*1506 Prior to July 2, 1936, petitioner executed a trust agreement and delivered printed bonds to a trustee to hold for exchange for outstanding preferred stock which was convertible into bonds. Prior to July 2, 1936, no bonds were issued by the trustee in exchange for preferred stock. Under the trust agreement petitioner was required to pay to the trustee $5,000 a year for a sinking fund for the bonds. The covenant in the trust agreement did not require that sinking fund payments should be made from earnings and profits. As of December 31, 1936, and December 31, 1937, petitioner paid to the trustee for the sinking fund $20,000 and $10,000, respectively. Held, that petitioner is not entitled, under section 26(c)(2) of the Revenue Act of 1936, to credits in those years for the amounts paid into the sinking fund, for purposes of computing the surtax on undistributed profits.
*427 The Commissioner determined deficiencies in income tax liability for the years 1936 and 1937 in the respective amounts of $54.54 and $2,417.52. He determined, also, *1507 an overassessment in excess profits tax for 1937 of $65.04. Petitioner denies the deficiencies and claims that taxes for 1936 and 1937 have been overpaid in the amounts of $547.53 and $282.48.
The only question is whether or not petitioner is entitled to credits of $20,000 and $10,000 in 1936 and 1937, under section 26(c)(2) of the Revenue Act of 1936, for amounts allegedly set aside for sinking fund requirements under a trust indenture securing bonds.
FINDINGS OF FACT.
Petitioner, a Kentucky corporation, owns and operates the Lafayette Hotel in Lexington. It keeps its books on the accrual basis. It filed its returns with the collector for Kentucky. It was organized in 1919. Its authorized capital stock included $300,000 first preferred 6 percent cumulative class A stock having a par value of $100 a share. There were 3,000 shares outstanding. This stock was, by its terms, convertible into first mortgage 6 percent bonds on the basis of 10 shares for 1 bond of a par value of $1,000.
On April 20, 1920, petitioner entered into a mortgage deed of trust with the Security Trust Co. of Lexington, trustee, to secure and to provide for the issuance of the first mortgage bonds. *1508 Petitioner agreed to deliver bonds to the trustee to be held and to be issued only in exchange for the class A stock. Under the trust agreement petitioner agreed to make sinking fund payments of $5,000 a year to the trustee, beginning July 1, 1925. Under the terms of the trust agreement petitioner was not required to apply in payment of sinking fund installments or set aside for sinking fund installments earnings or profits of the year or of any year.
Prior to July 2, 1936, no class A stock was exchanged for first mortgage bonds. During 1936, on and after July 2, 1936, 2,360 shares of stock were exchanged for 236 bonds, par value $236,000. During 1937, 40 shares of stock were exchanged for 4 bonds, par value $4,000.
As of July 1, 1936, sinking fund payments were due and unpaid in the amount of $25,000, petitioner having defaulted in sinking fund payments from 1932 on, and the trustee made demand for payment of *428 as much as could be paid into the sinking fund. Although petitioner had defaulted in making sinking fund payments, no court proceedings had been instituted to enforce any lien created by the mortgage given to secure bonds held by the trustee, or to seek*1509 appointment of a receiver, so that accruing rents and profits had not become the subject of any lien under the terms of the trust agreement. In 1936 petitioner paid $20,000 to the Security Trust Co., trustee, on account for sinking fund payments due, and $10,000 in 1937. As of December 31, 1936, and December 31, 1937, on petitioner's books, profit and loss was debited $20,000 and $10,000, and credits in the same amounts were made to an account entitled "Earnings Appropriated to Comply with Contract for Bond Retirement."
In addition to the class A preferred stock, petitioner had other stocks outstanding on which petitioner paid dividends at various periods.
