Opinion
Docket No. 104631.
1943-06-15
SENIOR INVESTMENT CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
R. M. O'Hara, Esq., and Benjamin E. Jaffe, Esq., for the petitioner. Philip M. Clark, Esq., for the respondent.
1. Where the provisions of an amendment to the charter of petitioner and certificates of stock issued thereunder prohibited the payment of dividends until the earnings and profits of petitioner should accumulate and be transferred in a certain amount to capital or capital surplus to wipe out a deficit, and such earnings and profits had not been accumulated in such amount in any of the taxable years, held that petitioner is not entitled to credits by reason of such provisions of its charter and certificates of stock in any of those years under section 26(c)(1) of the Revenue Act of 1936; held further, that the restrictions on the payment of dividends contained in the amended charter and certificates of stock superseded an agreement under which a recapitalization and reorganization of petitioner had been effectuated.
2. The petitioner had a deficit in accumulated earnings and profits at the close of each of the years preceding the taxable years, and it was prohibited by the General Corporation Act of Michigan from paying dividends during the existence of such deficits. Held, the petitioner is entitled to credits in the taxable years under section 26(c)(3) of the Revenue Act of 1936, added to that act by section 501(a)(2) of the Revenue Act of 1942.
3. Payments made by petitioner during the taxable years as they appear on running accounts, held not to entitle petitioner to a deduction of such amounts from its adjusted net income for the taxable years in determining its personal holding company surtaxes for those years, such payments not being shown to have been applied on an indebtedness of petitioner incurred prior to January 1, 1934. R. M. O'Hara, Esq., and Benjamin E. Jaffe, Esq., for the petitioner. Philip M. Clark, Esq., for the respondent.
The respondent determined deficiencies in income tax and deficiencies and an overassessment in personal holding company surtax as follows:
+------------------------------------------+ ¦ ¦ ¦Personal holding company ¦ +----+-----------+-------------------------¦ ¦ ¦ ¦surtax ¦ +----+-----------+-------------------------¦ ¦Year¦Income tax ¦ ¦ +----+-----------+-------------------------¦ ¦ ¦deficiency ¦ ¦ ¦ +----+-----------+------------+------------¦ ¦ ¦ ¦ ¦Over ¦ +----+-----------+------------+------------¦ ¦ ¦ ¦Deficiency ¦assessment ¦ +----+-----------+------------+------------¦ ¦1935¦ ¦$8,165.49 ¦ ¦ +----+-----------+------------+------------¦ ¦1936¦$132,261.91¦ ¦$44,244.69 ¦ +----+-----------+------------+------------¦ ¦1937¦100,174.60 ¦25,969.77 ¦ ¦ +------------------------------------------+
The petitioner in its petition contests all of the deficiencies and seeks determinations of overpayment in income tax for 1936 of $3,802.23 and in personal holding company surtax in the amounts of $49,690.90, $151,485.29, and $1,085.55, respectively, for 1935, 1936, and 1937. After the elimination of certain issues by stipulation, as hereinafter stated, the remaining issues are: (1) Whether, under section 26(c)(1) of the Revenue Act of 1936, or under section 26(c)(3) added to that act by section 501(a)(2) of the Revenue Act of 1942, the petitioner is entitled to credits of amounts equal to its adjusted net income in determining its undistributed profits tax for 1936 and 1937; and (2) whether, under section 351(b)(2)(B) of the Revenue Acts of 1934 and 1936, and section 355(b) of the Revenue Act of 1936 as amended and added by the Revenue Act of 1937, the petitioner is entitled to deduct from its adjusted net income for 1935, 1936, and 1937, the amounts of $458,066.92, $393,931.07, and $125,000 allegedly paid in those years on an indebtedness incurred prior to January 1, 1934, in determining its personal holding company surtax for those years.
The proceeding has been submitted upon the pleadings, testimony, documentary evidence, and a stipulation of facts. The stipulated facts not set forth are included herein by reference. By the stipulation petitioner withdrew certain assignments of error, as stated therein, and respondent confessed error with respect to his failure to allow $11,248.36 as a deduction for a loss incurred by petitioner in 1937. Effect will be given to the enumerated stipulations in the recomputation under Rule 50.
FINDINGS OF FACT.
The petitioner is a corporation of the State of Michigan, with its principal office in Detroit. It was a personal holding company of Fred J. Fisher during the taxable years 1935, 1936, and 1937, and filed income and excess profits tax returns and personal holding company surtax returns for those years with the collector at Detroit.
The petitioner was organized on July 31, 1929, with an authorized capital stock of 300,000 no par value shares, divided into 100,000 shares each of class A, class B, and class C stock. The 100,000 shares of B stock were issued to Fred J. Fisher on August 1, 1929, in exchange for a block of stock, including one-sixth of the voting stock, of Fisher & Co. (hereinafter sometimes referred to as Fisher), a personal holding company of the Fisher brothers, and 80,716 shares of the A stock were issued at the same time to Fred J. Fisher and his wife, Burtha M. Fisher, in exchange for various stocks and bonds and a small amount of other property. On the same date, the 100,000 shares of C stock were issued for a nominal consideration, 79,805 to Fred J. Fisher, 10,195 to Burtha M. Fisher, and 10,000 to Andrew E. Baldwin, an employee of Fisher, who became vice-president and manager of the petitioner. The cost to the Fishers and the market value on July 1, 1929, of the property paid in by them, together with the number of shares of A and B stock issued to them are shown in the following table:
+-----------------------------------------------------+ ¦Class A Stock ¦ +-----------------------------------------------------¦ ¦ ¦ ¦ ¦Market value ¦ +----------------+------+--------------+--------------¦ ¦ ¦Shares¦Cost ¦7-1-29 ¦ +----------------+------+--------------+--------------¦ ¦Fred J. Fisher ¦71,573¦$12,957,242.88¦$42,943,427.76¦ +----------------+------+--------------+--------------¦ ¦Burtha M. Fisher¦9,143 ¦699,350.00 ¦5,636,250.00 ¦ +----------------+------+--------------+--------------¦ ¦Total ¦80,716¦13,656,592.88 ¦48,579,677.76 ¦ +-----------------------------------------------------+
Class B Stock Fred J. Fisher 100,000 $894,060.02 $40,000,000.00
The 9,143 shares of A stock were owned by Burtha M. Fisher until December 9, 1931, when they were retired; the 100,000 shares of B stock were owned by Fred J. Fisher until August 29, 1933, when they were canceled in connection with the hereinafter mentioned reorganization of the petitioner; and the 10,000 shares of C stock issued to Baldwin were owned by him until January 9, 1936, when they were canceled upon the termination of his contract of employment with petitioner. The remainder of the A stock and C stock issued to Fred J. Fisher and Burtha M. Fisher, in the amounts stated above, was owned by them until December 31, 1937.
The C stock had voting power. The A stock was entitled to cumulative dividends of $24 per share per annum and no more from the net profits other than the net income from the Fisher stock. The B stock was entitled to receive in each year in dividends the total net income received by petitioner from the Fisher stock up to $24 per share per annum, and, if such net income exceeded the amount of $24 per share, the C stock was entitled to receive, from the excess, dividends of $1 per share and any amount remaining was to be distributed equally, share for share, between the B and the C stock. Increases in the book value of the Fisher stock were to accrue annually to the B and the C stock in prescribed proportions and the amount accrued to each such class of stock and each share of each class was to be credited in an account on the petitioner's books, subject to distribution only upon the liquidation of the petitioner. In addition to dividends payable out of net income received from the Fisher stock the C stock was entitled to such dividends as might be declared out of the net profits (except those arising from income from the Fisher stock) remaining after payment of the cumulative dividends on the A stock for all previous dividends and the setting aside of dividends thereon for the current dividend period. Upon the liquidation of the petitioner the A stock was entitled to receive out of the assets other than the Fisher stock $600 per share plus accrued dividends, and at any time prior to liquidation it was subject to redemption at such price not in excess of $600 as might be agreed upon by the shareholder and the petitioner. Upon liquidation the B stock was entitled to receive out of the Fisher stock then owned by the petitioner $400 in cash per share plus the distributable net income therefrom, and the remaining value of the Fisher stock was to be distributed to the holders of the B and C stock in the proportions and up to the amounts which the net increase in value had accrued to the B and C stock, and any balance over the amounts so accrued was to be distributed as assets other than Fisher stock. The B stock was subject to redemption at any time upon the same terms as in the case of liquidation. Upon liquidation the C stock was entitled to share ratably in all remaining assets after payment in full of the amounts due the holders of the A and B stock.
