*2533 1. Amounts paid by the petitioner in its fiscal years ended January 31, 1920, 1921, and 1922, to former creditors whose claims had been discharged by composition in 1915, held not to be ordinary and necessary expenses of its business, nor deductible from the income of those years.
2. Interest-bearing promissory notes of solvent and responsible makers, actually and bona fide paid in for stock of a Texas corporation, constitute invested capital of such corporation at the time paid in to the extent of their actual fair market value.
3. Where a tax return for the fiscal year ended January 31, 1921, wherein the tax liability was computed under the Revenue Act of 1918, was filed April 14, 1921, and a return indicating an increased tax under the Revenue Act of 1921 was filed on or about April 12, 1922, held that the statute of limitation began to run on April 12, 1922, and not from the date of filing the first return.
*705 This petition is for the redetermination of deficiencies asserted by the Commissioner for the*2534 fiscal years ended January 31 in each of the following years: 1920, $12,316.63; 1921, $13,941.47; 1922, $6,925.80; in the total amount of $33,183.90.
Three deficiency letters were mailed by the Commissioner and within 60 days from the date of each letter the petitioner filed separate *706 appeals with the Board. On motion of the respondent granted by the Board on March 13, 1928, these appeals were consolidated for hearing and determination. The Commissioner denied petitioner's application for assessment of its profits tax under the provisions of section 328 of the Revenue Acts of 1918 and 1921, for the years 1920 and 1921, and this is assigned as error. On May 9, 1928, the Board granted a motion filed by the respondent to limit the hearing in the first instance to the issues defined in subdivisions (a) and (b) of Rule 62 of the Board's rules of practice. In addition to the error in respect of special assessment, the petitioner makes five allegations of error, as follows:
(1) In disallowing as ordinary and necessary expenses, certain payments made to former creditors on debts which had been fully liquidated by compromise;
(2) In disallowing as invested capital certain*2535 notes in the amount of $100,750, paid in on June 1, 1920, for capital stock. In the alternative and in the nature of a claim for affirmative relief, the petitioner asserts that if such notes so paid in are not includable at their fair value in 1920 invested capital, interest received on such notes and included in the taxpayer's taxable net income for its 1921 fiscal year, is not in fact income taxable to the petitioner, but should be considered as a sum paid in to it to apply upon the purchase price of the stock;
(3) In issuing his letter mailed February 12, 1926, asserting a deficiency in tax for the fiscal year ended January 31, 1921, after the expiration of the statutory period in which, it is claimed, assessment may be made, had expired prior to the date of mailing of said letter;
(4) In disallowing depreciation of $1,812.99 on a "balconade" constructed by the petitioner in 1920; and
(5) In excluding from surplus on January 31, 1920, a dividend duly declared but unpaid at that date and included in the petitioner's balance sheet among its "Accounts Payable."
FINDINGS OF FACT.
Some of the issues have been determined by stipulation and there is no material dispute concerning*2536 the others, except that the respondent denies all allegations of error. Therefore, we find the facts substantially in accordance with the claims of the petitioner, to be that the petitioner is a Texas corporation with its principal office at Main and Akard Streets, Dallas. Petitioner carries on a retail business generally known as a "Department Store," handling, at retail only, women's and children's suits, dresses, coats, and accessories, dress goods by the yard, shoes, millinery, household and table linens, *707 underwear and such similar articles as are usually found in stores of that kind.
During the fiscal years ended January 31, 1920, January 31, 1921, and January 31, 1922, the petitioner kept its books on the accrual basis of accounting and made its tax returns upon such basis.
During 1915 petitioner became seriously involved financially. The company had difficulty in meeting the demands of its creditors and the demands of the banks. At that time the claims of the creditors, exclusive of bank claims, amounted to about $131,000. In order to save the situation and avoid bankruptcy, the petitioner entered into a composition agreement in April, 1915, with all creditors*2537 except the banks. Under this composition agreement, the creditors agreed to accept about 50 cents on the dollar. In other words, the petitioner paid the creditors about $65,000 and the creditors in turn relinquished their claims for about $65,000.
