May Hosiery Mills, Inc. v. Commissioner

MAY HOSIERY MILLS, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. May Hosiery Mills, Inc. v. Commissioner Docket No. 99006. United States Board of Tax Appeals 42 B.T.A. 646; 1940 BTA LEXIS 970; August 29, 1940, Promulgated *970 Petitioner, during the taxable year paid out $49,165.51 in purchase of shares of its preference stock Pursuant to an agreement by which it was required to set aside 15 percent of its net profits and apply them to the retirement of such stock. Held, petitioner is not entitled to a credit, under section 26(c)(2) of the Revenue Act of 1936, of the amount of either the profits required to be set aside or the amounts spent retiring the preference stock; held, further, petitioner may not claim a dividends-paid credit under section 27(f) of the Revenue Act of 1936 for that part of the $49,165.61 representing profits accumulated since February 28, 1913. Theodore B. Benson, Esq., for the petitioner. L. W. Creason, Esq., for the respondent. ARUNDELL *646 The respondent has determined a deficiency in income tax for the fiscal year ended August 31, 1937, in the amount of $5,069.28. This deficiency, for the redetermination of which this proceeding is brought, arises from the disallowance of a dividends-paid credit of $49,165.51 claimed by petitioner for the expenditure of that amount in retiring, pursuant to agreement, its preferred stock. Three*971 issues are raised for decision: (1) Whether petitioner is entitled to a credit under section 26(c)(2) of the Revenue Act of 1936 of $51,189.68 representing 15 percent of its net earnings which it was required by agreement to set apart during the taxable year as a sinking fund to retire its preferred stock, or (2) whether the credit to which petitioner is thus entitled is only $49,165.51, which is that part of the sinking fund used during the taxable year for *647 redemption purposes; (3) whether, if petitioner is not entitled to the credit claimed in (1) or (2), it may claim a dividends-paid credit under section 27(f) of the Revenue Act of 1936 in the sum of $37,468.44 for the distribution of that amount in liquidation out of profits accumulated after February 28, 1913. The facts are stipulated and as so stipulated are adopted as our findings. The material portions are set out hereinafter. FINDINGS OF FACT. Petitioner is a corporation, organized and existing under the laws of North Carolina. Its offices are in Burlington, North Carolina. On August 19, 1927, petitioner and National Dye Works, Inc., entered into an agreement of merger and consolidation, a copy of*972 which was filed on August 30, 1927, with the Secretary of State of North Carolina. The agreement provided for a total of 169,000 authorized shares of the new corporation divided into 43,000 shares of preference stock, 83,000 shares of class A common stock, and 43,000 shares of class B common stock, all without nominal or par value. The preferences and restrictions of the stock were provided as follows: The preference stock was to receive cumulative annual dividends of $4 per share, payable out of the surplus or net profits of the corporation before any dividends were payable on the common stock; in each year before the payment of any dividends on the common stock 15 percent of the net earnings of the corporation for the preceding fiscal year was to be set aside in a sinking fund for the retirement or redemption of the preference stock so long as any of it was outstanding, amounts put into such fund to be used to purchase outstanding preference stock in the open market or at a public or private sale at a price not in excess of the redemption price of $55. In addition it was provided that should the amount in the sinking fund equal or exceed $27,500 on January 20 of any year, all*973 sums in the sinking fund should be applied, on March 1 following, to redemption of the preference stock, provided that petitioner would not thereby be rendered insolvent. The board of directors might apply money in the sinking fund to the payment of the cumulative dividends on the preference stock, if necessary, provided such sums were later replaced before the payment of any dividends on the common stock. After the payment of the preference dividends and the proper addition to the sinking fund, such dividends as might be declared were made payable to the holders of common stock to the exclusion of the shares of preference stock. It was further provided that the preference stock might be redeemed on 30 days' notice at the fixed price of $55 mentioned above and that all preference stock, however, acquired by the petitioner *648 should be canceled. In the case of liquidation the petitioner's assets were made applicable first to the payment of all cumulated preference dividends and to the redemption of preference stock at $55 per share. Voting rights were reserved to the holders of common stock except in the case of default in the payment of four quarterly dividends on the*974 preference stock, when the holders of preference stock might elect a majority of the board of directors to serve until the default was cured. Certain veto powers in matters not material here were also given to the holders of the preference stock. During the taxable year the petitioner purchased in the open market through a broker, from such stockholders only as offered their stock for sale, 891 shares of its own outstanding preference stock at a total cost of $49,165.51. These shares were purchased from some but not all of the holders of preferred stock at different times and in varying amounts and were all canceled during the year in question. There was originally paid in to the petitioner for the 891 shares purchased a total amount of $11,697.07. The petitioner in its return for the fiscal year ended August 31, 1937, claimed a dividends-paid credit of $49,005, which sum plus $160.51 represents the total of $49,165.51 paid by the petitioner in the acquisition of its preference stock. OPINION. ARUNDELL: The petitioner seeks redetermination of the deficiency here in question on three different bases, each involving a different aspect of the same transaction. The first*975 two stem from the requirement that 15 percent of the petitioner's net income annually be set aside in a sinking fund and applied to the purchase or redemption of its preference stock. Petitioner argues that this provision of the agreement of August 19, 1927, brings within section 26(c)(2) of the Revenue Act of 1936 1 (1) the amount of $51,189.68 which was required during the taxable year to be set aside in the sinking fund, or (2) the amount of $49,165.51 which petitioner spent in the purchase of its *649 stock, thus entitling petitioner to a credit in one of those sums. We think petitioner may not claim a credit in either of these amounts. The statute provides a credit only when the amounts so set aside or expended are for the "discharge of a debt" and neither the sinking fund nor the expenditures in the instant case may be so characterized. The shares of stock retired plainly represented capital interest and not indebtedness. They had no fixed date of maturity, see United States v. South Georgia Railway Co., 107 Fed.