The dividend rate of $24 per share per annum on the A and B stock and the redemption values of $600 for the former class of stock and $400 for the latter were fixed by the incorporators on the basis of the anticipated earnings and the market values of the securities which were paid in, respectively, for the A stock and the B stock.
The officers of the petitioner up to January 10, 1936, were Fred J. Fisher, president; Andrew E. Baldwin, vice president and manager; Horace S. Maynard, secretary-treasurer; and John C. Moons, assistant treasurer. Baldwin retired on January 9, 1936, and from that time until December 31, 1937, Fisher was president, Maynard was vice president and secretary, and Moons was treasurer. The said officers, together with Leo M. Butzel, constituted the directors. Burtha M. Fisher was a director up to May 10, 1932. Maynard was a business associate of Fisher and had assisted him for many years in the management of his personal affairs and the affairs of corporations in which Fisher was interested.
The Senior Corporation is a corporation of the State of Delaware which was organized on August 26, 1933, with an authorized capital stock of 300,000 shares divided into 100,000 shares of class A stock and 100,000 shares of class B stock, each class having a par value of $10 per share, and 100,000 shares of class C stock without par value. It was formed pursuant to an ‘Agreement and Plan of Reorganization and Recapitalization of Senior Investment Corporation,‘ which was entered into by the petitioner and its stockholders on August 23, 1933, approved by its directors and stockholders on August 24, and signed by the Senior Corporation through Fred J. Fisher as president and Maynard as treasurer, with the approval of its directors, shortly after its formation. The said agreement, which is hereinafter referred to as the ‘reorganization agreement,‘ provided, inter alia, for the formation of the Senior Corporation with authorized capital stock of the amount and classes stated above for the transfer to it of the following assets of the petitioner in exchange for 71,573 shares of A stock and 100,000 shares each of the B and C stock of the Senior Corporation:
+------------------------------------------------------------------------+ ¦Cash ¦ ¦$2,000,000.00¦ +---------------------------------------------+------------+-------------¦ ¦Fisher stock ¦ ¦8,000,000.00 ¦ +---------------------------------------------+------------+-------------¦ ¦Amounts due from: ¦ ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Alfred J. Fisher ¦$71,005.54 ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Lawrence P. Fisher ¦1,130,018.49¦ ¦ +---------------------------------------------+------------+-------------¦ ¦William A. Fisher ¦228,703.29 ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Fisher & Co ¦31,272.91 ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Fred J. Fisher ¦1,100,000.00¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Edward F. Fisher ¦34,851.87 ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦The six Fishers by virtue of payments on note¦ ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦at Bankers Trust Co ¦501,108.63 ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦ ¦3,096,960.73¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Fred J. Fisher ¦5,862,747.40¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Burtha M. Fisher ¦1,814,386.22¦ ¦ +---------------------------------------------+------------+-------------¦ ¦Sundry accounts ¦64,231.28 ¦ ¦ +---------------------------------------------+------------+-------------¦ ¦ ¦ ¦10,838,325.63¦ +---------------------------------------------+------------+-------------¦ ¦Total ¦ ¦20,838,325.63¦ +------------------------------------------------------------------------+
The reorganization agreement provided that the shares of stock of the Senior Corporation should be issued to the stockholders of the petitioner at the rate of one share class A, class B, and class C stock of the Senior Corporation for each share respectively of class A, class B, and class C stock owned by the stockholders of the petitioner, and that the certificate of incorporation of the Senior Corporation should contain such provisions relating to the powers, preferences, and rights, and the qualifications, limitations, or restrictions of its several classes of stock as would substantially preserve to the owners of the A, B, and C stock of the petitioner the powers, preferences, and rights, and the qualifications, limitations, or restrictions which they then had ‘as affecting the assets and property‘ of the petitioner to be transferred pursuant to the agreement. The agreement further provided for the reduction of the capital and capital stock of the petitioner by cancellation of the 100,000 shares of its B stock, reduction of its authorized capital stock to 200,000 shares, consisting of 100,000 shares of A stock of the par value of $5 per share and 100,000 shares of C stock of the par value of $1 per share, for the stamping of the outstanding certificates of its A and C stock to evidence the change in the capital structure, and for the inclusion in its amended articles of incorporation of such provisions relating to the rights, voting power, preferences, and restrictions of its A and C stock as would substantially preserve to the owners of such stock the rights, voting power, preferences, and restrictions which they then had ‘as affecting the assets and property‘ which the petitioner was to retain.
The reorganization agreement stated that it was the intention of the parties that, upon its consummation, the sum total of the rights, powers, and privileges of the holders of each class of stock in the old and new corporation should be equal to the rights, powers, and privileges which the holders of each class of stock in the old corporation had in its assets prior to the consummation of the transaction, and the provisions incorporated in the charters of the two corporations to carry such intention into effect were so incorporated upon the advice of counsel so that the transaction would qualify under the revenue acts as a tax-free exchange.
On August 28, 1933, the petitioner delivered to the Senior Corporation an assignment of the assets hereinabove described and the Senior Corporation issued shares of its several classes of stock to the stockholders of the petitioner as follows:
+--------------------------------------------+ ¦ ¦A stock ¦B stock ¦C stock ¦ +-----------------+--------+--------+--------¦ ¦ ¦Shares ¦Shares ¦Shares ¦ +-----------------+--------+--------+--------¦ ¦Fred J. Fisher ¦71,573 ¦100,000 ¦79,806 ¦ +-----------------+--------+--------+--------¦ ¦Burtha M. Fisher ¦ ¦ ¦10,194 ¦ +-----------------+--------+--------+--------¦ ¦Andrew E. Baldwin¦ ¦ ¦10,000 ¦ +-----------------+--------+--------+--------¦ ¦ ¦71,573 ¦100,000 ¦100,000 ¦ +--------------------------------------------+
On August 28, 1933, the stockholders of petitioner approved and the petitioner executed an amendment of its articles of incorporation changing the capital structure and containing other modifications in accordance with the reorganization agreement, which amendment was filed in the office of the Michigan Corporation and Securities Commission on August 29, 1933. On August 28, 1933, the directors and stockholders of the petitioner ordered the cancellation of the 100,000 shares of its B stock and the evidencing of the change in its capital structure upon the outstanding certificates of A and C stock. On August 29, 1933, the certificates of the B stock were canceled and appropriate endorsements evidencing the change in the capital structure were stamped on the face of the certificates of the A and C stock of petitioner. This endorsement recited, inter alia, that the rights and restrictions with respect to the A and C stock were authorized by the amendment to the articles of incorporation here involved. The shares of stock of the Senior Corporation which were issued were owned by the individuals, as above stated, until December 31, 1937, except the 100,000 shares of C stock issued to Baldwin, which were canceled on January 9, 1936, upon the termination of his contract of employment with the petitioner. The officers and directors of the petitioner became officers and directors of the Senior Corporation upon its organization and both corporations had the same officers and directors throughout the period August 28, 1933, to December 31, 1937.
