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August 6, 1954

Walter J. ROTHENSIES, former Collector of Internal Reveune, First District of Pennsylvania, Joseph F.J. Mayer, former Acting Collector of Internal Revenue, First District of Pennsylvania, and Francis R. Smith, Collector of Internal Revenue, First District of Pennsylvania. CENTRAL-PENN NATIONAL BANK OF PHILADELPHIA v. Joseph F. J. MAYER, former Acting Collector of Internal Revenue, First District of Pennsylvania, and Francis R. Smith, Collector of Internal Revenue, First District of Pennsylvania

The opinion of the court was delivered by: GANEY

In the first action, Commonwealth Title Company of Philadelphia ('New Commonwealth') seeks to recover amounts totaling $ 762,891.03 *fn1" plus interest representing income and excess profits taxes alleged to have been erroneously paid by it for the period April 1 to December 31, 1944, and for the calendar year 1945 and 1946. In the second action Central-Penn National Bank of Philadelphia ('Central-Penn') seeks recovery of $ 118,689.67 *fn2" paid by it for the year 1944. Since the issues posed arise out of the 'consolidation and merger' of the same title insurance companies, the actions were tried together. The issues are five in number and they are, stated broadly, as follows:

1. Was New Commonwealth entitled to the carry over unused excess profits credits and carry over losses of Old Commonwealth for 1942, 1943 and for the period January 1 to March 31, 1944, under the provisions of § 710(c)(3) and § 122(b)(2)(A) of the Internal Revenue Code, 26 U.S.C.A. § 710(c)(3), 122(b)(2) (A). (If this question is answered in the negative, Old Commonwealth and New Commonwealth were required to compute their excess profits taxes for 1944 on the annualization basis provided in § 711(a)(3) of the Code);

  2. Did the Commissioner of Internal Revenue properly increase New Commonwealth's reportable gross income for the year 1944 by the amounts of $ 41,000 and $ 174,189.67, which he contends represented reinsurance premiums received by New Commonwealth to reinsure risks previously undertaken by Penn-Title, a former subsidiary of Central-Penn; may Penn-Title claim those amounts either as ordinary business expense under §§ 204(b)(5), 204(c)(1) and 23(a), or in the alternative as a loss allowable under §§ 204(c)(10) and 23(f) of the Code;

 3. (A) Whether certain expenditures made by New Commonwealth in 1945 and 1946 in rearranging information and improving its title plant under a contract with Remington Rand, Inc. were ordinary and necessary expenditures under §§ 204(c)(1) and 23(a)(1), or constituted capital expenditures according to § 117(a) of the Code as determined by the Commissioner; (B) If the expenditures were for capital improvements, is New Commonwealth entitled to deductions on account of depreciation of the materials purchased under the contract by virtue of §§ 204(c) (8) and 23(l)(1) of the Code;

 4. Were attorney's fees paid in connection with the Remington Rand contract deductible by New Commonwealth as ordinary and necessary expenses; and

 5. Was New Commonwealth in 1945 and 1946 entitled to a deduction for a reasonable allowance for exhaustion, wear and tear or obsolescence in connection with its title plants under §§ 204(c)(8, 10) and 23(l)(1) of the Code.

 From the stipulations of facts and the evidence presented to it, the court makes the following

 Findings of Facts

 I and II. Facts Concerning the

 First Two Issues

 1. The plaintiffs are as follows: (a) Commonwealth Title Company of Philadelphia ('New Commonwealth') a corporation organized under the laws of Pennsylvania on March 31, 1944 for the purpose of insuring owners of real estate, mortgagees and others interested in insuring real estate from loss by reason of defective titles, liens and encumbrances; and (b) Central-Penn National Bank of Philadelphia ('Central-Penn'), a national banking association created and existing under the laws of the United States. Both plaintiffs have their principal places of business in Philadelphia, Pa.

 2. In April of 1929 Commonwealth Title Company of Philadelphia ('Old Commonwealth') was incorporated and succeeded to the rights and liabilities of both The Title Company of Philadelphia and Commonwealth Title Insurance Company, and in so doing it acquired the title plants of those companies. *fn3" At that time Provident Trust Company, with the exception of qualifying shares, owned all the shares of Commonwealth Title Insurance Company, the successor to Commonwealth Title Insurance & Trust Company.

