*871 1. Petitioner, a manufacturing company, held, on the facts subject to tax under Revenue Act of 1934, section 102, as having been availed of during the taxable years for the purpose of avoiding surtax on its shareholders.
2. British income taxes deducted by petitioner's licensees from patent royalties dur held not to entitle petitioner to credit against its United States income tax for foreign income tax paid, under Revenue Act of 1934, section 131. Biddle v. Commissioner,302 U.S. 573">302 U.S. 573, followed.
*347 By this proceeding petitioner challenges determinations of deficiencies in income tax in the sum of $413,439.31 and $1,220,933.44 for the years 1934 and 1935, respectively.
Two issues are presented which are common to both years. They are (1) whether petitioner was availed of in the years in question for the purpose of preventing the imposition of surtax upon its shareholders or the shareholders of any other corporation through the medium of permitting gains*872 and profits to accumulate instead of being divided or distributed, within the meaning of section 102 of the Revenue Act of 1934 and (2) whether petitioner is entitled to credits under section 131 of the Revenue Act of 1934 for taxes paid to a foreign country.
By amended answer respondent asserts an increase in excess profits tax should it be determined that petitioner is entitled to the credit for taxes paid a foreign country.
FINDINGS OF FACT.
Petitioner was incorporated in 1920 under the laws of the State of New York. Its charter conferred upon it the powers and purposes of a manufacturing corporation and also authorized it to "acquire, and to hold, use, own, exercise, develop, operate and introduce, and to sell, or assign, grant licenses in respect of, or otherwise dispose of, any patents or inventions, * * * trade-marks and trade-names, * * * and * * * licenses * * *." It was also given the power to acquire, hold, sell or otherwise dispose of stocks, bonds, and other securities.
Petitioner's principal activities have been the manufacture and sale of automatic windshield wipers. Its main office and plant are at Buffalo, New York. Its Federal income tax returns for*873 the years in question were filed with the collector of internal revenue for the twenty-eighth district of New York.
Petitioner was organized to take over the assets and business of a former company organized by the same stockholders in 1917 and which had been engaged primarily in making hand operated windshield wipers. Between 1920 and 1927, the business grew and further capital was put into the company from time to time by the stockholders who personally borrowed money and bought the company's stock. An automatic windshield wiper was developed in 1921, which was the foundation of petitioner's subsequent success and prosperity. In 1925 petitioner's stockholders personally borrowed money and purchased from petitioner an issue of preferred stock to provide the capital for acquiring the plant and assets of the Folberth Auto Specialty Co. of Cleveland. The sum of $1,050,000 was paid for the plant and assets and another $300,000 for the buildings. The Buffalo plant and the Cleveland plant were both operated from then until 1927. Prior to *348 1927, because it always needed more money, petitioner paid relatively small dividends and ploughed the rest of its earnings back into*874 the business.
First Issue.
By the fall of 1927 petitioner was supplying automatic windshield wipers for part of the automobile production of every car manufacturer in the United States with the exception of Ford, to which hand-operated wipers were still being supplied.
The automatic windshield wiper manufactured in 1927 was the same in general design as that now used, although it has been developed in more elaborate models to meet changes in motor car design. The device was covered by patents, of which the principal ones were owned prior to October, 1927, by John R. Oishei, who was the president and general manager of the company. The basic patents expire in 1942. In 1927 petitioner had about 100 patents. It has always been seeking improvements, and now has approximately 600 additional patents, most of which are related to windshield wipers. It is hoped and anticipated that petitioner's contact position and its ability to produce will leave it dominating the field after the expiration of the basic patents. It is also protected to the extent thereof by improvement patents extending beyond 1942.
In 1927, prior to the reorganization in October, the corporation's common*875 capital stock consisted of 8,000 shares. It had 21 stockholders who were in general the same group which organized petitioner in 1920, and had been associated with John R. Oishei prior thereto. Their holdings of common stock at September 13, 1927, were as follows:
| Shares | |
| John R. Oishei | 2,363.39 |
| Peter C. Cornell | 2,156.565 |
| S. H. Evans | 921.884 |
| Charles H. Oshei | 764.176 |
| William P. Haines | 544.27 |
| Ieuan Harris | 400 |
| Wm. J. Tully | 231.514 |
| Walter J. Chellew | 149.852 |
| Others (13 in number) | 468.259 |
| Unissued | .09 |
| Total | 8,000. |
John R. Oishei was president, Cornell, treasurer, and Evans, secretary. They, together with W. J. Chellew, W. P. Haines, Ieuan Harris, W. J. Tully, and C. H. Oshei, constituted the board of directors. After the reorganization in 1927, J. W. Prentiss of the banking firm of Hornblower & Weeks became a director, representing that firm, and served until 1934. In 1930, Paul A. Schoellkopf succeeded W. J. Tully as a director on the latter's death. Schoellkopf represented Niagra Share Corporation, which had purchased in the market about 16,000 so-called "free" shares. He is still a director. C. H. Oshei, John R. Oishei, and B. *876 F. Oshei (also a stockholder) are brothers. R. J. Oishei and Julian R. Oishei are sons of John R. Oishei.
*349 In the summer of 1927 the stockholders of petitioner were approached by a representative of Lage & Co. with a proposal looking towards the recapitalization of the company. Hornblower & Weeks of New York came into the picture and was successful in getting the business. Lage & Co. was included in the syndicate, as was Hemphill Noyes & Co. The recapitalization involved the purchase by the bankers of a portion of the stock for resale to the public. The company's business has been prospering and it showed increased earnings. Its earnings in 1926 were approximately $807,000 and in 1927, which was the largest year up to that time, approximately $1,300,000. Its debts were small, its surplus in excess of $1,100,000, and its current assets between $1,000,000 and $1,500,000. The company's officers in 1927 were optimistic about the worth of the business and its ability to make money. During the course of the negotiations on this proposal the bankers investigated the plant, properties, and prospects of petitioner, obtained an appraisal of the fixed assets, and engaged*877 patent counsel to investigate and report on the patents under which petitioner was manufacturing its products.
These negotiations culminated in a contract dated September 1, 1927, between the bankers, the stockholders, and S. H. Evans as syndicate manager. Under the contract petitioner's stockholders agreed that its financial structure was to be changed so that it would have outstanding only common stock in the amount of 675,000 shares, without par value; that they would execute a contract with petitioner waiving certain dividends on 450,000 shares of such stock, which on receipt by them would be placed in a voting trust; that on release of the restriction the stock released was to be withdrawn from the trust. The bankers agreed to purchase 175,000 of the new unrestricted shares for $4,225,000 in cash.
It was further agreed that on closing petitioner would have no debts except current ones; that its fixed assets would not be less than $1,000,000 and current assets would not be less than an equal amount; that no changes would take place in the condition of the corporation as shown on its balance sheet of April 30, 1927, except changes arising in the ordinary course of business, *878 retirement of preferred stock and a cash dividend of $110,000 to be paid in July 1927; that all patents owned by John R. Oishei would have been assigned to petitioner and a salary and profit-sharing agreement made with him in substitution for his existing royalty agreements.
After the deduction of certain itemized expenses the $4,225,000 was to be ratably distributed among the stockholders. All statements of fact relating to the patents, products, or business of petitioner were to be approved by the representative of the stockholders before use by the bankers in presentation of the issue to the public.
*350 The agreement waiving dividends, inter alia, provided that the stockholders:
* * * hereby waive dividends up to but not exceeding $2.50 per share in each calendar year to the end that in any calendar year in which dividends may be declared $2.50 per share shall be declared and paid upon the remaining 225,000 shares of such new common stock (hereinafter called the free shares) without any declaration or payment thereof to or for account of such 450,000 shares of such new stock (hereinafter called the deferred shares) or the holders thereof. All dividends in excess*879 of $2.50 which may be declared and paid in any calendar year shall be declared and paid ratably share for share upon the entire 675,000 shares of new common stock.
It is agreed that commencing January 1, 1928, up to 112,500 deferred shares may be exchanged for free shares accordingly as net earnings of the Company for the calendar year 1927 or for any year thereafter shall be equal to $5 per share upon the sum of the free shares then outstanding plus the number of free shares required for such exchange and in like manner commencing January 1, 1929 additional deferred shares up to 112,500 may be exchanged accordingly as the net earnings of the Company for the calendar year 1928 or for any year thereafter are equal to $6 per share on the sum of the free shares plus the free shares required upon such exchange and in like manner the remaining 225,000 deferred shares may be exchanged accordingly as the net earnings of the Company for the calendar year 1929 or for any year thereafter are equal to $9 per share on the sum of the then outstanding free shares plus free shares required upon such exchange; provided that as condition precedent to such exchange in 1928, dividends at the rate*880 of $2.50 per share shall have been paid on the free shares from date of issuance and provided that at the date of each successive exchange herein provided for, dividends aggregating $2.50 shall have been declared and paid during the then next preceding twelve months upon the free shares then outstanding.
The provision agreed upon to be stamped or printed upon the face of the restricted stock certificates was as follows:
* * * "Dividends up to but not exceeding $2.50 in any calendar year have been waived upon the stock represented by this certificate in accordance with the terms of an agreement dated September 1927, between the original owner s of such stock and the Company, a copy of which is on file in the office of the Company and to which reference is hereby made for the terms and conditions of such waiver and for the terms upon which such stock may be freed from such agreement; and the holder of this certificate does by acceptance hereof ratify and confirm such waiver and agrees to hold such stock subject to said agreement. This certificate is transferable only into a certificate or certificates containing this provision."
And,
It is further consented and agreed by the*881 stockholders and covenanted and agreed by the Company that until all of the 450,000 shares of deferred stock shall have been exchanged for free shares in accordance with the terms hereof the Company will not voluntarily liquidate nor make any change in its capitalization or otherwise which will release waiver of dividends upon deferred shares herein provided for or in any manner impair preferential rights thereby created in favor of the free shares.
The agreement also contained a provision setting forth the method of determining net earnings for the purposes of the agreement.
The trustees of the voting trust established in the above agreement were John R. Oishei, S. H. Evans, Peter C. Cornell, and William P. *351 Haines. The stockholders who entered into this agreement were the above named trustees and Ieuan Harris and B. F. Oshei. It was also provided that other stockholders could deliver stock to the trustees for voting purposes. The agreement contained the following recital:
WHEREAS, the stockholders desire for the success and best interests of the company and its stockholders that the company shall be managed and directed during the next ten years under a definite*882 and fixed policy; * * *
This voting trust agreement could be terminated at any time by those holding a 60 percent interest therein.
In connection with the plan of recapitalization and the purchase by the bankers of 175,000 shares of the stock, a letter dated September 16, 1927, signed by John R. Oishei as president of the petitioner, was sent to Hornblower & Weeks, Hemphill Noyes & Co., and Lage & Co., who were the bankers. This letter recited in general the history and business of petitioner, its products, its assets, and a comparative statement of its prior earnings. The letter also recited the terms of the recapitalization, and with respect to the provisions as to release of restricted stock it stated:
By agreement of shareholders owning the entire 675,000 shares of authorized stock, dividends up to $2.50 a share per annum on 450,000 shares have been waived. These shares will accordingly receive no dividends unless dividends in excess of an annual rate of $2.50 are declared on the remaining 225,000 shares in which case they share ratably in such excess.
