*181 Decision will be entered for the respondent.
Green Bay & Western Railroad Co. had outstanding during the taxable years shares of common stock and certain class A and class B debentures. The debentures had no fixed date of maturity and provided for no fixed rate of annual return. They provided that the holders thereof should "in lieu of interest thereon, participate in the distribution of annual net income" in the manner set out in the debentures. Any disbursements in pursuance of such provisions had to be declared by the board of directors of the corporation in the same manner that dividends on the common stock were declared. It was provided that none of such payments should be cumulative. No remedy was provided for default in payments. Held, these debentures did not represent indebtedness of the corporation and the payments accrued thereon in the taxable years by the taxpayer were not deductible as interest under section 23 (b), Revenue Act of 1936 and the Internal Revenue Code.
*372 The Commissioner has determined *182 deficiencies in income tax against petitioner Green Bay & Western Railroad Co. and its affiliated corporation, the Ahnapee & Western Railway Co., of $ 30,143.03 for 1937 and $ 4,196.43 for 1939, a total of $ 34,339.46.
The deficiencies are due to several adjustments made by the Commissioner in the income tax returns filed by Green Bay & Western Railroad Co. and its affiliated corporation, the Ahnapee & Western Railway Co., for the taxable years in question. None of these adjustments are contested except adjustment (a) made for each of the taxable years. That adjustment is explained in the deficiency notice as follows:
(a) The amounts paid to the holders of your so-called Class A Debentures and Class B Debentures, $ 220,000.00 for the year 1937, and $ 30,000.00 for the year 1939, have been disallowed as deductions from gross income. Said amounts, however, have been included in the computation of your dividends paid credits for the years 1937 and 1939 under Section 27 of the Revenue Act of 1936 and the Internal Revenue Code. It is held that the foregoing payments are not deductible from gross income as interest on indebtedness within the meaning of Section 23 (b) of the Revenue Act*183 of 1936 and Section 23 (b) of the Internal Revenue Code; that the so-called debentures do not represent indebtedness within the meaning of that term as used in the statutes; and that they were intended to and do evidence a proprietary interest in your corporation.
By appropriate assignments of error petitioners contest this determination of the Commissioner.
*373 FINDINGS OF FACT.
The petitioners are domestic corporations, with their principal office and place of business at Green Bay, Wisconsin. They filed their consolidated income tax returns for the calendar years 1937 and 1939 with the collector of internal revenue at Milwaukee, Wisconsin.
Green Bay & Western Railroad Co., sometimes hereinafter referred to as petitioner, is a corporation organized and existing under the laws of the State of Wisconsin. The corporation was organized in the year 1896. The articles of incorporation provide that the amount of the capital stock of the corporation is $ 2,500,000, which consists of 25,000 shares of the par value of $ 100 each. All of the 25,000 shares were issued and outstanding in the years 1937 and 1939.
The articles of incorporation provide that the rights, powers, privileges*184 and franchises, and property of the predecessor corporations (the Green Bay, Winona & St. Paul Railroad Co. and the Green Bay, Stevens Point and Northern Railroad Co.) purchased under a decree of foreclosure of the railroads should be put into the new organization (the petitioner) for the following price:
Two million five hundred thousand dollars of capital stock divided into twenty-five thousand shares of One hundred dollars each, as above specified.
Six hundred thousand dollars face value of instruments to be issued by said new company to be known as Class A Debentures, which debentures shall be issued in amounts of One Thousand Dollars each, and shall be payable only as follows, viz: in the event of any sale or reorganization of the railroad and property of said company, the net proceeds thereof, after payment of all liens and charges thereon, shall be distributed to and among the holders of said Class A Debentures, and the capital stock pro rata, and until such payment the holders of such Debentures shall be entitled in lieu of interest thereon to receive out of the net earnings of the railroad in each year applicable to the payment of dividends on the stock 2 1/2% upon the face*185 value of such debentures if earned, and after payment of two and one-half per cent. (2 1/2%) dividend upon the said capital stock, to participate pro rata with the stock in the net earnings of the property for such year until five percent shall have been paid upon both the stock and the said Class A Debentures, the said debentures to contain such further provisions as may be agreed upon between the purchasers and the said company.
