Warner Co.
v.
Comm'r of Internal Revenue

Tax Court of the United States.Sep 27, 1948
11 T.C. 419 (U.S.T.C. 1948)
11 T.C. 419T.C.

Docket No. 7326.

1948-09-27

WARNER COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

George E. H. Goodner, Esq., and Scott P. Crampton, Esq., for the petitioner. Robert H. Kinderman, Esq., for the respondent.


On the record, held:

1. Where petitioner purchased at less than face value certain of its bonds with accrued interest coupons attached, which bonds had been issued at a discount, the gain realized on the principal of the bonds is to be determined by a proportionate allocation between principal and interest.

2. Where petitioner kept its books on an accrual basis, its liability for interest payments on its bonds became fixed on the dates specified in the original instrument and the interest was then properly accrued and deductible. Such interest is not a proper item of deduction in a subsequent year when actually paid.

3. Pennsylvania corporate loans tax, imposed by law on the individual bondholder, is not a tax as an inducement for the purchase of its bonds, but is, in effect, additional interest on borrowed capital.

4. The amounts of $236,250 and $235,613.79 received by bankers in connection with the purchase and sale of petitioner's first preferred stock are not properly includible in equity invested capital.

5. Since, in computation of net gain realized by petitioner on the purchase and retirement at less than par of certain of its bonds issued at a discount and includible in normal tax net income, the unamortized discount and expense are reflected by a deduction from gross gain and such net gain is excluded in the computation of excess profits net income under section 711(a)(2)(E) of the Internal Revenue Code, such unamortized discount and expense are not again deductible in the latter computation. George E. H. Goodner, Esq., and Scott P. Crampton, Esq., for the petitioner. Robert H. Kinderman, Esq., for the respondent.

This proceeding involves deficiencies in income tax for 1941 in the amount of $26,272.44 and excess profits tax for the year 1942 of $71, 623.79. This latter amount, the respondent, by amended answer, seeks to increase to the amount of $78,278.64.

The issues presented are:

(1) Did petitioner upon the purchase and retirement of its own bonds, realize taxable income of $49,320, $123,991.25, and $110,671.66 in the respective years 1940, 1941, and 1942?

(2) Is petitioner entitled to deduct from gross income for the year 1942 the amount of $709,380, representing the payment in that year of unpaid interest, totaling 18 per cent, on certain bonds for the years 1933, 1934, and 1935?

(3) Do the amounts accrued by petitioner in 1940, 1941, and 1942 as Pennsylvania corporate loans tax for those years represent additional interest on borrowed capital?

(4) Are the amounts of $236,250 and $235,613.79, received by the bankers in connection with the purchase and sale of first preferred stock of petitioner in 1929, properly includible in petitioner's equity invested capital?

(5) Are the amounts of $4,514.61, $3,674.92, and $10,788.27, representing unamortized debt discount and expense originally incurred in 1929, applicable to the first mortgage bonds retired in 1940, 1941, and 1942, deductible in computing excess profits net income for each of such years?

The case was submitted upon a stipulation of certain facts, oral testimony, and exhibits. The facts stipulated are so found. Additional facts are found from the evidence.

FINDINGS OF FACT.

Petitioner is a Delaware corporation having its principal office at Philadelphia, Pennsylvania. It is engaged in the business of furnishing building supplies to the construction industry.

Petitioner keeps its books and filed its Federal income and excess profits tax returns on the accrual basis of accounting by calendar years. Petitioner's tax returns for the periods here involved were filed with the collector of internal revenue for the first district of Pennsylvania.

The organization of petitioner resulted from the desire of the Charles Warner Co. (hereinafter called Warner) to acquire certain sand, gravel, and lime properties owned by the Van Sciver Corporation (hereinafter called Va Sciver) and to do so primarily with borrowed funds. After negotiations during the winter of 1928-29, the parties entered into a series of agreements dated February 6, 1929. Warner agreed to deliver its assets to a new corporation to be formed, which is the petitioner; Van Sciver agreed to sell its properties through an agent, F. W. Bacon, to that corporation; and certain banking interests headed by Dillon, Reed & Co. made certain agreements in reference to the securities to be issued by petitioner. The securities authorized to be issued by petitioner were $7,000,000 first mortgage bonds; 50,000 shares of first preferred stock of $100 par value; 57,500 shares of second preferred stock of $100 par value; and not more than 350,000 shares of common stock of no par value. Part of the proceeds from the issuance of these securities was to go to Warner and part to Van Sciver for their respective properties, and part was to be retained by petitioner for operating purposes.

With respect to the first preferred stock the agreement of the bankers provided, in part, that petitioner:

* * * shall sell to Bankers and Bankers shall purchase from Company Twenty-three thousand two hundred twenty-three (23,223) shares of said first preferred stock at $90.00 per share, if the same be $100.00 par, or Forty-six thousand four hundred forty-six (46,446) shares at $45.00 per share if the same be of $50.00 par or of no par value. Bankers may sell said stock at any price they may fix; but if in their discretion they sell said stock to the public at a price in excess of $98.00 per share for the $100.00 par stock, or in excess of $49.00 per share for $50.00 par stock or no par stock, then the Bankers will divide any excess over the sales prices mentioned per share, and accrued dividend, equally with the Company. * * *

The agreements of February 6, 1929, were carried out, subject to two or three changes. One change included the sale of all the first preferred stock for cash. Another included the offering by the bankers of the first preferred stock to the public prior to the actual settlement or completion of the transactions. The bankers oversold petitioner's preferred stock prior to its issuance and had to borrow additional such stock from petitioner's officials to fill their commitments.

