*1093 In 1927, at a special directors' meeting of petitioner, it was voted that $500,000 of petitioner's surplus on hand prior to March 1, 1913, should be distributed to petitioner's stockholders, in such manner and at such times within three months as might by its officers be determined to the advantage of the company. No actual distribution in pursuance of this resolution took place in either money or property to the stockholders. Instead the corporation executed a note for $500,000, payable to certain trustees who had been selected by the stockholders, due one year from date and drawing interest at the rate of 6 percent per annum. None of the principal of the note has been paid. Thirty thousand dollars annually has been paid to the trustees and distributed by them to the stockholders and petitioner claims the payment is interest on its indebtedness deductible as such. Held, the $500,000 note represents legal indebtedness of the corporation and the $30,000 payments in question were interest payments on its indebtedness and are deductible from the corporation's income under section 23(b) of the Revenue Act of 1932.
*44 These proceedings have been consolidated by order of the Board. In Docket No. 82625 the Commissioner has determined a deficiency in petitioner's income tax for the year 1932 of $3,481.50. In Docket No. 82879 the Commissioner has determined a deficiency for the year 1933 of $3,911.87. The deficiency for each year results principally from the Commissioner's disallowance of a deduction of $30,000 which petitioner has claimed as interest paid in each of the years on its indebtedness.
The error assigned in each petition is common to both proceedings and is as follows: "Respondent erred in disallowing a deduction from gross income of petitioner of $30,000 interest paid by petitioner during the taxable year on its indebtedness." There were other minor adjustments which the Commissioner made in determining petitioner's net income for each of the taxable years, but these petitioner does not contest and they will therefore stand as made.
FINDINGS OF FACT.
The petitioner is a corporation, organized under the laws of the State of Alabama.
At a special meeting of the board of directors*1095 of petitioner, held May 26, 1927, the following proceedings were had:
After discussing at length the advisability of distributing among the stockholders a part of the surplus of the company which had been accumulated and acquired prior to March 1st, 1913, it was moved by J. T. Boyd, and seconded by John R. Miller, that the company distribute among its stockholders, in proportion to their stock in the company, the sum of five hundred thousand dollars ($500,000.00), in such manner and at such times, within the next three months, as might, by its officers be determined to the advantage of the company. This motion was unanimously passed and adopted.
*45 On motion of J. T. Boyd, seconded by John R. Miller, the President and Secretary of this company were authorized to borrow from its stockholders, or from the Trustees representing its stockholders, the amount so distributed to them, and to give its promissory note, or notes, therefor in such amounts and payable at such times, as might be deemed advantageous to, or to the best interests of the company, said notes to bear interest at a rate not exceeding six per cent. (6%) per annum. The President and Secretary were authorized*1096 to execute and deliver said notes for and as the act of this company, and in its name, and to affix thereto the corporate seal of the company.
Following this action taken at the special meeting of the board of directors, the stockholders of the corporation executed an agreement which, omitting signatures, reads as follows:
STATE OF ALABAMA,
ESCAMBIA COUNTY.
KNOW ALL MEN BY THESE PRESENTS:
That we, the undersigned stockholders of T. R. Miller Mill Co., Inc., do hereby constitute, appoint and make W. T. Neal, John R. Miller, J. T. Boyd, John R. Downing, David B. Miller and Ed. Leigh McMillan our lawful attorneys in fact and agents, to receive from the T. R. Miller Mill Co., Inc., for us, the Five Hundred Thousand Dollars ($500,000.00) which was authorized to be distributed by the Board of Directors of the said T. R. Miller Mill Co., Inc., at a meeting of said board of directors held on to-wit, the 26th day of May, 1927; and we do hereby authorize and direct the said T. R. Miller Mill Co., Inc., to pay over to our said attorneys in fact and agents the said Five Hundred Thousand Dollars ($500,000.00) as authorized and directed to be distributed to the undersigned stockholders.
*1097 BE IT FURTHER KNOWN, that we, the undersigned, do hereby constitute, appoint and make the said W. T. Neal, John R. Miller, J. T. Boyd, John R. Downing. David B. Miller and Ed. Leigh McMillan our trustees to handle the distribution so received by them.
BE IT FURTHER KNOWN, that we do hereby authorize and direct our said trustees to lend or advance to the T. R. Miller Mill Co., Inc., the amount so received by them for us, to-wit, the sum of Five Hundred Thousand Dollars ($500,000.00), and to take a note, or notes, of the said T. R. Miller Mill Co., Inc., for said amount, the same to bear interest at the rate of six per cent. (6%) per annum, said interest payable semiannually.
