*42 Decision will be entered for the respondent.
1. The taxpayer, a manufacturer, sold shares of corporation X to the president of corporation Y, and at the same time corporation Y by separate contract agreed to sell paper to the taxpayer at a special discount. The amounts of the discount, held, reductions in the cost of paper and not part of the sale price of the shares.
2. A corporation's right to a credit under section 26 (c) (2), Revenue Act of 1936, held, not supported by a contract requiring it to discharge a debt annually in an amount determinable by reference to the preceding year's earnings and profits, the amount being payable from any source or in bonds.
3. A corporation's right to a credit under section 26 (c) (1), Revenue Act of 1936, must be based upon strict proof and may not be inferred from the provisions of a reorganization agreement to which its predecessor but not it was a party.
*1 The Commissioner determined deficiencies in petitioner's income tax of $ 2,913.77 for 1936 and $ 8,604.90 for 1937. (1) From cost of merchandise, *43 he excluded discounts which the petitioner contends were really part of the sale price of shares. (2) Petitioner also assails the disallowance of a dividend restriction credit claimed under section 26 (c).
FINDINGS OF FACT.
Petitioner, a Massachusetts corporation with principal office at Pittsfield, Massachusetts, is engaged in the manufacture of paper into stationery. It filed its income tax returns for 1936 and 1937 in the district of Massachusetts. In 1933 it owned 155 shares of the Eaton Paper Co., which owned a paper mill and appurtenant rights in Adams, Massachusetts, and was commonly called the Adams company. The remaining 45 shares of that company were owned by Henry J. Guild.
*2 1. On February 27, 1933, petitioner's predecessor, Guild, and the Adams company made an agreement whereby the predecessor bought Guild's 45 shares of the Adams company and the Adams company granted to Guild for six months an option to lease its land, plant, equipment, and water power rights for five years, and during the term of the lease, if made, the right to purchase those assets for $ 250,000, payable in ten equal annual installments. The remaining assets of the Adams company were transferred*44 to petitioner in consideration of petitioner's assumption of the transferor's obligations. On September 6, 1933, Guild exercised his option, the Adams company giving him a five-year lease which also granted to him an option to purchase the assets for $ 250,000, payable without interest in ten annual installments of $ 25,000 each. He was given the privilege of anticipating any installment, in which event he should receive a credit equal to 6 percent of the anticipated payment from date of payment to date due. Guild thereafter assigned the lease agreement to the Brightwater Paper Co., a Delaware corporation of which he was treasurer.
In the latter part of 1935 Guild entered into negotiations and made a series of proposals for purchase of the assets on terms differing from those specified in the option. In April 1936 he offered $ 100,000 in cash; petitioner refused the offer and asked $ 133,000. This figure was the present commuted value of the $ 250,000 payable over ten years under the option ($ 158,000), less a further reduction of $ 25,000 for cash. Guild wanted Brightwater to retain petitioner's business as a customer. He then worked out a method so that petitioner would receive*45 $ 133,000, i. e., the shares of the Adams company would be sold to him for $ 100,000 cash, and Brightwater would give petitioner discounts aggregating $ 33,000 on the invoice price of paper in excess of $ 200,000 per year for five years or until the $ 33,000 total "had been liquidated."
On April 20, 1936, petitioner and R. R. Young, Brightwater's president and a large shareholder, made an agreement and petitioner sold the 200 shares of Adams company to Young for $ 100,000 and the Adams company agreed to stay out of the paper business in the United States as long as its corporate name retained the word "Eaton." This agreement contained no reference to the contemporaneous discount agreement of Brightwater.
By a separate agreement of the same date, Brightwater agreed "for the period of five years from May 1, 1936," to grant petitioner a special discount of 10 percent on all net purchases of paper in excess of $ 200,000 for each calendar year "until said special discounts shall reach an amount equal to the sum of thirty-three thousand (33,000) dollars, together with interest thereon computed at the rate of six (6) per cent per annum, compounded semi-annually." Net purchases *3 were*46 defined to mean "gross purchases less returns, other discounts, and allowances"; it was further agreed that Brightwater might at any time pay petitioner the balance of the $ 33,000 plus accrued interest, whereupon the agreement should be deemed completed. In the event that Brightwater should fail to comply with the contract, petitioner "shall be entitled to the payment of thirty-three thousand (33,000) dollars, plus interest due thereon, on thirty (30) days written demand." This agreement contained no reference to the contemporaneous share purchase agreement with Young.
