companies agreed to pay the railroad company a total sum of $68,000, in full settlement of all claims against them growing out of the building of the railroad.
Some time after making of the contract with the railroad company, but before its completion, *2163 the stockholders of the Virginia Iron, Coal & Coke Co. organized the petitioner, Colony Coal & Coke Corporation, to which, by proper deed duly executed on December 31, 1920, they transferred all of the assets of the Virginia Iron, Coal & Coke Co. in exchange for all of its corporate stock. Following such transfer, this petitioner assumed all responsibilities for the obligations of the Virginia Iron, Coal & Coke Co., and paid to the railroad company $22,666.67 as its one-third part of the settlement agreed upon. For this payment a receipt was given to it by the railroad company, which acknowledged settlement in the following recitals:
| For payment in full of Colony Coal & Coke Corporation's | |
| (formerly Virginia Iron, Coal & Coke Company) one- | |
| third part of agreed compromise in final adjustment of | |
| all claims in any wise arising or growing out of con- | |
| struction of railroad up Carrs Fork, in Perry County, | |
| Ky., and of the suit instituted on account thereof, - | |
| the agreed amount being $ 68,000, and Colony Coal | |
| & Coke Corporation's one-third part thereof being | $22,666.67. |
A similar payment was made to the railroad company by petitioner Hazard Coal Corporation.
*2164 In making its income-tax returns for 1923 and 1924 petitioner Colony Coal & Coke Corporation first took a deduction of $22,666.67 from its gross income for 1923 as an alleged business expense, or loss not otherwise compensated for, which resulted in showing a net loss to it for said year of $17,511.50. Claiming it as a net business loss from 1923, the petitioner carried this last amount forward into 1924 and deducted it from its gross income for that year. The respondent denied these claims as made, but held that the petitioner was entitled to amortize the amount paid to the railroad company over a period of 40 years, being the estimated productive life of *332 its coal properties, and take deductions therefor at the rate of $666.66 per annum, which he accordingly allowed.
On October 3, 1927, petitioner Hazard Coal Corporation filed an amended return for 1923. In this amended return it claimed the sum of $22,666.67, paid to the railroad company in the settlement hereinbefore referred to as a business loss sustained that year, which return, as so amended, showed a net loss for 1923 of $25,570.75. In auditing this return, the Commissioner disallowed the full $22,666.67*2165 as a deduction for the year 1923, but allowed the sum of $666.66, under a ruling similar to that made in respect to the other petitioner's claim.
At the hearing of these appeals, it was stipulated in the record that the Colony Coal & Coke Corporation, Docket No. 37973, is entitled to deductions for depletion, in addition to the amounts allowed in the deficiency notice for the years 1923 and 1924, in the amounts of $203.35 and $1,899.74, respectively.
OPINION.
LANSDON: We must first decide whether the payments of $22,666.67 made by each of the coal companies to the railroad companies were capital or business expenditures. The petitioners contend that they were business expenditures, inasmuch as they were made in settlement of a disputed claim, and, further, that no capital asset was acquired by them as a result.
The record shows that these coal companies entered into a contract with the railroad company wherein they agreed, among other things, that if the latter would build the 6.2 miles of track to their mines they would pay all costs of such building in excess of $200,000, and that these payments were made, as shown by the receipts, in final adjustment of all claims in*2166 anywise growing out of such construction. It also shows that the building of this road was a part of the coal companies' plans to develop their properties and that all of their leases contained conditions which depended upon it. Under these leases the tenants were not required to begin work of development of the mines until after "actual construction" of the railroad had begun, and, unless begun within 12 months, they had the option of terminating them upon written notice. The rentals to be paid after the first year of the leases were limited to minimums which were binding upon the tenants only after the completion of the road. All of these facts are pointed out to the railroad company by the coal companies in their proposal of November 5, 1917, which formed the basis of their contract. No analysis of this contract is necessary other than to say that it was entered into for the sole purpose of *333 making available to the petitioners' properties railroad facilities for marketing their coal. The building of this road brought to their mines these facilities which made good their leases and added to the value of their properties, regardless as to who owned it when built. *2167 It constituted, then, an increment which increased the value of their income-producing capital assets. Under very similar conditions the United States Circuit Court of Appeals for the Fourth Circuit, in the recent case of Gauley Mountain Coal Co. v. Commissioner, reported in , held that payments made by the taxpayer to a railroad company for the building of four miles of track to its mines constituted invested capital within the meaning of the taxing statute. In that case, as in the case at bar, it was argued that since the railroad company owned the road when built, the taxpayer acquired nothing of a permanent value which it could take up in its invested capital. The court, however, said in answer to this objection:
* * * Before the branch line was built, the mines of the taxpayer were 4 miles away from a line of railroad, and for that reason could not be operated profitably. As a result of its construction, and the railroad connection thereby acquired, the facilities of a great railway system have been brought to the mines of the company, and this has done away with the necessity of transporting the coal to the line of the railroad.
*2168 The taxpayer has acquired property of permanent value in the same sense as does a manufacturing corporation which pays a railroad company to build an industrial siding to its plant, or a land development company which pays a bonus to a street railway company to build a line through its property. Whether the rights acquired as a result of the railroad connection obtained are to be defined as tangible or intangible property, it is not necessary to inquire. Intangible property, which enables a taxpayer to save or earn money, is as legitimate a form of capital investment as tangible property. * * *
Upon authority of this decision we must here hold that the payments made to the railroad company by these petitioners were capital expenditures and the action of the respondent in respect thereto is sustained. Compare also .
Judgment will be entered under Rule 50.