Utilities & Industries Corp. v. Commissioner

Full title: UTILITIES INDUSTRIES CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL…

Court: United States Tax Court

Date published: Mar 27, 1964

41 T.C. 888 (U.S.T.C. 1964)

Opinion

Docket Nos. 88306, 88307.

Filed March 27, 1964.

1. BASIS FOR GAIN OR LOSS-ACQUISITION BY REORGANIZATION OR PURCHASE. — Held, petitioner South Bay's acquisitions of the properties of two corporations in 1925 were in connection with separate reorganizations under section 203(h) of the Revenue Act of 1924, and pursuant to section 113(a)(7), I.R.C. 1939, petitioner's basis is the same as it would be in the hands of each respective transferor and, further, that petitioner failed to establish each transferor's basis and its own adjusted basis at date of sale as required by section 113(b), I.R.C. 1939. Held, further, that petitioner's acquisitions of properties of two other corporations in 1925 and of a fifth corporation in 1927 were by purchase and petitioner's basis is cost, but that petitioner failed to establish any foundation for allocation of any portion of cost to intangibles and, further, failed to establish its adjusted basis at date of sale as required by section 113(b), I.R.C. 1939. Respondent sustained on failure of proof.

2. INCOME — REIMBURSEMENT OF TAXES. — Held, that a portion of a condemnation award to petitioner South Bay for all its properties in 1951 constituted a reimbursement of local property taxes and ordinary income in 1951. Respondent did not err in reducing proceeds of sale by alleged reimbursement for taxes and including same in ordinary income. Respondent's determination approved.

3. INCOME TO DEBTOR — CANCELLATION OF INDEBTEDNESS. — Held, that petitioner South Bay did not realize additional ordinary income in 1951 as the result of discharge of indebtedness because the cancellation thereof was in connection with a corporate reorganization proceeding under chapter X of the Bankruptcy Act and, also, because the cancellation was by petitioner's principal common stockholder and constituted a contribution to petitioner South Bay's capital. Respondent's determination disapproved.

4. DIVIDENDS-PAID CREDIT ON PREFERRED STOCK OF PUBLIC UTILITY. — Petitioner South Bay was a "public utility" with outstanding preferred stock within meaning of section 26(h), I.R.C. 1939, over a long period of years up to and including the first part of the taxable year 1951. All of its utility properties were taken over under condemnation by a Water Authority in 1951, and, pursuant to a U.S. District Court order, it redeemed its preferred shares at the par value thereof and made payment of prior unpaid accumulated dividends thereon during the taxable year 1951. Held, that the dividend payment on preferred stock involved herein falls within the intent and purpose of section 26(h), and petitioner is entitled to the claimed dividends-paid credit under that section. Respondent's determination disapproved.

5. DEDUCTION — WORTHLESS DEBT. — With respect to petitioner Utilities Industries Corp., held, that accrued interest on loan accounts to South Bay did not become a deductible worthless debt in 1951, since the cancellation of such debt constituted a contribution to capital by South Bay's principal common stockholder. Respondent's determination approved.

6. INCOME TO CREDITOR — CANCELLATION OF INDEBTEDNESS. — With respect to petitioner Utilities Industries Corp., held, that ordinary income was not realized by reason of its cancellation, as a creditor, of South Bay's debt on a note plus accrued interest thereon, since such cancellation constituted a contribution to capital. Respondent's determination disapproved.

Robert J. Casey and Thomas J. McCoy, Jr., for the petitioners.

John J. O'Toole and Colin C. MacDonald, Jr., for the respondent.

HOYT, Judge:

These proceedings have been consolidated. Respondent determined income tax deficiencies against petitioners for the calendar year and in the amounts, as follows:

Petitioner Docket No. Year Deficiency Utilities Industries Corp. ....... 88306 1951 $311,373.24 The South Bay Corp. ................ 88307 1951 921,336.32 Petitioner, the South Bay Corp., claims an overpayment of $160,007.04 income tax for the year 1951.

There is no dispute herein with respect to certain adjustments made by respondent in the respective statutory deficiency notices. At the trial petitioner, the South Bay Corp., conceded that it realized additional capital gain in the amount of $89,509.62 in 1951, resulting from respondent's disallowance of the claimed basis for certain tangible properties sold in that year to the Suffolk County Water Authority.

The issues presented are whether respondent erred in his determination:

(1) That petitioner, the South Bay Corp., realized additional capital gain in the amount of $2,314,658 in 1951, resulting from the disallowance of petitioner's claimed basis for intangible assets sold in that year to the Suffolk County Water Authority under condemnation proceedings.

(2) That petitioner, the South Bay Corp., realized additional ordinary income in the amount of $53,433.36 in 1951, as a reimbursement of property taxes received by petitioner at the time of the sale to said Water Authority.

(3) That petitioner, the South Bay Corp., realized additional ordinary income in the amount of $605,577.85 in 1951, as the result of a discharge of indebtedness by cancellation of a demand note and accrued interest on the note and loan accounts deducted in prior years.

(4) That petitioner, the South Bay Corp., is not entitled to a dividends-paid credit of $165,662.73 for 1951, as claimed under section 26(h), I.R.C. 1939.

(5) That petitioner, Utilities Industries Corp., is not entitled to a claimed bad debt deduction in the amount of $113,329.57 for 1951 (error is assigned as to that sum out of an amount of $132,261.24 bad debts disallowed).

(6) That petitioner, Utilities Industries Corp., realized a gain of $500,213.77 in 1951, upon its claimed contribution of a demand note, together with accrued interest thereon, to the capital of the payor of the note, the South Bay Corp.

FINDINGS OF FACT

The stipulated facts are so found.

Petitioner in docket No. 88307, the South Bay Corp., was originally incorporated under New York law on November 7, 1902, under the name Quantuck Water Works Co. The corporate name was changed to South Bay Consolidated Water Co., Inc., on May 14, 1925, and to its present name in 1952. This corporation under its various names will hereinafter be referred to as South Bay.

Petitioner in docket No. 88306, Utilities Industries Corp., was originally incorporated under New York law under the name of New York Water Service Corp. On May 19, 1960, the corporate name was changed to its present name. This corporation under its various names will hereinafter be referred to as New York. On June 30, 1930, New York was a subsidiary of Federal Water Service Corp., now known as Federal Water Gas Corp. (hereinafter referred to as Federal).

The principal office of petitioner South Bay and of petitioner New York is at 425 Park Avenue, New York, N.Y. Each petitioner filed its Federal income tax return for the year 1951 on September 15, 1952, with the then collector of internal revenue for the second district of New York (now the Manhattan District). Timely extensions of time were granted for the filing of these returns. On its income and excess profits tax return for the calendar taxable year ended December 31, 1951, petitioner South Bay stated its principal business activity as "Public Utility (water)" and reported net income in the amount of $1,586,734.33 derived from utility operating revenue, interest, and a gain from involuntary conversion, by condemnation, of all its properties and assets relating to its water utility business. Said return reported income tax due in the amount of $394,366.06 which was paid in the amounts and on certain dates in 1952, as stipulated by the parties.

In the latter part of 1924, one Francis W. Collins (hereinafter referred to as Collins), who was experienced in water company operations, made an inspection of the plants and facilities of several water companies serving communities on Long Island, N.Y., and investigated the possibility of acquiring the stock of certain water companies for the purpose of merging them into one large company. After first acquiring an option to purchase a controlling stock interest in the Southampton Water Works Co. in November 1924, Collins began purchasing stock of the Quantuck Water Works Co. (petitioner South Bay herein) as the nucleus for his proposed merger, and he acquired all of the outstanding capital stock of that company by April 9, 1925. Prior to that date and in February 1925, Collins entered into a contract pursuant to which he subsequently purchased a controlling stock interest in the Great South Bay Water Co. Those acquisitions and other transactions of Collins and the several transactions of petitioner South Bay whereby the latter ultimately acquired the assets of five water companies, are hereinafter set forth.

Prior to May 6, 1925, South Bay's authorized capital stock consisted of 1,000 shares of $100 par value common stock, of which 850 shares were issued and outstanding. During the period November 21, 1924, to April 9, 1925, Collins purchased all of the outstanding shares of South Bay for $175 a share, a total payment of $148,750, and on April 9, 1925, he was elected president of that corporation. About a month later on May 6, 1925, the authorized capital stock of South Bay was increased to 30,000 shares of which 20,000 shares of 6 percent cumulative, $100 par value, were classified as preferred, and 10,000 shares, $100 par value, were classified as common. Authorization was granted by its board of directors, on the same date, for the execution of a mortgage, dated as of May 1, 1925, to the Seaboard National Bank (now Chase Manhattan Bank), to secure an issue of 25-year, 5 percent Gold Bonds, Series A, in an aggregate principal amount not to exceed $100 million.

