Fairbanks, Morse & Co. v. Harrison (63 F. Supp. 495, 1945)

CAMPBELL, District Judge.

This is a consolidated action involving four separate suits for the recovery of federal income and excess profits taxes:

Cause No. 4828.

On November 6, 1942, plaintiff, Fairbanks, Morse & Company, a corporation, filed its complaint in two counts. The first count alleges that on July 13, 1937, this plaintiff filed its income and excess profits tax return reporting an income tax liability of $355,774.76, which was duly paid. In reporting its gross income for the year 1936, the plaintiff claimed a deduction of $188,722.22 as a bad debt loss. This amount is claimed as the balance left due and owing to the plaintiff from Fairbanks, Morse Home Appliances, Inc., a corporation (whose stock was wholly owned by the plaintiff), after the complete liquidation and dissolution of the subsidiary corporation during 1936 and the application of its remaining assets to the partial payment of its open account with the plaintiff. In this count it is also alleged that plaintiff claimed a loss in its 1936 tax return of $7,110 which represented the cost to it of the capital stock of the subsidiary. Subsequently, the Commissioner disallowed these deductions and assessed additional tax and interest against the plaintiff in the sum of $82,444.10, which plaintiff paid. This assessment included an additional tax and interest thereon of $57,893.06 on the plaintiffs reduced claim of $128,466.63 as bad debt and investment loss in the subsidiary. Plaintiff contends that the bad debt and investment loss is properly deductible from gross income under Section 23(f) of the Revenue Act of 1936, 26 U.S.C.A. Int. Rev. Code, § 23(f), and now seeks to recover the tax that was assessed and paid on this amount.

In the same count, the plaintiff alleges that in its tax return for the year 1936, it failed to exclude from gross income the sum of $12,101.54 which it received in that year on bad debts that had previously been charged off in the tax years of 1931, 1932, and 1933. It is alleged that the charge offs did not result in tax benefit to the plaintiff because of large losses sustained in those years. Recovery is sought under what plaintiff contends to be an established principle of law as well as under Section 116 of the Revenue Act of 1942 which amended Section 22(b) of the Internal Revenue Code, 26 U.S.C.A. Int.Rev. Acts.

Also in the first count in Case No. 4828 plaintiff alleges that in its tax return for 1936 it failed to exclude from its gross income the sum of $24,645.98 which it received in 1936 as tax exempt interest on obligations of municipalities and other political subdivisions of the various states; that these obligations consisted of notes, warrants, certificates, bonds and other instruments executed and delivered by said municipalities and political subdivisions to the plaintiff in payment of the purchase price for machinery and equipment which they had bought, installed, operated and maintained as plants or facilities for the production of heat, water, light or power; that in the first instance1 general purchase agreements were executed whereby the municipalities became obligated to pay plaintiff the purchase price or unpaid portion thereof of the machinery and equipment and subsequently the notes, warrants, bonds, certificates or other instruments were issued by the municipalities pursuant to the terms of the purchase agreement; that with respect to such interest, the obligations are divided into two classes: (1) Instruments which bear interest by the terms thereof; and (2) instruments which do not specifically provide for the payment of interest but in the face amount thereof actually include interest to maturity on the unpaid balance of the purchase price. Plaintiff filed its claim for refund of taxes on the foregoing items and subsequently received from the Commissioner of Internal Revenue notices of disallowance and rejection after which the additional tax was assessed and paid.

In the second count of Case No. 4828 it is alleged that in its income and excess profit tax return for the calendar year 1938 plaintiff reported an income tax liability of $583,539.66 which was duly paid; that in the year 1937, plaintiff sustained a bad debt loss of $478,506 which it failed to deduct in tax return for that year; that the loss was sustained on an open account with its wholly owned subsidiary, Fairbanks, Morse & Company, Ltd., of London, England, which since 1909 had bought and resold plaintiff’s products in the United Kingdom. It is also alleged that the plaintiff sustained a further loss of $24,200 which represented the cost to plaintiff of the capital stock of the London Company, and that it likewise failed to deduct this loss in its 1937 tax return, that both losses resulted from the liquidation and dissolution of the subsidiary in January 1937, by reason of the assets remaining after the payment of other debts being insufficient to pay the balance of its open account with plaintiff.

