Newlyn Coal Co. v. Commissioner

NEWLYN COAL CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

MEADOW FORK COAL CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Newlyn Coal Co. v. Commissioner

Docket Nos. 9753, 9770.

United States Board of Tax Appeals

9 B.T.A. 835; 1927 BTA LEXIS 2503;

December 23, 1927, Promulgated

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1. The Newlyn Coal Co. purchased an electric locomotive in 1917 at a cost of $2,959.25 and claimed as a deduction from gross income in its 1919 tax return the cost of the locomotive less scrap value, $100. The locomotive was unsatisfactory in operation and was discontinued in use about the middle of 1917. Two or three years later it was rebuilt and used for a number of years. Held that the amount claimed as a deduction from gross income of 1917 was properly disallowed by the Commissioner.

2. The March 1, 1913, value of the leaseholds held by the petitioners and of the improvements made upon the leased premises determined; also the profit upon the sale of the Meadow Fork Coal Co. leasehold and the improvements thereon in 1917 determined.

3. The refusal of the Commissioner to determine the petitioners' tax liability for 1917 under section 210 of the Revenue Act of 1917 sustained.

W. L. Harrison, C.P.A., and J. B. Grice, C.P.A., for the petitioners.

C. H. Curl, Esq., for the respondent.

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SMITH

These are proceedings for the redetermination of deficiencies in income and profits tax for the year 1917 in the amount of $2,235.66 in the case of the Newlyn Coal Co., and in the amount of $1,750.76 in the case of the Meadow Fork Coal Co. The proceedings were consolidated for hearing and decision. The principal point in issue is the profit, if any, made by the Meadow Fork Coal Co. upon the sale of its lease, together with improvements upon leased premises for $90,000 in 1917. There is also the question of the cost of capital assets in the case of the Newlyn Coal Co. which may be charged off over the life of the lease and the correct amount deductible from gross income for exhaustion for the year 1917.

FINDINGS OF FACT.

The petitioners are two affiliated West Virginia corporations which were organized in 1904 by the same organizers and stockholders for the purpose of leasing two contiguous tracts of undeveloped coal lands in Fayette County, West Virginia, and for development and operation of the same. The lands were leased on April 1, 1904, and October 1, 1904, by the Newlyn Coal Co. and the Meadow Fork Coal Co., respectively, the tract leased by the former containing 456.36 acres and the tract leased by the latter 613.7 acres. Each of the leases was for a period of 25 years and both were from the same lessor, the McKell Family interests of Fayette County, West Virginia. The leaseholds were located in the Loup Creek District (which is in Fayette County, West Virginia) of the New River Smokeless Coal Field and were underlaid with what is known as the "Sewell," "Fire Creek," and several other coal seams, the only workable seams being the "Sewell" and "Fire Creek" seams. All of the other coal lands in the immediate vicinity of the petitioners' leaseholds had been leased prior to 1904. The coal in the leased tracts was very high-grade bituminous coal. The coal seams, however, were high up on the side of a mountain and any coal produced had to be lowered to the railroad track, which was from 300 to 500 feet below the tipples which might be built at the mouth of the mines for shipment.

Each of the petitioners was incorporated with a capital stock of $25,000. The shares of stock were subscribed for and paid up in cash at par by members of the "Thomas" Family. The leases had been acquired without payment of any cash bonus. Each lease provided for a royalty payment of 10 cents per gross ton of coal mined and sold and the leases provided for a minimum annual royalty payment of $4,000 in the case of the Newlyn Coal Co. and of $6,000 in the case of the Meadow Fork Coal Co., such minimum royalty payments to commence one year after the date of the lease, and the leases provided that in case the royalties actually accruing at the rate of 10 cents per ton of coal mined did not in any year equal the minimum royalty payment the excess of the minimum royalty payment for such year would be applied against the royalty payment due for the succeeding year in excess of the minimum royalty payment; but that any such credit for royalty payments not applied to such excess of the succeeding year lapsed in favor of the lessors. The surface of the leased lands was well timbered and the lease provided that the lessees could cut timber for mining operations where the timber was less than 20 inches in diameter, 2 feet from the ground. The leases also provided that certain kinds of timber, such as walnut and ash, were reserved to the lessors.