Great South Bay

In 1925 Great South Bay Water Co. (hereinafter sometimes referred to as Great South Bay) was a corporation engaged in furnishing water to the Bayshore-Patchogue area of Long Island, N Y It had previously acquired the properties and franchises of Suffolk County Water Co. and Brightwater Water Co. On February 28, 1925, its outstanding stock consisted of 4,723 shares of $100 par value preferred and 2,450.8 shares of $100 par value common. On February 28, 1925, Collins contracted with David A. Boody to purchase the latter's 1,355.6 shares of preferred and 1,003.2 shares of common in Great South Bay for $100 a share and $125 a share, respectively, and to purchase the shares of any other shareholders of Great South Bay at the same prices. Closing was set for May 15, 1925. By April 14, 1925, pursuant to the contract, Collins had acquired 2,802 shares (approximately 59 percent) of preferred and 1,988.4 shares (approximately 81 percent) of common of Great South Bay's outstanding stock, at a total purchase price of $528,750.

On April 21, 1925, the board of directors of petitioner South Bay formally resolved to purchase all of Great South Bay's properties, real, personal and mixed, rights, privileges and franchises, subject to the existing bonded indebtedness in the principal sum of $400,000 thereon, and in payment therefore to assume all other indebtedness of that company and in addition thereto to pay the shareholders of Great South Bay cash in the amounts of $100 per share of preferred and $125 per share of common stock outstanding plus any accrued dividends maturing since February 15, 1925. In lieu of such cash offer, it was further resolved to offer 1 share of South Bay preferred plus $25 cash and 1 share of South Bay preferred plus $35 cash for each share of Great South Bay preferred and common, respectively, amounting to a total offer of 7,173.8 shares of South Bay preferred plus $203,853 cash.

Petitioner South Bay acquired from Collins all of the Great South Bay stock owned by him and also acquired all of such stock owned by the other remaining individual shareholders in a number of small transactions. Such acquisitions by South Bay were not pursuant to the terms of the offer in the above-mentioned resolution, as shown by the schedule in the next succeeding paragraph, but instead involved an exchange for South Bay's shares of common and preferred stock, bonds, and cash. In that exchange Collins received, inter alia, shares of South Bay common stock, and in 1930 he still owned a total of 6,500 shares of such stock.

By June 19, 1925, petitioner South Bay had acquired all of the outstanding capital stock of Great South Bay. On that day, Great South Bay transferred all of its assets, subject to an outstanding $400,000 issue of 5 percent mortgage bonds, to petitioner South Bay which assumed the other liabilities of Great South Bay. South Bay recorded said assets on its books at its cost (that is, South Bay's consideration for acquisition of all of the stock and properties of Great South Bay) as follows:

Cash ............................................ $36,668 Petitioner's bonds, at par ...................... 750,000 Petitioner's preferred stock, at par ............ 337,760 Petitioner's common stock, at par ............... 665,000 Liabilities assumed in excess of assets ......... 508,174 --------- Total cost .................................. 2,297,602

The books of Great South Bay reflected, as of the date of its acquisition by South Bay, physical properties in the amount of $823,136, of which $24,745 was attributable to land. Petitioner South Bay recorded the assets at its cost on its books in its Fixed Capital account.

Southampton

Southampton Water Works Co. (hereinafter referred to as Southampton) during 1925 was a corporation engaged in furnishing water to the Southampton area of Long Island, N Y The capital structure of Southampton consisted of 1,000 shares of common stock. On June 1, 1925, petitioner South Bay agreed to (1) pay Collins $233,000 of South Bay's bonds and 1,334 shares of its preferred stock, in return for 667 shares in Southampton (which Collins would acquire under an option he had theretofore obtained) and $52,625 in cash; (2) pay to the other shareholders of Southampton $125 in cash and 2 shares of petitioner's preferred stock for each share of Southampton; and (3) offer to purchase all of Southampton's property and assets, rights, privileges, and franchises of every nature and to assume all of its liabilities.

On June 19, 1925, Collins acquired 667 shares (approximately 67 percent) of Southampton stock; 323 shares of such stock were owned by other parties on that date, and 10 shares were unaccounted for. On the same date, South Bay acquired all of the stock of Southampton, and on that date the latter transferred all of its assets to petitioner which assumed all of Southampton's liabilities. Petitioner South Bay recorded the assets on its books at its cost, as follows:

Cash paid ..................................................... $43,879 Petitioner's bonds at par ..................................... 233,000 Petitioner's preferred stock at par ........................... 198,000 -------- 474,879 Less: Cash received...................................... $52,625 Excess of assets over liabilities.................. 43,421 -------- 96,046 ------- Total cost.............................................. 378,833 The books of Southampton reflected, as of the date of its acquisition by South Bay, physical properties in the amount of $146,191, of which $4,182 was attributable to land. Petitioner South Bay recorded the assets at its cost in its Fixed Capital account.

Port Jefferson

Port Jefferson Water Co. (hereinafter referred to as Port Jefferson) in 1925 was a corporation engaged in furnishing water to the Port Jefferson area of Long Island, N.Y. On or about June 27, 1925, Collins contracted to purchase all of Port Jefferson's property and assets of every nature and description as a going concern, excepting cash and receivables as of July 1, 1925, and to assume its liabilities, which included $23,000 of 6-percent bonds due January 1, 1938. Collins agreed to pay therefore $34,780 in cash and South Bay's preferred stock in the amount of $15,800. The contract was assigned to petitioner South Bay on July 20, 1925, and the assets of Port Jefferson were transferred to South Bay. Petitioner South Bay recorded the assets on its books at its cost, as follows:

Cash .............................................. $34,780 Preferred stock, at par ........................... 15,800 Liabilities assumed in excess of assets ........... 24,021 ------- Total cost .................................... 74,601

The books of Port Jefferson reflected, as of the date of its acquisition by South Bay, physical properties in the amount of $64,487. No land was owned by it. Petitioner South Bay recorded the assets at its cost in its Fixed Capital account.

Amityville

Amityville Water Works Co. (hereinafter referred to as Amityville) in 1925 was a corporation engaged in furnishing water to the Amityville area of Long Island, N.Y. On or about July 1, 1925, Collins contracted to purchase all of the property and assets of Amityville, assume all of its liabilities, including $30,000 of 5 percent bonds due July 1, 1929, and to pay therefore $74,737 in cash and South Bay's preferred stock in the amount of $87,600 par value. The contract was assigned by Collins to petitioner South Bay on July 20, 1925, and all of the assets were transferred to South Bay on July 22, 1925. Petitioner South Bay recorded the assets on its books at its cost, as follows:

Cash ............................................. $74,737 Preferred stock at par ........................... 87,600 Liabilities assumed in excess of assets .......... 16,391 -------- Total cost ................................... 178,728

The books of Amityville reflected, as of the date of its acquisition by South Bay, physical properties in the amount of $105,886. Petitioner South Bay recorded the assets at its cost in its Fixed Capital account.

Kings Park

Kings Park Water Co. (hereinafter referred to as Kings Park) in 1927 was a corporation engaged in furnishing water to the Kings Park area of Long Island, N.Y. Shortly before June 22, 1927, Collins purchased 494.5 shares of stock of Kings Park at a total price of $56,200. On June 22, 1927, petitioner South Bay agreed to purchase these shares from Collins at the same price. On the same date South Bay offered to purchase all of the property and assets, rights, privileges, and franchises of Kings Park as a going concern, paying therefore cash or 1 share of South Bay's 6 percent preferred stock for each share of Kings Park stock not owned by South Bay. On June 24, 1927, Kings Park transferred all of its assets to South Bay and the latter assumed Kings Park's liabilities. Petitioner South Bay recorded the properties of Kings Park on its books at its cost (that is South Bay's consideration for acquisition of all of the stock and properties of Kings Park), as follows:

Cash ............................................. $60,089 Preferred stock, at par .......................... 8,000 Liabilities assumed in excess of assets .......... 1,219 -------- Total cost ................................... 69,308

The books of Kings Park reflected, as of the date of its acquisition by South Bay, physical properties in the amount of $43,464. Petitioner South Bay recorded the assets at its cost in its Fixed Capital account.