When the officers and stockholders of petitioner met on August 23, 1933, to consider the reorganization agreement, they had before them various papers and documents, including a balance sheet showing the book value and market value of the assets of the petitioner as of June 30, 1933, a work sheet showing the book and market values of the assets to be transferred and of those to be retained by the petitioner, copies of the proposed articles of incorporation of the Senior Corporation and of the proposed amendment to the articles of incorporation of the petitioner, both of which copies were in the form in which they were subsequently filed, and a memorandum of counsel setting forth various provisions which were incorporated in the articles of each corporation and were stated in the memorandum to be necessary to maintain the rights of the holders of each class of stock respecting dividends, redemption rights, and rights of the stockholders upon liquidation.
The balance sheet, showing book values and market values, with omission of details, was as follows:
+------------------------------------------------------------------+ ¦Balance Sheet June 30, 1933. ¦ +------------------------------------------------------------------¦ ¦ ¦Book value ¦Market value ¦ +--------------------------------------+-------------+-------------¦ ¦Assets: ¦ ¦ ¦ +--------------------------------------+-------------+-------------¦ ¦Cash ¦$2,620,477.12¦$2,529,279.27¦ +--------------------------------------+-------------+-------------¦ ¦Equity in brokers' accts ¦770,440.40 ¦378,818.40 ¦ +--------------------------------------+-------------+-------------¦ ¦Marketable stocks and bonds ¦9,563,836.98 ¦5,191,680.38 ¦ +--------------------------------------+-------------+-------------¦ ¦Other investments: ¦ ¦ ¦ +--------------------------------------+-------------+-------------¦ ¦Stocks not listed ¦959,966.04 ¦820,004.40 ¦ +--------------------------------------+-------------+-------------¦ ¦Fisher & Co ¦38,325,000.00¦8,000,000.00 ¦ +--------------------------------------+-------------+-------------¦ ¦Real estate ¦126,475.97 ¦50,000.00 ¦ +--------------------------------------+-------------+-------------¦ ¦Notes and accts. receivable ¦10,838,325.63¦10,838,325.63¦ +--------------------------------------+-------------+-------------¦ ¦Office furniture and fixtures ¦9,955.78 ¦9,955.78 ¦ +--------------------------------------+-------------+-------------¦ ¦Deferred charges ¦8,384.29 ¦8,384.29 ¦ +--------------------------------------+-------------+-------------¦ ¦Total ¦63,222,862.21¦27,826,448.15¦ +--------------------------------------+---------------------------¦ ¦ ¦ ¦ +--------------------------------------+---------------------------¦ ¦Liabilities: ¦ ¦ ¦ +--------------------------------------+-------------+-------------¦ ¦Current liabilities ¦1,309,495.33 ¦1,309,495.33 ¦ +--------------------------------------+-------------+-------------¦ ¦Land contracts payable ¦10,800.00 ¦10,800.00 ¦ +--------------------------------------+-------------+-------------¦ ¦Capital (issued): ¦ ¦ ¦ +--------------------------------------+-------------+-------------¦ ¦Class A, 71,573 shares ¦42,943,800.00¦42,943,800.00¦ +--------------------------------------+-------------+-------------¦ ¦B, 100,000 shares ¦40,000,000.00¦40,000,000.00¦ +--------------------------------------+-------------+-------------¦ ¦C, 100,000 shares ¦1.00 ¦1.00 ¦ +--------------------------------------+-------------+-------------¦ ¦Deficit ¦21,041,234.12¦21,041,234.12¦ +--------------------------------------+-------------+-------------¦ ¦Depreciation of securities (difference¦ ¦ ¦ +--------------------------------------+-------------+-------------¦ ¦between book value of investments and ¦ ¦ ¦ +--------------------------------------+-------------+-------------¦ ¦market value at June 30, 1933) ¦ ¦35,396,414.06¦ +--------------------------------------+-------------+-------------¦ ¦Total ¦63,222,862.21¦27,826,448.15¦ +------------------------------------------------------------------+
The work sheet disclosed that of the assets owned by the petitioner other than the Fisher stock, assets of the market value of $12,838,325.63 (consisting of $2,000,000 in cash and $10,838,325.63), or 69.37 percent thereof, were to be transferred to the Senior Corporation, and assets of the market value of $5,667,827.19 (consisting of the remaining assets of $6,988,122.52 less the liabilities of $1,320,295.33), or 30.63 percent thereof, were to be retained by the petitioner.
The memorandum of counsel stated that, in order to preserve the rights and privileges of the holders of the several classes of stock of the petitioner then outstanding, it would be necessary, among other things, to allocate the deficit of $21,041,234.12, representing losses actually sustained, between the Senior Corporation and the petitioner on the basis of the above percentages so that the Senior Corporation would assume $14,596,994.26 and the petitioner would retain $6,444,239.86 of such deficit; and that it would also be necessary to provide in the charter of each corporation for the transfer of its earnings to surplus until the deficit had been wiped out and for the prohibition of payment of dividends until the deficit had been restored.
The deficit of $21,041,234.12 shown on the balance sheet, which was agreed upon for the purpose of making the allocation between the petitioner and the Senior Corporation, was overstated by the amount of $461,361.72, due to the fact that a transaction occurring prior to June 30, 1933, was not entered on the books until August 30, 1933.
The proposed amendment of the articles of incorporation of the petitioner contained the following provision, which was included in the amended articles approved by its stockholders and filed on August 29, 1933:
The earnings and profits of the corporation to the extent of $6,444,239.96 shall from time to time be transferred to capital or capital surplus or surplus, and anything herein contained or otherwise to the contrary notwithstanding, no dividends, whether cumulated or current, shall be paid or set aside on any shares of stock of the corporation until earnings and profits of the corporation in the sum of $6,444,239.96 have been so transferred to capital or capital surplus or surplus.
Of the assets transferred by petitioner to the Senior Corporation in exchange for the latter's stock, the $2,000,000 in cash was paid by the petitioner to the Senior Corporation on August 30, 1933. Of the other assets so transferred, the certificates for the Fisher stock were delivered by petitioner to Fisher & Co. with instructions to transfer them to the name of Senior Corporation and transfer taxes were paid on the transfer and the accounts receivable due from Fisher and other individuals were transferred by entries crediting their accounts on the books of the petitioner and by opening new accounts on the books of the Senior Corporation charging them with the amount of the indebtedness transferred.
The assets paid in to petitioner by Fred J. Fisher in 1929 represented, to some extent, holdings resulting from promotional activities, and, in addition to engaging in market operations and a few transactions in real estate, the petitioner promoted and managed a number of large manufacturing corporations, including Vickers, Inc., the Udylite Corporation, the General Chromium Corporation, and United Chromium, Inc., and it operated in the same way after the formation of the Senior Corporation in 1933. It was intended to use the Senior Corporation in a similar way, if possible, but, because of market and general business conditions, that corporation did not engage in promotional or market operations during the taxable years. The only assets acquired by it during the period August 28, 1933, to December 31, 1937, were 4,500 shares of Consolidated Aircraft Corporation, purchased at a cost of $281,250, and a real estate mortgage for $26,025. One of the purposes of the parties in organizing the Senior Corporation was to transfer part of the petitioner's assets to a corporation of another state and to reduce the petitioner's original capitalization to correspond with the lower 1933 market values of its assets and thereby affect an annual saving of $37,000 in Michigan franchise taxes.
The earnings and profits of the petitioner for the period July 1, 1933, to December 31, 1937, computed on the basis of corporate cost, or value as of July 1929, of assets paid in at organization, and on the basis of actual cost to the petitioner of assets thereafter acquired, amounted to $951,428.05. Such earnings and profits for the same period, computed on the basis of the cost to the transferors of assets paid in at organization and on the basis of actual cost to the petitioner of assets thereafter acquired, amounted to $991,303.05; and, computed on the basis of market value on June 30, 1933, of all assets acquired prior thereto and actual cost to the petitioner of assets thereafter acquired, they amounted to $1,493,301.39.
