14 T.C. 1375">*1375 This proceeding involves deficiencies in income taxes for the years 1942, 1943, 1944, and 1945 in the amounts of $ 55.86, $ 2,124.73, $ 2,677.95, 14 T.C. 1375">*1376 and $ 2,340.06, respectively. The issues raised by the pleadings, and not abandoned or settled by stipulation, are whether a loss sustained on stock in 1943 is deductible as an ordinary loss or as a capital loss, and whether gain realized in the disposition of certain notes in 1944 is taxable as ordinary income or as long term capital gain. Petitioner alleges that it overpaid its income taxes for the years 1942, 1943, and 1944. From the stipulation of facts, which is incorporated herein by reference, and other evidence, we make the following findings of fact.

FINDINGS OF FACT.

The petitioner is and has been since 1927 a national bank engaged1950 U.S. Tax Ct. LEXIS 134">*136 in the commercial business of banking within the meaning of section 104 of the Internal Revenue Code, with its principal office in Mobile, Alabama. During the taxable years it kept its books and filed its returns with the collector at Birmingham, Alabama, on an accrual basis.

In 1933 the petitioner was affiliated with the Merchants Securities Corporation, which was engaged in activities, including dealing in securities, which could not be done by petitioner. The Banking Act of 1933 provided for a termination of the affiliation by June 16, 1934.

On May 31, 1934, the properties of the Merchants Securities Corporation, including capital stock of the Dorgan-McPhillips Packing Corporation, except its office building, were transferred to the petitioner, as trustee, for the purpose of liquidating the assets. The instrument of transfer empowered the trustee to operate the trust property to the best interests of the beneficial owners of the stock of the grantor, and to sell the property at such prices and on such terms as it considered proper, paying out of the proceeds thereof liabilities of the grantor, including deficits in the operation of the office building. The trust instrument 1950 U.S. Tax Ct. LEXIS 134">*137 contained a provision reading as follows:

Upon the payment of the liabilities of the Merchants Securities Corporation, said Trustee shall carry and transfer any overplus of the proceeds derived from the sale of said assets of the trust estate to the Undivided Profits Account of The Merchants National Bank of Mobile. Said The Merchants National Bank of Mobile, a National Banking Association, may acquire from itself as Trustee under this deed, after payment of all liabilities of the Merchants Securities Corporation, any or all of the remaining assets of the Merchants Securities Corporation, for such consideration as it deems wise, or for no consideration at all. When all of said assets of the Merchants Securities Corporation are disposed of by said Trustee, this trust shall terminate, and the Trustee shall be fully absolved and discharged as such.

The provisions of the trust instrument were explained to the chief bank examiner of the district in which petitioner's bank was located, and it was never criticized for its handling of the dissolution and transfer of assets.

14 T.C. 1375">*1377 The petitioner, as liquidating trustee, satisfied the liabilities of the grantor by March 31, 1937, when1950 U.S. Tax Ct. LEXIS 134">*138 it transferred the remaining unliquidated assets to itself as a commercial banking institution, including the stock of the Dorgan-McPhillips Packing Corporation, in accordance with the provisions of the trust instrument. Prior to the transfer one of the officers of petitioner examined the affairs of the Dorgan-McPhillips Packing Corporation to determine what should be done with the stock. Petitioner decided that it was an inopportune time to dispose of the stock and that it would be to its interest to hold the security until such time as it could be determined whether the earnings of the corporation would improve and market value of the stock would increase.

A deputy commissioner, on September 7, 1943, issued a letter ruling, addressed to the First National Bank of Boston, Boston, Mass., reading as follows:

Reference is made to Bureau letter dated July 19, 1943, in reply to your letter dated June 4, 1943. As a result of an informal conference held in this office recently further consideration has been given to that portion of your inquiry relating to the application of Office Decision (IT) 3600, Internal Revenue Bulletin No. 4, 55, published under date of February 25, 1943, to 1950 U.S. Tax Ct. LEXIS 134">*139 stocks acquired by your bank as a result of the liquidation of a security affiliate and as a result of a reorganization of a corporation whose bonds were held by the bank.

