Opinion
Docket No. 9734.
1948-01-23
McKINNEY MANUFACTURING COMPANY, A CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Jacquin D. Bierman, Esq., and J. R. McCartan, C.P.A., for the petitioner. Homer F. Benson, Esq., for the respondent.
1. Scrip delivered to petitioner's bondholders in reorganization based upon past due interest held to retain character as interest, and as such to be excluded from the computation of petitioner's borrowed invested capital under Internal Revenue Code, section 719(a)(1).
2. Issuance to petitioner's bondholders of scrip in face amount of full defaulted interest obligation held not to forecast loss to petitioner upon ultimate payment so as to justify amortization as bond discount, notwithstanding market value of fifteen-year, noninterest-bearing scrip was less than face amount. Jacquin D. Bierman, Esq., and J. R. McCartan, C.P.A., for the petitioner. Homer F. Benson, Esq., for the respondent.
By this proceeding petitioner challenges respondent's determination of deficiencies as follows:
+---------------------------------------------------------------+ ¦ ¦Fiscal year ¦Fiscal year ¦ +---------------------------------+--------------+--------------¦ ¦ ¦ended June 30,¦ended June 30,¦ +---------------------------------+--------------+--------------¦ ¦ ¦1942 ¦1943 ¦ +---------------------------------+--------------+--------------¦ ¦Declared value excess profits tax¦$905.74 ¦ ¦ +---------------------------------+--------------+--------------¦ ¦Excess profits tax ¦31,259.14 ¦$27,737.96 ¦ +---------------------------------------------------------------+
The disposition of several issues has been agreed to by the parties. The remaining issues are the fair market value of good will and assets acquired by petitioner in 1902 from a predecessor copartnership; the includibility of noninterest-bearing scrip issued by petitioner in connection with its reorganization as borrowed invested capital for the purpose of computing its excess profits tax credit; and whether petitioner is entitled to a ratable allowance for amortization of the difference between the face amount of the scrip outstanding and its value upon issuance.
The case was presented by a stipulation, together with incorporated exhibits and evidence adduced at the hearing. The findings hereinafter appearing which are not from the stipulation are otherwise found from the record.
FINDINGS OF FACT.
The stipulated facts are hereby found. Petitioner was incorporated on February 28, 1902, under the laws of the Commonwealth of Pennsylvania, having its office and principal place of business at 1400 Metropolitan Avenue, Pittsburgh, Pennsylvania. Petitioner filed returns for the taxable years ended June 30, 1942 and 1943, with the collector for the twenty-third district of Pennsylvania, at Pittsburgh, Pennsylvania.
Petitioner acquired all the assets and the business and assumed all the liabilities, as of January 1, 1902, of the McKinney Manufacturing Co., a copartnership consisting of J. P. and W. S. McKinney. For this, it issued $600,000 of preferred stock and $500,000 of common stock.
The net assets of the partnership as of January 1, 1902, included good will theretofore used and owned by the copartnership.
Petitioner's predecessor, the partnership, was established in 1878 and manufactured builders' hardware, including hinges, door hangers, and similar products. This business was continued by petitioner. The business is stable and operates with comparatively high amounts of invested capital. There are only a few competing concerns.