After acquiring their leases the petitioners began operations for mining coal. The $25,000 in the treasury of each company was soon exhausted in making improvements on the lease and the stockholders contributed additional amounts. The Newlyn Coal Co. began the mining of coal in a small way in 1905 or 1906, and the Meadow Fork Coal Co. mined its first coal in September, 1906. The former company mined on the "Fire Creek" seam and the latter on the "Sewell" seam. The former company soon ran into a "fault" in its mining operations which, at the time, was believed to be local in character. It was necessary for the company to either tunnel through this fault or else abandon its mine. In 1907 it began to tunnel through the fault and did not get through the same until 1910. The cost of this tunneling was approximately $35,000.

The petitioners kept their accounts and records on the basis of cash received and disbursed for the year 1917 and prior years and so reported their income on the Federal income and profits-tax return forms furnished them. They did not, prior to 1918, keep regular books of account such as ledgers and journals. The records kept consisted of prime papers, documents, and original records of transactions.

In 1906 or 1907, the petitioners were offered $200,000 for their leaseholds and the improvements thereon. The offer was rejected for the reason that the stockholders of the petitioners were of the opinion that the mines were more valuable.

In no year prior to 1917 did either of the petitioners mine as large a quantity of coal as was necessary to meet their minimum royalties at the rate of 10 cents per ton of coal mined. The production of the Meadow Fork Coal Co. reached its highest point in 1910, when 35,248 tons were mined. In 1913 only 22,467 tons were mined and in 1915 only 20,090 tons. In the schedule for valuation of coal properties filed with the respondent in 1922, for the year 1917, the Meadow Fork Coal Co. stated the number of tons mined for each of the years 1919 to 1917, inclusive, and stated under "Royalty paid per ton," the following:

Average about 20 cents per ton on the basis of $6,000 a year minimum royalty.

A report of an audit of the accounts and records of the Newlyn Coal Co. made by an accountant in 1924, states that the depreciated cost of the coal company's leasehold and improvements, including tools and livestock, at January 1, 1917, was $73,085.82 and that a corresponding figure for the Meadow Fork Coal Co. at January 1, 1917, was $58,959.17. The March 1, 1913, depreciated cost of the same classes of assets in the case of each company was about the same as at January 1, 1917.

In 1916 the Newlyn Coal Co. ordered an electric locomotive for the purpose of hauling coal cars from the interior of the mine to the tipple. The manufacturer demanded payment in 1917 but the petitioners at first refused payment upon the ground that the locomotive did not perform the work which it was guaranteed to perform. Upon a promise by the manufacturer that it would remedy the defects in the locomotive or take it back, the Newlyn Coal Co. in 1917 paid the purchase price, namely, $2,959.25. The manufacturer then sent its expert repairman to the mine. He worked for approximately two months in an effort to get the locomotive to function properly. He was unable to accomplish this result, however, and in the middle of the year 1917 the Newlyn Coal Co. discontinued its use. It was not until two or three years later that the Newlyn Coal Co. and the manufacturer entered into an agreement whereby each was to stand 50 per cent of the cost of rebuilding the locomotive. After the locomotive was rebuilt it was used for a period of two or three years and was not finally discarded until 1923.

The Meadow Fork Coal Co. sold its leasehold with all developments, improvements and coal-mining rights thereon on July 16, 1917, for $90,000. In determining a deficiency for the year 1917 the respondent appraised the value of the leasehold at $54,204 less 30 per cent depreciation, leaving $37,942.80, to which he added an item of "Royalties Payable" in the amount of $23,240.94, which then gave a net base amount of $61,183.74 as the cost or March 1, 1913, value, of the leasehold, whichever is higher, and from which he computed a profit on the sale of the leasehold of $28,816.26. The depreciated cost of the improvements and developments on January 1, 1917, was $58,959.17. On that date the Meadow Fork Coal Co. owed the lessor $23,240.94 accumulated royalty from 1906 to 1917, inclusive, and $528.51 for timber taken off the leased premises in 1906, which it was not privileged to take under the lease. The basis for determining the profit upon the sale of the leasehold is, therefore, $82,728.62.

The surplus of the Newlyn Coal Co. at January 1, 1917, was $45,541.49 and of the Meadow Fork Coal Co., $29,247.

The profit realized by the Meadow Fork Coal Co. was not distributed to its stockholders during 1917, but was retained in its own treasury and used for the purpose of meeting its liabilities and for strengthening the credit of both petitioners.

