9 T.C. 1018">*1018 The respondent determined a deficiency in the income tax of petitioner for the calendar year 1942 in the amount of $ 834,982.38. The 9 T.C. 1018">*1019 sole issue presented for our consideration is whether the petitioner, in computing the statutory "net operating loss deduction" for the year 1942, may deduct from gross income for 1940 amounts paid by it in that year in redemption of interest coupons for 1939 on its 3 per cent-6 per cent consolidated mortgage bonds. The parties have agreed upon other issues, and their agreement will be given effect upon settlement under Rule 50.

The evidence consists of a stipulation and supplemental stipulation of facts and certain documents introduced at the hearing.

FINDINGS OF FACT.

The facts as stipulated are so found.

Philadelphia Transportation Co. (hereinafter referred to as petitioner) is a Pennsylvania corporation, with office and principal place of business in Philadelphia, Pennsylvania. It keeps its books and files its tax returns on the accrual basis of accounting.

Petitioner's1947 U.S. Tax Ct. LEXIS 23">*26 consolidated Federal income and declared value excess profits tax return for the calendar year 1942 was filed with the collector of internal revenue for the first collection district of Pennsylvania at Philadelphia on June 15, 1943, pursuant to an extension to June 15, 1943, of time for filing duly granted by respondent on May 7, 1943. In that return petitioner reported taxable net income (i. e., "normal tax net income") in the amount of $ 1,780,269.13 and liability for income tax in the amount of $ 747,517.96, which was paid.

On October 23, 1945, petitioner paid to the collector of internal revenue at Philadelphia $ 925,052.05, of which $ 800,000 was in partial payment of the deficiency determined by respondent and $ 125,052.05 was interest on the $ 800,000 from March 15, 1943, to October 23, 1945. In its petition, filed December 27, 1945, petitioner claims a refund of taxes and interest paid, together with interest thereon as provided by statute.

On October 1, 1934, the Philadelphia Rapid Transit Co. (one of the petitioner's predecessors), a Pennsylvania corporation, operated a street railway system in Philadelphia. On October 1, 1934, it filed a voluntary petition under section1947 U.S. Tax Ct. LEXIS 23">*27 77-B of the Bankruptcy Act in the district court of the United States for the eastern district of Pennsylvania. It operated, as lessee under long term leases, properties of 64 other corporations, 27 of which filed petitions as additional debtors for reorganization under the 77-B proceedings. These 27 corporations are referred to in the reorganization "Plan" and herein as "Lessor Companies." The Philadelphia Rapid Transit Co., its subsidiaries and the "Lessor Companies" were referred to throughout the reorganization proceedings as "The Philadelphia Rapid Transit Company9 T.C. 1018">*1020 System." Neither the Philadelphia Rapid Transit Co. nor its subsidiaries owned stock of the 27 "Lessor Companies."

A plan known as the "Second Revised Plan of Reorganization," hereinafter called the "plan," was filed on December 1, 1937, and amended on June 1 and November 15, 1938, and approved on November 14, 1939.

Page 1 of the plan contains the following statement:

* * * The public holders of stock and stock trust certificates of Lessor Companies will receive in exchange for their present securities, approximately $ 31,974,000 face amount of 3%-6% Consolidated Mortgage Bonds and approximately $ 12,301,0001947 U.S. Tax Ct. LEXIS 23">*28 par value of Participating Preferred Stock (of a par value of $ 20 per share) of Transportation Company and approximately $ 2,204,000 in cash, as hereinafter set forth. The total fixed annual interest (3%) on the said new bonds will be approximately $ 6,141,000 less, and the total maximum interest payable if earned (6%) on the said new bonds will be approximately $ 5,182,000 less, than the annual rentals formerly paid to the holders of such securities of Lessor Companies under the old leases.

