*1350 Prior to May 1, 1936, petitioner executed a written contract which contained a provision prohibiting it from paying dividends until a debt owed by it was paid in full. By the terms of the debt petitioner was not required to pay it in full in the taxable year, but was permitted to do so. At the very end of the taxable year petitioner was able financially to pay the debt in full; and shortly after the end of the taxable year petitioner did pay the debt in full. Petitioner's failure to pay the debt in full in the taxable year was actuated by sound business purposes. Held, that under section 26(c)(1) of the Revenue Act of 1936 petitioner is entitled to a credit in the amount of its adjusted net income for purposes of computation of the surtax on undistributed profits.
*264 Respondent determined a deficiency of $4,394.26 in income tax for the year 1937. The sole question is whether under section 26(c)(1) of the Revenue Act of 1936 petitioner is entitled to a credit in the amount of its adjusted net income for purposes*1351 of computation of the surtax on undistributed profits.
FINDINGS OF FACT.
Petitioner is an Ohio corporation and has its principal place of business at Toledo, Ohio. It filed its corporation income and excess profits tax return for the year 1937, the taxable year, with the collector of internal revenue for the tenth district of Ohio.
On November 15, 1934, petitioner was indebted in the amount of $80,000 to the Commerce Guardian Bank of Toledo, which was being liquidated by the Superintendent of Banks of Ohio. On that date petitioner executed and delivered to the Superintendent of Banks in charge of the liquidation of the Commerce Guardian Bank a 6 percent mortgage bond in the amount of $80,000, maturing on November 15, 1941, and executed and delivered to the Toledo Trust Co. (hereinafter referred to as the trust company), as trustee, a mortgage and deed of trust under which petitioner conveyed certain property as security for the payment of the principal and interest on the bond. Both the bond and the mortgage and deed of trust contained the following clause:
The Maumee Malleable Castings Company agrees that no distribution of earnings or surplus shall be made to the stockholders*1352 of said corporation by way of dividends, or in any other manner or form whatsoever, until all of said bonds issued under and pursuant to said mortgage and deed of trust shall be fully paid or redeemed, and said mortgage satisfied and discharged.
Under the mortgage and deed of trust the prohibition on the payment of dividends set forth in the above clause could be waived with the consent of the trustee.
*265 On October 13, 1936, the trust company purchased the bond from the Superintendent of Banks in charge of the liquidation of the Commerce Guardian Bank for $71,865.46. On that date petitioner and the trust company executed a written agreement under which petitioner was to pay to the trust company $1,865.46 at the time of execution of the agreement, $777.14 on the 13th day of each month until November 15, 1941, or until $71,865.46 with interest at 6 percent had been paid to the trust company, and such additional sums on or before November 15, 1941, as would aggregate $71,865.46 with interest at 6 percent. The trust company was to surrender the bond for redemption and cancellation on or before November 15, 1941, upon the payment by petitioner of $71,865.46 with interest*1353 at 6 percent.
Between October 13, 1936, and December 31, 1936, petitioner made payments to the trust company which reduced the principal amount due under the bond from $71,865.46 to $69,143.58.
On December 17, 1936, petitioner requested the trust company to consent to the waiving of the prohibition on the payment of dividends on its capital stock. On December 18, 1936, the trust company refused to give such consent.