There follows a restatement of the release provisions. The letter further recited:
All of the Common shares on*883 which dividends have been waived, will be taken by myself and associates.
* * *
Management of the Company will continue in my hands and I plan to continue to devote myself to the management and development of the business as in the past. It is expected that a quarterly dividend of 62 1/2 cents per unrestricted Common share will be paid January 2, 1928, placing this stock on a $2.50 annual dividend basis. The Company will make application in due course to list the Common Shares on the New York Stock Exchange.
The prospectus issued by the bankers in connection with the sale of such stock to the public contained the above quoted language.
In a protest filed with the Bureau of Internal Revenue, John R. Oishei, in setting forth alleged reasons for petitioner's accumulation of surplus, stated as follows:
The contract of 1927 provided with respect to the release of shares that as a condition precedent the corporation should have paid dividends of $2.50 a share on all the free shares outstanding from the time of issuance to and including the year immediately preceding the release. If, therefore, the corporation should have a succession of years in which the earnings were insufficient*884 to pay the contemplated dividend of $2.50 a share, bearing in mind that the requirements for such dividends now exceed $1,125,000.00 a year, no share could be released on the basis of the subsequent year's earnings until the corporation had paid *352 on the free stock dividends which would bring the dividends paid on the issue to $2.50 a year per share. The amount of the surplus which might be required for such a contingency might amount to several million dollars. The normal dividend of $2.50 a share by these provisions of the contract, became a sort of cumulative preferred dividend constituting a charge on future earnings which would first have to be paid in order to place the corporation in a position to carry the provisions of the contract relating to the release of restricted stock.
The dividend on the free stock was not in effect cumulative and exchange of shares was conditioned only upon the payment of dividends amounting to $2.50 per free share in the 12 months next preceding the time of the exchange.
There was no agreement that dividends would be limited to $2.50 a share on the free stock and there was no agreement that the assets should be built up to a book*885 value of $31 a share. was to limit the sources from which the company could derive was to limit the sources from which the company could derive new cash capital until all the restricted stock is released. It would be somewhat difficult to work out any sort of financing by selling other stock or floating loans.
The contract was performed in 1927 with respect to the things to be done at that time. The original stockholders retained 50,000 shares of free stock and 450,000 shares of restricted stock. The restricted stock was stamped to show the restriction and was placed in the voting trust. In addition to the $4,225,000 the stockholders received more than $1,000,000 on the retirement of the preferred stock. Of the $4,225,000 purchase money, $340,000 went to make the quick assets equal $1,000,000 because the bankers did not consider a lesser working capital sufficient. The net worth of the company after such payment was slightly more than $3 a share.
All restricted stock has since 1927 been held by the original 21 stockholders, first in the voting trust required to be set up in the bankers' agreement of 1927, and subsequently through Trico Securities Corporation, which was*886 organized in 1929 to take the place of the voting trust and acquired all the then restricted stock, amounting to 337,500 shares, from the original stockholders, who became stockholders of Trico Securities Corporation in proportion to their holdings of the restricted shares.
The officeers and directors of Trico Securities Corporation for the years 1933, 1934, and 1935 were as follows:
| Officers | Directors |
| John R. Oishei, president | John R. Oishei |
| Peter C. Cornell, vice president | Peter C. Cornell |
| S. H. Evans, secretary and treasurer | S. H. Evans |
| V. H. Merrit, assistant secretary | C. H. Oshei |
| Ieuan Harris |
*353 Petitioner's stock, on the dates indicated, was owned as follows:
(Table omitted)
Because of the sale of approximately 25 percent of its stock to the public, petitioner had from 1,200 to 1,500 stockholders in 1928 and in 1935 approximately 2,200.
Under the agreements of 1927 the release of restricted stock to dividend participation would increase the distribution of earnings to the original stockholders and correspondingly reduce the proportion of earnings available for shares held by the public.
In 1927, when the original stockholders*887 held 50,000 shares of free stock and the public held 175,000 shares, the dividend participation of the original stockholders at the rate of $2.50 a share was approximately 28.5 percent of the distribution. Each release of restricted stock has increased the dividend participation of the original stockholders When and if all restricted shares are released the original stockholders will receive approximately 75 percent of all dividends distributed.
Petitioner, since 1927, has each year paid a regular dividends on all free shares outstanding in the amount of $2.50 a share. In each of the years 1936 and 1937 petitioner, because of the undistributed profits tax law, declared an additional dividend of $1.37 1/2 on all shares. In the year 1936, in order to receive a credit for distribution of dividends declared in previous years at the end of the year and paid January 2, following, the dividend declared at the close of the year was paid *354 December 24, 1936, making in that year a fifth dividend payment of 62 1/2 cents a share.
The dividends distributed in each of the years from 1928 to and including 1939 were as follows:
| 1928 | $655,243.09 |
| 1929 | 794,131.49 |
| 1930 | 914,052.47 |
| 1931 | 937,484.10 |
| 1932 | $937,484.85 |
| 1933 | 937,485.01 |
| 1934 | 937,485.62 |
| 1935 | 925,322.70 |
| 1936 | $2,211,997.98 |
| 1937 | 1,960,768.77 |
| 1938 | 1,046,304.01 |
| 1939 | 1,042,827.52 |
*888 In 1927 a charge of $1,338,419.68 was made to surplus by reason of the exchange of old shares for new and the resulting increase in the capital stock account set up on the books. After deducting such charege in 1927, the accumulated gains and profits at the close of each of the years indicated were not less than the following amounts: 1
| Dec. 31, 1933 | $5,252,534.99 |
| Dec. 31, 1934 | 6,086,607.61 |
| Dec. 31, 1935 | 8,762,708.19 |
| Dec. 31, 1936 | 10,913,737.07 |
| Dec. 31, 1937 | 2 $13,345,212.92 |
| Dec. 31, 1938 | 14,618,763.59 |
| Dec. 31, 1939 | 17,116,605.36 |
The net income not distributed was retained in the business and employed by investment first in Government bonds, and later in stocks, principally of General Motors Corporation, petitioner's largest customer.
Petitioner's total capital invested, its investment in*889 operating and nonoperating assets, and its investments in United States, state and municipal obligations, in marketable securities, stocks of domestic corporations, and other investments and loans on December 31 of the years indicated were as follows:
| Year | Amounts | Amounts | Amounts | Total | Total capital |
| invested in | invested in | invested in | invested in | stock and surplus | |
| operating | United States | stocks of | securities | ||
| assets | state, and | domestic cor- | (total of two | ||
| municipal | porations, | preceding | |||
| obligations | other invest- | columns) | |||
| ments and | |||||
| loan | |||||
| 1929 | $5,229,805.72 | $470,819.29 | $626,752.11 | $1,097,571.40 | $4,703,231.86 |
| 1930 | 5,408,655.11 | 1,616,949.55 | 446,191.00 | 2,063,140.55 | 5,669,196.92 |
| 1931 | 5,492,549.73 | 2,422,799.36 | 361,054.90 | 2,783,854.26 | 6,494,263.48 |
| 1932 | 5,310,675.82 | 2,751,969.99 | 373,475.61 | 3,125,445.60 | 6,521,742.89 |
| 1933 | 5,172,849.74 | 3,817,580.28 | 209,372.10 | 4,026,952.38 | 7,002,534.99 |
| 1934 | 5,469,100.74 | 4,721,488.92 | 358,641.88 | 5,080,130.80 | 7,836,307.61 |
| 1935 | 7,271,068.05 | 6,482,828.51 | 376,239.45 | 6,859,067.96 | a 10,512,708.19 |
| 1936 | 8,252,734.80 | 8,646,028.82 | 390,714.45 | 9,036,743.27 | b 12,663,737.07 |
| 1937 | 8,914,844.62 | 8,125,237.70 | 2,067,577.77 | 10,192,815.47 | *c 14,495,212.92 |
| 1938 | 9,275,942.38 | 8,125,237.70 | 2,084,761.77 | 10,209,999.47 | *d 15,768,763.59 |
| 1939 | 10,838,740.72 | 9,234,839.58 | 2,118,939.52 | 11,353,779.10 | *e 18,266,605.36 |
*355 By the end of 1939 petitioner was employing in its direct operations an amount of capital in excess of its entire capital and surplus of $10,512,708.19 which it had at the end of 1935, as appears from the following statement of items so employed taken from the balance sheet for 1939:
| Cash | $2,082,694.50 |
| Cash surrender value of life insurance policies | 270,926.00 |
| Deposits against future deliveries of raw material | 76,184.95 |
| Accounts receivable, less reserve | 1,321,240.06 |
| Inventories | 1,127,198.15 |
| Employees' stock purchase accounts | 92,840.11 |
| Plant and equipment, less depreciation | 2,839,588.41 |
| Patents, excluding those acquired in 1927, less amortization | 246,804.09 |
| Deferred charges to operations | 56,374.07 |
| Workmen's compensation insurance deposit | 106,376.39 |
| Investment in foreign subsidiary | 1,745.39 |
| Depreciation reserve on plant and equipment | 2,349,801.70 |
| Reserve for amortization of patents | 266,966.90 |
| Total | 10,838,740.72 |
*891 Petitioner had at that time current liabilities of $2,311,149.11.
The capital employed by petitioner in its direct operations at December 31, 1935, amounted to $7,271,068.05 and was in excess of petitioner's entire capital and surplus of $7,002,534.99 existing at December 31, 1933, as shown by the following items taken from the balance sheet for 1935:
| Cash | $1,199,527.52 |
| Cash surrender value of life insurance policies | 184,481.25 |
| Deposits against future deliveries of raw materials | 50,232.94 |
| Notes and accounts receivable, less reserve | 1,305,012.83 |
| Inventories | 709,908.51 |
| Employees stock purchase and other accounts | 106,919.68 |
| Deferred charges to operations | 44,761.79 |
| Insurance fund deposit | 76,760.13 |
| Investment in subsidiary | 104,475.49 |
| Land, plant and equipment, less depreciation | 1,500,956.57 |
| Patents, less amortization | 284,650.53 |
| Reserve for depreciation on plant | 1,292,227.02 |
| Reserve for amortization of patents | 411,153.79 |
| Total | 7,271,068.05 |
Petitioner had at that time current liabilities of $2,367,793.30.
On December 31, 1933, the amount of capital devoted to direct operations was $5,172,849.74, as appears from the following items taken*892 from the balance sheet of December 31, 1933:
| Cash | $602,718.11 |
| Cash surrender value of insurance policies | 143,160.50 |
| Deposits against future deliveries of raw materials | 85,764.07 |
| Notes and accounts receivable, less reserve | 413,931.66 |
| Inventories | $434,975.36 |
| Employees stock purchase and other accounts | 151,183.67 |
| Deferred charges to operations | 41,469.73 |
| Insurance fund deposit | 76,760.13 |
| Investment in and advances to subsidiary companies | 74,249.67 |
| Land, buildings, machinery and equipment, less depreciation | 1,496,699.06 |
| Patents, less amortization | 329,578.22 |
| Reserve for depreciation | 969,064.14 |
| Reserve for amortization of patents | 353,295.42 |
| Total | 5,172,849.74 |
*356 Current liabilities at that date were $779,054.57.
