Opinion
Docket No. 18055.
1949-11-28
NEW ENGLAND LIME COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Sumner H. Babcock, Esq., for the petitioner. Melvin L. Sears, Esq., for the respondent.
DEDUCTION— INTEREST OR DIVIDENDS.— Securities held to be evidence of indebtedness so that required annual payments to holders were deductible as interest. Sumner H. Babcock, Esq., for the petitioner. Melvin L. Sears, Esq., for the respondent.
The Commissioner determined deficiencies in the petitioner's income and excess profits tax as follows:
+-------------------------------+ ¦ ¦ ¦Excess profits ¦ +----+----------+---------------¦ ¦Year¦Income tax¦tax ¦ +----+----------+---------------¦ ¦1942¦$6,608.55 ¦$20,992.14 ¦ +----+----------+---------------¦ ¦1943¦9,583.44 ¦36,080.92 ¦ +-------------------------------+
The parties have settled several issues by stipulation and the only issue for decision is whether the petitioner is entitled to deductions of $16,143 for 1942 and $18,833.50 for 1943 claimed as accrued interest paid on debenture bonds but disallowed on the theory that the amounts in question represented dividends. Most of the facts have been stipulated.
FINDINGS OF FACT.
The petitioner, a Massachusetts corporation, filed its returns with the collector of internal revenue for the district of Massachusetts.
The petitioner was organized in 1935 to acquire, and it acquired on April 17, 1935, the assets of a predecessor corporation pursuant to a plan of reorganization under section 77-B of the Bankruptcy Act. The stock of the petitioner, consisting of 11,805 shares of $3 dividend preferred stock without par value, and 69,622 shares of common stock without par value, was issued as follows in accordance with the plan of reorganization:
+----------------------------------------------------------------------------+ ¦ ¦Preferred stock¦Common stock¦ +-----------------------------------------------+---------------+------------¦ ¦ ¦Shares ¦Shares ¦ +-----------------------------------------------+---------------+------------¦ ¦To predecessor's bondholders ¦11,805 ¦35,415 ¦ +-----------------------------------------------+---------------+------------¦ ¦To predecessor's preferred stockholders ¦ ¦8,907 ¦ +-----------------------------------------------+---------------+------------¦ ¦To predecessor's common stockholders ¦ ¦300 ¦ +-----------------------------------------------+---------------+------------¦ ¦To certain officers and employees of petitioner¦ ¦25,000 ¦ +-----------------------------------------------+---------------+------------¦ ¦Total ¦11,805 ¦69,622 ¦ +----------------------------------------------------------------------------+
The dividends on the preferred stock were to be noncumulative up to and including January 1, 1940, and thereafter were to be cumulative. No dividends were to be paid on the common stock until at least 6,000 of the outstanding shares of preferred stock had been retired, and no dividends were to be paid on the common stock unless there was set aside an amount at least equal to the dividend on the common stock. The preferred stock was redeemable at $50 a share, plus unpaid dividends. The common stock was to have exclusive voting power and the preferred stock was to have none except that, until at least 6,000 shares of the preferred had been retired, the holders of the preferred stock, voting separately, were to have the right to vote for and elect a majority of the directors of the new company, and the common stockholders, voting separately, were to have the right to elect the remaining directors.
No dividends were paid on the preferred or common stock prior to 1942.
Such sales as there were of stock of the petitioner were usually in units of one share of preferred and three shares of common, the ratio in which the two stocks had been issued to the bondholders of the predecessor corporation. The preferred stock was held by many stockholders scattered over the United States. Chauncey C. Loomis had been president of the petitioner and of the predecessor since 1931. He and others closely associated with him in the management of the petitioner, together with stockholders friendly to those persons, had working control of the common stock. Loomis and others felt that continuation of the existing management was essential to the success of the petitioner. One of the holders of the preferred and common stock of the petitioner came to Loomis in 1941 to advise him that a brokerage firm, not friendly to the management of the petitioner, was buying units of the preferred and common stock of the petitioner, possibly for the purpose of controlling the preferred stock. This stockholder saw no prospect of retiring the 6,000 shares necessary to deprive the preferred stock of voting rights and he suggested that an effort be made to exchange debentures of the petitioner for its preferred stock.
Loomis announced at a meeting of the board of directors on April 21, 1941, that he had discussed with some of the preferred stockholders the possibility of issuing debenture bonds to be exchanged for the preferred stock. A plan was approved by the board of directors on October 28, 1941. Steps were taken to arrange for an exchange of preferred stock for debenture bonds to be issued by the petitioner. The plan was to make the exchange as of January 1, 1941, but it was not until December 26, 1941, that a sufficient number of holders of common and preferred stock were represented at a meeting to permit the approval of the plan. The plan was approved at the meeting on December 26, 1941, and was thereafter carried out.
