*1414 Petitioner was incorporated in 1916, all of its capital stock (except for qualifying shares) being issued to the Foutana Co. and the Fontana Water Co., from which companies it acquired title to property necessary to the operation of its business. By contract it agreed to pay these companies an amount equal to the difference between the value of the stock and the value of the property, to be later determined, and pending such determination to pay to them all of its net profits. Later the Fontana Water Co. acquired from the Fontana Co. all of its stock and rights under this contract. The value of the property was never determined and the petitioner has continued to pay to the Water Co. all of its net profits. Held, that such payments during taxable years of 1935, 1936, and 1937 were distributions in the nature of dividends.
*1090 This proceeding involves income and excess profits tax liability for the years 1935, 1936, and 1937. The Commissioner determined deficiencies in income tax in the amounts of $2,536.66, $1,758.22, *1415 and $3,130.50, respectively, for those years; and deficiencies in excess profits tax in the amount of $922.42,$189.87, and $2,787.58, respectively. The petitioner seeks a redetermination of those deficiencies. The question presented is whether petitioner may deduct from its gross income certain payments made by it to its sole stockholder, which amounts petitioner asserts were payments of interest and respondent asserts were distributions in the nature of dividends.
FINDINGS OF FACT.
The parties have fully stipulated the facts in this proceeding, and, as stipulated, we have adopted those facts, which are materially as follows:
The Fontana Power Co., petitioner herein, was incorporated under the laws of the State of California on or about April 3, 1916, and at all times since has functioned as a public utility corporation, subject to the jurisdiction of and regulation by the Railroad Commission of the State of California. Its principal place of business is at Fontana, California.
The Fontana Union Water Co., hereinafter called the Water Co., was incorporated in 1912 under the laws of the State of California as a mutual water company for the irrigation of farm lands in the*1416 vicinity of the town of Fontana. The Water Co. has been held by the Bureau *1091 of Internal Revenue to be exempt under section 101 of the Revenue Acts of 1934 and 1936 from income and capital stock taxation.
The Fontana Co. was incorporated under California law prior to petitioner, and continued to be so incorporated until it was dissolved in 1927.
A.B.Miller was president of all three corporations.
Prior to August 9, 1916, the petitioner made application to the Railroad Commission of California for a certificate that public convenience and necessity require the construction of an electrical power plant and system near the town of Rialto; and for leave, inter alia, to execute a mortgage on its properties and to issue thereunder $350,000 face value of first mortgage 6 percent bonds, and for leave to acquire from the Water Co. and the Fontana Co. certain properties and property rights. Thereafter, prior to October 10, 1916, petitioner filed with the commission a supplemental application reciting that it appeared impossible at that time to prepare and submit to the commission data sufficient to enable the commission to fix the value and approve the purchase price*1417 of the properties proposed to be conveyed by the Water Co. and the Fontana Co. to petitioner. The application stated that petitioner had an option to purchase certain steel required for use in construction of its proposed pressure pipes, which option would expire October 6, 1916, after which time the price of steel would be considerably higher due to the wartime market. In order to prevent the loss of this steel contract and allow further time in which to prepare data for the commission respecting the fixing of the value and approval of the purchase price of the properties, it was proposed to enter into an agreement providing for the immediate conveyance of the properties to petitioner for the consideration of: (1) 100 shares of capital stock in the petitioner corporation; (2) petitioner's covenant to pay the Water Co. and the Fontana Co. the difference between the value of the 100 shares and the value of the properties so to be conveyed as soon as the value and the method of payment could be agreed upon between the three corporations and approved by the commission; and, (3) the further covenant of petitioner that, pending the fixing of the value and making of payment, the petitioner, *1418 from time to time, would pay over to the Water Co. and the Fontana Co. all its earnings remaining after paying or providing for payment of its operating expenses, taxes, and interest and all obligations it might have incurred or for which it might have become responsible.
Thereafter, on October 10, 1916, the Railroad Commission of California made and rendered its decision granting petitioner authority to issue the 100 shares of capital stock of the par value of $100 per share as part payment to the Water Co. and the Fontana Co. for a powerhouse site and certain property rights and to issue the $350,000 *1092 of its first mortgage 6 percent bonds upon certain conditions, and granting authority to petitioner to enter into the proposed contract with the Water Co. and the Fontana Co. on the proposed terms, conditioned upon the approval by the commission of a copy of the contract to be thereafter filed by petitioner. The commission also declared that public convenience and necessity required the construction by petitioner of the proposed hydroelectric power plant and system.