Also in the second count plaintiff seeks recovery of tax on $26,606.02 which it received as interest on municipal obligations similar to those involved in the first count. The total tax sued for in the second count is the sum of $160,116.02 and interest.

Cause No. 4829.

On November 6, 1942, plaintiff in this case, Municipal Acceptance Corporation, filed its complaint seeking recovery of the sum of $20,036.63 in income and excess profit taxes for the calendar year 1937. It is alleged that on March 15, 1938, plaintiff filed its income and excess profit tax return for 1937 showing tax liability of $34,255.10 which was paid; that in the return plaintiff failed to exclude from gross income tax exempt interest in the sum of $73,983.27, which it received during 1937 from municipalities of the various states; that the interest was paid on obligations issued by such municipalities for (1) cash advanced by plaintiff to the municipalities which was used to purchase machinery and equipment chiefly from Fairbanks,- Morse & Company for the construction, maintenance and operation of municipally owned power and water plants; or (2) on obligations issued by such municipalities to Fairbanks, Morse & Company in payment for such machinery and equipment which obligations were then purchased by plaintiff, Municipal Acceptance Corporation.

Since both of the above causes, insofar as the claims for recovery of taxes paid on interest alleged to be exempt are concerned, involve common questions of law and fact, they were by this court ordered consolidated for trial on March 22, 1943, as consolidated Cause Number 4828. Thereafter, a hearing was had on the issues in the consolidated cause and an agreed stipulation of facts was filed. Subsequently briefs were filed with the court by both parties. The briefs indicated a difference in the opinions of the parties with respect to the effect of the facts set forth in the stipulation and therefore this court ordered a further hearing on the issues to clarify all objections of the parties to the testimony heard or exhibits introduced, as well as to the contents of the stipulation of facts.

Cause No. 44 C 1442.

On November 28, 1944, the Municipal Acceptance Corporation filed its complaint seeking recovery of $11,755.95 in income and excess profit taxes on income which it failed to exclude from gross income in its tax return for the calendar year 1938. The income was in the form of interest received by the plaintiff from municipalities and the issues involve facts similar to those, in the preceding Causes Nos. 4828 and 4829.

Cause No. 44 C 1568.

On December 15, 1944, plaintiff Fairbanks, Morse & Company filed its complaint seeking recovery of an overpayment of $4,511.43 in taxes on income received in the calendar year 1938, in the form of interest on obligations issued by municipalities in circumstances, manner and form similar to those set forth in Complaint No. 4828. In this complaint, plaintiff also seeks to recover the tax paid on recoveries in 1938 of bad debts in the sum of $2,143.89 which it failed to deduct in its income tax return for that year. It is alleged that these debts had been deducted in tax returns for 1931, 1932 and 1933, without tax benefit.

On April 3, 1945, the latter Causes Nos. 44 C 1442 and 44 C 1568 were on agreed motion of all parties by order of this court consolidated for trial with Causes Nos. 4828 and 4829, and these four causes are now before the court as Consolidated Cause No. 4828.

After the four causes were consolidated, ‘he plaintiff introduced further testimony into the record pertaining to the value of the assets received by the plaintiff after the dissolution of the two subsidiary companies and which were applied toward payment of their respective open accounts with plaintiff. With respect to the claims in the latter suits, No. 44 C 1442 and 44 C 1568, for recovery of taxes paid on interest received on municipal obligations, a supplemental stipulation of facts was filed by the parties. The supplemental stipulation also contains certain statements which relate to the character of the entries made by the plaintiff Fairbanks, Morse & Company on its books with respect to the recoveries of bad debts claimed as deductions in the first count of Cause No. 4828.

