Court Opinion

ID: 4612273
Source: CourtListenerOpinion
Date Created: 2020-11-20 19:50:48.094994+00
Date Added: 2024-06-11T07:54:24.500328
License: Public Domain

THE NEW MCDERMOTT, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.New McDermott, Inc. v. CommissionerDocket No. 99360.United States Board of Tax Appeals44 B.T.A. 1035; 1941 BTA LEXIS 1244; July 17, 1941, Promulgated *1244  Petitioner corporation was organized by a committee of bondholders subsequent to default of interest on the bonds.  The bonds had been issued in connection with a mortgage on real property.  The real property was conveyed to petitioner, subject to the mortgage securing the bonds, by a corporation which had acquired the property subject to the mortgage at a sheriff's sale.  Petitioner keeps its books and files its returns on the accrual basis.  No interest was paid on the bonds from the time petitioner acquired the property until after the taxable year.  In the taxable year petitioner accrued on its books and deducted on its Federal income and excess profits tax return interest accrued on the bonds in that year.  Held, that the interest was properly accrued and is deductible by petitioner.  R. B. Albertson, Esq., for the petitioner.  Byron M. Coon, Esq., for the respondent.  HILL*1035  Respondent determined a deficiency in petitioner's income tax for the year 1936 in the sum of $1,114.81.  The only issue before the Board is whether or not petitioner is entitled to a deduction in the taxable year for accrued interest.  FINDINGS OF FACT.  *1245  Petitioner is a corporation, organized and existing under the laws of the State of Washington, with its principal office in Seattle, Washington.  Petitioner's income and excess profits tax return for the taxable year was filed with the collector of internal revenue for the district of Washington.  Under date of July 20, 1925, J. F. McDermott and his wife, Maud C. McDermott, the owners of certain real property located in Seattle, Washington, hereinafter referred to as the apartment property, entered into an indenture with the National Bank of Commerce of Seattle, Washington, hereinafter referred to as the bank.  The indenture was entitled "Trust Deed or Mortgage" and provided for the issuance by McDermott and his wife of 200 bonds of $1,000 denomination each, secured by a mortgage on the real property owned by the McDermotts and apartment buildings erected thereon, together with certain fixtures and installations on the premises.  The indenture provided that the bonds were to bear interest at the rate of 7 percent per annum, payable semiannually.  The bonds were to be retired serially between January 20, 1928, and July 20, *1036  1935.  The bank became trustee of the bond issue*1246  and, as trustee, certified the bonds in the aggregate amount of $200,000.  Under date of July 22, 1926, McDermott and his wife conveyed the apartment property by warranty deed to Glen E. Wilson, subject to the trust deed or mortgage entered into by the McDermotts and the bank on July 20, 1925, and other liens.  On or about December 21, 1926, Wilson and his wife conveyed the apartment property by warranty deed to McDermott Apartments, Inc., a corporation.  The apartment property was sold to the General Investment Co. at a sheriff's sale held on August 31, 1929.  The General Investment Co. acquired the property subject to the mortgage dated July 20, 1925, of which the bank was trustee.  In January 1933 a default occurred in the payment of interest on the bonds.  A bondholders' committee was formed and on May 1, 1933, a written "Deposit agreement" was entered into by the bondholders' committee and holders of bonds who deposited their bonds with the bank as depositary.  The deposit agreement provided that the bank should be the depositary of the bonds under the agreement.  The agreement further provided that: ARTICLE I.  * * * Section 3.  Forthwith upon this agreement being signed*1247  by the original members of the Committee, and upon an executed original or duplicate being filed with the Depositary, any holder of any of the bonds secured by said indenture may become a party to this agreement by depositing the bonds held by such holder, accompanied by all unpaid interest coupons appertaining thereto, in bearer form, with the Depositary at its office in Seattle, Washington, within such period or periods of time as the Committee, from time to time, may designate, and receive from the depositary a certificate of deposit or receipt, duly signed by it, in such form as may be fixed by the committee.  The action of a holder of bonds in thus becoming a party hereto shall be irrevocable, except as hereinafter provided.  * * * ARTICLE III.  Section 1.  No rights hereunder shall accrue to any depositor in respect to this agreement unless and until his bonds shall have been fully subject to the control of the committee by deposit of such bonds with the Depositary hereunder.  