Appeal from the Board of Tax Appeals.
Before MANTON, SWAN, and AUGUSTUS N. HAND, Circuit Judges.
The first question presented by the taxpayer's petition is whether the discount on bonds sold by predecessor corporations, which were consolidated to form the petitioner, can be amortized over the life of the bonds and a proportionate part thereof be deducted in each of the taxable years in question. The taxpayer made its income returns upon the accrual basis. Had the petitioner itself issued the bonds, there could be no doubt of its right to take a deduction of amortized bond discount in its income tax returns. Old Mission Portland Cement Co. v. Helvering, 293 U.S. 289, 55 S. Ct. 158, 160, 79 L. Ed. 367; Helvering v. Union Pacific R. Co., 283 U.S. 282, 55 S. Ct. 165, 79 L. Ed. 363. But the Commissioner contends that the right to the deduction is limited to the issuing corporation and excludes any deduction for amortization of discount upon bonds issued by a predecessor in ownership of the railroad property; and the Board of Tax Appeals so held, relying upon its own prior decisions, one of which was reversed in Western Maryland R. Co. v. Commissioner, 33 F.2d 695 (C.C.A. 4).
The bonds under discussion were issued between 1897 and April, 1914, and the yearly amortization of discount upon all of them amounts to $401,161.13. The companies which issued these bonds charged the discount to surplus at the close of the year during which the bonds were issued, except one company which charged the discount to cost of road. In 1906 the Indiana, Illinois & Iowa Railroad Company and several other corporations were consolidated to form the Chicago, Indiana & Southern Railroad Company, which assumed the obligation on the outstanding bonds in question. In 1914 the last-named corporation and several others were consolidated to form the New York Central Railroad Company, the petitioner, which likewise assumed the obligation upon the bonds in question. The petitioner did not set up any discount on these bonds in its books of account, but set up assets equal to the total liability on the bonds assumed.
The taxes for the years in question are levied under the Revenue Acts of 1916, 1918, and 1921, respectively (39 Stat. 756, 40 Stat. 1057, 42 Stat. 227). None of the statutes contains any specific authorization of a deduction of amortized bond discount. Such authorization is found in the Treasury Regulations. Article 150, T.R. 33 (Revised), relating to the 1916 act; article 544, T.R. 45 (1920 Ed.), relating to the 1918 act; article 545, T.R. 62 (1922 Ed.), relating to the 1921 act. The validity of these regulations has been recognized by the Supreme Court in the cases already cited. Therefore, as to bonds issued after 1909, the right to the deduction in each of the taxable years would clearly exist, were the issuing corporation the taxpayer. As to bonds issued prior to 1909, article 149 of Treasury Regulation 33 (Revised) is relied upon by the Commissioner as forbidding any deduction for the year 1917. Article 149 reads as follows:
"Art. 149. Discount on bonds issued prior to 1909. -- Discount on bonds issued and sold prior to the year 1909, if such discount was then charged against surplus or against the income of the year in which the bonds were sold, is held not to be deductible from the income of subsequent years, for the reason that the charging off prior to January 1, 1909, of the entire amount of the discount constitutes a closed transaction, and such transaction cannot be reopened for the purpose of reducing the taxable income of a corporation for subsequent years by deducting therefrom an aliquot part of the discount."
In our opinion this is an invalid regulation. The bookkeeping entry of charging the discount against surplus cannot make it a closed transaction, as is, indeed, recognized in article 150 dealing with bonds issued after 1909. As Mr. Justice Stone stated in Old Mission Portland Cement Co. v. Helvering, supra, "Amortized bond discount is deductible from the taxpayer's gross income only by way of anticipation of payment of the bonds at maturity." It is then that the taxpayer pays the sum which is the subject of amortization, namely, the difference between the amount realized upon the sale of the bonds and their par value. The principle which justifies spreading this sum over the life of bonds issued after 1909 is equally applicable to earlier issues which mature after the enactment of income tax legislation. See Helvering v. Union Pac. R. Co., supra. A regulation which purports to differentiate between the earlier and later issues in this respect we regard as so arbitrary as to be invalid. Hence the taxable year 1917 stands on the same footing as the taxable yers 1920 and 1923, and the question as to each is whether the petitioner has the right to deduct the amortized discount on bonds of the constituent companies.