OPINION.

SMITH: The deficiencies determined by the Commissioner are predicated upon the basis of the affiliation of the petitioners for the year 1917. The petitioners in their appeals and by amendments at the trial assigned the following errors, which are in issue in these proceedings:

1. Respondent allowed petitioners, as a deduction under section 203(a) of the Revenue Act of 1917, 7 per cent of the invested capital as a prewar credit in computing the excess profits deduction for 1917, instead of a 9 per cent deduction.

2. Respondent disallowed an item of $2,859.25, representing the cost to the Newlyn Coal Co., less scrap value, of an electric locomotive purchased and paid for in 1917, which was charged to expense in that year.

3. Respondent failed to allow, in the computation of petitioner's taxable income for the year 1917, the fair market value as of March 1, 1913, of the coal mining leasehold, including developments and improvements, of Newlyn Coal Co.

4. Respondent failed to allow, in the computation of petitioner's taxable income for the year 1917, the fair market value as of March 1, 1913, of the coal mining leasehold, including developments and improvements, of Meadow Fork Coal Co.

5. Respondent failed to allow depreciation, on the fair market value at March 1, 1913, of the developments and improvements on the leasehold of the Newlyn Coal Co. in computing its 1917 income.

6. Respondent failed to allow amortization, on the fair market value as of March 1, 1913, of the coal mining rights of the lessee, Newlyn Coal Co., in computing its 1917 income.

7. Respondent failed to allow depreciation, on the fair market value at March 1, 1913, of the developments and improvements on the leasehold of the Meadow Fork Coal Co. in computing its 1917 income.

8. Respondent failed to allow amortization, on the fair market value as of March 1, 1913, of the coal mining rights of the lessee, Meadow Fork Coal Co., in computing its 1917 income.

9. Respondent failed to include in the invested capital of the consolidation for the year 1917 the earned surplus of each corporation at January 1, 1917.

10. Respondent prorated the invested capital of the Meadow Fork Coal Co. from January 1, 1917, to July 16, 1917, instead of including the invested capital for the whole year 1917.

11. Respondent computed profit from the sale of the Meadow Fork Coal Co. leasehold on July 16, 1917 on a fictitious cost or value, instead of on the fair market vale as of March 1, 1913, less depreciation and amortization to said date of the sale.

12. Respondent added to the cost of the leasehold sold by the Meadow Fork Coal Co. an item of $23,240.94, representing royalities paid lessor in 1917, instead of deducting this expenditure as an operating cost for 1917.

13. Respondent by a mathematical error in his computation overstated, by an amount of $7,292.95, the profit in the year 1917 from the sale of the Meadow Fork Coal Co. leasehold.

14. Respondent failed, after committing the foregoing errors, to give petitioners the benefit of special relief, under section 210 of the Revenue Act of 1917, in the computation of their profits-tax liability for the year 1917.

1. We are satisfied from the evidence that the petitioners had no earnings or at least less than 7 per cent upon their invested capital during the prewar period. The denial by the respondent of a higher prewar credit than 7 per cent on invested capital is sustained.

2. The Newlyn Coal Co. claims to have sustained a loss in 1917 by reason of the improper functioning of an electric locomotive and that the amount of the deductible loss is the cost thereof less $100 for scrap value. We are of the opinion that the evidence does not prove a loss of this locomotive in the year 1917.

3-8, inclusive. The principal contentions of the petitioners are that the respondent has failed to allow the fair market value on March 1, 1913, of the petitioners' leaseholds, including developments and improvements, for the purpose of computing an exhaustion allowance for 1917 and also for the purpose of computing profit upon the sale of the Meadow Fork Coal Co. leasehold on July 16, 1917. The petitioners have no books of account from which the depreciated cost of development and improvements can be determined. They have submitted the testimony of numerous witnesses and mining men as to the fair market value of such improvements and also of the value of the coal-mining rights. Upon the basis of such evidence the Newlyn Coal Co. claims that the value of its developments and improvements at March 1, 1913, was $100,000 and the value of its coal-mining rights was $42,696, and the Meadow Fork Coal Co. claims that the value of its mine developments and improvements on March 1, 1913, was $100,000 and the value of the coal-mining rights, $76,858.80. An accountant, after a painstaking investigation of such records as the petitioners had in 1924, determined that the depreciated cost of the leasehold improvements, including tools and livestock of the Newlyn Coal Co., was on January 1, 1917, $73,085.82, and of the Meadow Fork Coal Co. on the same date was $58,959.17. We are of the opinion that these figures constitute as nearly as can be determined the depreciated cost of the leasehold improvements at January 1, 1917. We are also of the opinion that on March 1, 1913, the value of such leasehold improvements was not in excess of these figures, exhaustion and depreciation being taken into consideration in reaching such March 1, 1913, values.

