Paris & M. P. R. Co. v. Commissioner , 47 B.T.A. 439 ( 1942 )

PARIS & MT. PLEASANT RAILROAD COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. ¹

Paris & M. P. R. Co. v. Commissioner

Docket No. 103578.

United States Board of Tax Appeals

47 B.T.A. 439; 1942 BTA LEXIS 695;

August 4, 1942, Promulgated

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">*695 1. Petitioner is not entitled to credit for amount of adjusted net income under section 26(c)(1), Revenue Act of 1936, even though, under an existing capital deficit, it was prohibited by a Federal law from distributing its profits earned in taxable year as dividends. Crane-Johnson Co. v. Helvering,311 U.S. 54">311 U.S. 54, followed.

2. Petitioner is entitled, under section 26(c)(2), to a credit of $14,000, the amount of current earnings set aside as a sinking fund payment, that amount being less than it was required to pay into the sinking fund, cf. Brockway Glass Co.,43 B.T.A. 267">43 B.T.A. 267, and the payment having been made pursuant to a written contract executed prior to May 1, 1936.

T. D. Gresham, Esq., for the petitioner.

Donald P. Moyers, Ewq., for the respondent.

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HARRON

">*439 Respondent determined a deficiency in income tax for the year 1937 in the amount of $13,540.88. The deficiency results from respondent's disallowance of a credit under section 26(c)(1) of the ">*440 Revenue Act of 1936 in the amount of petitioner's entire adjusted net income. Petitioner contests the entire deficiency.

FINDINGS OF FACT.

">*696 The facts are stipulated and are adopted as our findings of fact. Facts necessary to understand the issues are set forth.

Petitioner is a Texas corporation, incorporated in 1909. It is a common carrier operating a railroad in intrastate and interstate commerce. Its principal office is at Paris, Texas. It keeps it books and makes its returns on the accrual basis. It filed its income tax return for 1937 with the collector for the second district of Texas.

In 1909 petitioner issued 750 shares of common stock, par value $100, aggregating $75,000. Petitioner has never paid a dividend on its stock. All of its authorized capital stock was outstanding in 1937.

Petitioner executed on July 1, 1912, a written deed of trust with the First Trust & Savings Bank, an Illinois corporation, and James L. Houghteling, Jr., as trustees, to secure the payment of its first mortgage 6 percent bonds. Pursuant to this indenture, petitioner issued and delivered for value 600 of its bonds with interest coupons attached, of the par value of $1,000 each, dated July 1, 1912, and due July 1, 1932.

The deed of trust provided, inter alia, as follows:

THIRTEENTH. * * *

The Railroad Company">*697 shall and will put aside and set apart, as a sinking fund for the payment and redemption of its said bonds, five (5%) per cent. of the gross earnings of the Railroad Company's system for each year beginning with the calendar year commencing January 1, 1915, and continuing until all of its said bonds are paid, or called for payment or redemption as provided for in Article Fourteenth hereof, and shall and will pay over such sinking fund moneys to the Corporate Trustee within thirty (30) days after the end of such calendar year, the first payment to be made within thirty (30) days after December 31, 1915, to be held by the Corporate Trustee as additional security for the payment of the bonds issued hereunder and hereby secured and to be used and expended by the Corporate Trustee for some one of the following purposes at the option and selection of the Railroad Company:

(a) For the purchase of the bonds issued by the Railroad Company hereunder and hereby secured, in the open market, at the best price obtainable not to exceed one hundred and five (105%) per cent. of their par value and accrued interest, and all of the bonds which may be so purchased shall be immediately cancelled by">*698 the Trustees.

(b) For the calling of the said bonds for prepayment or redemption at one hundred and five (105%) per cent. of their par value and accrued interest, at the next interest date at which said bonds can be called for prepayment or redemption, the said bonds so called for prepayment or redemption to be selected and notice of call to be made as provided in Article Fourteenth hereof.

