United States v. CLEVELAND, P. & ER CO.

• Citation: 42 F.2d 413
• Decision Date: 01 July 1930
• Docket Number: No. 5451.,5451.
• Parties: UNITED STATES v. CLEVELAND, P. & E. R. CO., Inc.
• Court: United States Courts of Appeals. United States Court of Appeals (6th Circuit)

42 F.2d 413 (1930)

UNITED STATES v. CLEVELAND, P. & E. R. CO., Inc.

No. 5451.

Circuit Court of Appeals, Sixth Circuit.

July 1, 1930.

John H. Pigg, of Washington, D. C. (Wilfred J. Mahon, of Cleveland, Ohio, and C. M. Charest, of Washington, D. C., on the brief), for the United States.

J. C. Little, of Cleveland, Ohio (Tolles, Hogsett & Ginn and J. W. Reavis, all of Cleveland, Ohio, on the brief), for appellee.

Before DENISON, MACK, and HICKS, Circuit Judges.

MACK, Circuit Judge.

Appeal from a judgment for defendant entered on the pleadings in an action by the United States under section 283(j) of the Revenue Act of 1926 (44 Stat. 9, 65, 26 USCA § 1064(j) to recover income and profits taxes for the years 1918 and 1919. The 1926 act provided that when, prior to its effective date, a hearing was had before the Board of Tax Appeals, there could be no review by the Circuit Court of Appeals but that the Commissioner might within one year bring suit for the collection of any amount disallowed by the Board. In such a suit, the findings of the Board are prima facie evidence of the facts. In the case at bar the findings of the Board were incorporated in the answer. Defendant moved for judgment on the pleadings. Since, for the purposes of such motion, all facts properly pleaded and not denied are to be taken as true, the statutory presumption may be disregarded, and the findings of the Board, which are not controverted by the government, considered merely as part of the facts stated in the complaint and answer. These may be briefly summarized as follows:

Defendant, the Cleveland, Painesville & Eastern Railroad Company, an Ohio corporation, was organized in 1895 to construct an interurban railway between Cleveland and Painesville, Ohio; in the following year it acquired and began to operate such a railway. In 1901 its charter was amended so as to authorize it to extend its line to Ashtabula, Ohio; it acquired rights of way and other property for this purpose. For some reason it was decided to have this extension constructed by a separate corporation. In April, 1901, the Cleveland, Painesville & Ashtabula Company, hereinafter called the Ashtabula Company, was organized; in 1902 it acquired the rights of way from defendant and constructed the road between Painesville and Ashtabula. Upon its completion, the trains of the two companies were operated between Cleveland and Ashtabula, over the tracks of defendant from Cleveland to Painesville, and over the tracks of the Ashtabula Company from Painesville to Ashtabula, under a series of traffic agreements between the two companies. From 1906 on, the properties of the two companies were operated as a single railroad. The business of both companies was controlled and managed by the same officers from defendant's office at Willoughby, Ohio. Defendant owned and operated the repair shops at which all repairs were made on the equipment of both companies, and supplied all electric power. All labor, supplies, and materials used in the operation of both roads were hired or purchased and all bookkeeping and financing done by defendant. The Ashtabula Company did not pay for these services and supplies, but defendant rendered monthly invoices for the expense of operating the Ashtabula line based upon an arbitrary apportionment of the total expense of operating both companies. These invoices were never paid, but annual demand notes were given to defendant for the amount of aggregate invoices; these notes likewise were never paid, so that during the tax years concerned the Ashtabula Company owed defendant more than $240,000 on this account, as well as about $120,000 for other advances.

The directors and officers of the two companies were identical, except that defendant had two more directors than the Ashtabula Company. During the years in question defendant owned 7090 of the outstanding 10,000 shares of stock of that company and $150,000 principal amount of first mortgage Ashtabula Company bonds; its chief stockholder, moreover, owned $282,000 of such bonds, out of a total issue of $1,000,000. Interest on the bonds was in default. Beginning in 1907, the Ashtabula Company sent to its stockholders notice of the annual meetings together with proxies running to the president and treasurer of defendant. At stockholder meetings of the Ashtabula Company during the calendar years concerned, 7,688 shares were voted in 1918, and 8,315 in 1919. Of these, defendant in 1918 voted the 7,090 which it owned and 541 shares through proxies, and in 1919, its own 7,090 shares and 1,187 proxies, so that during these years it actually voted more than 99 per cent. of the stock voted at these meetings. The outstanding 2,910 shares of the Ashtabula Company, not owned by defendant, were held in small blocks by approximately one hundred persons.