The earnings required to release the restricted stock under the contract of 1927 on the basis of $5 a share were $1,125,005 for the first share and $1,687,500 for the last share. To release the stock in the $6 block required earnings of $2,025,006 for the first share and $2,700,000 for the last share. To release the stock in the $9 block required earnings of $4,050,009 for the first share and will require earnings of $6,075,000*893 to release the last share.
The earnings of petitioner for each year considered in releasing stock, and the restricted shares released on those earnings following the close of such respective year were as follows:
| Year | Earnings | Shares released after close of year |
| 1927 | $1,372,303 | 49,460 |
| 1928 | 1,778,475 | 63,040 |
| 1929 | 2,249,947 | 37,491 |
| 1930 | 1,908,415 | None |
| 1931 | 1,762,550 | None |
| 1932 | 964,964 | None |
| 1933 | 1,418,277 | None |
| 1934 | 1,771,558 | None |
| 1935 | $3,567,404 | 75,009 |
| 1936 | 4,184,560 | 14,951 |
| 1937 | 3,792,244 | None |
| 1938 | 2,319,854 | None |
| 1939 | 3,540,669 | None |
| Total shares released | 239,951 |
Petitioner's income from interest on State of New York obligations, etc., interest on United States bonds, and dividends on stock, for the years indicated was as follows:
| Interest on State of New York obligations, etc. | Interest on United States bonds | Dividends | Total | |
| 1927 | $175.00 | $175.00 | ||
| 1928 | 175.00 | 175.00 | ||
| 1929 | 839.52 | $4,127.17 | $3,315.00 | 8,281.69 |
| 1930 | 4,277.74 | 42,830.79 | 6,300.00 | 53,408.53 |
| 1931 | 80,600.07 | 6,032.00 | 86,632.07 | |
| 1932 | 101,653.52 | 3,722.10 | 105,375.62 | |
| 1933 | 118,566.24 | 3,789.50 | 122,355.74 | |
| 1934 | 20,455.50 | 132,331.73 | 6,768.00 | 159,555.23 |
| 1935 | 37,119.66 | 150,054.70 | 18,851.00 | 206,025.38 |
| 1936 | 41,101.64 | 198,219.13 | 54,149.10 | 293,469.87 |
| 1937 | 44,697.31 | 222,002.13 | 108,198.15 | 374,897.59 |
| 1938 | 44,538.08 | 209,496.99 | 83,391.37 | 337,426.44 |
| 1939 | 45,223.22 | 223,664.69 | 156,187.70 | 425,075.61 |
*894 *357 Petitioner's total earnings from interest on United States and New York State and municipal obligations and dividends from 1927 to the close of 1939 amounted to $2,173,028.87.
Petitioner's policy regarding the investment and use of its liquid capital has not been to trade actively, but to make investments which in the judgment of the board of directors seemed safe, and at the same time to endeavor to obtain the best return possible on the capital. Up to 1937, these investments were chiefly in Government bonds to obtain safety of the principal, because of the conditions and experience during that period. Commencing in 1937, petitioner considered that it could safely acquire stock in customers with which it was principally doing business. About 1937 and 1938 it purchased such stocks in which were invested an aggregate of about $2,000,000. This was principally common stock of General Motors Corporation, which was petitioner's largest customer and took between 30 percent and 40 percent of its output. One reason for investing funds in stock of General Motors was for the return. The other was the large amount of business which petitioner was doing with General Motors, *895 which led petitioner to think that the security from the standpoint of earnings or the guarantee of earnings was as good as an investment in petitioner's own business. This investment raised the income rate from petitioner's liquid capital, which was low on the Government bonds. Since 1929, the average rate of return on petitioner's investments has been between 3 and 4 percent. Petitioner's return on the General Motors stock in 1940 was 7 3/4 percent.
Petitioner kept its securities in safe deposit boxes in Buffalo. They were not customarily taken out to use in the operation of the business. Notes payable of $400,000 and $950,000 at the end of 1938 and 1939, respectively, represented short term bank loans which were obtained at a low rate of interest by putting up Liberty bonds as collateral.
Its ten-year contract with General Motors Corporation effective from 1934 to the end of 1943 provides for payments by petitioner to General Motors by way of participation in profits. It has the option to make annual settlements, either in cash or in its stock. These amounts becoming payable to General Motors in any year may run as high as $750,000, and including the settlement for*896 1940 there remain four years of the contract term in which such settlements must be made. In order to accumulate the stock to be prepared to make the payments by delivery of stock, which might prove very profitable to petitioner through making its largest customer one of its largest stockholders and by favorable rises in the price of the stock, petitioner began *358 in 1935 to purchase shares of its own stock. Its yearly purchases of such treasury stock from 1935 through 1939 were as follows:
| Shares purchased | Average cost per share | Total cost | |
| 1935 | 12,415 | $38.35 | $476,224.29 |
| 1936 | 8,211 | 42.46 | 348,655.20 |
| 1937 | 21,605 | 39.74 | 858,603.28 |
| 1938 | 5,344 | 31.78 | 169,880.98 |
| 1939 | 500 | 30.41 | 15,205.00 |
| Total | 48,075 | 38.86 | 1,868,568.75 |
The stock was bought in the open market and none was acquired from the original stockholders. These shares are held in the treasury of petitioner. They could not be retired because of the provisions of the agreement with the bankers made in 1927, and they were not purchased for the purpose of retirement, but to be reissued either by delivery to General Motors Corporation or by sale. It would be impossible to acquire*897 in the open market the requisite number of shares to make such adjustments in a short time after deciding to exercise the option without raising the price of the stock to a point where it would be prohibitive. These purchases of petitioner's stock had and have the approval of the directors, including Paul A. Schoellkopf.
The shares of petitioner's stock held in the treasury have resulted in augmenting the capital funds of the corporation available for producing income by investment, because of the fact that no dividends were payable or paid on such shares. This retained dividend to the end of 1939 amounted to $452,700.79, and in effect increased the petitioner's surplus by that sum available for producing further income through investment. In 1940, and in subsequent years, on dividend distributions of $2.50 a share the retained dividend on the treasury shares amounts to approximately $120,000 a year, which is equivalent for the production of income to an increase in surplus by that amount.
The division of dividend payments paid the original stockholders and others since 1927, based on the original holdings of free stock and subsequent releases of restricted stock, have directly*898 and indirectly been as follows:
| Year | Free shares outstanding and held by each group | Dividend payment | Percentage of ownership of free shares and dividend distribution |
| Percent | |||
| 1927 - Original stockholders | 50,000 | $31,250.00 | 22.22 |
| Other stockholders | 175,000 | 109,376.05 | 77.77 |
| Total | 225,000 | 140,626.05 | 100 |
| 1928 - Original stockholders | 99,460 | 248,650.00 | 36.23 |
| Other stockholders | 175,000 | 437,506.13 | 63.76 |
| Total | 274,460 | 686,156.13 | 100 |
| 1929 - Original stockholders | 162,500 | $406,250.00 | 48.14 |
| Other stockholders | 175,000 | 437,506.59 | 51.85 |
| Total | 337,500 | 843,756.59 | 100 |
| 1930 - Original stockholders | 199,991 | 499,977.50 | 53.33 |
| Other stockholders | 175,000 | 437,506.84 | 46.66 |
| Total | 374,991 | 937,484.34 | 100 |
| 1931 - Original stockholders | 199,991 | 499,977.50 | 53.33 |
| Other stockholders | 175,000 | 437,506.70 | 46.66 |
| Total | 374,991 | 937,484.20 | 100 |
| 1932 - Original stockholders | 199,991 | 499,977.50 | 53.33 |
| Other stockholders | 175,000 | 437,507.41 | 46.66 |
| Total | 374,991 | 937,484.91 | 100 |
| 1933 - Original stockholders | 199,991 | 499,977.50 | 53.33 |
| Other stockholders | 175,000 | 437,507.61 | 46.66 |
| Total | 374,991 | 937,485.11 | 100 |
| 1934 - Original stockholders | 199,991 | $499,977.50 | 53.33 |
| Other stockholders | 175,000 | 437,508.41 | 46.66 |
| Total | 374,991 | 937,485.91 | 100 |
| 1935 - Original stockholders | 199,991 | 499,977.50 | 53.33 |
| Other stockholders | 175,000 | 437,510.30 | 46.66 |
| Total | 374,991 | 937,487.80 | 100 |
| 1936 - Original stockholders | 275,000 | * 1,375,009.18 | 66.97 |
| Other stockholders | 175,000 | * 678,125.00 | 33.02 |
| Total | 450,000 | * 2,053,134.18 | 100 |
| 1937 - Original stockholders | 289,951 | 1,412,377.50 | 67.56 |
| Other stockholders | 175,000 | 678,134.15 | 32.43 |
| Total | 464,951 | 2,090,511.65 | 100 |
| 1938 - Original stockholders | 289,951 | 724,877.50 | 62.36 |
| Other stockholders | 175,000 | 437,511.52 | 37.63 |
| Total | 464,951 | 1,162,389.02 | 100 |
| 1939 - Original stockholders | 289,951 | 724,877.50 | 62.36 |
| Other stockholders | 175,000 | 437,512.54 | 37.63 |
| Total | 464,951 | 1,162,390.04 | 100 |
*359 All the increase in the dividends of petitioner at the rate of $2.50 a share on free shares outstanding has gone to the original stockholders.
When and if all restricted shares are released from the dividend restrictions the original stockholders, based on the original division of free and restricted shares, will own directly and indirectly 500,000 free shares on which the dividend disbursement at $2.50 a share would amount to $1,250,000, and other stockholders will own a maximum of 175,000 shares on which the dividend disbursement would be $437,500. Any dividend disbursements after that time will be participated in in the same relative proportion.
*360 The number of shares of free stock held by stockholders of petitioner other than the original group of stockholders directly and indirectly, have, since 1927, remained approximately as they were after the sale of 175,000 free shares to the public. The free shares held by others than the original group on December*900 31 of the several years have been as follows:
| Shares | |
| 1927 | 172,803 |
| 1928 | 176,178 |
| 1929 | 202,686 |
| 1930 | 178,286 |
| 1931 | 175,092 |
| 1932 | 170,232 |
| 1933 | 183,548 |
| 1934 | 178,046 |
| 1935 | 167,867 |
| 1936 | 161,340 |
| 1937 | 137,364 |
The stockholdings of the original stockholders of petitioner, through their ownership of the stock of Trico Securities Corporation, which in 1929 was set up in substitution for the voting trust and acquired all the then restricted shares of petitioner numbering 337,500, were after 1929 through 1937 substantially in the same proportions as their respective holdings of the restricted stock at the time of the reorganization in 1927.
There have been 239,951 shares of restricted stock released to dividend participation and there remain restricted 210,049 shares. The free stock had been selling at the time of the hearing for around $34 to $35 a share. The mean price for it in any year since 1927 was not $25below.
In 1925 petitioner supplied 20 1/2 percent of the total automatic windshield wiper requirements of all automobile production in the United States and Canada. In 1927 this percentage was built up to 69 8/10 percent; by 1930 it reached*901 85 4/10 percent; in 1931, 98.5 percent; and in 1932, 100 percent. With minor exceptions it has since supplied all car manufacturers their full requirements.