Seven Million Dollars face value of instruments to be issued by said new company to be known as Class B Debentures, which debentures shall be issued in amounts of One thousand Dollars each and shall be payable only in the event of a sale or reorganization of the railroad and property of said company and then only out of any net proceeds of such sale or reorganization which may remain after payment of all liens and charges upon said railroad or property, and after payment of Six Hundred Thousand Dollars to the holders of said Class A Debentures and Two Million five hundred thousand dollars to the stockholders, any such net proceeds remaining after such payments to be distributed pro rata to and among the holders of the said Class B Debentures, the holders*186 thereof to be entitled to receive in lieu of interest thereon any net earnings of the railroad and property in each year remaining after payment of five per cent. upon the said Class B Debentures and the said stock. Such surplus net earnings, if any, to be paid to and distributed among the holders *374 of Class B Debentures pro rata and the said debentures to contain such further provisions as may be agreed upon between the company and the said purchasers.
The said purchasers hereby agreeing to accept said stock and debentures in consideration of the transfer of the said property to the said new organization, and as the price for the same.
On or about June 5, 1896, the rights, privileges, powers, franchises, and properties held by the bondholders' committee of the Green Bay, Winona & St. Paul Railroad Co. were transferred to the petitioner in exchange for all of its shares of capital stock in the aggregate of 25,000 shares, $ 600,000 of class A debentures, and $ 7,000,000 of class B debentures. The bondholders' committee apparently retained for the depositing bondholders all of the 25,000 shares of capital stock; but all the class A and class B debentures were by prearrangement*187 disposed of as shown by the following excerpt from the minutes of the first meeting of petitioner's board of directors:
And it further appearing to this Board from the communication aforesaid that the said Committee has arranged with a committee of certain of the Income Bonds and Preferred and Common Stock of the Green Bay, Winona and St. Paul Railroad Company, that upon such Committee taking the entire issue of the said $ 600,000, of Class A. Debentures, and paying unto them therefor the sum of $ 570,000, in cash, said Committee should be entitled to receive the entire issue of Class B. Debentures; and to surrender to said first named Committee for cancellation, all the Income Bonds and Preferred and Common Stock deposited with said second named Committee; and that the first named Committee, after paying out of the said $ 570,000, of cash, when received by it, all expenses of the reorganization, all amounts necessary to the proper improvement, Equipment etc. of the railroad, and any amounts payable in cash for prior liens upon said properties so purchased by them, or to First Mortgage Bondholders and First Consolidated Mortgage Bondholders of the Green Bay, Winona and St. Paul Railroad*188 Company, who may not have deposited their bonds with the said first named Committee and assented to the plan of reorganization prepared by said Committee, are to pay over the balance of said $ 570,000, then remaining unto this Company, or to or for its uses and purposes.
