Before BIGGS, Chief Judge, and MARIS, GOODRICH, McLAUGHLIN, KALODNER, STALEY and HASTIE, Circuit Judges.
Under long-standing Treasury Regulations a corporation which issues bonds at a discount can prorate or amortize such discount over the life of the bonds.
Sec. 19.22(a)-18(3) (a) of Treasury Regulations 103, applicable in the tax years here involved, provides:
"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."
The instant appeal involves the application of the aforementioned Treasury Regulations.
The undisputed facts, established by the record, may be summarized as follows:*fn1
American Power & Light Company ("American") a public utility company, on November 30, 1936, owned 100 per cent of the stock of the Montana Power Gas Company ("Gas") and 99.75 per cent of the common stock of Montana Power Company ("taxpayer"). On the date mentioned, Gas transferred to taxpayer certain natural gas properties which it had acquired in December, 1932, from American*fn2 and received in payment for the transfer $10,589,900 principal amount of taxpayer's 30-year 5 per cent debentures. The transaction was a tax-free reorganization under a plan submitted to and approved by the Federal Power Commission, which embodied in its approval, and in the agreement of transfer between Gas and taxpayer, the specific condition that if the cost of the transferred property to American was not established Gas would return to taxpayer "such amount of said $10,589,900 principal amount of debentures as shall be in excess of said cost so established.*fn3 Taxpayer in its 1936 tax return scheduled the net value of the assigned assets at $10,589,900 in a "Statement of Assets and Liabilities Transferred November 30, 1936, by Montana Power Gas Company to the Montana Power Company under Plan of Reorganization" appended to the tax return. The cost to Gas of the transferred assets was $11,183,595.53.*fn4
In 1945, nine years after the debentures were issued, they were retired by taxpayer by payment of their principal amount of $10,589,900 to certain banks then in ownership. As an incident of the prior tax-free reorganization, under Section 113(a) (7) of the Revenue Act of 1936, 26 U.S.C.A.Int.Rev.Acts, page 863, taxpayer was required to take the same adjusted tax-cost basis for the assets acquired from Gas as they had in the latter's hands - $7,044,544.44.
Taxpayer claimed that it was entitled, under the Treasury Regulations, to a bond discount deduction of $3,545,355.56 - the difference between the tax-cost basis of the assets acquired from Gas and the principal amount of the debentures which it had issued in payment for them. It premised its claim upon the proposition that, where a non-taxable reorganization is involved, bond discount is determinable solely by reference to the transferor's adjusted basis for the property exchanged for the debentures, which the transferee, issuer of the debentures, is required to use.
The District Court rejected taxpayer's contention and held that under our decision in American Smelting & Refining Co. v. United States, 3 Cir., 1942, 130 F.2d 883, taxpayer could only be entitled to a discount if it could establish that the debentures in question exceeded the actual "fair market value" of the assets acquired from Gas. On consideration of the evidence adduced by taxpayer the District Court made the factual finding that it had failed to establish that the "actual fair market value" of the assets acquired by taxpayer was less than the total of the issued debentures; it ruled that "Unless Montana, within thirty days, shall apply to establish by further evidence the fair market value of the gas properties at the time of their transfer to it by Gas Company, judgment will go for defendant." Taxpayer having failed to act within the time fixed by the District Court, it dismissed its action and entered judgment for the United States. Taxpayer appealed.
On this appeal taxpayer has summarized its position as follows: "It was settled by American Smelting & Refining Co. v. United States * * * that discount may arise when debt is issued for property"; "* * * the measure of said discount, when bonds are issued for property, is the difference between the amount realized and the principal amount of the debt"; "* * * the amount realized by the plaintiff (taxpayer) upon the issuance of its debentures is the tax-cost basis ($7,044,544.44) of the gas properties received in exchange for plaintiff's (taxpayer's) debt, which basis the plaintiff (taxpayer) was required to use for all relevant purposes under the tax law"; "The fair market value of the properties is not relevant in this case" and finally, "The fact that certain of the transactions took place between affiliated corporations neither changes said result nor renders it inequitable".*fn5
The sum of the government's position is that "the fallacy of the taxpayer's argument is that it rests upon the premise that all the taxpayer acquired for its bonds was a tax-basis, when, in fact, what the taxpayer acquired was property having a fair market value in no way related to the adjusted basis which the taxpayer was required to use solely because of its having chosen to participate in a non-taxable reorganization" and the taxpayer having failed to meet the burden of establishing, under the American Smelting decision, that the fair market value of the property acquired in exchange for the debentures was less than their principal amount is not entitled to a discount.
In the American Smelting case we laid down the rule that in instances where the discount regulation is applicable the taxpayer bears the burden of establishing that the fair market value of that for which the bonds were issued was less than their principal amount.
Here the taxpayer failed to introduce at the trial any evidence of the fair market value of the property received in exchange for the debentures which it issued and it further failed to do so within the thirty-day grace period granted by the District Court.