Petitioner had deficits in accumulated earnings and profits which at the close of the year 1935 exceeded its adjusted net income for the taxable year 1936, and which at the close of the year 1936 exceeded its adjusted net income for the taxable year 1937.
In its income and excess profits tax returns for 1936 and 1937 the petitioner reported adjusted net income for those years in the respective amounts of $685,273.50 and $478,855.63 and it claimed as a credit in each year, on account of contracts restricting dividend payments, an amount equal to its adjusted net income. The credits were disallowed by the respondent. The petition in this proceeding was filed on September 9, 1940.
From the time of the reorganization up to the close of the year 1937 the petitioner and the Senior Corporation entered into many transactions involving the use of their respective funds. The transactions were recorded on the petitioner's books of original entry and were posted to an account on its ledger covering the period August 28, 1933, to June 30, 1940, entitled ‘Miscellaneous Payable, Senior Corporation— Current Account,‘ hereinafter referred to as the petitioner's current account. They were likewise reflected by corresponding entries on the ledger of the Senior Corporation in an account entitled ‘Current Assets, Current Account,— Senior Investment Corporation,‘ hereinafter referred to as the Senior Corporation's current account. The entries appearing in petitioner's current account for the period August 28, 1933, to December 31, 1937, are as follows:
+--------------------------------------+ ¦ ¦Date¦Charges ¦Credits ¦ +-----+----+-------------+-------------¦ ¦ ¦1933¦ ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦ +-----+----+-------------+-------------¦ ¦Aug. ¦28 ¦$2,000,000.00¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦30 ¦ ¦$2,000,000.00¦ +-----+----+-------------+-------------¦ ¦ ¦30 ¦30,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦30 ¦ ¦17,829.17 ¦ +-----+----+-------------+-------------¦ ¦Sept.¦26 ¦5,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦30 ¦5,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦15 ¦ ¦7,002.78 ¦ +-----+----+-------------+-------------¦ ¦ ¦15 ¦ ¦5,617.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦15 ¦11,346.87 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦20 ¦ ¦600,000.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦30 ¦ ¦879.75 ¦ +-----+----+-------------+-------------¦ ¦ ¦14 ¦ ¦200.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦30 ¦ ¦500,000.00 ¦ +-----+----+-------------+-------------¦ ¦Oct. ¦31 ¦ ¦100.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦19 ¦ ¦700,000.00 ¦ +-----+----+-------------+-------------¦ ¦Nov. ¦29 ¦5,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦13 ¦ ¦150,000.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦24 ¦ ¦150,000.00 ¦ +-----+----+-------------+-------------¦ ¦Dec. ¦15 ¦ ¦31,108.63 ¦ +-----+----+-------------+-------------¦ ¦ ¦29 ¦150,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦29 ¦100,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦29 ¦300,000.00 ¦ ¦ +-----+----+-------------+-------------¦ ¦ ¦6 ¦ ¦1,000,000.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦20 ¦ ¦150.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦31 ¦ ¦10,400.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦31 ¦ ¦554.00 ¦ +-----+----+-------------+-------------¦ ¦ ¦ ¦2,606,346.87 ¦5,173,841.33 ¦ +-----+----+-------------+-------------¦ ¦Dec. ¦31 ¦Balance ¦2,567,494.46 ¦ +-----+----+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦ +--------------------------------------+
1934 Jan. 1 Balance 2,567,494.46 31 10,700.00 31 235,000.00 31 75,241.45 31 40.00 Feb. 28 400,000.00 Mar. 31 385,000.00 31 300.00 Apr. 30 5,000.00 30 400,000.00 30 64.94 30 120.00 May 31 200.00 June 30 400,000.00 Aug. 30 100.00 30 186.94 13,333.33 31 25,000.00 Dec. 31 644.52 15,986.94 4,502,438.70 Dec. 31 Balance 4,486,451.76
1935 Jan. 1 Balance $4,486,451.76 29 200,000.00 31 $342,458.08 31 500.00 Feb. 27 60,000.00 Mar. 2 25,000.00 Apr. 29 600.00 Sept. 9 40,000.00 Oct. 14 2,100.00 31 1,300.00 Dec. 31 50,000.00 31 40,000.00 31 108.84 458,066.92 4,790,451.76 Dec. 31 Balance 4,332,384.84
1936 Jan. 1 Balance 4,332,384.84 9 11,600.00 June 12 2,055.00 July 31 2,500.00 Aug. 3 2,500.00 31 3,737.47 Dec. 30 330,000.00 30 60,000.00 31 193.60 31 1,722.68 396,431.07 4,350,262.52 Dec. 31 Balance 3,953,831.45
1937 Jan. 1 Balance 3,953,831.45 4 5,015.00 5 100,000.00 26 100,000.00 9 10,713.33 Feb. 11 50,000.00 17 55,000.00 23 50,000.00 Mar. 31 40,270.00 July 1 18,000.00 1 18,000.00 Dec. 29 125,000.00 143,000.00 4,382,829.78 Dec. 31 Balance 4,239,829.78
The petitioner's current account contains the following entries for the month of January 1938:
+-----------------------------------------------------------------------------+ ¦ ¦ ¦ ¦ ¦Net total ¦ +-----+-----------------+-------------+-----------+---------------------------¦ ¦Date ¦Description ¦Charges ¦Credits ¦ ¦ +-----+-----------------+-------------+-----------+---------------------------¦ ¦ ¦ ¦ ¦ ¦Current month¦Year to date ¦ +-----+-----------------+-------------+-----------+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----+-----------------+-------------+-----------+-------------+-------------¦ ¦1938 ¦ ¦ ¦ ¦ ¦$4,239,829.78¦ +-----+-----------------+-------------+-----------+-------------+-------------¦ ¦Jan. ¦ ¦ ¦$120,000.00¦ ¦ ¦ ¦31 ¦ ¦ ¦ ¦ ¦ ¦ +-----+-----------------+-------------+-----------+-------------+-------------¦ ¦31 ¦T/S to 771 Bal. 1¦$2,567,494.46¦991,676.09 ¦ ¦ ¦ ¦ ¦/1/34 ¦ ¦ ¦ ¦ ¦ +-----+-----------------+-------------+-----------+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦$1,455,818.37¦2,784,011.41 ¦ +-----+-----------------+-------------+-----------+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+
The Senior Corporation's current account contains the following entries for the month of January 1938:
+-------------------------------------------------------------------------+ ¦ ¦ ¦ ¦ ¦Net total ¦ +-------+-----------+-----------+-------------+---------------------------¦ ¦Date ¦Description¦Charges ¦Credits ¦ ¦ +-------+-----------+-----------+-------------+---------------------------¦ ¦ ¦ ¦ ¦ ¦Current ¦Year to date ¦ +-------+-----------+-----------+-------------+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦month ¦ ¦ +-------+-----------+-----------+-------------+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------+-----------+-----------+-------------+-------------+-------------¦ ¦1938 ¦ ¦ ¦ ¦ ¦$4,239,829.78¦ +-------+-----------+-----------+-------------+-------------+-------------¦ ¦Jan. 31¦T/S to 271 ¦$991,676.09¦$2,567,494.46¦ ¦ ¦ +-------+-----------+-----------+-------------+-------------+-------------¦ ¦31 ¦ ¦120,000.00 ¦ ¦$1,455,818.37¦2,784,011.41 ¦ +-------+-----------+-----------+-------------+-------------+-------------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------------------------------------------------------------------------+
In its personal holding company surtax return for 1937 the petitioner deducted from its undistributed adjusted net income the sum of $125,000 as an amount paid to retire indebtedness incurred prior to January 1, 1934. At the time when it prepared and filed its personal holding surtax returns for the years 1935 and 1936 the petitioner believed that deductions for such payments were limited to payments on debts evidenced by bonds and notes and for that reason it did not claim therein any deductions for amounts paid to the Senior Corporation in those years on the current account. The petitioner thereafter, in hearings before the respondent, claimed deductions for payments on indebtedness to the Senior Corporation in the amounts of $115,000 for the year 1935 and $390,000 for the year 1936. The claimed deductions of $125,000, $115,000, and $390,000 were disallowed by the respondent.