The opening journal entries on the books of the petitioner record the transaction as follows:
| Construction | $ 9,954,000.00 | |
| Equipment | 123,359.28 | |
| Materials and supplies | 22,640.72 | |
| 10,100,000.00 | ||
| Capital Stock: | ||
| 25,000 shares at $ 100 each | 2,500,000.00 | |
| "A" Debentures: | ||
| 600 at $ 1,000 each | 600,000.00 | |
| "B" Debentures: | ||
| 7,000 at $ 1,000 each | 7,000,000.00 | |
| 10,100,000.00 |
*375 Distributions were made by the petitioner during the years 1937 and 1939 on account of the capital stock and the debentures as follows:
| 1937 | |
| On class "A" debentures | $ 45,000 |
| On class "B" debentures | 175,000 |
| On capital stock | 187,500 |
| 1939 | |
| On class "A" debentures | $ 30,000 |
| On capital stock | 125,000 |
These items were accrued on the regular books of account of the petitioner as follows:
| General | Folio | Feb-1937 | Folio | General |
| 21 | ||||
| $ 62,500 | 614 | Dividend approp. of Surplus (614) | ||
| 15,000 | 546 | Interest on Funded Debt (A's) (546) | ||
| 70,000 | 546 | Interest on Funded Debt (B's) (546) | ||
| Dividends Matured Unpaid (763) | 763 | $ 62,500 | ||
| Interest Matured Unpaid (762) A's | 762 | 15,000 | ||
| Interest Matured Unpaid (762) B's | 762 | 70,000 | ||
| 1936 Dividends 2 1/2%, Interest on | ||||
| A's 2 1/2% and Interest on B's | ||||
| 1% Declared on January 28, 1937. | ||||
| Dec-1937 | ||||
| 21 | ||||
| 125,000 | 553 | Dividend App'n of Income (553) | ||
| 30,000 | 546 | Int. on Funded Debt A's (546) | ||
| 105,000 | 546 | Int. on Funded Debt B's (546) | ||
| Div. Mat. Unpaid (763) | 763 | 125,000 | ||
| Int. Mat. Unpaid (762) A's | 762 | 30,000 | ||
| Int. Mat. Unpaid (762) B's | 762 | 105,000 | ||
| 1937 Dividends 5%; Int. on A's 5%; Int. on | ||||
| B's 1 1/2% Declared on November 12, 1937. | ||||
| Feb-1939 | ||||
| 18 | ||||
| 125,000 | 614 | Dividend app'n of Surplus (614) | ||
| 30,000 | 546 | Interest on Funded Debt (546) (A's) | ||
| Dividends Matured Unpaid (763) | 763 | 125,000 | ||
| Interest Matured Unpaid (762) | 762 | 30,000 | ||
| 1938 dividend of 5%, and Interest on A's | ||||
| of 5% declared on Jan. 30, 1939. | ||||
| 19 | ||||
| 125,000 | 763 | Dividends Matured Unpaid | ||
| C. W. Cox, Treas. Div. Acct | 708F | 125,000 | ||
| 1938 dividend of 5% paid on | ||||
| February 14, 1939. |
*189 The payments of 2 1/2 percent to holders of class A debentures ($ 15,000) and 1 percent to holders of class B debentures ($ 70,000), together with 2 1/2 percent to holders of the capital stock ($ 62,500) on February 23, 1937, were declared and paid or accrued pursuant to resolution of the board of directors at a special meeting held in New York City on January 28, 1937, as set forth in the minutes of said meeting, to wit:
Resolved, That on the 23rd day of February, 1937, out of the net earnings of the company for the year 1936, a payment of two and one-half percent (2 1/2%) of face value be made to the holders of Class A Debentures of the company, a dividend of two and one-half percent (2 1/2%) be paid to the holders of the capital stock of the company outstanding and of record at the close of business February 10, 1937, and a payment of one percent (1%) of face value be made to the holders of Class "B" Debentures of the company; said payments to be made at Room 801, No. 48 Wall Street, New York City.
*376 The payments of 5 percent made to holders of class A debentures ($ 30,000) and 1 1/2 percent made to holders of class B debentures ($ 105,000), together with 5 percent to holders*190 of the shares of capital stock of petitioner ($ 125,000) on December 21, 1937, were declared and paid or accrued pursuant to a resolution of the board of directors at a regular meeting of the board held in New York City, November 12, 1937, as set forth in the minutes of the meeting and which was similar in language to the resolution of February 23, 1937.
The payments of 5 percent made to holders of class A debentures and 5 percent to holders of shares of capital stock on February 14, 1939, in the total sum of $ 15,000, were declared and paid or accrued pursuant to resolutions adopted by the board of directors at a special meeting at New York City, January 30, 1939, as set forth in the minutes of the meeting, and were similar in language to the resolution of February 23, 1937, hereinbefore set out.