Office Decision (IT) 3600 has specific reference to the sale of personal property taken over by the bank, mortgage finance company, building and loan association, or insurance company in satisfaction of debts. It was held that such property was held "primarily for sale to customers in the ordinary course of * * * trade or business" within the meaning of section 117 (a)1 of the Internal Revenue Code, as amended, and the gains derived or losses incurred in such sales are to be treated as ordinary gains or losses and not as capital gains or losses.

In the situation referred to by you the personal property was acquired by the bank by virtue of the liquidation of the assets of the affiliate, which was engaged in the security business, and which was required to liquidate since The National Bank Act prohibited the continuation of the affiliation. Such Act also requires the sale, within a reasonable time, of the assets received, such assets consisting principally of stocks of various companies.

The stocks in question 1950 U.S. Tax Ct. LEXIS 134">*140 were apparently acquired by the affiliate primarily for resale to the customers in the ordinary course of the trade or business of the affiliate.

When the bank was required to take over such stocks, it was also required by The National Bank Act to dispose of such stocks as soon as possible.

After further consideration, it is the opinion of this office that the bank, due to the manner of acquisition of the stock, was placed in the same position, in respect of such stock, as that of the affiliate. It follows, therefore, that the bank held the stock "primarily for sale to customers in the ordinary course of * * * trade or business" and the gains and losses resulting from the sale constitute ordinary gains and losses.

In the case in which stocks of a corporation were acquired by the bank in satisfaction of bonds and other evidences of indebtedness, it is the opinion of this office that the rule laid down in Office Decision (IT) 3600 applies.

14 T.C. 1375">*1378 The conclusions stated in Bureau letter dated July 19, 1943, are, accordingly, modified as indicated herein.

The stock of the Dorgan-McPhillips Packing Corporation had a cost basis on March 31, 1937, of $ 43,770.17. Upon the liquidation1950 U.S. Tax Ct. LEXIS 134">*141 of the corporation in 1943 the petitioner received $ 2,380.65 for the stock. In its return for 1943, petitioner claimed the amount of $ 41,389.52 as a deduction for an ordinary loss sustained on the stock, citing the ruling made on September 7, 1943. The revenue agent held that as it did not appear that petitioner acquired the stock in satisfaction of a debt, the letter ruling made on September 7, 1943, was not applicable. In his determination of the deficiencies the respondent held that the stock was a capital asset within the meaning of section 117 (a) (1) of the Internal Revenue Code, and that the loss was a long term capital loss.

On January 1, 1941, there was a balance of $ 49,025 unpaid on notes petitioner held for loans made to the Alabama Naval Stores Co. Upon specific instructions given by national bank examiners, $ 20,000 of the unpaid amounts was charged off as bad debts in 1941 and the remainder in 1943. At those times petitioner agreed that the notes were worthless and should be charged off. Deductions for the charge-offs were allowed in full by the Commissioner in the years claimed and resulted in reductions of taxable income in the amount charged off each year.

1950 U.S. Tax Ct. LEXIS 134">*142 After the notes were fully charged off, petitioner held them at a zero basis as bad debts charged off. They were not shown in any books of petitioner.

In April or May 1944 petitioner received a letter from H. M. Hempstead in which he said that he would be interested in purchasing the notes, provided he was able to purchase from other creditors of the Alabama Naval Stores Co. the remaining obligations of that corporation for $ 25,000. The proposal was accepted by all the creditors and on July 1, 1944, petitioner assigned its notes to the order of H. M. Hempstead without recourse, receiving therefor the amount of $ 18,460.58.

Petitioner had not previously for about twenty years, and since then has not, assigned a note for a consideration which had been previously charged off as worthless.

The consideration of $ 18,460.58 was reported by the petitioner in its return for 1944 as long term gain. In his determination of the deficiencies the respondent held that the amount was taxable as ordinary income.