From 1928 to 1937, inclusive, petitioner's net profit or loss and dividends paid were as follows:
| Year | Net profit or loss | Dividends paid |
| 1928 | 1 $5,422.50 | $62,166 |
| 1929 | 72,179.99 | 76,344 |
| 1930 | 62,186.81 | 76,344 |
| 1931 | 56,694.05 | 62,166 |
| 1932 | 3,811.26 | 38,938 |
| 1933 | 1 $4,850.10 | $44,702 |
| 1934 | 38,851.29 | 14,656 |
| 1935 | 60,847.40 | 37,187 |
| 1936 | 33,737.84 | 22,927 |
| 1937 | 66,954.93 | 7,290 |
According to petitioner's books its capital account showed annual deficits from 1928 to and including*1510 1933. At the end of 1928 the capital deficit was $67,588.50. It increased each year to $197,503.62, as of the end of 1933. From 1934 through 1937 the capital deficit decreased each year, as follows: 1934, $173,308.33; 1935, $155,945.06; 1936, $155,020.68; 1937, $108,916.29.
In 1934 petitioner credited to capital surplus, net earnings in the amount of $38,851.29, and debited the same account with $14,746.75 for dividends paid and other expenditures, leaving a net credit to surplus of $24,104.54 from earnings for 1934. In 1935 net earnings credited to capital surplus were $60,847.40 and debits for dividends paid and other expenditures totaled $44,052.15, leaving a net credit to surplus of $16,795.25 from earnings for 1935. In 1936 net earnings credited to capital surplus were $33,737.84 and debits for dividends paid and other expenditures were $32,813.46, leaving $924.38 from earnings as a net credit to surplus. In 1937 net earnings credited to capital surplus were $66,954.93 and debits for dividends paid totaled $20,850.54, leaving net credits to surplus from earnings for 1937 in the amount of $46,104.39.
*429 At the end of the years 1935, 1936, and 1937 petitioner*1511 had cash on hand in banks in the amounts of $27,938.84, $5,774.88, and $10,127.37, respectively.
OPINION.
HARRON: Petitioner claims credits under the terms of section 26(c)(2) of the Revenue Act of 1936, 1 for purposes of computing the surtax on its undistributed profits. In order to obtain such credit under the pertinent statutory provision it must be shown as fact that the corporation not only paid or irrevocably set aside part of the earnings and profits of the taxable year, but that it was Required to do so by a provision of a written contract executed before May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year, and that the payment or setting aside of earnings was in discharge of a debt. As used in section 26(c)(2), the word "debt" does not include a debt incurred after April 30, 1936.
*1512 The petitioner, in 1920, executed a mortgage trust agreement to until such time as holders of petitioner's first preferred convertible until such time as holders of petitioner's first preferred convertible stock exercised an option to convert that stock into bonds, the trustee secure an issue of bonds which were delivered to the trustee to hold from April 20, 1920. Without reference to whether or not in any given year any of the bonds had been issued by the trustee in exchange for stock, the trust agreement provided that petitioner should make sinking fund payments of $5,000 a year, commencing with July 1, 1925. From 1932 on, petitioner did not make the sinking fund payments, so that on July 1, 1936, $25,000 was due the trustee. On July 1, 1936, no bonds had been issued in exchange for stock. Petitioner was not required to make the sinking fund payments from its earnings and profits each year. In fact, in 1932, 1934, and 1935 petitioner's business yielded substantial net earnings and profits, but petitioner did not pay or set aside any portion thereof for the sinking fund.
Petitioner contends that in 1936 and 1937 it was in substance and by contract required to use part of*1513 its net earnings for sinking fund payments which were due, and that its financial condition was such *430 that it did pay out of net earnings in 1936 and 1937, respectively, $20,000 and $10,000 to the trustee for the sinking fund. To support these contentions petitioner argues that, because its book account entitled capital surplus showed deficits at the end of 1935, 1936, and 1937 in the respective amounts of $155,945.06, $155,020.68, and $108,916.29, its financial condition was such that the amounts paid to the trustee in 1936 and 1937 must be held to have been paid from current earnings in each year. Petitioner argues further that a provision in the terms of the bonds in question, set forth in the trust agreement of 1920, must be construed as requiring, in 1936 and 1937, that the earnings in each year must be applied to the sinking fund payments said to be in default. Reference to that provision will be made hereafter. Neither contention of petitioner can be approved under the record in this case.
