Claridge Apartments Co. v. Com'r of Internal Revenue, 8296

• Decision Date: 22 December 1943
• Docket Number: No. 8296,8297.,8296
• Citation: 138 F.2d 962
• Parties: CLARIDGE APARTMENTS CO. v. COMMISSIONER OF INTERNAL REVENUE. COMMISSIONER OF INTERNAL REVENUE v. CLARIDGE APARTMENTS CO.
• Court: U.S. Court of Appeals — Seventh Circuit

138 F.2d 962 (1943)

CLARIDGE APARTMENTS CO. v. COMMISSIONER OF INTERNAL REVENUE.

COMMISSIONER OF INTERNAL REVENUE v. CLARIDGE APARTMENTS CO.

Nos. 8296, 8297.

Circuit Court of Appeals, Seventh Circuit.

December 1, 1943.

Rehearing Denied December 22, 1943.

Walter Hamilton, of Chicago, Ill., for petitioner.

J. P. Wenchel, Chief Counsel, Bureau of Internal Revenue, John W. Smith, Sp. Atty., Bureau of Internal Revenue, Samuel O. Clark, Jr., Sewall Key, and Gerald Wallace, all of Washington, D. C., and Samuel H. Levy and Muriel S. Paul, Sp. Assts. to Atty. Gen., for respondent.

John E. Hughes, of Chicago, Ill., amicus curiae.

Before EVANS and MINTON, Circuit Judges, and LINDLEY, District Judge.

EVANS, Circuit Judge.

This is a Federal income tax case wherein the chief issue arises out of the disputed basis for the depreciation of a large apartment building, acquired by taxpayer in 1935 in a Sec. 77B bankruptcy reorganization proceeding. 11 U.S.C.A. § 207. Corollary issues are:

(1) The applicability of Sec. 270 of the Chandler amendment to the Bankruptcy Act, 11 U.S.C.A. § 670, providing for a decrease of the predecessor's depreciation basis proportionate to a cancellation or reduction of indebtedness through a 77B reorganization. In other words, and to be more specific, taxpayer challenges the soundness of the Commissioner's holding that an exchange of stock for bonds constitutes a "cancellation or reduction" of the debt within Section 270.

(2) The possible retroactive effect of Sec. 270 to prior tax years in which years the tax has already been paid.

(3) The decrease of the depreciation base by the amount of interest liability allegedly forgiven in the reorganization.

(4) The propriety of the Tax Court's exclusion, from the base, of a substantial sum claimed to have been paid as commission to the entrepreneur of the property.

(5) The refusal of the Tax Court to permit deduction of certain expenses of upkeep of the property.

(6) A separate and distinct issue, arising out of taxpayer's challenge of evidentiary support of the Tax Court's finding as to the value of the property in 1924, is also conditionally present.

The aforestated legal questions arise out of a rather simple fact statement, with factual dispute well nigh nil.

The property involved is a 106 apartment building in Chicago, which was erected upon a vacant lot owned by Charles F. Henry, a contractor and builder. In 1924, Henry erected this building at an alleged cost of $385,326.37. He conveyed the land to taxpayer's predecessor, taking in payment therefor, all of its $100,000 of par value stock. He asserted that he earned and took a commission of ten per cent of the building cost, i. e., $38,532.64, for services in supervising the construction of the building. This item was excluded by the United States Tax Court in its determination of the cost of the building.

The taxpayer's predecessor fixed its basis for depreciation by adding three items: first, the $385,326.37 cost of the building; second, $38,532.64, for contractor's services in supervising construction; and third, a miscellaneous item of $750.18. On this basis, taxpayer's predecessor each year, in its income tax return, made its depreciation deduction. Up to August 1, 1935, when the taxpayer acquired the property upon the completion of the reorganization proceedings, a total depreciation of $139,253.71 had been charged. This left (with minor other adjustments not here important) an adjusted depreciation basis of $239,377.33. Taxpayer asserts this should be accepted as the depreciation basis for the years in dispute (1935-1938).

The Commissioner makes different computations and reaches a different conclusion. Factually, he challenged only the $38,532.64 item in the taxpayer's base, which item the U. S. Tax Court disallowed.¹

Commissioner's position is more nearly one of confession and avoidance. He asserts that the proper basis for depreciation was not $239,371.33, but rather a sum which was also the market value of the building on August 1, 1935, when the taxpayer acquired the property. The fair value was $164,450.

