October 20, 1931.
Suit by the Texas Pacific Railway Company against the United States.
Judgment for plaintiff.
This suit was instituted to recover $208,138.01, income tax alleged to have been erroneously and illegally collected for 1920, with interest.
The issues are: (1) Whether there should be included in taxable income $2,061,082.63 paid by the United States to the plaintiff under the provisions of section 209 of the Transportation Act of 1920 (49 USCA § 77) to make good an operating deficit of plaintiff for the guaranty period; (2) whether plaintiff is required to include as income for 1920 the amount of $17,707.97 representing the cost of constructing certain spur tracks which were paid for by the person for whose benefit they were constructed; (3) whether plaintiff is entitled to deduct a contribution to the Association of Railway Executives in the amount of $4,143.28 as an ordinary and necessary business expense.
As to the first issue, plaintiff contends that since section 209 of the Transportation Act of 1920 was not limited to railroads that had been under federal control nor to carriers under federal control contract, but applied to all carriers, whether or not under federal control and whether or not under contract, the payment of the guaranty was not for services that had been rendered, but was a bounty bestowed upon all carriers accepting the provisions of the act and was for the purpose of rehabilitating the carriers after the disruption caused by the World War conditions and of making it possible for them to operate during the read-justment period immediately following the World War; that the guaranty payments were therefore not income within the meaning of the Sixteenth Amendment to the Constitution.
On the second issue plaintiff contends that the cost of constructing spur tracks, paid for by the person for whose use and benefit they were constructed, is not taxable income to the corporation. And with respect to the third issue it is contended that the contribution to the Association of Railway Executives was an ordinary and necessary business expense.
1. Plaintiff was organized under an Act of Congress approved March 3, 1871 ( 16 Stat. 573), and has its principal office at Dallas, Tex. During the months of January and February, 1920, its properties were under federal control and were operated by the Director General of Railroads, and during the remainder of the calendar year 1920 its properties were operated by a receiver under a decree of the District Court, Western District of Louisiana, Monroe Division, which receivership terminated at midnight on May 14, 1924.
2. Plaintiff accepted the provisions of section 209 of the Transportation Act of 1920, 41 Stat. 464 (49 USCA § 77), and received for the "guaranty period" mentioned by that act an allowance by the Interstate Commerce Commission representing the amount necessary to make good the guaranty under section 209, supra, in the sum of $2,043,041.77, and its subsidiary, the Denison Pacific Suburban Railway Company, received a like allowance of $18,040.86.
3. March 15, 1921, plaintiff filed an income and profits tax return for 1920 showing a net income of $3,331,767.11 and a tax of $332,976.71, which was paid in three equal installments of $83,244.18 on March 15, September 7, and December 10, 1921, and $83,244.17 on June 4, 1921. An overpayment of $11,099.22 resulted from the above payments by reason of the failure of the carrier to apply the two rates of tax applicable to the year 1920. The overpayment mentioned was refunded to the carrier by the Director General of Railroads in his administration of section 1 of the Federal Control Act ( 40 Stat. 451) in connection with section 230(b) of the Revenue Act of 1918 ( 40 Stat. 1075).
4. Plaintiff's subsidiaries, the Weatherford Mineral Wells Northwestern Railway Company and the Denison Pacific Suburban Railway Company, filed their respective income and profits tax returns for 1920 on March 5 and March 15, 1921. These returns showed no tax liability, but, on the contrary, reported losses in the respective amounts of $10,114.53 and $562.23.
5. November 20, 1925, the Commissioner of Internal Revenue audited these returns and held that the plaintiff and the two other railway companies mentioned were affiliated for 1920 and consolidated them for the purpose of the determination of the tax liability. He determined a consolidated net income of $3,858,969.80 and an additional tax of $52,720.27. Among the adjustments set forth in his audit the commissioner included in taxable income the amount of $17,707.97, representing donations in that amount to the plaintiff to pay for the cost of constructing certain spur and side tracks and other improvements. The total of the said donations to plaintiff consisted of the cost of materials and labor, all of a capital nature, used in the construction of said tracks, the total of which was credited on its books to profit and loss account No. 606, "Donations."