When the petitioner made out its income-tax return for the fiscal year ended January 31, 1916, the amount of the claims relinquished by the creditors of about $65,000 was reported for tax purposes and a Federal income tax was paid thereon.
It soon developed that the composition agreement made in April, 1915, was affecting adversely the business of the petitioner. The credit of the petitioner was practically destroyed. The petitioner had considerable difficulty in securing loans. A number of houses refused to sell merchandise to it, even on a cash basis. Profits were reduced materially because of the credit situation and the adverse market situation resulting from the composition agreement.
During the period 1917 to 1920 the following amounts were paid for moving picture tickets which were given to purchasers of merchandise who made payments within a certain length of time after the date of purchase:
| 1917 | $10,316 |
| 1918 | 15,526 |
| 1919 | 27,446 |
| 1920 | 41,457 |
*2538 As a result of consulation held with the bankers, it was decided that the only way the petitioner could relieve the adverse situation, resulting from the 1915 composition agreement, was for it voluntarily to pay the amounts which had been relinquished by its former creditors. Petitioner announced that it intended to pay voluntarily from time to time, as circumstances permitted, the balance of the creditors' claims which had been compromised.
During the fiscal year ended January 31, 1920, an amount of $31,196.10 was paid to the former creditors. During the fiscal year ended January 31, 1921, an amount of $15,481.37 was voluntarily *708 paid to such creditors, and the amount of $15,241.17 was paid to them during the fiscal year ended January 31, 1922.
The announcement that the petitioner expected voluntarily to pay its former creditors immediately restored its credit. Up to that date the petitioner's rating in Dun and Bradstreet had been a negative one. Immediately after the announcement of payment to the creditors, petitioner was given a first-grade rating.
The voluntary payment to creditors at once reduced the cost of doing business, because the petitioner was*2539 enabled to discontinue the purchase of moving picture tickets, which had varied between $17,000 and $40,000 a year; and because it was able to borrow money at a lower rate of interest and take advantage of discounts on purchases. These payments also enabled petitioner to buy merchandise in the regular way with regular terms, at the regular discounts.
The amounts so voluntarily paid to its creditors were deducted by petitioner as ordinary and necessary expenses of doing business in the year in which the payments were made. In the determination made by the respondent, these deductions were disallowed.
On June 1, 1920, the capital stock of the petitioner was increased in the sum of $200,000. Stock in this amount was issued, of which $99,250 was paid for in cash. The remainder ($100,750) was issued for 8 per cent interest-bearing notes. The entire $200,000 was prorated from the date paid in to the corporation and was claimed as invested capital. The Commissioner has included only the cash amount of $99,250 prorated, to wit, $65,744.54. The petitioner accepted the notes as the equivalent of cash.
With the exception of one note, which was due 30 days after date, all of the*2540 notes were due two years after date. Interest on the notes was paid when due and all of the notes were paid off on or before the dates of maturity.
The Commissioner increased the petitioner's net income for the fiscal year 1921 in the amount of $1,812.99, by the failure to allow depreciation on the "balconade" constructed by the petitioner on May 1, 1920, at a cost of $23,173.25. The rate of depreciation claimed is 10 per cent and the period of depreciation is nine months.
Prior to the close of the fiscal year 1920, the petitioner declared a dividend of $22,500. Surplus was charged and "Dividends Payable" was credited. This unpaid dividend of $22,500 was reflected in the 1920 closing balance sheet as "Dividends Payable" under the general heading, "Accounts Payable." The Commissioner excluded this amount from surplus on January 31, 1920.
On April 14, 1921, petitioner filed a tax return for the fiscal year ended January 31, 1921, and computed its tax liability under the provisions of the Revenue Act of 1918. A return was made under *709 the provisions of the Revenue Act of 1921 and filed on or about April 12, 1922, which return indicated an additional tax of $16.67.
*2541 OPINION.
