A. E. Staley Mfg. Co. v. Commissioner

A. E. STALEY MANUFACTURING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. A. E. Staley Mfg. Co. v. Commissioner Docket No. 99347. United States Board of Tax Appeals 46 B.T.A. 199; 1942 BTA LEXIS 896; January 27, 1942, Promulgated *896 Under a trust indenture securing its bonded indebtedness petitioner was required, on June 1 of each year for a specified period, to make a sinking fund payment the amount of which was to be measured by whichever of the following two amounts was the greater: (1) 3 percent of the principal amount of its bonds, or (2) 25 percent of net earnings for the preceding year. Petitioner was given the right to make any sinking fund payment in whole or in part in its bonds issued and bought in by it. Petitioner was forbidden to make any anticipatory sinking fund payment in cash. At the end of 1936, the taxable year, petitioner estimated that 25 percent of net earnings for that year would be greater than 3 percent of the principal amount of its bonds and made a sinking fund payment in cash equal to 25 percent of estimated net earnings for that year. 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. See Fox River Paper Co.,44 B.T.A. 986. C. C. Le Forgee, Esq., for the petitioner. Frank F. Korell, Esq.*897 , for the respondent. HARRON *200 Respondent determined deficiency of $70,446.87 in income tax for the year 1936. The sole question is whether in the computation of the surtax imposed by section 14 of the Revenue Act of 1936 petitioner is entitled to a credit in the amount of $371,223.80 under section 26(c)(2). FINDINGS OF FACT. Petitioner is a Delaware corporation and has its principal office at Decatur, Illinois. It keeps its books of account and makes its income tax returns on the accrual basis and on a calendar year basis. It filed an original and an amended income tax return for the year 1936, the taxable year, with the collector of internal revenue for the eighth district of Illinois. On or about February 1, 1936, petitioner, as grantor, and the Chase National Bank of the city of New York, as trustee, entered into a trust indenture, the purpose of which was to secure an issue of petitioner's first mortgage bonds. Thereafter in the taxable year under the terms of the trust indenture the trustee authenticated and delivered bonds having an aggregate principal amount of $4,000,000. The bonds were in the principal amount of $1,000 each and were*898 payable on February 1, 1946. The bonds bore interest at the rate of 4 percent per annum payable semiannually on August 1 and February 1 in each year. Section 17 of the trust indenture securing the issue of bonds provided, in part, as follows: The Company covenants and agrees that on June 1, 1937, and on June 1 of each year thereafter to and including June 1, 1945, the Company will pay to the Trustee for the purposes of a sinking fund for the retirement of the Bonds of 4% Seres due 1946, whichever of the two following amounts is the greater, viz: (1) an amount sufficient to redeem three per cent, (3%) of the aggregate principal amount of all Bonds of said series theretofore authenticated and delivered by the Trustee hereunder * * * at the redemption price of the Bonds of such series provided in Section 20 hereof prevailing on the semi-annual interest payment date next succeeding the date of such payment, together with accrued interest thereon to such interest payment date, or (2) an amount equal to twenty-five per cent, (25%) of the net earnings of the Company and of its subsidiaries (as defined in Section 18 hereof) during the year ending on December 31 next preceding such payment. *899 At its option the Company, in lieu of making any such sinking fund payment in whole or in part in cash, may deliver to the Trustee Bonds of such series (except Bonds theretofore called for redemption either by operation of the sinking fund or at the option of the Company under any provision hereof) previously authenticated and delivered by the Trustee, with all unmatured coupons attached. Each Bond so delivered shall be received by the Trustee in lieu of cash in an amount equal to the redemption price of such Bond provided in Section 20 hereof prevailing on the next succeeding semi-annual interest payment date and accrued interest to such date. *201 The Company shall have the right at any time and from time to time to anticipate in whole or in part any one or more sinking fund payments, but only by the delivery of Bonds to the Trustee as hereinabove provided, and no anticipated sinking fund payment may be made in cash. With or prior to each such sinking fund payment the Company shall deliver to the Trustee a statement in reasonable detail showing the net earnings of the Company and of its subsidiaries (as defined in Section 18 hereof) during the year ending on the*900 next preceding December 31, certified by independent public accountants, accompanied by a statement of such independent public accountants that the net earnings of the Company and its subsidiaries have been computed as required by Section 18 hereof. The Trustee shall be protected in relying on such certified statement and shall be under no duty to make any verification of or investigation or inquiry as to any part thereof. Under section 18 of the trust indenture the phrase "net earnings of the Company and of its subsidiaries" was defined to mean the consolidated net profits of the company and of its subsidiaries "established by application of accepted accounting principles and certified to by a firm of independent public