The plan provided that petitioner, upon incorporation, would issue to holders of stock and stock trust certificates of 21 of the "Lessor Companies" petitioner's 3 per cent-6 per cent consolidated mortgage bonds, dated January 1, 1939, and bearing interest from that date, in the amount of $ 31,973,597.78 ¹ and to holders of first mortgage bonds of two of the "Lessor Companies" petitioner's 3 per cent-6 per cent consolidated mortgage bonds in the amount of $ 596,400. The 3 per cent-6 per cent consolidated mortgage bonds were to bear "Fixed Interest" of 3 per cent per annum and an "additional 3 per cent per annum only if and to the extent to which earned in any year." The $ 596,400 face amount1947 U.S. Tax Ct. LEXIS 23">*29 of 3 per cent-6 per cent consolidated bonds were to be, and were, in January 1940, issued as follows: $ 200,000 of said amount to holders of Doylestown and Willow Grove Railway Co. first mortgage 4 per cent bonds in exchange for $ 500,000 face amount of said bonds and the remaining $ 396,400 face amount to holders of Darby, Media & Chester Railway Co. 4 1/2 per cent first mortgage bonds in exchange for $ 991,000 face amount of said bonds. Semiannual interest in the amount of $ 10,000 due June 1, 1939, on the Doylestown & Willow Grove Railway Co. first mortgage 4 per cent bonds of the face value of $ 500,000 was paid by the trustees of the "Debtor" on or about July 30, 1939. "Fixed Interest Coupon No. 1" on the $ 200,000 face amount of 3 per cent-6 per cent consolidated mortgage bonds exchanged for said $ 500,000 bonds was removed before delivery. Interest in the amount of $ 500 for the period from June 1 to July 1, 1939, was on January 29, 1940, paid in cash by petitioner at the rate of 3 per cent on $ 200,000. Semiannual interest in the amount of $ 22,297.50 due, July 1, 1939, on the Darby, Media & Chester Street Railway Co. 4 1/2 per cent first mortgage bonds of the face value1947 U.S. Tax Ct. LEXIS 23">*30 of 9 T.C. 1018">*1021 $ 991,000 was paid by the trustees of the "Debtor" on or about July 30, 1939. "Fixed Interest Coupon No. 1" on the $ 396,400 face amount of 3 per cent-6 per cent consolidated mortgage bonds exchanged for said $ 991,000 of bonds was removed before delivery.

The plan also provided for the consolidation and merger of 65 of the corporations previously constituting the Philadelphia Rapid Transit Co. System. Pursuant to the plan, an "Agreement of Consolidation and Merger" was adopted by the 65 corporations. The plan and agreement provided that petitioner, a new corporation, would result from the merger and consolidation of the old companies.

Rentals on long term leases, accrued but unpaid, were recorded on the books of account of Philadelphia Rapid Transit Co. in the amounts of $ 28,692,245.94 as of December 31, 1938, and $ 35,463,063.74 as of December 31, 1939.

From October 1934 to February 24, 1939, the "Lessor Companies" had received no payments in respect of those1947 U.S. Tax Ct. LEXIS 23">*31 leases except three payments aggregating $ 2,300,000 paid by order of the United States District Court after October 1934 and prior to 1937, $ 2,000,000 paid pursuant to the order of the United States Circuit Court of Appeals for the Third Circuit on January 3, 1937, and $ 1,000,000 paid pursuant to order of the United States District Court entered June 6, 1938. All such payments were "ad interim allowances," without prejudice to any question pending in the reorganization proceedings.

On February 24, 1939, Union Traction Co. of Philadelphia, on behalf of itself and other lessor companies, filed a petition for a payment of $ 3,000,000. This was opposed by the Pennsylvania Public Utility Commission on the ground that such payment would dangerously deplete the working capital of the reorganized company and that the holders of stock and stock trust certificates of the lessor companies under the plan were to receive $ 2,204,000 in cash.

On June 1, 1939, said petition of Union Traction Co. was heard by the court and, it appearing that the Pennsylvania Public Utility Commission had given consideration to the amount of cash which after reorganization would be available for rehabilitation1947 U.S. Tax Ct. LEXIS 23">*32 and modernization of the system and that the city of Philadelphia had given consent to the action necessary on its part if and when the plan should be approved, the court ordered that an ad interim allowance of $ 700,000 be made to the Union Traction Co. and stated that such allowance was without prejudice to any question then pending.

Philadelphia Rapid Transit Co. filed a motion (verified on November 13, 1939) for confirmation of the plan, representing that, with the single exception of one class of creditors, all parties in interest, including the Pennsylvania Public Utility Commission and the city of Philadelphia, had accepted the plan and that an overwhelming majority of 9 T.C. 1018">*1022 the affected stockholders and creditors, representing in each class a majority in excess of the required statutory majority, had accepted the plan. The "Debtor" submitted drafts, for approval prior to execution, of substantially all documents necessary to consummate the plan, the consolidation of the several corporations, and the transfer of property.