While it is claimed that the liquidation of the two subsidiaries, Fairbanks, Morse Home Appliances, Inc., and Fairbanks, Morse & Company, Ltd., resulted in losses to plaintiff Fairbanks, Morse & Company from similar circumstances, there is a difference in the proof with respect to the two losses and these claims will be discussed separately in this opinion. The claims for recovery on bad debt exclusions in Causes No. 4828 for the year 1936 and No. 44 C 1568 for the year 1938 will be discussed as a single item. The claims for recovery of taxes paid on interest received on obligations of municipalities will also be discussed here as a single item.

To the complaints described above the defendant has filed answers which, in substance, admit allegations of fact where the facts appear of record, assert lack of knowledge of factual allegations which do not appear of record and deny all liability. Fairbanks, Morse Home Appliances, Inc.

This item is claimed as a deduction for the year 1936, by the plaintiff, Fairbanks, Morse & Company. The facts relied on to establish the right to this deduction are found in the written stipulation or in the exhibits attached thereto.

The plaintiff, Fairbanks, Morse & Company, has for a long time been a manufacturer of scales and similar articles. In April of 1934 the plaintiff purchased all of the capital stock of Audiola Radio Company for the sum of $7,110. A purchase agreement was executed. This agreement is of significance only because it contains a provision that the plaintiff should provide the Audiola Radio Company with necessary working capital not to exceed the sum of $75,000 by way of inter-company loans or advances on open account from the purchaser to or for the Audiola Radio Company; or at the option of the purchaser by purchasing additional capital stock of Audiola Radio Company. This provision is the basis for one of the contentions advanced by the defendant that the plaintiff could not have suffered a bad debt loss as the result of advances to the subsidiaries because such advances constituted investments rather than debts.

After the acquisition by plaintiff of Au-diola, the company immediately commenced to manufacture radios, refrigerators and washing and ironing machines. Two months later the name of this subsidiary was changed to Fairbanks, Morse Home Appliances, Inc. It appears from the stipulation of facts that from the time of the acquisition of the subsidiary, the plaintiff paid from its own bank account the cost of most of the materials and merchandise purchased by Home Appliances, Inc. To evidence these transactions such expenditures were entered on plaintiff’s books as debits in an account with Home Appliances, Inc. From time to time as finished goods were sold by Home Appliances. Inc., the proceeds of the sales were deposited by the subsidiary in its own bank account and at intervals remittances were made to the plaintiff in reimbursement. The plaintiff credited such remittances to its account with Home Appliances, Inc. The stipulation specifically states that these debits and credits were entered in the running account with Home Appliances, Inc.

On April 16, 1935, pursuant to a resolution of its Board of Directors, Home Appliances, Inc., ceased depositing in its own bank account the proceeds received from the sale of its products and instead forwarded such remittances for deposit in plaintiff’s bank account. The reason for this action does not appear in the stipulation or in the evidence introduced in the case. Thereafter plaintiff forwarded to Home Appliances, Inc., funds necessary for the payment of expenses and these were the only funds then deposited in the bank account of the subsidiary.

From the minutes of the meetings of Directors and Stockholders of Home Appliances, Inc., it appears that on January 2, 1936, it was decided to liquidate the Company by selling its assets to the plaintiff in consideration of the plaintiff assuming all of the debts of the subsidiary. On January 3, 1936, a bill of sale was executed embodying such provisions.

The sale of the assets of Home Appliances, Inc., to the plaintiff was carried out by the transfer to the plaintiff of all assets of the subsidiary. These assets were credited on plaintiff’s books to the account of Home Appliances, Inc. The gross amount credited was the sum of $681,302. The amount of the credit was determined by an appraisal by one of the officers of both the plaintiff and the subsidiary who appears to have been well qualified in that field. The values given to the merchandise, machinery, etc., were cost, or market, as of January 3, 1936, which ever was lower.