Between January 1 and December 31, 1937, petitioner made payments to the trust company which reduced the principal amount due under the bond from $69,143.58 to $14,053.05. During the taxable year, 1937, petitioner made payments to the trust company on account of the principal amount due under the bond as follows:
| Jan. 14 | $5,321.88 |
| Feb. 13 | 5,650.15 |
| Mar. 15 | 5,998.62 |
| Apr. 13 | 516.28 |
| May 15 | 5,851.81 |
| June 10 | 6,761.36 |
| July 13 | 7,178.43 |
| Aug. 12 | $7,621.16 |
| Sept. 13 | 8,091.24 |
| Oct. 13 | 696.38 |
| Nov. 12 | 699.86 |
| Dec. 11 | 703.36 |
| Total | 55,090.53 |
During the taxable year petitioner's net monthly sales were as follows:
| Jan | $54,314.04 |
| Fed | 60,635.45 |
| Mar | 91,323.62 |
| Apr | 83,576.48 |
| May | 66,944.28 |
| June | 71,465.32 |
| July | $50,399.09 |
| Aug | 42,133.82 |
| Sept | 51,507.21 |
| Oct | 52,580.40 |
| Nov | 36,130.92 |
| Dec | 25,820.86 |
*1354 *266 Petitioner's balance sheet showed assets and liabilities as of December 31, 1936, and as of December 31, 1937, as follows:
| Dec. 31, 1936 | Dec. 31, 1937 | |
| ASSETS: | ||
| Cash | $44,170.91 | $35,307.61 |
| Accounts receivable | 92,167.51 | 37,345.91 |
| Inventories | 77,510.43 | 85,556.31 |
| Other investments | 1,390.14 | 1,391.39 |
| Deferred charges | 2,582.35 | 3,290.02 |
| Capital assets | 153,596.89 | 146,565.59 |
| Other assets | 3,059.74 | 3,061.34 |
| Total | 374,477.97 | 312,518.17 |
| LIABILITIES: | ||
| Accounts payable | 25,615.93 | 6,867.40 |
| Bond | 69,143.58 | 14,053.05 |
| Accrued expenses | 17,635.93 | 11,284.97 |
| Federal income tax | 8,844.21 | 3,166.51 |
| Capital stock | 197,100.00 | 197,100.00 |
| Earned surplus and undivided profits | 56,138.32 | 80,046.24 |
| Total | 374,477.97 | 312,518.17 |
As of December 31, 1937, petitioner had a total of $21,318.88 in current liabilities, consisting of accounts payable, $6,867.40; accrued expenses, $11,284.97; and Federal income tax, $3,166.51.
On November 30, 1937, petitioner had a cash balance in the amount of $31,561.44. From November 30, 1937, to and including December 26, 1937, the amount of its cash balance gradually declined. On December 26, 1937, petitioner*1355 had a cash balance in the amount of $12,853.20. Petitioner received $7,843.63 in cash on December 27, $6,547.88 in cash on December 30, and $14,591.86 in cash on December 31. On December 31, 1937, petitioner had a cash balance in the amount of $34,819.83. Petitioner deposited the amounts of cash which it received on December 30 and 31 in its bank account on January 4, 1938.
On December 6, 1937, petitioner requested the trust company to consent to the waiving of the prohibition on the payment of dividends on its capital stock. In a letter to petitioner dated December 7, 1937, the trust company refused to give such consent, stating in part that its refusal was "warranted by the advisability of your company's conserving its cash resources in view of the very material decrease in the company's sales and production for the last half of the current year." No dividend was declared or paid on petitioner's capital stock during the taxable year. No dividend had been declared or paid on such stock since 1931.
On January 5, 1938, petitioner paid to the trust company the principal balance due under the bond in the amount of $14,053.05 and the bond was canceled. Shortly thereafter petitioner*1356 declared a dividend of one-half of one percent on its capital stock. In January 1938 petitioner had net sales in the amount of $19,817.89.
*267 OPINION.
HARRON: The sole question is whether under section 26(c)(1) of the Revenue Act of 1936 petitioner is entitled to a credit in the amount of its adjusted net income for purposes of computation of the surtax on undistributed profits.
Section 26(c)(1) of the Revenue Act of 1936, in so far as pertinent to the present question, provides as follows:
In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax -
* * *
(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
(1) PROHIBITION ON PAYMENT OF DIVIDENDS. - An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends.
On its corporation income and excess profits tax return for the taxable year petitioner took a "Credit for contracts restricting*1357 dividend payments" (line 28 of Form 1120) in the amount of its adjusted net income. On the statement attached to the deficiency notice respondent disallowed the credit.
Petitioner relies on the prohibition on the payment of dividends contained in both the bond and the mortgage and deed of trust executed by it on November 15, 1934. The bond and the mortgage and deed of trust were written contracts executed by petitioner prior to May 1, 1936. The contracts contained a provision expressly dealing with the payment of dividends. Under that provision petitioner was prohibited from making any "distribution of earnings or surplus * * * by way of dividends" until the bond had been fully paid. Cf. Kilby Steel Co.,41 B.T.A. 1237">41 B.T.A. 1237; Page Oil Co.,41 B.T.A. 952">41 B.T.A. 952; Sutcliffe Co.,41 B.T.A. 1009">41 B.T.A. 1009. Throughout the taxable year the bond was not fully paid; and at no time within the taxable year was petitioner under a legal obligation to pay the bond in full. See Auto Interurban Co.,40 B.T.A. 161">40 B.T.A. 161. Apparently the mortgage and deed of trust also contained a provision under which the prohibition on the payment of dividends might*1358 be waived with the consent of the trustee. In December of the taxable year petitioner requested the trustee to consent to a waiver of the prohibition, but the trustee refused. Cf. Kilby Steel Co., supra.Thus petitioner could not distribute any amount within the taxable year as dividends without violating the provision contained in both the bond and the mortgage and deed of trust. It follows that all of the literal requirements of section 26(c)(1) have been met. See Auto Interurban Co., supra.
