G. B. R. Oil Corp. v. Commissioner

G. B. R. OIL CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. G. B. R. Oil Corp. v. Commissioner Docket No. 92604. United States Board of Tax Appeals 40 B.T.A. 738; 1939 BTA LEXIS 812; October 18, 1939, Promulgated *812 Petitioner was a corporation engaged in the development and operation of oil leases. In 1934 it purchased several such leases with money which it borrowed from a bank. The bank required petitioner to execute deed of trust liens on the properties to secure the bank for its indebtedness and also required petitioner to execute written assignments to the bank of all proceeds from the oil produced on the leases. In the taxable year all receipts from oil produced on the properties were paid to the bank and the bank in turn advanced certain amounts to petitioner to pay operating expenses and certain development costs. The balance was applied by the bank as a credit on its indebtedness, such payments aggregating considerably more than petitioner's net income for the taxable year. Held, the payments were made under circumstances covered by section 26(c)(2), Revenue Act of 1936, and petitioner is entitled to the credit provided therein in computing the surtax, if any, on its undistributed profits as provided by section 14, Revenue Act of 1936. Robert Ash, Esq., and J. D. Anderson, C.P.A., for the petitioner. James H. Yeatman, Esq., and M. L. R. Wade, Esq.,*813 for the respondent. BLACK *738 The Commissioner has determined a deficiency in petitioner's income tax liability for the year 1936 of $6,905.46. In his deficiency notice the Commissioner gave, among other things, the following reason for his determination: In determining the undistributed net income subject to surtax you have claimed as a deduction $31,775.11 as credit for contracts restricting dividend payments with respect to which it is held that the credit claimed does not meet the requirements of section 26(c)(1) and (2) of the Revenue Act of 1936, and is, therefore, disallowed. Petitioner, in its assignment of error contained in the petition, alleges that $6,603.73 of the deficiency is due to the surtax which results from the disallowance by the Commissioner of the credit claimed by petitioner and that this action of the Commissioner was error. The remainder of the deficiency, $301.73, which does not relate to surtax, petitioner does not contest. FINDINGS OF FACT. The petitioner is a Texas corporation, with its principal office at Dallas, Texas. In 1934 the petitioner made an arrangement with the Republic National Bank & Trust Co. of Dallas, *814 Texas, sometimes hereinafter *739 referred to as the bank, whereby the bank agreed to loan the petitioner the necessary funds to purchase certain oil properties in East Texas. The petitioner was to secure the said loans by deed of trust liens on the properties and by further assigning to the bank all of the income from the properties, and in addition the loans were to be personally endorsed by George B. Ray, president of petitioner, and a man of substantial means. In accordance with this agreement, the bank loaned petitioner the money with which to purchase the following: (1) An oil and gas lease on certain property in Rusk County, Texas, known as the Thrash lease, and an 18/96 of the 1/8 royalty on the Thrash lease and on an additional one acre tract in Rusk County. (2) An undivided 3/4 of the 7/8 working interest in an oil and gas lease on certain property located in Rusk County, Texas, and known as the Towne Heirs lease. (3) A 15/32 interest in an oil and gas lease on certain property located in Rusk County, Texas, and known as the Lizzie Harmon lease. To secure the loans to purchase the foregoing leases and royalties, the petitioner executed and delivered*815 to the bank appropriate deeds of trust and also by separate instruments in writing assigned its interests in the properties to the bank in trust and authorized the bank to receive and collect all sums of money derived from the properties and to apply same on its indebtedness to the bank. The pertinent provisions of the agreements covering the Thrash lease, the Thrash Royalty, and the Towne Heirs lease are in effect the same as those which relate to the Thrash lease, and read: That as a part of the consideration for the loan heretofore made, and all loans that from time to time may hereafter be made, by the Republic National Bank and Trust Company of Dallas, Texas, to G. B. R. Oil Corporation, which loans are and will be evidenced by the notes of G. B. R. Oil Corporation, payable to the order of the Republic National Bank & Trust Company, and as security for the payment of all the indebtedness, present and future, of G. B. R. Oil Corporation to Republic National Bank and Trust Company, according to the faces, tenors, and effects of every and all the notes evidencing such indebtedness, and all renewals of all or any part thereof, as well as any and all other indebtedness of every*816 character