It shall not be necessary for a depositor to sign this agreement to become a party hereto.  Any depositor, by the act of depositing his bonds with the Depositary, as herein provided, shall by such*1248  act thereupon be and become a party to this agreement.  The committee may in its discretion fix or limit the period or periods within which holders of bonds may deposit the same hereunder, and the committee in its discretion, either generally or in special instances, may extend or renew any periods so fixed.  Holders of bonds not deposited hereunder within the periods fixed therefor will not be entitled to deposit the same or to become parties hereto, or to share in *1037  the benefits obtained hereunder, and shall acquire no rights hereunder, except upon obtaining the express consent of the committee, which may or may not be granted in its absolute discretion.  The committee shall have power to make equitable provisions for any lost or destroyed bonds or certificates of deposit.  * * * ARTICLE V.  Section 1.  The depositors, and each of them, hereby severally and irrevocably constitute and appoint the committee, and its successors, as their respective attorneys, agents and trustees for the purpose of carrying out this agreement and any plan which the committee may adopt in the interest of the depositors, and hereby severally confer upon the committee all power and authority*1249  to do and perform any and all acts and things which the committee may consider necessary or desirable, as fully to all intents and purposes as the depositors might or could personally do, hereby ratifying and confirming all acts and things that the committee may do or cause to be done.  * ** Section 2.  Without derogation from the general powers hereby conferred upon the committee, the committee shall have power and authority * * * to procure the organization of a new corporation or corporations, or to adopt or use any existing or future corporations; to take, hold, subscribe, pay for or otherwise give value for the securities and obligations of such corporation or corporations; to receive any new securities to be created and to vote upon the stock of any corporation now or in the future organized as part of any plan adopted by the committee for the protection of the depositors; to employ counsel, accountants, agents and assistants, and to pay the expenses thereof as part of the expenses of the committee, and to incur and discharge any and all expenses which the committee deems necessary and proper in functioning hereunder; to cause a new corporation to be formed to take over and/or*1250  acquire the mortgaged property, and to surrender and/or exchange the deposited bonds and/or coupons, in whole or in part, for all or part of the stock of such corporation upon such basis of exchange as the committee may determine.  * * * ARTICLE VII.  Section 1.  The depositors, severally and respectively, agree that the committee shall have power to extend the maturities of any bonds deposited hereunder and/or to reduce the rate of interest on such bonds; provided, however, that any such extension of maturities or reduction in interest rate shall apply to all deposited bonds, and no such extensions of maturities or reduction in interest rate shall be made which does not apply to at least two-thirds in amount of all outstanding bonds.  Section 2.  The depositors, severally and respectively, further consent and agree that the committee shall have power to modify, amend, or supplement the indenture securing the bonds by supplemental indenture and agreement in such form and containing such terms and provisions as may be approved by the committee.  In 1933 there were outstanding $139,000 of the original bonds secured by the mortgage on the apartment property.  Bonds in an aggregate*1251  amount of $131,000 were deposited while $8,000 of the bonds remained undeposited.  Unsuccessful efforts were made by *1038  the bondholders' committee to cause the holders of the $8,000 outstanding bonds to deposit them subject to the deposit agreement.  Each bondholder upon depositing his bonds received a certificate of deposit from the bank as depositary.  Pursuant to the powers granted by the "Deposit Agreement" petitioner was organized by the bondholders' committee and incorporated August 9, 1933.  Petitioner had an authorized capital stock of 1,390 shares of $100 par value common stock.  At the time petitioner was organized its stock was issued to the bondholders' committee in trust for the bondholders.  At the first meeting of petitioner's board of directors the following proposition was considered: Said bondholders' committee agrees to cause the said General Investment Company, a corporation, to convey by warranty deed to this corporation the premises covered by said trust deed or mortgage and described above but said conveyance is not intended to merge the bonds or deed of trust with the title to said premises.  