We further authorize and instruct our said trustees, at any time that it may appear to them to be to our best interests, to return to the said T. R. Miller Mill Co., Inc., or its successors or assigns, the said sum of Five Hundred Thousand Dollars ($500,000.00) so received and held by said trustees for us, said money to be paid to the T. R. Miller Mill Co., Inc., and applied in such way as it may appear to the said trustees to be to the best interests of the undersigned.
It is agreed and understood that*1098 the said Trustees herein named shall have the right, power and authority to mortgage, transfer, assign and hypothecate, for the use and benefit of the T. R. Miller Mill Co., Inc., the said distribution of Five Hundred Thousand Dollars ($500,000.00), or any part thereof; or to transfer, assign or hypothecate the note or notes securing or evidencing said distribution (the distribution in this paragraph referred to being the distribution which has been made to the undersigned stockholders by said T. R. Miller Mill Co., Inc., as hereinabove stated).
*46 The trustees herein named are instructed and authorized to collect from said T. R. Miller Mill Co., Inc., any interest due on any indebtedness arising in any way from said distribution, which said interest so collected shall be paid over to the undersigned stockholders in proportion to the amount of stock owned by them in the T. R. Miller Mill Co., Inc.
All amounts in cash coming into the hands of said trustees and arising from, or connected with, the trust herein created, or the trust fund administered, and not in the judgment of said trustees needed by the said T. R. Miller Mill Co., Inc., shall be distributed among the undersigned*1099 stockholders in the same proportion as the stock of the said T. R. Miller Mill Co., Inc., is owned by us, the undersigned stockholders.
No actual distribution of either cash or property was made to the corporation's stockholders as a result of the action taken at the special directors' meeting above referred to. None was made to the trustees named in the foregoing instrument. A note for $500,000 was executed by the corporation, payable to W. T. Neal, John R. Miller, J. T. Boyd, John R. Downing, David B. Miller, and Ed. Leigh McMillan, as trustees. This note, omitting signatures, is in words and figures as follows:
$500,000.
One Year after date, the undersigned, of Brewton, Ala., promise to pay to the order of W. T. Neal, Jno. R. Miller, J. T. Boyd, John R. Downing, David B. Miller and Ed. Leigh McMillan, as Trustees, at the office of CITIZENS BANK, BREWTON, ALABAMA, the sum of Five Hundred Thousand Dollars, for value received, with interest thereon from the 26th day of May, 1927, at the rate of 6 per centum. Said interest payable semi-annually.
The parties to this instrument whether maker, endorser, surety or guarantor, each for himself, hereby severally waive as*1100 to this debt, or any renewal thereof, all rights of exemption under the Constitution and Laws of Alabama, or of any other State, as to personal property and they each severally agree to pay all costs of collecting or securing or attempting to collect or secure this note, including a reasonable attorney's fee, whether the same be collected or secured by or any [sic.] attorney consulted with reference to suit or otherwise. And each maker, endorser, surety and guarantor of this note severally waives demand, presentment, protest, notice of protest, suit and all other requirements necessary to hold them, or any of them, and they severally agree that time of payment may be extended or renewal note taken or other indulgence granted without notice of or consent to such action, without releases of liability as to any such party. The bank at which this note is payable is hereby authorized to apply, on or after maturity, to the payment of this debt, any funds or credit held by said bank, on deposit, in trust, or otherwise for account of the maker, endorser, surety, guarantor, or any one of them, but shall not be required to make such application unless it shall so elect, nor be liable*1101 for any failure or omission in respect thereof. This note may be declared due and payable with interest computed or abated to date at any time by notation hereon by the holder in the event of the death, insolvency of, general assignment by, judgment against or petition in bankruptcy by or against any such party liable hereunder.
Witness its hand and seal this 26th day of May, 1927.
After the execution of the note, whenever stockholders transferred or assigned their stock they transferred and assigned at the same time *47 any interest that they might own "in and to that certain $500,000 note of the T. R. Miller Mill Co., Inc., payable to John R. Downing and others, Trustees, dated the 26th day of May, 1927."
Nothing has ever been paid on the principal of this note. Each year the corporation has paid to the trustees the sum of $30,000 for distribution to the stockholders, claiming that it is in payment of the annual interest due on said note, and has claimed it as a deduction from gross income as interest paid on its indebtedness. For the first few years the Commissioner allowed the deduction, but in the two taxable years before us, he has disallowed it. The grounds*1102 for such disallowance are stated in the statement accompanying the deficiency notice for the year 1933, as follows:
Explanation of Changes.
The interest deduction of $30,000 represents 6 per cent on $500,000 of the surplus of your corporation which was transferred to notes payable May 26, 1927. This amount is considered to be a distribution of earnings in accordance with Article 621 of Regulations 77, and is not an allowable deduction for income tax purposes.