LOVE: The fourth and fifth issues have been settled by stipulation and accordingly we find for the petitioner: (a) that its net income for the fiscal year ended January 31, 1921, as determined by the respondent, shall be decreased in the amount of $1,812.99 representing depreciation on a "balconade" acquired by the petitioner on May 1, 1920, at a cost of $24,173.25. The rate of depreciation shall be 10 per cent per annum, and the period of depreciation is nine months; (b) that its invested capital at February 1, 1920, shall be increased in the amount of $22,500, representing a dividend declared but unpaid at that date, excluded by the respondent from the petitioner's surplus.
In the first issue raised, we are of the opinion that the petitioner's contention that the payment to its former creditors, of $31,196 during its fiscal year ended January 31, 1920 (and amounts of an identical nature in subsequent years), constituted a part of the ordinary and necessary expenses paid in carrying on its trade or business, is not well taken. Without quibble as to whether these payments were "ordinary" and/or "necessary" expenses, we hold that clearly they did not constitute nor*2542 partake at all of the nature of business expenses, the benefit from which was exhausted in the taxable year in which the payments were made; but that they constitute an outlay and investment of capital deemed essential to restore the petitioner's credit which had been dissipated by its composition agreement with its creditors in April, 1915. It seems to us that the testimony of Arthur L. Kramer, the petitioning taxpayer's president since early in 1913 and its only witness, supports this conclusion so strongly as to render impossible any other.
Kramer testified that as a result of that composition, the "mercantile agencies gave us a bad credit rating"; that it made it "increasingly difficult to buy merchandise"; and that it had "a sort of bad moral effect." The market for the sale of commercial paper through note brokers "became closed to us at that time. We were not able to borrow on the open market." He testified that the large concerns in New York with whom the petitioner had been in the habit of dealing "were not willing to sell us again on credit" and that some would not sell "even on a cash basis." This condition "lasted up to the time that we made the first voluntary*2543 payment to the creditors * * * until about September 1, 1919."
Shortly before that date, at a conference with the petitioner's bankers, it was decided that making such voluntary payments "was the only way we were going to restore our credit standing and that *710 the restoration of our credit standing was a necessity in our business, and we decided then to make the first payment at that time."
On cross-examination:
Q. In making those payments to creditors you felt that you were doing something which was going to be of value to you in the years to come, didn't you?
A. I thought it would have that effect.Pedirect:
Q. Mr. Kramer, on cross-examination you were asked to state whether or not you ever expected to benefit in the future from these voluntary payments made to the creditors. I wish you would state just how you expected to derive this benefit.
A. Well, Mr. Haynes, that was just more or less the understanding of the whole thing. We made the payments because we found it was necessary to do it in order to restore our credit.
In the statement of facts propounded by the petitioner and which we have on this point adopted verbatim as our own findings, *2544 it is asserted that these voluntary payments to former creditors were the only way that the petitioner could relieve the adverse situation resulting from the 1915 composition agreement. And this has been fully substantiated by the testimony of the witness. The composition had failed of its purpose and the last state of the petitioner was worse than the first. Some immediate action had to be taken to preserve the very life and continuity of the business and the petitioner adopted the only remedy; it followed the only way that was left open to it, and brought back the credit which it had sacrificed in 1915. Credit is an intangible thing, but in the complexity of our modern economic structure, it is, for the business man or corporation, the pearl of great price; that essential asset without which, it may almost be said, none can engage in present-day commercial or even professional activities, except in the simplest way and upon the smallest scale.
The recovery of that essential asset was confessedly the chief purpose that motivated the so-called voluntary payments to former creditors. There was then under consideration no abstract moral issue; that payments were*2545 made to secure the possession of a real though intangible thing, not for a day, a month or a year, but for all time, so long as the petitioner's business might endure. And, as the evidence shows, the payments accomplished the purpose and secured the thing for which they were made, for "immediately after the first payment," says the witness, "it had the effect of restoring credit. Up to that time our rating in Dun and Bradstreet had been a negative rating after our composition with the creditors, and then after the payments immediately they gave us a first grade rating." The first payment "had a very valuable effect. We were able to buy merchandise in the regular way, with regular terms and with the regular discounts counts *711 that we had been previously able to do. It restored the (negotiable paper) market to us and we were able to discount our paper in the open market. It had a favorable effect in that I suspect it lowered our cost of doing business, because we immediately discontinued this ticket expense, the redemption of moving picture tickets, and it enabled us to borrow money at a lower rate of interest and to take our discounts on purchases."