As consideration for causing such conveyance to be*1252  made this corporation shall: 1.  Cause all of its capital to be issued to the members of said bondholders' committee to be held by them in trust for the owners and holders of the bonds secured by said trust deed or mortgage in proportion to the respective interests of said bondholders.  2.  This corporation to agree to purchase from the said General Investment Company the furniture and furnishings contained in the apartment house located upon the premises ocvered by said trust deed or mortgage for the sum of $10,000 payable in monthly installments of $300 or more each month, the first installment to be paid September 10, 1933 with interest upon the unpaid balance at the rate of 5% payable monthly.  Said purchase price to be evidenced by a promissory note of purchaser and secured by a chattel mortgage upon the said furniture and furnishings and also to be secured by an assignment of income by the purchaser to the owner upon said premises; said assignment, however, being limited to the payment of $300 per month and interest.  Upon consideration of this proposal the board unanimously adopted the following resolution: RESOLVED That the foregoing proposition made to this corporation*1253  by the bondholders' committee above named be and the same is hereby accepted and approved and the officers of this corporation ordered and directed to execute the necessary instruments and take the necessary steps to carry out the same.  Under date of August 1, 1933, in consideration of the sum of $10,000 payable at the rate of $300 a month and secured by a chattel mortgage on the furniture on the premises, the General Investment Co. executed a warranty deed in favor of petitioner.  The property was conveyed subject to the mortgage of July 20, 1925, securing the bond issue.  The sum of $10,000 payable to the General Investment Co. for the apartment property has been fully paid.  It was the *1039  intention of the corporation not to cancel the bonds if a plan could be worked out with the approval of the bondholders.  The bonds were never canceled.  Petitioner has supervised management of the apartment property since its acquisition of the property.  At a special meeting of the shareholders of petitioner held September 24, 1937, a resolution that the capital stock of petitioner should be reduced from $139,000 to $1,390 was unanimously adopted.  The articles of incorporation*1254  of petitioner were amended to reflect the reduction of the petitioner's capital stock and were filed with the Secretary of State of the State of Washington September 30, 1937.  Each share of $100 par value stock was reduced to a par value of $1.  After the stock was reduced the stock of petitioner was issued for the first time directly to the bondholders.  On or about November 22, 1937, petitioner entered into a written agreement with the bank as trustee for the bondholders for the extension of maturity of the bonds and reduction of interest.  The agreement stated that the sum of $134,000 remained unpaid upon principal of the bonds and that interest had been unpaid from July 20, 1932, to date.  It was provided that the maturity date of all outstanding bonds should be extended to July 20, 1947.  It was further provided that: In full payment for all of the unpaid interest on the outstanding bonds and coupons from July 20, 1932, to July 20, 1937, and in lieu thereof, there shall be issued by the corporation and delivered to each bondholder entitled thereto, for each $1,000.00 bond outstanding, ten shares of the common stock of The New McDermott, Inc., of the par value of $1.00 per*1255  share.  All of the seven per cent interest coupons which are attached to certain of the outstanding bonds shall be detached from said bonds and canceled by the trustee.  Under this agreement petitioner agreed to pay interest on outstanding bonds from July 20, 1937, until maturity at the rate of 5 percent a year.  Petitioner also agreed to pay the principal of the bonds at maturity unless previously retired.  At the date of the hearing in this proceeding title to the apartment property still remained in petitioner, subject to the mortgage securing the bond issue.  The bonds are being retired by payments from a sinking fund and interest provided under the interest reduction agreement is currently being paid.  A large number of bonds have been sold without the stock of petitioner and a large amount of stock of petitioner has been sold without the bonds.  Interest is being paid to bondholders who do not own stock.  The first separation of interest between bonds and stock took place in the latter part of 1937.  