At the times of the above-mentioned acquisitions by petitioner South Bay the parties to the respective transactions attributed a value for South Bay's preferred stock, common stock, and/or bonds equal to the $100 par value thereof, respectively, in determining South Bay's consideration for such acquisitions.

The following table shows the stipulated figures set out in several preceding paragraphs with respect to the book value of physical properties as reflected on the books of each transferor company as of the date of acquisition by petitioner South Bay and the amount at which each transferor's assets were recorded by South Bay on its books in its Fixed Capital account at cost, based, inter alia, on the $100 par value of its bonds and preferred and common stock issued in such acquisitions and, further, with respect to the assets son acquired, South Bay's recorded cost thereof in excess of such book values of the physical properties:

Book value of Cost of assets physical properties acquired as Transferor company reflected recorded on South on books of Bay books transferor Great South Bay ................... $823,136 $2,297,602 Southampton ....................... 146,191 378,833 Port Jefferson .................... 64,487 74,601 Amityville ........................ 105,886 178,728 Kings Park ........................ 43,464 69,308 _______________ ________________ Totals ...................... 1,183,164 2,999,072 Excess of recorded cost over transferor's Transferor company book value of physical properties Great South Bay ................... $1,474,466 Southampton ....................... 232,642 Port Jefferson .................... 10,114 Amityville ........................ 72,842 Kings Park ........................ 25,844 ________________ Totals ...................... 1,815,908 After the aforementioned acquisitions were carried out in 1925 and 1927, petitioner South Bay had waterplants in the Long Island communities of Amityville, Bay Shore, Patchogue (2 plants), Kings Park (2 plants), Port Jefferson (pumping and booster plants), Southampton, Westhampton, and Bellport. A plant was built at Smithtown by South Bay in 1928. Petitioner South Bay had franchises to provide water for domestic consumption and fire protection to the following communities on Long Island:

Amityville Hagerman Setauket Copiague Islip East Setauket Bellport Islip Manor Smithtown Bay Shore Islip Terrace Smithtown Branch Bayport Oakdale Southampton Blue Point Patchogue Westhampton Brightwater Sayville Westhampton Beach Central Islip West Islip Quogue East Islip West Sayville East Quogue East Sayville Kings Park Great River Port Jefferson

The physical properties acquired in 1925 and 1927 by petitioner South Bay were carried at its cost for book and tax purposes. The excess of purchase price over the original book value of physical properties of each transferor company was not depreciated for tax purposes.

In a series of independent transactions Collins individually became the owner of the majority stock interest in and control of Great South Bay and Southampton, respectively, prior to his transfers of such stock to petitioner South Bay in exchanges in 1925 in connection with separate reorganizations involving mergers. Collins owned the majority interest and control of South Bay prior to and immediately after each of those transfers. South Bay acquired all of the stock of Great South Bay and Southampton from Collins and other individual shareholders for the purpose of acquiring the assets of those companies through mergers. Collins entered into contracts for the purchase of the assets of Port Jefferson and Amityville in 1925 for the purpose of assigning them to petitioner South Bay which acquired the assets of those two companies by outright purchase. In 1927 Collins acquired the majority stock of Kings Park for the account of petitioner South Bay which acquired all of the stock of that company for the purpose of acquiring its assets.

In addition to the above-mentioned acquisitions and between 1925 and 1929 other small properties were similarly acquired by South Bay in transactions not disclosed by the record. As of December 31, 1929, the Fixed Capital account on petitioner South Bay's books showed a balance of $5,034,355.65 which consisted of the following:

Organization expense ................... $111,961.18 Cost of fixed capital acquired ......... 3,125,763.14 Construction (work in process and finished) ........................ 1,729,013.63 Undistributed construction expense .............................. 67,617.70 ------------ Total .......................... 5,034,355.65

The reserve for depreciation on the same date totaled $422,046.94.

Between 1925 and 1951 the Fixed Capital account (sometimes labeled "Utility Plant" or "Plant and Equipment") was shown on the balance sheets attached to petitioner South Bay's tax returns without allocation between depreciable and nondepreciable assets.

On June 30, 1930, there were 7,500 shares of petitioner South Bay's common stock issued and outstanding, of which 6,500 shares were owned by Collins and 750 shares were owned by Quantuck Realty Corp., South Bay's wholly owned subsidiary. On that date, Federal Water Service Corp. purchased Collins' 6,500 common shares for $725,000 in cash. On June 24, 1931, Federal purchased from Quantuck Realty Corp. 750 shares of South Bay's common stock for $113,000 in cash.

During the period June 30, 1930, to June 1, 1931, Federal made advances, totaling $1,598,820.20, to South Bay to enable it to construct additional facilities, rehabilitate its plant, etc. During the same period, the total advance was reduced by credits totaling $1,213,820.20, so that the net balance on June 1, 1931, was $385,000. On that date petitioner South Bay executed and delivered to Federal an instrument in the form of a demand note for $385,000 principal amount (hereinafter referred to for identification as the demand note), including a provision for interest at 6 percent, payment of which was subordinated to the payment of all dividends on South Bay's preferred stock.

During the period 1931 to 1947, Federal owned all of the common stock of New York Water Service Corp., now known as Utilities Industries Corp., petitioner New York herein. On June 25, 1931, Federal sold its 7,250 shares of petitioner South Bay's common stock and petitioner South Bay's demand note to New York for $1,155,360 and $385,000, respectively. Thereafter, to October 26, 1931, petitioner South Bay made payments totaling $107,000 with respect to the demand note, and on that date New York resold the demand note to Federal for $278,000. South Bay made semiannual payments with respect to the demand note from June 1, 1932, to December 31, 1934, in the total amount of $50,040, so that in March 1947, the book account with respect to the demand note had been reduced to $227,960. During that month Federal transferred the demand note to New York as an incident to the divestment of Federal and the recapitalization of New York under the Public Utility Holding Company Act of 1935. Other than the payments referred to above in reduction of the principal amount, no payments of any nature were made on the demand note after February 15, 1932, when the payment of dividends on South Bay's preferred stock was discontinued. On April 27, 1949, the accrued unpaid interest totaled $244,644.79.

During the period 1931 to 1943, inclusive, petitioner New York made cash advances through its loan account to South Bay totaling $3,259,396.40. During the same period, the total was reduced by repayments, totaling $2,784,296.40, so that, as at December 31, 1941, the net balance of the loan account was $475,000. That balance remained unchanged on April 27, 1949. From 1931 to May 31, 1941, interest totaling $203,383 was paid by petitioner South Bay to New York on the balances in the loan account. The interest rate was 6 percent per annum until January 1, 1941, when it was reduced by New York to 3 percent per annum. As of June 1, 1941, in accordance with regulations of the Securities and Exchange Commission, New York discontinued collection of interest on the loan account. Interest computed at 3 percent from June 1, 1941 to April 27, 1949, totaled $113,261.24. Petitioner New York accrued this amount and reported it on its income tax returns filed during the aforementioned period of June 1, 1941, to April 27, 1949.

Commencing in October of 1941, petitioner New York made periodic advances to South Bay through its current loan account. A total of $264,900 was advanced from October 1941 through April 27, 1949, and $234,900 was repaid, leaving a balance due to New York of $30,000 on April 27, 1949. Interest at 4 percent, totaling $1,661, was paid on the loans made through the current loan account in 1948 and 1949. On April 27, 1949, petitioner New York claimed accrued and unpaid interest of $111.11 on the balance.

On April 27, 1949, petitioner New York and three trade creditors of South Bay filed a petition in the U.S. District Court for the Southern District of New York for South Bay's reorganization under chapter X of the Bankruptcy Act. The petition was approved and a trustee appointed on May 9, 1949. New York filed three claims with the trustee:

(a) Claim for $5,361.80, representing the net amount due for expenditures made by New York for goods and services for the account of South Bay in the period March 1 to April 26, 1949.

(b) Claim for $618,261.24 composed of $505,000 principal of the loan accounts and $113,261.24 interest thereon to April 27, 1949.

(c) Claim for $472,604.70 on the demand note balance of $227,960, and $244,644.79 interest thereon to April 27, 1949.

On May 18, 1951, petitioner New York proposed in writing to the trustee with respect to its claims that, subject to the consummation of the condemnation proceeding as hereinafter set forth, the claims be settled as follows:

Claim (a) referred to above to be allowed in full.