The income tax returns of the petitioner for the taxable years were timely filed and the tax shown to be due thereon, namely, $ 2,474.24 in 1942, $ 44,003.62, including $ 98.32 declared1950 U.S. Tax Ct. LEXIS 134">*143 value excess profits taxes, 14 T.C. 1375">*1379 in 1943, $ 74,632.59 in 1944, and $ 112,832.99 in 1945, was paid in each instance in quarterly installments the succeeding year. Timely waivers were given by the petitioner extending to June 30, 1948, the time within which to assess additional taxes against it for 1942. Waivers were also signed extending to the same date the time within which to assess additional taxes against the petitioner for the years 1943 and 1944.

On December 27, 1948, the petitioner filed claims for refunds for the years 1942, 1943, and 1944 in the amounts of $ 284.17, $ 3,728.61, and $ 354.78, respectively, with interest thereon.

OPINION.

Petitioner insists that the respondent should have followed the ruling made by him on September 7, 1943, and allowed the loss sustained by it on the Dorgan-McPhillips Packing Corporation stock as an ordinary loss. Respondent asserts that the ruling is not applicable since the petitioner was not compelled to acquire the stock and did not acquire the asset in direct liquidation of the Merchants Securities Corporation. Petitioner argues that the intervening trust does not make the situation any different from what it would have been1950 U.S. Tax Ct. LEXIS 134">*144 if it had received the assets directly from its affiliate.

The ruling is based upon a situation where the bank is not only required to take over stock but to dispose of it as soon as possible. Here the trustee was empowered to sell the assets and required to distribute to petitioner any surplus funds after liquidating liabilities. Petitioner had a right to acquire with or without consideration assets remaining after all liabilities had been satisfied. We find nothing in the instrument compelling it to take over the assets at any time.

The ruling contemplates a requirement that the asset be sold as soon as possible. Upon receipt of the stock in 1937, petitioner elected to hold it for a higher market. That conclusion discloses intention to hold the asset as an investment rather than as property held primarily for sale to customers in the ordinary course of its business or as a business of the transferor. Holding an asset for six years can not reasonably be said to be within the requirement of the ruling. Moreover, no proof was made by petitioner that it endeavored to sell the stock or held it primarily for sale.

Petitioner argues that if the letter ruling is not applicable, I. 1950 U.S. Tax Ct. LEXIS 134">*145 T. 3600, 1943, C. B. 369, requires a holding in its favor. That ruling relates to property taken over in satisfaction of debts, a method of acquisition materially different from the manner in which the stock in question was acquired.

We find no error in respondent's action in treating the loss as a long term capital loss.

14 T.C. 1375">*1380 The difference between the parties on the second issue is whether the amount of $ 18,460.58 realized in the transaction is taxable as long term capital gain, as contended by petitioner, or as ordinary income, as determined by the respondent.

The petitioner argues that there were two distinct transactions in different years, first a charge-off of the notes as bad debts, and then a sale of the notes, a capital asset having a zero basis for tax purposes. It cites Rockford Varnish Co., 9 T.C. 171, Stanley Switlik, 13 T.C. 121, and similar cases as containing reasoning which requires a conclusion here in its favor, and Conrad N. Hilton, 13 T.C. 623, as governing the issue.

In the Rockford Varnish Co. case the notes were received in the ordinary course of the1950 U.S. Tax Ct. LEXIS 134">*146 taxpayer's business in payment of open accounts and not acquired for holding as an investment. Later the notes were sold at a loss. The notes not having been held primarily for sale to customers in the ordinary course of the taxpayer's business, it was held that they constituted capital assets within the meaning of section 117 (a) (1) of the Internal Revenue Code.

In the Stanley Switlik case it was held that taxes paid by the taxpayers as transferors of assets of a corporation in complete liquidation constituted an ordinary loss, and not a capital loss.

The Hilton case follows the same general lines as the Rockford case. There the taxpayer received a note in exchange for a judgment which he had obtained against the maker and, after payments had been made on the principal, sold it to a bank. The question of whether ordinary income or capital gain was realized on the transaction with the bank turned on whether the note was disposed of in a bona fide sale or whether the amount received constituted payment of the note by the maker thereof. It was held that part of the amount received was in substance paid to the taxpayer by the maker and that the remainder was a sale 1950 U.S. Tax Ct. LEXIS 134">*147 of $ 100,000 of the face amount of the note, a capital asset.

