Opinion
No. 42.
December 18, 1944. As Modified on Denial of Rehearing January 4, 1945.
Petition to Review a Decision of the Tax Court of the United States.
Petition by Fifth Avenue-Fourteenth Street Corporation to review a decision of the Tax Court of the United States, 2 T.C. 516, redetermining a deficiency in income tax imposed by Commissioner of Internal Revenue.
Reversed and remanded.
The Tax Court determined deficiencies in taxpayer's income taxes for the taxable years 1935, 1936 and 1937. In its findings of fact, the Tax Court said ( 2 T.C. 516):
"The issue is whether the petitioner realized income in the amounts by which the face value of certain mortgage certificates issued by the petitioner's mortgagee, exceed the prices at which the petitioner purchased them, the mortgagee having accepted the certificates at face value in reduction of the petitioner's indebtedness.
"Findings of Fact."The petitioner is a New York corporation, organized in February, 1921, and having its principal office at 11 West 42d Street, in New York City. Its returns for the taxable years were filed with the collector for the third district of New York.
"Since February 1921, and during the taxable years, the petitioner's business was the ownership and operation of a building known as 80 Fifth Avenue, New York City, which is its principal asset. The building was erected in 1909. It stands on a lot having a frontage of about 73 feet on the westerly side of Fifth Avenue and 107 feet on the southerly side of 14th Street. It is of brick and steel fireproof construction and consists of sixteen stories and a penthouse, having stores on the ground floor, and lofts above.
"Under date of June 1, 1925, the petitioner and the New York Trust Co. entered into an agreement, one of the purposes of which was to consolidate into one obligation and lien the aggregate principal amount of $1,000,000 then owing by the petitioner to the trust company on two bonds secured by mortgages on the petitioner's real estate. The agreement authorized the trust company to issue certificates in denominations of $1,000, $500, and $100, representing pro rata shares or parts of the bonds and mortgages and of the agreement, the aggregate principal amount of certificates outstanding at any one time not to exceed $1,000,000. The certificates were executed by the trust company only, and not by the petitioner. They provided that the bonds and mortgages were held for the benefit of the certificate holders; that the shares represented by the certificates were payable only out of moneys received by the trust company from the petitioner, beyond which the trust company undertook no responsibility. Provision was made for the reimbursement of certificate holders by the petitioner for certain Federal and state income and other taxes imposed on account of the ownership of the certificates. The due date of the petitioner's indebtedness and of the certificates was set at June 1, 1940. The petitioner agreed to make payments aggregating $85,000 a year to the trust company, to be applied first to the interest on the bonds and the balance to the reduction of the principal indebtedness, through the purchase or redemption and retirement by the trust company of certificates, in the manner provided in the agreement. It was further agreed that so much of any payment as should not be needed on account of interest might be satisfied by the delivery to the trust company of certificates issued under the agreement, with all unmatured interest warrants attached, which certificates the trust company agreed to accept at their face value in pro tanto discharge of the principal indebtedness. Certificates so applied in reduction of the principal indebtedness could not be reissued. Other pertinent provisions gave the petitioner an option to redeem certificates on any interest payment date upon payment of a prescribed premium after giving certain notice to the holders, permitted the trust company to declare the whole debt due upon petitioner's default in payment of principal or interest or upon breach of certain of its covenants, and entitled the trust company to reasonable compensation for its services rendered under or in connection with the agreement, to be paid by the petitioner.
"During the taxable years the petitioner purchased certificates of the aggregate face values and at costs as follows:
Year Face value Cost
1935 $ 17,200 $ 8,914.71 1936 62,000 44,267.78 1937 113,900 94,588.00
"Of the amounts so purchased, the petitioner actually surrendered to the trust company in each year certificates having face values and costs to petitioner follows:
Excess of face value Year Face value Cost over cost
1935 $ 16,600.00 $ 8,584.71 $ 8,015.29 1936 62,600.00 44,597.78 18,002.22 1937 113,900.00 94,588.00 19,312.00
"The trust company accepted the certificates at their face value in curtailment of the principal mortgage debt. No part of the debt reductions thus effected was reported on the petitioner's returns for the taxable years as resulting in the realization of income.