Claim (b) referred to above to be allowed to the extent of $505,000 of principal. With respect to the claim for interest of $113,261.24, New York to accede to the trustee's contention that it was not entitled to interest on said account.

Claim (c) referred to above, New York to make a capital contribution of the balance of the principal of the demand note and the accrued unpaid interest thereon in the form of the surrender and cancellation of the demand note and accrued interest.

Upon petition of the trustee, the District Court, by order dated May 24, 1951, approved and accepted New York's aforesaid proposal.

At the time of the petition for reorganization of petitioner South Bay on April 27, 1949, South Bay had outstanding two bond issues totaling $3,012,000 and 10,444 shares of preferred stock par value $100, and 7,500 shares of common stock. On June 1, 1951, upon the trustee's petition, the court ordered the payment in full on and after June 8, 1951, of the par value of South Bay bonds plus accrued interest, and the par value of all of South Bay's preferred stock plus an amount equal to unpaid dividends accrued to June 8, 1951. Thereafter, and during the taxable year 1951, petitioner South Bay paid the outstanding bonds and interest and distributed to its preferred shareholders the sum of $215.90 with respect to each outstanding share of its preferred stock. Of the total amount so paid to preferred shareholders, $165,662.72 represents 28 percent of payments on account of dividends unpaid and accumulated in taxable years ending after October 1, 1942.

In May 1949, proceedings had been initiated by the Suffolk County Water Authority (herein referred to as Water Authority), in order to acquire by condemnation or otherwise, all of South Bay's properties and assets. On June 12, 1949, the New York Water Power and Control Commission authorized the Water Authority to acquire all of the waterplants and properties of South Bay located in Suffolk County by condemnation or agreement, subject to the consent and approval of the U.S. District Court for the Southern District of New York. The Water Authority determined to proceed by condemnation. On February 13, 1951, the trustee entered into a supplemental agreement with the Water Authority whereby certain personal properties not included in the condemnation were transferred to the Water Authority. As of May 31, 1951, the Water Authority condemned and took over all of South Bay's physical properties, systems, plants, works, instrumentalities, rights, privileges and franchises, and all property of every kind or nature within the limits of Suffolk County, N.Y. The net award to petitioner South Bay for its properties totaled $7,508,111.25.

The supplemental agreement of February 13, 1951, between the trustee and the Water Authority provided that:

8. To avoid doubt as to the right of the Trustee to apply for refunds of prepaid real estate and special franchise taxes, it is understood and agreed that the Trustee will not apply for refunds and the Authority agrees that it will pay to the Trustee a sum equal to the amount of such taxes prepaid, except in any instance when such taxes have been prepaid for one month or less as of the date of closing.

The parties have stipulated that as of May 31, 1951, South Bay had prepaid real estate taxes in the amount of $53,433.36, and that the Water Authority paid this amount to South Bay as part of the condemnation award. The taxes prepaid were levied by the communities of Babylon, Islip, Brookhaven, Smithtown, and Southampton, N.Y. The levy date for said taxes was December 1, 1950.

In the statutory notice of respondent's determination of an income tax deficiency against New York, the "Statement" sets forth in part the following:

TAXABLE YEAR ENDED DECEMBER 31, 1951 ADJUSTMENTS TO NET INCOME Net income as disclosed by return ........................ $722,301.51 (a) Capital gain .......................... $76,806.91 (b) Bad debts ............................. 132,261.24 (c) Repairs ............................... 22,551.63 (d) Additional income ..................... 500,213.77 731,833.55 ---------- ------------ Total .............................................. 1,454,136.06 Nontaxable income and additional deductions: (e) Depreciation ..................................... 338.27 ------------ Net income as corrected .................................. 1,453,796.79

The respondent disallowed a claimed deduction for bad debts in the sum of $132,261.24 of which the amount of $113,329.57 is in controversy herein. Also, respondent determined that petitioner New York failed to report a gain of $500,213.77 realized with respect to the obligation owing in the principal amount of $227,960 on a demand note and accrued interest thereon claimed to have been contributed to the capital of South Bay, all of which is in controversy herein.

In the statutory notice of respondent's determination of an income tax deficiency against South Bay, the "Statement" sets forth, in part, the following:

TAXABLE YEAR ENDED DECEMBER 31, 1951 ADJUSTMENTS TO NET INCOME Net income as disclosed by return ........................ $1,586,734.33 Unallowable deductions and additional income: (a) Capital gain ...................... $2,350,734.20 (b) Reimbursed taxes .................. 53,433.36 (c) Discharge of indebtedness ......... 605,577.85 3,009,745.47 Net income as corrected ................... 4,596,479.80

EXPLANATION OF ADJUSTMENTS

(a) The capital gain you report on the sale of assets to the Suffolk County Water Authority is increased by the sum of $2,350,734.26, computed as follows:

Basis disallowed — Intangibles .......... $2,314,658.00 Basis disallowed — Tangibles ............. 89,509.62 ------------- Total ..................................... 2,404,167.62 Sales proceeds reduced — reimbursed taxes ................................... 53,433.36 ------------- Net addition to income ...................... 2,350,734.26

(b) It is determined that the sum of $53,433.36 received by you with respect to taxes paid at the time of the sale to Suffolk County Water Authority constitutes ordinary income.

(c) It is determined that as the result of a discharge of indebtedness you realized income of $605,577.85 computed as follows:

Cancellation of demand note ................... $227,960.00 Cancellation of interest deducted in prior years .................................... 377,617.85 ----------- Addition to income ........................... 605,577.85

It is determined that the dividends paid credit of $165,662.73 which you claim under the provisions of Section 26(h) of the Internal Revenue Code of 1939 is not allowable.

OPINION

Respondent determined that petitioner South Bay realized additional capital gain in the net amount of $2,350,734.26 resulting from several adjustments in the computation of the taxable gain realized from South Bay's sale of all its assets, both tangible and intangible. to the Suffolk County Water Authority under condemnation proceedings in 1951.

At the trial petitioner South Bay conceded the respondent's disallowance of $89,509.62. of the claimed basis for tangible properties involved in such sale and that adjustment is no longer in dispute.

The first issue herein involves respondent's disallowance of the amount of $2,314,658 claimed by petitioner South Bay as its basis for intangibles sold to the Water Authority in May 1951, and embracing intangible assets acquired from the five transferor corporations — Great South Bay, Southampton, Port Jefferson, Amityville, and Kings Park, respectively, as set out in our findings of fact.

With respect to the Great South Bay and Southampton transactions in 1925, respondent contends that the properties and assets formerly owned by each of those corporations were acquired by South Bay in connection with two separate reorganizations as defined in section 203(h) of the Revenue Act of 1924,¹ because both acquisitions resulted from mergers in which South Bay acquired all the outstanding capital stock and thence all the properties of each of those corporations with the requisite continuity of interest therein since South Bay's consideration was partly in its stock and securities. Respondent further contends that South Bay's basis for determining gain or loss on the 1951 sale of the properties in question, is the same as it would be in the hands of the transferors as required by the applicable provisions of section 113(a)(7) of the Internal Revenue Code of 1939,² since as therein provided the properties were acquired by South Bay in connection with reorganizations which occurred between the specified dates (after December 31, 1917, and before January 1, 1936) and with the specified interest or control remaining in the same person, in that Collins owned more than 50 percent control of both Great South Bay and Southampton, respectively, prior to the transfers and immediately thereafter more than 50 percent control of petitioner South Bay remained in Collins. Further, respondent contends that petitioner has failed to prove either the basis, if any, for the intangible properties in the hands of the transferors, or, its own adjusted basis for such assets at the time of the condemnation sale in 1951.

1 RECOGNITION OF GAIN OR LOSS FROM SALES AND EXCHANGES.

SEC. 203. (h). As used in this section and sections 201 and 204 —

(1) The term "reorganization" means (A) a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or substantially all the properties of another corporation), * * *

(2) The term "a party to a reorganization" includes a corporation resulting from a reorganization and includes both corporations in the case of an acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation.

2 SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.

(a) BASIS (UNADJUSTED) OF PROPERTY. — The basis of property shall be the cost of such property; except that —

* * * * * * *

(7) Transfers to corporation. — If the property was acquired —

(A) After December 31, 1917, and in a taxable year beginning before January 1, 1936, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 50 per centum or more remained in the same persons or any of them, or

* * * * * * *

then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made. This paragraph shall not apply if the property acquired consists of stock or securities in a corporation a party to the reorganization, unless acquired by the issuance of stock or securities of the transferee as the consideration in whole or in part for the transfer.