At the time of the dissolution of the subsidiary, its account with the plaintiff showed that it owed plaintiff the sum of $796,056.17. After the credit of assets remaining after the payment of other debts, plaintiff’s books showed a balance still due from the subsidiary on open account of $188,722.22. After credits for certain reserves, this balance was reduced to the sum of $128,466.63.

In its tax return for the year 1936, the plaintiff claimed the latter amount as a deduction from its income for that year. It also claimed as a deduction from income, the sum of $7,110 as an investment loss resulting from the liquidation of the subsidiary. This amount represented the cost to plaintiff of the original stock of the Au-diola Radio Company. In due course, after investigation and reports thereon were made by agents of the Bureau of Internal Revenue, these deductions were disallowed by the Commissioner of Internal Revenue.

The defendant contends that plaintiff is not entitled to this deduction because:

1. Plaintiff actually purchased the assets of the subsidiary and thereby extinguished the debt.

2. The payments made by the plaintiff for merchandise purchased by the subsidiary actually were investments and did not create debts.

3. Or, assuming that these payments did create debts owing to the plaintiff, the plaintiff did not ascertain the debts to be worthless and charge them off in the year 1936.

As to defendant’s contention that the payments advanced by the plaintiff did not create debts no applicable authorities are cited. Whether the funds advanced by the plaintiff as the sole owner of the stock of Home Appliances, Inc., were loans or contributions .to capital depends entirely upon the circumstances under which they were made. Such advances would be additional contributions to capital only if they had been intended to enlarge the stock investment and had not been intended as loans. Edward Katzinger Company v. Commissioner, 44 B. T. A. 533. Here the parties intended these advances as loans. This is shown by the character of the transactions. The plaintiff carried on its books an open account with Home Appliances, Inc. In this account the payments and advances were charged .to the subsidiary and remittances were credited to the account. The plaintiff did not purchase any additional capital'stock of the subsidiary. The contract whereby plaintiff acquired the stock of the subsidiary provided that advances made by the plaintiff should be in the form of inter-company loans or advances on open account unless plaintiff purchased additional capital stock of the subsidiary. Therefore, this portion of plaintiff’s claim falls within the well established rule that when the wholly owned subsidiary is liquidated jby the transfer of its assets to the parent company, the latter can deduct whatever loss results in the form of an unpaid balance due from the subsidiary on open account. Edward Katzinger Company v. Commissioner, 44 B.T.A. 533; H. G. Hill Stores, Inc., v. Commissioner, 44 B. T. A. 1182. This rule must govern the foregoing facts in this case unless the defendant can show that for some other reason plaintiff is not entitled to this deduction as a bad debt loss.

Defendant 'also contends that in the liquidation and dissolution of the subsidiary, Home Appliances, Inc., plaintiff purchased the assets of the subsidiary and in consideration therefor agreed to assume and discharge all of its liabilities. By this method, it is asserted plaintiff cancelled .the indebtedness due from the subsidiary.

A bill of sale was executed by Home Appliances, Inc. It recites the consideration to be the assumption and discharge by the plaintiff of all accrued liabilities of the subsidiary. The minutes of a directors’ meeting of Home Appliances, Inc., held on January 2, 1936, indicate that it was the intention of the directors to effect a dissolution of ¡the company by a sale of the assets to plaintiff Fairbanks, Morse & Company in consideration of .the plaintiff assuming and discharging all of the accrued liabilities of the subsidiary. However, this is not a novel method of liquidating a subsidiary without impairing, for income tax purposes, an unpaid debt due the parent company. This was the exact situation in the case of H. G. Hill Stores, Inc., v. Commissioner, 44 B.T.A. 1182, where the right to deduct from gross income the balance of indebtedness for advances made by the parent corporation to the subsidiary after the application to the account of all of the assets of the subsidiary was upheld. The defendant does not cite any cases in support of a different rule. The case of Dreyfuss v. Commissioner, 5 Cir., 140 F.2d 922, cited by plaintiff, does not involve similar facts.