whatsoever, whether direct or indirect, primary or secondary. fixed or contingent, which the said G. B. R. Oil Corporation may now or hereafter owe or in any manner be obligated for the payment of to the Republic public National Bank and Trust Company of Dallas, Texas, the said G. B. R. Oil Corporation does hereby transfer, assign, and convey unto the Republic National Bank and Trust Company of Dallas, Texas, all of the above described full 7/8 leasehold interest owned by G. B. R. Oil Corporation in and to the above described tract of land; and does hereby direct, authorize and empower the Republic National Bank and Trust Company, its successors and assigns, to receive and collect and hold all sums of money of every character whatsoever derived from the above described full 7/8 leasehold interest owned by G. B. R. Oil Corporation in and to the above described tract; every and all of which sums *740 so collected said Republic National Bank and Trust Company is hereby authorized to receive, collect and hold; applying same to the payment of the debts and all other obligations secured hereby, as they mature or become due; and all of the obligations and debts of every*817 character whatsoever of the said G.B.R. Oil Corporation to Republic National Bank and Trust Company secured hereby, having been duly paid and discharged, then the remainder of said proceeds, if any, derived from the above described full 7/8 leasehold interest owned by G.B.R. Oil Corporation in and to the above described tract of land, shall be paid over to the said G. B. R. Oil Corporation, upon its demand, and the reassignment of the above described full 7/8 lease hold interest owned by the said G. B. R. Oil Corporation in and to the above described tract of land will be made at the expense of grantor. The petitioner did not execute a similar separate contract or agreement with the bank covering the Lizzie Harmon lease, but the assignment to the bank in that case contained the following provision: The undersigned does also by this instrument transfer, assign and convey unto Republic National Bank & Trust Company, its successors and assigns, the entire proceeds from all oil, gas and minerals produced from the above described mineral interest and hereby directs the pipeline company and/or purchasers of said oil, gas and minerals to pay same directly to the Republic National Bank*818 & Trust Company, to apply upon the above described note as a credit and payment thereon. The documents above mentioned provided that all of the income from the properties should be paid to the bank and all of the instruments were executed in the year 1934 and were filed of record in the counties in which the properties were located and were also filed with the pipe line companies taking the oil from the company. In accordance therewith, the pipe line companies during the taxable year remitted direct to the bank the proceeds of all oil runs taken from the properties. As a practical matter, it was understood that the properties had to be operated, which meant that expenses had to be paid. Consequently, the bank, when it received the oil run checks, credited them to the petitioner's account under an understanding that out of the funds deposited nothing would be paid of any character whatsoever except the actual, necessary, and usual operating expenses and the balance would be applied to the reduction of the loans. Each month as soon as the deposits were made petitioner's president would go to the bank with a list of the bills then unpaid and to be paid to show what the expenses*819 for the month were, and would deliver to the bank a check for the balance to be applied upon the note. This enabled the petitioner to keep a record through its bank account of all receipts and disbursements. That method is still being followed. The agreement between the parties contemplated that certain development would be necessary and that the development costs *741 were to be paid out of income or by new loans. Under this arrangement, during 1936, $12,719.79 was expended for intangible drilling costs on the Thrash lease and $12,085.86 was expended for pipe and other tangibles in the development of the Thrash lease. The development increased production, which increased the income to be applied upon the bank's loans and also increased the security. The development costs above referred to were paid, in accordance with the understanding of the parties, out of the proceeds of oil and by loans dated June 12 and August 3, 1936, in the amounts of $8,000 and $500, respectively. These loans were paid out of oil proceeds on July 15 and August 13, 1936, respectively. Petitioner's properties had been purchased entirely with money borrowed from the bank, so there was no*820 paid-in margin. Petitioner's 1936 income all came from the oil properties here involved, with the exception of $154 and during the year, the petitioner paid the bank $52,703.81 on account of its indebtedness. Petitioner's bank balance on December 