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

PARIS & MT. PLEASANT RAILROAD COMPANY, * PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Paris & M. P. R. Co. v. Commissioner Docket No. 103578. United States Board of Tax Appeals 47 B.T.A. 144; 1942 BTA LEXIS 724; June 23, 1942, Promulgated *724 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, followed. 2. Petitioner is entitled to credit for amount of current earnings set aside as a sinking fund payment under section 26(c)(2), the amount being less than it was required to pay into the sinking fund, cf. Brockway Glass Co.,43 B.T.A. 267, and the payment having been made pursuant to a written contract executed prior to May 1, 1936. 3. Petitioner is not entitled to a credit under section 26(c)(2) for an amount paid on accrued interest on bonds, because no part of its earnings for the taxable year was required to be paid or set aside within the taxable year for interest on bonds under the terms of a written contract. T. D. Gresham, Esq., for the petitioner. Donald P. Moyers, Esq., for the respondent. HARRON *144 Respondent determined a deficiency in income tax for the year 1937*725 in the amount of $13,540.88. The deficiency results from respondent's disallowance of a credit under section 26(c)(1) of the Revenue Act of 1936 in the amount of petitioner's entire adjusted net income. Petitioner contests the entire deficiency. FINDINGS OF FACT. 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 its 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, *726 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. *145 Paragraph thirteenth of the deed of trust read in part as follows: The Railroad Company 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 * * *. 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*727 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 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*728 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 *146 the deed of trust, and on November 24, 1937, the Farmers & Merchants National Bank of Abilene transferred the sum of $14,507.60 to the First National Bank of Paris, which set the sum aside in a special account for the payment of the 8 bonds and interest coupons. During the period from Nomember 27, 1937, to March 28, 1938, the 8 bonds and interest coupons were paid in full. The remaining 592 bonds continued*729 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 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*730 $14,038.97 was due from petitioner. Petitioner irrevocably set aside $8,000 out of its earnings in 1937 into a sinking fund for the retirement of bonds in that principal amount, 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 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 *147 Interstate Commerce Act, as amended by the Transportation Act of 1920, it was prohibited from paying any dividends in the*731 taxable year because it had a capital deficit.1 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 Crane Johnson Co.,38 B.T.A. 1355; affd., 311 U.S. 54; and Helvering v. Northwest Steel Rolling Mills, Inc.,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*732 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.) 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 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. *733 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 contends that it is entitled to a credit under section 26(c)(2) in the amount of $14,000, which represents the amount set aside out of its current earnings of the taxable year to pay $8,000 of bonds principal amount, plus $6,000 of accrued interest. The facts show, and the respondent agrees, that in 1937 petitioner "irrevocably set aside" by paying to the Farmers & *148 Merchants National Bank of Abilene an amount which included the $14,000 in question. 2 Petitioner is not entitled to a credit under section 26(c)(2) for the $6,000 paid on accrued interest, because this payment does not come within the terms of the above section. The trust deed*734 did not require that any part of petitioner's earnings in each year should be paid or set aside within the taxable year to pay interest. It is true that the above amount was paid out of current earnings in the taxable year, but petitioner was not bound by contract to apply current earnings to interest on its bonds. The sinking fund provision in the trust deed did not deal with a sinking fund for the payment of interest. The petitioner was free, under the terms of the trust deed, to pay interest out of accumulated earnings, current earnings, borrowings, or any other type of funds, in its own discretion. It has been pointed out that this provision has not been loosely applied. Belle-Vue Manufacturing Co.,43 B.T.A. 12, 17; Hub Clothing House, Ltd.,39 B.T.A. 900; Eastern Building Corporation,45 B.T.A. 188, 192; Oregon City Manufacturing Co.,43 B.T.A. 212; Lafayette Hotel Co.,43 B.T.A. 426. The above leaves for consideration whether or not petitioner is entitled to a credit under section 26(c)(2) in the amount of $8,000, which was irrevocably set aside for payment into the sinking fund in the*735 taxable year. The only question is whether or not the $8,000 was paid in accordance with the requirements of a written contract executed prior to May 1, 1936, which expressly dealt with the disposition of earnings and profits of the taxable year. 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 8 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. *149 Under the terms of the sinking fund*736 provision petitioner is required to make sinking fund payments until all of its bonds are paid. It was required to deposit $22,657.14 in the sinking fund in 1937, or 5 percent of its gross earnings. Petitioner set aside $8,000. The entire amount was used to redeem 8 bonds in the principal amount of $8,000. Paragraph thirteenth of the trust deed provided, among other things, that the trustee could use money in the sinking fund to purchase or call bonds at not more than $105 and accrued interest. Respondent does not contend that the $8,000 was not a payment int0 the sinking fund. It is concluded that the payment to the bank of $8,000 for transfer to the new trustee was a sinking fund payment, and that it was made pursuant to the requirements of a written contract 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 $8,000. Cf. Brockway Glass Co.,43 B.T.A. 267, 270, 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 c0ntrasted with petitioner's setting aside less than was required. *737 See also Michigan Silica Co.,41 B.T.A. 511; affd., Commissioner v. Michigan Silica Co., 124 Fed.(2d) 397; Strong Manufacturing Co.,41 B.T.A. 1273; affd., Commissioner v. Strong Manufacturing Co., 124 Fed.(2d) 360; certiorari granted, 317 U.S. 102; Saginaw & Manistee Lumber Co.,45 B.T.A. 780. Decision will be entered under Rule 50. Footnotes *. Vacated; Order of July 20, 1942; Revised Report, p. 439. ↩ 1. 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. 2. Petitioner paid to the bank $14,507.60, which included $127.60 for "Federal income tax", leaving $14,380 for principal and interest on the bonds. Petitioner deducted in its return an amount for interest paid in the taxable year which included $380, so that the amount involved in the issue is $14,000, of which $6,000 was a payment for accrued interest. ↩