The petitioner's accounts were kept in accordance with the classification prescribed by the Interstate Commerce Commission for all railroads and the distributions on the debentures were entered under paragraph 546 of such prescribed rules of classification as "Interest on funded debt." This had been the regular practice of the petitioner in keeping its accounts since such rules were prescribed.
*191 The balance sheets of petitioner for the years 1937 and 1939 carried, among other things, the following:
| Capital stock | $ 2,500,000 | |
| Funded Debt Unmatured: | ||
| Debentures "A" | $ 600,000 | |
| Debentures "B" | 7,000,000 | |
| 7,600,000 |
Specimen copies of class A and class B debentures are in evidence and are incorporated herein by reference. The class A debentures read in part as follows:
The Green Bay and Western Railroad Company hereby certifies that this is one of a series of Six Hundred of its Class A Debentures, in the sum of One Thousand Dollars each, numbered consecutively from 1 to 600, aggregating in all the sum of Six Hundred Thousand Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof or if registered, to the person appearing on the books of the Said Company as the last registered owner hereof, only as follows, viz: in the event of any sale or reorganization of the railroad and property of said Company, the net proceeds thereof, after payment of all liens and charges thereon shall be first distributed to and among the holders of said Class A Debentures, and of the capital stock of said Company of the par value of Two Millions five hundred *192 Thousand Dollars ($ 2,500,000) pro rata, and any surplus remaining after payment of the face value of the entire series of such Class A Debentures, and the entire par value of said stock, shall be distributed pro rata to and among the holders of a series of $ 7,000,000 Class B Debentures issued, or to be issued, by the said company. * * * The said Railroad Company hereby Agrees that until such payment, the holders of this series of debentures shall in lieu of interest *377 thereon, participate in the distribution of annual net income, upon the following basis, viz: So much of the net earnings of the said Company in any year as would be applicable to the payment of dividends on stock shall be applied as follows, viz: To the holders of Class A Debentures, 2 1/2 per cent upon the face value thereof, or if such annual net earnings are insufficient for the payment of the same, then all of such net earnings shall be distributed pro rata among the holders of said Class A Debentures. After the payment of 2 1/2 per cent upon the face value of Class A Debentures, the stockholders of the Company are entitled to receive the balance of such net earnings until 2 1/2 per cent shall have been*193 paid out of the same upon the par value of the said stock, and all surplus net earnings then remaining shall be paid to the holders of Class A Debentures and of the stock, pro rata, until five per cent shall have been paid upon the face value of said Debentures, and upon the par of said stock, for such year, and any surplus net earnings then remaining shall be paid to the holders of Class B Debentures pro rata. None of such payments shall be cumulative. The amounts, if any, payable on Class A Debentures out of the net earnings in any year, will be fixed and declared by the Board of Directors annually on or before the 1st day of February in the following year, and when so declared any amount payable hereon will be paid at the office or agency of the Company in the City of New York on or before the first day of March in such year, to the holder of this Debenture, upon its production at such office or agency in order that such payment may be stamped hereon, or if registered, payment will be made by check mailed to the person appearing on the books of this company as the registered owner thereof at the last address furnished by him to the company. * * *
The class B debentures read in*194 part as follows:
The Green Bay and Western Railroad Company hereby certifies that this is one of a series of Seven thousand of its Class B Debentures in the sum of One Thousand Dollars each, aggregating in all the sum of Seven Million Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof, or if registered, to the person appearing on the books of the said Company as the last registered owner hereof, only in the event of a sale or reorganization of the Railroad and property of said company, and then only out of any net proceeds of such sale or reorganization which may remain after payment of any liens and charges upon such railroad or property, and after payment of Six hundred thousand Dollars to the holders of a series of debentures known as Class A, issued or to be issued, by said Company, and the sum of Two Millions five hundred Thousand Dollars to and among the stockholders of said company. Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures. * * * The said Railroad Company Hereby Agrees that until such payment, the holders of this series of Debentures shall in*195 lieu of interest thereon participate in the distribution of annual net income to the following extent only viz: So much of the annual net earnings of the said Company in any year as would be applicable to the payment of dividends on stock shall be applied as follows, viz: To the holders of Class A Debentures 2 1/2 per cent upon the face value thereof, or if such annual net earnings are insufficient for the payment of the same, then all of such net earnings shall be distributed pro rata among the holders of said Class A Debentures. After the payment of 2 1/2 per cent upon the face value of Class A Debentures, the stockholders of the Company are entitled to receive the balance of such net earnings until 2 1/2 per cent shall have been paid out of the same upon the par value of the said stock, and all surplus net earnings then remaining shall be paid to the holders of Class A Debentures and of the stock pro rata, until five per cent shall have been *378 paid upon the face value of said debentures and upon the par of said stock for such year, and any surplus net earnings arising in such year which may then remain shall be paid to and distributed among the holders of Class B Debentures*196 pro rata. None of such payments shall be cumulative. The amounts, if any, payable upon this series of debentures out of the net earnings in any year, will be fixed and declared by the Board of Directors on or before the first day of February, in the following year, and when so declared, any amount payable hereon will be paid at the office or agency of the Company in the City of New York on or before the first day of March, in such year, to the holder of this debenture, upon its production at such office or agency in order that such payment may be stamped hereon; or, if registered, payment will be made by check mailed to the person appearing on the books of this company as the registered owner hereof at the last address furnished by him to the company. * * *
In preparing its income tax returns for the calendar years 1937 and 1939, petitioner deducted as interest the aforesaid amounts of $ 220,000 in the year 1937 and $ 30,000 in the year 1939, accrued on account of the said A and B debentures. The Commissioner disallowed such deductions on the grounds stated in his deficiency notice, which have already been set out herein.
OPINION.
We have but one issue to decide in this proceeding, *197 and that is whether the disbursements made by petitioner Green Bay & Western Railroad Co. in the taxable years 1937 and 1939 on its class A and class B debentures represented interest paid on indebtedness which it owed to the holders of these debentures and therefore were deductible under section 23 (b) of the applicable revenue acts, or whether these disbursements were, as the Commissioner contends, in the nature of dividends paid to the holders of these debentures who were not creditors of the corporation but whose interests represented by these debentures were proprietary, and therefore payments thereon not deductible as interest under section 23 (b). There is no dispute as to the correct amounts of these disbursements which petitioner accrued on its books during the respective taxable years. The only dispute is as to their deductibility.
The statutes and regulations involved are printed in the margin. 1
*198 *379 The question of whether a certain obligation is in reality capital stock or indebtedness and whether the increment therefrom is therefore a dividend or interest has often been the subject of tax litigation. The leading cases are collected and analyzed in Mertens, Law of Federal Income Taxation, vol. 4, sec. 26.10. The Seventh Circuit recently in Commissioner v. Meridian & Thirteenth Realty Co., 132 Fed. (2d) 182, enumerated the criteria named to aid in the determination as follows:
Fixed maturity; payment of dividends out of earnings only; cumulative dividends, participation in management; whether unpaid dividends bear interest; right to sue in case of default, and whether status is equal to, or inferior to that of regular corporate creditors; nomenclature used in the documents; intent of the parties.
In the instant case neither debentures A nor B had any fixed date of maturity. They were only payable upon the sale or reorganization of the Green Bay & Western Railroad Co. The dividends were payable out of earnings only and were not cumulative. There was no provision that the holders might sue in case there was a default. All payments*199 had to be declared by the board of directors and it is clear that these debentures were subordinate to all creditors, both secured and unsecured. The holders of class B debentures were even subordinate to stockholders, as will be plainly seen by a reading of the class B debentures. In view of these facts we think we must hold that class A and class B debentures did not represent indebtedness against the corporation, but represented proprietary interest in the corporation. It is true that the holders of these debentures had no vote and could not participate in the management of the company, but that is by no means uncommon to holders of proprietary interests. Many issues of preferred stock have no voting rights and not infrequently corporations chartered under the laws of some of the states issue certain classes of common stock which have no voting rights.