The Rockford and Hilton cases involved sales of notes constituting capital assets, without a prior history of charge-offs and deductions from gross income with tax benefit. Here the full amount of the notes was charged off in prior years, and as a result the securities had no basis in the hands of the petitioner. The difference in facts is material.

The cost or capital petitioner had in the notes was recovered in prior years by the charge-offs with full tax benefit. Thereafter the notes, given for loans, ceased to be capital assets but represented income. National Bank of Commerce of Seattle v. Commissioner, 115 Fed. (2d) 875, affirming 40 B. T. A. 72. In that case the taxpayer acquired assets in a plan of reorganization, including some notes which 14 T.C. 1375">*1381 had been charged off earlier in the year by the transferors and had a zero basis in the hands of the transferee. In the course of its opinion holding that recoveries made by the transferee on the notes charged off by the transferors constituted income, the court said:

* * * However, when such1950 U.S. Tax Ct. LEXIS 134">*148 a loan becomes worthless, the amount thereof is loss of capital, but the income tax laws permit the bank to recoup its capital by deducting from the profits or income the amount of the loss. Thus the bank does not pay a tax on all its income, but on the amount of income less the loss on the worthless debt. The debt itself then loses its nature as capital, but represents that portion of the income which is not taxed, and the capital is the money taken from the profits or income. If the loan, after being deducted from income, is paid, then the lender is receiving profit or income -- otherwise the lender would double its capital on one transaction. In other words, the profits or income used to pay back the capital when the debt is charged off is represented by the worthless loan, so that when such loan is paid the profits are replaced.

* * * *

Thus, if the recoveries in question had been made by the smaller banks, they would of necessity been included in the returns as income.

* * * While the loans were not capital assets in the hands of the smaller banks, upon sale to petitioner, such loans became capital assets in petitioner's hands. * * *

In Commissioner v. First State Bank of Stratford, 168 Fed. (2d) 1004,1950 U.S. Tax Ct. LEXIS 134">*149 the taxpayer declared and paid a dividend in kind consisting of notes which it had in previous years charged off as worthless and deducted as bad debts. Recoveries were made on the notes later during the same year by the stockholders. The question was whether the recoveries thus made were income to the bank. The court, in holding that the recoveries represented income taxable to the bank, cited and quoted from the National Bank of Commerce case with approval, and remarked that the notes were assets of the bank in the sense that they represented potential income to the extent of the deduction previously allowed in taxes, but "were not capital assets for income tax purposes"; that in assigning the notes without recourse, "the bank assigned its vested right to receive the income that the notes represented" and that the property distributed as a dividend represented income and not a capital asset.

Petitioner seeks to distinguish the National Bank of Commerce and First State Bank of Stratford cases upon the ground that the payments there were made by the debtors and therefore the income was not received out of a sale to a third party. We are unable to agree with the view. 1950 U.S. Tax Ct. LEXIS 134">*150 The notes here ceased to be capital assets for tax purposes when they took on a zero basis as the result of deductions taken and allowed for charge-offs as bad debts.

Considering the matter realistically, as we must, petitioner recovered a portion of the amount that had previously reduced ordinary taxable income and the amount can not effectively offset the advantage so obtained without according it like treatment. As the court said 14 T.C. 1375">*1382 in Rice Drug Co. v. Commissioner, 175 Fed. (2d) 681, affirming 10 T.C. 642: "The 'recovery of bad debts' envisages the whole cycle of a claim becoming worthless and later being recovered by the same taxpayer, or perhaps one standing in his shoes, with the usual attending accounting and legal consequences." A sale of the right to receive income to other than the debtor did not alter the character of the asset from which the income was derived. To hold otherwise would place form above substance, contrary to the well established rule. The substance of the transaction was a recoupment of ordinary income which had escaped taxation by bad debt deductions.

In the Hilton case the1950 U.S. Tax Ct. LEXIS 134">*151 note was a capital asset when sold, contrary to the situation here.

The reasoning of the National Bank of Commerce of Seattle and First State Bank of Stratford cases controls the question. Accordingly, we sustain the respondent on this issue.

To reflect adjustments agreed to in the stipulation,

Decision will be entered under Rule 50.