31, 1936, was $379.68. OPINION. BLACK: There is no dispute in this proceeding as to petitioner's net income for the taxable year. Petitioner's net income as shown on its income tax return was $36,109.32 and petitioner paid the normal tax thereon of $4,334.21, which did not include any surtax because of undistributed profits. By certain adjustments made in petitioner's income for the taxable year, the Commissioner has determined petitioner's corrected net income to be $38,430.31. This results in an increase of $301.73 in petitioner's normal tax over that shown on its return. This part of the deficiency petitioner does not contest. Petitioner does contest the surtax of $6,603.73 which the Commissioner has computed under the provisions of section 14 of the Revenue Act of 1936. Petitioner contends that it is entitled to a credit under section 26(c)(2) of the Revenue Act of 1936 of the entire amount which the Commissioner has held*821 to be undistributed net income within the meaning of the statute and subject to the surtax provided in section 14. Section 26(c)(2) is printed in the margin. 1 *822 *742 The Commissioner, in his deficiency notice, determined that the credit claimed by petitioner does not meet the requirements of "section (c)(1) and (2) of the Revenue Act of 1936." Petitioner, in its brief, does not claim that section 26(c)(1) is applicable and it appears that it is not. Therefore, we have not printed (c)(1) in the margin. The Board cases which have dealt with the surtax on undistributed profits under the 1936 Act have dealt with the application of section 26(c)(1) and are, therefore, not applicable to this proceeding. See ; affd. (C.C.A., 8th Cir.), ; . We are cited to no Board or court case, either by petitioner or respondent, which construes section 26(c)(2), supra.Section 26(c)(2) was not contained in the 1936 Revenue Bill, either as it passed the House or the Senate, but was added in conference between the two Houses. Therefore, nothing with reference to this particular provision is contained either in the Report from the Committee on Ways and Means of the House or in the Report of the Finance Committee*823 of the Senate, and no comment is made upon it in the Conference Report. That portion of article 26-2 of Regulations 94 which relates to section 26(c)(2) of the Revenue Act of 1936 is printed in the margin. 2 *824 *743 In determining whether the claimed credit of a corporate taxpayer falls within section 26(c)(2) and the regulations promulgated thereunder, three things seem to be necessary: (1) There must be a written contract executed prior to May 1, 1936, which expressly deals with the disposition of earnings and profits of the taxable year. (2) The credit relates to that portion of the earnings or profits which are required to be paid or irrevocably set aside in the discharge of a debt. (3) The credit is allowable to the extent that the money has been so paid or set aside. We shall give consideration to these three necessary conditions as disclosed by the facts of the instant case. (1) We find that all the written contracts of assignment were executed prior to May 1, 1936. As to this, there is no dispute between the parties. Did these contracts "expressly" deal with the disposition of earnings and profits of the taxable year? The word "express" is defined by Webster's New International Dictionary, Second Edition, Unabridged, as follows: Directly and distinctly stated; expressed, not merely implied or left to inference; as an express commitment; hence definite, *825 clear, explicit, unmistakable; not dubious or ambiguous; as express consent; express command. The contracts in question directed, authorized, and empowered the Republic National Bank & Trust Co. to "receive and collect and hold all sums of money of every character whatsoever" from the oil leases in question. Thus it seems to us that the contracts in question not only assigned to the bank that portion of petitioner's "earnings and profits" which resulted from the operation of these properties, but the entire gross receipts therefrom as well. It is true that these written assignments did not refer specifically to the taxable year 1936, but the language of the assignments was certainly broad enough to include the taxable year 1936 and the parties have so construed the contract in their dealings with each other. (2) As we have already stated, by these written contracts of assignments, not only a portion of petitioner's earnings and profits were required to be paid to the Republic National Bank & Trust Co. in discharge of its debt, but all of the receipts from the property were required to be so paid. All of petitioner's income for 1936 came from these oil properties except $154. *826 The evidence shows that all of the gross receipts from these oil properties were in fact paid to the bank and that it then permitted petitioner to use sufficient of the funds for its necessary operating expenses and certain development costs incurred in