Petitioner South Bay argues that respondent's contentions with respect to reorganizations, continuity of interest, and a substituted basis are correct only if Collins individually acquired and owned controlling stock interests in Great South Bay and Southampton prior to acquisitions of all their outstanding stock by South Bay in separate independent transactions. Petitioner contends that the record supports contrary conclusions, namely, that Collins acquired stock rights and shares of stock as the agent and for the account of South Bay and thus there was not the requisite continuity of interest remaining in the prior original shareholders of the transferor corporations; that all of the steps taken by Collins and South Bay in the Great South Bay and Southampton transactions were interdependent steps in an integrated transaction solely for the purpose of purchasing the properties and assets of those corporations by South Bay; and that therefore its basis is cost. Petitioner further contends that its total cost in excess of each transferor's stipulated book value of the physical properties, as of the date of acquisition by South Bay, constitutes its cost basis of alleged nondepreciable intangible properties such as franchises, easements, etc., acquired at that time, without further adjustment in arriving at its own adjusted basis for determining gain on the 1951 sale.

On the record herein we conclude that petitioner South Bay has failed to prove error in respondent's determination with respect to the properties acquired in the Great South Bay and Southampton transactions. There is no convincing evidence of record to establish or even indicate that Collins was an agent acting solely on behalf of South Bay. To the contrary, the evidence discloses that Collins was acting on his own behalf and in furtherance of his own plans to bring about mergers and remain in control of the continuing corporation. Collins, acting entirely on his own behalf, first obtained an option for a controlling stock interest in Southampton and then began buying all the stock in South Bay as the nucleus of his proposed merger and while so engaged he also obtained a contract pursuant to which he acquired a controlling stock interest in Great South Bay. Collins did not assign his stock rights or transfer his purchased shares of Great South Bay and Southampton to petitioner South Bay at the cost thereof to him acting as its agent under any prior agreement with or authorization by South Bay. Instead, Collins independently made stock purchases and dealt with South Bay as an individual stockholder in transferring his controlling stock interest in Great South Bay and Southampton, respectively, in separate exchanges for stock and securities of South Bay whereby he substantially increased his individual interest in and retained control of the latter corporation. Also, the facts show that Collins obtained better terms on his exchanges than did the other remaining stockholders of Great South Bay and Southampton, which was reflected in the writeup on South Bay's books in its Fixed Capital account. The transactions or steps beginning with Collins' stock acquisitions and ending with the mergers were not so integrated or interdependent as to be solely for the purpose of South Bay's purchase of assets. Further, there is no showing that the properties acquired by mergers could not have been acquired by direct purchase by South Bay.

In the exchange involving the Great South Bay stock, the record fails to show the specific number of shares of South Bay common or the shares of preferred and/or bonds received by Collins, but it establishes that prior thereto he owned all 850 shares of South Bay common then outstanding and in 1930 he still owned 6,500 of the 7,500 shares of common outstanding. The record does not disclose any issuance of South Bay common to Collins other than in the exchange involving Great South Bay and, therefore, it must be assumed that he received at least 5,650 such shares in the said exchange. This resulted in his remaining in control of petitioner South Bay throughout the entire period of its several acquisitions involved herein.

Petitioner South Bay has failed to establish factual circumstances warranting its contended-for conclusion that the Great South Bay and Southampton transactions of both Collins and South Bay ending in the mergers, were interdependent steps in an integrated transaction solely for the purpose of South Bay's purchase of the properties of those two corporations, so that there were no reorganizations and South Bay's basis for the properties acquired, is its cost. Long Island Water Corporation, 36 T.C. 377 (1961). In that case the facts involved in the taxpayer's ultimate acquisition of the properties of one corporation led this Court to the conclusion that certain transactions were interdependent steps of an integrated transaction for the purchase of assets and, therefore, under the rule established by cited cases, the taxpayer's basis was its cost. The facts there involved are clearly distinguished from those involved herein. In the Long Island case the taxpayer also acquired the assets of two other corporations through stock acquisitions and mergers which the Court found to be statutory reorganizations and accordingly held that the taxpayer's basis for such assets was the same as it was in the hands of each of its transferors. In the Long Island case this Court discussed at some length numerous prior cases involving varying factual circumstances attending corporate acquisitions through mergers and the rules applicable in determining whether the acquisitions were by statutory reorganizations or by purchase, for the purpose of ascertaining the proper basis in the hands of the transferee. We do not deem it necessary to rehash here what was said there.

On the record we conclude and find that the properties formerly owned by Great South Bay and Southhampton were acquired by petitioner South Bay in 1925 in connection with two separate reorganizations as defined by section 203(h) of the Revenue Act of 1924, supra, and that petitioner's basis is the same as it would be in the hands of the transferors as required by section 113(a)(7) of the 1939 Code, supra. However, as further contended by respondent, petitioner has failed to establish the basis, if any, of the intangible properties in the hands of its transferors Great South Bay and Southampton, respectively, and thus the basis petitioner was required to take at the time of its acquisitions in 1925. Furthermore, the record fails to show whether such basis at time of acquisition was subject to adjustment for depreciation or otherwise to arrive at petitioner's adjusted basis for the purpose of determining the gain" realized on the sale in 1951. Section 111(a) of the Internal Revenue Code of 1939 provides in part that "the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 113(b) for determining gain and section 113(b) provides in part that "the adjusted basis for determining gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under subsection (a) adjusted as hereinafter provided." (Emphasis supplied.) The record is entirely silent on what adjustments, if any, are required by statute. On this phase of the first issue the respondent's determination is sustained.

The next phase of the first issue involves petitioner South Bay's basis for the intangible properties formerly owned by Port Jefferson, Amityville, and Kings Park. Petitioner contends that it acquired the properties of Port Jefferson and Amityville by outright purchase in 1925; that the 1927 Kings Park transactions were interdependent steps in an integrated transaction solely for the purpose of purchasing the properties of that corporation by South Bay; and that its basis for all such properties is its cost. Petitioner further contends that its total cost in excess of each transferor's stipulated book value of the physical properties, constitutes its cost basis of alleged nondepreciable intangible properties.

On brief respondent concedes that South Bay is entitled to a cost basis for the properties acquired in the Port Jefferson, Amityville, and Kings Park transactions, but contends that it has failed to establish its cost basis, if any, for the intangible properties on the dates of acquisition thereof and its adjusted basis therefore on the date of the sale in 1951.

The stipulated facts show only the book value of the physical properties of each transferor on the date of South Bay's acquisition and the record fails to establish the fair market value of the tangibles and intangibles, respectively, or any other basis or foundation for a reasonable allocation to the intangibles of any portion of South Bay's total cost, even assuming on this record that cost included an amount equal to the full par value of the stock and securities issued at time of acquisition. Further, the record fails to show whether the intangibles were subject to adjustment for depreciation or otherwise in arriving at South Bay's adjusted basis for such properties at the time of the 1951 sale, for purposes of determining the gain thereon, as required by section 111(a) and section 113(b) of the 1939 Code, supra. On this phase of the first issue respondent's determination is sustained.

Accordingly, we conclude and find that petitioner South Bay has failed to sustain its burden of proof of error on the first issue involved herein.

The second issue herein involves petitioner South Bay's assignment of error in respondent's determination that it realized additional ordinary income in the amount of $53,433.36. In connection with the 1951 sale of South Bay's properties to the Water Authority, the respondent's deficiency notice reduced the "sales proceeds" by $53,433.36 in determining the amount of capital gain realized from such sale and included that amount in ordinary income as reimbursed taxes.

As of May 31, 1951, the Water Authority condemned and took over all of South Bay's properties and the net award to South Bay for such properties totaled $7,508,111.25. By a prior supplemental agreement between the Water Authority and South Bay's trustee in reorganization under which, according to the stipulation of facts, "certain personal properties not included in the condemnation were transferred to the Authority," there was included as a part of the award the amount of $53,433.36 which was "a sum equal to the amount" of South Bay's prepaid local real estate taxes levied against South Bay on December 1, 1950, while it was still the owner of the properties. Under the supplemental agreement such sum was included in the award because of doubt as to the right of the trustee to apply for refunds of prepaid taxes.

