*892 The petitioner, a corporation, by indenture of lease transferred possession of all its properties to a lessee for an annual rental, the maximum amount of which was an amount equal to the sum of 7 percent on $3,000,000 par value of preferred and $271,800 par value of common stock and 6 percent of $1,750,000 par value of preferred stock of petitioner, provided such amount should not exceed the gross earnings of the leased railroad less certain stated deductions. In the taxable year such maximum rental did not exceed such gross earnings less the allowable deductions. The lessee held $3,000,000 par value of the preferred and $157,600 par value of the common stock of petitioner. In addition to such stock held by the lessee, there were outstanding $1,750,000 par value of 6 percent preferred and $114,200 par value of common stock of petitioner in the hands of the public. The rental was to be paid as dividends on petitioner's stock directly to its stockholders. In the taxable year such payment by the lessee was so made of the ratable portion of the rental payable as dividends to petitioner's stockholders other than the lessee. No application of the rental was made to the payment of*893 dividends on the stock held by the lessee. The lessee merely withheld that part of the rental so applicable. Held, the entire rental provided in the indenture of lease was income to the petitioner in the taxable year.
*1163 This proceeding involves income taxes for the calendar year 1933 in the amount of $52,243.75, comprising a determined deficiency of $32,845.31, and an asserted overpayment of $19,398.44 which is the subject of a claim for refund. Respondent based the determined deficiency upon the inclusion of additional income of $238,875 representing unreported rental income in accordance with the provisions *1164 of section 22(a) of the Revenue Act of 1932 and articles 51 and 70 of Regulations 77. Petitioner bases its claim for refund on the ground that petitioner had no property in 1933 and that, therefore, the $141,079.58 reported as rental income on the return for 1933 was erroneously reported as income to the petitioner.
FINDINGS OF FACT.
*894 The facts in the instant proceeding are for the most part stipulated, and only in so far as this Board considers them material are they set forth herein.
The petitioner is a corporation, organized April 10, 1877, and existing under and by virtue of the laws of the State of Missouri, with its principal office at 340 West Harrison Street, Chicago, Illinois. It was oincorporated for the purpose of constructing, acquiring, maintaining, and operating a railroad for public use. Its books and records were maintained and its Federal income tax return for the year 1933 was filed on the accrual basis of accounting.
On March 15, 1878, petitioner and the Chicago & Alton Railroad Co., an Illinois corporation, entered into a written indenture, by the terms of which petitioner sold and transferred to the Chicago & Alton Railroad Co., its successors, and assigns $3,000,000 of its bonds dated March 15, 1878, maturing May 1, 1903, and $1,500,000 of its 7 percent preferred stock; and by this indenture petitioner demised and leased to the Chicago & Alton, its successors, and assigns, forever, all the property then owned or thereafter to be acquired by it. The Chicago & Alton agreed thereunder*895 that it would acquire at its own expense necessary additional right of way and would construct, furnish with rolling stock, and forever operate the railroad so demised and leased as a part of its main line, and keep the same in proper repair. The material provisions of the indenture are as follows:
And the said party of the first part, [the petitioner herein] for and in consideration of the covenants and agreements hereinafter contained, hereby sells and transfers unto the said party of the second part [the Chicago & Alton Railroad Co.], and its successors and assigns, the said bonds of the party of the first part hereinbefore mentioned, amounting in the aggregate to Three Millions of Dollars, with the coupons thereto attached, and the preferred stock hereinbefore mentioned, amounting in the aggregate to One Million Five Hundred Thousand Dollars, and also the proceeds of all subscriptions for capital stock and all subscriptions made by any and all persons or corporations of money or property for the purpose of aiding in the construction of said road or any portion thereof.
And the said party of the first part hereby demises and leases to the said party of the second part, *896 its successors and assigns, forever, all and singular the right of way, railroad track, bridges, * * * and property of every kind, name and nature of the said party of the first part now owned by it, or which may be hereafter acquired by the same: TO HAVE AND TO HOLD the said *1165 bonds, coupons and preferred stock of the party of the first part, and the proceeds of the said subscriptions to the said party of the first part, and also all and singular the said right of way, railroad track, bridges, * * * and property of every kind, name and nature of the said party of the first part, now owned by it, or which may be hereafter acquired by the same, unto the said party of the second part, its successors and assigns forever, * * *
* * *
And the said party of the second part hereby further agrees that it, the said party of the second part will pay unto the said party of the first part, as an annual rental for the use of said demised premises, half-yearly payments, to be made on the first days of May and November in each year, a sum which shall be ascertained by a computation based upon the gross earnings of the preceding year ending on the 31st of December, as follows, that*897 is to say:
From the gross earnings of said railroad during each year ending on the 31st of December, shall first be deducted sixty-five per cent. thereof for operating expenses, renewals and repairs, which shall be retained by said party of the second part. Second, All taxes and assessments of every description; and after deducting all Federal, State, county and municipal taxes and assessments from thirty-five per cent. of said gross earnings, the residue of the same shall constitute the rental for the calendar year, subject to the limitation hereinafter stated.