On November 14, 1939, "Drexel & Co., Agent" for each of the corporations which were parties to the plan, filed an "Affidavit re Acceptances of Plan" 1947 U.S. Tax Ct. LEXIS 23">*33 showing the percentage of acceptances of the plan as of the close of business November 13, 1939, by holders of affected issues of stock, stock trust certificates, and bonds.

On November 14, 1939, the motion of the "Debtor" for confirmation of the plan was heard. The court found, among other facts, that the plan had been submitted to and approved by the Pennsylvania Public Utility Commission, had been accepted by the city of Philadelphia and by all necessary parties except one class of creditors, for the protection of whose rights provision was made, and that "12. The compromise set forth in the Plan is approved as reasonable, fair and equitable."

The court ordered that:

8. The new company, upon confirmation of the Plan, will be authorized to take all action necessary to carry out the Plan and all authorizations, approvals or consents required by law have been obtained.

and that:

13. The Plan provides that the new company shall assume liability for the payment of, and will pay in full in cash, all taxes legally due or which may become due to the United States of America, the Commonwealth of Pennsylvania, the City of Philadelphia, and/or any other taxing authority by the debtor, 1947 U.S. Tax Ct. LEXIS 23">*34 the additional debtors, the trustees thereof, other merging companies and/or wholly-owned subsidiaries whether or not proofs of claim therefor have been filed in this reorganization proceeding (unless such taxes are fully paid and satisfied prior to the confirmation of the Plan) and such taxes shall be assessed against, collected from, and paid by transportation company ² in the same manner subject to the same provisions of law as would be applicable to the debtor, the additional debtors, other merging companies and wholly-owned subsidiaries had this reorganization proceeding not intervened.

and that "15. The Plan is hereby confirmed and approved."

On the same day, November 14, 1939, the court entered an order approving the documents and the terms and procedure for carrying out the order confirming the plan, providing, among other matters, that "3. The transfer books for all securities of all companies parties to the Plan shall be closed as of 3:00 P. M. on the 1947 U.S. Tax Ct. LEXIS 23">*35 date of this order," and making provision for the adjustment of the interest on the "First and Refunding Bonds of the New Company" and on the "Consolidated Mortgage Bonds of the New Company" in those instances where the 9 T.C. 1018">*1023 holders of bonds which were to be surrendered in exchange for the bonds of the new company had received payments of interest applicable to the year 1939 on their old bonds.

In accordance with the plan and as a result of the "Agreement of Consolidation and Merger," petitioner came into existence as a corporation on January 1, 1940, immediately after midnight, December 31, 1939.

On January 29, 1940, petitioner, pursuant to said plan, executed and delivered its 3 per cent-6 per cent consolidated mortgage bonds in the amount of $ 32,529,943.54, dated January 1, 1939, and bearing interest from January 1, 1939, ³ to the Fidelity-Philadelphia Trust Co., then and now trustee for the bondholders, for authentication. The trustee forthwith authenticated the bonds and delivered them to Drexel & Co., depository, for delivery.

1947 U.S. Tax Ct. LEXIS 23">*36 Said bonds were secured by a mortgage upon all of the properties of the petitioner, subject only to the prior encumbrances listed in the plan. The trust indenture evidencing the mortgage was executed and delivered by the petitioner on January 4, 1940, and recorded in Philadelphia County, Pennsylvania, on January 9, 1940, in Delaware County, Pennsylvania on January 10, 1940, in Bucks County, Pennsylvania, on January 11, 1940, and in Montgomery County, Pennsylvania, on January 11, 1940.

On January 29, 1940, petitioner delivered its check in the amount of $ 977,112 to the trustee for bondholders of the 3 per cent-6 per cent consolidated mortgage bonds, with direction to the trustees to pay to the bondholders an amount equivalent to 3 per cent of the face amount of the respective bonds upon surrender for redemption of coupons numbered 1 and 2 affixed to the bonds, which coupons were designated in the trust indenture as "Fixed Interest Coupons." This transaction was recorded on the books of petitioner by a debit of $ 977,112 against two items of liability, $ 966,952.30 and $ 500, appearing on journal entry No. 1, hereinafter mentioned. Subsequently, the item of $ 977,112 was decreased1947 U.S. Tax Ct. LEXIS 23">*37 by proper refunds and credits to $ 967,452.30. ($ 966,952.30 plus $ 500.)