These purely incidental*2546 secondary results in no way minimize or modify the fact that the restoration of credit was the object that it was hoped to obtain and which was obtained by these payments. This accomplished, the other results followed as matters of course.
Under conditions such as are pictured in the petitioner's statement of facts and in the testimony of its witness, we do not see how we can do other than find for the respondent. In Herbert Brush Manufacturing Co.,15 B.T.A. 673">15 B.T.A. 673, a case substantially on all fours with this present proceeding, we found that the benefit anticipated from such payments as these was an improved (in this case, a restored) credit reputation or standing; that is to say, an intangible asset with a probable life coextensive with the business; and we held that as such it did not represent a current transaction, the whole or any part of which is allowable as a deduction for income-tax purposes. We so hold here.
We find for the petitioner in its allegation that the Commissioner erred in excluding from invested capital certain notes in the amount of $100,750 paid in on June 1, 1920, for capital stock. The testimony of the witness Kramer stands*2547 unrefuted and unchallenged.
He testified that on the above date the capital stock of the petitioner was increased in the sum of $200,000, of which $99,250 was paid in cash and $100,750 in notes executed by himself and seven others, which notes were accepted by the petitioner as the equivalent of cash. With the exception of one 30-day note, all were due in two years after date. The witness knew all the makers well. To most of them he was related by either consanguinity or affinity. He was acquainted with the financial responsibility of the makers of all of these notes and in June, 1920, the fair market value of the notes was their face value. They all bore interest at 8 per cent; the interest was paid as due and the notes were paid on or before the dates of maturity. An amount of $71,710 was paid on a joint note for $87,000 of the witness and his brother-in-law, Leon Harris, by the transfer of a warehouse owned jointly in equal parts by them, and used exclusively in the business of the petitioner. The remainder of that note and all the other notes were paid in cash.
Under similar circumstances the Board, in a number of cases, has held that such notes were properly included*2548 in invested capital.
*712 In Appeal of American Steel Co.,1 B.T.A. 839">1 B.T.A. 839, we repeated what we had said in Appeal of Hewitt Rubber Co.,1 B.T.A. 424">1 B.T.A. 424, and we quote again here:
Congress intended by the language used in section 326(a) that for the purpose of computing the profits tax, notes in reality and without fraud or collusion paid in for stock should be included in invested capital unless such sale of stock is rendered absolutely void by positive statute. * * * A state statute imposing certain restrictions upon corporations for the purpose of enforcing full payment for its stock, designed and intended to serve an entirely different purpose, can not operate to nullify the plain provisions of the Federal statute.
The bona fide sale of stock in the instant case fulfilled every condition as set forth above. The case first cited supra was that of a New York corporation; the second, that of a Pennsylvania company. We have under consideration here a Texas corporation, but we find nothing in the statutes of that State that makes it necessary to distinguish it and except it from our earlier rulings.
Article XII, sec. 6, of the*2549 Constitution of Texas, is as follows:
No corporation shall issue stock or bonds except for money paid, labor done or property actually received, and all fictitious increase of stock or indebtedness shall be void.
Article 1146 of the Revised Statutes of Texas of 1914, in effect at the time of the transactions herein considered, reads as below:
No corporation, domestic or foreign, doing business in the state, shall issue any stock whatever, except for money paid, labor done, which is reasonably worth at least the sum at which it was taken by the corporation, or property actually received, reasonably worth at least the sum at which it was taken by the company. Any corporation which violates the provisions of this article shall, on proof thereof in any court of competent jurisdiction, forfeit its charter, permit or license, as the case may be, and all rights and franchises which it holds under, from or by virtue of the laws of this state.