In Western Maryland R. Co. v. Commissioner, 33 F.2d 696 (C.C.A. 4), it was held that a consolidated corporation steps into the place of the constituent corporations and is entitled to deduct amortized discount on bonds issued by them. We think this decision is sound and should be followed in the case at bar. The consolidated corporation does not succeed to the rights and liabilities of the constituent companies as a purchaser but as a successor by operation of law. See Cortland Specialty Co. v. Commissioner, 60 F.2d 937, 939 (C.C.A. 2); Commissioner v. Oswego Falls Corp. (C.C.A.) 71 F.2d 673, 676 (C.C.A. 2). The assets of the consolidated corporation have the same cost basis as they had when held by the old companies, and are subject to the lien of the bond issues. Hence the consolidated corporation will suffer a loss when it pays the bonds at par, and the regulations as to spreading this loss over the life of the bonds should apply. They do not in terms confine discount deductions to the issuing corporation, and should not be construed to do so. If the new corporation cannot take the deduction, no one can, for the old companies sustained no loss when the consolidation was effected. As already stated, the subject of amortization is the difference between the cash realized on the bonds and their par value. This difference the consolidated corporation will pay when the bonds mature, and this expenditure it should be allowed to anticipate by yearly amortization during the life of the bonds in order more clearly to reflect its income.
The Commissioner argues that allowable deductions are personal to the taxpayer and cannot be transferred to or used by another. But the cases which announce this doctrine deal with losses sustained by a predecessor and sought to be deducted by a successor. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 54 S. Ct. 788, 78 L. Ed. 1348; Brandon Corp. v. Commissioner, 71 F.2d 762 (C.C.A. 4); May Oil Burner Corp. v. Commissioner, 71 F.2d 644 (C.C.A. 4); Cem Securities Corp. v. Commissioner, 72 F.2d 295 (C.C.A. 4); Athol Mfg. Co. v. Commissioner, 54 F.2d 230 (C.C.A. 1). In the case at bar, no loss was sustained by the issuing corporations in selling their bonds at a discount; the loss will be sustained by the consolidated corporation when the bonds mature and are paid. Hence the deductions here in question are by way of anticipation of the taxpayer's own loss and should have been allowed.
With respect to the claimed deduction of discount on equipment trust certificates, the situation is slighly different. These were issued in 1913 by New York Central & Hudson River Railroad Company, one of the constituent corporations which consolidated to form the petitioner. The discount was charged to profit and loss upon the books of the issuing company. The equipment trust certificates mature serially, and the amounts claimed as deductions for the respective years are $10,912.62 for 1917, $7,937.14 for 1920, and $4,960.68 for 1923. By article 150 of Treasury Regulations 33 (Revised), it is provided that, if discount on bonds sold after 1909 was charged off on the books against earnings or surplus but not deducted in the corporation's return of net income, such discount as was not then deducted may be spread over the life of the bonds and an aliquot part of the discount may be deducted from the gross income of each year until the bonds mature or are redeemed. The Board made no finding whether the discount on the equipment trust certificates, which was charged to profit and loss when they were issued, was then deducted in the issuing corporation's return of net income. If it was, the petitioner should not also have a deduction. The future expenditure when the certificates mature cannot be amortized and deducted annually by way of anticipation, if it has already been deducted in the year when the certificates were issued. Upon the remand of the case to the Board, it should make a finding on this subject.
The petitioner also claims to be entitled to deduct in each of the taxable years the amount of $29,518.97 discount on bonds of predecessor companies which were merged with the petitioner. The principles above discussed as applicable in case of consolidation are equally applicable to merger. The companies issuing these bonds charged the discount to profit and loss for the year in which the bonds were issued. But, as in the case of equipment trust certificates, the Board made no finding whether the discount was then deducted in the issuing corporation's return of net income.Such a finding is necessary in order to determine the petitioner's right to the claimed deduction.
It is also contended that the petitioner's affiliate, the Cleveland, Cincinnati, Chicago & St. Louis Railway Company, was entitled to deduct from its gross income for 1923 the amount of $5,764.05 discount on bonds of predecessors that were consolidated to form said company. Under the principles already discussed, this item was deductible.
The next contention of the taxpayer relates to deductions, claimed but disallowed, on account of depreciation of leased equipment. Three leases are involved, one for 99 years, one for 999 years, and one for 99 years and thereafter in perpetuity at the option of the lessee. In each case the lessee agreed to make necessary renewals to keep the leased railroad in good operating condition and upon termination of the lease to return to the lessor the leased equipment in as good condition as when received, or, in lieu thereof, to return other property of like use and value as the leased equipment. The lessee set up on its books a liability to the lessor for the inventory value of the equipment acquired under the lease. In the case of the Boston & Albany lease, this liability was entered in the accounts when the lease became effective, July 1, 1900. In the cases of the Canada Southern lease and the Chicago Junction lease, the practice was to enter a liability for the inventory value of retired units of equipment when such units were retired from service. It is the contention of the petitioner that under section 12 of the Revenue Act of 1916 (39 Stat. 767) and under section 234 (a) (7) of the Revenue Acts of 1918 and 1921 (40 Stat. 1077, and 42 Stat. 255), it is entitled to deduct from gross income for the years 1917, 1920, and 1923 amounts representing depreciation and loss on retirements of Boston & Albany equipment, or, in the alternative, the inventory value of such equipment retired during the taxable year. A similar claim is made on behalf of the petitioner's affiliate Michigan Central Railroad Company with respect to Canada Southern equipment for the years 1920 and 1923, and on behalf ...