6. Thereafter, on December 30, 1926, the commissioner made a reaudit of the returns of plaintiff and its subsidiaries for 1920 and determined a consolidated net income of $3,586,524.78 and an additional tax of $25,475.77 in lieu of his determination of November 20, 1925. In this reaudit the commissioner disallowed as a deduction from gross income the amount of $2,589.55, representing a portion of a contribution paid to the Association of Railway Executives which was assessed to the plaintiff by that association of which plaintiff was, and is, a member. The total amount paid by plaintiff to the Association of Railway Executives in 1920 as its proportion of expense of maintaining and furthering the activities of that association was $1,143.28. The commissioner allowed as a deduction from gross income only $1,553.73 of this amount.
The Association of Railway Executives is a voluntary association composed of officials of all Class I railroads, with one exception, and was organized many years ago for the purpose of attending to matters of common concern to the railroads. It was believed that the principal problem confronting the railroads just prior to the war was the impairment of their credit, due in large measure to an unsympathetic public opinion. The World War and the consequent taking over of the railroad properties by the Director General of Railroads delayed the program which the association had tentatively adopted for correcting such unfavorable public impression.
Upon the close of the war and in view of the imminent return of railroad properties to private ownership, the association resolved in 1919 to renew its plans for presenting the cause of the railroads to the public by means of a nation-wide advertising compaign. An assessment was made against each member of the road, on a mileage basis, designed to raise a fund of $1,600,000, of which $1,000,000 was estimated to be necessary for carrying on such advertising campaign. The assessment was made payable in four equal installments, two of which fell within the calendar year 1919 and two within the calendar year 1920. The ratio of $1,000,000 to $1,600,000, or ten sixteenths, was the basis for the commissioner's disallowance of $2,589.55 of the contribution made by the plaintiff in 1920.
The association expended a total of $828,518.40 in connection with a series of eight advertisements inserted in newspapers covering the entire country instead of $1,000,000 as estimated. The balance of $171,481.60 was turned into the general treasury of the association. The eight advertisements purported to outline the part which had been played by the railroads in the development and progress of the Nation, the reasonableness of freight rates, the tremendous investment in railroad properties, the necessity for additional capital to enable the railroads to keep abreast of the times, comparisons of American railroads with foreign railroads, and other problems then facing the railroads, and appealed to the public for a more sympathetic understanding of such problems and for confidence and cooperation in working out their solution.
7. April 8, 1927, the Commissioner of Internal Revenue made his final determination with respect to the tax liability for 1920, in which he determined a consolidated net income of $3,639,968.48. The total tax liability as finally determined in notices mailed April 8, 1927, was allocated by the commissioner to the plaintiff and its subsidiary, the Weatherford Mineral Wells Northwestern Railway Company, in the amounts of $361,797.42 and $1,999.43, respectively, and, based upon said allocation, the commissioner determined a deficiency against plaintiff of $28,820.71 and a deficiency against the subsidiary of $1,999.43. May 6, 1927, plaintiff paid the deficiency of $28,820.71 determined by the commissioner with respect to its tax for 1920. This deficiency constituted in part an overpayment of tax which arose as a result of the failure of the Commissioner of Internal Revenue to apply the two rates of tax applicable to the year 1920. The amount of $960.69 was refunded to the carrier by the Director General of Railroads in his administration of section 1 of the Federal Control Act in connection with section 230(b) of the Revenue Act of 1918. The net amount of tax therefore finally paid by the carrier was $349,737.51.
8. The consolidated net income of plaintiff and its subsidiaries as finally determined by the commissioner in his notice of April 8, 1927, included as taxable income the aforementioned allowance under section 209 of the transportation act of 1920 for the "guaranty period" in the aggregate sum of $2,061,082.63, as well as the aforementioned items of donations by the public of $17,707.97 and the contribution to the Association of Railway Executives of $2,589.55.