In the operation of an electric railway system petitioner is subject to regulations issued by the Pennsylvania Public Utility Commission and is required to keep its accounts in accordance therewith. Pursuant to such regulations, petitioner prepared its journal entry No. 1, "to Open the Books of Philadelphia Transportation Company on January 1, 1940." This was prepared in the late spring of 1940 as of January 1, 1940.

9 T.C. 1018">*1024 On journal entry No. 1 "To Open the Books of Philadelphia Transportation on January 1, 1940," under "Liabilities," the following entries were made:

1947 U.S. Tax Ct. LEXIS 23">*38 All of the said items are reflected in petitioner's opening balance sheet as of January 1, 1940.

The liability appearing in the journal entry as "Drexel & Co., Agent -- Exchange of Doylestown & Willow Grove St. Railway Co. 1st Mtge. Bonds $ 500.00" was paid on January 29, 1940, pursuant to court order in the adjustment in respect of 1939 made upon the exchange of petitioner's 3 per cent-6 per cent consolidated mortgage bonds for bonds of "Lessor Companies."

9 T.C. 1018">*1025 The liability appearing in the journal entry as "Drexel & Co. Agent -- Exchange of Lessor Companies Bonds for Phila. Transp. Co. 1st & Refunding 4% Bonds $ 22,172.06" was entered pursuant to court order in the adjustment in respect of 1939 made upon the exchange of petitioner's first and refunding mortgage 4 per cent bonds for bonds of the "Lessor Companies." This item was not claimed as a deduction from gross income on petitioner's 1940 return.

The liability appearing in the journal entry as "Fidelity-Phila. Tr. Co. Trustee-Fixed Interest for year 1939 on Phila. Transp. Co. Consolidated Mtge. Bonds Series 'A' $ 966,952.30' was paid as part of the item $ 977,112 paid by petitioner on January 29, 1940. It was computed1947 U.S. Tax Ct. LEXIS 23">*39 as follows:

The item appearing in the journal entry as "Income Interest on Phila. Transportation Co. Consolidated 3 per cent-6 per cent Bonds $ 820,225.18" constituted the variable payment on said bonds required to be made on July 1, 1940. It was computed at the rate of 2.52 per cent on $ 32,529,943.54 face amount of outstanding bonds in accordance with a report made to petitioner by Lybrand, Ross Brothers & Montgomery, certified public accountants, dated April 29, 1940.

In said report, Lybrand, Ross Brothers & Montgomery stated that:

* * * the holders of your company's Consolidated Mortgage 3%-6% Series A bonds, due January 1, 2039, are to receive income interest not to exceed three per cent based on the net income1947 U.S. Tax Ct. LEXIS 23">*40 for the calendar year 1939, under [the hypothesis that] the plan of reorganization being [became] effective as of January 1, 1939. We have stated the income account for the calendar year 1939 after giving effect to said plan. [Words in brackets supplied.]

Rentals payable by the Philadelphia Rapid Transit Co. to the "Lessor Companies" for 1939 in the amount of $ 7,470,817.80 and an interim payment of $ 700,000 paid to certain "Lessor Companies" in 1939 in connection with the reorganization proceedings and pursuant to an order of the Federal District Court having jurisdiction thereof, are not reflected in said report.

On June 28, 1940, petitioner delivered its check in the amount of $ 819,754.48 to the trustee for bondholders of the 3 per cent-6 per cent consolidated mortgage bonds, with direction to the trustee to pay to 9 T.C. 1018">*1026 the bondholders an amount equivalent to 2.52 per cent of the face amount of their respective bonds upon surrender for redemption of coupon No. 1 affixed to the bonds, which coupon was designated in the trust indenture as "Income Interest Coupon." This transaction was recorded on the books of petitioner by a debit of $ 819,754.58 against the liability1947 U.S. Tax Ct. LEXIS 23">*41 of $ 820,225.18 shown on journal entry No. 1. Said sum was paid to the bondholders on July 1, 1940.

