Commissioner of Int. Rev. v. Pittsburgh & WV Ry. Co.

• Decision Date: 09 February 1949
• Docket Number: No. 9632.,9632.
• Citation: 172 F.2d 1010
• Parties: COMMISSIONER OF INTERNAL REVENUE v. PITTSBURGH & W. V. RY. CO.
• Court: U.S. Court of Appeals — Third Circuit

172 F.2d 1010 (1949)

COMMISSIONER OF INTERNAL REVENUE v. PITTSBURGH & W. V. RY. CO.

No. 9632.

United States Court of Appeals Third Circuit.

Argued November 1, 1948.

Decided February 9, 1949.

S. Dee Hanson, of Washington, D. C. (Theron Lamar Caudle, Asst. Atty. Gen., and Sewall Key and George A. Stinson, Sp. Assts. to Atty. Gen., on the brief), for petitioner.

Norman D. Keller, of Pittsburgh, Pa. (W. A. Seifert and Reed, Smith, Shaw & McClay, all of Pittsburgh, Pa., on the brief), for respondent.

Before BIGGS, Chief Judge, and McLAUGHLIN and KALODNER, Circuit Judges.

KALODNER, Circuit Judge.

This appeal is taken from the decision of the Tax Court.

The single question presented is whether the taxpayer realized taxable income in the taxable years 1941 and 1942 when it purchased in the open market its own first mortgage bonds at a cost less than the issue price and immediately, pursuant to its covenants in a junior trust indenture, deposited and pledged the purchased bonds with the trustee as additional collateral to the junior note issue.

The facts as found by the Tax Court¹ may be summarized as follows:

The taxpayer is a corporation, organized under the laws of Pennsylvania and West Virginia for the purpose of operating a steam railroad. Its principal office is in Pittsburgh. Its tax returns for the year involved were filed with the Collector for the Twenty-Third District of Pennsylvania.

On July 1, 1940, the taxpayer borrowed $7,400,000 and issued its five-year 4% notes in such amount, secured by an indenture dated July 1, 1940, between the taxpayer and First National Bank at Pittsburgh, as trustee.

Under the terms of the indenture, the taxpayer was required during the calendar year 1941 to devote not less than 25% of its "Available Net Income" for 1940, and during each calendar year thereafter, so long as any of the notes were outstanding and unpaid, not less than 50% of its "Available Net Income" for the preceding year "to the purchase at the lowest price or prices available in the open market but not exceeding the principal amounts thereof" of its then outstanding series A, B, and C first mortgage 4½% bonds, "and the Company (taxpayer) covenants and agrees that any and all of such bonds so purchased by the Company shall remain alive and forthwith be delivered to and pledged with the Trustee to be held by the Trustee as Pledged Securities under and subject to the terms of this Indenture."

If any described event of default were to occur, the trustee was given discretion to convert into money at public sale any of the pledged securities.

Pursuant to the provisions of the indenture, the taxpayer, in the year 1941, purchased $550,000 face value of its series A, B, and C first mortgage 4½% bonds for the sum of $349,220, and in the year 1942 purchased $282,000 face value of such bonds for the sum of $159,271.25, and immediately upon such purchases delivered the bonds so purchased to, and pledged them with, the bank as trustee under the indenture. The bonds remained pledged with the trustee until June 28, 1945, when they were returned to the taxpayer by the trustee upon the payment of the taxpayer's five-year 4% notes.

The bonds were secured by an indenture of mortgage and supplemental indentures between the taxpayer and the Union Trust Company of Cleveland, Ohio, and Robert S. Crawford, as trustees, dated December 1, 1928, April 1, 1929, April 30, 1929, and April 1, 1930, covering all properties owned or which would subsequently be acquired by the taxpayer, except cash, accounts receivable, bills receivable, stocks, bonds, notes, and similar intangible property and such of the real estate of the taxpayer as is not included within its rights-of-way and real estate upon which no structures used for railroad purposes are located, and engines, tenders, cars, and other rolling stock.

The Commissioner included in the taxpayer's gross income for the years 1941 and 1942 the difference between the face value and the purchase price of its bonds purchased and pledged by the taxpayer as aforesaid.

The Tax Court reversed the Commissioner's determination stating that it subscribed to the taxpayer's contention that the obligation embodied in the repurchased bonds "remained alive in the hands of another and was not extinguished until June, 1945 when the five-year notes were paid." It further held that the taxpayer "did not, in reality, obtain a cancellation of its debt in the instant years"; that "it did not effectively free any part of the mortgaged assets from the continuing lien of the bonds," and, "it could not be said with certainty at that time that, if the pledged bonds had to be resold, the entire transaction might not result in a loss."

