Chicago & North Western Ry. Co. v. Comm'r of Internal Revenue

• Decision Date: 27 February 1958
• Docket Number: Docket No. 37425.
• Citation: 29 T.C. 989
• Parties: CHICAGO AND NORTH WESTERN RAILWAY COMPANY, PETITIONER, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

29 T.C. 989

CHICAGO AND NORTH WESTERN RAILWAY COMPANY, PETITIONER, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 37425.

Tax Court of the United States.

Filed February 27, 1958.

Nelson Trottman, Esq., Harry B. Sutter, Esq., C. I. Waldo, Jr., Esq., Charles W. Davis, Esq., and Frederic W. Hickman, Esq., for the petitioner.

Gerald W. Broooks, Esq., Harold H. Hart, Esq., and Andrew Kopperud, Jr., Esq., for the respondent.

1.Petitioner owned 93.66 per cent of the stock of a railroad company referred to as Omaha.In 1929 Omaha had obligations amounting to $45,186,000 which would mature in 1930.At that time, Omaha's credit would not permit a refinancing without the guaranty of petitioner.Petitioner, in 1929, issued $72,335,000 of its own 4 3/4 per cent bonds and loaned $45,186,000 of the proceeds of this issue to Omaha, and took Omaha's note which was later exchanged for $45,186,000 of Omaha's 5 per cent bonds.Petitioner accrued and reported as income all the interest due from Omaha during the years 1930, 1931, and 1932 and approximately 50 per cent of such interest during 1933 and 1934, plus a few months of the 1934 interest.Thereafter, it did not accrue any of the bond interest due from Omaha.Of the interest thus accrued, Omaha paid petitioner a total of over $3,600,000 during the years 1930, 1931, and 1933.During the taxable years 1942 and 1943, Omaha made sufficient income due to the war to pay the current bond interest during those years but during those years it was hopelessly insolvent and owed petitioner past due interest of over $25,500,000 and an open account balance of over $2,900,000.Respondent determined that petitioner should accrue and report as income the current interest which became due in 1942 and 1943.In the alternative, the respondent pleaded that, under section 45,I.R.C. 1939, petitioner's net income for 1942 and 1943, and for the 2 years prior thereto due to carryovers, should be increased by the amount of interest petitioner had deducted on $45,186,000 of its 1929 bond issue.Held, (1) in view of the large amount of past due indebtedness, it was unreasonable to expect that Omaha could pay petitioner any of the current interest due in 1942 and 1943 within a reasonable time thereafter and that respondent erred in determining that petitioner should accrue and report as income such current interest which became due in 1942 and 1943; and (2)section 45 is not applicable to the facts of this case.

2.During the years 1940 through 1943, petitioner retired many units of roadway property which had been acquired prior to March 1, 1913.Although petitioner reported on an accrual basis, it, like many railroads, for purposes of depreciation and retirement of its roadway property, used the ‘retirement method.’This was permissible.Held, in determining the adjusted basis of the retired property under section 113(b)(1)(C),I.R.C. 1939, no adjustment to the ‘statutory cost’ of the property retired should be made for depreciation sustained prior to March 1, 1913.Los Angeles & Salt Lake Railroad Co., 4 T.C. 634, followed.

OPINION.

ARUNDELL, Judge:

Respondent determined deficiencies in income and surtaxes for the calendar years 1942 and 1943 in the amounts of $331,198.28 and $303,689.61, respectively.Petitioner claims there are no deficiencies and that it is entitled to a refund in each year.Respondent, on the other hand, has made claim for increased deficiencies under section 272(e) of the Internal Revenue Code of 1939.¹The years 1940 and 1941 are also involved in connection with a net operating loss carryover deduction from those years to the taxable year 1942.

The pleadings raised a large number of issues, all of which have been settled by the parties except two, namely: (1) Whether the respondent erred in including as interest income from a 92.66 per cent owned subsidiary, referred to herein as Omaha, an amount of $2,454,578 in each of the taxable years 1942 and 1943 and, in the alternative, if it should be finally determined that petitioner's net income for 1942 and 1943 should not be so increased, then whether interest deductions of petitioner and Omaha should be distributed, apportioned, or allocated under section 45 of the Internal Revenue Code of 1939 so that petitioner's net income for each of the years 1940 to 1943, inclusive, shall be increased by $2,146,335; and (2) whether the respondent erred in reducing the basis of items of roadway property retired in 1940, 1941, 1942, and 1943 by alleged depreciation sustained on such property prior to March 1, 1913, in the amounts of $280,123.65, $867,412.57, $651,813.88, and $297,761.90, respectively.

