*1085 During October 1935 petitioner by an exchange of letters entered into an agreement with a local bank whereby it was agreed that in the event petitioner declared any dividends in excess of the semiannual dividend of $2.50 a share on the preferred stock, then "the Bank shall have the right at its option to declare any note of your company held by it at once due and payable." During the taxable years 1936 and 1937, petitioner was indebted to the bank and paid no dividends except dividends on its preferred stock. The Commissioner has allowed a dividends paid credit for the dividends so paid. Held, that the writings between petitioner and the bank were not a contract prohibiting petitioner from the payment of dividends and, in computing the surtax on undistributed profits under section 14 of the Revenue Act of 1936, petitioner is not entitled to any credit under section 26(c)(1) of the same act.
*657 The respondent determined deficiencies in income tax against petitioner for the calendar years 1936 and 1937 in the amounts of $35,259.11 and $43,910.69, *1086 respectively. A summary of the respondent's determination of these amounts is as follows:
| 1936 | 1937 | |
| Normal tax, sec. 13, 1936 Act | $82,592.85 | $82,393.37 |
| Surtax on undistributed profits, sec. 14, 1936 Act | 38,225.87 | 38,306.38 |
| Total income tax | 120,818.72 | 120,699.75 |
| Income tax assessed | 85,559.61 | 76,789.06 |
| Deficiency | 35,259.11 | 43,910.69 |
Thus it will be seen from the above figures that the entire deficiency for 1936 is due to the determination by the Commissioner of a surtax on petitioner's undistributed profits and that $38,306.38 of the deficiency for 1937 is due to the same cause.
Petitioner contends that it is not liable for any surtax on undistributed profits for either year, and that it is entitled to a refund of $2,966.76 normal tax for 1936. It concedes that it is liable for a deficiency in normal tax for the year 1937 in the amount of $5,604.31.
In a statement attached to the deficiency notice the respondent, among other things, said:
The amount claimed as a credit for contracts restricting dividend payments in each of the taxable years 1936 and 1937 is disallowed for the reason that there was not a prohibition on the payment of dividends*1087 by written contract executed prior to May 1, 1936 within the meaning of Section 26(c)(1) of the Revenue Act of 1936.
*658 As a foundation for its contention that it was not liable for any surtax on undistributed profits for either year petitioner assigned several errors. In its brief, however, petitioner narrows the controversy with the statement that "The single question left for consideration is whether the contract between petitioner and The First National Bank of Atlanta is the type of contract contemplated by Section 26(c)(1) of the Revenue Act of 1936."
FINDINGS OF FACT.
We adopt the stipulation of facts as a part of our findings of fact and summarize some of the facts contained therein as follows:
Petitioner is a corporation incorporated under the laws of the State of Georgia, with its principal office and place of business in Atlanta. Prior to November 1936 petitioner's corporate name was "Atlantic Ice & Coal Company," but at or about that date its name, by an amendment to its charter, was changed to "Atlantic Company."
Petitioner's returns for the years here involved were filed with the collector of internal revenue for the district of Georgia.
On October 10, 1935, F. *1088 T. Davis, assistant vice president of the First National Bank of Atlanta (hereinafter sometimes referred to as the bank) sent a letter to petitioner's president, F. W. Beazley, the body of which is as follows:
In the absence of Mr. Williams and in line with his understanding with you, we have been very glad indeed to set up for the use of your good company a line of credit of $350,000. at 4%.
In connection with these loans, while it is, of course, our desire to cooperate with the request of your good company in every reasonable way and we certainly know of no reason at this time why we shall not be glad to handle renewals or partial renewals in line with your conversation with Mr. Williams, it is understood that we have no commitment beyond the maturity date of each individual note as handled.
It is further understood that in the event any action or suit is instituted to collect any of the back dividends on the preferred stock or to require the company to declare and pay any of the back dividends on the preferred stock, or if any back dividends are declared on the preferred stock or any dividend in excess of the semi-annual dividend of $2.50 a share on the preferred stock is*1089 declared, or in the event that any dividend is declared on any of the other stock of the company, then, in the event of any of said events, the Bank shall have the right at its option to declare any note of your company held by it at once due and payable.
I know that you will fully appreciate our reason for having this understanding and want to assure you that we are delighted to have the loans of your good company and stand ready to be of service in every reasonable way.
In order to complete our records I will appreciate your acknowledging the terms of our agreement as outlined above by returning the enclosed copy of this letter with your acceptance thereon.
On October 17, 1935, Beazley wrote and delivered to Davis a letter, *659 the body of which is as follows: "We acknowledge your letter of October 10th, and shall be governed accordingly."