On April 8, 1929, the parties made their simultaneous settlements pursuant to the several agreements of February 6, 1929, as revised. Petitioner came away from this settlement owning the Van Sciver properties and the assets of Warner, subject to a $7,000,000 first mortgage and the miscellaneous liabilities of the predecessor company. It had outstanding 31,500 shares of first preferred, 57,500 shares of second preferred and 213,000 shares of no par common stock.

In 1929 the first mortgage 6 per cent sinking fund bonds of petitioner in the amount of $7,000,000, mentioned above, were issued and sold to the bankers at a discount. Each bond had a face value of $1,000. The form of the bond and the interest coupon attached reads as follows:

No.

$1,000.

For value received, Warner Company (hereinafter called the ‘Corporation‘), a corporation of the State of Delaware, hereby promises to pay to bearer, or, if this bond be registered, to the registered owner hereof, on the first day of April 1944, at the principal office of Tradesmens National Bank and Trust Company, in the City of Philadelphia, Pennsylvania, or at the principal office of National Bank of Commerce in New York, in the Borough of Manhattan, City, County and State of New York, or of its successor or successors, One Thousand Dollars ($1000), in gold coin of the United States of America of or equal to the standard of weight and fineness as it existed on April 1, 1929, and to pay interest thereon from the first day of April, 1929, at the rate of 6% per annum, in like gold coin, at the principal office of Tradesmens National Bank and Trust Company, in the City of Philadelphia, Pennsylvania, or at the principal office of National Bank of Commerce in New York, in the Borough of Manhattan City, County and State of New York, or of its successor or successors, semi-annually, on the first day of April and the first day of October in each and every year until payment of said principal sum, but until maturity, only upon presentation and surrender of the interest coupons therefor, hereto attached, as they severally mature; and such interest hereon is payable without deduction for such part of any normal Federal Income tax as shall not exceed two per cent. (2%) thereof per annum, which the Corporation, the Trustee hereinafter mentioned, or any paying agent may be required or permitted to pay thereon or to retain or deduct therefrom under any present or future law or requirement of the United States of America, and without deduction for any taxes, assessments or other governmental charges payable to the Commonwealth of Pennsylvania, which the Corporation, or the Trustee hereinafter mentioned, or any paying agent, may be required or permitted to pay thereon or to retain or deduct therefrom under any present or future law or requirement of the Commonwealth of Pennsylvania, but not in any calendar year in excess of four (4) mills upon each dollar of the face value of such bonds.

It is provided in the Indenture of Mortgage hereinafter referred to that the Corporation, to the extent and subject to the conditions set forth in said Indenture of Mortgage, will reimburse (2) to the owner of any bond, who may be a resident of the Commonwealth of Pennsylvania (should the law or conditions so change that such holder shall be personally liable for the return and payment of said tax) when paid by him, personal property taxes, other than estate, succession, income or inheritance taxes, paid by such owner under the laws of the said Commonwealth by reason of the ownership of said bond by such owner, provided that the Corporation shall not in any such case be obligated to refund in excess of four (4) mills per annum on each dollar of the taxable value of said bonds; and (b) to the owner of any bond, who may be a resident of the State of Maryland, when paid by him, personal property taxes, other than estate, succession, income or inheritance taxes, paid by such owner under the laws of the said State by reason of the ownership of said bond by said owner, provided that the Corporation shall not in any such case be obligated to refund in excess of four and one-half (4 1/2) mills per annum on each dollar of the taxable value of said bonds, provided in all such cases that the Corporation shall not be required to pay or refund taxes of more than one such State or Commonwealth on the same bond for the same calendar year.

This bond is one of an authorized issue of bonds of the Corporation, known as its ‘First Mortgage 6% Sinking Fund Bonds,‘ limited to the aggregate principal amount of Seven Million Dollars ($7,000,000), of like date, tenor and effect, issued under and all equally and ratably secured by an Indenture of Mortgage, dated as of the first day of April, 1929, executed and delivered by the Corporation to Tradesmens National Bank and Trust Company as Trustee (hereinafter called the ‘Trustee‘), to which Indenture of Mortgage reference is hereby made for a description of the property mortgaged, the nature and extent of the security, the rights of the holders of such bonds to said security, and the terms and conditions upon which said bonds are issued and secured.