Next, defendant argues that assuming there was an indebtedness, plaintiff did not both ascertain the debts to be worthless and charge them off in 1936. It is further argued that in order to show that the debt was ascertained to be worthless, the proof must show that the debt was collectible in the preceding year. I do not un•derstand this to be the law and the defendant does not cite cases to support such an •argument.

To entitle the taxpayer to deduct a bad debt he must show: First, that the ■debt actually was uncollectible during the year in which he claims the deduction; and second, that he actually ascertained the worthlessness for the first time and charged off the debt in the tax year in question. San Joaquin Co. v. Commissioner of Internal Revenue, 9 Cir., 130 F.2d 220. This involves a subjective test; that is, the proper year to claim the deduction is the one in which the taxpayer ascertained the debt to be worthless and charged it off. The stipulation of facts shows that on January 2, 1936, Home Appliances, Inc., owed plaintiff, Fairbanks, Morse & Company, the sum of $796,056.17; that the plaintiff received from the subsidiary, after deducting all liabilities except its own debt, assets of the value of $607,333.95, which left an unpaid balance on the open account between the plaintiff and the subsidiary of $188,722.22. After deduction of $60,255.59 representing certain allowances and reserves, there was a net balance still due the plaintiff in the sum of $128,466.63. By the terms of the stipulation, the entries reflecting this indebtedness, the application of the assets of the subsidiary to (the indebtedness, and the net balance due plaintiff, appear in the form of regular entries on plaintiff’s books. Certainly when such a substantial amount of assets was received from the subsidiary and was applied to the indebtedness due from it to the plaintiff and credits reflecting this transaction were entered in plaintiff’s books, the entire debt due the plaintiff in any prior year from Home Appliances, Inc., could not have been worthless. For the same reason the plaintiff must have first ascertained in 1936, the portion of the debt that was worthless. The rule is well settled that the taxpayer need not claim a deduction for partial worthlessness of a bad debt. He may do so at his option. But, i f he fails to do so in any year, this fact does not foreclose a taxpayer from claiming in a later year a deduction for partial or complete worthlessness of the debt. Reed v. Commissioner, 4 Cir., 129 F.2d 908; Blair v. Commissioner, 2 Cir., 91 F.2d 992: Moock Electric Supply Company v. Commissioner, 41 B.T.A. 1209. Therefore, when Home Appliances, Inc., was liquidated in 1936, plaintiff was entitled to deduct .from gross income .the unpaid balance due on its account with the subsidiary.

Defendant next argues that even if the plaintiff’s advances to the subsidiary constitute debts and were ascertained to be worthless and charged off in 1936, the plaintiff has not established the corree; amount of such worthless indebtedness. The only argument made in support of this contention is that the correct value of the assets of Home Appliances, Inc., was not ascertained when they were transferred to the plaintiff in 1936. A true and correct balance sheet of Home Appliances, Inc., as of December 31, 1935, is attached to the stipulation of facts. The balance sheet shows an account due and payable to the plaintiff in the sum of $796,056.17. The balance sheet is stipulated to be true and correct. Therefore, the amount of the entire indebtedness is not in controversy. At the second hearing before this court on June 15, 1945, plaintiff introduced in evidence tlxe testimony of S. T. Kiddoo, the Vice President and Treasurer of plaintiff, Fairbanks, Morse & Company, on the value of the assets of the subsidiary when they were transferred ,to the plaintiff. This testimony showed the witness to be well qualified in the valuation of the assets involved and also showed the value of such assets to be the same as that set forth in the stipulation, namely, $681,302.00. After deducting liabilities due to others than the plaintiff in the sum of $73,968.05, the value of the assets remaining was $607,333.95 as shown on the plaintiff’s books. Therefore, the bad debt deduction claimed by plaintiff in the sum of $128,466.61 is sustained.

Capital Stock of Home Appliances Inc.