On October 31, 1936, R. C. Williams, vice president of the bank, wrote and delivered to Beazley a letter, the body of which is as follows:
With reference to our recent conversation regarding the loans the Atlantic Ice & Coal Company has with us and your request in connection with the renewal thereof, we call your attention*1090 to the fact that on October 10, 1935, we wrote you fully setting forth the terms on which loans would be made to your company, especially with reference to the declaration of dividends by the Atlantic Ice & Coal Company, which terms were accepted by you under date of October 17, 1935.
We have, of course, since October 17, 1935, extended credit to the Atlantic Ic & Coal Company under the terms contained in our contract with you, copy of which is hereto attached.
While we are quite certain you have no such plans in mind, we wish to remind you that any declaration of dividends by the Atlantic Ice & Coal Company, other than as permitted by the agreement between us, above referred to, would be considered by us as a breach of that contract. There remains unpaid of the indebtedness of the Atlantic Ice & Coal Company to the Bank the sum of $253,785.78.
In this connection, we call your attention to the fact the agreement above referred to and set forth in our letter of October 10, 1935, remains in force until you have paid us in full the indebtedness you own us.
We will thank you to confirm our understanding of the arrangements between us and of your intentions to comply therewith.
*1091 On November 2, 1936, Beazley wrote and delivered to Williams a letter saying:
I acknowledge your letter of October 31st, 1936 with regard to our contract with your good institution of October 10th, 1935.
Please be advised that we have complied with the terms stated therein as interpreted by you, and will continue to do so.
On December 1, 1937, Herman Jones, Jr., who was vice president of the bank, wrote and delivered to Beazley a letter, the body of which is as follows:
We acknowledge receipt of note signed Atlantic Company, dated today, payable 90 days after date, in the amount of $725,000 secured by 7 mortgage notes signed by Atlantic Company, in the amount of $114,285.71 each.
We are discounting this note and placing the proceeds to your credit and charging your account with the notes we now hold totaling $350,000. and are crediting your account with the unearned discount to which you are entitled on account of the pre-payment, cancelled notes and duplicate memoranda enclosed.
For the past several years you have acknowledged receipt of a letter agreeing to certain restrictions with respect to dividend payments by your company. Inasmuch as your bank debt has not*1092 been liquidated, this agreement is, of course, still in effect, but in addition thereto, it is our understanding that for the coming year no dividends are to be paid by your company on any class of your stock without the prior approval of the banks extending credit to your company.
*660 We will appreciate your acknowledging receipt of this letter and indicating that it is in line with your understanding by signing and returning to us the enclosed copy.
On December 3, 1937, Beazley acknowledged the letter from Jones, saying:
I acknowledge your letter of December 1st with particular reference to the payment of dividends by our Company. Your letter conforms to our understanding.
However several days ago we obtained permission to pay the dividend on the First Preferred Stock January 1st, 1938, in the amount of $75,000.00.
At the time the letter of October 10, 1935, was written petitioner had a secured note of $107,000 outstanding with the bank which was dated September 19, 1935, and was due December 19, 1935. This note was paid in five installments, the last installment being on the due date.
On December 18, 1935, petitioner borrowed $64,000 from the bank and*1093 gave the bank its secured note, due March 17, 1936. This note was once renewed for a balance of $39,358.27, which balance was paid on June 16, 1936.
On June 16, 1936, petitioner borrowed $111,000 from the bank and gave the bank its secured note, due September 14, 1936. This note was paid in two installments after one renewal for the full amount and one renewal for the second installment of $53,423.68, which was paid on December 23, 1936.
The security given for the three preceding notes (sometimes referred to herein as the collateral notes) consisted of bills receivable of petitioner's customers. As these bills were collected, the collections were applied against the respective notes.
