*812 1. Petitioner, during the taxable year 1936, was obligated under a mortgage indenture securing its bond issue to pay or declare no dividends on its second preferred or common stock if such action would reduce its net current assets below $1,000,000. Held, that payment of cash dividends in excess of the amount actually paid by petitioner in 1936 would have so reduced the net current assets in violation of the mortgage indenture; held, further, that under the established facts, petitioner could have paid common stock dividends, only, on its outstanding common stock which would not have constituted taxable dividends in the hands of the recipients and, consequently, even though it is not prohibited from paying such dividends, that does not preclude the allowance of the credit under section 26(c)(1) of the Revenue Act of 1936. Paraport Theatre Leasing Corporation,44 B.T.A. 108">44 B.T.A. 108; Columbia River Paper Mills,43 B.T.A. 263">43 B.T.A. 263.
2. Expenditure by petitioner, during 1936, for improvements to a club house is not deductible as a business expense for that year under section 23(a) of the Revenue Act of 1936, but is a capital expense and depreciable in*813 the amount here determined.
*801 This proceeding involves the redetermination of a deficiency in income tax for the year 1936 in the amount of $30,000.81. The issues are (1) whether petitioner is entitled to a credit for the taxable year in computing the surtax on its undistributed profits under section 26(c)(1) of the Revenue Act of 1936, and (2) whether petitioner is entitled to deduct an amount contributed to a fund for the benefit of a club as an ordinary and necessary expense paid during the taxable year in carrying on its business under section 23(a) of the Revenue Act of 1936.
The case was submitted on a formal stipulation of facts, together with exhibits and oral testimony.
FINDINGS OF FACT.
Petitioner is a corporation organized under the laws of the State of New York, with its principal office located at Fulton, New York. Its formation occurred as a result of an agreement dated January 30, 1922, entered into by the Oswego Falls Pulp & Paper Co., the Skaneateles Paper Co., and the Sealright Co., under*814 which those companies became a single corporation known as the Oswego Falls *802 Corporation. It has two subsidiaries, known as Sealright, Inc., and Sealright Pacific, Ltd. The former subsidiary has no assets or liabilities except its name but the latter does. The petitioner filed a Federal income and excess profits tax return for the taxable year 1936 with the collector of internal revenue for the twenty-first district of New York.
On July 1, 1926, petitioner entered into a mortgage indenture with the Equitable Trust Co. of New York as trustee. This indenture was in full force and effect throughout the calendar year 1936.
Pursuant to the provisions of this indenture, there were issued first mortgage 6 percent sinking fund gold bonds dated July 1, 1926, in the amount of $300,000,000. On December 31, 1936, there were outstanding bonds of this issue in the amount of $2,256,000, which represented the smallest amount of bonds outstanding at any time during the year 1936. Between January 1 and May 1, 1936, petitioner purchased its bonds in the face amount of $72,000, and between May 1 and December 1, 1936, it purchased additional bonds in the face amount of $52,000. Under*815 the indenture, all bonds which are redeemed were required to be canceled and no new bonds could be issued in lieu thereof.
The indenture contained the following pertinent provisions:
That no dividend shall be paid or declared upon or set apart for the Preferred Stock ($750,000 issue) or for the Common Stock of the Company if such action will result in the reduction of its net current assets below One Million Dollars ($1,000,000).
The term "net current assets" shall be taken to mean the excess of the value of the current assets over the amount of current liabilities, as said terms "current assets" and "current liabilities" are hereinafter defined.
The term "current assets" shall be taken to mean (a) cash on hand and in bank (other than cash deposited with the Trustee hereunder), (b) good and collectible customers' notes, bills, trade acceptances and customers' accounts receivable, acquired or contracted in the ordinary course of business which are unpledged and which by their terms mature within one year after their date, excluding notes and accounts of subsidiaries, (c) accrued interest, rents and royalties receivable, (d) stocks of merchandise manufactured, produced or*816 in process of manufacture, including by-products, raw material and supplies, which shall be taken at cost exclusive of interest, or at a fair market value, whichever is lower, (e) bonds and certificates of indebtedness of the United States of America which shall be taken at not exceeding their fair market value, (f) shares of stock, bonds and other securities (other than shares of stock of subsidiaries), which shall be taken at their fair market value, and (g) the cash surrender value of any policies of life insurance carried by the Company on the lives of any of its officers. The current assets of any subsidiary the entire capital stock of which is owned by the Company shall be included in the current assets of the Company.
