Before Duffy and Knoch, Circuit Judges, and Grubb, District Judge.
This is a petition for review of a decision by the tax court disallowing certain deductions by the petitioner in the years 1953 and 1954. There are two issues, one involving the preferred stock of the petitioner and the other involving its accounting method.
Petitioner is a corporation organized on October 7, 1952, under the laws of the State of Wisconsin. It filed its returns for the taxable years 1953 and 1954 with the Director of Internal Revenue for the District of Wisconsin. It kept its books of account and filed its Federal income tax returns in accordance with an accrual method of accounting and on the basis of calendar years.
In the year 1952 and for several years prior thereto, the public passenger transportation system in the City of Milwaukee and its environs was owned and operated by the Milwaukee Electric Railway and Transport Company (hereinafter called the "Transport Company") which was a wholly owned subsidiary of the Wisconsin Electric Power Company (hereinafter called the "Power Company"). Both the parent and the subsidiary were Wisconsin corporations, and the parent also was a registered public utility holding company subject to the provisions of the Federal Public Utility Holding Company Act of 1935 (Title 15 U.S.C.A. § 79).
During the 1940's the management of the Power Company and of the Transport Company came to realize that by reason of the provisions of the Public Utility Holding Company Act of 1935, it would be necessary to remove the public passenger transportation properties owned by the subsidiary Transport Company from the holding company system of the parent Power Company.
On December 30, 1952, the petitioner purchased the transportation facilities of the Transport Company. The purchase price of $10,000,000 was payable in the following manner: $4,000,000 in cash to be raised by the sale of bonds to outside parties which would be secured by a first mortgage on the assets; $3,000,000 of the petitioner's promissory notes to be issued to the Transport Company and which were secured by a second mortgage; and $3,000,000 in preferred stock to be issued to the Transport Company. In addition, the organizers of the petitioner were to invest a total of $500,000 in common stock of the petitioner in order to supply working capital.
The tax court found as fact that:
"* * * it was the belief of the parties that, if the issuance of the securities by the purchasing corporation was to receive the required approval of the Public Service Commission of Wisconsin (hereinafter called the P.S.C.), the ratio of corporate debt to equity capital could not be too high. Also it was believed that, if the sale was to receive the required approval of the United States Securities and Exchange Commissioner (hereinafter called the S.E.C.), as a divestiture by the Power Company of the public passenger transportation properties, the preferred stock would have to contain redemption provisions - so that any retention of an ownership interest would be of a temporary rather than a permanent nature."
The material provisions of the purchase contract follow:
"The base purchase price [of $10,000,000] to be paid by the Purchaser to the Seller at the closing shall be as follows:
"(b) $3,000,000 principal amount of the Purchaser's 5% Secured Promissory Notes, secured by a second mortgage covering the Purchaser's bondable transportation property, * * *; and
"(c) 30,000 shares of the Purchaser's 5% Cumulative Preferred Stock, fully paid and non-assessable, having a par value of $100 per share, * * *.
"The Seller represents that it has no present intention of disposing of the 5% Secured Promissory Notes and the 5% Cumulative Preferred Stock of the Purchaser to be received by it under this Agreement, except to an associate company in the same holding company system, which will in turn acquire such securities with a view to holding them as an investment and not with a view to distribution.
"Section 3. The purchaser agrees that prior to the closing it will issue and sell for cash at not less than the par or stated value thereof, Common Stock having a total par or stated value of at least Five-Hundred Thousand Dollars ($500,000).
"(b) The obligation of the Seller hereunder to convey the property to be sold hereunder is subject to the following conditions precedent:
"1. That * * * counsel for the Purchaser shall have given an opinion to the Seller * * * that the 30,000 shares of 5% Cumulative Preferred Stock of the Purchaser to be delivered to the Seller * * * are validly issued, fully paid and non-assessable.
"Section 7. This agreement is made subject to obtaining all consents, authorizations and orders which shall be required by law to be obtained from any regulatory authority in order to carry out the terms of this Agreement, which each of the parties hereto agrees forthwith to apply for and to prosecute with due diligence; * * *."
Article III(a) of the petitioner's amended articles of incorporation provides as follows:
"(a) The capital stock of the corporation shall consist of 30,000 shares of Cumulative Preferred Stock of the par value of $100 each (hereinafter called 'Preferred Stock') and 500,000 shares of Common Stock of the par value of $1.00 each (hereinafter called 'Common Stock')."
The preferred stock certificate contained the following provisions:
"(B) The holders of the preferred stock shall be entitled to receive, when and as declared by the board of directors, out of surplus or net profits, cumulative dividends in cash at the rate of 5% per annum and no more, payable quarter-yearly * * *.Such dividends on the preferred stock shall be cumulative from and after the 30th day of December, 1952.
"(C) The corporation, at the option of the board of directors, may redeem the preferred stock at the time outstanding, in whole at any time or in part from time to time, upon notice duly given as hereinafter specified, by paying therefor in cash the par value thereof, together with a sum equal to 5% per annum on the par value thereof from the 30th day of December, 1952 to the date fixed for redemption, less the aggregate amount of all dividends theretofore paid thereon. * * *
"(D) So long as any shares of the preferred stock remain outstanding, there shall be set aside [annually] as a sinking fund for the retirement of preferred stock, [beginning on a date 15 months after the first mortgage bonds and second mortgage notes had been retired] * * *,
"(1) An amount in cash sufficient to redeem at the redemption price hereinabove provided 3,000 shares of preferred stock; and
"(2) An amount in cash sufficient to redeem an aggregate par value of shares of preferred stock (to the nearest full share) equal to one-half of the net income of the corporation for the above twelve months' period, determined as hereinafter provided.
"For the purposes of this paragraph (D) the term 'net income' shall mean [operating revenue, less operating expenses and dividends on preferred stock, and plus or minus nonoperating income or nonoperating loss] * * *."
Petitioner's attorney advised the Transport Company in a letter dated December 30, 1952, as follows:
"6. The 30,000 shares of Preferred Stock, a temporary certificate for which has been delivered to you today, are validly issued, ...