In addition to the three collateral notes referred to above, petitioner, during 1936 and 1937, but prior to December 18 1937, obtained from the bank six different unsecured loans, which may be described in tabulated form as follows:
| Note No. | Original date | Amount | Disposition |
| 1 | Jan. 2,1936 | $250,000 | Renewed twice and paid Aug. 31, 1936. |
| 2 | April 16, 1936 | 100,000 | Renewed once and paid Sept. 30, 1936. |
| 3 | May 22, 1936 | 200,000 | Renewed 3 times and one-half paid Sept. 16, 1937; balance renewed 3 times and then included in $725,000 loan on Dec. 1, 1937. See letter above. |
| 4 | Nov. 7, 1936 | 250,000 | Renewed 4 times and then included in $725,000 loan on Dec. 1, 1937. See letter above |
| 5 | Dec. 1, 1936 | 150,000 | Renewed twice and paid Aug. 30, 1937. |
| 6 | Jan. 6, 1937 | 150,000 | Renewed twice and paid Aug. 5, 1937. |
*1094 Petitioner's indebtedness to the bank (exclusive of interest) as of the close of each month during 1936 and 1937 was as follows:
| 1936 | 1937 | |
| January | $314,000.00 | $750,000 |
| February | 314,000.00 | 750,000 |
| March | 289,358.27 | 750,000 |
| April | 389,358.27 | 750,000 |
| May | 589,358.27 | 750,000 |
| June | 661,000.00 | 750,000 |
| July | $661,000.00 | $750,000 |
| August | 411,000.00 | 450,000 |
| September311,000.00 | 350,000 | |
| October | 253,423.68 | 350,000 |
| November | 503,423.68 | 350,000 |
| December | 600,000.00 | 725,000 |
*661 The income tax assessed against petitioner for the calendar year 1936 in the amount of $85,559.61 was paid by petitioner on the dates and in amounts as follows:
| May 15, 1937 | $21,389.91 |
| June 29, 1937 | 21,389,90 |
| Oct. 4, 1937 | 21,389.90 |
| Dec. 17, 1937 | 21,389.90 |
| Total | 85,559.61 |
On or about March 9, 1940, petitioner filed with the collector of internal revenue for the district of Georgia a claim for the refund of income tax paid for the calendar year 1936 in the amount of $2,966.76.
Petitioner did not pay any dividends during 1936 and 1937 other than a semiannual dividend of $2.50 a share on its preferred stock for 1936, which amounted to $250,000, *1095 and three dividends on April 1, July 1, and October 1, respectively, of $1.50 a share each on its preferred stock for 1937, which amounted to $225,000. In his determination the respondent allowed petitioner these amounts as a dividends paid credit under section 27(a) of the Revenue Act of 1936, but did not allow petitioner any credit under section 26(c)(1) on account of contracts prohibiting the payment of dividends.
In addition to the foregoing summary from the stipulation of facts we find the following facts from the oral testimony which was introduced:
The officials of the First National Bank of Atlanta construed the letter of October 10, 1935, as establishing definitely and certainly a line of credit on behalf of petitioner for $350,000, under which petitioner could borrow up to that amount from time to time as it needed it without the further approval of officials of the bank. The officials of the bank construed their agreement with petitioner to continue this line of credit in force until such time as the bank should serve notice on petitioner of the termination thereof, for some cause deemed by the bank sufficient. No such notice was served on the Atlantic Co. by the*1096 bank during the years 1936 or 1937. The officials of the bank and of petitioner construed the clause in the letter of October 10, 1935, which dealt with the payment of dividends by petitioner as prohibiting petitioner from paying any dividends while petitioner was indebted to the bank except dividends of $2.50 semiannually on its preferred stock. *662 The contract as thus construed was lived up to by the parties throughout the years 1936 and 1937.
OPINION.
BLACK: We are asked to reverse the respondent's determination of liabilities for surtax on undistributed profits under section 14 of the Revenue Act of 1936 of $38,225.87 for 1936 and $38,306.38 for 1937 on the ground that the respondent erred in not allowing petitioner a credit under section 26(c)(1) relating to contracts prohibiting the payment of dividends. The provisions of section 26(c) material to this proceeding are set forth in the margin. 1 Petitioner contends that the letters which passed between it and the First National Bank of Atlanta on October 10 and 17, 1935, followed by loans made by the bank to petitioner in pursuance thereof, constituted such a contract as is contemplated by section 26(c)(1) of*1097 the Revenue Act of 1936 for reasons as follows:
(1) The letters between the bank and petitioner constitute a contract;
(2) This contract is in writing;
(3) It was executed by petitioner prior to May 1, 1936;
(4) The provisions thereof deal expressly with the payment of dividends;
(5) It would have been a violation of this contract for petitioner to pay more than $2.50 per share semiannually on its preferred stock, or to have paid any other dividend in any amount or in any form on any of its other stock.
On the other hand, the respondent contends that the above mentioned letters*1098 are not such a contract as is contemplated by the statute; that the letter of October 10 does not prohibit or restrict the payment of dividends by petitioner; and that petitioner could have paid dividends when and as it saw fit to do so "without violating a provision" of the alleged contract, for the reason that the only consequence of so doing would have been the possibility of the bank exercising its option to declare any note of petitioner held by the bank at once due and payable.