Petitioner's net profits per books for each year, after all deductions, including Federal taxes for the current year, and excluding dividends and interest on United States, New York State, and municipal obligations, and the percentage of such net profits to net sales, were as follows:
| Year | Net profit (excluding dividends and interest on obligations) | Percentage of such net profit to net sales |
| Percent | ||
| 1927 | $1,345,512.54 | 36.1 |
| 1928 | 1,797,646.56 | 33.5 |
| 1929 | 2,241,666.28 | 38.6 |
| 1930 | 1,855,007.35 | 39.4 |
| 1931 | 1,675,918.69 | 35.4 |
| 1932 | 859,588.70 | 27.8 |
| 1933 | 1,295,921.47 | 34.6 |
| 1934 | $1,612,003.30 | 31.9 |
| 1935 | 3,361,379.04 | 37.7 |
| 1936 | 3,891,090.94 | 31.7 |
| 1937 | 3,417,347.03 | 27.1 |
| 1938 | 1,982,428.24 | 27.5 |
| 1939 | 3,115,593.68 | 32.7 |
*361 Petitioner's yearly production of windshield wipers follows generally the yearly trend of production of automobiles. In petitioner's business increased sales have always resulted in increased profits.
In 1933 the total production of motor vehicles in*902 the United States and Canada was 1,985,909. In 1935 it was 4,119,811, and in 1937 it was 5,015,974.
Petitioner's gross sales for the years indicated were as follows:
| 1933 | $3,950,520.69 |
| 1934 | 5,479,920.37 |
| 1935 | 9,695,428.41 |
| 1936 | 13,456,985.43 |
Gross sales for the eight years from 1927 to and including 1935 were approximately $44,000,000. For the four years from 1936 to 1939, both inclusive, the gross sales were approximately $44,000,000.
Sales to General Motors, Chrysler, and Ford from the years 1934 to 1939, inclusive, amounted to $40,629,062, composed as follows:
| General Motors | Chrysler | Ford | |
| 1934 | $1,369,076 | $1,010,265 | $937,340 |
| 1935 | 3,265,992 | 1,605,592 | 1,653,626 |
| 1936 | 4,695,814 | 2,224,444 | 1,849,739 |
| 1937 | 4,716,215 | 2,504,018 | 2,191,229 |
| 1938 | 2,852,866 | 1,032,946 | 1,475,956 |
| 1939 | 4,000,845 | 1,156,043 | 2,087,056 |
| Total | 20,900,808 | 9,533,308 | 10,194,946 |
In 1934 petitioner made a contract with General Motors to supply the entire requirements of that corporation for windshield wipers for a period of ten years. The purchases of General Motors during that period will run from $35,000,000 to $40,000,000 and amount to*903 35 percent to 40 percent of petitioner's business. Petitioner had term requirement contracts with Chrysler, but they have since expired. Petitioner never had a term or requirement contract with Ford, but has operated on a requisition basis for short periods. These three manufacturers are the largest customers of petitioner and together take about 75 percent to 80 percent of petitioner's output.
The market for petitioner's present products is controlled entirely by automobile production. Petitioner's officers were of the opinion that since petitioner supplies practically the entire requirements of the automobile industry in the United States and Canada, no substantial expansion of business could be expected without the development of other products, or a substantial increase in volume of automobile production.
Petitioner has employed over 3,000 employees at one time. Its annual payroll has run as high as $2,000,000. From 1927 to 1936, inclusive, manufacturing labor costs averaged 18.45 percent of net *362 sales, with a high of 20.4 percent and a low of 16.5 percent. For the same period "cost of goods sold" as shown on its books, not including selling and overhead*904 expense, averaged 48.5 percent of "Net Sales", with a high of 55 percent and a low of 43 percent. Accounts receivable reached $1,800,125. The average period during which customers' accounts are carried is about 30 days. Petitioner has few bad debts. Petitioner has produced as high as 30,000 units in a day, involving each from 60 to 80 parts.
The declared value of the capital stock of petitioner for excess profits tax purposes in 1936 was $50,000,000, and an excess profits tax was paid.
In the years from 1927 to the end of 1935, petitioner expended for additions to its land, buildings, machinery, and equipment $1,674,929.95. In the years 1936 to 1939, inclusive, petitioner expended for additions to land, buildings, machinery and equipment, $2,396,206.52, of which more than $2,000,000 was expended in 1936 and 1937 because petitioner was unable with its then existing facilities to take care of the demand of the automobile industry and was operating under three eight-hour schedules. Petitioner, since 1925, has always been able to take care of plant additions for each year out of the current earnings for that year.
Petitioner in December of 1940 was endeavoring to acquire*905 the adjoining city block for expansion. It was building up its plant to maximum efficiency by 1942.
At the time of the reorganization and sale of the stock to the bankers in 1927 the bankers required that petitioner obtain title to the patents used by the corporation then owned by J. R. Oishei, which included the basic patent on the automatic windshield wiper. This they did by giving him a profit-sharing agreement. These patents were the principal source of petitioner's earning power and gave it its monopoly position. They were carried on the books of petitioner for the nominal value of $1, and the payments to John R. Oishei under the agreement were charged to expense. Such payments in 1934 and 1935 amounted to $379,105.50 and $649,818.35, respectively.
Immediately following the reorganization of petitioner in 1927, its stated capital was $1,750,000. No change in the stated capital was made until the end of 1935 when petitioner transferred from surplus to capital account $5,000,000, making the stated capital $6,750,000. The stated capital was increased by transfers from surplus in 1936 to $7,750,000, in 1937 to $8,750,000, in 1938 to $9,250,000, and in 1939 to $10,250,000.
*906 Petitioner's authorized capital and total shares were not changed and no new shares were issued.
*363 These transfers were made on the advice and recommendation of petitioner's accountants on the ground that the principal patents expiring in 1942 are wasting assets and were carried on petitioner's books at $1.
An entry was also made on December 31, 1935, transferring $5,122,431.02 from marketable securities account (U.S. Government securities) to a new account called "Funds held for anticipated diversification of Company's products." Further entries were made at or about the close of succeeding years with the result that at the close of 1939 the account "Funds held for anticipated diversification of Company's products" stood at $8,721,818.23. Of this amount of $7,311.33 was made up of transfers from U.S. Government securities account, and $2,010,438.90 less reserve of $600,000 or $1,410,438.90 of transfers from common stocks account.
The above mentioned reserve of $600,000 was set up on December 31, 1937, by journal entry as a "reserve for current valuation of common stocks" purporting to show the unrealized loss due to the decrease in market value of the stocks*907 owned by petitioner. Petitioner's accountants, Price Waterhouse & Co., suggested setting up the reserve. The amount so set up was charged to profit and loss for 1937 and is shown as a deduction in arriving at the net book profit of $3,792,244.62 for 1937, the figure considered in releasing stock. At December 31, 1937, the cost of these stocks, most of which had been purchased in 1937, was $2,007,992.40. These stocks consisted almost entirely of common stock of General Motors Corporation.
Petitioner has a large experimental department and has been conducting research and experiments in the field of vacuum-operated devices for years for the purpose of expanding and diversifying. Certain products have been marketed from time to time with more or less success in a minor way. A tone horn developed by it was quickly copied. It also developed a vacuum-operated automobile fan which is still an important product in its business. In the past year petitioner has developed and introduced a vacuum-operated device for raising and lowering windows in automobiles. It was introduced to the trade at the Automobile Show in New York in October 1940, and has been received by the industry with*908 much enthusiasm. It is expected that this device will be adopted by the industry to a substantial degree and can be produced and sold by petitioner at a price which will permit its adoption as standard equipment even on low-priced automobiles. The fact that at the time of the hearing it appeared that automobile manufacturers would not bring out new models in 1941, because of demands on industry for national defense, was thought to make the automobile manufacturers more ready to adopt changes in equipment *364 which will add sales appeal to cars. The installation of this device requires a vacuum unit for each door of the car. The adoption of this device on 1,000,000 cars a year would require plant expansions by petitioner of an estimated cost of between $3,000,000 and $5,000,000 for the reason that such a demand would double petitioner's production. The device is covered by patents, and manufacturers would have to wait until petitioner could meet the demands.
On March 2, 1932, there was a discussion at a meeting of petitioner's directors concerning the contract with John R. Oishei and controversies which had arisen between John R. Oishei and the Federal taxing authorities. *909 As a result of the discussion it was, according to the minutes, "Resolved, that either the vice president or secretary be and are hereby authorized to draft and execute a modification of said contract so as to advise Mr. Oishei that his salary as general manager is to continue at $15,000 a year and that $135,000 a year be paid for the term of the contract to him as part consideration for the interest in the patents assigned by and to be assigned by Mr. Oishei pursuant to the provisions of said agreement of September 14, 1927."
All of the large individual stockholders of petitioner were in the taxable year, and for several years prior thereto, men of substantial wealth. They had large incomes each year on which they paid Federal income taxes. They knew in general that the tax rate increased as income increased and that if additional distributions of dividends had been made by petitioner during the taxable years they would have to pay more Federal surtaxes.
The surtaxes avoided by the following stockholders by reason of the failure of petitioner to distribute the undistributed portion of its net book income are as follows:
| Surtax avoided 1934 | Surtax avoided 1935 | |
| Trico Securities Corporation | $53,978.54 | $433,417.28 |
| John R. Oishei | 29,419.45 | 97,346.23 |
| Peter C. Cornell | 28,654.78 | 93,825.49 |
| S. H. Evans | 6,128.65 | 30,706.89 |
| Leuan Harris | 15,968.00 | 53,145.46 |
| W. J. Chellew | 367.07 | 1,245.47 |
| Total | 134,516.49 | 709,686.82 |
*910 At the close of 1934 and 1935 the above six stockholders owned nearly 74 percent of the outstanding capital stock of petitioner. By reason of purchases by petitioner of treasury stock from the public the holdings of these stockholders had increased to approximately 78 percent at the close of 1937.
Had petitioner distributed the undistributed portion of its net book income and had the share so received by Trico Securities Corporation *365 been distributed by it, the additional surtaxes payable by the stockholders indicated below would be as follows:
| Additional surtax | ||
| 1934 | 1935 | |
| John R. Oishei | $108,729.03 | $356,734.85 |
| Peter C. Cornell | 97,924.94 | 322,260.16 |
| S. H. Evans | 35,166.41 | 134,599.02 |
| Ieuan Harris | 19,981.40 | 65,878.65 |
| C. H. Oshei | 12,008.17 | 69,071.52 |
| W. J. Chellew | 1,754.45 | 7,455.37 |
| Total | 275,564.40 | 955,999.57 |
The above six stockholders during the taxable years owned approximately 87 percent of the outstanding capital stock of Trico Securities Corporation. Together with the other few original stockholders or relatives they owned approximately 100 percent.
During the taxable years petitioner permitted its gains and profits*911 to accumulate beyond the reasonable needs of its business.
During the taxable years petitioner was availed of for the purpose of preventing the imposition of the surtax upon its shareholders, and the shareholders of another corporation, through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.