Thereafter, on January 30, 1917, the Railroad Commission of California issued a supplemental order approving*1419 the mortgage and trust deed, which approval was the condition precedent to the issuance of the mortgage bonds. The supplemental order recited that the $350,000 6 percent mortgage bonds were to be secured by a mortgage upon all the property then owned or thereafter to be acquired by petitioner.
On February 6, 1917, the Railroad Commission of California issued a second supplemental order, reapproving the mortgage and trust deed in slightly amended forms. Thereafter, on June 6, 1917, the commission, by its third supplemental order, authorized petitioner to enter into a contract with the Water Co. and the Fontana Co. substantially in the form of the contract as filed with the commission on February 23, 1917, which contract has heretofore been set out in substance.
Thereafter, on June 15, 1917, petitioner entered into the contract with the Water Co. and the Fontana Co. and the latter two corporations conveyed the properties and rights to the petitioner. Pursuant to the commission's order petitioner also executed the trust indenture, and bonds of petitioner in the amount of $350,000 were issued and sold under the indenture, and the proceeds were used in the development of petitioner's*1420 property. The properties and rights acquired from the Water Co. and the Fontana Co. were leased by petitioner to the Southern California Edison Co. for 30 years, commencing July 1, 1917, and were mortgaged by petitioner under the trust indenture to secure its bond issue.
When petitioner was incorporated, 5 qualifying shares were issued. Thereafter, pursuant to the commission's order authorizing the contractual agreement with the Water Co. and the Fontana Co., petitioner issued to the Fontana Co. 50 shares of stock and a like number to the Water Co. In 1927 the Water Co. acquired the 50 shares originally issued to the Fontana Co., and also acquired all interests and rights originally acquired and owned by the Fontana Co. under the agreement; and at all times since the Water Co. has been, and still is, the owner of the 100 shares of stock and of all rights originally acquired by the Fontana Co. and the Water Co. in and under the agreement. These 105 shares of stock are the only shares of petitioner corporation which have ever been issued.
*1093 During the year 1937 the Water Co. and the petitioner executed an agreement for the purpose of construing and resolving the*1421 meaning of certain provisions of the original agreement. By this 1937 agreement petitioner was allowed to deduct from its gross income, when calculating net income for purposes of the original agreement, all charges for discount of its outstanding bonds and any expense in connection therewith. By order of October 25, 1937, the Railroad Commission of California approved this interpretation of the agreement.
During the year 1917, petitioner constructed the proposed hydroelectric plant on the powerhouse site, and also constructed pipe lines along the right of way conveyed to it by the Water Co. and the Fontana Co. Aside from income arising out of its business, petitioner never acquired any property of substantial value other than that conveyed to it by the deeds from the Water Co. and the Fontana Co., and the improvements acquired with the proceeds from the sale of the bonds.
Commencing July 1, 1917, and at all times since its construction, the plant has been operated by the Edison Co. under the lease whereby petitioner reserved and receives electricity generated in said plant for supplying its customers, and the Edison Co. pays a rental determined by and based upon the excess*1422 power generated in the hydroelectric plant. At all times since the plant's erection the only business of petitioner has consisted of supplying its customers in the Fontana territory with electric power, either generated at its plant, or, in the case of a deficiency for its requirements, purchased and received by petitioner from the Edison Co.
The amounts claimed by petitioner as deductions from gross income, which amounts were disallowed by respondent (being $18,262.39, $16,244.55, and $27,000 for the years 1935, 1936, and 1937, respectively), were paid by petitioner to Water Co. pursuant to that provision of the agreement between the corporations calling for the payment of all annual net income.
The value of the properties and rights conveyed to petitioner by the Water Co. and the Fontana Co. has not yet been fixed, and the method of payment of the remainder of the purchase price thereof has not yet been determined, and, since the commencement of petitioner's operations in 1917, all of its net income in excess of operating and other expenses and an 8 percent dividend on its outstanding capital stock has been paid to the Water Co. and the Fontana Co., pursuant to the agreement*1423 between the three corporations.
No orders have been issued by the Railroad Commission of California bearing on the valuation of the properties conveyed to petitioner or bearing on the agreement between the three corporations or the lease to the Southern California Edison Co. or the trust indenture *1094 or the bonds issued thereunder other than the orders mentioned above.