*268 However, respondent contends in his brief that section 26(c)(1) must be construed so that, in the case of a prohibition on the payment of dividends until a debt is paid, the taxpayer will be denied a credit if by its terms the debt can be paid in its entirety in the taxable year and if the taxpayer is able financially to pay the debt in its entirety in that year. He argues that such a construction is necessary to carry out the legislative intent underlying section 26(c)(1). In support of such a construction he quotes from I.T. 3130, C.B. 1937-2, p. 107, 109, 1 and *1359 Auto Interurban Co., supra.He then contends that petitioner is not entitled to a credit under section 26(c)(1) because the bond by its terms could have been paid in full in the taxable year and petitioner was financially able to pay the bond in full in that year.
In our opinion, respondent's contention is without merit. The record does indicate that petitioner at the very end of the taxable year was in such financial position as to be able to pay off the remaining balance*1360 of principal due under the bond and thus to remove the prohibition on the payment of dividends. Petitioner's failure to pay off the remaining balance of principal due under the bond until shortly after the end of the taxable year appears to have been actuated by sound business purposes. During the first six months of the taxable year petitioner's net monthly sales averaged over $70,000, but petitioner's net monthly sales fell to about $50,000 in July and continued at about that figure through October. Thereafter its net monthly sales dropped to about $36,000 in November, $26,000 in December, and $20,000 in January of 1938. Petitioner made substantial payments on account of the principal amount due under the bond in each month from January to September, inclusive, with the exception of April, when it made only a nominal payment. In view of the considerable shrinkage in the volume of its net monthly sales in the last half of the taxable year petitioner sought to conserve its cash and, therefore, made only relatively small payments on account of the principal amount due under the bond in October, November, and December.
On November 30, petitioner had about $31,500 in cash. From*1361 that date up to and including December 26 the amount of its cash gradually declined. On December 26 it had about $12,800 in cash. From December 26 up to and including December 31 the amount of its *269 cash substantially increased. On December 31 it had about $35,000 in cash. The amount of its cash increased about $6,500 on December 30 and about $9,000 on December 31. As of December 31 the amount of petitioner's cash ($35,307.61) approximately equaled the total amount of its current liabilities ($21,318.88) plus the amount of principal remaining due on the bond ($14,053.05). Petitioner deposited the substantial amounts of cash which it had received on December 30 and 31 in its bank account on Junuary 4, 1938. And on January 5, 1938, it paid the balance of principal remaining due under the bond in the amount of $14,053.05. It is true that as of December 31 petitioner had accounts receivable in the amount of $37,345.91 in addition to cash in the amount of $35,307.61. However, this does not seem to be a case where "a corporation, with cash and liquid assets greatly in excess of both its current obligations and its secured obligations" has delayed the redemption of its*1362 secured obligations "for an unreasonable length of time for the purpose of obtaining the credit provided for by section 26(c)(1) of the Act of 1936." See Auto Interurban Co., supra.The preponderance of the evidence indicates that any failure to pay the bond in full in the taxable year was actuated by sound business purposes. Moreover, in the taxable year petitioner paid a total of $55,090.53 on the principal amount due under the bond, although by the terms of the bond it was required to pay only $9,325.68 in that year, and although it had a net taxable income of only $27,141.04 in that year. After a careful consideration of all the facts, we believe that the allowance to petitioner of a credit under section 26(c)(1) in the amount of its adjusted net income will not tend to defeat the legislative intent underlying that section.
Accordingly, it is held that under section 26(c)(1) petitioner is entitled to a credit in the amount of its adjusted net income for purposes of computation of the surtax on undistributed profits.
Reviewed by the Board.
Decision will be entered for the petitioner.
Footnotes
1. * * * The credit above referred to would, therefore, not be allowable after the corporation becomes financially able to repay these obligations, since the restriction on the payment of dividends would then not be the result of the provisions of the contracts but the result of the corporation's willful failure to retire the obligations. Upon the payment of the obligations or upon the corporation becoming financially able to repay them, all restrictions on the payment of dividends would be removed and the corporation would be charged with the distribution of its adjusted net income for the entire taxable year in which the restrictions were removed. (Article 26-2(b) 2, Regulations 94.) ↩