In accordance with regulations of the Public Utility Commission of the Commonwealth of Pennsylvania, the payments of $ 966,952.30 and $ 500 and $ 819,754.58 were not charged as an expense in petitioner's accounts for 1940.

Petitioner accrued on its books in 1940 the fixed and income interest payments due with respect to the 3 per cent-6 per cent consolidated mortgage bonds and payable as follows:

It deducted these amounts on its tax return for the year 1940 as interest and respondent has allowed the deductions. These deductions are not in issue in this proceeding.

On its corporation income and declared value excess profits tax return for 1940 (Schedule 1-A "Reconciliation of Net Income Year Ending December 31, 1940") petitioner, among other items, subtracted the sum of $ 1,787,206.88 designated "Payment on Philadelphia Transportation Co. 3%-6% Consolidated Mortgage Bonds Schedule 12" from "Income per books" to arrive at "Net Income [loss] per Tax Return."

1947 U.S. Tax Ct. LEXIS 23">*42 On its Federal income tax return for the calendar year 1940 petitioner claimed as a deduction $ 1,787,206.88 ($ 967,452.30 paid in January 1940, plus $ 819,754.58 paid in July 1940) as interest paid in computing its 1940 taxable income [loss].

Petitioner's consolidated income and declared value excess profits tax return for the calendar year 1940 was filed on July 22, 1941, pursuant to an extension to August 15, 1941, of time for filing duly granted by the respondent on June 4, 1941. No waivers or extensions of the period for assessment were ever filed.

In determining petitioner's net operating loss deduction for 1942, respondent disallowed the item of $ 1,787,206.88 claimed as a deduction on the return in computing the net operating loss for 1940 to be carried over to 1942. Except for minor items in respect of which the parties are now in agreement, that disallowance is the cause of the deficiency.

By letter dated September 23, 1940, petitioner asked respondent for a specific ruling. A letter to petitioner dated October 9, 1940, signed "Timothy C. Mooney, Deputy Commissioner by L. K. Sunderlin, Chief of Section," stated:

9 T.C. 1018">*1027 Mr. Renner has requested a specific ruling with1947 U.S. Tax Ct. LEXIS 23">*43 regard to the treatment, for the purposes of the Federal income tax, of the amounts paid by your company as interest on its Consolidated Mortgage Bonds, the filing of ownership certificates on form 1012 with respect to such interest payments, and the withholding of tax at the source with regard to the interest payments made to nonresident alien stockholders.

and ruled:

* * * The distribution under consideration in the instant case is held to represent a payment of interest on an outstanding obligation. Accordingly, as the payments made in January 1940 represent payments of interest, ownership certificates are required with respect to such payments. Furthermore, tax at the prescribed rate must be deducted and withheld from all payments of interest made to nonresident alien bondholders. ( Section 143 (b) of the Internal Revenue Code and section 143 (b) of the Internal Revenue Code, as amended.)

On its return for 1940 petitioner reported a "Normal net income" (loss) of $ 3,077,666.75, computed as follows:

1947 U.S. Tax Ct. LEXIS 23">*44 The internal revenue agent in charge at Philadelphia, Pennsylvania, wrote petitioner under date of January 19, 1943, as follows:

In re: Income Tax Return

Year(s) covered: 1940

Upon examination of your income tax return(s) for the year(s) indicated above, the conclusion has been reached that it (they) should be accepted as filed.

I am sure you will appreciate that should subsequent information be received which would materially change the amount reported, it will be necessary under existing laws to redetermine your tax liability.

9 T.C. 1018">*1028 OPINION.

The respondent contends that the payments made by petitioner in the redemption of the 1939 coupons were not payments of interest; that the obligation to redeem the 1939 coupons did not accrue in 1940; that it was imposed in 1939 and became a fixed liability on November 14, 1939; that the 1939 coupons were to counterbalance the difference between 1939 rentals and the $ 700,000 ad interim payment; that the amount of $ 1,787,206.88 paid to redeem the 1939 coupons was computed on 1939 income; that it is treated on petitioner's books exactly in accordance with respondent's determination; that this obligation became fixed in 1939; that petitioner1947 U.S. Tax Ct. LEXIS 23">*45 may not in 1940 accrue "interest" on the same obligation for the years 1939 and 1940; and that the accrual of the alleged 1939 interest and the accrual of the actual 1940 interest as deductions from gross income of 1940 distorts petitioner's net operating loss for that year.

