Sharon Herald Co. v. Granger, Civ. A. 6870.

• Citation: 97 F. Supp. 295
• Decision Date: 30 April 1951
• Docket Number: Civ. A. 6870.
• Parties: SHARON HERALD CO. v. GRANGER, Collector of Internal Revenue.
• Court: U.S. District Court — Eastern District of Pennsylvania

97 F. Supp. 295

SHARON HERALD CO. v. GRANGER, Collector of Internal Revenue.

Civ. A. 6870.

United States District Court W. D. Pennsylvania.

April 30, 1951.

Leo H. McKay, (of Brockway, McKay & Brockway, Sharon, Pa.), for plaintiff.

Maurice P. Wolk, Special Asst. to Atty. Gen., Edward C. Boyle, U. S. Atty., Pittsburgh, Pa., for defendant.

GOURLEY, Chief Judge.

This is a suit for the refund of $2,878.27, plus accrued interest, paid as income and excess profits taxes for the fiscal years ended March 31, 1941, 1942 and 1943.

The assessment resulted from the disallowance by the Collector of Internal Revenue of the Pennsylvania Corporate Loans Tax paid by the taxpayer in the years 1941, 1942 and 1943 on bonds issued by the taxpayer.

The Corporate Loans Tax here involved was imposed by the Act of Assembly in Pennsylvania against the bond holders in the first instance, Act of June 22, 1935, P.L. 414, § 17, its supplements and amendments, 72 Purdon's Statutes Pa. § 3250-10.

In order that a clear picture will exist as to the factual and legal questions which exist, a detailed historical statement is required.

Prior to 1935 there were two daily newspapers published in the City of Sharon, one known as "The Sharon Herald Publishing Company" (Herald), and the other known as "The News Telegraph Company" (Telegraph). In 1935, Herald was owned by four stockholders. For twelve years McDowell, one of the stockholders, had been the president of that company. In 1935, Telegraph was owned by three stockholders. Lartz was the general manager of Telegraph, and had been with that company for approximately ten (10) years. Prior to that time he had been with Herald. It is thus apparent that Lartz, having had a connection with both newspapers, could easily visualize the advantage of there being a single newspaper, rather than two competing papers, in the City of Sharon and vicinity. Lartz obtained a power of attorney from his associates and McDowell obtained a power of attorney from his associates, authorizing these two men to work out a program for consolidating the two papers.

Some of the seven owners were getting along in years and desired financial security. Lartz and McDowell were now interested in possible future profits. Accordingly, the financial structure and its division among the seven owners was fixed as follows:

                                       7% Debenture         7%  Preferred
                    Name                  Bonds                 Stock           Common Stock
                Dickinson               $65,000.00           250 Shares          150 Shares
                Aiken                                        200 Shares          450 Shares
                Lartz                                                            700 Shares
                Buchholz                32,500.00            325 Shares
                Ramsey                  15,000.00            150 Shares          350 Shares
                Pharmer                  5,000.00             50 Shares          100 Shares
                McDowell                                                         750 Shares
                                       __________            __________          __________
                Total Original Issue  $117,500.00            975 Shares         2500 Shares
                

The capitalization of both papers was represented by common stock only. Neither company had any bonded indebtedness, although there was a small mortgage on Telegraph which was paid shortly after the consolidation of the papers. After several months of negotiations between Lartz and McDowell, during which time each discussed the developments with their respective associates and obtained their suggestions, these two men eventually worked out a plan of consolidation of the two papers. It is to be noted that the younger men, Lartz and McDowell, did not take any debenture bonds or preferred stock, but took 1450 shares of the 2500 shares of common stock. They thereby acquired the control of the common stock and of the policies of the new company.

During the negotiations, prior to the incorporation of the new company, Dickinson, who was to hold the major share of the bonds, raised the question with Lartz as to who should pay the state tax on the bonds to be issued by the new company, and Lartz and McDowell agreed that this tax would be assumed by the corporation so that the bonds would be tax free in the hands of the holders.

At the final meeting of all the owners of the two companies, prior to the formal consolidation, the plan in its entirety, including the payment by the corporation of the state tax, was agreed to by all seven, without deduction from the interest due the bondholders. One reason for the agreement as to payment of the state tax by the corporation was to provide that the holders of the debenture bonds would receive the same seven percent net return as the holders of the seven percent preferred stock. There was no tax on dividends of a Pennsylvania corporation at that time. The same is true today.