 3. Upon the formation of Old Commonwealth, the name of Commonwealth Title Insurance Company was changed to Provident Title Company. The latter was allowed to remain inactive until it was dissolved in 1945, so as to permit most of the possible liabilities on outstanding policies to become 'washed out' by virtue of the running of the statute of limitations. Prior to its dissolution, a reinsurance premium of $ 50,000 was paid by Provident Title Company to Old Commonwealth in consideration of the latter's reinsuring the almost 'washed out' risks.

 4. In 1929 Central-Penn absorbed American Title & Trust Company which had at that time about 25 million dollars of outstanding title policies. Central-Penn, through its subsidiary, then orgainzed American Title which assumed these liabilities. Central-Penn then paid American Title a reinsurance premium of $ 25,000 which was approximately one-tenth of one percent of the amount of the title policies reinsured.

 5. On December 3, 1929, Pennsylvania Title Insurance Company of Philadelphia ('Penn-Title') was organized.

 6. On December 24, 1929, Central-Penn acquired all but 300 of the 50,800 outstanding shares of stock of Penn-Title as part of a final liquidating dividend of a subsidiary at a cost of $ 838,039.06. At the time, the additions to the reserve fund of Penn-Title totaled $ 49,189.89. This sum was not taken into account in determining the cost of the 50,500 shares of Penn-Title stock. Between February 17 and April 1, 1944, Central-Penn acquired an additional 210 shares of Penn-Title stock at a cost of $ 3,000; the remaining 90 shares were held by three directors of Penn-Title.

 7. Also on December 24, 1929, Penn-Title absorbed the rights and liabilities of American Title Company. As a result of the merger, the reserve fund of Penn-Title was increased by $ 3,025.81, the amount of the reserve fund of American Title. Over the years in which such fund was accumulated, American Title included such increments in its gross income for federal tax purposes.

 8. From 1930 until March 31, 1944, as required by Pennsylvania law, Penn-Title had accumulated a reserve fund of $ 174,189.67. This fund was earmarked and kept separate and apart from the general funds of the company. In its books, separate accounts were maintained entitled 'Reinsurance Reserve Fund', 'Uninvested Re-insurance Reserve Fund' and 'Invested Re-insurance Reserve Fund'. Securities and mortgages, approved by the Insurance Commissioner of Pennsylvania, in which the funds were invested were registered in the name of 'Pennsylvania Title Insurance Company, Reinsurance Reserve Fund' of 'Pennsylvania Title Insurance Company, in Trust for its Re-insurance Reserve'. Cash funds were deposited in a separate bank account held in the name of 'Pennsylvania Title Insurance Company, Reinsurance Reserve Fund'. This fund had been accumulated by Penn-Title by deductions from title insurance premiums received by it during the fourteen-year period of its existence. In the calendar years in which the deductions were made, Penn-Title has included such amounts in its gross income for federal tax purposes.

 9. Immediately prior to April of 1944, of the title companies mentioned, only Old Commonwealth and Penn-Title were competitively engaged in the business of insuring titles to real property in the Philadelphia area. Over the period of fourteen years during which Penn-Title had been doing business, it had paid out approximately $ 25,000 in actual losses upon titles it had agreed to insure.

 10. Sometime in the early 1930's, the Comptroller of the Currency requested Central-Penn to dispose of its interests in title insurance companies since they were non-legal holdings for a national bank. Several years later Central-Penn began to make efforts to sell its title insurance interests in view of the renewed insistence of the Comptroller. It turned to Old Commonwealth as a logical transferee. The latter was interested and negotiations leading up to the agreement of March 15, 1944 got under way. These negotiations had at all times been conducted at arm's length.

 11. The original proposal of Central-Penn contemplated the sale of the entire shares of stock of Penn-Title at a figure approximating its net book value. This proposal was turned down by Old Commonwealth for two reasons: (a) It did not want to purchase all of the assets of Penn-Title, and (b) Pennsylvania law would not permit it to purchase any part of the shares of stock.

 12. Old Commonwealth then suggested that Penn-Title be liquidated and its insurance liabilities reinsured. This suggestion was turned down by Central-Penn because a transfer under that form would have required, among other things, Penn-Title to transfer its reserve fund to the Insurance Commissioner and would not create the impression for the benefit of former customers of Penn-Title that Old Commonwealth was continuing the business of Penn-Title.