At the option of the Corporation all or any part of said bonds may be redeemed on any interest payment date, prior to maturity, on at least thirty days' written notice by publication once a week for four successive weeks in daily newspaper of general circulation published in the City of Philadelphia, Pennsylvania, and in one such newspaper published in the Borough of Manhattan, City and State of New York, all as provided in said Indenture of Mortgage at the principal amount and accrued interest, together with a premium equal to the following respective percentages of the principal amount:

Five per cent. if redeemed on or before April 1, 1934; four and one-half per cent. if redeemed thereafter and on or before April 1, 1935; four per cent. if redeemed thereafter and on or before April 1, 1936; three and one-half per cent. if redeemed thereafter and on or before April 1, 1937; three per cent. if redeemed thereafter and on or before April 1, 1938; two and one-half per cent. if redeemed thereafter and on or before April 1, 1939; two per cent. if redeemed thereafter and on or before April 1, 1940; one and one-half per cent. if redeemed thereafter and on or before April 1, 1941; one per cent. if redeemed thereafter and on or before April 1, 1942; and one-half of one per cent. if redeemed at any time thereafter and prior to maturity.

As provided in said Indenture of Mortgage, this bond is also subject to redemption by operation of the sinking fund therein provided at the aforesaid redemption price.

In case an event of default, as defined in said Indenture of Mortgage, shall occur, the principal of all of the bonds issued thereunder may become or be declared due and payable, in the manner, with the effect and subject to the conditions provided in said Indenture of Mortgage.

This bond shall pass by delivery unless registered as to principal in the name of the owner on books to be kept at the office of the Trustee in the City of Philadelphia, Pennsylvania, such registry to be noted on this bond, and thereafter no transfer shall be valid unless made by the registered owner in person or by attorney and similarly noted hereon, but this bond may be discharged from registry and its transferability by delivery be restored, by like transfer to bearer noted hereon, after which it may again from time to time be registered as to principal or made transferable to bearer as before. No registration, however, shall affect the negotiability of the coupons which shall always be payable to bearer and transferable by delivery merely.

The bonds are issuable as coupon bonds in the denomination of $1,000.

No recourse shall be had for the payment of the principal of or the interest on this bond, or any part thereof, or of any claim based hereon or in respect hereof, or of said Indenture of Mortgage, against any incorporator, or any past, present or future stockholder, officer or director of the Corporation or of any predecessor or successor corporation, whether by virtue of any constitution, statute, or rule of law or by the enforcement of any assessment or penalty or otherwise, all such liability being, by the acceptance hereof and as part of the consideration for the issue hereof, expressly waived and released, as more fully provided in said Indenture of Mortgage.

Neither this bond nor any coupon hereto appertaining shall be valid or obligatory for any purpose until this bond shall have been authenticated by the execution of the certificate endorsed hereon by Tradesmens National Bank and Trust Company, Trustee under said Indenture of Mortgage, or its successor in said trust.

In Witness Whereof, said Warner Company has caused this bond to be singed in its corporate name by its President or one of its Vice-Presidents and its corporate seal to be hereunto affixed and attested by its Secretary or one of its Assistant Secretaries, and the said interest coupons, bearing the facsimile signature of its Treasurer, to be annexed hereto, and this bond to be dated as of the first day of April, 1929.

WARNER COMPANY, By President. Attest: Secretary.

(Form of Interest Coupon)

No.

$30.00

On the first day of . . . , 19 . . . , Warner Company shall pay to bearer, unless the bond hereinafter mentioned shall have been called for previous redemption and provisions made for the payment thereof, on the surrender of this coupon, Thirty Dollars ($30.00) in United States gold coin of the standard of weight and fineness existing on April 1, 1929, at the principal office of Tradesmens National Bank and Trust Company, in the City of Philadelphia, Pennsylvania, or at the principal office of National Bank of Commerce in New York, in the Borough of Manhattan City, County and State of New York, or of its successor or successors, without deduction for such part of any normal Federal income tax as shall not exceed two per cent. (2%) thereof per annum, being six months' interest then due on its First Mortgage 6% Sinking Fund Bond, No.

Treasurer.

Because of the depression starting in 1929, petitioner suffered losses of some $4,000,000 and was unable to pay its bond interest. As a result, petitioner, in the winter of 1932-33, began negotiations leading to a readjustment of its obligations to pay semiannual interest on its first mortgage bonds. These negotiations culminated in the execution of a supplemental indenture, providing, in part, as follows:

Section 2. Fixed interest on the said bonds for the three years, represented by the coupons maturing April 1, 1933, October 1, 1933, April 1, 1934, October 1, 1934, April 1, 1935, and October 1, 1935, is hereby waived by all Bondholders who, before or after the date hereof, shall have had their bonds stamped to be subject to this supplemental indenture, in the manner hereinafter set forth, and also by all subsequent holders of the said bonds so stamped, and, as to all such consenting Bondholders, the Corporation is relieved from the payment of such fixed interest, but only to the extent hereinafter set forth. The Corporation covenants to pay interest during the three years, represented by the aforesaid coupons, hereinabove specified, on the bonds so stamped only to the extent that available earnings are sufficient for such payment but not in excess of 6% per annum; provided, however, that, if interest at less than the rate of 6% per annum is paid during the three years, represented by the aforesaid coupons, hereinabove specified, the Corporation covenants to pay any deficiency of such interest upon maturity or any other earlier redemption of the bonds. The available earnings of the Corporation for any calendar year shall be the balance, to be determined by independent certified public accountants in accordance with principles of good accounting remaining after deducting from the gross revenues of the Corporation, from all sources, all its operating costs, selling, general and administrative expenses, reserves for bad debts, taxes other than income taxes, ground rents, fixed interest charges, and after deducting also a reserve for depreciation and depletion in an amount which shall in no event exceed the sum of $600,000 per annum. During the period of the three years represented by the coupons maturing April 1, 1933, up to and including October 1, 1935, such interest y payable only in multiples of 1%, and to the extent that in any year in said period interest actually paid shall be less than six per cent, the deficiency shall accumulate and shall be paid out of available earnings of later years, and if the total amount of such interest paid within said three year period, with respect to the interest for such period, shall be less than 18% of the principal of the bonds upon which the same is payable, the Corporation covenants to pay any deficiency of such interest upon maturity or any other earlier redemption of the bonds, or earlier, at the convenience of the Corporation. All coupons attached to the said bonds, which mature on April 1, 1936, and subsequently thereto, shall be paid as provided in said coupons and in the Indenture of Mortgage securing the bonds, to which the said coupons are attached, and nothing in this Supplemental Indenture shall be deemed or construed to relieve the Corporation from its obligation to pay such coupons in the manner provided in the original Indenture of Mortgage. All payments of interest hereunder shall be made without deduction for taxes in the manner and to the extent stipulated in said bonds and in the Indenture of Mortgage securing the same.

Section 3. All bonds, subject or hereafter subjected to the terms of the Plan, shall be presented to the Trustee and the six coupons maturing on April 1, 1933, October 1, 1933, April 1, 1934, October 1, 1934, April 1, 1935, and October 1, 1935, shall be removed therefrom and shall be cancelled by the Trustee. In substitution therefor 18 coupons shall be attached to the said bonds and the remaining coupons thereon, which substituted coupons shall represent the obligation of the Corporation to pay interest in multiples of 1% respectively if the available earnings of the Corporation are sufficient to permit such payment as hereinabove provided. Said substituted coupons shall each be in the following form with the exception that they may bear an appropriate symbol or letter identifying the same:

(Form of interest coupon)

No.

$10.

Unless the bond to which this coupon appertains shall have been called for previous redemption and payment duly provided for, Warner Company will pay to the bearer at the principal office of Tradesmens National Bank and Trust Company, in the City of Philadelphia, Pennsylvania, or at the principal office of Guaranty Trust Company of New York, in the Borough of Manhattan, The City of New York, or of its successor or successors, upon surrender of this coupon, Ten Dollars in lawful money of the United States of America, being on account of interest on its First Mortgage 6% Sinking Fund Bond, due April 1, 1944, when such interest shall become payable according to the terms of the Supplemental Indenture of Mortgage to which the accompanying bond has been subjected, dated the tenth day of January, 1934, but in any event not later than April 1, 1944.

Treasurer.

Following the execution of the supplemental indenture, the first-mortgage bonds were turned in to the trustee. The original semi-annual coupons falling due April 1 and October 1 of 1933, 1934, and 1935, were detached and replaced with 18 coupons of $10 each, as provided therein. At the time of this readjustment the outstanding first mortgage bonds amounted to $5,840,000 and were held by approximately 1,400 individuals.

Petitioner acquired, through purchase, some of these bonds with the 18 per cent interest coupons attached as follows:

+-----------------------------+ ¦Year¦Face value¦18% interest ¦ +----+----------+-------------¦ ¦1939¦$51,000 ¦$9,180 ¦ +----+----------+-------------¦ ¦1940¦274,000 ¦49,320 ¦ +----+----------+-------------¦ ¦1941¦490,000 ¦88,200 ¦ +----+----------+-------------¦ ¦1942¦644,000 ¦115,920 ¦ +-----------------------------+

In purchasing these bonds petitioner in most instances paid less than face value and in a few instances paid more than face value.

The gain on the acquisition of the bonds at less than face value of the principal amount of the bonds was reported in the taxable year 1941 as income. On the acquisition of the bonds at more than face value of the principal amount a net loss was claimed as a deduction in the taxable year 1942.

During the years 1932, 1933, and 1934, petitioner accrued the interest on the bonds on its books and claimed deductions on its original returns for those years of the following amounts:

+-----------------+ ¦1932¦$351,300.65 ¦ +----+------------¦ ¦1933¦350,400.00 ¦ +----+------------¦ ¦1934¦336,495.00 ¦ +-----------------+

In 1935 petitioner accrued on its books interest on the bonds in the amount of $237,465, but did not claim that amount as a deduction in its return for that year.