No attempt has at any time been made by petitioner to fix the value of the properties conveyed to it or to secure the approval of the Railroad Commission of California to the fixing of that value other than the mention of the value of $349,500 in the amended application of petitioner to the commission in October 1916. Petitioner has never made any of the payments provided for in the agreement other than to issue the 100 shares of stock and the payments of income, as per agreement, as set out above.
In its annual reports to the Railroad Commission of California and in its Federal tax returns from 1917 to date, petitioner has deducted from its gross income the payments made by it pursuant to the agreement with the Water Co. and the Fontana Co.
OPINION.
KERN: In the original petition filed with*1424 this Board the taxpayer claimed that the amounts paid to the Water Co. under the agreement were deductible as "rentals or other payments" within the meaning of section 23(a) of the Revenue Acts of 1934 and 1936. Petitioner has apparently abandoned that theory, and properly so, inasmuch as title to the properties conveyed was passed to the taxpayer, whereas section 23(a) applies only to properties to which the taxpayer has not or is not taking title or in which he has no equity. Petitioner, however, does assert that the payments to the Water Co. should be considered as analogous to the payments of Maryland and Pennsylvania ground rents, which, if the ground rent is irredeemable, should be deductible to the extent they constitute a proper business expense pursuant to the general language of section 23(a) and without regard to the specific clause having to do with rentals. This ingenious argument is without validity. The contract does not call for the payment of ground rents. It provides for a method by which a purchase price for the property granted to petitioner may at some future time be determined if the parties should choose to do so, and, pending such determination, provides*1425 for payment to the grantors, who held all of petitioner's stock (with the exception of qualifying shares), of all of petitioner's net earnings. We are not disposed to construe such a contract, executed in California by California corporations and having as its subject matter California real estate, in a way which introduces into that commonwealth the feudal relics of real property law which have happened to survive because of historical reasons in the two states of Pennsylvania and Maryland. We are equally unwilling to draw analogies in any interpretation of the revenue laws from "distinctions spun out of the tenuosities of surviving feudal law", to use a phrase of Mr. Justice Frankfurter in his opinion in .
*1095 By amendment to his original petition, the taxpayer now makes the further claim that the amounts in controversy are deductible as interest payments by virtue of section 23(b). It appears from the stipulation filed in this proceeding that the Water Co. has been held by the Bureau of Internal Revenue to be exempt under section 101 of the Revenue Acts of 1934 and 1936 from income and capital stock taxation, but*1426 petitioner has not claimed exemption under section 101(14); nor could such a claim be sustained had it been advanced. The issue before us is whether the disputed payments must be called interest payments or distribution of profits in the nature of dividends.
Both parties to this proceeding have cited numerous cases in their briefs in support of their respective contentions. The cited cases do not lay down any comprehensive rule which may be applied in all cases; and in each proceeding of this nature it must be determined on the facts presented whether the real transaction was that of an investment in the corporation or a loan to it. ; affd., . On this question the designation of the instrument and the terms therein incorporated, while not to be ignored, are not conclusive. . The real intent of the parties is to be ferreted out and for this latter purpose evidence aliunde the contract is admissible. *1427 In a majority of the cases of this nature which have come before this Board the instrument issued by the corporation has been some form of stock certificate. In the instant proceeding the provision for payment of petitiqner's earnings to the Water Co. is not found on the capital stock certificates, but in the same agreement under which petitioner issued the 100 shares of capital stock to the Water Co.
The Water Co. advanced properties and property rights to the petitioner. It was not money which was advanced, but assets which had a monetary value. Had the Water Co. wanted to treat the transaction merely as a loan, with a definite annual income, in the nature of interest, from the transaction, it could have demanded a certain fixed payment from the petitioner each year until a certain fixed date, when the principal should become unconditionally due. The value of the properties transferred was, however, not agreed upon at the time of the transaction.
Let us look at petitioner's condition at the time of the transaction. It had a charter and an option to purchase certain piping, but these appear to have been its sole assets. It was*1428 desirous of securing a franchise and for this purpose needed the assets which the Water Co. transferred pursuant to the agreement in question. It, in turn, borrowed from the bank in order to purchase and erect the building, pipe lines, etc., on the properties, and, in exchange for this loan, issued $350,000 worth of 6 percent first mortgage bonds. The bonds were specifically secured by all the interest of petitioner in and to any of *1096 its properties held at that time, or property interests to be acquired in the future, including the benefits to be received from a 30-year lease which petitioner made with the Edison Co., under which all its properties were turned over for that term to the Edison Co.
