*1366 In 1933 petitioner entered into a written contract for the purchase of a dredge to be used in its mining business, and as a part of the consideration therefor agreed that no dividends should be paid on its common stock until all preferred stock had been redeemed. During the taxable year 1937, on or prior to November 15, petitioner called and retired the preferred stock at par, plus accrued dividends, and thereafter in the same year paid substantial dividends on its common stock, for all of which dividends it was allowed credit in computing surtax on undistributed profits. Held, petitioner is not entitled to any additional credit under subdivision (1) or (2) of section 26(c), Revenue Act of 1936.
*208 This proceeding is for the redetermination of a deficiency in income tax, consisting of surtax on undistributed profits, for the year 1937 in the amount of $3,185.34. The issue is whether petitioner is entitled to the credit provided in either subdivision (1) or (2) of section 26(c) of the Revenue Act of 1936, quoted in the margin. 1
*1367 FINDINGS OF FACT.
Petitioner is a corporation, organized under the laws of the State of Washington on January 13, 1932. Amended articles of incorporation were filed on September 18, 1933, and second amended articles of incorporation were filed on January 2, 1935. The original articles of incorporation provided for an authorized capital of $49,500, consisting of 250,000 shares of common stock of the par value of 1 cent each and 470 shares of preferred stock of the par value of $100 each. The amended articles provided for an authorized capital of 250,000 shares of common stock of the par value of 1 cent each and 1,000 shares of preferred stock of the par value of $100 per share. Article V thereof provided:
The preferred stock shall be preferred both as to dividends and assets as heretofore provided for in the by-laws, shall be non-voting and callable in whole and/or in part by the corporation, and when so called in may be cancelled and/or reissued and/or cancelled as before, any number of times.
The second amended articles of incorporation provided for an authorized capital of $103,000, consisting of 300,000 shares of common stock of the par value of 1 cent each, and 1,000*1368 shares of preferred stock of the par value of $100 each. It was further provided that thee increase, consisting of 50,000 shares of common stock, "being made necessary for further financing of the corporation and/or to fulfill commitments theretofore made, should be placed in the hands of the board of directors and be sold within the State of Washington only for cash and/or to take up outstanding obligations and/or commitments and/or for property and/or services, upon such terms and/or at such prices as the directors might deem to be for the best interests *209 of the corporation, the present stockholders having waived their preemptory rights to subscribe for such stock."
At a special meeting of the stockholders of petitioner, certain of its bylaws were amended to read, and at all times subsequent to September 5, 1933, were in full force and effect, as follows:
Section 3. The capital stock of this corporation shall consist of two (2) classes, to-wit: two hundred and fifty thousand (250,000) shares of common stock of the par value of one (1??) cent per share and one thousand (1,000) shares of preferred stock of the par value of One hundred ( $100) Dollars each.
Section*1369 4. The holders of the preferred stock shall be entitled to receive dividends in amounts of 7% per annum from date of issue before any dividends are declared or paid to the holders of the common stock. Such dividends shall be cumulative and if the profits in any one year declarable as dividends shall not be sufficient to pay or warrant the declaration of dividends, then the same shall be made up from the profits of a later period until the full amount of dividends herein specified, without interest, shall have been paid upon or set apart for the preferred stock before any dividend is declared or paid on the common stock. The balance of the net profits, if any, declarable as dividends, shall be distributed among the holders of the common stock at such time as may be fixed by the trustees.
Section 5. The par value of the preferred stock and accumulated and unpaid dividends thereon shall also, upon dissolution of the company and distribution of its assets, be paid in full before any sum whatever is paid on account of the common stock and thereafter the common stock shall be entitled to the remainder.
Section 6. The preferred stock shall be non-voting and is callable by the corporation*1370 at any time, in whole or in part, at its option by giving written notice to the holder or holders of the preferred stock and paying a sum equaling One hundred ( $100) dollars per share together with any unearned and unpaid dividend. When so called in the same shall be cancelled, but may be reissued and again called in, in whole or in part, as before any number of times.