Second Issue.
Petitioner held certain patents of the United Kingdom of Great Britain relating to the "wind screen" wipers. On March 20, 1929, a license agreement was entered into between petitioner as "grantors" and Trico-Folberth, Ltd., of Manchester, England, a British corporation, as "licensees." With respect to the amount of royalties to be paid, the agreement provided:
The Licencees shall in respect of each windscreen wiper constructed in accordance with * * * the invention the subject of any scheduled patents * * * manufactured by or for and sold hereunder by the Licencees * * * pay to the Grantors such sum by way of royalty as shall after deduction therefrom of English Income Tax at the rate for the time being in force be equal to 10 cents United States currency. * * *
and,
* * * The Licencees shall with each such*912 [periodical] statement [of wipers sold] remit to the Grantors * * * free from any deduction whatsoever (except Income Tax) or expense to the Grantors the amount of royalties by such statement shown to be due.
On November 25, 1930, petitioner entered into two other agreements with Trico-Folberth, Ltd., covering improvements on the wiper. In one it was provided:
The Company [Trico-Folberth, Ltd.] shall in respect of each and every automatic windshield cleaner constructed as aforesaid manufactured and sold hereunder *366 by the Company prior to the date of this License pay to Trico at Buffalo, New York, free from any deduction whatsoever such sum by way of royalty as shall after deduction therefrom of English Income Tax at the rate for the time being in force be equal to the sum of Sixty five cents ($.65) United States currency. * * *.
In the other it was similarly provided that the company should pay petitioner "free from any deduction whatsoever such sum by way of royalty as shall after deduction therefrom of English Income Tax at the rate for the time being in force be equal to the sum of two cents (2 cents) United States currency."
On September 24, 1930, petitioner*913 also licensed Joseph Lucas, Ltd., of Birmingham, England, to use certain of its British patents. With respect to royalties the agreement provided:
The sums * * * to be paid by the Licensees to Grantors by way of royalties shall be as follows:
* * *
(b) In respect of each quarter year in the year commencing first April One thousand nine hundred and thirty two the sum of Five thousand two hundred and fifty dollars United States currency.
(c) In respect of each subsequent quarter year during the continuance of the said License the sum of Five thousand five hundred dollars United States currency.
* * *
(f) All sums of royalty payable hereunder and under said License shall be paid free and clear of all deductions except British Income Tax and the Licensees shall in making such payment of royalty furnish to Grantors a certificate to the effect that British Income Tax has been deducted therefrom and that such tax has been or will be duly accounted for and paid to the British Inland Revenue.
In the year 1934 there became payable to Trico Products Corporation from Joseph Lucas, Ltd., and Trico-Folberth, Ltd., certain royalties under the patent license agreements. There likewise*914 became payable to petitioner from Trico-Folberth, Ltd., in 1934, the sum of $2,200 interest on a promissory note or notes. In the year 1935 further sums became payable as patent license royalties to the petitioner from Joseph Lucas, Ltd., under the patent license agreements.
In making payment to petitioner of these sums the debtors did not include certain sums aggregating $8,195.46 in the sums which were payable in 1934 and $4,950 in the sums which were payable in 1935, and paid to petitioner only the aggregate amount of $27,617.80 for the sums which were payable in 1934 and $17,050 for the sums which were payable in 1935. The debtors transmitted to petitioner a certificate designated "Certificate of Income Tax." The following is a copy of the certificate furnished in connection with the first quarterly payment of royalties by Joseph Lucas, Ltd., in 1934, and it is typical of the remaining certificates:
*367 R 185. *CERTIFICATE OF DEDUCTION OF INCOME TAX.
I CERTIFY that on paying to TRICO PRODUCTS CORPORATION OF BUFFALO, NEW YORK, U.S.A. the Sum mentioned in the third Column of the subjoined Statement, I deducted the amount of Income Tax shown in the fourth Column*915 of the Statement, and I further certify that this Tax has been or will be paid by me either personally to the proper Officer for the receipt of Taxes or by way of deduction from rent or other income when received by me.
Date 19th April 1934.
Signature R. W. POWELL,
Asst. Secretary.
Business Address (if none, state Residence)
| Nature of | Description | Gross | Amount | Period (i.e., year, half for |
| the annual | of the Pro- | gross | Income Tax | year, and c., which the pay- |
| Payment, | perty, 1 or | amount of | of deducted | ments due, and Date to which |
| e.g., | profits, out | the Payment | by me * | payable |
| ground rent | of which the | from which | ||
| Mortgage or | annual pay- | I have de- | ||
| Loan Inter- | ment is made | ducted the | ||
| est, | tax | |||
| Annuity etc | ||||
| 1. | 2. | 3. | 4. | 5. |
| Pound s.d. | Pound s.d. | |||
| Royalty. | 1070 o 9 | 267 10 2 | ||
| equivalent | $5500 | $1375 | Covering period 1st. January | |
| 1934 to 31st. March 1934. | ||||
| Payable 31st. March 1934. |
*916 The following is a summary showing the items and amounts reported on the certificates as "Nature of annual payment", "Gross amount of the payment from which I have deducted the tax" and "Amount of income tax deducted by me" and in the last column the amounts actually received by petitioner:
| 1934 | Date | "Nature of | "Gross | "Amount of | Amount |
| annual pay- | amount of | income tax | actually | ||
| ment" | the pay- | deducted | received by | ||
| ment from | by me" | petitioner | |||
| which I | |||||
| have de- | |||||
| ducted the | |||||
| Tax" | |||||
| Joseph Lucas, Lt'd | 3/31/34 | Royalties | 5,500.00 | 1,375.00 | 4,125.00 |
| 6/30/34 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 | |
| 9/30/34 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 | |
| 12/31/34 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 | |
| Trico Folberth, Lt'd | 10/31/34 | * Royalties | 11,613.26 | 2,612.96 | 9,000.30 |
| 10/31/34 | * Interest | 2,200.00 | 495.00 | 1,705.00 | |
| Total (1934) | 35,813.26 | 8,195.46 | 27,617.80 | ||
| 1935 | |||||
| Joseph Lucas, Lt'd | 3/31/35 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 |
| 6/30/35 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 | |
| 9/30/35 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 | |
| 12/31/35 | Royalties | 5,500.00 | 1,237.50 | 4,262.50 | |
| Total (1935) | 22,000.00 | 4,950.00 | 17,050.00 |
*368 On its Federal income tax returns for 1934 and 1935 petitioner reported as gross income the amounts shown above as the gross amounts and deducted as a credit for foreign taxes the amounts indicated, to the extent allowed by section 131, Revenue Act of 1934.
Respondent in the notice of deficiency considered as income to the petitioner only the amounts actually received by it from the two British companies and with respect to the items in controversy allowed no credit for taxes imposed by the British Government on the theory that the liability was that of the British companies and not of petitioner; that the certificates of deduction do not specifically state that the amount withheld was petitioner's tax liability; that the receipts are for the entire tax as one lump sum, with no part designated as a "withholding."
A letter of October 4, 1937, from the British taxing authorities on a form letterhead bearing printed headings "Inland Revenue" and "H. M. INSPECTOR OF TAXES, Birmingham 6th District, *918 Richmond House, 84, Newhall Street, Birmingham, 3.", was directed to attorneys "Messrs. C. Herbert Smith & Russell, 71 Edmund Street, BIRMINGHAM, 3.", in connection with Joseph Lucas Limited. The letter reads as follows:
Dear Sirs,
Joseph Lucas Limited.
With reference to your Clients' request for a certificate of deduction of British Income Tax on Royalty payments made to Trico Products Ltd, Buffalo, New York.
I beg to state that if Messrs Lucas Ltd, complete the usual certificate on Form 185 this Office will be prepared to certify that Messrs Lucas Ltd, have accounted for the tax they have deducted from Trico Products Ltd. The Royalty is added back in arriving at Messrs Lucas Ltd Income Tax liability, and is charged together with other items on them in one sum. It is regretted that no separate receipt can be issued, but no doubt the certificate, certified if necessary, will meet your requirements.
Yours faithfully,
[SIGNED] A. EAE.
The income of Trico-Folberth, Ltd., subject to liability for British income tax for the year ending October 31, 1934, agreed to by it with the British taxing authorities, was computed as follows:
| Profit as per Accounts | Pound 8,297 | |
| Add Depreciation charged in Accounts | 1,125 | |
| Add Gross Royalty charged in Accounts - Trico Products Corporation | 2,318 | |
| Add Gross loan Interest charged in Accounts - Trico Products Corporation | 438 | |
| Pound 12,178 | ||
| Less Sundry Adjustments re Schedule "A" | ||
| Assessment on company premises &c | 434 | |
| Agreed Assessment | Pound 11,744 | |
| Agreed Allowance for Depreciation | Pound 1,012 | |
| Assessment | Pound 11,744 | |
| Depreciation Allowance | 1,012 | |
| Pound 10,732 |
*919 Income Tax paid on Pound 10732 at 4/6 d. in the Pound = Pound 2,414.14.0.
*369 The particulars of assessment of the British taxing authorities in connection with the above income are as follows:
| Amount of Assessment: | Pound | s. | ||
| From Profits from Trade, etc., of | 11444[SIC] | |||
| Less Deductions for - | ||||
| Machinery and Plant: Wear and Tear and Additional Deduction of One-Tenth. | ||||
| Pound s | ||||
| 1012 | 1012 | |||
| NET AMOUNT CHARGEABLE | 10732 | |||
| Pound | s | d | ||
| TAX CHARGEABLE THEREON, at 4/6 in the Pound | 2414 | 14 | 0 |
The income of Trico-Folberth, Ltd., subject to liability for British income tax for the year ending October 31, 1935, was computed in a manner similar to that for 1934, showing adjustment of interest of Pound 549 shown as paid or payable to Trico Products Corporation. The net amount so computed was Pound 11,858 taxable at 4/6d. in the Pound. The particulars of assessment were similar to those for 1934.
The net profits of Trico-Folberth, Ltd., for its taxable years 1934 and 1935, reported or agreed to by it with the British taxing authorities as subject to British income tax, were in excess of the interest and royalties paid by it to petitioner. *920 The evidence does not disclose the amount of net profit of Joseph Lucas, Ltd., reported or reportable to the British taxing authorities for those years.
Part I of the British Income Tax Act of 1918, as amended, provides as follows:
1. Where any Act enacts that income tax shall be charged for any year at any rate, the tax at that rate shall be charged for that year in respect of all property, profits, or gains respectively described or comprised in the schedules marked A, B, C, D, and E, contained in the First Schedule to this Act and in accordance with the Rules respectively applicable to those Schedules.
* * *
Schedule *370 D of Part I provides as follows:
1. Tax under this Schedule shall be charged in respect of -
(a) The annual profits or gains arising or accruing -
(i) to any person residing in the United Kingdom from any kind of property whatever, whether situate in the United Kingdom or elsewhere; and
(ii) to any person residing in the United Kingdom from any trade, profession, employment, or vocation, whether the same be respectively carried on in the United Kingdom or elsewhere; and
(iii) to any person, whether a British subject or not, although*921 not resident in the United Kingdom, from any property whatever in the United Kingdom, or from any trade, profession, employment, or vocation exercised within the United Kingdom; and
(b) All interest of money, annuities, and other annual profits or gains not charged under Schedule A, B, C of E, and not specially exempted from tax;
in each case for every twenty shillings of the annual amount of the profits or gains.