OPINION.
TYSON, Judge:
One of the issues presented by the petition filed herein is whether, in computing surtax on undistributed profits for each of the years 1936 and 1937, the petitioner should be allowed for each of such years, under the provisions of section 26(c)(1) of the Revenue Act of 1936, a credit of an amount equal to its entire adjusted net income. While the proceeding was under advisement, Congress amended section 26(c), effective as of the date of the enactment of the Act of 1936, by adding paragraph (3) which authorizes a credit in the case of a deficit corporation. Sec. 501(a)(2), Revenue Act of 1942. Section 26(c), as thus amended is set forth in the margin.
SEC. 26. CREDITS OF CORPORATIONS.In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax—(c) RESTRICTIONS ON PAYMENT OF DIVIDENDS.—(1) PROHIBITION ON PAYMENT OF DIVIDENDS.— An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. * * *(3) DEFICIT CORPORATION.— In the case of a corporation having a deficit in accumulated earnings and profits as of the close of the preceding taxable year, the amount of each deficit, if the corporation is prohibited by a provision of a law or of an order of a public regulatory body from paying dividends during the existence of a deficit in accumulated earnings and profits, and if each provision was in effect prior to May 1, 1936.(4) DOUBLE CREDIT NOT ALLOWED.— If more than one of the credits provided in the foregoing paragraphs (1), (2), and (3) apply, then the paragraph which allows the greatest credit shall be applied; and, if the credit allowable under each paragraph is the same, only one of such paragraphs shall be applied.
Because of the change in the applicable law, we entered an order on January 16, 1943, directing the parties to file supplemental briefs on the question of the effect of section 501(a)(2) of the Act of 1942 upon the petitioner's claim for credit. Such supplemental briefs have been filed and the question for determination is whether a credit is allowable either under section 26(c)(1) or section 26(c)(3), supra.
Is a credit allowable under section 26(c)(1)? The facts reveal a prohibition against the payment of dividends contained in the charter of the petitioner as amended on August 29, 1933, and also in the amended stock certificates through the endorsement thereon of a reference to the changes effected by the charter amendment. That prohibition was effective until such time as the petitioner's earnings and profits to the extent of $6,444,239.86 should be transferred to capital or capital surplus or surplus, and, as the petitioner's earnings and profits up to the close of the year 1937 fell far short of that amount, the restriction upon the payment of dividends remained in force during the taxable years 1936 and 1937.
The petitioner contends that, under the authority of Lehigh Structural Steel Co. v. Commissioner, 127 Fed.(2d) 67, the charter amendment and the amended stock certificates must be considered ‘a written contract executed by the corporation‘ within the meaning of section 26(c)(1). The Circuit Court of Appeals for the Third Circuit in that case held that stock certificates issued by a corporation meet the statutory test and it said that it found nothing in the opinion of the Supreme Court in Helvering v. Northwest Steel Rolling Mills, Inc., 311 U.S. 46, which supports the argument that neither a charter nor a certificate of stock can ever be the kind of ‘written contract‘ which is meant by section 26(c)(1). This interpretation of the statute and of the language used by the Supreme Court in the Northwest Steel Rolling Mills case has been rejected by the Circuit Court of Appeals for the Sixth Circuit, Warren Telephone Co. v. Commissioner, 128 Fed.(2d) 503; certiorari denied, 317 U.S. 697; Metal Specialty Co. v. Commissioner, 128 Fed.(2d) 259; Bishop & Babcock Manufacturing Co. v. Commissioner, 133 Fed.(2d) 199; and by the Circuit Courts of Appeals for the First and Seventh Circuits, Elliott Addressing Machine Co. v. Commissioner, 131 Fed.(2d) 700; Central West Coal Co. v. Commissioner, 132 Fed.(2d) 190; certiorari denied, 318 U.S. 778; and, upon the authority of those cases and our previous decisions in Lehigh Structural Steel Co., 44 B.T.A. 422; Bishop & Babcock ManufacturingCo., 45 B.T.A. 776; Budd Wheel Co., 45 B.T.A. 963; and McLean County Service Co., 45 B.T.A. 1004, we hold that the petitioner is not entitled to credit under section 26(c)(1).
However, the petitioner does not rely alone upon the provisions of the charter amendment and the stock certificates to bring its case within the requirements of section 26(c)(1), supra. It argues that, independently of such documents or taken in connection therewith, the reorganization agreement executed by the petitioner, its stockholders, and the Senior Corporation on August 23, 1933, meets those requirements, and that we must look to all of the documents which were before the parties at the time of its execution and to those documents which were executed pursuant thereto— including the memorandum of counsel, the resolutions adopted by the directors and stockholders, the amendment to the petitioner's articles, and the certificate of incorporation of the Senior Corporation— in determining the whole contract executed by the petitioner, and that we must read the provisions of such documents as if they were set out in detail in the reorganization agreement itself. It is true that the reorganization agreement required the fixation of the rights, powers, privileges, limitations, and restrictions respecting each class of stock of the petitioner and the Senior Corporation so as not to affect the rights, powers, privileges, limitations, and restrictions which the holders of each class of stock in petitioner had in its assets before the consummation of the transaction; and it may also be true that because of such requirement the parties regarded it as essential to the effectuation of such purpose that restrictions be placed upon the power of each corporation to pay dividends until such time as the deficit allocated to each should have been restored from its earnings. Assuming that the reorganization agreement, under these circumstances, may be said to deal ‘expressly * * * with the payment of dividends‘ (Gehring Publishing Co., 1 T.C. 345), it nevertheless did not operate as a contract restriction upon the dividend powers of the petitioner. The agreement merely required the adoption of charter provisions by petitioner defining the various rights of and restrictions upon each class of its stock. This is manifest from the memorandum of counsel which states that the earnings be transferred to capital until the deficit of $6,444,239.86 had been restored and that no dividends might be paid on the class A stock until such sum had been restored to capital. Upon the filing of the amended articles of the petitioner and of the charter of the new corporation and the exchange of assets for stock the reorganization agreement was discharged by a performance in accordance with its terms. It is therefore clear that after full performance and discharge of the agreement the only contracts which remained in force and which could operate to restrict the payment of dividends by petitioner were the petitioner's amended charter and its amended modified stock certificates, which had superseded the agreement in that respect, cf. Elliott Addressing Machine Co. v. Commissioner, supra; and, as we have held, the amended charter and the stock certificates are not such contracts as are within the intendment of section 26(c)(1).
Is credit allowable under section 26(c)(3)? The petitioner contends that at December 31, 1935, and at December 31, 1936, it had a deficit in accumulated earnings and profits in excess of its adjusted net income for the succeeding calendar year, and that, by provisions of the General Corporation Act of Michigan, hereinafter mentioned, it was prohibited from paying dividends during the existence of such deficit. The respondent's position is (1) that in reality the petitioner had no deficit in accumulated earnings and profits at those dates, and (2), assuming that it did, the petitioner was not prohibited by the Michigan law from distributing its net earnings of the taxable years.