Upon these facts, the Board of Tax Appeals held, reversing the ruling of the Commissioner, that the Ashtabula Company and defendant were affiliated during the taxable years 1918 and 1919. Appeal of Cleveland, Painesville & Eastern Railroad Co., 4 B. T. A. 637. The District Court adopted the conclusion of the Board and entered judgment accordingly. 34 F.(2d) 316. The government contends that the question whether or not defendant and the Ashtabula Company were affiliated is a question of law, and that, under a proper interpretation of section 240 (b) of the Revenue Act of 1918 (40 Stat. 1082), and articles 631 and 633 of Regulations 45, there was no affiliation. Respondent contends that the patent purpose of the statute was to tax business units as such, and therefore the government's contention that ownership of stock is alone determinative and actual economic control must be disregarded, is unsound.

Section 240(b) of the Revenue Act of 1918 (40 Stat. 1057, 1082) provides:

"(b) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns directly or controls through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if substantially all the stock of two or more corporations is owned or controlled by the same interests."

(1) Few provisions in any of the income tax statutes enacted since the ratification of the Sixteenth Amendment have required a greater amount of litigation and judicial labor for their clarification than those relating to "invested capital"¹ in the Act of 1917 and subsequent acts, and those attempting to define corporate "affiliation" in the act of 1918 and later statutes. We shall at the outset endeavor to ascertain the purpose and meaning of section 240(b) by resort to the legislative history of that section and then by examination of the conflicting interpretations given it both by the Board of Tax Appeals and the courts.

The first requirement that "affiliated" corporations file a consolidated return of net income and invested capital appeared in an administrative regulation² promulgated by the Commissioner pursuant to the War Revenue Act of October 3, 1917, 40 Stat. 300, in which regulation affiliation was stated to exist "when one such corporation owns directly or controls through closely affiliated interests or by a nominee or nominees, all or substantially all of the stock of the other or others, or when substantially all of the stock of two or more corporations is owned by the same individual or partnership, and both or all of such corporations are engaged in the same or a closely related business; or (2) when one such corporation (a) buys or sells to another products or services at prices above or below the current market, thus effecting an artificial distribution of profits, or (b) in any way so arranges its financial relationships with another corporation so as to assign to it a disproportionate share of net income or invested capital."

It is apparent that this regulation embraced affiliations not only on the basis of stock ownership or control but also on that of economic interdependence or domination, and sought to tax the business unit irrespective of the form that the corporate structure assumed or of the method by which control was achieved. See Brownsville Coal & Coke Co. v. Heiner (D. C.) 38 F.(2d) 248; Haig et al., The Federal Income Tax (1921) 188 et seq.

When the bill which was to become the Revenue Act of 1918, H. R. 12863 (H. R. Doc. 1267, Sept. 3, 1918, 65th Cong., 2d Sess., p. 19), was pending before Congress, the Senate Finance Committee thought it desirable to incorporate therein the departmental regulation concerning consolidated returns. In reporting to the Senate, it stated:

"Provision has been made in section 240 for a consolidated return, in the case of affiliated corporations, for purposes both of income and profits taxes. A year's trial of the consolidated return under the existing law demonstrated the advisability of conferring upon the Commissioner explicit authority to require such returns.

"So far as its immediate effect is concerned consolidation increases the tax in some cases and reduces it in other cases, but its general and permanent effect is to prevent evasions which can not be blocked in any other way. * * * (After discussing methods of evasion.) While the committee is convinced that the consolidated return tends to conserve, not to reduce, the revenue, the committee recommends its adoption not primarily because it operates to prevent evasion of taxes or because of its effect upon the revenue, but because the principle of taxing as a business unit is sound and equitable and convenient both to the taxpayer and to the Government." (Italics ours.) Sen. Rep. 617, to accompany H. R. 12863, Dec. 6, 1918, 65th Cong., 3d Sess., pp. 8-9. See, also, Hearings Before the Senate Finance Committee on H. R. 12863, Sept. 26, 1918, 65th Cong., 2d Sess., Pt. II, pp. 21-23. Cf. Appeal of Farmers, etc., Bank, 5 B. T. A. 520, 525. The proposed Senate amendment survived the conference...