The basic transaction was the one between the Fontana Co. and Water Co. and petitioner. Unless petitioner could have acquired some assets to start with, it would not have been able to carry out either of the other two transactions. The president and treasurer of the Water Co. and the Fontana Co. had become the president and treasurer of petitioner. To say that all three corporations were on friendly terms would be a gross understatement. The central management thought of*1429 the newly formed corporation merely as another source of profit. By the issuance of the 100 shares of capital stock (the entire issue except for the qualifying shares), the other two corporations secured control over petitioner's profits and were assured of an 8 percent annual dividend on the stock. No amount equivalent to the value of the properties transferred could have been paid in cash by petitioner at that time, inasmuch as it had neither cash nor unpledged assets; nor could it ever be paid in the future if the Water Co. held petitioner to the terms of the agreement, because so long as the annual net income had to be paid over to the Water Co. the petitioner never could amass cash or free assets with which to repay the Water Co. at any time for the properties transferred. If there were no profits in any year, then the Water Co. and the Fontana Co. would get nothing. If the profits were enormous, then the Water Co. and the Fontana Co. would get them all. The Water Co. chose to gamble. The mere fact that the aggregate net income paid over to the Water Co. approximates in amount legal interest on the unpaid balance of a loan estimated at $350,000 is merely coincidental. The*1430 transaction was strictly an investment from 1916 up to and including the taxable years.
As we said in ; affd., :
* * * a creditor is one who has loaned money or its equivalent to his debtor, the contract giving the creditor not only the unconditional right to demand payment of the principal sum at a definite maturity date, but usually, also, the right to demand, and receive, compensation for its use or retention, i.e., interest. A stockholder, on the other hand, is one who risks his money in an enterprise, participates in its profits and management, shares its losses, and is entitled to receive an aliquot portion of its assets in the event of liquidation. ; ; affd., .
It may be true that the agreement of 1916 indicated a possibility of the dreation of a debtor-creditor relationship and the method to be followed if such a relationship were to be created in the future, but the mere existence of this possibility, which*1431 was never fulfilled, *1097 can not affect our conclusion that, in reality, during the years in question the relationship of the Water Co. to petitioner was that of an investor and not that of a creditor.
Certain other factors lend further weight to this conclusion. From the facts it appears that in all the years from 1917 until the present time there was no attempt made to agree on a valuation of the properties and thus carry out that clause of the agreement and the order of the Railroad Commission of California which provided for payment of principal. We must assume that the reason for this was that, since the Water Co. during the years in question was the sole stockholder, that company and the petitioner were satisfied with an arrangement whereby all the profits went to the Water Co. under the agreement, and were not interested in creating any debtor-creditor relationship.
That part of petitioner's argument to the effect that the annual payments by petitioner were payments of interest which is based upon a supposed analogy to Pennsylvania and Maryland ground rents is no more convincing than its argument based on the same analogy to the effect that these payments were*1432 ordinary and necessary business expenses, the fallacy of which we have already discussed.
Neither are we impressed by petitioner's argument that the payments involved here, made by petitioner to its stockholders for so many years, can not be considered as distributions in the nature of dividends because (1) they were made pursuant to a contract and not pursuant to the rights of the payees as stockholders, and (2) the distributions consisted of the net earnings and not the surplus profits technically available for dividends. We are persuaded that the contract was executed and the distributions were made for so many years pursuant thereto because the Fontana Co. and/or the Water Co. were the holders of all of the stock of petitioner (except qualifying shares). It was because of this latter fact that the arrangement proved so permanently satisfactory to petitioner's controlling stockholders, and if we are to recognize the realities we must conclude that the ultimate reason for the distributions made to the Fontana Co. and/or the Water Co. was because, for all practical purposes, they were the sole stockholders of petitioner. As to them, by the peculiar arrangement present in this*1433 proceeding, it made little difference whether the distribution consisted of petitioner's net earnings or surplus profits. By the contract which they imposed on their wholly owned subsidiary they were entitled to the former. Without the contract they would have been entitled to the latter. The amount to be received by them would be the same. The practical effect of the transactions was to distribute an amount equivalent to the net profits of petitioner to its stockholders.
*1098 We conclude that the payments made by petitioner to the Water Co. according to the agreement in the taxable years were distributions in the nature of dividends, and, accordingly, were not payments of interest, or ordinary and necessary business expenses.
Decision will be entered for the respondent.