Section 7. If any stockholder shall neglect or refuse to surrender his preferred stock when the same is called in and after written notice thereof, he shall not share in any further dividends on the said preferred stock.
On September 7, 1933, petitioner, as party of the second part, entered into a contract in writing with one Arthur J. Baldwin, as party of the first part, reading in material part as follows:
WHEREAS, the party of the first part is the owner and in possession of one bucyrus Erie Dredge, 5 cu. ft. capacity, together with Power plant, Transmission Lines, Cables, Tools and other equipment used, had and enjoyed in connection with said property, situated on Osborn Creek in the Cape Nome Mining & Recording District, Territory of Alaska; and whereas the party of the second part is desirous of purchasing*1371 said dredge together with said equipment, now, therefore, in consideration of One ($1.00) dollar, the receipt whereof is hereby acknowledged, the party of the first part hereby gives and grants to the party of the second part an option to purchase the said dredge, power, plant, transmission lines, cables, tools and other equipment used, had and enjoyed in connection with said dredge, upon the following terms and conditions:
Five thousand ($5,000) dollars to be paid to the party of the first part in cash on or before the 1st day of June, 1934, and delivery made to the party of the first part of three hundred and fifty (350) shares of the capital stock of the *210 preferred class of the party of the second part at One hundred dollars ( $100) per share, aggregating Thirty-five thousand ($35,000) dollars, and thirty-five thousand (35,000) shares of the capital stock of the common class of the party of the second part.
IT IS FURTHER AGREED AND UNDERSTOOD that as a part of the consideration for the sale of said dredge the party of the second part shall raise sufficient capital to finance its mining operations at Nome, Alaska, in an amount of not less than Sixty thousand ($60,000) *1372 dollars, to be raised on or before the 1st day of June, 1934, from sale of stock.
IT IS FURTHER AGREED by and between the parties hereto that all of the preferred stock shall be called in and retired by the party of the second part before it shall pay any dividends on its common stock.
IT IS FURTHER AGREED AND UNDERSTOOD that the party of the second part, upon the payment of said sum of $5000, shall be given possession of the said dredge with the right to begin the operation of dismantling and moving the same and that as soon as the capital stock herein referred to shall have been delivered and the Sixty Thousand ($60,000) dollars raised, from sale of stock, the party of the first part shall convey to the party of the second part by way of warranty bill of sale, free and clear of all encumbrances, the title to said dredge.
IT IS FURTHER AGREED THAT unless the party of the second part shall make the payments, deliver the stock and fulfill all of the covenants herein on or before the 1st day of June, 1934, this option shall expire, be void and of no effect and any moneys paid under and by virtue of this option by the party of the second part shall be forfeited to the party of*1373 the first part as liquidated damages.
The Baldwin contract remained in full force and effect until all the provisions thereof were carried out by the respective parties. Pursuant to the terms of the agreement, the preferred stock referred to therein was called and retired.
At a meeting of the directors of petitioner held on September 22, 1937, the following motion was adopted:
It was directed that fifty percent of the outstanding and preferred stock with a par value of $50,000 be called and retired at September 30, 1937, and that said $50,000 par value of the stock so called for redemption shall not share in any further dividends after September 30, 1937.
Such $50,000 of the outstanding preferred stock was called and retired on September 30, 1937.
At a meeting of petitioner's directors held on November 4, 1937, the following motion was made and carried:
The officers of the company were directed to call for redemption all remaining outstanding Preferred Stock of record at November 15, 1937, and to retire same in amount of $50,000 on that date.
The remaining preferred stock was so called and retired as of November 15, 1937.
All of petitioner's preferred stock was*1374 in fact called and retired in 1937, and payments made in that year to the stockholders of record in the full amount of $100,000, plus accrued dividends of $26,268.21, or a total of $126,268.21, in fulfillment of the terms and conditions of the Baldwin contract.