When a Texas corporation is organized or its stock increased, the statutes require that (1) the full amount of stock or of the increase must then be subscribed; (2) 50 per cent thereof must be paid in at that time; and (3) the remaining unpaid*2550 50 per cent of the subscription must be paid within 2 years.
Counsel for the petitioner admits in his brief that by judicial interpretation the unsecured note of a subscriber to capital stock is held in Texas not to be "property actually delivered" within the meaning of the foregoing provisions. The courts of Texas hold that property has not been actually delivered to the corporation until the note has been actually paid, and that until that time the statutory obligation of the subscriber has not been fulfilled. But it is argued that the transactions interdicted by the constitution and the statute above quoted, are those in which 50 per cent of the subscription has not been paid in, but in which payment is attempted by the giving *713 of a note, or the stock is finally issued and delivered in consideration of merely a note. It is contended that where, as in this case, 50 per cent of the stock increase was actually paid in cash at the time of the increase, and notes given payable in two years for the remainder, the transaction is perfectly legal. And so it seems to us.
In *2551 Washer v. Smyer,211 S.W. 987">211 S.W. 987, where stock had been issued and delivered in consideration of a note, but with no cash or other payment, the court said:
There is no declaration in the constitutional provision that a transaction in which something other than money, property, or labor is received in payment for the corporation's stock, shall be utterly void. It prohibits such a transaction and therefore makes it unlawful, but that is the extent to which it goes. If a security he accepted in payment for the stock, such, for instance, as a subscriber's note, which is not property for such a purpose, the Constitution does not say either that it, or the stock issued for it, shall be void. The acceptance of the note in payment for the stock and the issuance of the stock are only interdicted. The word "void" is used but once in the constitutional provision, and that, it is to be noted, is not in the clause which prohibits the issuance of stock for other than money, property or labor. It is in the distinct clause which says that all fictitious increase of stock or indebtedness shall be void. While the term is found in that clause of the section, the framers of the*2552 Constitution avoided its use in the other. It must be assumed that they did so deliberately.
There is an essential difference between prohibiting a certain form of transaction - making it unlawful, and declaring that it, with all securities issuing out of it, shall be utterly void. It is a distinction familiar in the law.
In order to hold a negotiable note unenforceable in the hands of a bona fide holder, it is not enough that it be founded upon an illegal consideration. It is not sufficient that it issue from a transaction prohibited by law, or one even denounced as criminal. To avoid it in the bona fide holder's hands there must be a constitutional or statutory provision which expressly, or by unavoidable implication, declares it or the transaction of which it is a part, to be void. Such is the rule announced by Chitty, Story and Daniel. It is the rule followed by this court, and generally by courts elsewhere. (Italics are the court's.)
There is more of this tenor in the opinion from which the above is quoted and it would be easy to multiply similar pronouncements by the Texas courts, but we think that we have said enough to warrant us in holding that in this*2553 respect the Texas statutes do not differ in substance from those of New York and Pennsylvania, under which we held that such notes received in good faith should be included in the taxpayer's invested capital at their fair market value. We so hold here and we find that the fair market value of the notes here in question, was on June 1, 1920, and at all subsequent times until their dates of maturity, their fact value.
In respect to its third issue, the petitioner admits that we have heretofore disposed of the point concerning the running of the statutory period in John Wanamaker Philadelphia,8 B.T.A. 864">8 B.T.A. 864, with which holding the petitioner does not agree. The petitioner *714 raises the issue here to protect its rights of appeal, all of which it reserves in the event that it deems an appeal advisable. On this point we find for the respondent.
In view of the decision in respect of the issues other than the claim for special assessment, the abnormality claim may no longer exist, and for that reason we do not pass at this time upon petitioner's claim for special assessment. The Commissioner is directed to file a recomputation of the tax liability for the*2554 taxable years in accordance with this opinion, and if the petitioner so desires, after service of a copy of such computation, the Board will make a determination in respect of the special assessment issue, upon motion of the petitioner to that effect. Otherwise judgment will be entered under Rule 50.