On June 30, 1933, the petitioner had a deficit, as disclosed by its books, of $21,041,234.12, and in the reorganization $14,596,994.26 of this deficit was assumed by the Senior Corporation and $6,444,239.86 was retained by the petitioner. It is the rule that, where the assets of one corporation pass to a successor corporation in a tax-free reorganization, the accumulated earnings and profits of the old corporation pass to the successor with the same status and are available for the payment of dividends by the latter, Commissioner v. Sansome, 60 Fed.(2d) 931; certiorari denied, 287 U.S. 667; United States v. Kauffmann, 62 Fed.(2d) 1045; Reed Drug Co. v. Commissioner, 130 Fed.(2d) 288; Helen V. Crocker, 29 B.T.A. 773; an d that, where only part of the assets are so transferred, it is proper to make an allocation of the earnings and profits between the two corporations in proportion to the assets transferred and the assets retained. Barnes v. United States, 22 Fed.Supp. 282; Estate of Howard H. McClintic, 47 B.T.A. 188, 202.
The respondent questions the petitioner's claim that it is a deficit corporation; but he makes no contention that the principles of the foregoing cases do not apply to the inheritance or absorption of a deficit. He questions the deficit only in two respects. His first objection relates to the method of dividing the deficit. At the time of the reorganization the assets transferred to the Senior Corporation consisted of the Fisher stock of the market value of $8,000,000 and other assets of the market value of $12,838,325.63. The remainder of the petitioner's assets which it retained had a market value of $5,667,827.19. The parties agreed to divide the deficit on the basis of the market value of the assets transferred, exclusive of the Fisher stock, and the market value of the assets retained, or in the proportion of 69.37 percent to the Senior Corporation and 30.63 percent to petitioner. At that time the deficit of $21,041,234.12 was overstated on the petitioner's books by the amount of $461,361.72. The contention of the respondent is that the exclusion of the $8,000,000 value of Fisher stock in fixing the percentages used in dividing the deficit shows that there was ‘no relationship between the division of assets and the division of the deficit ‘ and that therefore there is ‘no sound basis on the theory of proportion of assets transferred and retained for computing the division of the deficit in accordance with those identical percentages;‘ and, with respect to the overstatement of $461,361.72, he states that such overstatement leaves ‘no rational basis for the precise amount of the deficit.‘
The exclusion of the Fisher stock in fixing the percentage for dividing the deficit was adopted by the parties, as the findings of fact show, in order to preserve the existing rights of the holders of the various classes of stock of the petitioner. Whether that method was proper under the circumstances shown we need not decide. Assuming that it was not, and assuming that the division should have been made on the basis of all assets transferred (including the Fisher stock) and all assets retained in the ‘split-up‘ reorganization, so that the deficit retained would be that proportion of the total deficit which the assets retained bore to the total assets (cf. Howard H. McClintic, supra), a computation made along the lines suggested by the respondent's argument would nevertheless establish a deficit retained by the petitioner in an amount sufficient to give it the benefit of the credits here claimed.
The value of all of the petitioner's assets, including the Fisher stock, was $26,506,152.82, and the assets retained by the petitioner, namely, $5,667,827.19, comprised 21.4 percent of the total value. A division of the deficit on the basis of 21.4 percent to the petitioner and 78.6 percent to the Senior Corporation would result in an allocation to the petitioner of $4,502,824.10 of the deficit— an amount which, after further adjustment for the overstatement of $461,361.72, is far in excess of the petitioner's accumulated earnings and profits from June 30, 1933, to the close of the year 1937.
The respondent also attacks the June 30, 1933, deficit of $21,041,234.12 on the ground that it was computed on the basis of the book value of assets, that is, the fair market value of the petitioner's property in 1929, when it was acquired from the Fishers in exchange for capital stock. The property paid in by Fisher and his wife had a fair market value of over $88,000,000 in 1929 and it had been acquired by them prior to that time at a cost of $6,412,271.74. After retirement of part of Mrs. Fisher's stock in 1931, and at June 30, 1933, the petitioner's books disclosed assets of the book value of $63,222,862.21, current liabilities of $1,320,295.33, capital stock liability of $82,943,801, and a deficit of $21,041,234.12. The respondent's position is stated in his brief (p. 57) as follows:
On the basis of cost to Fred J. Fisher and his wife, the transferors of assets to petitioner for stock on July 1, 1929, there is no foundation in the record for the existence of the deficit determined as of that date nor, in fact, for any deficit whatever. The recapitalization and reorganization of petitioner in August, 1933, (sic) was nontaxable. Hence, there was neither rational basis for determination of the claimed deficit in the amount stated as of June 30, 1933 nor in fact did such deficit exist.
The transfer of the property by the Fishers to the petitioner in 1929 in exchange for its capital stock was a tax-free exchange, and the taxable income of the petitioner from the disposition of such property was required to be computed on the basis of the cost of such property to the Fishers. Secs. 112(b)(5) and 113(a)(8), Revenue Act of 1928. However, the gain or loss reflected by the use of the transferor's basis is not the true or actual gain or loss as it affects the capital of the corporation. Whether a corporation has an earned surplus or a deficit which impairs capital is to be determined on the basis of the actual gain or loss, and the actual gain or loss is to be measured by the cost of the property to the corporation, which, in a case such as the instant one, is the fair market value of the property received in exchange for all of its capital stock. W. S. Farish & Co., 38 B.T.A. 150, and authorities cited therein; affd., 104 Fed.(2d) 833. See also F. J. Young Corporation, 35 B.T.A. 860; affd., 103 Fed.(2d) 137; Dorothy Whitney Elmhirst, 41 B.T.A. 348; and Estate of John H. Wheeler, 1 T.C. 640.
The rule established by the above cited cases is applicable here notwithstanding the provisions of section 501(a) of the Second Revenue Act of 1940. Although that section amends section 115 of the Internal Revenue Code so as to require the use of the adjusted basis for determining gain in the computation of earnings and profits and directs that gain or loss realized from the sale or other disposition of property by a corporation shall increase or decrease the earnings and profits to, but not beyond, the extent to which such a realized gain or loss was recognized in computing net income under the law applicable to the year in which the sale or disposition was made, and thereby supersedes the rule of the Farish and other cases cited above (H. Rept. 2894, 76th Cong., 3d sess., pp. 41, 42), the amendment, though retroactive as if it were a part of prior revenue acts, does not affect the tax liability of any taxpayer for any year which on September 20, 1940, was pending before the Board of Tax Appeals. Sec. 501(c); Estate of John H. Wheeler, supra. The petition herein was filed on September 9, 1940, and the case has been pending since. The respondent's contention that the earnings and profits should be computed by using the cost to the petitioner's transferors is therefore without merit.
The deficit of $21,041,234.12 appearing on the petitioner's books at June 30, 1933, was computed on the basis of actual gains and losses of the petitioner from its organization up to that date. The respondent admits the accuracy of the books except for overstatement of the deficit by the amount of $461,361.72. After giving consideration to the $8,000,000 value of the Fisher stock in the division of the deficit between the petitioner and the Senior Corporation and after making allowance for the admitted overstatements, it is plain that the deficits existing at December 31, 1935, and December 31, 1936, exceeded the amount of the petitioner's adjusted net income for the years 1936 and 1937. The petitioner therefore qualifies as a deficit corporation under section 26(c)(3), supra.
The petitioner relies upon the General Corporation Act of Michigan, enacted in 1931, to establish the necessary prohibition against the payment of dividends during the existence of the deficit. That act appears as Title 21, chapter 195, 15 Mich.Stats.Ann., and the sections relied upon are sections 21.22, 21.23, and 21.48 of the annotation, which are in part set forth in the margin.