*211 OPINION.
HILL: The issue submitted in this case is whether or not petitioner is entitled to a credit in any amount against adjusted net income under section 26(c) of the Revenue Act of 1936, quoted supra, on account of a contract executed prior to May 1, 1936, restricting payment of dividends or requiring a payment within the taxable year out of profits in discharge of a debt.
Petitioner's contentions do not clearly appear from the record. In its income tax return for 1937, in the undistributed profits surtax computation, petitioner claimed a dividends-paid credit of $134,841.29, which included a dividend carry-over from the preceding year of $94,008.08, but on brief petitioner says that it asserts no rights under section 27(b)(2), providing for the dividend carry-over. In its petition, petitioner assigned as error the failure of respondent to allow a dividend credit under subdivision (2) of section*1375 26(c), supra, on account of $100,000 of preferred stock redeemed during the year 1937. In its original brief petitioner states that the payment in retirement of the preferred stock, because of the Baldwin contract, constituted an allowable dividend-paid credit in the amount of $26,268.21 under subdivision (2) of section 26(c). Yet petitioner presents some argument that it is entitled to credit also under subdivision 1 of that section.
Petitioner on brief disavows any claim of credit on account of a dividend carry-over under section 27(b)(2), and we think it has shown no right to any credit under either subdivision of section 26(c).
Under the Baldwin contract, petitioner purchased a dredge upon certain terms and for a stated consideration. As a part of the consideration for the sale of the dredge, petitioner agreed to raise additional capital to finance its mining operations in an amount of not less than $60,000 and further agreed that all of its preferred stock should be called in and retired before payment of any dividends on its common stock. The contract did not require petitioner to redeem its preferred stock at any time, nor that it should be redeemed out of profits. *1376 Petitioner simply was prohibited from declaring any dividends on its common stock until the preferred stock had been redeemed.
During the taxable year petitioner, for reasons satisfactory to it, decided to and did call in and redeem all of its preferred stock, and thereafter there was no restriction on the payment of dividends on its common stock. The amount required to redeem was materially in excess of the net profits as computed both by petitioner and respondent. Obviously, therefore, petitioner used other funds at least in part to effect such redemption. The fact that petitioner elected to use *212 its profits to redeem its preferred stock, in the absence of any contractual requirement, does not entitle it to a credit under section 26(c)(1). If it had elected to invest its profits in other assets, it would hardly have contended that it would thereby be entitled to such credit. Since the contract which prohibited the payment of dividends on common stock was fully discharged within the taxable year, section 26(c)(1) can have no application, notwithstanding that petitioner did in fact apply its net profits of the taxable year in redemption of the preferred stock. Cf. *1377 ; .
Petitioner is in no better position in respect of its principal contention, more strongly urged, that it is entitled to credit under subdivision (2) of section 26(c). That subdivision, so far as pertinent here, allows as a credit 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, expressly dealing with the disposition of earnings and profits of the taxable year, to be paid within the taxable year in discharge of a debt. The Baldwin contract did not expressly deal with the disposition of the earnings and profits of the taxable year, nor did it require that any portion of petitioner's earnings and profits of the taxable year be used to redeem its preferred stock; and furthermore the amount so applied by petitioner was not "paid in discharge of a debt." Certificates of preferred stock do not evidence indebtedness, but an investment in the corporate enterprise. *1378 , and authorities cited. See also ; ; affd., ; ; affd., .
Petitioner paid dividends during the taxable year on its preferred stock in the total amount of $26,268.21 and dividends on its common stock in the amount of $14,565, or total dividends of $40,833.21, for which respondent allowed petitioner a dividends-paid credit in computing surtax on undistributed profits. In our opinion petitioner is not entitled to any additional credit on account of redemption of its preferred stock pursuant to the Baldwin contract.
Decision will be entered for respondent.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
In the case of a corporation the following credits shall be allowed * * *
* * *
(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) 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. * * * ↩