The opinion of the court was delivered by: HARTSHORNE
The question in this case is whether or not the debentures of plaintiff Montana Power, 'Montana', were issued at a discount, and, if so, whether or not such discount is to be determined and deducted in Montana's income and excess profits tax returns, according to the principle laid down in American Smelting & Refining Co. v. United States, 3 Cir., 1942, 130 F.2d 883. The pertinent principle stated in that case is that, in ascertaining the existence of bond discount for Federal tax purposes the discount is 'the difference (between) the par value of (the) bonds and the fair market value' of that which is received by the issuer of the bonds in return therefor, whether same be cash or property. Montana claims, because the situation in the case at bar was that of a tax-free reorganization, which was not the case in American Smelting, that in ascertaining the existence of a bond discount and its amount, it is not the 'fair market value' of the property received for the bonds, or debentures on the reorganization transfer, which should be used, but the 'adjusted basis for determining the gain or loss' on a sale of the property,
which should be used. Defendant Government insists that the American Smelting rule is fully applicable, and that, in any event, the debentures in fact were not issued at a discount. We turn to the facts, here stipulated for the decision of the Court sitting without a jury.
American Power & Light, 'American', a holding company which in 1931 had acquired natural gas properties in Montana, in 1932 transferred these properties to Montana Power Gas Co., 'Gas Company', in return for the Gas Company's issuance of all its stock to American, whereby it became American's wholly-owned subsidiary. In 1936 Gas Company, still controlled by American, transferred these properties to plaintiff Montana, also stock-controlled by American. This transfer was paid for by Montana's 30-year 5% debentures, of which $ 10,589,900 in par were issued for that purpose and turned over to Gas Company. This transaction constituted a tax-free reorganization, as a consequence of which the parties agree that the 'adjusted basis' of said assets (the gas properties) in the hands of Montana immediately after said exchange, was the same adjusted basis which said assets had in the hands of Gas Company immediately prior to said exchange, to wit, some $ 7,000,000. It should be noted that the above 'adjusted basis' of the gas property refers under the statute, not to the then value of the debentures or any discount thereon, but to the method of determining capital gains or loss on a subsequent sale of the gas properties which has not yet occurred, and may never occur.
In fact, there is no reference in the Revenue Act itself to debenture, or bond, discount, and the right to deduct it on the payment of income or excess profits taxes. The only reference thereto is in the regulations of the Bureau of Internal Revenue, which the parties admit have the force of law, to the effect that
'If bonds are issued by a corporation at a discount the net amount of such discount is deductible and should be prorated or amortized over the life of the bonds.' 1949 Ed. C.F.R. Title 26 Internal Revenue, Sec. 29.22(a)-17(c)(1).
That such a bond discount is to be deducted and amortized is recognized by American Smelting, as based upon Helvering v. Union Pacific R. Co., 1934, 293 U.S. 282, 55 S. Ct. 165, 79 L. Ed. 363.
The above tax-free reorganization transfer of the gas properties by Gas Company to Montana, and the payment therefor by Montana's above debentures, was under a plan submitted to and approved by the Federal Power Commission, which embodied in its approval, and in the above agreement of transfer between the Gas Company and Montana, the following condition:
'It is understood that if the cost to American Power & Light Company (American) as provided in said order of the Federal Power Commission is not established, you (Gas Company) will return to us (Montana) such amount of debentures as shall be in excess of said cost so established.' (Parentheses the Court's.)
In the stipulation of facts the cost of such gas properties on the books of the Gas Company, as received from its parent company, American, and transferred to Montana, similarly controlled by American, is itemized (Exhibit A) as amounting to some $ 11,000,000, substantially the par value of the debentures. In the stipulated 'statement of assets and liabilities transferred November 30, 1936 by Montana Power Gas Company to the Montana Power Company under plan of reorganization' -- the transfer for which the debentures were issued -- the net value of such assets is stated as $ 10,589,900. This is the exact amount of the par value of the debentures issued by Montana and turned over to Gas Company on the transfer in question. (Stipulation, Exhibit E, Schedule N, Sheet a-28.) In 1945, nine years after the issue of the debentures, though twenty-one years before they matured, Montana retired these debentures by paying in cash, to certain banks, their par value -- $ 10,589,900.