The term "current liabilities" shall be taken to mean all current liabilities of the Company, whether absolute or contingent, including (a) notes, bills, *803 acceptances, accounts payable and other obligations, which mature within one year after their date, (b) loans from banks or bankers, (c) accrued salaries, wages, interest, rent, royalties and taxes, including income and profits taxes, and (d) any overdue Sinking Fund payment or any part thereof. *817 In determining contingent liabilities arising out of endorsements or guarantees, credit shall be allowed as a corresponding current asset for the recourse of the Company against prior obligors of the obligation endorsed or guaranteed, but only if such prior obligors are solvent and responsible. The contingent liabilities for account of subsidiaries and the current liabilities of any subsidiary the entire capital stock of which is owned by the Company shall be included in the current liabilities of the Company.
That it will not, except as herein allowed, do or suffer any act or thing whereby the trust estate might or could be impaired, and that it will at all times maintain, preserve and keep the mortgaged property and every part thereof, in good condition, repair and working order. * * *
The assets and liabilities of petitioner for the year 1936 consisted of the following items:
| Assets | Liabilities |
| Cash | Accounts payable, accrued accounts, |
| etc. | |
| Notes and accounts receivable | |
| Inventories | Federal tax on income (1936) - |
| estimated | |
| Security investment - at cost | |
| Corporation's own bonds (reacquired) | Federal tax on income (1931) |
| Cash value of life insurance | Payments due within one year on long |
| term debt: | |
| Accounts receivable - Sendel Corp. | |
| Deposit with Mutual Insurance Co. | Contract for purchase of equipment, |
| etc. | |
| Sundry personal accounts, advances, etc. | Contract for repurchase of common |
| stock | |
| Property, plant and equipment | |
| Intangible assets | First mortgage 6% sinking fund bonds |
| Deferred charges | Contract for purchase of equipment |
| Contract for repurchase of common | |
| stock |
*818 For the year 1936, petitioner had "current assets" and "current liabilities" of the kind defined by section 39 of the indenture mortgage, as follows:
| Current assets | Current liabilities |
| Cash | Accounts payable, accrued accounts, etc. |
| Notes and accounts receivable | |
| Inventories | Federal tax on income (1936) estimated |
| Security investment at cost | |
| Corporation's own bonds (reacquired) | Federal tax on income (1931) |
| Cash value of life insurance | Payments due within one year on long term |
| debt: | |
| Contract for purchase of equipment, etc. | |
| Contract for repurchase of common stock |
*804 The totals of the "current assets", "current liabilities", and "net current assets", as defined by section 39 of the indenture mortgage, at the close of each of the months during the year 1936 were as follows:
| January | February | March | April | |
| Current assets | $1,043,678.95 | $1,091,736.63 | $1,155,880.02 | $1,135,520.04 |
| Current liabilities | 145,645.51 | 196,583.18 | 205,477.55 | 196,831.01 |
| Net current assets | 898,033.44 | 895,153.45 | 950,402.47 | 938,689.03 |
| May | June | July | August | September |
| $1,217,745.73 | $1,265,818.44 | $1,340,811.89 | $1,332,263.82 | $1,382,124.35 |
| 212,635.50 | 207,467.58 | 243,588.84 | 261,304.47 | 339,665.47 |
| 1,005,110.23 | 1,058,350.86 | 1,097,223.05 | 1,070,959.35 | 1,042,458.88 |
| October | November | December |
| $1,354,241.33 | $1,265,481.06 | $1,045,521.08 |
| 339,423.47 | 298,063.96 | 289,230.15 |
| 1,014,817.86 | 967,417.10 | 756,290.93 |
From January 1 to September 10, 1936, outstanding capital stock of petitioner consisted of three issues, viz., first preferred 8 percent cumulative ( $100 par value per share), hereinafter referred to as first preferred; preferred 8 percent cumulative (second) ( $100 par value per share), hereinafter referred to as second preferred; and common ( $100 par value per share).
The $750,000 issue of preferred stock mentioned in section 38 of the indenture was the second preferred issue. Of the 2,500 shares of first preferred stock authorized before September 10, 1936, 1,400 shares had been retired as of that date leaving 1,100 shares outstanding. As of that same date there were 7,500 shares of second preferred authorized of which 1,293 shares had been reacquired, leaving 6,207 shares outstanding. Also there were 15,000 shares of common stock authorized before that date, of which 1,320 shares had been reacquired, leaving 13,680 shares outstanding.
Under petitioner's charter, both before and after the recapitalization*820 in 1936, none of the redeemed shares of first preferred stock could be reissued or other shares issued in lieu thereof. Also, its charter provided that dividends on its common stock could not be paid until the accumulated dividends on its second preferred stock had been paid.