2. Tax under this Schedule shall be charged under the following cases respectively; that is to say, -
Case I. - Tax in respect of any trade not contained in any other Schedule;
Case II. - Tax in respect of any profession, employment, or vocation not contained in any other Schedule;
Case III. - Tax in respect of profits of an uncertain value and of other income described in the rules applicable to this Case;
* * *
Case VI. - Tax in respect of any annual profits or gains not falling under any of the foregoing Cases, and not charged by virtue of any other Schedule;
and subject to and in accordance with the rules applicable to the said Cases respectively.
Rules applicable to Cases I. and II.
1. - (1) The tax shall be charged without any other deduction*922 than is by this Act allowed.
* * *
3. In computing the amount of the profits or gains to be charged, no sum shall be deducted in respect of -
* * *
(l) any annual interest, or any annuity, or other annual payment payable out of the profits or gains:
(m) any royalty or other sum paid in respect of the user of a patent.
Under "Miscellaneous Rules applicable to Schedule D" it is provided:
1. Tax under this Schedule shall be charged on and paid by the persons or bodies of persons receiving or entitled to the income in respect of which tax under this Schedule is hereinbefore directed to be charged.
Under "General Rules Applicable to Schedules A, B, C, D and E" the Act provides as follows:
1. Every body of persons shall be chargeable to tax in like manner as any person is chargeable under the provisions of this Act.
* * *
19. - (1) *371 Where any yearly interest of money, annuity, or any other annual payment (whether payable within or out of the United Kingdom, either as a charge on any property of the person paying the same by virtue of any deed or will or otherwise, or as a reservation thereout, or as a personal debt or obligation by virtue of any contract, *923 or whether payable half-yearly or at any shorter or more distant periods), is payable wholly out of profits or gains brought into charge to tax, no assessment shall be made upon the person entitled to such interest, annuity, or annual payment, but the whole of those profits or gains shall be assessed and charged with tax on the person liable to the interest, annuity, or annual payment, without distinguishing the same, and the person liable to make such payment, whether out of the profits or gains charged with tax or out of any annual payment liable to deduction, or from which a deduction has been made, shall be entitled, on making such payment, to deduct and retain thereout a sum representing the amount of the tax thereon at the rate or rates of tax in force during the period through which the said payment was accruing due.
The person to whom such payment is made shall allow such deduction upon the receipt of the residue of the same and the person making such deduction shall be acquitted and discharged of so much money as is represented by the deduction, as if that sum had been actually paid.
(2) Where any royalty, or other sum, is paid in respect of the user of a patent, wholly*924 out of profits or gains brought into charge to tax, the person paying the royalty or sum shall be entitled, on making the payment, to deduct and retain thereout a sum representing the amount of the tax thereon at the rate or rates of tax in force during the period through which the royalty or sum was accruing due.
20. The profits or gains to be charged on any body of persons shall be computed in accordance with the provisions of this Act on the full amount of the same before any dividend thereof is made in respect of any share, right or title thereto, and the body of persons paying such dividend shall be entitled to deduct the tax appropriate thereto.
*21. - (1) Upon payment of any interest of money, annuity, or other annual payment charged with tax under Schedule D, or of any royalty or other sum paid in respect of the user of a patent, not payable, or not wholly payable, out of profits or gains brought into charge, the person by or through whom any such payment is made shall deduct thereout a sum representing the amount of the tax thereon at the rate of tax in force at the time of payment.
(2) Where any such payment as aforesaid is made by or through any person, that person*925 shall forthwith deliver to the Commissioners of Inland Revenue, for the use of the Special Commissioners, an account of the payment or of so much thereof as is not made out of profits or gains brought into charge, and of the tax deducted out of the payment or out of that part thereof, and the Special Commissioners shall assess and charge the payment of which an account is so delivered on that person.
[*As amended by section 26 of the British Finance Act of 1927.]
(2A) The Special Commissioners may, where any person has made default in delivering an account required by this Rule, or where they are not satisfied with the account so delivered, make an assessment according to the best of their judgment, and if any person neglects or refuses to deliver an account so required, he shall forfeit the sum of one hundred pounds over and above the tax chargeable.
(2B) All the provisions of the Income Tax Acts relating:
(a) to persons who are to be chargeable with income tax and to income tax assessments;
*372 (b) to appeals against such assessments;
(c) to the collection and recovery of income tax;
(d) to cases to be stated for the opinion of the High Court, shall, so*926 far as they are applicable, apply to the charge, assessment, collection and recovery of income tax under this Rule * * *.
Section 237 of the British Act defines "body of persons" to mean "any body politic, corporate, * * * and any company * * * whether corporate or not corporate."
23. (1) A person who refuses to allow a deduction of tax authorized by this Act to be made out of any payment, shall forfeit the sum of fifty pounds.
(2) Every agreement for payment of interest, rent, or other annual payment in full without allowing any such deduction shall be void.
* * *
*25. (1) Where the usual place of abode of the owner of a copyright is not within the United Kingdom, Rule 21 of the General Rules shall apply to any payment of or on account of any royalties or sums paid periodically for or in respect of that copyright as it applies to annual payments not payable out of profits or gains brought into charge.
[*As amended by Finance Act 1927.]
* * *
*39. (1) Such of the provisions of the Income Tax Acts as provided that income tax may be deducted from any payment at the rate or rates of tax in force during the period through which the payment was accruing due, or that*927 there may be deducted from any dividend the tax appropriate thereto, or that a proportionate deduction of the tax charged shall be allowed by any person out of any produce or value payable to him, shall have effect as if they provided that tax may be deducted or shall be allowed at the standard rate for the year in which the amount payable becomes due:
* * *
(3) Where a person is required to be assessed and charged with income tax in respect of any property, profits or gains out of which he makes any payment in respect of any annual interest, annuity or other annual sum, or any royalty or other sum in respect of the user of a patent, he shall, in respect of so much of the property, profits or gains as is equal to the said payment and may be deducted in computing his total income, be charged at the standard rate only.
[*As amended by Finance Act 1927.]
*18. (1) Where any payment to which section twenty-five of the Finance Act, 1927, applies (which section provides for the taxation of copyright royalties by deduction in cases where the usual place of abode of the owner of the copyright is not within the United Kingdom) is made through an agent resident in the United Kingdom, *928 and that agent is entitled as against the owner of the copyright to deduct any sum by way of commission in respect of services rendered, the amount of the payment shall for the purpose of Rule 21 of the general rules be taken to be the amount thereof as diminished by the sum which the agent is so entitled to deduct.
Provided that, where the person by or through whom any such payment is made does not know that any such commission is payable or does not know the amount thereof, any tax deducted by or assessed and charged on him shall be computed in the first instance on, and the account to be delivered of the payment shall be an account of, the total amount of the payment without regard being had to any diminution thereof, and in that case, on proof of the facts to the satisfaction of the special commissioners, there shall be made to the agent on *373 behalf of the owner of the copyright such payment of tax as is proper in respect of the sum deducted by way of commission.
[*As amended by Finance Act 1930.]
Income Tax 1918, Fifth Schedule, XVII provides:
Declarations and Statements of Total Income.
First. Declaration of the amount of value of property or profits*929 or gains returned, or for which the claimant has been, or is liable to be, assessed.
* * *
Third. Declaration of the amount of interest, annuities, or other annual payments to be made out of the property or profits or gains assessed on the claimant, distinguishing each source.
* * *
Fifth. Statement of any tax which the claimant may be entitled to deduct, retain or charge against any other person.
OPINION.
OPPER: Respondent has found that petitioner's accumulation of earnings in the taxable years was in violation of Revenue Act of 1934, section 102. The burden is upon petitioner to disprove facts leading to such a determination. ; certiorari denied, . See ; . Cf. .
In applying section 102 the triers of the issue are given the benefit of two statutory rules of prima facie evidence as aids in determining the existence of the forbidden*930 purpose. One applies against a mere holding or investment company, but petitioner's position as an operating company, as respondent concedes, is so clear that no question need trouble us on that score. The other operates if the taxpayer's gains and profits are permitted to accumulate beyond the reasonable needs of the business.
Since one party to this proceeding asserts and the other denies that such was the case, it is not unnatural that much of the evidence and a great part of the argument should be directed toward aspects of this question. In order to sustain its burden of showing that the accumulations did not exceed business needs, petitioner relies upon the facts that stock sold to the public yielded a price greatly in excess of the book value of the corporation's assets, which it accordingly attempted to build up; and that its principal product, a windshield wiper, was protected by a basic patent which would expire in 1942.
Petitioner's case, however, is founded upon the assertion that neither of these represented an exclusive nor indeed primary purpose for retaining accumulations which grew from about $500,000 in the *374 year of petitioner's recapitalization*931 to something over $8,000,000 in the nine years that ended with the last tax year before us. It is in that posture of the record that we must analyze the problem inherent in the application of the provisions of section 102.
The primary issue in these cases is purpose. . The prima facie case which the statute creates in respondent's favor where earnings are accumulated beyond the reasonable needs of the business is accordingly to be read as it affects that underlying issue. The prima facie case is an affirmative one created in respondent's favor. The statute does not provide that if accumulations are within the reasonable needs of the business we must find an absence of purpose. Nor is it to be read in such a manner as to insulate ultimate from contributory evidence. So that if the reasonable needs of the business are to be relied upon as a means of convincing us of the complete innocence of petitioner's purpose, this must at least require a demonstration that there was a purpose to provide for those business needs so satisfying and persuasive that it is unnecessary to look further for a motive for the action under criticism. *932 And to this it must be added that a demonstrated purpose may be "not inconsistent with another purpose to reduce income taxes by having a corporation accumulate its gains and profits rather than distribute them." . And "It is to this complete lack of the condemned purpose that its evidence must be directed and if it does not fairly prove an absence of such purpose it must fail regardless of what other purposes it may prove." ; affd., ; certiorari denied, .
That being the case, the incidental purposes which petitioner advances as justifying the accumulations are all of but secondary importance. Even if they satisfied us that the accumulations were caused in part by the plan or purpose to provide for reasonable business needs, there would remain to be examined what is expressly advanced as the principal purpose. The incidental ones would still appear as excuses, or afterthoughts, rather than evidence of an absence of the purpose described by the statute.
