Fox River Paper Co. v. Commissioner

FOX RIVER PAPER COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Fox River Paper Co. v. Commissioner Docket No. 96961. United States Board of Tax Appeals 44 B.T.A. 986; 1941 BTA LEXIS 1247; July 11, 1941, Promulgated *1247 Where a trust mortgage securing petitioner's bonded indebtedness required payment to the sinking fund of an amount equal to a percentage of its earnings for any year, and in any event, a minimum payment, but gave petitioner the "right" to tender to the trustee its bonds issued under the mortgage, and bought in by it, in satisfaction of any payments to be made under the trust mortgage, held, petitioner was not required to pay or set aside in the taxable year any portion of its earnings of the taxable year and is not entitled to a credit under section 26(c)(2) of the Revenue Act of 1936. Edward J. Dempsey, Esq., for the petitioner. D. A. Taylor, Esq., for the respondent. TYSON *986 The respondent has determined a deficiency of $3,814.02 in income tax (normal tax and surtax) for the year ended December 31, 1936, due to various adjustments, of which only one is in controversy in this proceeding. Petitioner assigns error in respondent's disallowance of a credit of $25,000, claimed under section 26(c)(2) of the Revenue Act of 1936, relating to contracts restricting the disposition of earnings, in computing its undistributed net income subject*1248 to surtax. The proceeding has been submitted upon testimony and a stipulation of facts, which stipulation is adopted as part of our findings and incorporated herein by reference. FINDINGS OF FACT. Petitioner is, and was at all times material herein, a Wisconsin corporation which had outstanding 5,000 shares of common stock of the par value of $100 per share. *987 On or about October 1, 1931, petitioner issued for value its first mortgage 5 percent gold bonds, series A, in the principal amount of $1,000,000, secured by a duly executed and delivered trust mortgage, dated October 1, 1931, designating the First Trust Co. of Appleton, Appleton, Wisconsin, as trustee and creating a lien on petitioner's lands, manufacturing plants, machinery, and equipment. In article VII of the mortgage, headed "Sinking Fund for Bonds of Series A", it was provided, in part, that petitioner "covenants that it will * * * pay to the Trustee * * * on the 1st day of March 1933, and on said date in each and every year so long as any of said bonds of Series A are outstanding, an amount equal to twenty-five per cent of its net earnings, * * * for the preceding fiscal year", ending on December*1249 21 in each year, the net earnings to be calculated by deducting from gross revenue certain operating expenses, charges, etc., as specified in the trust instrument; that in any event petitioner will pay to the trustee for the account of the sinking fund, a minimum of $25,000 on March 1 of each year for the preceding year; and that when a payment to the sinking fund in any year is in excess of $25,000, the excess shall be available for credit against future minimum payments for years in which 25 percent of its net earnings is less than $25,000. Article VII also provided that petitioner "shall have the right to tender to the Trustee in satisfaction of any payment to be made to the Sinking Fund provided for in this Article, any bonds of Series A outstanding under this Mortgage which it may purchase at a price not exceeding the redemption price thereof", but that petitioner will not so tender any of said bonds held in its treasury except those previously marketed and bought in by it. Pursuant to the provisions of the trust mortgage the petitioner paid to the trustee thereunder the sum of $25,000 on March 1 of each of the years 1933, 1934, and 1935. Such payments were made, as required*1250 by the trust instrument, for the years ended December 31, 1932, 1933, and 1934, respectively, in each of which years petitioner's net earnings were less than $100,000. With the amounts so paid by petitioner, the trustee purchased and retired petitioner's bonds having a par value of $75,000, leaving outstanding as of December 31, 1935, bonds having a par value of $925,000. Prior to December 31, 1935, petitioner had purchased, and as of that date held in its treasury, certain of its series A bonds having a par value of $175,000. During 1936 petitioner purchased and held in its treasury additional series A bonds having a par value of $200,000. On April 1, 1936, petitioner delivered to the above mentioned trustee, for retirement, certain of its treasury series A bonds having a par value of $25,000. *988 As of December 31, 1936, petitioner had outstanding $900,000 par value series A bonds, of which petitioner held in its treasury bonds purchased by it having a par value of $350,000. Petitioner's books and records were kept on the accrual basis of accounting and, as shown by such books, its net earnings for 1936 amounted to $103,500.65, computed in accordance with the*1251 provisions of the trust mortgage. Due to the taking of inventories, etc., it was impossible to accurately determine petitioner's 1936 net earnings until after the close of that year, but a reasonably close estimate of such earnings could be made during December 1936. On December 17, 1936, the petitioner, anticipating on then available information that its net earnings would be in the immediate neighborhood of $100,000, paid to the trustee $25,000 representing its payment for the account of the sinking fund for the year ended December 31, 1936, although such payment was not due under the provisions of the mortgage until March 1, 1937. In its 1936 income and excess profits tax return, filed on the accrual basis, petitioner claimed the above mentioned payment of $25,000 made on December 17, 1936, as a credit for contracts restricting the disposition of earnings and profits of the taxable year. Such claimed credit was disallowed by respondent in his determination of petitioner's surtax on its undistributed profits for 1936. OPINION. TYSON: The issue presented on the facts in the instant proceeding is whether or not the petitioner is entitled to the claimed credit under the*1252 provisions of section 26(c)(2) of the Revenue Act of 1936, set out in the margin. 