"The petitioner's balance sheets, as reflected on its books and reported on its returns, were as follows: Assets Liabilities
1/1/35 12/31/35 12/31/36 12/31/37 Cash $ 14,728.55 $ 14,804.28 $ 8,442.31 $ 3,885.16 Accounts receivable 562.51 2,553.68 733.34 586.67 Bonds of domestic corporations 3,525.00 2,527.50 Deferred charges: Prepaid insurance, taxes, etc. 1,156.76 606.61 7,803.43 9,853.90 Building (after depreciation) 629,464.22 602,678.50 575,892.78 548,107.06 Land 675,000.00 675,000.00 675,000.00 675,000.00 Unamortized discount 27,500.00 22,500.00 17,500.00 __________________________________________________________ TOTAL $1,351,937.04 1,320,670.57 1,285,371.86 1,238,432.79 Accounts payable 4,164.60 11,000.00 Bonds, notes, mortgages (less than one year) 15,000.00 5,980.00 Mortgages 740,000.00 714,900.00 648,300.00 640,000.00 Accrued expenses 13,668.08 12,747.79 14,899.01 7,447.45 Security deposits 5,916.66 6,916.66 7,250.00 7,250.00 Rents paid in advance 183.33 225.00 125.00 Capital stock 15,000.00 15,000.00 15,000.00 15,000.00 Surplus 573,187.70 570,922.79 573,697.85 562,630.34 __________________________________________________________ TOTAL $1,351,937.04 1,320,670.57 1,285,371.86 1,238,432.79 The book value of the petitioner's building, if the reserve for depreciation be restored, is $1,000,000. The land is carried at $675,000. The fixed asset value of $1,675,000 thus reflected includes a book write-up or appreciation of some $783,000 made in 1926 in petitioner's property account."During the taxable years the petitioner made payments of cash dividends in the amounts of $12,000 in 1935, $21,000 in 1936, and $30,000 in 1937. It reported net income (or loss) on its returns in the amounts of $10,317.81 (loss) for 1935, and $4,292.87 for 1936, and $1,361.02 for 1937. The net profit or loss on the operation of its building as shown on its profit and loss statements for 1935 and 1936 was in the same amount as the income or loss shown on the returns for those years. The statement for 1937 showed profit of $4,793.73.
"In 1937 the petitioner obtained a loan of $600,000, secured by a first mortgage on its real estate from the Aetna Life Insurance Co. Before granting the loan the company caused a physical inspection of the property to be made by members of its mortgage department, had an independent appraisal made by a firm of real estate appraisers in New York, and examined statements of earnings submitted by the petitioner. It required also the assignment of four of the major leases held by the petitioner as collateral security for the debt. The loan was granted for a 10-year period, but was prepaid by the petitioner in 1942.
"During the taxable years the fair market value of the property known as 80 Fifth Avenue was not less than $800,000. The petitioner was not insolvent during the taxable years."
In its opinion, the Tax Court said in part:
"Upon brief, the petitioner states that in order for it to have been solvent the value of its property would have to be as much as $746,333.28 on December 31, 1934, $717,362.32 on December 31, 1935, $689,998.36 on December 31, 1936, and $658,830.82 on December 31, 1937. In our opinion it has not been shown to have been less than those amounts. After careful consideration of all the evidence, including the opinions of the expert witnesses of both parties, and meaning by fair market value the price at which a willing buyer and a willing seller would meet, we think that the land and building together had a fair market value of at least $800,000. It follows and we hold that the petitioner was solvent during all of the taxable years. * * * In the instant case there was no direct negotiation between debtor and creditor, and there could not have been, since, strictly speaking, there was no obligation owing by the petitioner directly to the certificate holders, the rights of the latter being enforceable only through the trust company mortgagee. The certificates were dealt in on the market as property. Such situation does not contain the elements which, in our opinion, motivated the Court to hold as it did in the [Helvering v.] American Dental [Company] case [ 318 U.S. 322, 63 S.Ct. 577, 87 L.Ed. 785]. We think that case inapplicable here, and hold that the petitioner realized taxable income in the amounts by which the face value of the certificates surrendered exceed their cost to the petitioner."
Harry Friedman, of Washington, D.C., for petitioner.
Samuel O. Clark, Jr., of Washington, D.C. (Sewall Key, A.F. Prescott, and Harold C. Wilkenfeld, all of Washington, D.C., of counsel), for respondent.
Before L. HAND, AUGUSTUS N. HAND, and FRANK, Circuit Judges.
1. Assuming for the moment that we must accept the facts as found by the Tax Court, affirmance is required by United States v. Kirby Lumber Co., 284 U.S. 1, 52 S.Ct. 4, 75 L.Ed. 131. For, on those facts, here, as there, the taxpayer "as a result of its dealings made available * * * assets previously offset by the obligation of bonds now extinct." The transaction gave rise to income which was then "realized," and therefore taxable, because the taxpayer then relieved all its assets in an amount equal to the difference between the amount of its obligations payable out of those assets and the reduced figure at which it paid off those obligations. The mortgage indebtedness was not merely a lien upon specific property, but a liability owing by the taxpayer. This is therefore not like a case where property is purchased subject to a mortgage on which a taxpayer is not liable; in such a case, if the taxpayer pays off the mortgage for less than its face, he has not realized any income but has merely reduced the amount paid for the property, so that no income is realized until he subsequently sells the property.