9. On or prior to December 19, 1925, plaintiff filed with the Commissioner of Internal Revenue a waiver of the limitation within which assessment of additional taxes for 1920 might be made extending the said limitation to December 31, 1926, and on or before December 20, 1926, plaintiff filed a second waiver for extending the time for assessment of additional taxes for 1920 to December 31, 1927.
June 21, 1927, plaintiff filed a claim for refund for 1920 of $2,029.75 on account of taxes alleged to have been erroneously and illegally assessed and collected as set forth in findings 5 and 6. This claim was rejected by the commissioner September 21, 1927. Thereafter, on March 31, 1928, plaintiff filed an additional claim for refund for 1920 of $206,108.26, alleged to have been erroneously and illegally assessed and collected upon the allowance of $2,061,082.63 included in income by the commissioner as above set forth. This claim was rejected June 14, 1928.
10. Plaintiff is the sole owner of this claim. No assignment thereof has been made and no action has been taken thereon before Congress, the courts, or in any department of the government as hereinbefore set forth.
Chester A. Gwinn, of Washington, D.C. (Humphreys Gwinn, of Washington, D.C., on the brief), for plaintiff.
Montgomery B. Angell, of New York City, amicus curiæ.
Charles B. Rugg, Asst. Atty. Gen. (Joseph H. Sheppard, of Washington, D.C., on the brief), for the United States.
Before BOOTH, Chief Justice, and GREEN, LITTLETON, WILLIAMS, and WHALEY, Judges.
On the first issue the plaintiff contends that the amount of $2,061,082.63 received from the United States under the provisions of section 209 of the Transportation Act of 1920 to make good an operating deficit for the guaranty period was strictly a bounty or a subsidy from the sovereign to the railroad and, as such, was free from taxation by the United States. We are unable to agree with this contention. This question was before the United States Board of Tax Appeals in Gulf, Mobile Northern Railroad Co. et al., 22 B.T.A. 233, wherein the board in a well-reasoned opinion reached the conclusion that such payments made by the United States under section 209 of the Transportation Act of 1920 constituted taxable income. We agree with the reasoning of the board and the conclusion reached in the above-mentioned case.
The plaintiff relies upon the case of Edwards v. Cuba Railroad Co., 268 U.S. 628, 45 S. Ct. 614, 69 L. Ed. 1124, but we think that case is not in point. The payment made under section 209 of the Transportation Act was not a contribution to capital nor was it strictly and correctly a bounty or subsidy as would be exempt from taxation. While there was no legal obligation on the part of the United States to make such payment to the railroads before section 209 of the Transportation Act became law, the government was bound by legal obligation after the railroads had accepted the terms of this statute to make the necessary payments and the railroads were equally bound to pay certain excess earnings over the specified amounts to the government. There was mutuality of arrangement and mutuality of benefit as well as of obligation. The whole matter of such payments grew out of the control and operation of most of the railroads in the country by the United States, and the purpose of the act providing for such payments was to guarantee to the railroads that for a period following the release of railroads from federal control their operating income, of which their owners and security holders received the benefit, would not be less than their average railway operating income for the test period of three years prior to federal control ending June 30, 1917. It was the railway operating income in a specifically restricted sense which was guaranteed. The railroads, in order to receive the guaranty payments under section 209, were required to accept in writing all provisions of that section within a certain time. One of these conditions was, should the railway operating income exceed a certain amount, the excess would be paid to the government. This constituted a contractual agreement between the carrier and the government, and it could not be ascertained until an accounting had been had whether the government would pay the railroad or whether the railroad would pay the government. This feature of the case takes away any basis for holding that the payments by the government were pure gifts or subsidies to the railroads. Although Congress was impelled by no legal obligation in enacting this legislation requiring the government to make these payments, it seems clear that the government took into consideration the benefits to be derived by the people of the United States and that there were obligations of "an equitable, moral, and honorary nature" on the part of the government existing on account of the condition of the railway systems immediately following federal control and largely as a result thereof. United States v. Realty Co. et al., 163 U.S. 427, 16 S. Ct. 1120, 41 L. Ed. 215. Such an obligation may well be said to take the place of a legal obligation to such an extent as to take payments under section 209 of the Transportation Act out of the class of pure gratuities or subsidies. If the payments by the government to the railroads constitute gifts or gratuities free from tax, the question naturally arises as to the nature of payments made by the railroad to the government where they had excess income. It would be a strained construction to say that amounts paid by the railroads to the government where their income exceeded certain amounts were gifts by them to the government. We think the railroads were not making voluntary contributions to the federal government, and certainly they did not so consider it. Nor do we consider that the government was making gifts or voluntary contributions to the railroads where their operating income did not equal the guaranteed amount. As was well stated by the United States Board of Tax Appeals in Gulf, Mobile Northern Railroad Co. et al., supra: "The payments by the Government, however, were dependent upon the operation of the railroad, that is, the use of both capital and labor. The payments were not received for the guaranty period unless the railroads were in operation during that period, and then only in the event that their operating income was less than the guaranteed amount, and we cannot overlook the fact that it was railway operating income which was guaranteed and made up. The Government derived a substantial benefit from the payments. It received consideration from the substantial good obtained for or expected to be obtained for the people as a whole on account of the more efficient operation of the railroads and the further establishment of their credit."