 13. Different plans were then considered for the transfer of the assets and liabilities of Penn-Title. The plans differed as to which assets would be transferred to Central-Penn and which to Old Commonwealth, and the price which the latter would pay for those assets. Finally the negotiations centered upon the transfer to Old Commonwealth of Penn-Title's plant, furniture, fixtures and reserve fund, and Old Commonwealth's assumption of Penn-Title's insurance liabilities.

 14. The book value, less depreciation, of these assets, not taking into consideration the reserve fund, was $ 320,722.66. After further bargaining on the part of Old Commonwealth that figure was reduced by subtracting $ 43,722.69 as follows:

 (a) $ 25,000: this sum was based on the supposition that from Penn-Title's fourteen years experience in the title business, New Commonwealth would in all likelihood have to pay out approximately that amount in losses following the latter's assumption of liabilities on title insurance policies underwritten by Penn-Title;

 (b) $ 16,000: the amount equal to the balance remaining in the assets of Penn-Title out of a reinsurance premium of $ 25,000 paid by Central-Penn to American Title prior to the latter's merger with Penn-Title. (This amount was included in the deductions on the theory that if there was any reason for paying the $ 25,000 reinsurance premium in 1929, a contingent liability risk of $ 16,000 still remained on that group of policies); and

 (c) $ 2,722.66: the sum equal to the price to be paid for obtaining nine shares of stock of Old Commonwealth which were to be turned over to three directors of Penn-Title in liquidation of their 90 shares of Penn-Title stock and to qualify them as directors of New Commonwealth when it became organized.

 15. In an arms-length transaction, a company reinsuring the outstanding insurance liabilities of Penn-Title would, in all probability, request a premium in the neighborhood of $ 215,000.

 16. In order to overcome the unfavorable features of a liquidation and reinsurance, and to create an appearance of continuity so that former customers of Penn-Title would tend to regard New Commonwealth as continuing the business of Penn-Title, it was ultimately decided by the parties concerned that the transfer be effected through the form of a statutory merger and consolidation. Under this form of transfer New Commonwealth would become liable, as a matter of law, on all of Penn-Title's outstanding policies.

 17. Therefore on March 15, 1944, Old Commonwealth and Penn-Title entered into an agreement designated as: 'Joint Plan of Merger and Consolidation'. Pursuant to that agreement New Commonwealth was to be incorporated under the name Commonwealth Title Company of Philadelphia. According to the joint plan, upon its consummation all the rights of both Old Commonwealth and Penn-Title, subject to certain provisions for the distribution of Penn-Title's assets, were to be deemed as being transferred to New Commonwealth, and the title plant, furniture, fixtures and reserve fund of Penn-Title were to be transferred to New Commonwealth. For the transfer of these assets Central-Penn had the option of either accepting $ 277,000 in cash from Old Commonwealth or receiving shares of stock of New Commonwealth in exchange for the stock of Penn-Title at the rate of one for ten. However it was understood by Old Commonwealth and Central-Penn that the latter would not become a stockholder of New Commonwealth. The capital stock of Old Commonwealth was to be converted into that of the new corporation by an exchange on a share for share basis, and the present certificates of shares of stock of Old Commonwealth were to be the certificates for the shares of stock of New Commonwealth; that is, no exchange of certificates was necessary.

  18. As of this date Old Commonwealth had outstanding 20,000 shares of stock of par value of $ 100 each, while Penn-Title had 50,800 outstanding shares of par value of $ 10 each.

 19. On March 20, 1944, Central-Penn, in order to facilitate liquidation of Penn-Title, purchased $ 220,000 worth of mortgages from Penn-Title. Between March 24 and 31, 1944, Central-Penn, as 'trustee' for Penn-Title's stockholders who would not accept shares of New Commonwealth, received from Penn-Title, as a liquidating dividend, cash in the amount of $ 464,441.00 and assets having a net fair market value of $ 192,326.77, or a total of $ 656,767.77.

 20. As of March 31, 1944, the securities comprising the major portion of the reserve fund of $ 174,189.67 had been liquidated in contemplation of its transfer along with the remaining assets to New Commonwealth.

 21. On March 31, 1944, New Commonwealth was incorporated with an authorized capital stock of $ 3,125,000 divided into 31,250 shares of par value of $ 100 each. Besides taking over all the assets which had been owned by Old Commonwealth, it adopted the seal and by-laws of that company and had the same powers and privileges possessed by the former company.