Respondent contends that South Bay surrendered or transferred for valuable consideration its right to a benefit it had by virtue of having prepaid its taxes and that such right was not a capital asset, citing Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130 (1960), and, further, that such right was not related to any existing investment or the capitalization of a property right but rather to a benefit derived from the earning of ordinary income, citing Anton L. Trunk, 32 T.C. 1127 (1959), and J. J. Shea, 36 T.C. 577 (1961). The Gillette Motor Transport case held that an award representing fair rental of property was ordinary income and that the taxpayer owner's right to the use of property was not a capital asset under the circumstances there obtaining.

The Trunk case held that a taxpayer owner's sale of his right to a condemnation award for a prospective taking of certain front footage of his property to his lessee, resulted in a capital gain which reduced his basis of the property. The Shea case held that a taxpayer's payment for a release of liability under a guaranty was not a loss from the sale of a capital asset, but an ordinary loss incurred in a transaction entered into for profit. Those cases, while not exactly in point, are illuminating here.

South Bay contends that the prepaid real estate taxes included by the Authority in the total condemnation award are part of the proceeds from the sale of the properties and part of the investment which South Bay had made in its properties condemned, citing Magruder v. Supplee, 316 U.S. 394 (1942); Van Dyke v. United States, 156 F. Supp. 155 (1957); Norman Cooledge, 40 B.T.A. 1325 (1939); and S.M. 4122, V-1 C.B. 55 (1926). Petitioner therefore concludes that its treatment of this amount as capital gain is correct and that respondent erred in determining that it constituted ordinary income.

In the instant case South Bay prepaid local real estate taxes while it was the owner of the properties against which such taxes were assessed. No explanation for such prepayment is given, but it is obvious that the condemnation was well along and in process of being completed when the taxes were paid. The condemnation proceedings had been instituted in May of 1949, over a year and one-half before the tax levy for these taxes became effective.

While it is true that the parties to the award agreement could not change the incidence of local taxes, or the effective levy date, and the Water Authority merely paid a sum equal to such taxes as a part of the total award, it is also true that petitioner has produced no evidence whatever to establish that the reimbursement it received was for a capital asset, nor has it shown that there was a transfer of a right to file claim for a real property tax refund. We conclude and find that South Bay has not met its burden to overcome the respondent's determination that this portion of the condemnation award constituted ordinary income. We do not conceive that annual taxes or other expenses such as insurance, repairs, or maintenance constitute investment in real property or that compensation for such items, if prepaid, would be proceeds of the sale of a capital asset. As pointed out in the Gillette Motor Transport case the term "capital asset" is to be construed narrowly to afford capital gains treatment only in situations typically involving the realization of appreciation in value over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in 1 year. In the instant case the parties to the agreement merely agreed that "to avoid doubt as to the right of the trustee to apply for refunds of prepaid real estate * * * taxes * * * the trustee will not apply for refunds and the Authority * * * will pay to the trustee a sum equal to the amount of such taxes prepaid."

The cases relied upon by South Bay involved claimed deductions by taxpayers for real estate taxes assumed or paid by them but which had accrued as a liability of the vendor of real property prior to the sale. In denying the deduction to vendees because they did not pay taxes that they owed, the courts have laid down the rule that payment of such taxes should be included in the vendees' purchase price of the property thereby increasing the cost basis for income tax purposes. Such cases are clearly distinguishable from the question presented here. We are not concerned with deductions for taxes or additions to the vendees' cost basis.

In this case petitioner is seeking to obtain capital gains treatment for a portion of a condemnation award paid to reimburse the property owner for prepaid real estate taxes. We hold that no right or asset, much less a capital asset, was transferred to or acquired by the Water Authority but instead South Bay's trustee merely agreed to forbear a doubtful claim against a third party, the local real estate taxing authorities. The net result of the transaction was to reimburse South Bay for a prepaid business expense and the payment of $53,433.36 under the supplemental contract as part of the total award was merely a substitute for the possible refund of the real property taxes prepaid by South Bay at an earlier date. Under such circumstances, there was no sale or transfer of a capital asset and the income derived should be taxed as ordinary income. Cf. Hort v. Commissioner, 313 U.S. 28 (1941), affirming 112 F.2d 167 and 39 B.T.A. 922, and J. J. Shea, supra. Respondent did not err in reducing the proceeds of sale of petitioner South Bay's properties by the sum of $53,433.36 and in determining that such amount constituted additional ordinary income.

The third issue herein involves petitioner South Bay's assignment of error in respondent's determination that it realized additional ordinary income in the total amount of $605,577.85 in 1951 from the discharge of indebtedness by cancellation of a demand note for $227,960 and accrued interest deducted in prior years in the total sum of $377,617.85. The major portion of such accrued interest is identified by the stipulated facts, namely, $244,644.79 interest on the note and $113,261.24 interest on two loan accounts, both as accrued up to April 27, 1949. The remaining amount of $19,711.82 embraced in respondent's determination of canceled accrued interest is not specifically identified.

On April 27, 1949, New York and three trade creditors of petitioner South Bay filed a petition in the U.S. District Court for the Southern District of New York for South Bay's reorganization under chapter X of the Bankruptcy Act and such petition was approved and a trustee appointed. New York filed three claims with the trustee for debts owed to it by South Bay, two of which are involved in this issue. One claim was for $618,261.24 composed of $505,000 principal balance on two loan accounts (for $475,000 and $30,000, respectively) and accrued interest thereon in the amount of $113,261.24 to April 27, 1949. A second claim was for $472,604.70 composed of $227,960 principal balance due on South Bay's demand note and $244,644.79 accrued interest thereon to April 27, 1949.

The District Court, by order dated May 24, 1951, approved a proposed settlement between the court-appointed trustee and New York as a creditor, whereby the claim for South Bay's debt of $505,000 principal amount of the loan accounts was allowed in full and New York acceded to the trustee's contention that it was not entitled to the claimed accrued interest thereon and, further, South Bay's debt for the principal of the demand note and accrued interest thereon was canceled as a contribution to South Bay's capital. At that time and for several years prior thereto New York owned at least 7,250 of the 7,500 shares (if not all thereof as stated in briefs of both parties) of the outstanding common stock of South Bay.

Respondent determined that a cancellation of South Bay's indebtedness on both the note and the loan accounts occurred in 1951, as the premise of his assertion that it thereby realized taxable income in that year. If there was no actual cancellation of a debt as respondent argues at one point in his brief, then there is no basis for his application of the general rule that gratuitous cancellation of indebtedness, in whole or in part, results in realization of income to the debtor. However, based upon the stipulated facts herein, we conclude and find that respondent correctly determined that there was a cancellation in 1951 of South Bay's indebtedness involved herein.

With respect to the item of $113,261.24, accrued interest on the loan accounts, the parties involved treated it as a valid debt. Respondent determined that South Bay accrued and deducted such interest on its tax returns for prior years and the stipulated facts show that New York accrued and reported such interest as income on its tax returns for prior years. Under the court-approved settlement the principal due on the loan accounts was recognized as a debt and allowed in full on New York's creditor claim, while as to the accrued interest thereon the settlement between creditor and debtor used inconclusive terminology that New York acceded to the trustee's contention that it was not entitled to such interest. This was not a determination that no valid debt for interest existed. We construe the language to mean simply that, by agreement of the parties, New York would not collect the accrued interest and thereby South Bay's debt for $113,261.24 interest was canceled. The court-approved settlement specifically canceled South Bay's debt for both principal and accrued interest on the demand note by way of contribution to the capital of South Bay by its common stockholder New York.

There are two avenues of approach in viewing the tax consequences to petitioner South Bay resulting from the above-mentioned cancellations of its indebtednesses, both of which lead to the conclusion that no taxable income was thereby realized. Subsection (a) of section 29.22(a)-13 of Treasury Regulations 111,³ in effect for taxable years beginning prior to December 31, 1951, provides that a gratuitous cancellation of indebtedness of a corporation by its stockholder constitutes a contribution to the capital of the corporation to the extent of the principal of the debt, and the courts have held that this rule applies to indebtedness embracing both principal and accrued interest regardless of prior years' treatment of such interest for tax purposes. Commissioner v. Auto Strap Safety Razor Co., 74 F.2d 226 (C.A. 2, 1934), affirming 28 B.T.A. 621; Lidgerwood Manufacturing Co. v. Commissioner, 229 F.2d 241 (C.A. 2, 1956), affirming 22 T.C. 1152, certiorari denied 351 U.S. 951 (1956); and In the Matter of Triple Z Products, Inc., Bankrupt, an unreported case (S.D.N.Y. 1940), 27 A.F.T.R. 1164, 40-2 U.S.T.C. par. 9705. A contribution to the capital of a corporation is not income to it. Secondly, since the cancellations of South Bay's indebtednesses were in connection with a corporate reorganization confirmed under chapter X of the Bankruptcy Act, no income was thereby realized by South Bay pursuant to subsection (b)(1) of the above-cited regulation.