Petitioner's Federal income tax returns for the years 1932 to 1935 inclusive, showed losses as follows:

+-------------------+ ¦1932¦$1,616,662.77 ¦ +----+--------------¦ ¦1933¦1,579,467.41 ¦ +----+--------------¦ ¦1934¦945,754.45 ¦ +----+--------------¦ ¦1935¦614,119.72 ¦ +-------------------+

It became known in financial circles that petitioner was in the market to purchase its bonds for retirement in small blocks as funds were available. The purchases were handled by Alfred D. Warner, Jr., vice president and treasurer. The bonds were quoted to petitioner by brokers, investment bankers, and dealers and traders in securities at a flat price plus current interest or a flat price plus current interest and a brokerage of 1/4 of 1 per cent.

Petitioner had no crystallized plan for taking care of the impending maturity and back interest which matured on April 1, 1944. On December 10, 1942, an agreement was consummated whereby the maturity date of the then outstanding bonds was extended to April 1, 1951. When its bonds were purchased by petitioner, the 18 per cent unpaid back interest coupons were required to be attached to constitute good delivery. No discussion of the 18 per cent interest took place between petitioner and the sellers of the bonds for the reason that all parties holding, dealing in, and selling the bonds were aware that the 18 per cent back interest coupons were attached to each bond. When petitioner purchased a bond, or bonds, it issued a check for one amount, and no breakdown or allocation of this amount to principal, 18 per cent back interest, or accrued interest was shown on the check.

From 1929 to December 1933 the bonds of petitioner were traded in on the New York Exchange and possibly on the Philadelphia Exchange. Subsequent to 1933, the bonds were not listed, but, continuously through 1942, were actively traded in over-the-counter. The bonds were bearer bonds, and very few were registered. Petitioner purchased no registered bonds.

Except in about three instances the persons and firms from or through whom petitioner acquired its bonds were brokers, dealers, investment bankers or traders in securities. Lilley & Co., from whom petitioner bought many bonds, are traders and speculators in unlisted securities. They identify themselves with a particular security and then make a market for it. The market thus made in such securities, including the bonds of petitioner, was made by barter and almost entirely by telephone. The transactions of Lilley & Co. in bonds of petitioner during the period 1939 through 1942 totaled 623. The approximate highs and lows for each of the years 1939 through 1942 in petitioner's bonds, as disclosed by the records of Lilley & Co., were as follows:

+------------------+ ¦Year¦High ¦Low ¦ +----+------+------¦ ¦1939¦70 1/2¦70 ¦ +----+------+------¦ ¦1940¦84 ¦69 ¦ +----+------+------¦ ¦1941¦95 ¦90 ¦ +----+------+------¦ ¦1942¦97 1/4¦91 1/2¦ +------------------+

Petitioner was only one of Lilley & Co.'s patrons and they dealt with petitioner at arm's length on quoted prices. Lilley & Co. canvassed other brokers and dealers and in some cases circularized particular areas in dealing in petitioner's bonds. Their transactions with petitioner in the latter's bonds were numerically much fewer than Lilley & Co. had in the street.

In its returns for the years 1941 and 1942, petitioner excluded from income subject to tax, and included in its analysis of surplus as items of nontaxable income, amounts of $88,200 and $115,920, respectively, with the explanation that they represented gain on cancellation of 18 per cent accrued interest on bonds acquired, which interest had not been effective in reducing taxable income when previously accrued and deducted in its returns. In its returns for 1939 and 1940, petitioner excluded from taxable income similar items in the amounts of $9,180 and $49,320, respectively.

In 1942 petitioner was convinced it would be unable to pay its outstanding bonds and the ‘18 per cent interest‘ thereon by the maturity date in 1944. And, as heretofore stated, it negotiated for a seven-year extension. Only by agreeing to pay the 18 per cent interest was petitioner able to secure this extension. The agreement was consummated on December 10, 1942. On that date petitioner paid to the then bondholders the 18 per cent interest, amounting to the sum of $709,380. The maturity date was thereupon extended to April 1, 1951. None of the bonds on which the 18 per cent interest was paid were retired in 1942. In its 1942 income tax return petitioner did not claim any part of the $709,380 payment as a deduction. By amended petition the amount of $709,380 is claimed as a deduction for 1942 from normal tax net income and excess profits net income, representing accrued but unpaid interest totaling 18 per cent for the years 1933, 1934, and 1935, which was thus actually paid in 1942.

During the years 1940, 1941, and 1942, petitioner accrued and subsequently paid on behalf of those of its bondholders residing in Pennsylvania the Pennsylvania corporate loans taxes in the amounts of $9,103.58, $9,015.50, and $8,490.77. All of these amounts were deducted by petitioner in determining its normal tax net income and excess profits net income in its returns for the respective years. In his deficiency notice the respondent, in computing petitioner's excess profits tax, disallowed 50 per cent of such deductions on the ground that such amounts represented interest on borrowed capital.

The Pennsylvania corporate loans taxes, referred to above, were paid by petitioner pursuant to the Pennsylvania Corporate Loans Tax Law, Act of June 22, 1935, Public Law 414, and pursuant to the provisions of the original and supplemental mortgage indentures covering the first mortgage 6 per cent bonds.