The petitioners' claim for a value for their leases on March 1, 1913, in excess of the depreciated cost of the improvements is not sustained by the evidence. The value of $42,696 for the coal-mining rights of the Newlyn Coal Co. on March 1, 1913, was determined by an engineer, who was a witness for the petitioner, upon the assumption that the lessee had a right to mine coal from the lease for a period of 25 years from March 1, 1913, whereas it had that right for a period of only 16 years. The determinations of the values for these mining rights appear also to have been predicated upon the supposition that the per-ton royalty was only 10 cents and that this was somewhat less than the royalties paid by other lessees in the same district. The record shows, however, that it was not practicable or possible with the equipment of the mines to produce the minimum amount of coal which was necessary to meet the minimum royalties at the rate of 10 cents per ton. An engineer testifying for the petitioners stated that these small mines would not warrant the investment of a large amount of money in equipment to produce a large tonnage at these mines. The royalties actually paid during all the years up to 1917 were the equivalent of approximately 20 cents per ton and apparently for some years considerably in excess of that amount. The person who offered $200,000 for the leaseholds in 1906, or 1907, did not undertake to testify as to the value of the leaseholds in 1913. The offer made in 1906 was apparently for the purpose of controlling the market price of coal in the Loup District of West Virginia. The evidence would indicate that at that time there was a prospect that the mines could and would be operated successfully. The experience of the petitioners, however, up to 1913 was that the mines were operated at only a small profit, if any. In the light of all of the evidence, we are of the opinion that the petitioners are not entitled to deduct from the gross income of 1917 any amount upon an assumed value of the mining rights at March 1, 1913. The only allowances for exhaustion and depreciation to be spread over the life of the leases are those based upon the depreciated cost of the improvements and developments on January 1, 1917.

9 and 10. The ninth issue is as to the inclusion of the surplus in the invested capital on January 1, 1917, of the two companies, namely, the Newlyn Coal Co. and the Meadow Fork Coal Co., of $45,241.49 and $29,247, respectively, making a total surplus in the consolidation of $74,788.49. The tenth issue is the right of the Meadow Fork Coal Co. and the consolidation to have the benefit of the invested capital of the Meadow Fork Coal Co. for the entire year 1917, instead of prorating such invested capital from the sale of the leasehold and improvements on July 16, 1917, as has been done by the Commissioner.

The petitioners are sustained upon both of these points.

11 and 12. The Meadow Fork Coal Co. sold its lease and improvements thereon in 1917 for $90,000. The depreciated cost on January 1, 1917, of the improvements, including tools and livestock, was $58,959.17. The company also owed $23,240.94 back royalties and $528.51 for timber cut off the land in 1906, contrary to the terms of the lease. The sum of these three amounts is $82,728.62. Petitioner received $90,000 from the purchaser. The difference represents the profit upon the sale of the mining property. The petitioners make much of the fact that in the determination of the deficiency the respondent has added to the cost of the leasehold sold $23,240.94, representing royalties paid by the petitioner in 1917, instead of deducting this expenditure for an operating cost in 1917. This proposition is as broad as it is long, however, upon the basis of the facts found. The result is the same whether it be added to the cost of the leasehold or treated as an operating expense for 1917.

13. This issue relating to a mathematical error by the respondent in the computation of the profit from the sale of the Meadow Fork Coal Co. leasehold appears to be well founded. It will be settled under Rule 50.

14. The petitioners contend that the respondent has failed to give them the benefit of special relief under section 210 of the Revenue Act of 1917 in the computation of their profits-tax liability for 1917. We are of the opinion that the evidence does not establish that the invested capital can not be satisfactorily determined and a determination of the tax under section 210 is not warranted.

Judgment will be entered on 15 days' notice, under Rule 50.

Considered by TRUSSELL, LOVE, and LITTLETON.