* * * and for the purpose of ascertaining the gross earnings of the railroad hereby demised, it is agreed that all rates common to the road of the party of the first part and the road of the Louisiana and Missouri River Railroad Company, or properly to be divided between them, shall be divided between said parties pro rata according to mileage; Provided, That from all rates for traffic which shall have crossed the Missouri River at or near Glasgow, said second party may, at its option, deduct a reasonable sum for bridge or ferry tolls before such division of rates between the party of the first part and the Louisiana*898 and Missouri River Railroad Company is made, and the amount so deducted shall be considered part of the gross earnings of the property of the party of the first part herein referred to, and it is hereby agreed that the party of the second part shall at all times pay out of said rental the coupons issued with the said bonds of the party of the first part, and all dividends upon its preferred stock guaranteed to be paid by the said party of the second part, and the annual rental for each calendar year shall never be less than the coupons issued with said bonds outstanding and falling due in such year, and the dividend or dividends on the said preferred stock guaranteed to be paid by the party of the second part in such year.
And it is further agreed, that the annual rental for each calendar year shall never be more than the outstanding coupons falling due in such year, and a dividend in that year of seven per cent. upon the preferred and common stock of the party of the first part then outstanding.
* * *
AND WHEREAS, the party of the second part may desire to convert the bonds of the party of the first part hereby sold to the party of the second part into the preferred stock*899 of the party of the first part hereinbefore mentioned, it is therefore agreed that the said party of the second part, may at its option exchange any or all of said bonds for preferred stock herein provided to be issued for said bonds upon the terms herein mentioned, and that upon such exchange, the party of the first part will issue certificates for such stock in the usual form, and deliver the same to the said party of the second part, transferable in the same manner as other stock of the party of the first part is allowed to be transferred.
*1166 And the said party of the second part may guarantee the absolute payment of a dividend of seven per cent. for each calendar year ending the 31st day of December, free of all United States taxes, on the aggregate amount of preferred stock not exceeding One Million Five Hundred Thousand Dollars, and upon request shall be entitled to certificates therefor in the usual form; and the holders of said preferred stock so guaranteed as aforesaid, shall be paid the said dividend out of the net earnings of the said party of the first part, if sufficient for that purpose, after paying coupons, taxes and assessments before any dividends shall*900 be paid upon the residue of the preferred stock of the said party of the first part.
And the said party of the second part hereby further agrees that it will at all times pay all taxes and assessments hereafter, whether Federal, State, county or municipal, which are, or may be imposed against the premises hereby demised at the time when said taxes may be due and payable. * * *
* * *
And the said party of the first part hereby covenants and agrees that it will at all times hereafter maintain its corporate organization and existence under the laws of Missouri; * * *
The action so taken by the petitioner had been authorized by its board of directors at a meeting held March 5, 1878, and by its stockholders at a meeting held the following day. At these meetings corporate action was also taken to authorize an issue of $3,000,000 face value of 7 percent bonds and an issue of $3,000,000 par value of 7 percent preferred stock which could be issued at any time to the Chicago & Alton Railroad Co., upon its request, but only in exchange for the $3,000,000 of bonds. At the same time an additional issue of $1,500,000 par value of 7 percent preferred stock was similarly authorized, which*901 was to be upon an equality with the $3,000,000 of preferred stock already authorized.
Thereafter, by an agreement dated May 29, 1879, between the petitioner, the Chicago & Alton Railroad Co., and the United States Trust Co. of New York, $1,750,000 par value of 6 percent preferred stock was issued to the Chicago & Alton Co. in lieu of the $1,500,000 par value of 7 percent preferred stock theretofore issued to it. The agreement further recited that the Chicago & Alton Co. had fully paid for the $1,750,000 par value of preferred stock by the construction and equipment of petitioner's railroad, and that, for the purpose of selling such stock, the Chicago & Alton Co. covenanted and agreed with the United States Trust Co. that it would, on the first day of February, May, August, and November in each year, at the office or agency of the Chicago & Alton Railroad Co. in New York City, pay to the holders of the preferred stock of $1,750,000 a quarterly dividend of 1 1/2 percent for each calendar year ending December 31, free of all United States taxes thereon.