The largest items accrued but unpaid in the taxable year were those relating to interest and taxes.  Current expenses were normally paid as billed.  *1040  Petitioner's*1256  Federal income tax returns have always been filed and its books kept on the accrual basis.  In its income and excess profits tax return for the year 1936 petitioner deducted interest due in that year on the 7 percent bonds in the sum of $9,730.  Respondent disallowed the deduction.  OPINION.  HILL: The single issue before us is whether or not petitioner is entitled to a deduction in the taxable year for interest accrued on Petitioner contends that it has always kept its books and filed its returns on the accrual basis and that it properly accrued the sum of $9,730 as interest on the bonds due in the year 1936.  It maintains that, even though it was not primarily liable on the mortgage, it is entitled to the deduction by virtue of article 23(b)-1 of respondent's Regulations 94. 1 Respondent argues that petitioner was not on the accrual basis of accounting and hence may not deduct interest due but unpaid.  He asserts that the bonds have been canceled by operation of law and relies upon the case of . *1257  Petitioner was on the accrual basis of accounting.  Its returns were consistently filed and its accounts were kept on that basis.  The fact that the largest expense items relating to interest and taxes were accrued while current operating expenses were paid does not constitute petitioner's bookkeeping a "hybrid" system.  We are convinced that petitioner's income is clearly reflected by its use of the accrual basis.  In order that petitioner may have a deduction for interest accrued, however, the interest must be due on indebtedness of the taxpayer.  ; certioraridenied, ; ; . Petitioner received the apartment property from the General Investment Co. by warranty deed, subject to the mortgage in favor of the bank as trustee for the bondholders.  Petitioner did not assume the mortgage until after the taxable year.  We are nevertheless of the opinion that the indebtedness was that of petitioner within the meaning of the authorities which require the debt to be that of the taxpayer in order to*1258  support an interest deduction.  Cf.  . The mortgage indebtedness is a lien on the property of which petitioner is the legal owner and upon which petitioner must necessarily rely for its source of income.  Petitioner's whole *1041  reason for being would be negatived if the mortgage were foreclosed and the property sold to satisfy the mortgage.  Interest accrued on the mortgage is interest on petitioner's indebtedness in spite of the fact that petitioner was not primarily liable on the mortgage.  Petitioner does not come within the letter of article 23(b)-1 of respondent's Regulations 94, since that regulation speaks only of "interest paid." We see no reason, however, in the absence of statutory specification, to grant a deduction to a taxpayer on the cash basis for interest paid and deny deductibility to interest accrued by a taxpayer on the accrual basis.  The interest here was properly accrued and the claimed interest deduction is allowable.  Respondent maintains that the bonds were canceled "by operation of law" and urges that *1259 , controls.  The bonds were still outstanding at the date of the hearing and interest under the maturity extension and interest reduction agreement was still being paid on them.  Respondent has suggested that under the doctrine of merger the bonds were canceled when the legal title was acquired by petitioner.  We are of the opinion that the facts in the instant case do not justify application of the doctrine of merger.  The resolution adopted by the shareholders of petitioner at their first meeting comcerning the acquisition of the mortgaged property clearly indicates that no merger of the legal and equitable titles was intended.  The fact that some of the bonds were never subject to the deposit agreement is in itself sufficient to preclude merger and consequent cancellation of the bonds.  See ; . The Sheppard case is distinguishable from the instant proceeding.  There the taxpayer was an individual trustee acting for bondholders.  We held that it was not contemplated that there should be an obligation on the taxpayer to pay interest on the mortgage, *1260  or even if there were such an obligation, the taxpayer was a mere trustee acting for the bondholders to whom the alleged interest was owing.  Here, petitioner and the bondholders are not identic.  Petitioner's shares are sold both with and without bonds and some of the bonds were never deposited.  We hold that respondent's determination was erroneous to the extent that he disallowed a deduction for accrued interest in the amount of $9,730.  Reviewed by the Board.  Decision will be entered under Rule 50.Footnotes1. Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.  * * * ↩