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In the event of default or breach of any of the provisions in this deed of trust contained, any and all sinking fund moneys or securities or other property so held ">*441 by said First Trust and Savings Bank, Trustee, shall be held and applied by it for the equal and pro rata use and benefit of the holders of each and all of the bonds and coupons hereby secured.

FOURTEENTH. The Railroad Company, at its option, either out of its own moneys or out of the sinking fund moneys provided for in Article Thirteenth hereof, may pre-pay or redeem on July 1, 1915, or on any semi-annual interest payment day thereafter, any or all of its bonds issued hereunder and hereby secured, by the payment of the principal thereof with interest accrued thereon and a premium of five (5%) per cent. of">*699 the principal of the bonds so paid, * * *

Until 1937 no portion of petitioner's earnings or profits was ever put aside or set apart in a special account as a sinking fund, or reflected on petitioner's balance sheet for the retirement of its bonds and interest coupons.

From February 26, 1920, to December 31, 1930, petitioner was operated by a receiver, but the receivership did not foreclose or impair the outstanding bonds or interest coupons. On December 31, 1930, when the receivership was terminated, the property and assets in the hands of the receiver were returned to and repossessed by petitioner.

The interest on the bonds was defaulted on January 1, 1925. On February 7, 1935, all of the bonds and interest coupons were past due and unpaid, and on that date the deed of trust and all the terms, conditions, and stipulations thereof were acknowledged, confirmed, and continued in full force and effect.

At the beginning of the taxable year 1937 the 600 outstanding bonds, evidencing an existing valid liability in the aggregate principal amount of $600,000, continued in default, with interest past due of approximately $592,560. Of the 600 bonds, 592 were owned by Percy Jones">*700 of Abilene, Texas, and the other 8 bonds by various parties. The holders of the 8 bonds, aggregating the principal amount of $8,000, with past due interest amounting to $6,380, demanded payment thereof. Petitioner and Percy Jones were desirous of effecting a change in the trustees named in the deed of trust. The trustees agreed to resign in favor of a successor trustee providing the 8 bonds and interest coupons were paid in full, whereupon Percy Jones agreed that the 8 other bondholders should receive full payment of their bonds and interest. This was provided for on October 1, 1937, when petitioner deposited with the Farmers & Merchants National Bank of Abilene the sum of $14,507.60 (including $127.60 of Federal income tax), out of its 1937 earnings and profits, with the direction to transfer that sum of money to the successor trustee when appointed under the deed of trust.

Thereupon the original mortgage trustees resigned and the First National Bank of Paris, Texas, qualified as successor trustee under the deed of trust, and on November 24, 1937, the Farmers & Merchants National Bank of Abilene transferred the sum of $14,507.60 ² to the ">*442 First National Bank of">*701 Paris, which set the sum aside in a special account for the payment of the 8 bonds and interest coupons. During the period from November 27, 1937, to March 28, 1938, the 8 bonds and interest coupons were paid in full. The remaining 592 bonds continued in default at the close of the taxable year 1937, with interest past due of approximately $603,609.

At the beginning of the year 1937 petitioner had a deficit of $418,516.69 in earned surplus and undistributed profits. At the end of the year it had a similar deficit of $365,008.46. Petitioner's gross income during this year was $453,142.80, 5 percent of which is $22,657.14.

In its income tax return for 1937 petitioner deducted interest in the amount of $35,900, which represented $35,520 current interest paid in 1937 on the 592 bonds belonging to Jones, and $380 current, 1937, interest on the 8 bonds. Respondent allowed petitioner the claimed deduction.

In its 1937 income tax return petitioner made no computation of any undistributed">*702 profits surtax, stating that, because of its deficit in earned surplus and undistributed profits at the close of the taxable year, it was prohibited by both Federal and the State of Texas statutes from paying dividends and therefore was not liable for a surtax on undistributed profits under the Revenue Act of 1936. Respondent denied this contention and in making his adjustments determined that an undistributed profits surtax in the amount of $14,038.97 was due from petitioner.