In March 1903 the original bonds were exchanged by the Chicago & Alton Co. for $3,000,000 par value of petitioner's 7 percent*902 preferred stock, authorized March 5 and 6, as above set forth.
*1167 The Board finds as a fact that the substitution of the $1,750,000 par value of 6 percent guaranteed preferred stock for the original $1,500,000 par value of 7 percent guaranteed preferred stock, and the substitution of the $3,000,000 par value of 7 percent preferred stock for the bonds originally outstanding, was made without change in the basis for computation of annual payments.
During the year 1931, pursuant to final decree of foreclosure and sale entered by the District Court on July 6, 1929, the Alton Co. acquired the assets and business of the Chicago & Alton Railroad Co., which included, among other assets, the aforesaid leasehold estate created by the indenture of March 15, 1878. Included also in such assets were the $3,000,000 par value of 7 percent preferred stock of petitioner and also $157,600 par value of petitioner's common stock. An election was provided in the decree whereby the Alton Co. had a period of one year in which to disaffirm any contracts entered into by the Chicago & Alton Railroad Co. Extensions of time have been obtained from time to time on this election clause by order*903 of the court, and such election was still available to the Alton Co. at least until July 18, 1940.
During the year 1933 petitioner's outstanding securities were held as follows:
| Stocks | Alton Co. | Public |
| $3,000,000 par value 7% preferred | $3,000,000 | |
| $1,750,000 par value 6% preferred | $1,750,000 | |
| $271,800 par value common | 157,600 | 114,200 |
During the years 1917 to 1933, inclusive, books and records of the Alton Railroad Co. and of its immediate predecessor, the Chicago & Alton Railroad Co., were kept pursuant to the classification of income, profit and loss, and general balance sheet accounts for steam roads prescribed by the Interstate Commerce Commission in accordance with section 20 of the Act to Regulate Commerce, effective July 1, 1914. Under this classification an account, No. 542, captioned "rent for leased roads" was a part of the income accounts so maintained. The account represents a deduction from income under the general heading "Fixed Charges." For the years 1917 to 1924, inclusive, a constitutent part of this account (which was stated in gross) was an amount of $112,994 representing 6 percent dividends on the $1,750,000 of petitioner's guaranteed*904 preferred stock and 7 percent dividends on the 11,420 shares of its publicly owned common stock. From 1925 to 1932, inclusive, the constituent amount was $124,026, being an increase of $11,032 over the prior amount, representing the addition of the amount of 7 percent dividends on petitioner's common stock owned by the Alton Co. For the year 1933 this amount was further augmented by the sum of $19,398.44, being *1168 the accrued income tax liability evidencing the amount of income taxes on such dividends, making a total constituent amount of $143,424.44 in the account.
From 1881 to 1908, inclusive, the petitioner regularly declared annual dividends on all of the outstanding common stock and intermittently on the $3,000,000 of 7 percent preferred stock and the $1,750,000 of the 6 percent guaranteed preferred stock. From 1908 to 1916, inclusive, the petitioner regularly declared annual dividends of 7 percent on the $3,000,000 of 7 percent preferred stock; 6 percent on the $1,750,000 guaranteed preferred stock, and 7 percent on the $271,800 of common stock. From 1916 to and including 1933, the petitioner regularly declared annual dividends of 6 percent on the $1,750,000*905 of 6 percent guaranteed preferred stock and 7 percent on the $271,800 of common stock. All dividend payments that were actually made were at all times paid by the Alton Co. directly to petitioner's stockholders. There were no dividend payments made at any time of dividends declared on stock of the petitioner owned by the Alton Co. The Alton Co.'s books contained no entries reflecting payment or receipt of dividends on any of petitioner's stock owned by Alton until 1925, when entries were made reflecting the dividends on the Alton owned common stock of the petitioner.
During the calendar year 1933 the dividends declared by petitioner were paid by the Alton Co. in the following amounts, to wit: 6 percent on the $1,750,000 of petitioner's preferred stock held by the public, and 7 percent on the $114,200 par value of petitioner's common stock in the hands of the public. Such dividend payments were made by the Alton Co. directly to the holders of the stock. No dividend payments were made by the Alton Co. on the $3,000,000 par value of 7 percent preferred stock of petitioner owned by the Alton Co.
However, during the year 1932, there were net revenues from the premises here in*906 question available for the payment of rent in the approximate amount of $729,000, this amount having been computed by deducting from gross earnings of the premises operating expenses of 65 percent of gross earnings and all taxes thereon.