The evidence in this case was presented before a commissioner of this Court.The commissioner made a report of his findings of fact, which report has been served upon the parties.Both parties have filed some objections to these findings.The objections have been carefully considered.Most of the objections are not meritorious.The Court, therefore, adopts for the purpose of this opinion the findings of fact served upon the parties, with the exceptions and corrections noted in the next succeeding paragraph.

The last sentence in paragraph 42 of the findings is deleted.The amount of $693,728.39 appearing in the seventh line of paragraph 50 is corrected to read $693,782.39.The words ‘and freight’ are inserted after the word ‘passage’ in line 2 of paragraph 62.The words ‘including materials and supplies' are inserted after the word ‘assets' in the first line of paragraph 68.

A brief statement of the principal facts relative to the interest issue is summarized below.

Petitioner owned 92.66 per cent of the voting stock of Omaha from December 31, 1927, through the taxable years in question.Both petitioner and Omaha reported their income on an accrual basis of accounting.Both petitioner and Omaha, at all times here material, had the same president and other principal officers and a majority of common directors.

From 1921 to 1929, inclusive, the net income of Omaha, before deducting interest, averaged $3,069,463.Its total interest charges during the same 9-year period averaged $2,605,222.Omaha met all of these interest charges.During the first 5 months of 1930, obligations of Omaha amounting to $45,186,000 were to mature.At that time Omaha's credit would not permit a refinancing of these obligations without the guaranty of petitioner.

On November 1, 1929, petitioner issued $72,335,000 of its 20-year 4 3/4 per cent convertible gold bonds due November 1, 1949.Kuhn, Loeb and Company was paid an underwriting commission of $1,808,375 for its service in connection with the issue.Petitioner then loaned $45,186,000 of the proceeds of this issue to Omaha to enable the latter to discharge its maturing obligations of that amount and took in exchange Omaha's note dated June 1, 1930, due on or about January 1, 1940.The note was secured by a deposit of $45,186,000 of Omaha's 5 per cent bonds, dated March 1, 1930, and due March 1, 2000.These bonds were in turn secured by a first mortgage on the entire property of Omaha, dated May 1, 1929, and were later actually issued to petitioner on March 1, 1933, in exchange for the above-mentioned note of Omaha dated June 1, 1930.Petitioner charged Omaha with $1,250,566.15 of the above underwriting commission which was first placed in an open account.Later, in 1933, Omaha delivered to petitioner additional bonds totaling $1,000,000 in partial liquidation of the open account.

As of December 31, 1940, and through December 31, 1943, Omaha's indebtedness to petitioner remained constant at $46,186,000 in bonds and $2,905,559.71 in open account.Each drew interest at 5 per cent, which amounted annually to $2,309,300 on the bonds and $145,278 on the open account, or a total of $2,454,578.It is this interest which respondent contends petitioner should have accrued as income in each of the years 1942 and 1943.

During the 10-year period from 1930 to 1939, inclusive, the net income of Omaha, before deducting interest, averaged $525,406.Its total interest charges during the same 10-year period averaged $2,674,705.

On June 28, 1935, petitioner instituted proceedings for reorganization under section 77 of the Federal Bankruptcy Act.From that date until May 31, 1944, its property was in the custody of the United States District Court for the Northern District of Illinois, Eastern Division.During that period the legal title to petitioner's property was vested in successive trustees appointed by the court.The reorganization was consummated on June 1, 1944.

During the years 1932, 1933, and 1934, petitioner² borrowed a total amount of $46,588,133 from the R.F.C.These loans were secured by pledge of various collateral, including the above-mentioned $45,186,000 of Omaha bonds which were delivered by petitioner to the R.F.C. on or about March 1, 1933.Prior to 1944petitioner repaid $4,338,000 of the amount borrowed.In the summer of 1944 shortly after the consummation of the reorganization, petitioner's remaining obligations to the R.F.C. were liquidated by petitioner and the pledged $45,186,000 of Omaha bonds were returned to petitioner and have been held ever since in petitioner's treasury.

From the date of issue in 1929 until June 1, 1944, petitioner deducted on its Federal tax returns the full amount of interest accruing on its bond issue of $72,335,000.It did not pay the interest due thereon from January 1, 1939, to May 1, 1944, which unpaid interest amounted to a total of $14,316,302.In the reorganization the holders of such bonds received for them and for the unpaid interest due thereon petitioner's common stock in the amount of $45,860,390.

During the years 1929 to 1943, inclusive, Omaha took deductions on its Federal tax returns for interest accrued on its indebtedness to petitioner.The total amount of such interest deductions for those years was $34,786,925.25.³Of this amount,...