Accumulated dividends on the preferred stock were then due and unpaid in the amount of $4.50 per share. The plan was that the corporation would issue its debentures to be dated January 1, 1941, and to be due January 1, 1966, bearing interest at the rate of 9 per cent per annum for the calendar year 1941 and thereafter at a fixed rate of 3 per cent per annum, plus additional interest at the rate of 3 per cent per annum from January 1, 1941, ‘if and to the extent the net income of the Company, as defined in the Indenture, is sufficient to make this payment.‘ Net income was defined in the indenture by a fixed formula leaving no discretion to anyone. The principal was payable unconditionally. The debentures could be redeemed prior to maturity. The bonds were to be unsecured, but the petitioner could not mortgage property owned by it without providing equal security for the debentures. The preferred stockholders had the right to exchange their stock for bonds on the basis of $50 principal amount of bonds for each share of preferred stock with accrued dividends. The restrictions on dividends on common were to be removed and the common was to have exclusive voting rights.
The preferred stockholders were notified of the plan by Loomis in a letter dated November 3, 1941. He reminded them that the preferred stock had been made noncumulative until January 1, 1940, in order to give the management a chance to use all available funds in research and plant development in the hope that thereafter the stockholders might receive some steady return on their original investment. He said the hope was based upon an expected increase in construction, which was the major outlet in 1935, and upon the development of new products outside the building field through research and plant development. Increase in construction had not yielded as much as had been hoped for, but new products outside the building field were yielding satisfactory profits and it appeared that gross earnings for 1941 would, for the first time, permit a return to the preferred stockholders. He pointed out that, if preferred stock could be exchanged for bonds, interest on the bonds would be deductible in computing net income, and Federal taxes were on net income, so that the company might pay interest on bonds where it could not pay an equivalent in dividends on stock.
Bonds of the face value of $538,100 were issued in exchange for 10,762 shares of preferred stock to stockholders agreeing to the plan prior to February 16, 1942, and those preferred shares were retired. Some bonds were registered and the others had coupons attached. The petitioner paid or accrued the following amounts as interest in accordance with the provisions of the debentures:
+-------------------------+ ¦ ¦Rate of ¦ ¦ +----+--------+-----------¦ ¦Year¦interest¦Amount ¦ +----+--------+-----------¦ ¦1941¦9% ¦$48,429.00 ¦ +----+--------+-----------¦ ¦1942¦3% ¦16,143.00 ¦ +----+--------+-----------¦ ¦1943¦4 1/2% ¦18,843.50 ¦ +-------------------------+
None of the property of the petitioner was mortgaged or pledged at the close of 1941.
No value was assigned to common stock on the balance sheets of the petitioner at any time material hereto.
The following is a summary of comparative balance sheets of the petitioner for November 30 and December 31, 1941:
+------------------------------------------------------+ ¦ ¦Nov. 30, 1941¦Dec. 31, 1941¦ +--------------------------+-------------+-------------¦ ¦ASSETS ¦ ¦ ¦ +--------------------------+-------------+-------------¦ ¦Cash ¦$89,878.36 ¦$79,398.31 ¦ +--------------------------+-------------+-------------¦ ¦Receivables ¦61,421.07 ¦72,678.73 ¦ +--------------------------+-------------+-------------¦ ¦Inventories ¦84,441.52 ¦94,468.38 ¦ +--------------------------+-------------+-------------¦ ¦Prepaid and deferred items¦5,155.57 ¦4,493.47 ¦ +--------------------------+-------------+-------------¦ ¦Investments ¦74.90 ¦74.90 ¦ +--------------------------+-------------+-------------¦ ¦Net capital assets ¦369,122.19 ¦451,461.25 ¦ +--------------------------+-------------+-------------¦ ¦Total ¦610,093.61 ¦702,575.04 ¦ +------------------------------------------------------+
LIABILITIES Accounts payable 23,350.73 30,712.82 Commissions, etc 988.98 Interest on debentures 48,429.00 Accruals and reserves 35,712.22 18,469.52 Reorganization expense 4,262.39 8,653.92 Bonds to be issued to preferred stockholders accepting 538,100.00 plan prior to Feb. 11, 1942 Preferred stock—11,536 shares 392,449.91 774 shares 26,331.48 Common stock Capital surplus 4,165.38 12,368.52 Earned surplus 150,152.98 18,520.80 Total 610,093.61 702,575.04
The earned surplus as of December 31, 1941, represents the net profit for 1941. The earned surplus as of January 1, 1941, was transferred to capital surplus in connection with the plan of exchanging debenture bonds in the amount of $50 principal amount for each share of preferred stock which had a stated book value of $34.02. The capital surplus as of December 31, 1941, represents the capital surplus of December 31, 1940, in the amount of $8,427.77, plus the earned surplus as of January 1, 1941, plus the value of a leasehold brought on the books as of January 1, 1941, in accordance with the vote of the directors on January 19, 1942, less $10,500 for expenses incurred in exchanging the bonds for stock, and less $171,981.57 representing the difference between $34.02, the stated value of preferred stock, and $50, the amount of bonds exchanged for each preferred share, multiplied by the number of shares of preferred held by stockholders agreeing to the exchange prior to February 16, 1942— 10,762 times $15.98 plus. The net result of $12,368.52 represents the difference between $50 and $34.02, or $15.98 for the 774 shares of preferred stock whose owners had not consented to the plan of exchange prior to February 16, 1942.