At the time the resolution was adopted at the special directors' meeting, May 26, 1927, providing that "the company distribute among its stockholders, in proportion to their stock in the company, the sum of five hundred thousand dollars ($500,000) in such manner and at such times, within the next three months, as might, by its officers be determined to the advantage of the company", there was no intention to presently distribute to the stockholders of petitioner, either in money or other property, the sum of $500,000. When the note for $500,000 was executed following the resolutions adopted at the special directors' meeting, there was no intention on the part of the corporation to pay the note within one year from the*1103 date thereof as provided in the note, and it was so understood by the stockholders of the corporation and their designated trustees. It has not been shown when the corporation intends to pay the note and it still remains an outstanding legal obligation against petitioner. The note in question was executed by the corporation in discharge of its dividend obligation to its stockholders created by the resolution of May 26, 1927, and represents a legal indebtedness of petitioner to the designated trustees for the benefit of stockholders. The note, although it bears date of May 26, 1927, was not executed until some time thereafter during 1927.
OPINION.
BLACK: As has already been pointed out, there is only one issue in these proceedings and that is whether $30,000 paid by petitioner to trustees for the benefit of its stockholders in each of the taxable years represents interest paid on its indebtedness.
*48 The facts have been set out fully above and need not be repeated in this opinion. Respondent contends that the payments were not interest, but constituted dividends under article 621 of Regulations 77, applicable to these proceedings.
If petitioner is entitled to*1104 the deductions claimed, it is by reason of section 23(b) of the Revenue Act of 1932, which reads in part as follows:
In computing net income there shall be allowed as deductions:
* * *
(b) INTEREST. - All interest paid or accrued within the taxable year on indebtedness, * * *
Article 621 of Regulations 77, which respondent relies upon in his determination that the payments in question were dividends and not interest, reads in part as follows:
ART. 621. Dividends. - The term "dividends" for the purpose of Title I (except when used in sections 203(a)(4) and 208(c)(1)) comprises any distribution in the ordinary course of business, even though extraordinary in amount, made by a domestic or foreign corporation to its shareholders out of its earnings or profits accumulated since February 28, 1913.
* * *
* * * A taxable distribution made by a corporation to its shareholders shall be included in the gross income of the distributees when the cash or other property is unqualifiedly made subject to their demands.
It seems clear from the evidence in this case that at the time of the corporate resolution of May 26, 1927, the corporation did not, despite the language used*1105 in the resolution, intend to presently distribute, in money or other property, $500,000 of its surplus to its stockholders. The corporation was a closed one, all of its stock being owned and held by the members of a few families, and it had been agreed upon that instead of actually distributing $500,000 in money or other property to the stockholders, the corporation would execute its promissory note for that amount, payable to designated trustees for the benefit of stockholders, the note to be due one year from date and to draw interest from date at the rate of 6 percent per annum. Does this arrangement make the distribution provided for in the resolution any less a dividend? We think not.
The declaration of a dividend creates the relationship of debtor and creditor between a corporation and its stockholders. ; affd., . Though a dividend is payable upon a day not yet appointed, or at such time as in the opinion of the directors the corporation's finances justify such payment, nevertheless the debtor-creditor relation arises upon the date of declaration. *1106 ; ; and ; .
*49 We are not concerned here with the question as to whether or not the dividend distribution was a taxable one. The resolution declared that the distribution was to be out of surplus accumulated prior to March 1, 1913. Whether or not that was done in such a manner as to make the dividend nontaxable to the stockholders we do not in any manner decide. What we do decide is that the resolution of May 26, 1927, called for a dividend distribution and its effect was not changed by payment in the form of a promissory note, payable to trustees selected by the stockholders, drawing interest from date, instead of payment being made in cash or other property.
We see no essential difference in this method of payment from that which obtains when a corporation declares and pays a scrip dividend. Dividends paid in scrip have been ruled to be equivalent to a payment in cash and an investment of the cash in the scrip. See Paul and Mertens, vol. 1, sec. 8.68. Scrip*1107 dividends were held taxable under the Act of June 30, 1864, . The regulations of the Treasury Department applicable to the present proceedings provide for the taxation of scrip dividends. Article 627 of Regulations 77 provides, among other things: "Scrip dividends are subject to tax in the year in which the warrants are issued." What is a scrip dividend? Fletcher's Cyclopedia Corporations, vol. II, sec. 5357, defines a scrip dividend as follows:
* * * Scrip is simply a writing or certificate issued to shareholders in lieu of a dividend, entitling them to money, stock, bonds, land, or other benefit at some future time - "an interim or provisional document or certificate, to be exchanged, when certain payments have been made or conditions complied with, for a more formal certificate, as of shares or bonds, or entitling the holder to the payment of interest, a dividend, or the like." "A scrip dividend is resorted to where the company has profits not in cash."
