Western Maryland Ry. Co. v. Com'r of Internal Revenue

• Decision Date: 01 July 1929
• Docket Number: No. 2837.,2837.
• Citation: 33 F.2d 695
• Parties: WESTERN MARYLAND RY. CO. v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Fourth Circuit

33 F.2d 695 (1929)

WESTERN MARYLAND RY. CO. v. COMMISSIONER OF INTERNAL REVENUE.

No. 2837.

Circuit Court of Appeals, Fourth Circuit.

July 1, 1929.

George P. Bagby and Eugene S. Williams, both of Baltimore, Md., for petitioner.

John Vaughan Groner, Sp. Asst. Atty. Gen. (Mabel Walker Willebrandt, Asst. Atty. Gen., J. Louis Monarch, Sp. Asst. Atty. Gen., C. M. Charest, Gen. Counsel, Bureau of Internal Revenue, and P. S. Crewe, Sp. Atty., Bureau of Internal Revenue, both of Washington, D. C., on the brief), for respondent.

Chester A. Gwinn and Humphreys & Gwinn, all of Washington, D. C., amici curiæ.

Before PARKER and NORTHCOTT, Circuit Judges, and SOPER, District Judge.

PARKER, Circuit Judge.

This is a petition by the Western Maryland Railway Company to review a decision of the Board of Tax Appeals. The point involved is the right of the railway company to deduct in its income returns for the years 1918 and 1919 an amortized portion of the bond discount arising upon the sale of bonds by The Western Maryland Railway Company, its predecessor in the ownership of its railroad property. The Board of Tax Appeals based its denial of the deduction primarily upon the fact that a new corporation had been created as a result of the consolidation of The Western Maryland Railway Company with its various subsidiary corporations in 1917, and that this new corporation had assumed the payment of the bonded indebtedness. It reasoned that the new corporation, which took over the property of the old and assumed its debts, had paid no discount on the bonds and consequently was not entitled to amortize same.

The facts as to the bonded indebtedness and the discount are that between April, 1904, and August, 1911, the corporation which was the predecessor of the petitioner, the Western Maryland Railway Company, issued and sold $46,633,000 of first mortgage 4 per cent. bonds, dated October 1, 1902, and maturing October 1, 1952, at a discount of $3,638,451.67. This discount was set up on the books of the company as of January 1, 1910, and the annual proportion thereof, amounting to $80,796.24, was charged off each year thereafter.

The facts with regard to the reorganization are that the corporation which held the railroad property at that time, The Western Maryland Railway Company, owned all of the stock in seven subsidiary corporations whose property it operated in all respects as its own, keeping but one set of books and making reports to the Interstate Commerce Commission just as though all of the properties of all of the corporations were owned and operated by it as a single system. At that time it had outstanding $50,000,000 common and $10,000,000 preferred stock, and owed, in addition to the bonded indebtedness to which we have referred, notes aggregating $17,742,050, most of which were held by its stockholders. The railway company and its subsidiaries were consolidated on February 17, 1917, under the name of Western Maryland Railway Company, pursuant to article 23, §§ 33 to 35, of the Maryland Code, the inclusion of those of the subsidiaries which had been organized under the laws of Pennsylvania being effected pursuant to the Acts of March 24, 1865, P. L. 49 (Pa. St. 1920, §§ 18586, 18588, 18589, 18592, 18593-18596), and April 10, 1869, P. L. 24 (Pa. St. 1920, § 18612), of that state. Under the reorganization, the common stock of the new company was exchanged share for share for the common stock of the old, second preferred of the new was exchanged share for share for the preferred of the old, and first preferred to the amount of $17,742,050 was issued and given in exchange for the notes held against the old company. The bonds which constituted a lien upon the property were not affected by the reorganization, but their payment was assumed by the new corporation, which assumed all of the obligations of the old corporation and its subsidiaries and took over all of their assets. Among the assets, which were shown by the books of the old corporation and which were taken over by petitioner upon the reorganization, was the amount set up on account of discount in the sale of the bonds.

Not only do the books of petitioner show the bond discount, but it also appears that petitioner is required by the Interstate Commerce Commission, under the latter's classification of income, profit, and loss, and general balance sheet accounts, prescribed in accordance with section 20 of the Interstate Commerce Act (49 USCA § 20), to carry on its general balance sheet the unextinguished discount on the bonds in question and to amortize same by a charge against income for the remaining life of the bonds.

Two questions are presented by the petition: (1) Whether, where bonds are sold at a discount, such discount may be amortized, for income tax purposes, over the life of the bonds, by deducting the annual proportion thereof from gross income for each year; and (2) if so, whether the right to deduct the discount was lost in this case by reason of the reorganization and the taking over of the assets and liabilities by the consolidated company.

On the first question it appears that the books of the railway company are kept upon the accrual basis, and section 234(a) (2) of the Revenue Act of 1918 provides for the deduction of all interest paid or accrued within the taxable year on its indebtedness. 40 Stat. 1077. Bond discount is in reality additional interest payable upon the maturity of the bonds, and a proportionate part of it accrues each year and should be treated as interest paid or accrued on the bonds for that year. This is expressly provided for in the Regulations of the Commissioner of Internal Revenue. Article 544(3) (a) of these regulations reads in part as follows: "If bonds are issued by a corporation at a discount, the net amount of such discount is deductible and should be prorated or amortized over the life of the bonds."

In article 563 it is provided: "If it sells its bonds at a discount, the amount of such discount is treated in the same way as interest paid. * * *"

And article 848 provides: "Discount allowed on the sale of bonds is in effect an advance on account of interest, so that the effective rate of interest in such a case is equal to the sum of the nominal rate plus the rate necessary to amortize the discount over the life of the bonds."

These regulations of the Commissioner are in accord with the requirements of the Interstate Commerce Commission, and have recently been approved by the Board of Tax Appeals in the case of Chicago, Rock Island & Pacific Railway Co. v. Commissioner of Internal Revenue, 13 B. T. A. 988. They are also in accord with the practice laid down by approved accounting authorities. See Accounting Practice and Procedure, by Arthur Lowes Dickinson (1919) pp. 66, 134-155; Corporation Accounting, by R. J. Bennett (1917) pp. 269-272; Modern Accounting, Its Principles and Some of its Problems, by Henry Rand Hatfield (1913) pp. 187-189; Outline of Accounting, by William S. Krebs (1923) pp. 434, 435; Accounting, Theory & Practice, by Roy B. Kester (1918) pp. 367, 368; Accounts in Theory and Practice, by Earl A. Saliers (1920) pp. 168-170. In the Chicago, Rock Island & Pacific Railway Company Case, the Board of Tax Appeals went into the matter very fully, and laid down what we think is the correct rule in such matters in the following language:

"Whenever a corporation contemplates issuing long-term securities, three methods present themselves: Shall the bonds carry the market rate of interest and be issued at par, or shall they carry a greater rate than the market rate and be sold at a premium, or shall they carry a rate less than the market rate and be sold at a discount? Which of these methods should be pursued is determined by the present needs and the future prospects of the company, but it matters not which plan is adopted, other things...