Before Biggs, Chief Judge, and Mclaughlin and Kalodner, Circuit Judges.
This appeal is taken from the decision of the Tax Court.
The signle question presented is whether the taxpayer realized taxable income in the taxable years 1941 and 1942 when it purchased in the open market its own first mortgage bonds at a cost less than the issue price and immediately, pursuant to its covenants in a junior trust indenture, deposited and pledged the purchased bonds with the trustee as additional collateral to the junior note issue.
The facts as found by the Tax Court*fn1 may be summarized as follows:
The taxpayer is a corporation, organized under the laws of Pennsylvania and West Virginia for the purpose of operating a steam railroad. Its principal office is in Pittsburgh. Its tax returns for the year involved were filed with the Collector for the Twenty-Third District of Pennsylvania. f
On July 1, 1940, the taxpayer borrowed $7,400,000 and issued its five-year 4% notes in such amount, secured by an indenture dated July 1, 1940, between the taxpayer and First National Bank at Pittsburgh, as trustee.
Under the terms of the indenture, the taxpayer was required during the calendar year 1941 to devote not less than 25% of its "Available Net Income" for 1940, and during each calendar year thereafter, so long as any of the notes were outstanding and unpaid, not less than 50% of its "Available Net Income" for the preceding year "to the purchase at the lowest price or prices available in the open market but not exceeding the principal amounts thereof" of its then outstanding series A, B, and C first mortgage 4 1/2% bonds, "and the Company (taxpayer) covenants and agrees that any and all of such bonds so purchased by the Company shall remain alive and forthwith be delivered to and pledged with the Trustee to be held by the Trustee as Pledged Securities under and subject to the terms of this Indenture."
If any described event of default were to occur, the trustee was given discretion to convert into money at public sale any of the pledged securities.
Pursuant to the provisions of the indenture, the taxpayer, in the year 1941, purchased $550,000 face value of its series A, B, and C first mortgage 4 1/2% bonds for the sum of $349,220, and in the year 1942 purchased $282,000 face value of such bonds for the sum of $159,271.25, and immediately upon such purchases delivered the bonds so purchased to, and pledged them with, the bank as trustee under the indenture. The bonds remained pledged with the trustee until June 28, 1945, when they were returned to the taxpayer by the trustee upon the payment of the taxpayer's five-year 4% notes.
The bonds were secured by an indenture of mortgage and supplemental indentures between the taxpayer and the Union Trust Company of Cleveland, Ohio, and Robert S. Crawford, as trustees, dated December 1, 1928, April 1, 1929, April 30, 1929, and April 1, 1930, covering all properties owned or which would subsequently be acquired by the taxpayer, except cash, accounts receivable, bills receivable, stocks, bonds, notes, and similar intangible property and such of the real estate of the taxpayer as is not included within its rights-of-way and real estate upon which no structures used for railroad purposes are located, and engines, tenders, cars, and other rolling stock.
The Commissioner included in the taxpayer's gross income for the years 1941 and 1942 the difference between the face value and the purchase price of its bonds purchased and pledged by the taxpayer as aforesaid.
The Tax Court reversed the Commissioner's determination stating that it subscribed to the taxpayer's contention that the obligation embodied in the repurchased bonds "remained alive in the hands of another and was not extinguished until June, 1945 when the five-year notes were paid." It further held that the taxpayer "did not, in reality, obtain a cancellation of its debt in the instant years"; that "it did not effectively free any part of the mortgaged assets from the continuing lien of the bonds," and, "it could not be said with certainty at that time that, if the pledged bonds had to be resold, the entire transaction might not result in a loss."
The Commissioner urges that the Tax Court's disposition was not in accordance with the provisions of Section 22(a) of the Internal Revenue Code;*fn2 the pertinent Treasury Regulations;*fn3 and the authorities. He contends that the realization of taxable gains was not precluded in the taxable years by the taxpayer's pledging the purchased bonds as security for the then outstanding five-year note issue; that upon their repurchase the bonds became the taxpayer's property even though pledged, and thereafter its liability thereon was only contingent, its unconditional obligation on the bonds having been extinguished upon repurchase; and that upon the latter, the assets were ...