But in fact the record fails to convince us as to a business*933 purpose in either of these instances. The evidence purporting to sustain an intention to increase petitioner's assets so that the book value of the stock would equal the figure at which it was sold to the public is less than persuasive. One of the bankers testified that the details of the capitalization effected when the stock was sold to the public were devised in order "to make the management work, and make these patents valuable, develop the business, build up earning power." Recognizing that there was nothing inherent in this part of the plan *375 to prevent a speedy dissolution of the corporation even before the earning power of the business had been built up, a provision was ultimately inserted forbidding change in capital structure or voluntary dissolution until a restriction upon dividends, which will be more specifically dealt with later, had been released as to all shares. There was no reference to the creation of asset value in that provision. And, of course, if the corporation continued in operation for a sufficient time during which its earnings were satisfactory, which was inevitable under the provision forbidding dissolution, and if the earnings distributable*934 to the public were declared as dividends, the minority stockholders could have built up their own reserve against the possibility of ultimate dissolution. In fact, there was no thought of dissolving the corporation even when, in 1942, the basic patent was due to expire; and petitioner's president expressed the belief that the preeminent position of petitioner would continue after that time. Not only was there no enforceable contract to devote the corporation's earnings to the creation of asset value, but if there were even a nebulous plan of that kind it was not so inflexible but that as soon as there came to be a pecuniary advantage in the distribution of larger dividends as the result of the undistributed surplus tax in 1936 and 1937, the corporation had no difficulty in departing from the program and practically doubling its dividend declarations.
The requirements of the business said to result from petitioner's patent situation are equally unsatisfying. It is urged that upon the termination of the basic patent, petitioner's business would be adversely affected unless it were prepared to maintain its position either in a competitive market or by means of new products or in*935 some other way. But we can not believe that there is no limit to the sum, no matter how great, which would be a proper accumulation under those circumstances and for those purposes. It may be that the amount of accumulations appropriate to the situation would be a matter of opinion. But the question is the reasonable needs of petitioner's business; and the determination of what is reasonable under a given set of circumstances is typically a judicial question. See ;; . "What would be reasonable in one situation or for one business might be clearly unreasonable in another." . We can not satisfy ourselves that our function would be performed merely by accepting the decision of petitioner's interested officers in the place of our independent judgment as to what was reasonably necessary to protect petitioner's future position. See *936
*376 We know that at the beginning of 1934, the first taxable year before us, petitioner's capital and surplus was nearly $7,000,000; that at the end of 1935 it was over $10,000,000; that the general trend of its earnings had been upward since its organization; that its business was stable and assured; and that on the basis of past experience petitioner could look forward to surplus earnings running into the millions annually. The initial cost to petitioner of all its patents was trifling; and while the basic patent would expire in 1942, petitioner had constantly improved and protected the development of its product by improvement patents. We are given no basis in the facts for a determination as to what the expense to petitioner would be of meeting competition or supplying itself with a new product, except in one respect. And that raises an inference unfavorable to petitioner's contention, for it was testified that at the time of the hearing there had been developed a device for raising automobile windows, and it is suggested that this will be available to take the place of the windshield cleaner. But the cost of preparing for the*937 manufacture of that article was said to be form three to five million dollars, which could be deferred over a period of time. Even without considering that petitioner's surplus prior to the instant years would have more than covered it, this amount would not constitute an undue burden on petitioner's current excess earnings. And, of course, there would still remain the petitioner's existing plant, either for conversion to the new use or for continued operation on the old product. We could not find from these facts that there were no accumulations beyond the reasonable needs of petitioner's business. 3
It is also urged, somewhat casually, that later events have demonstrated the necessity of these accumulations. The difficulty with the suggestion is that admittedly there was no such thought in the minds of petitioner's responsible officers during the years in issue. It is contended that whereas at the end of 1935 petitioner's total capital and surplus, including all accumulations of undistributed earnings in whatever form, were*938 approximately $10,500,000, by 1939 operating capital alone was in the neighborhood of $10,800,000. Respondent by no means concedes the accuracy of these figures. He contests the propriety of including depreciation reserves in operating capital and objects to the inclusion of current assets without the deduction of current liabilities. But we have included in our findings of fact figures substantially in accord with those proposed by petitioner, since we are not satisfied that its position is wholly untenable.
*377 The objection to it, as we have said, is that if this was a result, it was not a purpose. The record abounds in references to the belief on the part of petitioner's officials that its operating income and manufacturing business was static and would not increase. Petitioner's president, in answer to a request on cross-examination for his opinion as to the necessity of the accumulation of earnings in 1934 and 1935 in the operation of the business, as then being conducted, testified:
If you bring that word "business" down merely, down to the operation of a manufacturing plant, there might be some question as to what more money was needed, but we considered the*939 business, the enterprise, an enterprise involving the interests of stockholders who had a contract to release stock * * *.
The testimony thus supports the view that the natural growth of the business bore no relation to the corporate purpose, was not a ground for the accumulations, and was not foreseen at the time by those responsible for them. The connection between accumulations and reasonable business needs, particularly if prospective rather than immediate, would have no helpful bearing on the resolution of an inquiry as to the application of section 102 unless it were intended that retained earnings limited to the requirements of the business should be so designed and thus throw light upon the purpose of the accumulation, which must always be the main object of our investigation. 4 Since it is clear from the record that the prospective needs of the business in its ordinary and anticipated expansion contributed in no degree toward the determination to accumulate earnings, we can not place upon the growth and extension of the business the importance required for the conclusion that by that showing petitioner has demonstrated the absence of a purpose to accumulate earnings for*940 reasons dictated by the tax situation of its stockholders.
This brings us to a consideration of what was, on the theory of the taxpayer, the real purpose motivating the accumulation of its earnings. That was an outgrowth of the recapitalization in the course of which the public distribution of petitioner's stock took place. In order, apparently, to make more attractive the stock available to the public, the bankers insisted that a dividend restriction be imposed upon most of the stock retained by the original group of controlling stockholders. The restriction took the form of an agreement with *378 the petitioner, the terms of which were endorsed upon the certificates representing the*941 restricted stock, providing that no dividends would be paid thereon until $2.50 per share had been paid annually upon the unrestricted stock; that after such payment earnings distributed would be shared equally by restricted and unrestricted stock; and that the restricted shares might be released from the agreement from time to time in accordance with a formula which required an increasing amount of annual earnings per share to the point where the last share to be released would require that the corporation have annual earnings of $9 per share for all of its stock or a total of approximately $6,000,000.
Petitioner urges as its principal contention that it was a reasonable need of the business to build up an invested capital which, by increasing total earnings, would enable the controlling stockholders to release a larger amount of stock from the restriction originally placed upon it. This may have been a natural course for the majority of the stockholders to cause the corporation to adopt for their own private ends, but it had nothing to do with the needs of the business, and in fact to the extent that it benefited the controlling stockholders there was a corresponding detriment*942 to the remainder. 5 Congress can not have intended that the term "reasonable needs of the business" should be satisfied by the financial interests of a limited stockholding group. For, of course, the interests of these stockholders as individuals were also served by the company's policy of withholding dividends in so far as their income taxes were correspondingly reduced. But that can not be a reasonable need of the business, for it is that result which the statute is designed to attack.
Although it was repeatedly asserted that the benefit to the stockholders, from the standpoint of saving taxes, was never discussed or referred to as an element either in the original plan of recapitalization or in the policy adopted by the company of limiting*943 its dividends to the minimum preferred amount, the pecuniary weight of the tax-saving was so overwhelmingly greater than the benefit derived by the majority stockholders from the release of shares that it is difficult to believe that it was only the latter and never the former to which they allowed their purposes to stray. See .
For example, according to figures in petitioner's brief, the total shares which were released as a result of interest and dividends paid *379 on accumulated and invested funds to the end of 1935 were 6 approximately 20,000. All the other shares released had been the result of earnings derived from operations, of which of course, the stockholders would have had the benefit without the accumulation of prior earnings from the investment of which the interest and dividends were derived. They received during the taxable years 1934 and 1935 on these 20,000 shares dividends of $2.50 a year or a total of $100,000 for the two years. In those same two years they saved in surtaxes not less than $840,000. Or, again employing petitioner's figures, the total dividends received on all shares released*944 through income derived from invested accumulation of prior earnings for all the years from 1927 through 1935 is only $336,205, less than half the tax saving for the two years here in issue. We are not advised what surtaxes were saved for the years prior to 1934 or for those subsequent to 1935. Finally, if we take all the dividends received by the controlling stockholders on shares released by income resulting from investment of accumulated earnings for the full history given by the record, 1927 through 1939, the figure is only $720,000, which is still less than the tax saving for only two years. It may be that "In the absence of the condemned purpose, the effect alone is no foundation for the tax." But "This is not to say that the effect is of no significance, for it may, and perhaps often does, indicate the probability of a purpose to induce it. In ordinary life it is not unreasonable to infer that the effect of a voluntary act is among the purposes of the actor. * * * And in determining the purpose, the actor's categorical statement may be of less weight than the facts and circumstances which affect it." *945 "Admittedly, circumstances may evidence a purpose, and circumstances such as we find here, without a further showing, justify the finding of the prohibited purpose at which these provisions are aimed." .
If the unrestricted stock had been represented by preferred shares with the provision that the common shares corresponding to the restricted stock would share in earnings only after preferred dividends, the situation would not be dissimilar to the present arrangement. But it could hardly be contended that a reasonable need of the business, as opposed to the interests of the controlling stockholders, would require the accumulation of funds for the retirement of the preferred shares and the consequent vesting in the common stockholders of the right to monopolize total corporate earnings. ; *946 ; reversed other grounds (C.C.A., 3d Cir.), .
*380 But forsaking narrow procedural matters such as presumptions and burden of proof, we can not read the record as a whole without being satisfied that a preponderance of the evidence affirmatively establishes that petitioner was "availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation through the medium of permitting gains and profits to accumulate instead of being divided or distributed."
Some of the factors leading to this conclusion appear in the foregoing discussion. The preponderant fiscal advantage to the individual stockholders comprising the controlling group, all having large incomes protruding heavily into the surtax brackets, would be reason enough for the corporate act of curtailing distribution. There is an absence of conviction in any other explanation offered. The insiders were in undisputed control and the corporation could readily be made the instrument of their individual intention and molded to the effectuation of their private advantage as, in fact, *947 it concededly was. The avowed primary purpose of the dividend policy pursued was admittedly one involving comparable, though less important, discriminatory benefits. The stockholders and the corporate officers are shown to have been aware of the tax situation confronting themselves. They apparently had no financial need for the dividends. It seems to us that a naive and credulous tribunal would be required for the assumption that in the confirmed practice of methodical accumulation there was no taint of a purpose to procure so desirable a monetary result for the individuals responsible for the petitioner's decisions.
The business of the corporation was as free from hazard, as firmly established, and as favorable in prospect as could well be imagined. Production costs were constant, sales certain, collection losses negligible. If at the beginning of the tax years in issue petitioner's officers had looked back over its history since the recapitalization in 1927, they would have seen a constantly mounting record of earnings, with the exception of the three depression years 1930 through 1932; and that even in those years the requirement for the $2.50 dividend was approximately*948 doubled, except in the single low depression year of 1932, when it was safely met. If, at the beginning of the years in issue the corporation had had no surplus, the record fails to show a probable future need to justify accumulations of approximately one and three-fourths millions of dollars (petitioner's entire stated capital) in one year and two and one-half millions in the next. But in fact there were accumulations of over five and over seven millions at the beginnings of the respective years. And, as bearing upon purpose, we may look to the history following this period which discloses *381 ultimate accumulations of seventeen millions of dollars in an interval of a dozen years; or, in matter of ratio, approximately ten times the stated capital with which the corporation began operations so short a time before.