The taxpayer urges that application of the "fair market value" doctrine "upsets the balance of the tax situation" because Gas was required to hold the debentures at $7,044,544.44 (tax-cost basis) and was thus subject to tax on the difference between that amount and the proceeds of the debentures, on disposition or retirement, while it, the taxpayer, could never recover more than $7,044,544.44 through deductions or depreciation or as an offset against the proceeds from re-sale of the property. In other words, says the taxpayer, the government would be directly taxing Gas on $3,545,355.56 (assuming that it realized the principal amount of the debentures) and would in effect tax it on an additional $3,545,355.56 in the manner above stated.
The District Court [121 F.Supp. 583] in dealing with this same contention observed that "'The tail goes with the hide'"; that Gas, the taxpayer and their holding company, American, "must be presumed to know the law * * * they decided to take advantage for their own benefit of this tax-free reorganization * * * even had this reorganization worked out in other aspects to their disadvantage, it was they who made the decision in the light of the law" and "They could not complain now, even were a tax disadvantage to counterbalance the advantage, which they chose to take."
We agree with the District Court on this score. It is well-settled that a taxpayer is free to adopt such organization for his affairs as he may choose but having done so he must accept the tax consequence of his choice; this is so whether he contemplated such consequence or not.*fn6 And on that score it must be noted that allowance of deductions does not turn upon general equitable considerations and that such allowance "depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed."*fn7
We should like to note, however, that in our view the result reached is not inequitable in the instant situation. During the four years that Gas owned the assets which it transferred to the taxpayer in November, 1936, it had, using round figures, reduced their cost basis by approximately $4,000,000, from $11,000,000 to $7,000,000, via depreciation and depletion allowances, amortization of lease costs and capitalization development costs. The deductions, of course, reduced Gas' annual income taxes during the years in which they were taken. American, as parent of Gas and taxpayer, could have avoided the "balance of tax" dilemma of which taxpayer complains had it caused the latter to issue debentures for $7,000,000, the tax-cost basis of the transferred assets. However, instead, indulging in practices all too prevalent in the free-booter days of the holding company era, in a Tinker-to-Evers-to-Chance play, American arranged to have the taxpayer pay, again using round figures, $10,500,000 (in debentures) for assets which had a tax-cost basis of $7,000,000 utilizing the reorganization revenue statute to make it all tax-free. And then, American (in 1937) liquidated Gas into it and became the direct owner of taxpayer's debentures.*fn8 By the steps taken, American, assuming eventual realization in full of the principal amount of the debentures netted a neat $3,500,000 profit, subject only to payment of a 25 per cent capital gains tax. Incidentally, as earlier stated, the record discloses that the debentures were retired in 1945 by payment in full to two banks which then held them. No evidence was introduced below as to the purchase price paid by the banks to American for the debentures. However, it may be noted that the taxpayer in presenting its "balance of tax" contention has premised it on the supposition that American would be required to pay a capital gains tax on $3,500,000, which, of course, would only be so if it had realized the principal amount of the debentures in their sale to the banks.
While the taxpayer urges that "The principal issue involves the plaintiff as a separate taxable entity and does not transcend corporate lines to other companies which are separate taxable entities in and of themselves"*fn9 it incongruously argues, in its "balance of tax" contention, the tax consequence to both it and American. In doing so taxpayer has asked us in effect to look into the treasury chests of two corporations but not to pierce or penetrate the corporate veils of either in doing so.
Well, even a passing glance reveals that American, via taxpayer, seeks to achieve the storied aim of "getting the cake and keeping the penny too"; it wants its $3,500,000 profit (less capital gains tax) and its $3,500,000 discount too. To that we say, we just can't go along.
One final comment. The taxpayer's "balance of tax" contention stressing its loss of a $3,500,000 source of deductions should its "discount" plea fail, ignores the fact that a corporation, such as the taxpayer, operating natural gasproducing properties, would be entitled to percentage depletion deductions, which continue even after the entire capital investment has been recovered, and thus, it is possible that it may, in fact, be able to recover by way of depletion deductions an amount in excess of its entire debenture investment.
For the foregoing reasons all the members of the court except Chief Judge BIGGS agree that the taxpayer is not entitled to the relief it seeks in view of its failure to establish the fair market value of the property involved. We reach this conclusion without regard to the applicability of the discount regulation to the transaction, a question which a majority find it unnecessary to decide. Judge STALEY and the writer of this opinion, however, are of the view that this question should be considered and that its consideration supplies additional reasons for reaching the conclusion of the court that the judgment of the District Court should be affirmed. We think:
(1) The Treasury Regulations relating to bond "discount" are inapplicable in situations where bonds are issued in payment for property.
(2) Assuming applicability of the Treasury Regulations in cases where bonds are issued in payment for property, they cannot be invoked where there was no arms-length dealing, as was the case here.
On the score of the first point:
It must immediately be noted that the District Court, taxpayer and the United States have construed our decision in American Smelting & Refining Co. v. United States, supra, as a sweeping holding that under any and all circumstances bond ...