The petitioner contends that the amounts it paid in redemption of the 1939 coupons on its 3 per cent-6 per cent consolidated mortgage bonds constituted interest on indebtedness which accrued in 1940 and hence was deductible from gross income for that year. In the alternative it contends that the deductions claimed on its 1940 income tax return were allowed by the respondent within the meaning of the Internal Revenue Code, and respondent, therefore, erred in disregarding them in computing its income tax liability for 1942.

Section 23 (b) of the Internal Revenue Code permits a taxpayer to deduct all interest paid or accrued within the taxable year on indebtedness.

This Court has held in a number of cases, relied upon and cited by petitioner, that interest accrued or paid under circumstances substantially the same as those here involved is deductible. Columbia River Paper Mills, 43 B. T. A. 104;1947 U.S. Tax Ct. LEXIS 23">*46 affd., 126 Fed. (2d) 1009; Oregon Pulp & Paper Co., 47 B. T. A. 772 (petition for review dismissed, C. C. A., 9th Cir., Nov. 2, 1943); Ernst Kern Co., 1 T.C. 249; Pressed Steel Car Co. v. Commissioner, 152 Fed. (2d) 280, affirming, per curiam, Tax Court memorandum opinion, Docket No. 107623, August 16, 1944. The Circuit Court of Appeals for the Seventh Circuit reached a contrary conclusion on similar facts in Commissioner v. Drovers Journal Publishing Co., 135 Fed. (2d) 276. The latter case is relied upon by the respondent.

The above cited cases, excluding the Drovers case, which we respectfully decline to follow, require that our decision on the issue presented for our consideration be in favor of petitioner. Having reached this conclusion, no useful purpose would be served by any detailed discussion of the respondent's contentions and argument. Suffice to say that we do not have before us the question of the tax treatment to be 9 T.C. 1018">*1029 accorded purchase money applied to an indebtedness existing prior to the acquisition1947 U.S. Tax Ct. LEXIS 23">*47 of property, or an instance where property was acquired subject to the obligation of a third party. Cases such as Pratt-Mallory Co. v. United States (Ct. Cls.), 12 Fed. Supp. 1020, 1023; Rodney, Inc. v. Commissioner, 145 Fed. (2d) 692, affirming 2 T.C. 1020; Koppers Co., 3 T.C. 62; affd., 151 Fed. (2d) 267; Magruder v. Supplee, 316 U.S. 394">316 U.S. 394; Automatic Sprinkler Co. of America, 27 B. T. A. 160, cited by respondent, do not, therefore, have any application here. The plan of reorganization does not contain any provision imposing upon petitioner, as the new company, a liability to discharge the obligation of any other party to the reorganization to pay rentals or interest. When petitioner made the payments in redemption of the 1939 coupons it was paying its own obligation -- not that of another party. The 3 per cent-6 per cent consolidated mortgage bonds constituted an indebtedness of petitioner. These bonds and the coupons in redemption of which the payments in1947 U.S. Tax Ct. LEXIS 23">*48 controversy were made, all required the payment of the questioned sums as interest. The respondent himself recognized that these payments constituted interest when, on October 9, 1940, in advising petitioner that it was required to withhold income tax on payments made to nonresident alien bondholders, he said: "The distribution under consideration in the instant case is held to represent a payment of interest on an outstanding obligation." Inasmuch as petitioner did not come into existence until 1940, did not issue its bonds until 1940, did not exchange them with the depositing security holders in the reorganization proceedings until 1940, and did not actually undertake any liability until all these things had taken place, it was impossible for the interest to accrue prior to 1940. Inherent in the accrual of an obligation is the existence of an obligor, and petitioner's obligation accrued in 1940 when it came into existence and was legally capable of contracting obligations. We hold that the petitioner properly accrued and deducted in its income tax return for 1940, interest in the amount of $ 1,787,206.88 which it paid in that year.

Having reached this conclusion, we deem it unnecessary1947 U.S. Tax Ct. LEXIS 23">*49 to discuss or decide the petitioner's alternative contention.

Decision will be entered under Rule 50.