The plaintiff’s claim of an investment loss on account of the capital stock of Home Appliances, Inc., becoming worthless involves a different rule of law. The year in which the stock became worthless is purely a question of fact. To be entitled to a deduction on account of stock becoming worthless, the taxpayer must submit evidence to show that the stock actually became worthless in the year for which the deduction is claimed. Bartlett v. Commissioner, 4 Cir., 114 F.2d 634, and cases there cited, San Joaquin Co. v. Commissioner of Internal Revenue, 9 Cir., 130 F.2d 220. To discharge this burden of proof it is imperative that the evidence show that the stock had some value, potential or intrinsic, in the preceding year. In the instant case, the stipulation of facts does not contain any statements relative to the value of this stock. The stipulation does recite that the plaintiff purchased the stock of Audiola Radio Company (name later changed to Fairbanks, Morse Home Appliances, Inc.) on April 18, 1934, for, the sum of $7,110; that on December 31, 1935, plaintiff charged its earned surplus with the book deficit of Home Appliances, Inc., as of December 31, 1934, in the amount of $103,177.81. Also on December 31, 1935, plaintiff charged its general profit and loss account with the sum of $99,748.-71, which represented the net loss of Home Appliances, Inc., for the year 1935. In its tax return for the year 1935, plaintiff increased its book income for that year by $99,748.71, thereby including this amount as taxable income for that year. However, this would not alter .the fact that Home Appliances, Inc., did sustain a net loss of that amount at the close of the year 1935. The balance sheet of Home Appliances, Inc., attached to the stipulation dated as of December 31, 1935, shows that the liabilities of the subsidiary far exceeded its assets at that time. If measured by the ratio of assets .to liabilities, the proof would not show that the capital stock of Home Appliances, Inc., ever had any value or that it actually became worthless in the year 1936.

However, Home Appliances, Inc., continued in operation only from April 18, 1934, until January of 1936. Defendant concedes that this company was a new business venture by the plaintiff. After it acquired the stock, plaintiff advanced to the subsidiary over a million dollars by way of advances and loans for the payment' of merchandise. The subsidiary continued in active operation until in January 1936. The value of the stock during the life of the subsidiary always depended upon future possibilities. This is often true when new firms risk their capital in new ventures. Therefore, the stock of the subsidiary must have had a potential value so long as it was backed by the assets of the plaintiff.

It is a well established rule that when a subsidiary corporation that is wholly owned by a taxpayer ceases doing business the parent corporation can take its loss on the capital stock of the subsidiary in the year of its cessation. In the case of American Utilization Company v. Commissioner, 38 B.T.A. 322, it was held that mere depreciation in the value of stock, even to almost the vanishing point, does not entitle a taxpayer to take a deduction of his investment therein. A deduction is permissible only when the stock has become entirely worthless and usually some identifiable event should occur in the taxable year to determine such worthlessness. On the well established rules of law governing loss deductions on account of worthless stock and bad debts of a subsidiary, the facts in the instant case entitle the plaintiff to a deduction in the year 1936 of its investment in the capital stock of Home Appliances, Inc. Houghton & Dutton Co. v. Commissioner, 26 B.T.A. 52; Prosperity Company v. Commissioner, 27 B.T.A. 28.

However, defendant contends that the stock of Home Appliances, Inc., actually became worthless in some year prior to 1936. As stated by the Circuit Court of Appeals of the Seventh Circuit in the case of Morton v. Commissioner of Internal Revenue, 112 F.2d 320, the worthlessness of a stock as of a particular year is a question of fact requiring practical consideration of all the facts and circumstances and each case must stand on its own facts. St. Louis Union Trust Co. v. United States, 8 Cir., 82 F.2d 61, 66; Forbes v. Commissioner, 4 Cir., 62 F.2d 571; and Industrial Rayon Corporation v. Commissioner, 6 Cir., 94 F.2d 383. In the instant case, plaintiff purchased the stock of Audiola Radio Company on April 18, 1934, for the sum of $7,110. From all the facts in evidence it appears that this was a bona fide business transaction and that the stock