Commissioner reached his conclusion in this way: In March, 1924, taxpayer's predecessor floated a $340,000, 6½% bond issue which was defaulted in October, 1931, at which time $277,000 of bonds were still outstanding. In February, 1932, there was a foreclosure decree, and in June, 1934, bankruptcy proceedings were instituted under Sec. 77B. A plan of reorganization was approved in May, 1935, and the final decree entered, March 1, 1937. The execution of that plan necessitated the exchange of ninety per cent of taxpayer's no par stock for the $277,000 of bonds — one share for each one hundred dollars face value of bonds — and the remaining ten per cent of stock going to predecessor's stockholders. The Court found the fair market value of this stock never exceeded $45 per share.

The Tax Court found that the fair market value of the building at the time of the confirmation of the plan was not in excess of $141,000 and the fair market value of the land was $16,000.²

Whether we should accept taxpayer's base of $239,377.33 or the Commissioner's here-asserted base of $141,000 turns not so much upon the ascertainment of the facts (concerning which there is dispute as to one item only) as it does on the Commissioner's legal contention that in determining the basis of depreciation he was required to reduce the original basis by the amount of indebtedness of the predecessor which was cancelled or reduced in said bankruptcy proceeding, not however below the fair market value of the property.

In other words, we are confronted preliminarily by two questions.

First, by accepting stock in taxpayer company and surrendering the bonds of taxpayer's predecessor, was there a "cancellation or reduction" of the amount of the original indebtedness of taxpayer's predecessor? If this question be answered in the affirmative, then certain other issues become unimportant because of the United States Tax Court's finding that the value of the building in 1935 was $141,000.

The second question is the applicability of Sec. 270 to the determination of a depreciation base made prior to its enactment. In other words, is Sec. 270 retroactive so as to affect the tax base for depreciation for tax years prior to its enactment.

The decision of the Tax Court satisfied neither party. Both sides appealed (and one brief amicus curiae has been filed). Their appeals have been consolidated in this court.

The Tax Court held: (1) Section 270 was applicable to the tax year 1938. (2) Section 270 was not applicable to the prior tax years. (3) There was no "cancellation or reduction" of the indebtedness within the meaning of this statute when the bonds were exchanged for stock of equal book value, so as to require diminution of the depreciation base. (4) The interest item which was wiped out in the reorganization was deductible, under Sec. 270, from the 1938 depreciation base. (5) The 10% commission was improperly included in the original cost, and therefore in the depreciation base. (6) Certain items of taxpayer's alleged expense were, by it, improperly deducted.

The Commissioner appeals from rulings (2) and (3). The taxpayer appeals from the holding of the court in (1), (4), (5), and (6).

Several of the above-stated issues will become moot if the Government's first contention, namely, that Sec. 270 controls, is upheld. We therefore turn first to a consideration of this section, which is quoted below.³ Also quoted is Sec. 268,⁴ 11 U.S. C.A. § 668.

Rejecting the Government's urge that this section applied, the Tax Court said:

"The substitution of common stock for bonds is not a cancellation or reduction of the liability represented by the bonds, no matter how much less the stock may be worth, since `the assets are not thereby freed from obligation. * * * While the bond loan has been terminated, the amount borrowed is now committed to capital stock liability instead of to the liability of a fixed indebtedness.'"

We are unable to accept this view of the statute. The acceptance of the stock for the bonds wiped out a direct debt liability, enforceable by legal action. The debt carried an interest obligation and priority of rights. The stock carried no right to interest and not even to dividends, unless surplus existed, and a declaration of distribution had been made. It carried no right to collect the sum represented by the investment therein. At best it is a right only to a proportionate distribution of the assets over and above all debts of the corporation, in case of liquidation.

As the Court said in Eyster v. Centennial Board of Finance, 94 U.S. 500, 502, 24 L.Ed. 188:

"The liability of a corporation to its stockholders on account of their stock is not a debt. The shares of a stockholder represent his proportion of the property of a corporation; and, upon the winding up of its affairs, the assets remaining after all liabilities are discharged are for division among the stockholders, according to their respective interests. The payment to stockholders upon such a division is for a dividend of the property divided, not for a debt owing by the corporation."

The words "canceled or reduced," as used in this statute, are comprehensive. Given their ordinary or literal meaning, they cover a case such as is here presented. Here there was an elimination of the bonded indebtedness. Assume that the former bondholders, in accepting the stock in the new company, received all of the assets of the old company (they received only 90%) and the new company had the same assets as the old company, they still gave up their status as creditors with the correlative right to interest, to sue to collect a debt if default occurred, to priority against lesser and subsequent creditors. They also gave up the interest which they forgave.

If we search for the intent of Congress as affecting the construction of these words, the...