Petitioner reported net income for 1936 and 1937 in the respective amounts of $53,737.84 and $75,094.60, which respondent adjusted to $51,912.41 and $74,136.87, respectively. *1514 Respondent refused to allow credits for $20,000 and $10,000 under section 26(a)(2). Respondent contends that the provision in the mortgage deed of trust under which petitioner claims the credits fails to meet the requirements of section 26(c)(2) for a written contract, because it does not require a portion of earnings in the taxable years to be used for annual sinking fund payments, and because no debt was incurred prior to April 30, 1936, at which time no bonds had been exchanged for convertible stock. Respondent relies on ; affd., ; and , as authority for the proposition that an obligation to set aside funds to retire preferred stock is not an obligation to retire indebtedness, since the stockholder relation is not one of a debtor and creditor.
Admittedly petitioner was not required to set aside earnings each year for sinking fund payments, by any provision to that effect in the mortgage deed or trust. Petitioner argues, however, that defaults in the payments made all annual profits subject to the lien of the mortgage given to secure*1515 bonds, when, as, and if issued, and that the rule of , is applicable here. Paragraph 5 of the mortgage deed of trust provides that, in the event of breach of any obligations imposed by the trust on petitioner, all subsequently sequently accruing rents and profits shall pass under the lien of the mortgage, "provided any proceedings are instituted in a court of competent jurisdictiov for the enforcement of the lien created by this mortgage, or for the appointment of a receiver or for both of said purposes." The trustee at no time instituted such proceedings as are referred to above. By the end of 1936 petitioner had substantially cured defaults in sinking fund payments and, so far as the record shows, no *431 proceedings to enforce the lien of a mortgage against petitioner's earnings ever were instituted by the trustee. Since no bonds were issued by the trustee prior to July 2, 1936, there is considerable doubt whether at that date the trustee, under the mortgage deed of trust securing the bonds, had any equitable lien on the earnings from petitioner's property which was covered by the mortgage. *1516 it is concluded that paragraph 5 of the trust was not put into operation in the taxable years so as to require, as under a written contract, the application of petitioner's earnings in the taxable years in payment of the sinking fund installments. The G. B. R. Oil Corporation case is distinguishable on the facts, the circumstances which were present in that case not being present here. If we regard the mortgage deed of trust as the kind of written contract referred to in section 26(c)(2), for argument, we find no provision therein which inevitably required petitioner to set aside earnings in the taxable years in payment of a debt incurred prior to April 30, 1936. . It has been pointed out previously that the pertinent statutory provision is to be construed precisely as it is written. . Section 26(c) refers primarily to "Contracts Restricting Payment of Dividends." Petitioner during the taxable years and in prior years paid dividends each year, and, as far as the record shows, at no time regarded the terms of the mortgage deed of trust as a contract restricting*1517 payment of dividends. Petitioner's contentions call for a strained construction. See ; .
Petitioner's contentions fail for two other reasons. The record does not prove conclusively that the $20,000 paid to the trustee in 1936, and the $10,000 paid in 1937 were paid from the earnings and profits of each respective year. Also, it can not be held that the payments in the taxable years were paid in discharge of a debt incurred prior to April 30, 1936.