As to September 10, 1936, a recapitalization was effected whereby the second preferred stock, together with accrued and unpaid dividends which had accumulated thereon since 1930, was extinguished and the par value of the common stock was reduced from $100 per *805 share to $5 per share. The authorized number of common shares was increased to 244,500. No change was made with respect to the first preferred stock except that the authorized number of shares was reduced to 1,275.
There were never any defaults, either before or after the recapitalization, in paying the dividends on the first preferred stock. The dividends on such stock, accruing during the year 1936, amounted to $9,850 and were paid in cash. Also, cash dividends amounting to $125,251.20 were paid on the new common stock ( $5 par value) during the year. The Commissioner has allowed a dividends paid credit of $135,101.20 covering these*821 dividend payments. The petitioner reported these dividend payments in its tax return for 1936 as having been paid as follows:
| Dates paid | First preferred | Common | Total |
| Feb. 1, 1936 | $2,550 | ||
| May 1, 1936 | 2,550 | ||
| Aug. 1, 1936 | 2,550 | ||
| Oct. 1, 1936 | $62,625.60 | ||
| Nov. 1, 1936 | 2,200 | 20,875.20 | |
| Dec. 26, 1936 | 41,750.40 | ||
| Total | 9,850 | 125,251.20 | $135,101.20 |
Petitioner reported a net taxable income on its income and excess profits tax returns, for the year 1936, in the amount of $350,090.83 and paid a total tax of $51,353.62. Its undivided profits or surplus as of December 31, 1936, amounted to $1,139,014.08. Petitioner's tax return for the year 1936 was made on the accrual basis.
The Fulton Club is a nonprofit organization formed in 1932 by taking over the former Chamber of Commerce and the Citizens Club, which had been in financial difficulties. The club serves luncheon and dinner to the members and their guests, for which the members have to pay the club's steward. The club also furnishes a place for business as well as educational meetings. It has a reading room and facilities for playing pool and cards. Its funds are raised by charging its members*822 $20 per year for dues. Its membership is limited to 200.
Petitioner is the only large corporation in Fulton, New York, and its business is done on a national scale. The town of Fulton has a population of about 13,000 people and its restaurants and hotels are considered unsuitable to entertain petitioner's out-of-town guests. The club serves as a place for petitioner to entertain these guests and as a place of entertainment for its employees. Petitioner also holds its meetings in the club.
Petitioner employs about 40 men whose ages range from 21 to 32 years. It is desirous that these men use the facilities of the club. *806 In 1936, it contributed $3,500 to a fund for making improvements to the club. Other persons and corporations also contributed. These contributions were used to add a new room to the club and install a new heating plant. Petitioner had no facilities at its own plant similar to those of the club and the contribution was made in lieu of providing such facilities on its own property.
OPINION.
LEECH: The first issue is whether petitioner is entitled to a credit under section 26(c)(1) of the Revenue Act of 1936 1 by reason of a provision of*823 a written contract executed prior to May 1, 1936, expressly dealing with and restricting the payment of dividends. Petitioner relies on the mortgage indenture executed July 1, 1926, as a contract which operates as a restriction on the payment of dividends within the meaning of the statutory provision. It contends that section 38 of the mortgage, providing that "no dividend shall be paid or declared upon or set apart for the Preferred Stock ($750,000 issue) or for the Common Stock of the Company if such action will result in the reduction of its net current assets below One Million Dollars ($1,000,000)", constituted an effective contractual restriction on the payment of dividends, thereby entitling it to the statutory credit. Respondent argues that the petitioner's "net current assets", as defined in the indenture, were not, at all times, below $1,000,000 during the taxable year. Moreover, he says that even if they were below this minimum amount, the petitioner was not prohibited by the indenture from paying dividends in some form such as bonds with maturities in excess of one year or taxable stock dividends.
*824 It is clear that section 38 of the indenture is intended as a prohibition on petitioner's payment of dividends on its preferred ($750,000 issue) or its common stock only if such action would result in a reduction of its net current assets below $1,000,000. The term "net current assets" is defined in section 39 as "the excess of the value of the current assets over the amount of current liabilities." Thus, to determine whether the "net current assets" were below $1,000,000, it is necessary to ascertain what items are included in "current assets" and "current liabilities" within the definitions in section 39 of the indenture.
