PENNSYLVANIA WATER & POWER COMPANY v. COMMISSIONER OF INTERNAL REVENUE, Docket No. 56720.
| Decision Date | 24 August 1937 |
| Docket Number | Docket No. 56720. |
| Citation | 36 BTA 467 |
| Parties | PENNSYLVANIA WATER & POWER COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. |
| Court | U.S. Board of Tax Appeals |
Edwin M. Sturtevant, Esq., and Clyde T. Warren, Esq., for the petitioner.
William E. Davis, Esq., for the respondent.
The Commissioner disallowed several hundred thousand dollars, claimed by petitioner as deductions from its gross income in its return for the year 1928, and determined a deficiency in income tax against it for said year in the amount of $86,508.25. He concedes that he erred in disallowing $399,900.10 but contends that a deficiency of $39,675.82 exists by reason of the fact that $337,659.52 of the amount deducted by petitioner was improperly deducted and should be included in its taxable income. All of the facts were stipulated. We set out herein the portion of the stipulation especially pertinent to the issues raised.
1. Prior to 1924, petitioner generated all electricity sold by it exclusively by water power at its hydroelectric plant located on the Susquehanna River at Holtwood, Pennsylvania. The amount of electrical energy generated at Petitioner's hydroelectric plant varied from time to time due to changing river conditions. When the flow of the water in the Susquehanna River was high a maximum amount of electrical energy could be generated, and when the water was low, or ice had accumulated at the dam, the output of the plant was materially reduced. In order to supply Petitioner's customers with adequate and continuous service, and utilize the river flow to the best advantage, it became necessary to provide an auxiliary supply of electrical energy generated by steam.
2. Petitioner was advised by its counsel that it had no corporate powers to engage in the business of generating electricity by steam, and that it would be necessary to incorporate a subsidiary to carry on this activity. Accordingly, on August 9, 1924, Holtwood Power Company, hereinafter referred to as the "Holtwood Company," was incorporated under the laws of the Commonwealth of Pennsylvania, with an authorized capital of $1,500,000 consisting of 15,000 shares of the par value of $100 each. All of these shares were purchased by Petitioner and 50 of the shares were placed in the names of seven directors in order to qualify them as directors, Petitioner, however, remaining the equitable owner of the said 50 shares. With the funds paid by Petitioner to the Holtwood Company for the capital stock, and the proceeds received from the sale of the bonds hereinafter mentioned, Holtwood Company erected the auxiliary steam generating plant on a site immediately adjacent to Petitioner's hydroelectric plant.
3. By an agreement between Petitioner and the Holtwood Company, dated August 26, 1924, a copy of which is attached hereto as "Exhibit No. 1," which agreement ran to January 1, 1975, Holtwood Company agreed to deliver to Petitioner, on its order, electric power up to the full capacity of the steam generating plant, and Petitioner agreed to pay, or provide for the payment, monthly of every obligation and expense of the Holtwood Company, and a net return of 8% annually upon the par value of all its securities at any time outstanding. Among the items enumerated in the agreement to be paid by Petitioner were (1) "a sum to provide for amortization of debt, discount and security issue expense," and (2) "the expenses attending the issue, registration and transfer of the capital stock and bonds * * * now or hereafter issued and outstanding, and all interest on its bonded or other indebtedness at any time outstanding or existing, as and when said several interest payments may become due and payable."
From the date of completion of the Holtwood Company's steam plant on August 16, 1925, to the date of the consummation of the "short form of merger," hereinafter mentioned, of the Holtwood Company into Petitioner (December 21, 1927), all the electric energy generated at the steam plant was delivered to Petitioner. Petitioner's officers were officers of the Holtwood Company, and the Holtwood Company, during its entire existence, was managed and the steam plant operated by Petitioner's officers and employees. The officers of the Holtwood Company did not receive any salaries from that Company and the said Company did not have any employees. Petitioner, however, increased the number of its employees in order to operate the steam plant. The steam plant of the Holtwood Company was operated only at such times as conditions of river flow made it necessary for Petitioner to utilize an auxiliary supply of electric energy. It was operated at all times as a department of Petitioner.