 22. Upon New Commonwealth's incorporation, Central-Penn did not receive any stock in New Commonwealth, but accepted payment of $ 277,000 in cash from Old Commonwealth. New Commonwealth, having succeeded to the rights of Old Commonwealth, obtained title to the title plant, fixtures, furniture and the $ 174,189.67 fund of Penn-Title; it also assumed, as a matter of law, the contingent liabilities of over 347 million dollars of outstanding title insurance of Penn-Title.

 23. The fund of $ 174,189.67 was transferred from the account in which it was deposited with Central-Penn to the new account opened by New Commonwealth by check drawn on the 'Pennsylvania Title Insurance Co. Reinsurance Reserve Fund' to the order of the 'Commonwealth Title Company of Philadelphia Legal Reserve Fund'. This fund was added to that of New Commonwealth's reserve fund, bringing it to a total of $ 490,644.88, just $ 9,355.12 short of the required statutory maximum of $ 500,000. This reserve fund was earmarked and kept separate and apart from the general funds of New Commonwealth just as Old Commonwealth and Penn-Title had done in the past with their reserve funds.

 24. The assets of Penn-Title were transferred to Central-Penn and New Commonwealth by means of a liquidation. Those assets, exclusive of the reserve fund, transferred to New Commonwealth were purchased for $ 277,000 in cash.

 25. The reduction of $ 41,000 in the purchase price and the transfer of the $ 174,189.67 fund were in consideration of New Commonwealth's assumption of Penn-Title's insurance liabilities. Together they constituted a premium for reinsurance.

 26. On or about March 31, 1944, Penn-Title delivered to the designated three directors three shares each of New Commonwealth stock. These shares were purchased by Old Commonwealth for the sum of $ 2,722.66.

 27. The stock certificates representing the 50,710 shares of Penn-Title were retained by Central-Penn and were at no time surrendered or transferred by it.

 III. Facts Concerning the Third Issue

 28. For some time prior to 1945, New Commonwealth had given consideration to ways and means of improving the operation of its active title plant -- the one which had originally been acquired from the Title Company of Philadelphia in 1929 -- in order to eliminate some of the labor and to reduce the time required to issue settlement certificates. While the information contained in that plant in conjunction with that obtained from the other two plants was adequate, the arrangement of records and the method of compiling the desired information was cumbersome for the purpose of searching the title on a particular piece of property when title insurance was ordered. Therefore it decided to install a system proposed by Remington Rand, Inc. for additions and a rearrangement of some of the information already contained in the active plant.

 29. On June 4, 1945, New Commonwealth entered into a contract with Remington Rand, Inc. under which the latter agreed to furnish materials, services and part of the labor needed in connection with the installation of the system. *fn4"

 30. Pursuant to that contract, with certain modifications, Remington Rand did the following:

 (a) Dexigraphed (photostated) all deeds recorded in the Recorded of Deeds office during the period November 1, 1925 to October 1, 1945;

 (b) Prepared a title folder for each parcel of real estate in Philadelphia; bound in chronological order all the dexigraphs of the recorded deeds relating to a particular piece of property and placed them in the folder for that property; transcribed on the folder in the space provided for that purpose the volume numbers and pages of the official deed books in which the related deeds appear and the dates of the deeds, and also the application number of the policy (back title bundle), if previously insured by New Commonwealth and its predecessors in title, covering the parcel of real estate or a larger tract of which the parcel is a part. These folders were filed in accordance with the prior locating code. They eliminated the use of registry books and the making of typed abstracts of recorded deeds.

 (c) Prepared 'Soundex' cards, an index system of various colored cards, on which information possibly affecting wills were typewritten.

 (d) Assisted in setting up the 'Photo Plan Index' by photographing each city block in Philadelphia shown on the large locating map, and then filing each photograph alphabetically or numerically by street names. 31. A summary of the amounts paid by New Commonwealth for the labor and materials supplied by Remington Rand, and the year in which and the purpose for which it was paid is as follows: 1945 1946 a. Dexigraphs Material $ 11,908.07 $ 137,852.70 b. Title Folders Labor 6,591.93 86,544.30 Material 20,384.00 c. Soundex Cards Labor 32,500.00 3,500.00 Material 4,937.53 1,524.71 d. Photo Index Plan Labor 5,400.24 Total: $ 76,321.53 $ 234,821.95


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