We think the facts of the instant case are no stronger for the taxpayer than were the facts in Commissioner v. Schmoll Fils Associated, Inc., 110 Fed. (2d) 611. In that case the corporation involved had issued nonmaturing debentures under a refinancing plan to former holders of cumulative preferred*200 stock, providing that 7 percent cumulative interest should be payable exclusively from profits until principal should be paid or debentures should be called for redemption; that common stock should not receive dividends until two years surplus for payment of debenture interest had been accumulated; and that debentures should be subordinated to rights of bank creditors. Under the facts the court held that the payments which Schmoll Fils Associated, Inc., made to the holders of these debentures were in substance "dividends" and not "interest on indebtedness" within the *380 meaning of the statute authorizing the deduction of interest. We think we must so hold in the instant case. Cf. Golden Belt Lumber Co., I. T. C. 741; Ticker Publishing Co., 46 B. T. A. 399.
Petitioner relies upon, among other cases, H. R. De Milt Co., 7 B. T. A. 7, and John Kelley Co., 1 T. C. 457, now on review by the Seventh Circuit. These cases we think are clearly distinguishable on their facts. In the De Milt case, while there are some points of similarity to the facts of the instant case, there are*201 others of very important differences. In the De Milt case the debentures had a definite date of maturity, whereas the debentures here have no definite date of maturity. In the De Milt case the 6 percent payable annually on the debentures was cumulative. Here the debentures expressly provide that the payments shall not be cumulative. In the De Milt case it was provided that all interest must be paid on the debentures before any dividends could be paid on the capital stock of the corporation. Here the provisions in the debentures with reference to the distribution of earnings to the debenture holders were very different from what they were in the De Milt case. These provisions are fully set out in our findings of fact and need not be repeated here. Suffice it to say that class A debentures and capital stock were entitled to receive distributions of earnings up to 5 percent when declared by the board of directors before the holders of class B debentures were entitled to receive anything. These facts which we have enumerated above we think serve to distinguish the De Milt case from the instant case.
In the case of John Kelley Co., supra,*202 another case strongly relied upon by petitioner, there were important points of difference from the facts of the instant case. In the Kelley case (1) there was a trust indenture setting forth the terms and conditions upon which the debenture bonds were issued and the power and duties of the trustees. Here there is no trust indenture. (2) There was a definite date of maturity. Here there is none. (3) The interest of 8 percent per annum was payable quarterly out of earnings, and did not have to be declared by the board of directors. Here all payments on the debentures must first be declared by the board of directors. (4) Remedy for default in payment of the interest was provided. Here no remedy for default is provided. (5) The debentures were to be subordinated to all creditors, but were to be paid ahead of stockholders. Here the debentures are subordinate to all creditors, but are not to be paid ahead of stockholders. Payments of the principal of class A debentures were to be paid pro rata with stockholders and class B debentures were not entitled to any payment on principal until all class A debentures and stockholders had been paid in full. The above enumerated*203 differences we think clearly distinguish the instant case from the Kelley case. Petitioner cites and urges other cases, but *381 it would unnecessarily prolong this opinion to discuss them all in detail. Suffice it to say that we think they are distinguishable on their facts.
For reasons stated above we sustain the Commissioner in his disallowance of the claimed deductions by petitioner in the years 1937 and 1939 of alleged interest on class A and class B debentures.
Decision will be entered for the respondent.
Footnotes
1. Revenue Act of 1936 and the Internal Revenue Code --
SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(b) Interest. -- All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from the taxes imposed by this title.
Regulations 94 and 101 --
Art. 23 (b)-1. -- Interest. -- * * *
* * * *
* * * So-called interest on preferred stock, which is in reality a dividend thereon, cannot be deducted in computing net income. * * *↩