Petitioner irrevocably set aside $14,000 out of its earnings in 1937 into a sinking fund for the retirement of bonds, and this was done in compliance with the requirements of a written contract executed prior to May 1, 1936. The arrangement made in 1937 to redeem 8 bonds did not constitute a "new agreement" entered into after May 1, 1936.

OPINION.

HARRON: The respondent determined a deficiency in income tax for the year 1937 in the amount of $13,540.88. The deficiency results from the respondent's determination that petitioner is liable for surtax on undistributed profits in the amount of $14,038.97, which is computed by applying the provisions of section 14(b) of the Revenue Act of 1936 to undistributed">*703 adjusted net income in the amount of $68,482.78. Petitioner agrees on the amounts of its taxable net income and its adjusted net income.

Petitioner contends, first, that it is not a corporation which comes within the terms of section 14(b), because under the provisions of the Interstate Commerce Act, as amended by the Transportation Act of 1920, it was prohibited from paying any dividends in the taxable year ">*443 because it had a capital deficit.³ During the taxable year petitioner's deficit amounted to in excess of $400,000. Petitioner argues, in effect, that before it could pay dividends out of current earnings it was required to accumulate earnings until the capital deficit was extinguished. Petitioner has not cited us to any other provisions of the Interstate Commerce Act which prescribe what funds are "properly includable in the capital account." Assuming, arguendo and without deciding the point, that provisions of the Interstate Commerce Act prevented the petitioner from paying any dividends out of earnings in the taxable year, there is nothing in this case to take it out of the rule of ">*704 Crane Johnson Co.,38 B.T.A. 1355">38 B.T.A. 1355; affd., 311 U.S. 54">311 U.S. 54; and Helvering v. Northwest Steel Rolling Mills, Inc.,311 U.S. 46">311 U.S. 46. In both cases the corporations had existing deficits and they were prohibited by state statutes from paying dividends except out of surplus. Section 26(c)(1) allows a credit if dividends can not be distributed without violating the terms of a written contract executed prior to May 1, 1936, which expressly deals with the payment of dividends. "The language used in section 26(c)(1) does not authorize a credit for statutorily prohibited dividends." (Italics added.) 311 U.S. 46">Northwest Steel Rolling Mills, Inc., supra.It provides no distinction here that the statute which, presumably, prohibited petitioner from paying dividends, was a Federal statute. The provisions of the Interstate Commerce Act are not a "contract" within the meaning of section 26(c)(1). The Crane Johnson Co. and Northwest Steel Rolling Mills, Inc., cases, supra, are controlling. Furthermore, petitioner is not a corporation within the classes of corporation specifically exempted from the surtax on undistributed profits">*705 by section 14(d). Section 14(b) makes the surtax applicable to "every corporation", which means, upon reading section 14 in its entirety, every corporation except those specifically exempted.

For the above reasons, it is held that petitioner is not entitled to a credit in the amount of its adjusted net income, or $68,482.78.

In the alternative, petitioner claims that it is entitled to a credit under section 26(c)(2) of the Revenue Act of 1936, ⁴ in the sum of ">*444 $14,000, which amount was irrevocably set aside in the taxable year out of earnings and profits in discharge of a debt. Petitioner contends that the above amount was set aside pursuant to the terms of a written contract executed prior to May 1, 1936, which terms expressly dealt with the disposition of earnings and profits of the taxable year, so that the amount in question squarely comes within">*706 the provisions of section 26(c)(2). The respondent agrees that petitioner irrevocably set aside in 1937 $14,000 of its earnings and profits of the taxable year for the discharge of a debt by paying that amount to the Farmers & Merchants National Bank of Abilene.

">*707 The question is whether or not the $14,000 was paid in accordance with the requirements of a written contract executed prior to May 1, 1936. The deed of trust executed July 1, 1912, was continued in effect in all of its terms on February 7, 1935. Under the facts it must be concluded that the deed of trust in all its terms was in effect in 1937. When the holders of eight bonds held back their consent to the appointment of a successor trustee, for which paragraph seventeenth of the trust deed provided, until it was agreed that petitioner would redeem their bonds, there was no modification of any of the terms of the trust deed, or of paragraph thirteenth, relating to the payment of 5 percent of the gross earnings of each year into a sinking fund. The arrangement made with them, to which Jones consented, did not constitute the making of a new agreement in 1937. Jones' consent simply constituted a waiver of his right, under the default, to have all of the moneys in the sinking fund applied pro rata for the benefit of each bondholder.