Even if the $2.50 dividend had been cumulative, as petitioner urges, there was thus an overabundant assurance that it would not default. But in fact the documents show that it was not cumulative, and we have so found. And even if the restricted stock were deprived of all share in the earnings, the record shows the normal operation of the business was sufficient*949 to release shares which had in a few years placed the dominant stockholders where they could garner the larger proportion of corporate earnings. But in fact there was no prohibition upon an equal division of earnings between restricted and unrestricted stock after the payment of a dividend in the preferential amount; and on the record if surplus earnings had been so distributed in accordance with a recognized and confirmed corporate policy, instead of the reverse, the income on the restricted shares would have been so considerable and their future prospects so satisfactory that we can not concede the absence of marketability and market value upon which petitioner insists. In fact in 1936 and 1937, when it became advantageous to do so, dividends on the restricted stock were paid "because of the Undistributed Profits Tax Law." That the payments in these years were not larger may well be due, as respondent suggests, to the mathematical result that at some point increased individual surtaxes on the controlling stockholders would exceed the undistributed profits tax levied against the corporation for failing to distribute current income.
We have already seen to what extent the pecuniary*950 benefit to the controlling stockholders from tax savings exceeded that secured from the release of stock. By a similar comparison we know that as of, say, the beginning of 1934, the earnings from operations furnished a much more probable source for the release of future stock than would any such inconsequential addition to income as could be expected in the not too remote future from earnings on invested accumulations. This result is due in part to the form of petitioner's investments which were largely in the highest grade securities with the lowest yield.
In sum, petitioner advances, as its controlling reason for these excessive accumulations, the personal advantage to its principal officers to be attained by securing earning power for the restricted stock; and complains of a lack of value in those shares until that could be done. But it was from operations that the great bulk of the earnings was to be expected; the remedy for the restriction on dividends lay in large part in the hands of these very individuals, who could cause *382 their shares to participate in earnings by the simple process of a more complete distribution; and all the facts involved in the history*951 and background of petitioner and its moving spirits are consistent with no explanation for these distributions so much as with a desire to secure the greatest possible personal benefit to the individuals in control, as end which could not have overlooked the tax aspect. In greater detail, the situation is reflected in our findings. Alone or in combination, these preponderate in favor of respondent's position. All explanations failing, we can not ignore the inferences from these affirmative facts. We regard them as sufficient justification for respondent's determination and for our ultimate finding that petitioner was availed of for the inhibited purpose.
Finally, petitioner urges as a matter of law that the section is to be construed so as to require that the purpose to avoid surtax extend to all the stockholders, a situation not shown to exist here. Without stopping to suggest that petitioner in this way seeks to avail itself of a failure of proof on an issue requiring it to sustain the burden of the affirmative, we reject the contention on its merits. The words of the statute furnish no support for it, and the purpose to be served affirmatively repudiates it. If it were*952 necessary for all the stockholders to escape surtax, the condemned intent and the detriment to the revenue could remain and still the stipulated penalty fail of application. A construction calling for an enforcement so capriciously dependent on fortuitous and irrelevant circumstance is certainly to be avoided. Even more detrimental to the evident statutory goal is the open and facile method of avoidance afforded, if the provision meant that a corporation could secure one impoverished stockholder not subject to the surtax rates and thus laugh in the face of any practical effort to prevent surtax avoidance through corporate accumulations. We are satisfied that the section can not carry the suggested meaning.
The second issue involves petitioner's claim under Revenue Act of 1934, section 131, 7 to a credit against its taxes for amounts said to have been paid as income tax to the British Crown. The dispute is whether the amounts admittedly paid were income taxes of petitioner so as to afford it the benefits conferred by the section relied upon. Respondent contends that petitioner is not entitled to have the amount of the taxes deducted from its income tax to the United *383 *953 States, but should have treated the British payments as though forming no part of its compensation, which of course would reach the same result as though the payments of British taxes were regarded as income to petitioner and then as deductions from gross income in computing net income and the United States tax thereon.
We can not distinguish this proceeding from . Although that case involved dividends paid to the taxpayers from British sources, and this concerns patent royalties, 8 the taxing device established by the British legislation appears to be essentially the same. And the*954 question under section 131 is whether petitioner paid "the tax within the meaning of our own statute. That must ultimately be determined by ascertaining from an examination of the manner in which the British tax is laid and collected what the stockholder (here the patent licensor) has done in conformity with British law and whether it is the substantial equivalent of payment of the tax as those terms are used in our own statute."
On the question of fact presented in determining the British law, we have before us only "The Income Tax Act, 1928" and statutory amendments thereto. We must accordingly consider that recourse to British case law and interpretation would be beyond the scope of this record; though that is not to say, of course, that any further light would be shed on the subject if such authorities were available to us.
Confining ourselves then to the statutory scheme, we find that income tax payments were required from petitioner's licensees to the British taxing authorities to be*955 computed upon the "full amount" of their "profits and gains", and that they are specifically forbidden to deduct therefrom in computing their own income tax the amount of "any royalty or other sum paid in respect of the user of a patent." General Rule 19. This is essentially identical with the situation applicable to a corporation which is to pay the tax on the "'full amount' of the profit 'before any dividend thereof is made in respect of any share * * *.'" , footnote 3.
In the case of patent royalties the licensee is authorized to deduct the tax payment from the amount of royalties remitted to the licensor and the latter is commanded to receive the diminished amount in full satisfaction of his claim. This, however, is no different from the situation applicable to a corporation which upon "paying such dividend shall be entitled to deduct the tax appropriate thereto." Op. Cit.
In the case of individual stockholders such as those involved in the Biddle case there is a further requirement that the stockholder *384 include as part of his surtax income the tax paid by the corporation as so required; and in the Biddle*956 case the taxpayers had in fact included that tax in the income shown by their returns to the British Government, had paid the surtax thereon, and had treated the payments in the same way in making their United States income tax returns. That element, together with the privilege given the British taxpayer to claim a refund of the proportionate share of the tax paid by the corporation under appropriate circumstances, were the principal contentions relied upon by the taxpayers in the Biddle case; and the Court there acknowledged that "for these limited purposes which do not affect the assessment and payment of the tax it is true that the British acts treat the stockholder as though he were the taxpayer."
Notwithstanding these circumstances and a series of administrative interpretations favorable to the taxpayers, the Court concluded "that the taxpayer has not paid or become subject to the foreign tax here in question."
Since petitioner is a corporation and not subject to the British surtax and since we are not advised that this petitioner might have successfully appealed from the tax paid by its licensees or whether or to what extent it would be liable for the tax upon default*957 of the British taxpayer primarily responsible for its payment, cf. , we can not find in petitioner's situation even those considerations apparently thought to be favorable to the taxpayers in the Biddle case. If any of these elements are a part of the British law, no deficiency in the presentation of evidence thereof can operate in petitioner's favor. What we have before us is even less an indication that this tax was either assessed upon or paid by petitioner than was the case in
In , upon which petitioner primarily relies, the payments of British tax were with respect to "royalties or sums paid periodically for or in respect of * * * a copyright * * *", concerning which an altogether different series of provisions "for the taxation of copyright royalties by deduction in cases where the usual place of abode of the owner of the copyright is not within the United Kingdom" appears in the British statutes. General Rules 18 and 25. The tax is not paid as a part of the income tax of the British obligor, who owes the royalty, *958 but that person is required to "deduct thereout a sum representing the amount of the tax thereon at the rate of tax in force at the time of payment." And "that person shall forthwith deliver to the Commissioners of Inland Revenue, * * * an account of the payment * * *." This is the same procedure as that required where a British obligor remits payments out of sources other than or in excess of his own taxable income (General Rule 21), a circumstance *385 which, of course, makes it impossible to collect the tax by the expedient of levying it upon him and prohibiting the deduction from his income of the payment due his obligee. This difference in British statutory treatment prevents , from serving as a precedent for the disposition here.
We find no evidence that Parliament has chosen to make this petitioner liable for the British tax except at most through the indirect economic results of its payment which , found insufficient. Since the principle for which that case stands, as we view it, is that section 131 does not treat "as taxpayers those upon whom no legal duty to pay*959 the tax is laid", respondent's position on this issue is sustained; and we find it unnecessary to consider his further argument that the form of the contracts in any event placed the burden of the tax upon the English licensee and relieved petitioner of it.
Reviewed by the Board.
Decision will be entered under Rule 50.
Footnotes
1. These amounts do not all appear in surplus for the various years since in 1934 and subsequent years various amounts were transferred from surplus to capital account. ↩
2. This does not give effect to a deduction from surplus made on the books for 1937 and years subsequent, to set up a reserve of $600,000 against decrease in security market prices. ↩
a. Petitioner held in treasury free shares costing it $476,224.29. ↩
b. Petitioner held in treasury free shares costing it $824,879.49. ↩
*. On December 31, 1937, a reserve of $600,000 was set up for current valuation of stocks owned by petitioner. Figures above reflect stock at cost. ↩
c. Petitioner held in treasury free shares costing it $1,683,482.77. ↩
d. Petitioner held in treasury free shares costing it $1,853,363.75. ↩
e. Petitioner held in treasury free shares costing it $1,868,568.75. ↩
*. Based on declared dividends. Actual payments in 1936, to obtain credit for the last quarterly dividend usually paid January 2 of following year, included an additional 62 1/2 cents a share. ↩
1. In the case of Property, its situation, including Street Address (if any), Parish, County, and names of Occupiers must be distinctly stated.
This form should be signed by the person deducting the Tax and responsible to account for such Tax to the Revenue. The signature of the Claimant's solicitor or other agent is not sufficient. ↩
*. N.B. - This form is not applicable and should not be used where Income Tax has not in fact been deducted from the gross amount payable (e.g., because the payer has undertaken not to deduct tax). ↩
*. Petitioner's Exhibit #17 carries these as 1936 payments, but we have found facts as requested by respondent since they are to that extent more favorable to petitioner. ↩
3. This substitute product was not in existence in the instant tax years, so that it really formed no premise for any accumulations at that time. ↩
4. * * * It requires no argument to support the premise that the cited sections do not contemplate that a business should remain static; it must be assumed that any business shall have the right to grow. Necessarily incident to the exercise of this right are the making and pursuit of plans both as to organization and as to finances which will permit the accomplishment of the contemplated development. [.] ↩
5. Petitioner's brief concedes that "Distributions in excess of $2.50 a share * * * would be to the disadvantage of the original stockholders because the other stockholders would receive a preponderant part of the total dividend distribution in such case." And, "That the carrying out of those purposes and intentions [to release the restricted stock] is of benefit of 75 percent of the stockholders, including the principal stockholders." ↩
6. Respondent computes the shares so released at a very much smaller figure, less than 1 percent of the total. ↩
7. SEC. 131. TAXES OF FOREIGN COUNTRIES AND POSSESSIONS OF UNITED STATES.
(a) ALLOWANCE OF CREDIT. - If the taxpayer signifies in his return his desire to have the benefits of this section, the tax imposed by this title shall be credited with:
(1) CITIZEN AND DOMESTIC CORPORATION. - In the case of a citizen of the United States and of a domestic corporation, the amount of any income, war-profits, and excess-profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States; * * * ↩
8. A small portion of the payments was for interest, but the parties do not contend that these should be disposed of differently. ↩