The following were the net earnings and net worth of petitioner's predecessor for the years 1897 through 1901:
+---------------------------------+ ¦ ¦ ¦Net worth at¦ +-------+------------+------------¦ ¦Year ¦Net earnings¦beginning of¦ +-------+------------+------------¦ ¦ ¦ ¦year ¦ +-------+------------+------------¦ ¦1897 ¦$121,043.14 ¦$554,327.93 ¦ +-------+------------+------------¦ ¦1898 ¦122,487.89 ¦602,663.81 ¦ +-------+------------+------------¦ ¦1899 ¦216,331.23 ¦665,197.63 ¦ +-------+------------+------------¦ ¦1900 ¦89,824.73 ¦790,238.35 ¦ +-------+------------+------------¦ ¦1901 ¦212,842.54 ¦621,461.56 ¦ +-------+------------+------------¦ ¦Total ¦762,529.53 ¦ ¦ +-------+------------+------------¦ ¦Average¦152,505.91 ¦646,777.86 ¦ +---------------------------------+
In the bill of sale, dated July 11, 1902, transferring the assets from the copartnership to the corporation, the assets were valued as follows:
+-----------------------------------------------------------------------------+ ¦One plot of ground bounded by Locust, Market, Greenwood and ¦ ¦ ¦Magnolia Sts., on which is erected one three story & basement ¦ ¦ ¦factory building 386' x 50' with L 70' x 50'. One iron warehouse¦ ¦ ¦150' x 50'. One Boiler house, and one stable. Machinery and dies¦$650,000.00 ¦ ¦for the mfg. of their complete line of steel goods, engines, ¦ ¦ ¦boilers, elevators, scales, heaters, sprinkler and electric ¦ ¦ ¦lighting equipment. Horses, wagons, office furniture and ¦ ¦ ¦fixtures ¦ ¦ +----------------------------------------------------------------+------------¦ ¦Good Will of business, established in 1878 ¦$200,000.00 ¦ +-----------------------------------------------------------------------------¦ ¦* * * * * * * * ¦ +-----------------------------------------------------------------------------¦ ¦Inventory Finished Goods materials and supplies as inventoried ¦162,596.48 ¦ ¦this date ¦ ¦ +----------------------------------------------------------------+------------¦ ¦Accounts, Amts. due us as per Ledger (good) ¦57,511.10 ¦ +----------------------------------------------------------------+------------¦ ¦Notes, Bills Rec. (good) ¦8,324.68 ¦ +----------------------------------------------------------------+------------¦ ¦Cash, Bal. in banks this date ¦31,931.82 ¦ +----------------------------------------------------------------+------------¦ ¦Investment, Real estate & Improvements on Preble Ave., and ¦25,000.00 ¦ ¦Greenwood and Locust & Magnolia ¦ ¦ +----------------------------------------------------------------+------------¦ ¦Total Assets ¦1,135,364.08¦ +----------------------------------------------------------------+------------¦ ¦ ¦ ¦ +----------------------------------------------------------------+------------¦ ¦Accounts payable amounted to $16,718.92 ¦ ¦ +-----------------------------------------------------------------------------+
In computing the value of the net assets acquired by petitioner in 1902 from the predecessor partnership, respondent attributed $500,000 to the value of plant and real estate and $200,000 to the good will, resulting in a value of assets of $943,645.16.
The fair market value of the good will acquired by petitioner from its predecessor copartnership in 1902 in exchange for petitioner's stock was $200,000; the fair market value of its plant and real estate at that time was $675,000.
As of February 1, 1939, there were $507,000 of 6 per cent first mortgage sinking fund gold coupon bonds of petitioner (consisting of 507 $1,000 bonds) outstanding in the hands of the public. Interest on these bonds was at the rate of 6 per cent per annum, payable semi-annually on October 1 and April 1. This interest was secured under the mortgage indenture, and when in default bore interest. As of October 1, 1938, six years accrued interest, or $360, represented by unpaid coupons, was in default on each bond.
Under a plan of reorganization accepted by the shareholders and bondholders of petitioner, and made effective as of February 1, 1939, each $1,000 6 per cent bond, with all unpaid coupons attached, was exchangeable for 10 shares of 5 per cent preferred stock, of a par value of $100 each, and $360 of noninterest-bearing scrip maturing 15 years after January 1, 1939.
All the outstanding $1,000 bonds were exchanged for the preferred stock and scrip, and were extinguished and cremated by the trustee of the indenture under which the bonds had been issued, the Peoples-Pittsburgh Trust Co.
The bondholder receiving in exchange for each $1,000 bond the 10 shares of preferred stock and $360 of noninterest bearing scrip could elect either to hold the securities so received in exchange or to exercise either of the two following options: (1) To convert the preferred stock into common stock for each share of preferred stock, and to retain the scrip; of (2) to sell 2 shares out of each 10 shares of preferred stock, plus $360 of scrip, for a total sum of $200, being $82 a share for the preferred stock and $36 for $360 face value of scrip.
Each certificate of scrip was in engraved form, numbered serially, and contained the promise of petitioner to pay the bearer thereof the face sum, without interest, upon presentation and surrender of the scrip, at petitioner's principal place of business on January 1, 1954. By its terms the scrip was transferable by delivery. It was not secured by any lien.
The scrip issued by petitioner was bought and sold at about the date of issue at about 10 cents on the dollar.
As of February 1, 1939, an interest rate of 5 per cent would have been used in computing the present value of petitioner's scrip.
For the years ended June 30, 1941, 1942, and 1943, the average amount of petitioner's scrip outstanding in the hands of the public was $182,520, $182,352.75, and $182,157.88, respectively.