Cf. Helvering v. American Chicle Co., 291 U.S. 426, 430, 54 S.Ct. 460, 461, 78 L.Ed. 891, where, as the Court said, the taxpayer "assumed — promised to pay — * * * the seller's outstanding bonds."
Of course, in such a case as is described in the text of the opinion the "basis" when the taxpayer sells the property is reduced by the amount of the debt reduction, whereas in the instant situation, it will not be so reduced.
Helvering v. American Dental Company, 318 U.S. 322, 63 S.Ct. 577, 87 L.Ed. 785, reaffirmed the Kirby doctrine. It made an exception, not pertinent here, i.e., where a taxpayer procures "the complete satisfaction of an indebtedness by partial payment by the voluntary act of the creditor * * *," and not "through the purchase" of its obligation "in an arm's-length transaction"; because in the American Dental case the reductions thus resulted from the voluntary acts of the creditors and not from "arm's-length transactions," the Court held that they constituted "gifts" by the creditors.
The Court said, 318 U.S. 322 at page 327, 63 S.Ct. 580, 87 L.Ed. 785: "In United States v. Kirby Lumber Co., 284 U.S. 1, 52 S.Ct. 4, 76 L.Ed. 131, the taxpayer purchased its own bonds at a discount. It was held taxable on the increase in net assets which resulted. This holding was confirmed by Helvering v. American Chicle Co., 291 U.S. 426, 54 S.Ct. 460, 78 L.Ed. 891. See, also, Commissioner [of Internal Revenue] v. Coastwise Transp. Corporation, 1 Cir., 71 F.2d 104."
2. Taxpayer asserts that the mortgage indebtedness was incurred in connection with the purchase of the mortgaged property. There is grave doubt, to say the least, whether the evidence so shows. But, in any event, that fact is irrelevant. To be sure, some cases have held that the doctrine of the Kirby case is inapplicable where the reduced indebtedness is a purchase money obligation, i.e., one incurred by the taxpayer in acquiring property. We consider such a distinction irrational, and doubt whether the Supreme Court intended to approve it by its passing mention of those cases in the American Dental case. At any rate, that distinction, if valid, is limited to a case of a purchase money obligation where the vendor-mortgagee, in negotiations directly relating to the purchase price, agrees to a reduction; it has not been applied where the reduction results from an "arm's-length" transaction relating solely to the debt itself, or from a purchase of the taxpayer's obligations at less than par in the market. Thus limited, the distinction is inapposite here; for the certificateholders were, in effect, the beneficial owners of the mortgage debt, and the taxpayer acquired the certificates in question from certificateholders in the open market.
Commissioner of Internal Revenue v. Sherman, 6 Cir., 135 F.2d 68; Helvering v. A.L. Killian Co., 8 Cir., 128 F.2d 433; Hirsch v. Commissioner of Internal Revenue, 7 Cir., 115 F.2d 656.
Commissioner of Internal Revenue v. Coastwise Transp. Corporation, 1 Cir., 62 F.2d 332, Id., 1 Cir., 71 F.2d 104, certiorari denied 293 U.S. 595, 55 S.Ct. 110, 79 L.Ed. 689.
Helvering v. American Chicle Co., 291 U.S. 426, 54 S.Ct. 460, 78 L.Ed. 891, reversing 65 F.2d 454, 455, where we had said: "When a taxpayer gets money by issuing an obligation which he later discharges for less than its face, the transaction is completed, because money need not be sold or exchanged to be `realized.' So we read United States v. Kirby Lumber Co., supra, 284 U.S. 1, 52 S.Ct. 4, 76 L. Ed. 131. But if he buys property by an obligation in the form of a bond, note, or the like, and if it remains in kind after the debt is paid, there can be no `gain.' The cost has indeed been definitively settled, but that is only one term of the equation; as long as the other remains at large, there is no `realized' gain."
3. The taxpayer argues that it was not obligated to pay the mortgage debt in dollars; that it had the option of paying either in dollars or certificate; and that, where a person has the right to pay an obligation in one of two forms, as here, either by cash or by certificates, he receives no taxable income from the payment in certificates, despite the fact that he thereby pays less than he would have paid if he had chosen to pay in dollars. In support of this position, taxpayer relies on Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, 46 S. Ct. 449, 70 L.Ed. 886. That case is not in point. It was distinguished in the Kirby case on the ground that no taxable income had resulted because "the transaction as a whole was a loss." See also Burnet v. Sanford Brooks Co., 282 U.S. 359, 364, 51 S.Ct. 150, 75 L.Ed. 383; Helvering v. American Chicle Co., 291 U.S. 426, 430, 54 S.Ct. 460, 78 L.Ed. 891. We think that the Kerbaugh-Empire doctrine has been limited to its precise or to almost precisely equivalent facts. The general rule must be that, if a taxpayer borrows money and has an option to repay either in money or in property, he realizes a taxable gain if he elects to pay in property which at the time has a value less than the face of his obligation.