Petitioner reported $141,079.58 as taxable income for the year 1933, being the aggregate amount of the dividends on the guaranteed preferred stock and the common stock (including that owned by the Alton Co.), a total of $124,026, plus the tax thereon of $17,053.58, which was paid by the Alton Co.
OPINION.
HILL: The question presented involves the determination of the amount of income, if any, received or accrued to petitioner during the taxable year under the terms of the leasehold agreement.
*1169 Petitioner in its income tax return reported income in the total amount of $141,079.58, comprised of $124,026 representing the amount of dividends paid for it by the Alton Co. plus Federal income tax thereon in the amount of $17,053.58 paid for it by such company. The deficiency determined herein results from the action of respondent in increasing petitioner's income to the amount of $379,954.58, comprising $334,026 determined by respondent*907 as representing the amount of dividends on petitioner's stock paid or payable for it by the Alton Co. in the taxable year plus $45,928.58 representing, as determined by respondent, the amount of income tax on such last amount paid or payable by the Alton Co. for petitioner.
Aside from the question of whether the amount of Federal income tax on the net earnings of petitioner's railroad, paid or payable by the lessee out of the gross earnings of such railroad, is chargeable as rental under the lease, the maximum amount of the rental to petitioner provided by the leasehold agreement is the total of a 7 percent dividend on $3,000,000 par value of preferred stock and $271,800 par value of common stock, and a 6 percent dividend on $1,750,000 par value of preferred stock. Such maximum rental is payable only in the event the gross earnings of the railroad for the year preceding the taxable year, less a deduction of 65 percent thereof for operating expenses, renewals and repairs and less a further deduction of all texes and assessments of every description, are sufficient to pay the full amount of such dividends. We have found that the total amount of such dividends in the taxable year*908 was $334,026 and the amount of the gross earnings of the railroad for the year preceding, less the stated deductions, was approximately $729,000.
A somewhat parallel situation was presented in the case of Gold & Stock Telegraph Co.,26 B.T.A. 914">26 B.T.A. 914; affd., 83 8fed.(2d) 465. In holding in favor of the Commissioner, the Board there said:
* * * But they argue that they are under no obligation to their stockholders and therefore do not own or derive any benefit from the payments to the stockholders. The use to which money is put does not determine whether or not it was income before being so used. Nor need it determine who owned the income. Rent is income of the lessor who is entitled to say what shall be done with it. Why should it make any difference what the lessee agreed to pay on behalf of the lessor, whether a debt or a dividend? In either case it has applied the rent in accordance with the wishes of the lessor. If constructive receipt applies in the one case it may just as well apply in the other. Cf. *909 Blalock v. Georgia Ry. & Elec. Co.,246 Fed. 387. * * *
On appeal the decision of the Board was affirmed; the Circuit Court, per Hand, C.J., adding:
It is argued that the rentals payable upon the large stockholdings of the Western Union [lessee] itself should not be taxed as income of the lessor because the rentals to that extent were not paid out, but we can see no merit in the contention. The Western Union, like every other stockholder of the *1170 lessor, chose to acquire an interest in the corporate association. Rent accrued to it as a stockholder of the corporation and, whether it chose to pay to itself or not, its rights were as truly worked out through the corporation as those of the other stockholders. The property of the corporation of which it was a beneficiary yielded a return, and that corporation cannot avoid taxes because the guaranty could not be enforced by the Western Union against itself. * * *
Petitioner has pointed to the later case of Louisville, Henderson & St. Louis Ry. Co.,20 Fed.Supp. 483 (1937), in an effort to distinguish the instant case from the Gold & Stock Telegraph case. In the Louisville*910 case, the court, in finding for the taxpayer, pointed out that the lessee in the Gold & Stock Telegraph case was required to pay a lump sum in rent. The fact in the latter case was that the Western Union Co. agreed to pay annual rental of $300,000, payable quarterly, being a sum equal to 6 percent per annum on the lessor's stock.
In the instant case, although the amended instrument does not name any lump sum, it does name the method by which a sum certain can be obtained as the result of a simple arithmetical calculation. This difference between the two cases is immaterial. However, to return to the Louisville, Henderson & St. Louis case, supra, the real distinction between that case and the instant case is pointed out by the court in its opinion:
In the cited case, [Gold & Stock] the lessee was required to pay a lump sum in rent. It was not measured by the number of shares of stock of the lessor outstanding, excluding that owned by the lessee, nor did the contract fixing rent exclude in measurement the stock of the lessor owned by the lessee.