For the foregoing reasons and for additional reasons fully stated and discussed by the United States Board of Tax Appeals in Gulf, Mobile Northern Railroad Co. et al., supra; Missouri Pacific Railroad Co., 22 B.T.A. 267; Kansas City Southern Railway Co. and Affiliated Companies, 22 B.T.A. 949; Galveston Wharf Co., 22 B.T.A. 1312; and Chicago North Western Railway Co., 22 B.T.A. 1407, we are of opinion that the Commissioner of Internal Revenue correctly held that the amounts received by the plaintiff from the government under the provisions of section 209 of the Transportation Act constituted income for the year 1920.
The next issue concerns the question whether plaintiff was required to include in income for 1920 an amount representing the cost of constructing certain spur tracks which were paid for by the person or persons for whose benefit they were constructed. In the course of plaintiff's business as a carrier it is customary to construct spur tracks, side tracks, culverts, etc., at the request and for the benefit of persons and corporations along its right of way. The railroad furnishes the labor and materials for such construction and charges the actual cost thereof to the person for whose benefit the work was done and is reimbursed therefor by such beneficiary. To so much of such construction as is on plaintiff's right of way it acquires title and to that extent its capital account is increased. The actual cost of such improvements is, under a system of accounting prescribed by the Interstate Commerce Commission, required to be credited to profit and loss account No. 606, entitled "Donations."
We are of opinion that these transactions did not give rise to the receipt of taxable income by the plaintiff and that the defendant erroneously included in plaintiff's income for 1920 the amount of $17,707.97 on account thereof. Liberty Light Power Co., 4 B.T.A. 155; Great Northern Railway Co., 8 B.T.A. 225.
The last question is whether a payment of $4,143.28 made by plaintiff to the Association of Railway Executives, as set forth in finding 6, was an ordinary and necessary business expense allowable as a deduction from gross income for 1920. The Commissioner of Internal Revenue allowed a deduction of $1,553.73 of the total amount paid. This left a balance of $2,589.55. Plaintiff contends that this was an ordinary and necessary business expense and should be allowed as a deduction from gross income, while the defendant takes the position that the portion of the contribution disallowed falls within art. 562 of regulations 45 providing that sums of money expended for lobbying purposes, the promotion or defeat of legislation, the exploitation of propaganda, including advertising other than trade advertising, and contributions for campaign expenses, are not deductible from gross income.
We are of opinion that the nature of the contribution in question and the circumstances under which it was made bring it within the field of ordinary and necessary business expense and that it should be allowed as a deduction from gross income. Great Northern Railway Co., supra; Texas Pacific Ry. Co., 9 B.T.A. 365; Western Maryland Ry. Co., 12 B.T.A. 889; Los Angeles Salt Lake Railroad Co., 18 B.T.A. 168; and Norfolk Southern Railroad Co., 22 B.T.A. 302.
Judgment will be entered in favor of plaintiff for $1,962.09, with interest thereon at 6 per cent. per annum, as provided by law. It is so ordered.