bringing in new oil wells on the property. We do not see where this concession made by the bank to the petitioner affects in any way the validity of its assignments of all the earnings *744 from these oil properties to the bank or in any way voids the application of section 26(c)(2). (3) The record shows that $52,703.81 was actually paid to the bank from these oil receipts during the taxable year on its indebtedness. The fact that the amount of these payments exceeds petitioner's net taxable income as determined by the Commissioner in the notice of deficiency is probably due to statutory depletion allowances and other items which, although affecting taxable net income, do not affect gross receipts. But be that as it may, the $52,703.81 which petitioner has paid to the bank on its indebtedness out of these oil receipts in 1936 is considerably greater than petitioner's net income as determined by the Commissioner. It had*827 to be paid under the terms of the written assignments which were executed prior to May 1, 1936, and we think petitioner is entitled to the credit which it claims under the provisions of section 26(c)(2). Petitioner had no right to disburse any of these oil receipts to its stockholders until its indebtedness to the bank was paid, and in the taxable year before us it made no such distribution. The general purpose of section 26(c)(2), it seems to us, is to give a credit where a dividend paid credit can not be secured. In other words, the basic intent of Congress seems to have been to include in the provision only contracts which inevitably require in their performance a drawing on current earnings, thus removing current earnings as a source of dividend payments. See Paul and Mertens, par. cumulative supplement. Respondent in his brief cites no authority in support of his contention, but, after quoting the language of the assignments from petitioner to the bank, says: We are unable to find in these contracts or assignments any provision which expressly deals with the disposition of petitioner's earnings and profits of the taxable year. It is true, *828 as we have already said, that the assignments in question do not expressly refer to "earnings and profits" as such, but they certainly do require that all of petitioner's gross receipts from these properties be paid to the bank and that would certainly include all "earnings and profits" from them. Respondent says in his brief that petitioner "could have declared a dividend out of its earnings and profits of the taxable year and paid same with borrowed money, notes, credits, or in stock." Perhaps it could have done so. We do not consider that is a matter which we have to decide. Even assuming that it is so, we do not see where that fact affects the application of the credit provided by section 26(c)(2). We sustain petitioner in this assignment of error. Reviewed by the Board. Decision will be entered under Rule 50. Footnotes 1. 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) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. - * * * (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 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. ↩ 2. (c) Disposition of profits of taxable year. - Under the provisions of section 26(c)(2) a corporation is allowed a credit in an amount equal to that portion of the earnings and profits of the taxable year which, by the terms of a written contract executed by the corporation prior to May 1, 1936, and expressly dealing with the disposition of the earnings and profits of the taxable year, it is required within the taxable year to pay in, or irrevocably to set aside for, the discharge of a debt incurred on or before April 30, 1936. The credit is limited to that amount which is actually so paid or irrevocably set aside during the taxable year pursuant to the requirements of such a contract. Only a contractual provision which expressly deals with the disposition of the earnings and profits of the taxable year shall be recognized as a basis for the credit provided in section 26(c)(2). A corporation having outstanding bonds is not entitled to a credit under a provision merely requiring it, for example, (1) to retire annually a certain percentage or amount of such bonds, (2) to maintain a sinking fund sufficient to retire all or a certain percentage of such bonds by maturity, (3) to pay into a sinking fund for the retirement of such bonds a specified amount per thousand feet of timber cut or per ton of coal mined, or (4) to pay into a sinking fund for the retirement of such bonds an amount equal to a certain percentage of gross sales or gross income. Such provisions do not expressly deal with the disposition of earnings and profits of the taxable year. A contractual provision, however, shall not be considered as not expressly dealing with the disposition of earnings and profits of the taxable year merely because it deals with such earnings and profits in terms of "net income," "net earnings," or "net profits." ↩