Sec. 21.22 Dividends; source of payment; restrictions * * * SEC. 22. The directors of every corporation formed or existing under this act, subject to any restrictions contained in its articles, shall have power to declare and pay dividends upon the shares of its capital stock either from earned surplus or from net earnings. (Italics supplied.) In determining earned surplus appreciation of value of the assets of the corporation shall not be included until realized: Provided, That appreciation of value shall not be construed to include any increases which result from readjustment of previous reductions of value to correctly reflect the accounts of the corporation at the time of such determination of earned surplus. In determining what is earned surplus the judgment of the board of directors shall be conclusive unless it shall be shown that the directors acted in bad faith or were grossly negligent.Nothing in this section contained shall prevent a corporation from declaring and paying dividends upon its preferred stock from any surplus: Provided, That if such dividend shall be declared and paid from any surplus other than earned surplus the shareholders receiving the same shall be advised of that fact at the time of the payment to them * * *Sec. 21.23 Same; not to be paid except in accordance with act; medium of payment; * * * SEC. 23. No corporation formed or existing under this act, nor the directors thereof, shall pay or authorize the payment of dividends upon any shares of the capital stock of the corporation except in accordance with the provisions of this act.* * * Sec. 21.48 Liability for illegal dividends and distributions. SEC. 48. The directors of a corporation shall not declare or pay dividends or authorize the withdrawal or distribution of any part of its assets except as authorized in this act * * * In case of any wilful or negligent violation of the provisions of section twenty-two (22) or twenty-three (23) of this act or of this section, the directors * * * shall be jointly and severally liable * * * to the corporation for the full amount of any of such dividends, withdrawal or distributions so unlawfully paid. * * *
The respondent contends that the Michigan statute does not expressly prohibit but, on the contrary, affirmatively authorizes, the payment of dividends ‘either from earned surplus or from net earnings,‘ and he argues that for this reason, since the petitioner had net earnings in each of the years 1936 and 1937, it could have distributed them without violating the statute. While section 21.22, in permissive terms, authorizes payment of dividends ‘either from earned surplus or from net earnings,‘ section 21.23 prohibits their payment ‘except in accordance with provisions of this act,‘ which means, of course, except in accordance, inter alia, with section 21.22. Thus there is a clear and express prohibition in the Michigan statute against the payment of dividends except out of earned surplus or net earnings.
Under the second paragraph of section 21.22 dividends may also be paid on preferred stock from any surplus.
The respondent contends further in effect that, even though the statute expressly prohibits the payment of dividends, the term ‘net earnings‘ is used therein in the sense of current or annual net earnings, and that petitioner, having earnings in each of the years 1936 and 1937, was not prohibited from paying dividends in those years, notwithstanding it then had no earned surplus. The petitioner controverts this contention and insists that the term means the net earnings of the corporation from its inception.
‘Net earnings‘ is not defined in the Michigan statute, nor is it qualified therein by any words definitely stating any certain period for which they are to be computed. Net earnings of a corporation, as a general proposition, have been defined as ‘the excess of the gross earnings over the expenditures defrayed in producing them, aside from, and exclusive of the expenditure of capital * * * .‘ Union Pacific Railroad Co. v. United States, 99 U.S. 402; see also Mobile & Ohio Railroad v. Tennessee, 153 U.S. 486; and R. M. Weyerhaeuser, 33 B.T.A. 594. And dividends are payable out of both current and accumulated earnings. Lynch v. Hornby, 247 U.S. 339. The common and ordinary meaning of the term ‘net profits,‘ uniformly recognized by the courts, takes into account losses sustained and capital invested in the business. ‘Net profits‘ are ‘the clear pecuniary gain remaining after deducting from the gross earnings of the business the expenses incurred in its conduct, the losses sustained in its prosecution, and the capital invested.‘ Lich v. United States Rubber Co., 39 Fed.Supp. 675; affirmed per curiam, 123 Fed.(2d) 145; Hunter v. Roberts, Throp & Co., 83 Mich. 63; 47 N.W. 131; Guaranty Trust Co. v. Grand Rapids, G. H. & M. Railway Co., 7 Fed.Supp. 511; affd., 85 Fed.(2d) 331; Fraser v. Great Western Sugar Co., 29 Fed.(2d) 810. Cf. National Newark & Essex Banking Co. v. Durant Motor Co., 1 Atl.(2d) 316; 124 N.J.Eq. 213; affd., 5 Atl.(2d) 767. In the Fraser case the court quotes with approval authority to the effect that the actual value of the assets with which the corporation began business is to be deducted and that the business of a corporation is to be viewed as a unit in determining whether there are net profits. In Willcuts v. Milton Dairy Co., 275 U.S. 215, the Court held that a corporation can not have undivided profits unless the net assets exceed the capital stock, and that, therefore, where capital is impaired, profits, though earned and remaining in the business, are not surplus or undivided profits if they are insufficient to offset the impairment.
While we are without the benefit of an interpretation of its present statute by the courts of Michigan, we think the foregoing authorities fully support the petitioner's contention that it was prohibited from paying dividends during the existence of the deficit. The Lich case, supra, provides a complete answer to the construction of the Michigan statute contended for by the respondent. The New Jersey statute there under consideration provided that the directors ‘shall not pay dividends except from its surplus * * * or from the net profits arising from the business,‘ and the corporation there, as in the present case, had a deficit in excess of its net earnings of the current year. It was contended that the term ‘net profits‘ should be construed as meaning ‘annual net earnings‘ and that in determining the net profits for the current year the losses of prior years should be disregarded. In its opinion the court said:
What are ‘net profits‘ within the meaning of the statute? The statute is devoid of any definitive answer. The term, however, is one of common usage and the ordinary acceptation must be adopted. The term connotes the clear pecuniary gain remaining after deducting from the gross earnings of the business the expenses incurred in its conduct, the losses sustained in its to the existence of net profits that the assets of a corporation exceed the liabilities, including the liability on the capital stock. Where capital is impaired, annual net earnings, if insufficient to offset the impairment, do not constitute net profits. Willcuts v. Milton Dairy Company, 275 U.S. 215, 218; * * * Foley Securities Corp. v. Commissioner * * *, 106 F.2d 731, 733. The term net profits is not synonymous with the term annual net earnings. Annual net earnings may be productive of net profits, or, as in the instant case, reductive of the deficit. * * *
In the immediate case there were, in the years in question, * * * no net profits to which the inchoate right to dividends could have attached. There was, * * * in each of the said years, a substantial deficit which greatly exceeded the annual net earnings of the corresponding year, and, to the reduction of which the annual net earnings were applied. It is manifest, therefore, that the annual net earnings of each of the said years resulted, not in a profit, but in a reduction of the deficit. There was in each of the said years no source from which dividends could have been paid lawfully; the payment of dividends under the circumstances would have been unlawful.
The court's construction * * * finds support in the case of National Newark & Essex Banking Co. et al. v. Durant Motor Co. et al., 124 N.J.Eq. 213, 1 A2d 316, * * * in which it was stated: ‘Our statute forbids the payment of dividends except from surplus or 'from the net profits arising from the business of the corporation.’ * * * In my opinion, no dividends out of net profits are earned until there is a balance of assets over liabilities, arising from the business of the corporation. * * *
It is in effect contended by the plaintiff that the statutory term ‘net profits‘ is synonymous with ‘annual net earnings‘, and that in determining the net profits for the years in question, the losses of preceding years, as indicated by the deficit, may be disregarded. The fallacy of this contention is obvious. This theory would permit that which the statute * * * expressly prohibits, to wit, the payment of dividends out of annual net earnings, even though such payment resulted in an impairment of capital. The payment of dividends out of annual net earning when, as in the immediate case, a deficit exists, would result in an impairment of capital, * * *
It must be presumed that the Legislature of Michigan used the term ‘net earnings‘ in its ordinary and commonly accepted meaning. If it had been the intention to limit it to earnings of a particular year, it would have been a simple matter to do so by the insertion of the words ‘annual‘ or ‘current‘ preceding the term ‘net earnings.‘ In some states which have adopted the policy of permitting the payment of dividends during the existence of a deficit, the legislators have resorted to language adequate to express that intention. See Rev. Code Del., 1935, Sec. 2066; Cal. Civ. Code, 1937, Sec. 346.