Under the terms of the sinking fund provision petitioner is required to make sinking fund payments until all of its bonds are paid. It was required">*708 to deposit $22,657.14 in the sinking fund in 1937, or 5 percent of its gross earnings. Petitioner set aside $14,000. Under the facts there can be no serious contention that the $14,000 irrevocably set aside to redeem the eight bonds was not a sinking fund payment. It is immaterial that it was less than the required 5 percent of gross earnings of the year. It is concluded that the above amount was a sinking fund payment.

Respondent argues that paragraph thirteenth of the trust deed did not require "the retirement of any specific bonds in the manner here employed"; that the retirement of the eight bonds was undertaken only to afford a change in the trustees; and that, therefore, the setting aside of the $14,000 was not in pursuance of a requirement of a written contract. This argument is without merit. First, petitioner was required by the terms of the deed of trust to set aside during each year certain amounts as a sinking fund out of the current earnings of each year, and, second, out of the sinking fund the corporate trustee could, at the option of petitioner, use money ">*445 in the sinking fund for the purchase or redemption of bonds at 105 percent of par value plus">*709 accrued interest. Furthermore, in the event of default, any sinking fund moneys held by the corporate trustee had to be applied for the use and benefit of the holders of bonds and interest coupons secured by the sinking fund. The fact that Jones waived his right, under the terms of the last part of paragraph thirteenth of the trust deed, to have all of the sinking fund moneys applied pro rata to all outstanding bonds, including the bonds held by him, did not invalidate, amend, or change the other requirement of paragraph thirteenth relating to the setting aside of moneys in the taxable year out of gross earnings of the taxable year for the sinking fund.

It must be concluded that the $14,000 was irrevocably set aside in 1937 out of the earnings of 1937, pursuant to the terms of a written contract expressly dealing with earnings of the taxable year, and that the written agreement was one which was executed prior to May 1, 1936. The payment comes within the provisions of section 26(c)(2), and petitioner is entitled to a credit in the amount of $14,000. Cf. ">*710 Brockway Glass Co.,43 B.T.A. 267">43 B.T.A. 267, 43 B.T.A. 267">270, 43 B.T.A. 267">271, where the taxpayer deposited in a sinking fund more than it was required to set aside out of earnings in the taxable year, as contrasted with petitioner's setting aside less than was required. See also Michigan Silica Co.,41 B.T.A. 511">41 B.T.A. 511; affd., 124 Fed.(2d) 397; Strong Manufacturing Co.,41 B.T.A. 1273">41 B.T.A. 1273; affd., 124 Fed.(2d) 360; certiorari granted, 316 U.S. 651">316 U.S. 651; Saginaw & Manistee Lumber Co.,45 B.T.A. 780">45 B.T.A. 780.

Decision will be entered under Rule 50.

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Footnotes

• 1. The report in this proceeding which was promulgated on June 23, 1942, 47 B.T.A. 144, was vacated by order of the Boare. This report supersedes the earlier report, supra.↩

• 2. Of the amount paid to the Abilene bank only $14,000 is involved in this proceeding, which amount was applied to the redemption of the eight bonds at par, plus accrued interest of $6,000. ↩

• 3. The Interstate Commerce Act, as amended by the Transportation Act of 1920, U.S.C.A., Title 49, sec. 20(a)(12)↩, pp. 292-293, provides in substance that it shall be unlawful for the director of any carrier to participate in the paying of any dividends from any funds properly includable in the capital account.

• 4. SEC. 26. CREDITS OF CORPORATIONS.

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  (c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -

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  (2) DISPOSITION OF PROFITS OF TAXABLE YEAR. - An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. For the purposes of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word "debt" does not include a debt incurred after April 30, 1936. ↩