The issuing of a bond or scrip dividend by a corporation to represent an investment of bona fide profits is not prohibited by a statute requiring*1108 dividends to be made only from surplus profits of the corporation, and providing that it shall not be lawful for corporations to divide or pay to stockholders any part of the capital, or to reduce the capital stock. Nor is such a dividend contrary to public policy. The rights of the holder of scrip depend upon the terms of his contract as therein expressed. Such a dividend, when the obligation to pay is absolute, is a debt due absolutely to the stockholders, although payment is postponed to a future time.
To warrant the recovery of interest therein provided for, it must be shown that the dividend was legally declared.
Although the note for $500,000 payable to trustees which was executed in payment of the dividend declared pursuant to the resolution of May 26, 1927, was made payable one year from date, the evidence shows that it was not intended to pay the note on the date due. We do not think that fact however renders the note any the less a legal obligation of the corporation. The note on its face represents an unconditional *50 promise to pay and the fact that the stockholders and the corporation were willing to agree upon a longer term of payment than the note*1109 itself provided, we do not think changes the character of the obligation and makes it any the less the legal indebtedness of the corporation.
Ed. Leigh McMillan, who was one of the witnesses for petitioner in these proceedings and was its secretary, was asked the following question by petitioner's counsel: "Mr. McMillan, Mr. Neal has just been asked whether it was ever intended to pay this note or not. What is the fact on that question?" McMillan's answer was: "The note was to be paid. The note was an obligation of the company as much as any obligation, and just how it was to be paid and when, I could not say that, but it was an obligation of the company and it was to be paid at some time."
If we had the stockholders before us in these proceedings on the question as to whether the dividend distribution was taxable in 1927 (leaving aside the question that the distribution was made out of earnings accumulated prior to March 1, 1913), we do not think it would avail them anything as a defense to say that the note, although unconditional in its obligation to pay, was not to be paid on the date stated therein. The fact that the note bore interest from date and interest thereon was*1110 actually paid and extensions of time were apparently made by mutual consent between the corporation and its stockholders, would render unimportant, we think, the factor of time extensions in payment.
We think the facts of the instant proceedings serve to distinguish them from the holdings in , and . In these cases the question at issue was whether a cash dividend had been declared and paid, as the Government contended, or whether the transactions as a whole showed the declaration and payment of stock dividends. The decision of the court was that, as to the taxpayers involved before it, the transactions amounted to the payment of a stock dividend and were not taxable.
We have in these proceedings no question of the declaration and payment of a stock dividend. Our question here is raised by the Commissioner's contention that, under the circumstances related in our findings of fact, no dividend at all was declared and no distribution of surplus was made or intended to be made, and therefore the promissory note of $500,000 did not represent legal indebtedness*1111 of the corporation. On this issue we hold against the Commissioner. A contrary view was expressed by the presiding member at the conclusion of the hearing, but this view has been changed upon review by the full Board.
*51 As we have already pointed out, we see no distinction in principle between the form of payment in the instant case and the ordinary scrip dividend, and the Treasury's own regulations provide for the taxation of scrip dividends and for the allowance to the corporation of interest paid thereon.
Reviewed by the Board.
Decision will be entered under Rule 50.
LEECH, dissenting: The necessary premise of the majority opinion is that petitioner paid dividends to its stockholders in the amount of the corporate note. The argument to sustain that position is that the note was similar to "scrip", that a corporate debt was thus created and the contested interest paid thereon was therefore deductible.
The fallacy in that argument seems to me to be that such note was not similar to "scrip." It was drawn to trustees. The petitioner, not the stockholders, was the real beneficiary of the trust. The only interest the stockholders received*1112 in the proceeds of the note was the right to a proportionate distribution of any such proceeds which were "not in the judgment of said trustees needed by the said T. R. Miller Mill Co., Inc." (Emphasis supplied.) And such rights as the stockholders had in the notes could be wiped out at any time at the discretion of the trustees since they had the "right, power and authority to mortgage, transfer, assign and hypothecate, for the use and benefit of T. R. Miller Mill Co., Inc., the said distribution of Five Hundred Thousand Dollars ($500,000.00), or any part thereof; or to transfer, assign or hypothecate the note or notes securing or evidencing such distribution * * *."
Even had this so-called distribution of $500,000 been made in cash to such a trust, could it be reasonably held that the petitioner thus actually paid or the stockholders really received anything?
In such circumstances, I think no dividend was paid, no corporate debt existed, and no interest thereon is therefore deductible.