The government suggests that it applies only to cases in which foreign money was borrowed and repaid, the rate of exchange having fluctuated in the interim. We need not decide whether that suggestion is correct.
Whether the certificates here were tendered to the trustee in the same year in which they were purchased is not entirely clear. Whether, if not, there would be any difference in the result we need not consider since in the Tax Court that question was not raised and on oral argument here both sides asked us not to consider it.
4. Taxpayer also contends that its obligations to pay were not absolute but contingent. We cannot agree. Corporacion de Ventas, etc. v. Commissioner of Internal Revenue, 2 Cir., 130 F.2d 141 is clearly not in point; for there the obligations were payable only out of a certain percentage of profits if earned.
5. The Supreme Court made the American Dental doctrine applicable regardless of the solvency or insolvency of the taxpayer, but clearly indicated ( 318 U.S. 322 at page 330, 63 S.Ct. 577, 87 L.Ed. 785) that where (as here) the Kirby doctrine applies, the taxpayer's insolvency is of importance. But we think that, in such circumstances, insolvency has this and only this effect: If the insolvent taxpayer "buys in" its debts, or any of them, for an amount equal to or greater than the amount which would have been paid to the creditors upon the taxpayer's liquidation, then there is no realized taxable gain; where, however, the taxpayer "buys in" its debts for less than such an amount, then, to that extent, there is realized taxable gain.
6. The Tax Court found that in the taxable years the taxpayer was not insolvent. There is substantial evidence to sustain this and the other findings, and we would therefore affirm except for the following: The court's finding as to solvency turned on its finding as to the value of taxpayer's land and building, and the court expressly said that it arrived at that latter finding after considering all the evidence "including the opinions of the expert witnesses of both parties." Taxpayer complains that the Tax Court erred in shutting out an inquiry affecting the competence or credibility of one of the government's experts. The facts are these:
Taxpayer asserts that even if not insolvent, it was in financial difficulties; but financial difficulties which are not the substantial equivalent of insolvency are, we think, irrelevant. Cases arising under the Revenue Act 1939, 26 U.S.C.A. Int.Rev. Acts, page 1167, and later Acts are not in point. Moreover the evidence, we think, does not show that the taxpayer was in any serious financial difficulties in the pertinent period.
At the trial, a witness for taxpayer testified that the fair market value of the taxpayer's land and building in 1935, 1936 and 1937 was "less than $600,000 for sale purposes." A witness, Warner, Assistant Manager of the Mortgage Loan Department of the Aetna Life Insurance Company, called by the government, testified that that company made a mortgage loan to taxpayer on its land and building in 1937 in the amount of $600,000, and that, before doing so, it had obtained the appraisal of the firm of Brown, Wheelock, Harris Stevens, Inc., expert real estate appraisers who had valued the property at $1,200,000. The government then called Stevens, a member of that firm, who testified that such an appraisal had been been made with his approval, the land having been appraised at $700,000 and the building at $500,000. On cross examination, he stated that he did not have with him the certificate of appraisal that was issued but that he did have with him his working papers. He also said that he had testified from those papers which showed the figures to which he had testified and the "break-down" which he had made; and that they related to the testimony which he had given on direct; and that they showed the basis upon which he had made his appraisal. Counsel for taxpayer asked to examine the papers, but the request was denied. On direct examination, in response to certain specific questions, Stevens had used the papers to refresh his recollection as to matters not directly bearing on the appraisal. But his entire testimony leaves little doubt that, in the course of his direct examination, he had used those papers to refresh his recollection concerning the appraisal. We think it was clearly improper to deny the request of the taxpayer's counsel and that, in the circumstances, considering the high appraisal figure to which the witness testified and the importance of the valuation issue, there was an abuse of discretion in this respect. We therefore remand for the limited purpose of permitting taxpayer to scrutinize the witness' papers and to cross examine him with respect thereto. Should the Tax Court, as a result of such cross examination, find that the taxpayer was insolvent in the pertinent period, it should apply the criterion above stated in point 5 of this opinion.
At one point he consulted the papers to determine whether he himself had inspected the building and at another as to whether or not the papers disclosed the name of the company to whom application had been made for a mortgage loan by the taxpayer.
Pursuant to the stipulation of the parties, the Tax Court, on the remand of these proceedings, shall also, however, make a determination of the deficiencies, if any, due by reason of the reduction of the amounts deducted for real estate taxes for the years 1935, 1936 and 1937 which had been previously allowed.
Reversed and remanded for further proceedings in accordance with this opinion.