Petitioner's balance sheet as of January 31, 1939, immediately prior to its reorganization, was as follows:
+--------------------------------------+ ¦ASSETS ¦ +--------------------------------------¦ ¦ ¦ ¦ +-------------------------+------------¦ ¦CURRENT ASSETS: ¦ ¦ +-------------------------+------------¦ ¦Cash ¦$28,246.96 ¦ +-------------------------+------------¦ ¦Notes receivable ¦2,773.51 ¦ +-------------------------+------------¦ ¦Accounts receivable—trade¦139,587.02 ¦ +-------------------------+------------¦ ¦Accounts receivable—other¦1,995.11 ¦ +-------------------------+------------¦ ¦Inventories—materials ¦54,000.00 ¦ +-------------------------+------------¦ ¦Inventories—semi-finished¦56,000.00 ¦ +-------------------------+------------¦ ¦Inventories—finished ¦136,600.00 ¦ +-------------------------+------------¦ ¦ ¦419,202.60 ¦ +-------------------------+------------¦ ¦INVESTMENTS ¦502.00 ¦ +-------------------------+------------¦ ¦PLANT AND EQUIPMENT ¦2,390,099.57¦ +-------------------------+------------¦ ¦DEFERRED CHARGES: ¦ ¦ +-------------------------+------------¦ ¦Bond discount and expense¦$12,044.89 ¦ +-------------------------+------------¦ ¦Unexpired insurance ¦8,738.97 ¦ +-------------------------+------------¦ ¦Prepaid expenses ¦4,992.35 ¦ +-------------------------+------------¦ ¦ ¦25,776.21 ¦ +-------------------------+------------¦ ¦Total ¦2,835,580.38¦ +--------------------------------------+
LIABILITIES CURRENT LIABILITIES: Accounts payable $25,081.42 Accrued wages 20,357.91 Accrued commissions 5,779.69 Accrued expense 633.79 Accrued taxes 6,051.45 57,904.26 DEFERRED TAXES UNDER ABATEMENT ACTS 91,711.79 FIRST MORTGAGE BONDS 513,000.00 ACCRUED BOND INTEREST 184,680.00 697,680.00 RESERVES: For depreciation 363,751.03 For bad debts 4,736.36 368,487.39 CAPITAL STOCK 3,208,631.17 SURPLUS (deficit) (1,588,834.23) Total 2,835,580.38
In respondent's deficiency notice no amounts were included in invested capital for the years ended June 30, 1941, 1942, or 1943, as borrowed invested capital on account of the scrip outstanding during those years.
No deduction from petitioner's income for the years ended June 30, 1941, 1942, or 1943, was allowed for amortization on account of petitioner's scrip.
OPINION.
OPPER, Judge:
The parties insist, but in unrelated situations, that we can accept as the best evidence of contemporaneous value the sale price agreed upon by buyer and seller when petitioner acquired the property in controversy. We agree as to both items; with the consequence that, contrary to petitioner's contention as to the good will and the respondent's contention as to the real estate, we have found as the amount of petitioner's capital invested in these items the agreed figures at which they changed hands at the time. No comparably good evidence of fair market value appears otherwise in the record or from the formula described in A.R.M. 34, 2 C.B. 31, for cases where other evidence fails.
The second issue requires consideration of the nature of the obligation incorporated in petitioner's issue of scrip. This was delivered to its bondholders upon its reorganization in 1939 on account of past due and unpaid interest on the bonds and was based solely on the interest obligation. If this scrip retained its character as interest, it is excluded from the computation of borrowed invested capital under the provisions of section 719(a)(1). We think it did so. Palm Beach Trust Co., 9 T.C. 1060. Respondent's action in excluding the total amount of this scrip from borrowed invested capital is sustained.
Finally, petitioner contends that, in the computation of its excess profits income, it should be permitted a deduction to represent an amortizable ‘discount‘ due to the fifteen-year term of the scrip and to the fact that its market value when issued was only a small fraction of its face amount. The payment, however, which petitioner will be called upon to make when the scrip becomes due, is not greater than the interest obligation existing prior to its issuance, since, as we have said, the scrip was based precisely on the interest obligation. Even if the scrip is ultimately paid at face, petitioner will thus have suffered no loss. Since bond discount is founded upon the concept of compensation for a prospective loss, there seems no warrant for its application to petitioner's situation. Atlanta & Charlotte Air Line Railroad Co., 36 B.T.A. 558. We find no error in respondent's failure to permit an allowance for such discount in computing petitioner's excess profits income.
Decision will be entered under Rule 50.