accountants satisfactory to the trustee", with certain specified adjustments. Under section 20 of the trust indenture the redemption price of bonds redeemed on or before August 1, 1942, was stated to be $1,020. As of December 1, 1936, petitioner estimated that the net earnings of itself and of its subsidiaries for the 11 preceding months of the taxable year were $1,507,884.70 and that such net earnings for the entire 12 months of the taxable year would be approximately*901 $1,600,000. In a letter dated December 15, 1936, petitioner informed the trustee that the net earnings of petitioner and of its subsidiaries for the 11 preceding months of the taxable year was approximately $1,507,000; that it was "certain" that such net earnings for the entire 12 months of the taxable year would not be less than $1,507,000 and might possibly amount to $1,600,000; that (25% of) such net earnings for the taxable year would be "in excess of a sum necessary to redeem 3% of the aggregate of the outstanding bonds"; that on December 31, 1936, it would pay to the trustee for the purpose of the sinking fund 25 percent of the estimated net earnings for the taxable year; that as soon as practicable after the amking of said payment it would deliver to the trustee the statements provided for by section 17 of the trust indenture; that on or before June 1, 1937, it would pay to the trustee any amount necessary to make the sum paid equal 25 percent of such net earnings, as shown by such statements; and that if the amount paid exceeded 25 percent of such net earnings, as shown by such statements, then such excess was to be repaid to it. On December 26, 1936, petitioner delivered*902 to the trustee a check in the amount of $400,000. *202 In a letter dated December 28, 1936, the trustee acknowledged receipt of the check and referred to it as "representing a payment in anticipation of the June 1, 1936, sinking fund operation pursuant to" section 17 of the trust indenture, and being "an estimated 25% of the net earnings of your Company for the calendar year 1936." The trustee credited its sinking fund account with the amount of $400,000 under date of December 29, 1936. This entry was described as "payment received * * * in anticipation of sinking fund requirements for 6/1/37" pursuant to section 17 of the trust indenture, "being estimated 25% of net earnings for 1936." Petitioner's balance sheet showed a surplus of $1,604,421.18 as of December 31, 1935, and a surplus of $2,974,244.67 as of December 31, 1936. Petitioner's balance sheet showed an investment of $75,000 in its 4 percent first mortgage bonds as of December 31, 1936. On June 3, 1937, a statement showing the net earnings of petitioner and of its subsidiaries for the taxable year was delivered to the trustee in accordance with sections 17 and 18 of the trust indenture. The statement showed*903 that the net earnings of petitioner and its subsidiaries for the taxable year was $1,484,895.18. Twenty-five percent of such net earnings for the taxable year was $371,223.80. On June 8, 1937, the trustee delivered a check to petitioner in the amount of $28,776.20, the difference between $400,000 and $371,223.80. The trustee debited its sinking fund account in the amount of $28,776.20 under date of June 8, 1937. This entry was described as "repayment to company * * * covering excess funds deposited 12/28/36 for account 6/1/37, sinking fund operation." OPINION. HARRON: The sole question is whether in the taxable year in the computation of the surtax imposed by section 14 of the Revenue Act of 1936 petitioner is entitled to a credit in the amount of $371,223.80 under section 26(c)(2), the provisions of which are set forth in the margin. 1 On its income tax return for the taxable year in the *203 computation of the surtax imposed by section 14, petitioner took a credit for contracts restricting dividend payments in the amount of $371,223.80. The credit was disallowed by respondent on the ground that it was not a proper credit within section 26(c). *904 In its brief petitioner claims that it is entitled to the credit in question under section 26(c)(2) and bases its claim on the provisions of section 17 of the trust indenture. Section 26(c)(2) grants a credit in the nature of a special tax exemption and is to be strictly construed. See . Therefore, the provisions of section 17 of the trust indenture must be carefully scrutinized to determine whether the requirements of the statute are met. The first paragraph of section 17 provided in substance that on June 1, 1937, and on June 1 of each year thereafter for a specified period, petitioner was to make a sinking fund payment the amount of which was to be measured by whichever of the following two amounts was the greater: (1) 3 percent of the aggregate principal amount of its bonds, or (2) 25 percent of the net earnings of the preceding year. The second paragraph of section 17 gave petitioner the right to make any sinking fund payment either in whole or in part in cash or in its bonds issued and bought in by it. It could make the sinking fund payment all in cash, all in bonds, or part in cash and part*905 in bonds. The third paragraph of section 17 allowed petitioner to anticipate a sinking fund payment in its bonds, only, but forbade it to anticipate a sinking fund payment in cash. In December of the taxable year petitioner estimated that net earnings for that year would amount to about $1,600,000, and that 25 percent thereof, or $400,000, would exceed 3 percent of its bonds, or $120,000, and petitioner made a sinking