The Commissioner urges that the Tax Court's disposition was not in accordance with the provisions of Section 22(a) of the Internal Revenue Code²; the pertinent Treasury Regulations³; and the authorities. He contends that the realization of taxable gains was not precluded in the taxable years by the taxpayer's pledging the purchased bonds as security for the then outstanding five-year note issue; that upon their repurchase the bonds became the taxpayer's property even though pledged, and thereafter its liability thereon was only contingent, its unconditional obligation on the bonds having been extinguished upon repurchase; and that upon the latter, the assets were thereby freed to the extent of the extinguished unconditional obligation, and in turn superimposed with only the separate and distinct liability upon the pledging of the bonds.

Finally, the Commissioner asserts that under the Amended Treasury Regulations and the decisions, the failure to retire or cancel the bonds immediately after their repurchase is immaterial and that for tax purposes the pledging of the bonds was a transaction separate and independent from the one involving their repurchase at a discount.

The taxpayer's position is, in sum, that it actually derived no taxable income in the years 1941 and 1942 from the purchase of its bonds at a discount since they were required to be and were, immediately pledged as additional security for the outstanding notes and that consequently the taxpayer's assets did not become available for its use freed from the obligation of the bonds.

The taxpayer concedes the general rule that income is realized by the purchase of one's obligations at less than their face value or issue price. United States v. Kirby Lumber Co., 1931, 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131; Helvering v. American Chicle Co., 1934, 291 U.S. 426, 431, 54 S.Ct. 460, 78 L.Ed. 891; Commissioner v. Jacobson, 69 S.Ct. 358. It contends, however, that the principle becomes applicable only when the obligation of the repurchased bonds is extinguished thereby freeing the assets securing the bonds. Here, it urges, the obligation of the bonds was not extinguished until the five-year notes were paid and it was only on such payment that the assets securing the bonds were freed.

We cannot subscribe to the taxpayer's view.

Taxability, where the taxpayer purchases its own obligations at a discount, is based "on the increase in net assets which resulted." Helvering v. American Dental Co., 1943, 318 U.S. 322, 327, 63 S.Ct. 577, 580, 87 L.Ed. 785. The increase in net assets constitutes taxable income in the year in which the transaction takes place.⁴

The simple test to be applied in determining the existence of taxable income is whether there was simultaneously "a decrease of liabilities with corresponding increase of net assets," by reason of the purchase of ones outstanding obligations at a discount. Helvering v. American Chicle Co., supra; Central Paper Co. v. Commissioner of Internal Revenue, 6 Cir., 1946, 158 F.2d 131, 133.

It was the Kirby case which originally established the principle that on the repurchase of one's own obligations at a discount there is "* * * an accession to income, if we take words in the plain popular meaning, as they should be taken here" 284 U.S. 1, 52 S.Ct. 4, and that the reduction of a liability is a separate transaction which immeditely creates taxable income during the year in which it takes place.

Thus here, the taxpayer's contention, to which the Tax Court subscribed, that ascertainment of the fact whether taxable income had been derived from the repurchase of the bonds would have to await the outcome of the pledging transaction with the note indenture trustee, is at variance with the established rule.

In Burnet v. Sanford & Brooks Co., 1931, 282 U.S. 359 at page 363, 51 S.Ct. 150, 151, 75 L.Ed. 383,⁵ the Court said:

"All the revenue acts which have been enacted since the adoption of the Sixteenth Amendment have uniformly assessed the tax on the basis of annual returns showing the net result of all the taxpayer's transactions during a fixed accounting period, either the calendar year, or, at the option of the taxpayer, the particular fiscal year which he may adopt. * * *"

And 282 U.S. at pages 364-365, 51 S.Ct. at page 152, 75 L.Ed. 383:

"A taxpayer may be in receipt of net income in one year and not in another. The net result of the two years, if combined in a single taxable period, might still be a loss; but it has never been supposed that that fact would relieve him from a tax on the first, or that it affords any reason for postponing the assessment of the tax until the end of a lifetime, or for some other indefinite period, to ascertain more precisely whether the final outcome of the period, or of a given transaction, will be a gain or a loss.

"The Sixteenth Amendment was adopted to enable the government to raise revenue by taxation. It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation. * * *"

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