Petitioner's argument that its financial condition was such as to require payment of the sinking fund installments from earnings is without merit. Reliance is placed entirely upon a book deficit in the capital surplus account at the end of each taxable year and upon book entries at the end of each taxable year charging, for the sinking fund payments which were made, the profit and loss account and crediting an account entitled "Earnings Appropriated to Comply with Contract for Bond Retirement." Direct evidence on the source of the payments made in the taxable years is limited. The complete*1518 financial condition of petitioner, as would be shown by the profit and loss account and a balance sheet, is not in evidence. The capital account, standing alone in the record, is not conclusive, and it is difficult to understand. *432 The capital deficit was accumulated from 1928 to 1933, and thereafter it was gradually reduced. From 1928 through 1933 annual dividends in very large amounts were paid each year, even as the capital deficit increased. For the years 1934 and 1935 net profits exceeded paradoxically dividends and other items paid by the respective amounts of $24,104.54 and $16,795.25. In 1936 net profits exceeded dividends and other items paid by $924.38. It is possible that the total sinking fund payments of $30,000 made in 1936 and 1937 were from surplus accumulated in the capital surplus account in the years 1934 and 1935, and the record does not indicate the contrary. The evidence does not disclose that petitioner's financial situation in the taxable years and in the immediately preceding years was such as to demand a construction of the mortgage trust deed as requiring that earnings in the taxable years be paid into the sinking fund. *1519 And further, it has been pointed out in , that section 26(c)(2) allows a credit only for an amount equal to earnings and profits of the taxable year which is required to be paid within the taxable year in discharge of a debt, among other things. If petitioner's contention was sound, in general, which it is not, arguendo, the provision in the 1920 mortgage deed of trust provides for a payment of $5,000 per annum only. Under the rule of the Brockway Glass Co. case petitioner could not validly claim credits in the taxable year for amounts in excess of $5,000 in each year. And, further, petitioner must prove that the sum paid in each taxable year was in fact paid from earnings and profits of the taxable year, and, as indicated above, petitioner has failed to so prove beyond doubt.
The convertible first preferred stock was entitled to 6 percent per annum dividends, cumulative, and payable from surplus or net profits. This stock was convertible at any time into bonds, and within 25 years with respect to the bonds referred to in the 1920 mortgage deed of*1520 trust. Since no bonds were issued in exchange for stock prior to July 2, 1936, and April 30, 1936, it would appear that any sinking fund created prior to July 2, 1936, must be regarded as a fund for the retirement of outstanding preferred stock. It was possible that no exchanges of stock for bonds would ever be made, and if such proved to be true, the petitioner's agreement to create a sinking fund would represent no more than an agreement to create a fund to retire stock rather than to pay an indebtedness. There is no evidence here to show that the terms and conditions under which the first preferred cumulative convertible stock was issued were such as to make the shares of stock evidence of indebtedness rather than preferred stock, in fact. ;Here, as in the cited cases, the preferred stock did not by its terms have a definite maturity date. The 25-year conversion period *433 was first agreed to in the 1920 mortgage deed of trust and it is a limitation upon the trustee thereunder after which time the trustee may not issue the particular bonds referred to in that trust*1521 deed in exchange for stock. See also, . When preferred stockholders exercised the option to exchange stock for bonds, no doubt a debtor-creditor relationship arose, but no exchanges were made until after July 2, 1936. The Commissioner has ruled in his regulations that "An indebtedness evidenced by bonds or other similar obligations issued by a corporation is incurred as of the date such obligations are issued * * *." Art. 26-2(c), Regulations 94. This appears to be a reasonable regulation. Here, there was no bonded debt until July 2, 1936, and thereafter, and whatever part of the sinking fund payments made in 1936 and 1937 can be allocated to the retirement of bonds issued in the taxable years can not be said to represent payments in discharge of a debt incurred prior to April 30, 1936, within the terms of section 26(c)(2).
Petitioner fails on all contentions made and taken together; but petitioner fails primarily because it can not be held that under the terms of a written contract executed by it prior to May 1, 1936, expressly dealing with the disposition of earnings and profits, it was required to pay or set aside*1522 earnings in each taxable year for the discharge of a debt within the particular terms of section 26(c)(2).
Decision will be entered for the respondent.
Footnotes
1. Loss. ↩
1. SEC. 26. CREDITS OF CORPORATIONS.
* * *
(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
* * *
(2) DISPOSITION OF PROFITS OF TAXABLE YEAR. - An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. For the purposes of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word "debt" does not include a debt incurred after April 30, 1936. ↩