In April 1929 petitioner sold to the bankers 31,500 shares of its first preferred stock. The amount received by petitioner was $2,850,750, representing $90.50 per share. The bankers in turn sold the first preferred stock for $98 or $99 per share, realizing $3,087,000. The difference between what the bankers paid to petitioner and the amount received is $236,250. Petitioner also sold to the bankers for cash $7,000,000 of its first mortgage bonds. In connection with the purchase of the bonds and the first preferred stock of petitioner, the bankers received, as part compensation to the underwriters, 18,980 shares of no par common stock of petitioner, which had a fair market value of $40 per share when issued, aggregating $759,200. The fair market value of the no par common stock was allocated between the bonds and first preferred stock as follows:

+----------------------------------------+ ¦Allocable to bonds ¦$523,586.21¦ +----------------------------+-----------¦ ¦Allocable to preferred stock¦235,613.79 ¦ +----------------------------+-----------¦ ¦Total ¦759,200.00 ¦ +----------------------------------------+

The amounts so allocated represent additional cost of the issuance of the respective securities. The issuance of the common stock, the first preferred stock and the bonds and the receipt of the funds by petitioner took place simultaneously on April 8, 1929, in accordance with the original contract as amended by subsequent agreements between petitioner and the bankers.

In its 1940, 1941, and 1942 returns petitioner deducted the unamortized portion of the debt discount and expense originally incurred in 1929 applicable to the first mortgage bonds retired in 1940, 1941, and 1942 in the respective amounts of $4,514.61, $3,674.92, and $10,788.27.

In his deficiency notice the respondent, in determining excess profits net income for each year, disallowed the deduction of all of such amounts, but allowed the deductions in computing petitioner's normal tax net income for each of those years.

Petitioner during all the periods involved herein was solvent.

OPINION.

LEECH, Judge:

The first question presented is whether petitioner realized a taxable gain by the purchase and retirement of certain of its bonds at less than face value in the years 1940, 1941, and 1942. A determination of this issue as to 1940, pertinent in arriving at the net income for 1940, is material only for the purpose of computing the excess profits credit carry-over. Petitioner contends that the situation is controlled by Helvering v. American Dental Co., 318 U.S. 322, and there was a gratuitous forgiveness of indebtedness of both principal and interest. The respondent argues that the facts presented require the application of the rationale of United States v. Kirby Lumber Co., 284 U.S. 1.

The record satisfactorily establishes that during the period involved the bonds of petitioner were actively traded in as unlisted securities in over-the-counter transactions at various quoted prices. Purchases and sales in which petitioner was not involved numerically exceeded those in which petitioner engaged. All of such trading and dealing in such securities was at arm's length and based on quoted prices. Where willing buyers and willing sellers freely trade in a given security, we think there exists an ‘open market.‘ Where there exists an ‘open market‘ establishing market value, a situation is presented where the principle of forgiveness has no proper application. In such circumstances, we regard it as immaterial whether the securities are acquired at less than face value in a transaction direct with the creditor, or through agents. In the recent case of Commissioner v. Jacobson, 164 Fed. (2d) 594; certiorari granted (Apr. 5, 1948), relied upon by petitioner, it is stated: ‘As the Tax Court found, none of these bonds were listed or had a quoted price and nobody was buying them except the taxpayer * * * .‘

The situation disclosed by this record requires us to hold that the instant case is controlled by United States v. Kirby Lumber Co., supra. Cf. Edmont Hotel Co., 10 T.C. 260.

There remains to be considered how the amount of realized gain on the principal of the bonds is to be determined. Each bond which petitioner purchased had attached coupons of the face value of $180, representing back interest for the prior years of 1933, 1934, and 1935. Such coupons were required to be attached to the bonds to constitute proper delivery. When petitioner purchased a bond or bonds it issued a check for one amount, to cover the principal, the 18 per cent accrued interest, and the current interest. Petitioner made no allocation or breakdown between principal and the 18 per cent back interest. Since it was the obligation of petitioner to pay both the principal of the bonds and the 18 per cent interest, the respondent contends that the amount paid should be appropriately allocated. He suggests two methods: (1) The application of the amounts paid, first to interest and the remainder to principal, or (2) the allocation of the total amount to principal and to the 18 per cent interest on a proportionate basis. The respondent argues that the latter method is the more equitable. We hold that the latter method is proper. The rule that, where an amount is paid as an unallocated unit on a debt and interest thereon, such amount should first be applied to the interest due and the balance to the principal debt, has no application where the entire debt, including the interest, is being liquidated by such unit payment. Since the basic figures are not in dispute and the allocation is purely mathematical, the appropriate amounts can readily be determined in a computation under Rule 50.

We have found as a fact that petitioner received no tax benefit in the years 1933, 1934, and 1935, when it accrued on its books and claimed as a deduction the interest represented by the 18 per cent coupons attached to the bonds purchased during the period involved. Respondent concedes that, to the extent petitioner received no tax benefit from the interest deductions in the tax years 1932 to 1935, inclusive, the portion of the gain attributable to back interest should not be included in petitioner's taxable income for the taxable years involved. We do not agree with the contention of petitioner that if we determine, as we have, that the purchase price is to be allocated between principal and the 18 per cent interest, that portion allocated to interest constitutes a proper deduction in the respective years the bonds were purchased. The basis for our conclusion will be discussed in connection with the next issue, which also involves a claimed deduction for interest paid.