It is easy to see that the same distinction could be applied to the present case. Consequently, in following the*911 Gold & Stock Telegraph case, we do not misinterpret the doctrine of the Louisville case.
Petitioner insists, however, that Treasury Regulations 77, article 70, 1 has no bearing on the present controversy, inasmuch as that article deals only with leases, and petitioner asserts that under the laws of the State of Missouri, the instrument in controversy here is the acknowledgment of a transfer in fee. Regardless of which is the correct view of the indenture, and this Board makes no determination *1171 thereof, the conclusions to be arrived at in either case must be the same. If there is a ground upon which to sustain the Commissioner's determination other than that evoked by Commissioner, this Board feels compelled to take notice of that ground and render decision accordingly. If, as petitioner asks, the instrument be treated as an absolute conveyance, the petitioner nevertheless is in a sense, by reason thereof, being relieved of an annual obligation. It is true that this obligation, except in regard to the guaranteed preferred stock, was conditioned on the sufficiency of petitioner's net income. It is also obvious, however, that, since there could never be income*912 other than that provided under the instrument, the "rent" provision was intended to be looked upon as a satisfactory annual income for the corporation, and on such understanding the stockholders ratified the plan. This was the wish of the petitioner. A taxpayer can not retain its corporate form of association and the benefits to be derived therefrom without being subject to the taxes which are naturally involved. 2
*913 There remains the question of liability for income taxes guaranteed to be paid by the Alton Co. because of dividends on the stock. On this question we have found as a mixed conclusion of fact and law that the indenture, even as amended, requires the Alton Co. to pay taxes on account of the dividends on the 6 percent guaranteed preferred stock only; and in effect such taxes in the amount of $14,437.50 actually were paid therefor by the Alton Co. Consequently, petitioner realized income in this amount but not in the amounts of any other income taxes claimed by respondent to have been assumed by the Alton Co., except for any amounts actually paid by the Alton Co. because thereof, which were in the amount of $2,616.08.
There is also the question as to whether the Alton Co. owed all petitioner's stockholders the amounts set forth as maximum rental or only that amount required as the minimum in any one year. The indenture is sufficiently clear on this point, and, if the gross income of the premises (computed according to the formula set forth in the indenture), is sufficient to pay the maximum rent, then the maximum is due. Inasmuch as we have found as a matter of fact that the*914 application of this formula to the gross income derived by the Alton Co. from the premises in 1932 was sufficient to cover the maximum *1172 rent, it must of necessity follow that the Alton Co. was obliged in the taxable year 1933 to pay that maximum.
That part of such maximum rental not paid by the Alton Co. in the taxable year represented the amount of dividends payable to it on stock of petitioner which the Alton Co. held. Funds being available in the hands of the Alton Co. under the terms of the lease contract for the payment of such maximum rental, the obligation of petitioner in respect of such dividends was discharged, notwithstanding that the Alton Co. neither credited petitioner nor charged itself with such payment. Consequently petitioner is taxable on an amount as income equal to such stated amount of maximum rental.
Finally petitioner makes the contention that the Alton Co. did not assume the obligations of its predecessor under the indenture. The ground for this contention is that the Alton Co. never ratified the contract in writing, and still has the power under the court decree to disaffirm contracts entered into by its predecessor. As respondent points*915 out, however, this is a power to disaffirm, not to affirm, and consequently the mere fact that the Alton Co. enjoyed the benefits of the indenture in the year 1933 is sufficient ground to estop it from denying the obligations set forth therein. Cf. Dunlop v. James,67 N.E. 60">67 N.E. 60 (1903); Broadwell v. Banks,134 Fed. 470 (1905).
Decision will be entered under Rule 50.
Footnotes
1. ART. 70. Income to lessor corporation from leased property.↩ - Where a corporation has leased its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor's capital stock or the interest on the lessor's outstanding indebtedness, together with taxes, insurance, or other fixed charges, such payments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends and interest are paid by the lessee directly to the shareholders and bondholders of the lessor. The fact that a corporation has conveyed or let its property and has parted with its management and control, or has ceased to engage in the business for which it was originally organized, will not relieve it from liability to the tax. While the payments made by the lessee directly to the bondholders or shareholders of the lessor are rentals as to both the lessee and lessor (rentals paid in one case and rentals received in the other), to the bondholders and the shareholders such amounts are interest and dividend payments received as from the lessor and as such shall be accounted for in their returns.
2. Revenue Act of 1932 -
SEC. 22. GROSS INCOME.
(a) GENERAL DEFINITION. - "Gross income" includes gains, profits, and income derived from salaries, wages, or compensation for personal service, of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. * * * ↩