1 It is clear that the trust mortgage executed by petitioner on October 1, 1931, constituted a written contract executed by the petitioner corporation prior to May 1, 1936, expressly dealing with the disposition of petitioner's earnings and profits relative to a debt incurred prior to May 1, 1936. Our question is whether under the provisions of that contract the portion of petitioner's earnings and profits of the taxable year 1936, here involved, is required to be *989 paid or irrevocably set aside, within the taxable year, in or for the discharge of its bonded indebtedness. 1 *1253 Respondent contends that under the provisions of the mortgage the petitioner could have satisfied the sinking fund requirement for the taxable year 1936 by tendering to the trustee, in lieu of cash, an equivalent amount of its bonds purchased, owned, and held by it; and that, therefore, petitioner was not required under the provisions of the mortgage to pay, out of its earnings for the taxable year 1936, the sinking fund payment of $25,000 which it made during that year and for which it claims a credit. We sustain the contention of respondent. The credit allowed under section 26(c)(2), supra, pertinent to the question presented is: "An amount equal to the portion of the earnings and profits of the taxable year which is required * * * to be paid * * *, 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." Under the provision of the mortgage here involved giving petitioner the "right" to tender to the trustee any of its series A bonds purchased by it and held in its treasury in "satisfaction of any payment" required by that instrument to be made to the sinking fund, it seems clear*1254 that the petitioner was not required under its contract to pay, or irrevocably set aside, either during or as of the taxable year 1936, any portion of its 1936 net earnings and profits. When in December 1936 petitioner made its anticipatory cash payment of $25,000 to the sinking fund for the year 1936 it then held in its treasury its purchased bonds far in excess of $25,000 and far in excess of 25 percent of its net earnings for 1936, which bonds were obviously purchased with funds other than from its 1936 earnings. Under the contract petitioner had the privilege of tendering to the trustee for the sinking fund, in lieu of the cash payment of 25 percent of its earnings for 1936, an equivalent amount of bonds; and this regardless of whether or not such bonds were purchased with net earnings of the taxable year 1936. Having that privilege and having in its treasury more than a sufficient amount of bonds, purchased with other than 1936 earnings, to meet the required sinking fund payment for the taxable year 1936, petitioner could have availed itself of such privilege by tendering $25,000 of such bonds to the trustee in lieu of the $25,000 cash payment. By reason of this privilege*1255 and petitioner's ability to exercise it, no part of 1936 net earnings was required to be paid under the provisions of the mortgage. Instead, petitioner was free to pay out such earnings as dividends so far as any restriction in the contract is concerned. "The general purpose of section 26(c)(2), * * * is to give a credit where a dividend paid credit can not be secured. In other words, the *990 basic intent of Congress seems to have been to include in the provision only contracts which invariably require in their performance a drawing on current earnings, thus removing current earnings as a source of dividend payments." . The instant case is distinguished on its facts from (on appeal to the Sixth Circuit). In that case the taxpayer was required absolutely to first pay in cash a percentage of its earnings into the sinking fund within the meaning of section 26(c)(2), supra, but thereafter it had the option of purchasing its bonds on the open market and, upon delivery thereof to the trustee for cancellation, of receiving payment from the sinking fund in*1256 redemption thereof. Such option placed the taxpayer in the position of an ordinary bondholder, except for certain specified limitations, to have bonds owned by it redeemed from the sinking fund which it had already created by its payments of cash required by its contract. The taxpayer's option in the cited case is materially different from the right which petitioner in the instant proceeding had under its contract, namely, to tender its treasury bonds in satisfaction of any required payments due the sinking fund and in lieu of payments in cash out of the taxable year's earnings. We hold that petitioner is not entitled to the claimed credit under section 26(c)(2), supra. Reviewed by the Board. Decision will be entered for the 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. - (1) PROHIBITION ON 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 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. ↩