The second issue presented is whether petitioner is entitled to deduct from gross income the amount of $709,380, as interest paid on its bonds in the taxable year 1942. This item of interest represents the 18 per cent interest coupons attached to petitioner's bonds still outstanding in 1942.

The pertinent facts underlying this issue may be briefly summarized. Petitioner's bonds and the accrued 18 per cent interest coupons matured on April 1, 1944. Petitioner, realizing it would be unable to meet the maturity date, began negotiations for a seven-year extension until April 1951. Such an agreement was consummated with the then bondholders on December 10, 1942, upon condition that petitioner make immediate payment of the deferred interest. On December 10, 1942, petitioner paid such interest, totaling $709,380. Petitioner now contends that it is entitled to an interest deduction in 1942, the year of payment. Petitioner used the accrual system of accounting and concedes that is interest must be deducted when it accrues. Petitioner argues, however, that the supplemental indenture under which the 18 per cent interest coupons were substituted for the original coupons attached to the bonds which required the payment of interest semi-annually on April 1 and October 1 in the years 1933, 1934, and 1935 extended the liability to pay the interest, so that the amounts of interest accrued on its books in those years were items which were properly deductible for income tax purposes in 1942 when paid. The argument, we think, is without substance. The supplemental indenture did not postpone or alter the unconditional liability to pay such interest. It merely extended the time for payment. All the events occurred which fixed the amount and determined the liability for the interest, and under petitioner's accrual system of accounting the right to deduct the amounts of interest became absolute in the years when accrued, notwithstanding actual payment was not made until a later date. Such rule is firmly established. United States v. Anderson, 269 U.S. 422; American National Co. v. United States, 274 U.S. 99; Cumberland Glass Mfg. Co. v. United States, 44 Fed.(2d) 455. The fact that petitioner in such years had other deductions, so that it would receive no tax benefit from the amounts of interest accrued in those years, is not controlling.

We conclude that petitioner is not entitled to deduct the sum of $709,380 as interest paid in the taxable year 1942.

The third issue raises the question whether certain amounts accrued by petitioner as Pennsylvania corporate loans taxes represent additional interest on borrowed capital. During the years 1940, 1941, and 1942, petitioner accrued and subsequently paid on behalf of those bondholders residing in Pennsylvania the respective amounts of $9,103.58, $9,015.50, and $8,490.77 representing Pennsylvania corporate loans taxes. The respondent disallowed as a deduction 50 per cent of such amounts in computing petitioner's excess profits net income for each of those years, pursuant to section 711(a)(2)(B) of the Internal Revenue Code. It is the respondent's position that these payments constitute interest on borrowed capital. Petitioner contends the payments are deductible, payments of tax or business expense, and that it is entitled to deductions of the entire amounts paid. It is stipulated that the Pennsylvania corporate loans taxes here involved were imposed against the individual bondholders. In order to make its bonds more attractive to Pennsylvania investors, petitioner's bonds provided that the 6 per cent interest shall be paid ‘without deduction for any taxes, assessments or other governmental charges payable to the Commonwealth of Pennsylvania, * * * but not in any calendar year in excess of four (4) mills upon each dollar of the face value of such bonds.‘ Petitioner treated these payments on its books as tax payments and so claimed deductions as payments of Pennsylvania corporate loans taxes. It is well settled that taxes are deductible only by persons against whom they are imposed. Pacific Southwest Realty Co., 45 B.T.A. 426; affd., 128 Fed.(2d) 815; certiorari denied, 317 U.S. 663. The voluntary assumption of the tax liability of another does not, under that rule, render the contested item deductible as a payment of tax or as a business expense. National Piano Mfg. Co. v. Burnet, 50 Fed.(2d) 310; Robinson v. Commissioner, 53 Fed. (2d) 810. We think the payments by petitioner of the Pennsylvania loans tax in the years involved constituted, in effect, additional interest to its bondholders resident in Pennsylvania. The respondent's allowance of only 50 per cent of the amounts paid, pursuant to section 711(a)(2)(B) of the code, is sustained.

SEC. 711. EXCESS PROFITS NET INCOME.(a) TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1939.— The excess profits net income for any taxable year beginning after December 31, 1939, shall be the normal-tax net income, as defined in section 13(a)(2), for such year except that the following adjustments shall be made:(2) EXCESS PROFITS CREDIT COMPUTED UNDER INVESTED CAPITAL CREDIT.— If the excess profits credit is computed under section 714, the adjustments shall be as follows:(B) Interest.— The deduction for interest shall be reduced by an amon? equal to 50 per centum of so much of said interest as represents interest on the indebtedness included in the daily amounts of borrowed capital (determined under section 719(a)).

Pennsylvania Corporate Tax Law, Act of June 22, 1935, Public Law 414.

The fourth issue presents the question whether the respective amounts of $236,250 and $235,613.79 should be included in petitioner's equity invested capital for the taxable years involved. The amount of $235,613.79 represents the allocated portion of the fair market value of 18,980 shares of petitioner's no par value common stock, having a fair market value of $40 per share, which petitioner issued to the bankers as commissions for the sale of its preferred stock.