fund payment of $400,000 in cash on December 26, 1936. Net earnings for the taxable year actually amounted to $1,484,895.18 and 25 percent thereof amounted to $371,223.80, which is the amount of the credit in question. In June of 1937 the trustee made a repayment to petitioner of $28,776.20, the difference between $400,000 and $371,223.80. In support of its contention that section 17 meets the requirements of the statute, petitioner relies especially on the Board's decision in , which, subsequent to the filing of briefs in this case, has been affirmed by the Circuit Court of Appeals for the Sixth Circuit in *906 . See also, ; ; and , all of which were decided by the Circuit Court of Appeals for the Sixth Circuit on December 9, 1941, on the authority of its opinion in the Strong Manufacturing Co. case. The contractual provision on which the allowance of the credit was *204 based in that case was in some respects similar to the first paragraph of section 17; the taxpayer was required to make a sinking fund payment of a fixed percentage of the net earnings of each year for a specified period of years, but was not required by the terms of the contractual provision to make such payment until 3 1/2 months after the end of the respective year. The contractual provision in that case did not contain, inter alia, paragraphs similar to the second and third paragraphs of section 17, here, which allow the making of sinking fund payments in bonds and prohibit the making of an anticipatory sinking*907 fund payment in cash. The opinion of the Sixth Circuit in the Strong Manufacturing Co. case is apparently in conflict with the opinion of the Fourth Circuit in , and with the opinion of the Eighth Circuit in , on the question as to whether under section 26(c)(2) the contractual provision must in terms require that a part of the earnings and profits of the taxable year be irrevocably set aside or paid within the taxable year. The Fourth Circuit, in the Antietam Hotel Corporation case, and the Eighth Circuit, in the Moloney Electrical Co. case, held that the contractual provision must in terms so require, while the Sixth Circuit, in the Strong Manufacturing Co. case, came to the contrary conclusion. If the conclusion reached by the Fourth and Eighth Circuits is correct, then the credit is not allowable in this case because section 17 did not in terms require that 25 percent of the earnings of the taxable year be paid or irrevocably set aside within the taxable year. *908 Even if the conclusion reached by the Sixth Circuit in the Strong Manufacturing Co. case were correct, the credit would not be allowable in this case for several reasons. In the first place, section 17 contained a paragraph not contained in the contractual provision in the Strong Manufacturing Co. case, to the effect that petitioner had the right to make any sinking fund payment in whole or in part in its bonds issued and bought in by it. Because of the presence of a very similar paragraph, a credit under section 26(c)(2) was disallowed in (on appeal to the Seventh Circuit). In that case, under a trust mortgage securing its bonds, the taxpayer on March 1 of each year during a specified period was to make a sinking fund payment equal to 25 percent of its net earnings for the preceding fiscal year ending on December 21. In December of 1936 the taxpayer estimated that its net earnings for that year would be about $100,000 and made a sinking fund payment of $25,000. Under the trust mortgage petitioner had the right to make any sinking fund payment in its bonds issued and bought in *205 by it. The Board held that, since*909 it had this right, it was not required under the trust mortgage to pay or irrevocably set aside, either during or as of the taxable year 1936, any portion of its 1936 net earnings and profits. It is true that in the Fox River Paper Co. case the taxpayer had in its treasury in December of 1936 bonds issued and bought in by it having a principal amount far in excess of $25,000, and far in excess of 25 percent of its net earnings for 1936, while in this case the record indicates that petitioner had in its treasury in December of 1936 bonds issued and bought in by it having a principal amount of $75,000, or less than $371,223.80, the amount of the credit in question. However, petitioner could have converted other assets into a sufficient amount of bonds to make the sinking fund payment of $371,223.80 and thus could have paid out all of its current earnings free of the restrictions of section 17. In the second place, section 17 contained a paragraph which forbade an anticipatory sinking fund payment in cash. Such a paragraph was not contained in the contractual provisions involved either in the Fox River Paper Co. case or the Strong Manufacturing Co. case. Despite petitioner's*910 contention to the contrary, the payment made by it in December of 1936 clearly was an anticipatory sinking fund payment in cash. The payment was not called for under section 17 until June 1 of the following year. The trustee labeled the payment as one "in anticipation" both in the letter which it sent acknowledging receipt of the payment and in the entries which it made on its books recording the receipt of the payment. Obviously, the payment of $371,223.80 in cash in December of 1936 not only was not required, but was expressly forbidden, by section 17 to be made in the taxable year. Respondent's determination is sustained. 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. - * * * (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. ↩