We think that undoubtedly all the conditions contained in section 26(c)(1) as contended by petitioner are met except that described *663 in (5) of petitioner's contentions above noted. As to that contention, we think respondent must be sustained in his position that the contract, as evidenced by the writings, did not operate as a legal restriction upon petitioner as to the amounts which it could distribute within the taxable years as dividends.
In , the Supreme Court ruled that section 26(c)(1) of the Revenue Act of 1936 must be "strictly construed" and that in enacting this section of the statute "Congress*1099 indicated that any exempted prohibition against dividend payments must be expressly written in the executed contract." See also ; ; .
Article 26-2(a) of Regulations 94 provides that the credit provided for in section 26(c) "is not available under every contract which might operate to restrict the payment of dividends, but only with respect to those provisions of written contracts executed by the corporation prior to May 1, 1936, which satisfy the conditions prescribed in the Act." Article 26-2(b) provides:
(b) Prohibition on payment of dividends. - The credit provided insection 26(c)(1) is allowable only with respect to a written contract executed by the corporation prior to May 1, 1936, which expressly deals with the payment of dividends and operates as a legal restriction upon the corporation as to the amounts which it can distribute within the taxable year as dividends. * * *
We have held that the above regulations are reasonable and correctly interpret the statute. *1100 ; .
In , in denying a credit under section 26(c)(1), we said:
To support the statutory credit, a contract is to be construed according to its legal effect rather than in the light of an assumed business policy.
And in , in holding that section 26(c)(1) did not apply, we said that "Congress intended to give a credit to a corporation only where the corporation had bound itself not to pay a dividend."
In view of the authorities cited above, we do not think the letters relied upon by petitioner and the performance under those letters amounted to such a contract as is contemplated by the statute. We do not think it can be said that petitioner, prior to May 1, 1936, ever bound itself not to pay any dividends in addition to the semiannual dividend of $2.50 a share on its preferred stock. The contract as construed by the parties may have operated to have that effect, but that is not enough. The contract itself, its very terms, must operate as a legal restriction*1101 upon petitioner as to the amounts which *664 it can distribute within the taxable year as dividends. Petitioner did not agree with the bank that it would not declare any dividends other than the semiannual dividend of $2.50 a share on its preferred stock. It merely agreed that if it did do so, then, in that event, the bank was to have the right, at its option, to declare any note of petitioner held by the bank at once due and payable. With that understanding it may well be that petitioner would adopt a business policy and did in fact adopt a business policy of not declaring dividends except $2.50 semiannually on its preferred stock, but that falls short of being in the position of having legally obligated itself not to declare dividends in excess of a specified amount. If during the taxable years petitioner had declared dividends in excess of the semiannual dividend of $2.50 a share on its preferred stock, it seems certain that the bank could not have enjoined petitioner form paying such dividends. All that it could have done in such a case would have been to exercise its option to declare any note of petitioner held by it to be at once due and payable. Cf. *1102 . In the instant case, as we have already said, the facts undoubtedly show that petitioner construed its understanding with the bank as restricting it from the payment of any dividends except on its preferred stock, but this we attribute to a business policy adopted by petitioner pursuant to what it conceived to be its obligation ot the bank, rather than any legal restriction imposed upon it by any written contract executed by petitioner prior to May 1, 1936. That being the case, petitioner is not entitled to a credit under section 26(c)(1). This may seem to be a narrow ground upon which to deny petitioner the credit which it claims, but nevertheless it is a statute of Congress which we have to construe and the Supreme Court has said in , that the statute must be strictly construed.
Petitioner contends that , and *1103 , are in point and resolve the present issue in its favor. These cases are readily distinguishable from the case at bar. The agreement in the Page Oil Co. case, among other things, provided:
The party of the first part [Page oil co.] agrees that until said loans (i.e., the development notes) shall have been paid in full with interest, no dividend of any kind or nature will be declared by it; * * *
Likewise in the Sutcliffe Co. case the agreement there provided in part as follows: "11. During such time as the applicant [Sutcliffe Co.] * * * may be indebted to the Bank, it will not pay any dividends * * *."
If the taxpayers in the two preceding cases had paid dividends, they would have violated an express written contract not to do so. *665 In the instant case, as we have endeavored to point out, petitioner could have paid dividends in excess of the semiannual dividend of $2.50 a share on its preferred sotck without violating a provision of a written contract.
That is the controlling difference as we view it between the facts of the instant case and those present in *1104 , and
For the reasons stated, we sustain the determination of respondent.
Reviewed by.the Board.
Decision will be entered for respondent.
OPPER concurs only in the result.
ARUNDELL and MELLOTT dissent.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax -
* * *
(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
(1) PROHIBITION ON PAYMENT OF DIVIDENDS. - An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. * * * ↩