3 Regulations 111.
SEC. 29.22(a)-13. CANCELLATION OF INDEBTEDNESS. —
( a) In general. — The cancellation of indebtedness, in whole or in part, may result in the realization of income. * * * In general, if a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation to the extent of the principal of the debt.
( b) Proceedings under Bankruptcy Act. — * * * Furthermore, income is not realized in any case by a taxpayer in the case of a cancellation or reduction of his indebtedness under —

(1) a plan of corporate reorganization confirmed under * * * Chapter X of the Bankruptcy Act, as amended;

* * * * * * *
If, however, such plan of corporate reorganization or agreement of composition referred to in (1) to (4) above had for one of its principal purposes the avoidance of income tax, the cancellation or reduction of indebtedness, under such plan or agreement confirmed * * * under Chapter X, * * * of the Bankruptcy Act, as amended, may result in the realization of income. * * *

Respondent's position on this issue is not clear-cut. Respondent argues, inter alia, that considering the legal relationship of New York as sole common stockholder of its debtor South Bay and looking to substance as opposed to mere form, the purported surrender and cancellation of the demand note and accrued interest thereon was not actually a contribution to capital because it was something of no value to South Bay since the debtor and sole stockholder were one and the same person and South Bay's assets were thereby neither relieved nor increased and, further, that the purported contribution was for the purpose of disguising what was substantially a taxable transaction because in any event New York as creditor or stockholder would be paid from whatever assets South Bay owned. Respondent further argues that South Bay realized taxable gain in the entire amount of $605,577.85 in 1951, as determined by him, in spite of the provisions of the first part of subsection (b)(1) of section 29.22(a)-13 of the Regulations, supra, because no actual cancellation existed since South Bay remained legally obligated in any event to distribute its assets to its stockholder New York; and thus the purported cancellation is within the purview of the latter portion of subsection (b)(1) providing that if the plan of reorganization "had for one of its principal purposes the avoidance of income tax, the cancellation or reduction of indebtedness * * * may result in the realization of income." Respondent's contentions are, to say the least, confusing.

The stipulated facts herein do not present a transaction couched in mere form for the purpose of tax avoidance as opposed to real substance. Petitioners South Bay and New York, respectively, were distinct and separate taxable entities prior to, during, and subsequent to the taxable year 1951. The filing of the petition in the District Court for reorganization of South Bay under chapter X of the Bankruptcy Act, the court's appointment of a trustee, the filing of New York's claims as a creditor, and the court-approved settlement of those claims, were all matters of substance. We perceive no purpose of tax avoidance, nor the disguising of what was otherwise a taxable transaction. If, in the reorganization proceeding, South Bay had been required to pay its indebtednesses to New York, such payment would not have been a taxable event as to either South Bay or New York. The cancellation of the debts relieved South Bay of accrued liabilities. New York's cancellation of the debts constituting a contribution to the capital of South Bay increased New York's capital investment in its shares of common stock of South Bay and the latter's possible distribution in liquidation at some future time has no bearing on the taxable year before us.

Our discussion of this issue has revolved around the specifically identified South Bay indebtedness owing to New York on the demand note plus interest thereon and interest on the loan accounts. The stipulated facts do not specifically identify the remaining $19,711.82 out of the total sum of $605,577.85 embraced in respondent's determination of additional income realized in 1951 from discharge of indebtedness by cancellation. Nevertheless, assuming that there was a cancellation of additional accrued interest in the amount of $19,711.82 owing by South Bay (either to New York or some other creditor) such cancellation must of necessity have been in connection with the corporate reorganization proceeding under chapter X of the Bankruptcy Act, and accordingly no income was thereby realized by South Bay in 1951.

On the third issue herein we conclude and find that respondent erred in his determination that petitioner South Bay realized additional ordinary income in the amount of $605,577.85 in 1951 as the result of discharge of indebtedness by cancellation.

The fourth issue involves petitioner South Bay's assignment of error in respondent's determination that it is not entitled to a dividends paid credit of $165,662.73 for the taxable year 1951, as claimed under section 26(h) of the Internal Revenue Code of 1939.⁴ Said section provides for the computation of the amount and the allowance of a credit in the case of a "public utility," as defined therein, on account of dividends paid during the taxable year on its "preferred stock," as defined therein and issued prior to October 1, 1942, and, further that for purposes of the credit the amount of dividends paid shall not include a distribution for dividends unpaid and accumulated in any year ending prior to October 1, 1942.

4 SEC. 26. CREDITS OF CORPORATIONS.
In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax —
* * * * * * *
(h) CREDIT FOR DIVIDENDS PAID ON CERTAIN PREFERRED STOCK. —
(1) AMOUNT OF CREDIT. — In the case of a public utility, (A) for a taxable year beginning on January 1, 1951, and ending on December 31, 1951, an amount equal to 28 per centum of the lesser of (i) the amount of dividends paid during the taxable year on its preferred stock or (ii) the adjusted net income for such taxable year minus the credit for dividends received provided in subsection (b) for such year, * * * For the purposes of the credit provided in this subsection the amount of dividends paid shall not include any amount distributed in the current taxable year with respect to dividends unpaid and accumulated in any taxable year ending prior to October 1, 1942. * * * The credit provided in this subsection shall be subtracted from the basic surtax credit provided In section 27.
(2) DEFINITIONS. — As used in this subsection, subsection (b), and sections 13 and 15 —

(A) Public Utility. — The term "public utility" means a corporation engaged in the furnishing of telephone service or in the sale of electric energy, gas, or water, if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof or by an agency or instrumentality of the United States or by a public utility or public service commission or other similar body of the District of Columbia or of any State or political subdivision thereof.

(B) Preferred Stock. — The term "preferred stock" means stock issued prior to October 1, 1942, which during the whole of the taxable year (or the part of the taxable year after its issue) was stock the dividends in respect of which were cumulative, limited to the same amount, and payable in preference to the payment of dividends on other stock. Stock issued on or after October 1, 1942, shall be deemed for the purposes of this paragraph to have been issued prior to October 1, 1942, if it was issued * * * to refund or replace bonds or debentures issued prior to October 1, 1942, or to refund or replace other preferred stock.

On June 1, 1951, in the proceeding for reorganization of South Bay under chapter X of the Bankruptcy Act, the U.S. District Court ordered the trustee of South Bay to pay in full on or after June 8, 1951, the par value of all its preferred stock plus dividends unpaid and accumulated thereon to June 8, 1951. Thereafter, pursuant to such order and during its calendar taxable year 1951, South Bay distributed to its preferred shareholders the sum of $215.90 with respect to each outstanding share of its $100 par value preferred stock, that is, it redeemed each preferred share at par and paid $115.90 as accumulated dividends thereon. It is stipulated that of the total amount so paid to South Bay's preferred shareholders, $165,662.72 represents 28 percent of payments on account of dividends unpaid and accumulated in taxable years ending after October 1, 1942.

Such percentage and the years involved are part of the requirements in the computation of the amount of the dividends paid credit provided for by section 26(h) (1), supra, and, further, no issue is raised as to the correctness of the amount of the claimed credit, that is, that it is 28 percent of the lesser of (i) the dividends paid during the taxable year or (ii) the adjusted net income for such year minus credit for dividends received for such year, as provided in that subsection. There is no question herein but that the preferred stock involved was issued prior to October 1, 1942, and that the dividends thereon were cumulative, limited to the same amount, and payable in preference to dividends on other stock, as required by section 26(h) (2) (B), supra. Furthermore, under the facts herein, there is no question but that South Bay was an operating corporate "public utility" which was "engaged * * * in the sale of * * * water" as required by section 26(h) (2) (A), supra, over a long term of years prior and subsequent to October 1, 1942, and up to and including the first part of the calendar taxable year 1951, in which the unpaid accumulated dividends involved herein were paid.

South Bay's properties were condemned and taken over by the Suffolk County Water Authority as of May 31, 1951, for which an award was made in payment therefor, and on June 1, 1951, the district court ordered the redemption of South Bay's preferred stock at par and payment of the dividends accrued thereon up to June 8, 1951. While its water utility properties were liquidated and both its bonds and preferred stock were redeemed in 1951, South Bay remained in existence throughout the calendar year and its tax return for that year, filed as a public utility, reported income from operating revenue from sale of water, interest, and gain on involuntary conversion of its properties.