The net sales of the petitioner for the years 1935 through 1943 ranged from about $300,000 in 1935 to a high of $583,591.50 in 1941. The sales fell off in 1942 and 1943. The net income of the petitioner as shown on its return ranged from a few hundred dollars in 1938 to a high of about $37,000 in 1939. It was about $25,000 for 1941 and about $35,000 for 1942.
The balance sheet of the petitioner when it began business on April 17, 1935, showed total assets of $3,113,906.04, liabilities of $1,543,453.26, preferred stock in the total amount of $890,700, common stock in the amount of $1,788,523.25, and a deficit of $1,108,770.47.
A few shares of the common stock of the petitioner were sold in the latter part of 1941 at 50 cents a share and a few shares were sold during that year at $1 a share. Sales of common in small lots were made during 1942 at prices ranging from $1 to $2 per share, and the bid and asked prices for the common on two days in 1942 were $1.25 bid, $2.25 asked.
The stipulation of facts is incorporated herein by this reference.
OPINION.
MURDOCK, Judge:
A number of factors must be taken into consideration in determining whether a certain security is stock or evidence of indebtedness. John Kelley Co., 1 T.C. 457, 462; affd., 326 U.S. 521. Here many of them are favorable to the petitioner's contention. The debentures of the petitioner were always called and recorded as debenture bonds requiring the payment of interest. They were issued in both registered and coupon form. They are unqualifiedly due and payable 25 years from their date. A part of the interest is absolutely fixed, while the remainder is payable unqualifiedly if earned, but is not cumulative. Cf. Kelley Co. v. Commissioner, 326 U.S. 521, affirming 1 T.C. 457. The payment of the interest is not dependent upon the discretion of anyone. The right of the debenture holders to the interest is on a parity with the rights of other creditors and not subordinate thereto. Although a part of the interest is dependent upon earnings, still that arrangement was not merely a scheme to distribute earnings to stockholders. The holders of the debentures, as such, had no voice in management. The stockholders did not hold the debentures in a uniform proportion to their stock. The stock and bonds were widely distributed. The change from stock to debentures had business purposes other than the saving of taxes. General creditors do not take precedence over the bondholders and, if the corporation ever decides to mortgage any of its properties, it must set aside an equal amount in value of its property to secure these debentures. Unfavorable to the petitioner is the fact that preferred stock was exchanged for the debentures without the lending of any money at that time. Cf. 1432 Broadway Corporation, 4 T.C. 1158; affd., 160 Fed.(2d) 885. However, the preferred stock had been received originally in exchange for debts owed the recipients by the old corporation before the reorganization under section 77-B.
The principal argument of the respondent is that there was no capital invested in stock of the petitioner and the debt structure was excessive, so that the ‘debentures‘ in fact represented equity capital at the risk of the business. He claims this is one of the ‘extreme situations‘ referred to in John Kelley Co., supra, and in Swoby Corporation, 9 T.C. 887. Cf. Mullin Building Corporation, 9 T.C. 350; affd., 167 Fed.(2d) 1001. It is true that the balance sheets for November and December, 1941, listed the common stock without any stated value. However, 774 shares of preferred stock remained outstanding, and the balance sheet showed net assets of slightly more than $57,000, a part of which would have to be attributed to the common stock after allocating a proper amount to the outstanding preferred stock. The petitioner made no effort to show what the true value of its assets was at any time material hereto, but it did prove sales of its common stock in the latter part of 1941 and during 1942 at prices ranging from 50 cents a share to $2 a share. These sales, although of small quantities, appear to have been arm's length transactions and indicate that the outstanding common stock actually had substantial value. The substantial value in the outstanding stock, the wide and disproportionate distribution of the stock and bonds, the shift of the voting power to the common stock, and other factors mentioned above, serve to distinguish this case from those relied upon by the respondent. The respondent also claims that the change from preferred stock to debentures was made solely as a tax avoidance scheme, but the evidence does not support this contention. It shows, on the contrary, that there were other real reasons for the change, including the desire to give the officers and others voting rights on their common shares. The parties recognized that the shift would help the petitioner taxwise, but that is not sufficient reason for denying the deductions claimed. The respondent raises no question about the correctness of the amounts claimed as deductions in these two years.
The case appears to be fully as strong for the taxpayer as was the Kelley case, supra, when all of the factors involved have been weighed. The amounts in question are deductible as interest. Cf. Toledo Blade Co., 11 T.C. 1079.
Reviewed by the Court.
Decision will be entered under Rule 50.