4. For the purpose of providing part of the funds for the construction of the steam power plant, Holtwood Company executed a mortgage and deed of trust to the New York Trust Company, Trustee, dated September 1, 1924, whereby it conveyed all its property to the said trustee for the purpose of securing bonds to be issued under said deed of trust not in excess of $25,000,000 at any one time outstanding. A copy of the said deed of trust is filed herewith, marked "Exhibit No. 2." The deed of trust (page 15) provided that the bonds might be issued in one or more series; that a series of bonds limited to $2,750,000 in aggregate principal amount should be designated "Series A" (page 16); that Series A bonds should be dated September 1, 1924 (page 17), should bear interest at the rate of six per centum (6%) per annum (page 16), should mature September 1, 1954 (page 16), and should be redeemable at the option of the Holtwood Company, as a whole or in any part, on any interest date prior to maturity at the principal amount thereof, together with a premium of seven per centum (7%) of the principal amount thereof in the case of bonds redeemed on or before September 1, 1929 (page 17), which premium was to be reduced one-fourth of one per cent, on March 1, 1930, and on the first day of March in each year thereafter until March 1, 1953, when the redemption price would be 101 per cent. (page 17).
5. Subsequent to the execution of the said deed of trust, the Holtwood Company sold to the public $2,750,000 par value of its Series A 6% First Mortgage Sinking Fund Gold Bonds, dated September 1, 1924, maturing September 1, 1954, and received therefor a cash consideration of $2,612,500.
6. The issuance of the Holtwood Bonds comprehended a financing cost of $162,749.87 represented by discount and expenses as follows:
Discount _________________________________ $137,500.00
Expenses _________________________________ 25,249.87
___________
Total _______________________________ $162,749.87
7. This amount of $162,749.87 was set up on the books of the Holtwood Company as "Unamortized Bond Discount and Expense." Each year from 1924 to 1927, inclusive, the discount and expense was amortized on the books of the Holtwood Company by charging off an aliquot portion of the said discount and expense based on the life of the bonds.
8. The Holtwood Company had no income other than payments made to it by Petitioner pursuant to the agreement dated August 26, 1924, above referred to and filed herewith as "Exhibit No. 1."
9. Each year from 1924 to 1927, inclusive, a consolidated income tax return was filed for Petitioner and the Holtwood Company. In the said income tax returns the discount and expense, applicable to the Holtwood Bonds, was pro-rated or amortized by taking as deductions in each of said years an aliquot portion of the said discount and expense based on the life of the bonds.
The Petitioner was required by the agreement of August 26, 1924, to make payments to the Holtwood Company on account of the amortization of bond discount and expense, which payments were deductible from Petitioner's gross income as ordinary and necessary business expenses (cost of power), and the Holtwood Company reported these payments as income, which were offset by its deductions on account of amortization of discount and expense. The said agreement ran to January 1, 1975 and the Holtwood Bonds matured September 1, 1954.
10. After the incorporation of the Holtwood Company, Petitioner was advised by its counsel that Petitioner and the Holtwood Company could not consolidate or merge because they were not engaged in similar businesses, since Petitioner had power to supply water to the public, which power the Holtwood Company did not possess. On June 26, 1926, the Supreme Court of Pennsylvania, in the case of York Haven Water and Power Co. et al. v. Public Service Commission of Pennsylvania et al., 287 Pa. 241, 134 Atl. 419, decided, under similar facts, that such companies might consolidate or merge provided the power to supply water be legally discarded. On October 4, 1927, pursuant to the holding of the Court in that case, Petitioner surrendered its corporate power to store, transport and supply water in accordance with the procedure prescribed by the corporation law of Pennsylvania.
Thereafter a "short form of merger" of the Holtwood Company into Petitioner was effected under Section 23 of the Act of the Commonwealth of Pennsylvania of April 29, 1874, as amended by Section 5 of the Act of April 17, 1876, and the Act of June 2, 1915, a copy of which is filed herewith as "Exhibit No. 3." Pursuant to and in accordance with the procedure prescribed by the said Act, as amended, Holtwood Company, by deed dated December 21, 1927, transferred all its franchises and property, real, personal and mixed to Petitioner, the sole consideration for the transfer being the delivery to the Holtwood Company of all its capital stock, and Petitioner assuming the indebtedness of the Holtwood Company. Thereupon, pursuant to the provisions of the Act of 1874, as amended, Holtwood Company, by operation of law ceased to exist. All the returns and certificates...
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