*807 We have found the items which fall within the definition of "current assets" and "current liabilities" as those terms are used in the indenture. Respondent argues, however, that the asset, "account receivable - Sendel Corporation" should be included in current assets since the petitioner has not sustained its burden of showing that it is not a "good and collectible" account within the definition of "current assets." We think the evidence is sufficient to support the exclusion of this itme from current assets, as we have found. Respondent also*825 maintains that the item "Federal tax on income (1936) estimated" is not a current liability and should be excluded therefrom on the ground that a taxpayer's liability for income tax is determined on an annual basis and does not accrue until the end of the year. However, we are not concerned here with whether this item may be accrued during the year for tax purposes, but whether the accrual of the item is properly included in "current liabilities" as defined by section 39 of the indenture. We think it is and have so found. See W. A. Paton, Accountants' Handbook, 2d Ed., p. 874.
During the taxable year, petitioner paid dividends on its first preferred stock in full and, in addition, paid dividends on its common stock in the amount of $125,251.20 for which a dividends paid credit has been allowed. Since the payment of those dividends reduced "net current assets" below $1,000,000, petitioner could not have paid additional dividends without violating section 38 of the mortgage indenture.
In support of his contention that petitioner was not restricted in paying dividends in bonds maturing in more than a year, respondent argues that dividends so paid would not fall within the definition*826 of current liabilities in section 38 of the indenture. This section defines current liabilities as "all current liabilities of the Company, whether absolute or contingent, including (a) notes, bills, acceptances, accounts payable and other obligations, which mature within one year after their date." It might be true that dividends paid in bonds maturing in more than a year would not fall within the definition of current liabilities and, as a consequence, would not affect the net current assets. But we think such action would be a violation of the indenture provisions. The indenture "must be read in its entirety and with due regard for the purpose which it was intended to achieve." . It is clear that the primary intent and purpose of the indenture was to preserve all of the petitioner's assets, other than its current assets, for the benefit of the bondholders under the mortgage and to permit current assets to be used for the payment of dividends only to the extent that the net current assets exceeded $1,000,000. Under section 30 of the indenture petitioner is under an obligation that it will not, *808 except*827 as allowed, "do or suffer any act or thing whereby the trust estate might or could be impaired * * *." A distribution of dividends in the form of bonds with maturities occurring in less than a year would obviously be reflected in the current liabilities and thereby affect the net current assets in violation of section 38 of the indenture. We think that such a distribution with maturities in excess of a year would be similarly violative of the indenture provisions.
Respondent's last argument is that the petitioner was not prohibited from paying dividends in stock. The answer to this is simple. Such dividends could only be paid, if at all, on the common stock, since dividends on the preferred stock were required to be paid in cash. Petitioner had no authorized first preferred stock subject to issue for any purpose, and its treasury second preferred stock could not be issued as a stock dividend until it first paid the cash dividends which had accrued since 1930 on its issued second preferred, which, of course, would have resulted in a violation of the indenture. Thus, it is clear that it could only have paid a common stock dividend on its common stock and then only after the extinguishment*828 of the second preferred issue resulting from the recapitalization on September 10, 1936. Such a dividend, however, would be nontaxable in the hands of the recipient. We have consistently held that the ability or authority to pay a dividend does not preclude the allowance of the credit under section 26(c)(1), supra. ; ; ; cf. .
We are not unmindful of the recent decision of the Eighth Circuit Court in , in which that court announced a contrary view. However, with all due respect for that court, we adhere to our declared position.
The several violations of section 38 of the mortgage indenture, during the taxable year, may be some indication of a waiver of its restrictions. See . However, there is no evidence here, as there was there, that the other party to the restricting contract waived*829 such restrictions. In any event, respondent has not raised the point and we therefore pass it.
We hold, therefore, that the credit under section 26(c)(1) should be allowed.
The second issue is whether petitioner is entitled to deduct a contribution of $3,500 to a fund to be used for making improvements to the Fulton Club as ab ordinary and necessary expense paid in the taxable year in carrying on its business within section 23(a) of the *809 Revenue Act of 1936. 2 While we think that petitioner derived a direct business benefit as a result of this contribution, we are unable to agree that the enjoyment of such a benefit was limited to the year for which the deduction is made. Petitioner was on the accrual basis. The contested contribution was made for improvements, the benefits of which would be enjoyed over a period of years. In fact, they were made to preclude the necessity of petitioner making such improvements at its own plant. It is settled that such an expenditure should have been capitalized when made and then exhausted over the period for which the benefits would be enjoyed.
*830 Petitioner, it is true, has not shown what part of such expenditure was exhausted during the taxable year. However, some part of it undoubtedly was. Following the rule announced in , we hold that 2 percent of the contested expenditure, or $70, was exhausted during the taxable year. Petitioner's reduction will be limited to that amount.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
* * *
(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. * * * ↩
2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
(a) EXPENSES. - All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. ↩