Petitioner South Bay contends that under the stipulated facts and the provisions of section 26(h), supra, it is clearly entitled to the claimed credit for dividends paid on its preferred stock during the calendar taxable year 1951.

Respondent makes a double-barreled contention that the claimed credit is not allowable. First, respondent contends that regardless of South Bay's identity as a public utility prior to the time all of its physical properties were condemned and taken over by the Water Authority as of May 31, 1951, thereafter South Bay failed to meet the specific definition of a "public utility" because it was not actually "engaged * * * in the sale of * * * water" as required by section 26(h) (2) (A), supra, on the date of the distribution made on or after June 8, 1951. Second, respondent states that the facts clearly show that no part of the distribution was attributable to the purported accumulated dividends on preferred stock within the meaning of section 26, supra, and that the entire payment made to preferred stockholders in 1951 was in redemption of stock on liquidation of South Bay. Based on such premise, respondent contends that section 115(c) of the Internal Revenue Code of 1939⁵ is applicable and requires that the entire distribution on preferred shares "shall be treated as in full payment in exchange for the stock" as provided in that section.

5 SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
(a) DEFINITION OF DIVIDEND. — The term "dividend" when used in this chapter * * * means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year * * * without regard to the amount of the earnings and profits at the time the distribution was made.
* * * * * * *
(c) DISTRIBUTION IN LIQUIDATION. — Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. In the case of amounts distributed (whether before January 1, 1939, or on or after such date) in partial liquidation (other than a distribution to which the provisions of subsection (h) of this section are applicable) the part of such distribution which is properly chargeable to capital account shall not be considered a distribution of earnings or profits.
* * * * * * *
(g) REDEMPTION OF STOCK. —

(1) IN GENERAL. — If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.

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(i) DEFINITION OF PARTIAL LIQUIDATION. — As used in this section the term "amounts distributed in partial liquidation" means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock.

The respondent's statement as to the factual circumstance in respect to the character of the total $215.90 payment per share on preferred stock, is contrary to the stipulated facts. Pursuant to the District Court order of June 1, 1951, the preferred stock was in fact redeemed at its $100 par value (i.e., no premium was paid) and unpaid accumulated dividends of $115.90 per share were in fact paid. Undoubtedly the redemption payment of $100 per share was "in full payment in exchange for the stock" under section 115(c), supra, but respondent fails to cite section 115(g) of the 1939 Code⁵ which provides that a stock redemption distribution which is "in whole or in part essentially equivalent to the distribution of a taxable dividend, * * *, shall be treated as a taxable dividend."

5 See footnote on preceding page.

On the record herein we conclude and hold that the portion of South Bay's 1951 distribution on its preferred stock in excess of the $100 par value thereof, constituted "dividends paid during the taxable year" within the meaning of section 26(h) (1), supra. Cf. Atlantic City Electric Co. v. United States, 142 Ct. Cl. 519, 161 F. Supp. 811 (1958), certiorari denied 358 U.S. 834 (1958).

In the Atlantic City Electric Co. case the Court of Claims discussed at length the provisions of section 26(h) and 115(c), supra. With reference to the enactment of section 26(h) the court said it appears that, for tax purposes, Congress desired to give to public utility companies which had financed themselves by issuing preferred stock a status similar to that of such corporations which had financed themselves by issuing bonds, and since the interest on bonds was deductible the dividends on preferred stock were made deductible by way of a credit. In that case preferred stock issued by the taxpayer, a public utility, provided that the corporation at its option could redeem its $100 par value shares for $120 plus accrued dividends, and the corporation did so redeem them. The court stated that, "The accrued dividends so paid were clearly deductible under the provisions of section 26(h), and they are not involved in this case." The redemption payments of $20 per share in excess of par value were also claimed by the taxpayer as "dividends paid" for the purposes of section 26(h) credit, and the court held that they were not the payments of $6 per share which accrued annually on the preferred stock, but were a part of the redemption paid to liquidate the stock under the provisions of section 115(c).

Respondent cites no authority in support of his narrow interpretation of section 26(h), supra, to the effect that the claimed credit is not allowable to South Bay because its properties were condemned and taken over as of May 31, 1951, and it was no longer actually "engaged * * * in the sale of * * * water" on the date of the subsequent distribution in the taxable year pursuant to a court order of June 1, 1951. The statute itself is silent as to either the allowance or denial of the dividends paid credit under the factual situation here involved, and so are Treasury Regulations 111, section 29.26-5,⁶ applicable to the taxable year in question. Those regulations disclose a fair and reasonable interpretation of the statutory provision in several other respects, for instance, that the credit will not be denied solely because part of a corporation's gross income consists of revenue derived from sales at rates which are not regulated by a public authority, or denied in the case of a given class of preferred stock merely because another class of preferred stock has preference in the payment of dividends, and that it is immaterial whether the preferred stock be voting or nonvoting stock. In Rev. Rul. 228, 1953-2 C.B. 26, under Regulations 118, section 39.26(h), see footnote 6, it was ruled that the dividends paid credit would not be denied because a corporation was not solely a "public utility" as defined in section 26(h) of the 1939 Code, supra, in that it derived income from both utility and nonutility sources and, further, that since the statute is silent as to nonutility activities, the allowance of the credit under "an apportionment formula which allocates the dividends paid credit upon a basis of utility and nonutility income avoids extreme results and attains a reasonable and practical interpretation of section 26(h) of the Code."

6 Treasury Regulations 111 (applicable only to years beginning after Dec. 31, 1941) sec. 29.26-5, as originally promulgated and amended by T.D. 5384, June 30, 1944; by T.D. 5950, Dec. 2, 1952; and by T.D. 6195, Aug. 8, 1956. Treasury Regulations 118 (applicable only to years beginning after Dec. 31, 1951) sec. 39.26(h) has no provision covering this situation, nor for that matter does the Internal Revenue Code of 1954, sec. 247, providing for a deduction for dividends paid on certain preferred stock of public utilities, or Treasury Regulations, sec. 1.247-1, promulgated thereunder.

In Public Service Electric Gas Co. v. United States, 141 Ct. Cl. 404 (1958), 157 F. Supp. 846, the Court of Claims held that the taxpayer, a "public utility" corporation, was entitled to a dividends paid credit under section 26(h) of the 1939 Code, although the preferred stock with respect to which the credit was claimed was issued after October 1, 1942, in exchange for and to replace old preferred stock of its parent holding company, which was not a "public utility." The Commissioner argued that the preferred stock issued by the taxpayer did not qualify as a replacement under section 26(h) (2) (B) because the preferred stock of the parent did not qualify as preferred stock of a "public utility" with respect to which the credit was available. The portion of section 26(h) (2) (B) there involved does not specifically require that the preferred stock replaced shall itself qualify for the dividends paid credit. The court held that the allowance of the claimed credit was within the intent and purpose of the statute.

In the instant case South Bay was unquestionably operating as a "public utility" engaged in the sale of water, within the meaning of section 26(h), supra, over a long period of years up to and including the first part of the taxable year 1951 and the unpaid accumulated dividends paid during the taxable year related to such business. On the record we conclude and find that the dividend payment involved herein falls within the intent and purpose of section 26(h), supra, and that petitioner South Bay is entitled to the claimed dividends paid credit under that section. On this issue we hold that respondent erred in his determination.

In our opinion the fifth and sixth issues herein involving petitioner New York are controlled by our holding with respect to the related third issue herein. We have held that the debt for accrued interest on the loan accounts and also the debt for the principal of the demand note and accrued interest thereon owed to New York by South Bay, were canceled by the latter's shareholder and thereby constituted contributions to the capital of South Bay. It follows that the accrued interest on the loan accounts (in the stipulated amount of $113,261.24 to April 27, 1949, or the larger amount of $113,329.57 as alleged by petitioner New York) did not become a worthless debt in 1951 and respondent's disallowance of the claimed bad debt deduction involved in the fifth issue herein is approved. Further, since New York's cancellation of the note and interest thereon as a contribution to South Bay's capital increased New York's capital investment in its shares of common stock of South Bay, it follows that New York did not thereby realize taxable income and with respect to the sixth issue herein we hold that respondent erred in including in petitioner New York's income for 1951 an additional amount of $500,213.77 as set forth in the statutory deficiency notice.

Decision in each docket number herein will be entered under Rule 50.