Southern Ry. Co. v. Commissioner of Internal Revenue

• Citation: 74 F.2d 887
• Decision Date: 08 January 1935
• Docket Number: No. 3707-3710.,3707-3710.
• Parties: SOUTHERN RY. CO. v. COMMISSIONER OF INTERNAL REVENUE (three cases). HELVERING, Commissioner of Internal Revenue, v. SOUTHERN RY. CO.
• Court: United States Courts of Appeals. United States Court of Appeals (4th Circuit)

74 F.2d 887 (1935)

SOUTHERN RY. CO. v. COMMISSIONER OF INTERNAL REVENUE (three cases).

HELVERING, Commissioner of Internal Revenue, v. SOUTHERN RY. CO.

Nos. 3707-3710.

Circuit Court of Appeals, Fourth Circuit.

January 8, 1935.

W. T. Joyner and Sidney S. Alderman, both of Washington, D. C. (S. R. Prince, of Washington, D. C., on the brief), for Southern Ry. Co. and affiliated corporations.

Morton K. Rothschild, Sp. Asst. to the Atty. Gen. (Frank J. Wideman, Asst. Atty. Gen., and J. Louis Monarch, Sp. Asst. to the Atty. Gen., on the brief), for Commissioner of Internal Revenue.

Before PARKER, NORTHCOTT, and SOPER, Circuit Judges.

PARKER, Circuit Judge.

These are petitions to review decisions of the Board of Tax Appeals relating to tax assessments against the Southern Railway Company and its affiliated corporations for the years 1920, 1921, and 1922. The principal questions involved relate to the treatment of allowances made the railway company and its affiliates by the Director General of Railroads on account of undermaintenance and as additional compensation for the use of property during the period of federal control and for rental interest on completed additions and betterments made during that period. There is another and independent question relating to the right of one of the affiliates to deduct amortized bond discount for the years 1920, 1921, and 1922 on bonds sold at a discount and subsequently purchased by the company.

After the termination of federal control, negotiations looking to a settlement of the liability of the government were entered into between the Director General of Railroads and the company and its affiliates which were claiming $34,738,230.80 for undermaintenance and $10,338,031.10 for additional compensation. A lump sum settlement was agreed upon, as a result of which the company and its affiliates received $19,427,485.90 in money and credits, all of which was allocated by the company and its affiliates to undermaintenance. The Director General, without the knowledge of the company, allocated on his books only $11,966,199.35 to undermaintenance; but the Commissioner concedes that additional items of $280,000 and $559,734.33 should be allocated to this item, making the total undermaintenance allowance $12,805,933.68. The Director General allotted $4,836,764.58 as additional compensation generally and $244,800.38 as additional compensation on account of computation of mail pay, making the total of additional compensation in controversy $5,081,564.96. The company contends that this also is undermaintenance, making the total of that item, according to the company's contention, $17,887,498.64.

The company in making its tax returns for the year 1920 deducted $55,556,415.21 expended for maintenance in the last ten months of that year. The Commissioner reduced this amount by the amount which the Director General had allowed for undermaintenance; and the Board affirmed this action, adding by consent an item of $280,000 to the undermaintenance item. The petition of the company questions this ruling of the board, and the question so raised is the principal matter here in controversy. The Commissioner found that the $5,081,564.96, to which we have referred above, was additional compensation and taxable as income of the years of the final settlements in which it was allowed. The Board affirmed the Commissioner in holding it to be additional compensation and taxable as income, but held that it should be taxed as income of the period of federal control. The contention of the company and its affiliates in their petition is that it is not income at all but a part of the allowance for undermaintenance. The Commissioner, on the other hand, files petition complaining because it is held income of the period of federal control and asking that it and another item of $1,213,333.35, which is admittedly an allowance for additional compensation, and an item of rental interest of $391,347.60, allowed on completed additions and betterments, be held taxable as income of the years when allowed. Another question is presented as to the right of one of the affiliates to deduct from income amortized bond discount on mortgage bonds held by the company.