Petitioner admits that the case of Palomar Laundry, 7 T.C. 1300, supports the respondent's disallowance of the amount of $235,613.79 as equity invested capital. The facts in the instant case are indistinguishable from those in the cited case and, on the authority of Palomar Laundry, supra, we sustain respondent.

The amount of $236,250, which is also in issue, represents the difference between the price at which the bankers received the first preferred stock from the petitioner and the price at which the bankers sold the stock to the public. Petitioner relies on American Business Credit Corporation, 9 T.C. 1111.

The material facts on which our decision in the American Business Credit Corporation case was premised are clearly distinguishable from the facts here. In the instant case, the record establishes quite plainly that the bankers purchased for their own account a specified number of shares of petitioner's first preferred stock at $90 per share. The agreement between petitioner and the bankers provides that petitioner ‘shall sell to Bankers and Bankers shall purchase from Company Twenty-three thousand two hundred twenty-three (23,223) shares of said first preferred stock at $90.00 per share * * * . Bankers may sell said stock at any price they may fix; but if in their discretion they sell said stock to the public at a price in excess of $98.00 per share * * * then the Bankers will divide any excess over the sales prices mentioned per share, and accrued dividend, equally with the Company.‘ Petitioner contends that this latter provision to divide the excess constitutes the bankers the agents of petitioner. We do not agree with this construction of the agreement. The contingency under which there was to be a division of the excess price received on a resale to the public was for the purpose of limiting the profit of the bankers. It does not change the character of the agreement as one of purchase and sale between the bankers and petitioner. In American Business Credit Corporation, supra, the broker was the mere agent o?the taxpayer. We, therefore, determine that the gross proceeds received from the stockholders were to be properly included in the taxpayer's equity invested capital. It should be noted, however, that in the last cited case the facts show that, inter alia, the agreements also provided for the sale by the taxpayer and the purchase by the broker of three blocks of 20,000 shares each of common stock at the respective prices of $5, $5.50 and $6 per share, and a reoffering by the brokers of such shares to the public at an additional price of $1.25 per share. In its equity invested capital the taxpayer included only the sum of $330,000, representing the net amount received from the broker for the 60,000 shares sold to the broker. The respondent made no adjustment with respect to such amount. No issue was therefore presented as to the inclusion of the additional $1.25 per share in taxpayer's equity invested capital.

In the instant case the bankers were not agents for petitioner, taxpayer, in the purchase of the stock. They were themselves the purchasers of the stock. They bought at a discount from par, and the profit realized on a resale to the public is not to be included in petitioner's equity invested capital. Cleveland Graphite Bronze Co., 10 T.C. 974. We sustain the respondent on this issue.

The fifth issue presents the question whether in computing excess profits net income the respective amounts of $4,514.61, $3,674.92, and $10,788.27, representing unamortized debt discount and expense originally incurred in 1929, applicable to the first mortgage bonds retired in 1940, 1941, and 1942, are deductible.

In computing normal tax net income, petitioner included in gross income the gross gain realized on the retirement of its bonds issued at less than par. It then took as a deduction the unamortized debt discount. In computing excess profits net income, petitioner deducted the gross amount of gain realized on the retirement of its bonds issued at a discount from normal tax net income.

When a corporation purchases any of its bonds at a price less than the issuing price, as in the instant case, the net gain or income therefrom is the difference between the purchase price and the face value minus any amount of discount not yet deducted. Expense incident to the issuance of bonds is, of course, in the same category for present purposes as the discount. This is apparently conceded. The income thus determined is to be included in gross income for normal tax purposes. Treasury Regulations 111, sec. 29.22(a)-17(3)(a). In determining excess profits net income, the basis for which is normal tax income, income from retirement or discharge of bonds outstanding for more than 18 months, later amended to six months, is to be excluded under section 711(a)(2)(E). The amount to be so excluded in determining excess profits net income is the same amount which is included in gross income for the purposes of determining normal tax net income. Since the amount of unamortized discount is reflected in determining the net gain or income by reducing that figure for normal tax purposes, no further adjustment is necessary or proper in computing excess profits net income. The correct amount of gain or income realized by petitioner upon the retirement of its bonds in the respective years involved, determined under the method of allocation hereinabove adopted as proper, is includible in petitioner's gross income for the purpose of arriving at normal tax net income, and such amount is to be excluded in computing petitioner's excess profits net income.

See Sec. 711(b), I.R.C.

In the taxable years 1940 and 1941, section 711(a)(2)(E) required the obligations to be outstanding more than ‘eighteen months.‘ The section was amended by section 207(d) of the Revenue Act of 1942 by inserting ‘6 months‘ in lieu of ‘eighteen months.‘ The amendment was made effective for the taxable years beginning after the year 1941.

Certain other facts and figures have been stipulated, some of which are dependent upon our determination of the issues presented. In the computation under Rule 50, all stipulated facts will be considered and appropriately applied.

Decision will be entered under Rule 50.