The new Sharon Herald Company (Sharon) was incorporated May 13, 1935, upon the basis of the agreed financial structure.

When the new corporation came into existence, it adopted the agreement that the bonds were to be tax free in the hands of their holders by its corporate conduct in paying the state tax from the beginning without deducting that amount from the interest paid to the bondholders.

The obligation to pay this tax was not printed on the bonds nor did it appear on the minutes. The reason for this was that it was a small, closed corporation and the owners understood their arrangement with each other. Details were left to accountants and attorneys, and the incorporation of the understanding in the minutes or on the bonds themselves was probably not deemed necessary.

Between May 13, 1935 and March 29, 1937, it became apparent that seven percent bonds and seven percent preferred stock took too much out of the earnings of the company; and all of the holders of the seven percent debentures and the seven percent preferred stock exchanged their holdings for five percent debentures, thereby eliminating all of the preferred stock.

In 1943, the Collector of Internal Revenue, in making the regular audit of the corporation business, questioned the deduction for payment of the corporate loans tax and refused to allow it for that year. He also went back to the years 1942 and 1941, that being as far back as the federal law permitted the re-examination and restatement of tax to be made. (The deduction had not been questioned for the years 1936 to 1940, inclusive.)

Following this disallowance and as far as the Federal government was concerned, the matter seeming to hang on the fact that there was no written resolution by the company formally agreeing to pay the corporate loans tax or statement on the fact of the bond that it was tax free, a formal resolution was adopted by the Board of Directors of the company on November 15, 1943, and approved by the stockholders on November 27, 1943.

This resolution provided: It was strictly understood and agreed among the owners of Herald and Telegraph that the new company, Sharon, should pay any tax levied upon the holders of the debenture bonds, which tax had been paid by Sharon upon the outstanding 7% debenture bonds, and also upon the 5% debentures, the issue in their place; that the company would continue to pay any tax-federal, state or county-that might be levied against the holders of such debenture bonds, in order that the holder would receive the whole amount of 5%. This agreement and understanding among the seven persons who were the owners of the two papers was carried out by Herald, while the 7% debenture and 7% preferred stock were outstanding, and also since the redemption of said preferred stock and debentures, and the issuance in their place of the present 5% debenture bonds; that this assumption of the taxes was one of the reasons why the owners were willing to accept the lower rate of interest; that this obligation of the company has been recognized up to the present time by both the federal and state taxing authorities.

Following the adoption of this resolution, there was attached to each outstanding debenture a printed statement to the effect that the company would assume the corporate loans tax.

The deduction for this tax has been recognized by the Federal government since that time. The payment of this tax to the Commonwealth of Pennsylvania has been handled, since the adoption of the resolution, in exactly the same way that it was previously handled under the informal oral agreement.

Question Presented.

In computing its income and excess profits taxes, is the taxpayer entitled to a deduction under the provisions of the Internal Revenue Code for state loan taxes which it paid on behalf of its bondholders?

In support of its claim to deduct the payments made to the Commonwealth of Pennsylvania, taxpayer points, not to one, but to three provisions of the Internal Revenue Code which it contends authorize the deduction: Section 23(a)(1) relating to ordinary and necessary business expenses; Section 23(b) relating to interest payments; and Section 23(c) relating to payments of taxes.

Section 23, as amended by Section 121(a), Revenue Act of 1942, c. 619, 56 Stat. 798, provides, as it applies to the instant case. "Deductions from gross income. In computing net income there shall be allowed as deductions:

"(a) Expenses.

"(1) Trade or business expenses.

"(A) In general. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *.

* * * * * *

"(b) Interest. All interest paid or accrued within the taxable year on indebtedness, * * *

"(c) Taxes generally. Taxes paid or accrued within the taxable year". 26 U.S. C.A. § 23.

It is axiomatic that the allowance of deductions from gross income does not turn upon equitable considerations, but depends upon legislative grace. Accordingly, an expenditure is deductible from gross income only where there is a clear statutory basis therefor. Interstate...