(2d) 3. Cf. *976 Commissioner v. Holding Corporation, 76 Fed.(2d) 11; Palmer, Stacy-Merrill, Inc.,39 B.T.A. 636; affd., 111 Fed.(2d) 809. The principal amounts and dividends were made payable only out of net profits, see Haffenreffer Brewing Co.,41 B.T.A. 443. The obligation imposed by contract on the petitioner to set aside and apply a percentage of its profits to the retirement of its stock does not alter the nature of the transaction. The significant characteristic of a debt certain - that its payment may be forced in case of default, see United States v. South Georgia Railway Co., supra - is here lacking. At least the two elements of the contingency of the profits from which payment was to be made and the absence of a maturity date for the shares retired brand the stock here a capital interest for the redemption or retirement of which no credit may be claimed under section 26(c)(2) of the Revenue Act of 1936. *977 Moreover, for an additional reason in the present case the petitioner may not claim a credit for the $51,189.68 which was required to be set aside during the taxable year in the sinking fund for the redemption of preference stock. It is not enough that this amount was required to be irrevocably set aside; the credit is allowed only to the extent that the required amount is actually set aside. In the present case no evidence has been presented that the required $51,189.68 was so set aside and in face of this lack of evidence we are unable to hold that petitioner is entitled to a credit in that amount. The third position taken by the petitioner is that the payment of $49,165.51 made to its stockholders was in fact a distribution in liquidation, $37,468.44 of which represents profits accumulated since February 28, 1913, for which petitioner is entitled to a dividends-paid credit under section 27(f) of the Revenue Act of 1936. 2 Against this contention of the petitioner, the respondent argues that the sum paid out may not by its nature be considered a distribution *650 in liquidation and entitles petitioner to no credit under section 27, supra, even if labeled a liquidating*978 distribution, since it was not made pro rata or without preference among shares of the same class, as required by section 27(g). Petitioner contends, however, that subsection (g) may not be applied to distributions in liquidation in the absence of specific provision to that effect, since such distributions are granted the credit in question by singular language in subsection (f). We do not think petitioner can succeed in this argument. By its very terms section 27(g) applies to "any distribution" and, following as it does subsection (f), must, we think, be applied to liquidating distributions. This interpretation is in keeping with the ruling of the Commissioner in I.T. 3244 (C.B. 1939-1), which by its terms covers the exact situation presented here. The facts are accurately reflected by the headnote: The M Company is not entitled to a dividends-paid credit with respect to liquidating distributions made in acquiring a part of its outstanding preference shares at different prices by direct purchases from stockholders and by purchases on the R stock exchange. *979 The reason for this holding is assigned to the "fact that the purchase of preference shares for cancellation and retirement was not on a pro rata basis and that every shareholder of the class did not receive (in proportion to the number of shares held by him) his pro rata part of the distribution" and, therefore, "it is held that the M Company is not entitled to a dividends-paid credit for any portion of the distribution in partial liquidation by reason of the limitation imposed by section 27(g) of the Act." With this interpretation of the statute we are in agreement. It plainly appears in the instant case that the purchase of the shares was made unequally among the holders of preference stock. We are not shown the prices at which individual shares were purchased. It is sufficient that they were bought from only a portion of the holders of preference stock. There is no merit in petitioner's argument that the stockholders to whom the distribution was made constituted a separate class by virtue of the fact that their stock was purchased for retirement and that section 27(g) is thus satisfied. It seems plain that all of the preference shares issued were of the same character, *980 with identical provisions. The purchase of preference stock by the issuing corporation does not alter this character, however much retirement and cancellation may by destroying it take the stock out of the class. See Black Motor Co.,41 B.T.A. 300. In view of our conclusion it is unnecessary to pass on the additional contention of the respondent that the $49,165.51 was not paid out as a liquidating distribution. Decision will be entered for respondent. 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 a 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. ↩ 2. SEC. 27. CORPORATION CREDIT FOR DIVIDENDS PAID. * * * (f) DISTRIBUTIONS IN LIQUIDATION. - In the case of amounts distributed in liquidation the part of such distribution which is properly chargeable to the earnings or profits accumulated after February 28, 1913, shall, for the purposes of computing the dividends-paid credit under his section, be treated as a taxable dividend paid. (g) PREFERENTIAL DIVIDENDS. - No dividends-paid credit shall be allowed with respect to any distribution unless the distribution is pro rata, equal in amount, and with no preference to any share of stock as compared with other shares of the same class. ↩