We are of the opinion that the petitioner is entitled to the credits claimed under section 26(c)(3), and we so hold.
The second issue for decision is whether in determining the petitioner's undistributed adjusted net income for personal holding company surtax purposes for each of the years 1935, 1936, and 1937, the petitioner is entitled to deduct certain amounts paid to the Senior Corporation in those years as amounts used to pay or retire indebtedness incurred prior to January 1, 1934. Sec. 351(b)(2)(B), Revenue Acts of 1934, 1936, and sec. 355(b), Revenue Act of 1936, as added by sec. 1, Revenue Act of 1937.
SEC. 351. * * *(b) DEFINITIONS.— As used in this title—(2) The term ‘undistributed adjusted net income‘ means the adjusted net income minus the sum of:(B) Amounts used or set aside to retire indebtedness incurred prior to January 1, 1934, if such amounts are reasonable with reference to the size and terms of such indebtedness;By section 355 of the Act of 1936 added by section 1 of the Revenue Act of 1937 and effective for taxable years beginning after December 31, 1936, clause (B) was changed to read:‘(b) Amounts used or irrevocably set aside to pay or to retire indebtedness of any kind incurred prior to January 1, 1934, if such amounts are reasonable with reference to the size and terms of such indebtedness.‘
The petitioner contends that prior to January 1, 1934, it was indebted to the Senior Corporation in the sum of $2,567,494.46 as shown by petitioner's and the Senior Corporation's current accounts, and that it should receive credits as against that sum in the amounts of $458,068.92, $393,931.07, and $125,000 for the respective taxable years 1935, 1936, and 1937 for the reason that such amounts paid in those years should be applied to the $2,567,494.46 because the latter sums embraced the oldest items on petitioner's and the Senior Corporation's current accounts. The respondent controverts this contention, on the grounds that, even if the transactions as reflected in such current accounts were based upon a true debtor and creditor relationship, a charge to the Senior Corporation by petitioner on petitioner's current account and a corresponding entry on the Senior Corporation's current account show that the $2,567,494.46 was paid or discharged on January 31, 1938, and therefore subsequent to the taxable years; and, in the alternative, respondent contends those transactions as reflected in the respective current accounts were not realities based upon a true debtor and creditor relationship in that those transactions and the existence of the Senior Corporation collectively constituted a mere fiction.
It appears from the record that for the year 1936 the respondent has determined a deficiency in income tax of $132,261.91 and an overassessment in personal holding company surtax of $44,244.69. Since we have no jurisdiction of overassessments (Cornelius Cotton Mills, 4 B.T.A. 255), the proceeding must be dismissed in so far as it pertains to the personal holding company surtax for the year 1936. Will County Title Co., 38 B.T.A. 1396; Union Telephone Co., 41 B.T.A. 142; Hobbs Western Co., 43 B.T.A. 5.
The current accounts of petitioner and the Senior Corporation disclose a balance due from the petitioner to the Senior Corporation of $2,567,494.46 at December 31, 1933, as a result of transactions occurring in the period August 28, 1933, to December 31, 1933; and the amounts here claimed as deductions are the amounts of $458,066.92, $393,931.07, and $125,000, which are the total amounts shown by petitioner's current account to have been debited to the Senior Corporation and by the Senior Corporation's current account to have been credited to petitioner in the respective taxable years 1935, 1936, and 1937. It appears also from those current accounts that during the years 1934 to 1937 the petitioner was charged with amounts which the aggregate largely exceeded the total amount of the credits received by it during those years.
The deduction allowed by the statute is for ‘amounts used * * * to retire indebtedness incurred prior to January 1, 1934,‘ and the burden rests upon the petitioner to show that it comes clearly within the terms laid down in the statute. New Colonial Co. v. Helvering, 292 U.S. 435. In Pembroke Realty & Securities Corporation, 42 B.T.A. 341 (reversed on another ground, 122 Fed.(2d) 252), we said that it is reasonable to assume that ‘indebtedness incurred prior to January 1, 1934‘ (the crucial date there) was intended to refer to debts which, under the local law governing the relations of debtor and creditor, would be treated as having been incurred prior to that date. The rule prevailing in Michigan is stated in Mauro v. Davie, 236 Mich. 309; 210 N.W. 308, as follows:
The debtor may direct the application (of the payment) before or at the time the payment is made. If he does not, the creditor may apply it as he pleases, either at the time the payment is made or afterwards, if before any controversy arises concerning it. In the absence of direction on the part of the debtor or application by the creditor, if the credit appears in the general account and there be no evidence of an understanding to the contrary, the credit will be applied to the debits in the order of time in which the debits occur.
See also Jarecki Mfg. Co. v. Ragir, 272 Mich. 689; 262 N.W. 323; and Wanner v. Snider, 289 Mich. 464; 286 N.W. 685. This rule obtains in many other jurisdictions. 48 C.J. 653, 104.
In our opinion, the petitioner is not entitled to have the Michigan rule invoked in its favor. The running accounts of petitioner and the Senior Corporation in evidence claimed as payments, we are informed only that they were paid to the Senior Corporation or advanced on its behalf and were charged against it in the petitioner's current account with corresponding entries on the Senior Corporation's current account. Although the witnesses asserted complete knowledge of every transaction, they have not indicated that no direction was made by the debtor and no application was in fact made by the creditor, nor did they testify that no express understanding existed with respect to the application of specific payments. In our opinion, the rule is not to be applied in the absence of evidence upon which a specific findings can be made as to the existence of those conditions which are held by the law of Michigan to be necessary for the application of the rule. See Jarecki Manufacturing Co. v. Ragir, supra.
The current account of the petitioner and the corresponding current account on the books of the Senior Corporation contain entries made under date of January 31, 1938. The entry on the Senior Corporation's current account shows that the petitioner on that date was credited with the amount of $2,567,494.46, this being the identical amount of the balance of the indebtedness shown by the two current accounts of petitioner and the Senior Corporation to have been owing by the petitioner to the Senior Corporation at December 31, 1933. The entry on petitioner's current account shows that the same amount was, accompanied with a notation ‘T/S to 771 Bal. 1/1/34.‘ These parts of the accounts were introduced in evidence, without qualification, and none of the witnesses explained the nature of the transaction represented by this entry.
The book entries of January 31, 1938, standing alone, may not be conclusive evidence of an actual payment on that date by the petitioner of the amount of $2,567,494.46 to the Senior Corporation, but they are evidence of the fact that on that date the petitioner received a credit on the books for the identical amount of the indebtedness which was shown by other entries and in the same accounts to be due to the Senior Corporation on December 31, 1933. The entries are inconsistent with the theory here advanced by the petitioner that the amounts appearing in the accounts as credits in favor of petitioner for the years 1935, 1936, and 1937 were payments on account of the indebtedness existing at January 1, 1934. On the record as it stands we are unable to make a finding that the amounts credited in the accounts during the years 1935 and 1937 were amounts used to retire the indebtedness existing at January 1, 1934, and for that reason, the determination of the respondent (involved in the second issue and in so far as it pertains to the taxable years 1935 and 1937) in disallowing the deductions is approved.
The failure of the petitioner to show by its proof that any amount was paid in the years 1935 and 1937 to retire such indebtedness renders unnecessary consideration of the question whether the deductions claimed for those years should be denied upon the alternative contention of the respondent, although many facts of record, which are not set our in our findings are pertinent to that contention.
Decision will be entered under Rule 50, except that in so far as the proceeding pertains to personal holding company surtax for the year 1936 an order will be entered dismissing the proceeding for want of jurisdiction.