The records before us are voluminous; but, after the elimination of immaterial matters and questions upon which the parties are agreed, the case narrows itself to four questions, viz.: (1) Should the deduction on account of the company's expenditures for maintenance during the last ten months of the year 1920 be decreased by the amount allowed for undermaintenance during the period of federal control? (2) Should the $5,081,564.96 which the Commissioner and the Board treated as additional compensation be held to be a part of the allowance for undermaintenance? (3) If not held to be undermaintenance, should this and the other items of additional compensation and rental interest on additions and betterments be taxed as income of the years when allowed, or as income of the period of federal control? And (4) Is amortized bond discount allowable as a deduction where the bonds are held by an affiliate and a consolidated return is filed?

1. The Undermaintenance Question.

The allowance for undermaintenance was made the company and its affiliates by the Director General of Railroads because of the obligation of the government to maintain the properties while under federal control in as good condition as when taken over by the government. The property was returned to them in a run-down condition as compared with its condition when taken over; and the allowance on account of undermaintenance was to compensate for the damage which had been done to it as a result of the failure of the government to maintain it properly. The allowance was supposed to be determined by a comparison of the expenditures for upkeep during the period of federal control with those made during the test period of private operation; i. e., the period of three years preceding June 30, 1917. As we shall point out hereafter, we think that $12,805,933.68 was the portion of the allowance made to the company and its affiliates which is properly allocable to undermaintenance.

The road was turned back to the company and its affiliates on March 1, 1920, and was operated by them thereafter. During the remaining ten months of that year they expended for upkeep and maintenance the sum of $55,556,415.21, which they have deducted from income as a usual and necessary expense of the business. It is admitted that the worst conditions of undermaintenance existing on March 1, 1920, were repaired out of this expenditure; but it is also admitted, not only that the expenditure of the $55,556,415.21 was less than normal when compared with like expenditures of the test period, but also that the road was in a worse state of disrepair at the end of 1920 than it was on March 1st. With respect to this matter, the finding of the Board of Tax Appeals was as follows:

"The general physical condition of the federal controlled companies' ways and structures was not as good on December 31, 1920, as on March 1, 1920; and in June, 1921, the said properties were still undermaintained as compared with the maintenance standard of the test period.

"With reference to maintenance of equipment, the general condition of passenger cars, with regard to the percentages thereof in bad order, slightly improved between March 1, 1920, and December 31, 1920, there having been 8.41 per cent and 8.21 per cent of Southern Railway System passenger cars in bad order on those dates, respectively. As to freight train cars, 2.90 per cent of all revenue cars on line at March 1, 1920, were in bad order, while at December 31, 1920, the percentage had grown to 4.71. With regard to locomotives, 16.61 per cent of Southern Railway System locomotives were out of service for repairs at March 1, 1920, while at December 31, 1920, the percentage had grown to 18.29 per cent. These figures, though including Southern Railway System lines, some of which lines are not involved in these proceedings, are representative of the condition of equipment on the railroads comprising petitioner, 78 per cent of the passenger cars, 76 per cent of the freight train cars, and 85 per cent of the locomotives referred to above being owned by the Southern Railway Company alone.

"Locomotive repairs represent approximately 50 per cent of the money spent by petitioner in 1920 for maintenance of equipment, and the conditions in the locomotive repair department are representative of the freight train car repair department. Locomotive repairs are divided into two classes, known as `Classified Repairs,' which consist of such repairs as serve to rehabilitate or replace the fundamental parts of a locomotive, and `Running Repairs,' which consist of the minor repairs that come up purely in the operation of the locomotive and which do not restore or rehabilitate the condition of the locomotive to any material extent. During the test period, the Southern Railway Company expended for classified repairs 40.72 per cent of its entire expenditures for locomotive repairs, while in the last ten months of 1920 it expended only 27.25 per cent of its total locomotive repair expenditures for that class of repairs. Its expenditures for temporary or running repairs in the test period and in the last ten months of 1920 were 59.28 per cent and 72.15 per cent, respectively, of the total locomotive repair expenditures of these periods. * * *

"Making due allowances for differences (1) in the purchasing power of the dollar, (2) in amount of property maintained, and (3) in the use of property maintained, as between the test period and the last ten months of 1920, the expenditures of the federal controlled companies for maintenance of ways, structures, and equipment were less in the last ten months of 1920 than in an average ten months of the test period, by approximately $1,300,000."

The question on this branch of ...