Such being the facts, Montana claims its above debentures were issued at a discount, and that such discount should be calculated by subtracting from the par value of its debentures $ 10,589,900 -- not the 'fair market value' at that time of the gas properties it purchased therewith, but the 'adjusted basis' at that time of such gas properties, as fixed for determining gain or loss on any subsequent sale, i.e., some $ 7,000,000. This difference, some $ 3,000,000, when amortized over the 30-year life of the bonds, under Union Pacific and American Smelting, as Montana thinks they should be modified to meet its circumstances, would thus entitle Montana to a deduction of some $ 118,000 a year on the taxes in question. It consequently sues, in three separate causes of action, for the return of this amount which it allegedly was unlawfully compelled to pay defendant, because of defendant's failure to permit it to take the above deductions, on its income tax for 1940, on its income tax for 1941, and on its excess profits tax for 1941. Defendant denies Montana's right thereto.
We of course take as settled law the principles laid down in both Union Pacific and American Smelting, as above, that the issuance of bonds, or debentures, at a discount, requires the deduction of such discount under the Federal Revenue Acts, this deduction to be amortized over the life of the debentures; and further that the amount of the discount is the difference between the par value of the debentures and the fair market value of that which the issuer of the debentures receives in return therefor, whether this be cash or property. Furthermore, American Smelting holds that 'the burden was upon him (the taxpayer) to make this showing' (to prove the discount) 130 F.2d at page 886. The first question thus is, whether Montana has met this burden of proving that its debentures were issued at a discount.
Here we note the following facts: (1) On the transfer of the gas properties by Gas Company in 1936 to Montana, their cost on the books of the Gas Company was some $ 11,000,000 -- substantially the par value of the debentures. (2) Montana itself, in its income tax return for 1936, swore that the net value of these properties as so transferred to it was $ 10,589,900, the exact par value of the above debentures. (3) The Federal Power Commission conditioned its approval of this transfer to Montana, upon Montana's arranging to obtain the return from Gas Company, both being subsidiaries of American, of any excess of the par value of the debentures over the cost of the gas properties to American, the holding company of both Gas Company and Montana. That not only the Federal Power Commission, but Montana, as well as Gas Company and American, considered this cost to American to be the cost to Gas Company, and thereafter to Montana, is evident also from the fact that the issuance of Montana's debentures were conditioned thereon, and that such condition was embodied in the contract between Gas Company and Montana governing the transfer in question. (4) No such debentures have been returned. This is proven by the fact that nine years thereafter this entire issue of debentures was retired. (5) Thus, not only American, but its subsidiaries, Gas Company and Montana, have apparently insisted over the years that this cost of these gas properties to American, and to Montana, was a fair cost -- the fair market value of the property at that time. (6) Twenty-one years before the maturity of these debentures, Montana, instead of retiring them at a discount, retired them by paying for them dollar for dollar at par.
All these facts indicate that the actual 'fair market value' of these gas properties, when transferred to Montana in return for Montana's debentures, was probably not some $ 7,000,000, as Montana claims in its complaint, but was at least $ 10,589,900, the par value of such debentures. In any event, under the rule laid down in American Smelting, Montana clearly has not borne the burden of proving that the debentures in question were issued at a discount. Thus the action of the Collector in refusing to allow Montana the claimed deduction was in accord with the law as laid down in American Smelting.
Montana claims, however, that the above rule in American Smelting must be modified when it is applied to tax-free reorganization situations such as the present, this on the theory that tax inequities may otherwise, result, or as American Smelting puts it, theoretically only and not as a fact, 'the balance of the tax situation' may be upset, 130 F.2d at page 885. Our inquiry thus is, whether the application of the rule stated in American smelting to tax-free reorganization cases will result in such glaring tax ...