On the same date, petitioner and Brightwater, as assignee of Guild's 1933 agreement with petitioner, amended that agreement by reducing the price of the leased assets under the lessee's purchase option from $ 250,000 to $ 150,000, payable in ten equal annual installments. Any payment made in advance of the due date was to be credited against the anticipated installment at face amount, "plus simple interest thereon at the rate of six (6) per cent per annum from the date of payment to the due date of such instalment or instalments."
Petitioner purchased large quantities of paper from Brightwater, receiving a 3 percent*47 cash discount and a 3 percent trade discount. These discounts are customary in the trade. After the 1936 agreement, petitioner was given in addition a 10 percent discount on its annual purchases from Brightwater in excess of $ 200,000. In 1936 the amount of this discount was $ 2,560.02; in 1937, $ 12,649.97. In reports to its shareholders for 1936 and 1937, petitioner's profit and loss summary contained the following item:
| 1936 | 1937 | ||
| 1 (Proceeds from) (Payments received during the year | |||
| 2 in connection with) the sale of the capital | |||
| stock of Eaton Paper Company, Inc., a subsidiary | |||
| (paper mill located at Adams, Mass.) which was | |||
| considered worthless at the date of | |||
| reorganization and consequently written off at | |||
| that time | $ 12,649.97 | $ 102,560.02 |
When Guild saw this in petitioner's annual report to shareholders, he mentioned it to petitioner and indicated that Brightwater would account for it differently. On Brightwater's income tax returns, the discount of 10 percent was taken as an expense.
The Commissioner determined that the amounts of $ 2,560.02 and $ 12,649.97 "constitute discounts to be deducted from gross invoice*48 prices in determining the cost of paper purchased."
2. In 1933 petitioner issued first mortgage 5 1/4 percent bonds of a face value of $ 656,000 pursuant to a "plan of reorganization and deposit agreement of March 8, 1933." Article III of the mortgage indenture, dated May 1, 1933, and executed July 21, 1933, contained provisions for a sinking fund which are in part as follows:
*4 Section 1. The Company, as and for a sinking fund for the purchase and/or redemption of bonds from time to time, will make a payment to the Trustee on or before the 1st day of April, 1937, and on or before the 1st day of April in each and every year thereafter so long as any of the bonds are outstanding, or until this indenture shall have been discharged, the amount of each such sinking fund payment to be computed as follows:
(1) If the net earnings of the Company for the next preceding fiscal year did not exceed seventy-five thousand dollars ($ 75,000), the amount of such sinking fund payment shall be the amount by which such net earnings exceeded the amount of interest payable for such fiscal year on the outstanding bonds; or
(2) If the net earnings of the Company for the next preceding fiscal year*49 did exceed seventy-five thousand dollars ($ 75,000), the amount of such sinking fund payment shall be the amount by which seventy-five thousand dollars ($ 75,000) exceeded the amount of interest payable for such fiscal year on the outstanding bonds.
Any such sinking fund payments may be made, at the option of the Company, either in cash or in bonds, or partly in cash and partly in bonds, all bonds for such purpose to be taken at their cost to the Company, or the redemption price thereof, whichever is lower.
The computation of "net earnings" was specifically prescribed. With moneys in the sinking fund the trustee was to purchase the corporation's bonds in the open market, or to advertise for them, and if none should be offered, to draw by lot and call the largest number redeemable on the next November 1 with money then held by him. In March 1937 the trustee estimated that the amount of the sinking fund payment due on April 1 was $ 12,398.40, and so notified petitioner. In March 1938 the trustee's estimate of the amount due on April 1 following was $ 15,537.93. The following notes appear on the corporation's reports to stockholders for 1936 and 1937, respectively:
(Note B) -- *50 A sinking fund provision with respect to the first mortgage bonds requires the payment to the Trustee of approximately $ 12,300.00 on or before April 1, 1937, such amount being payable in cash and/or in bonds at cost to the Corporation.
Note B -- A sinking fund provision with respect to the first mortgage bonds requires the payment to the Trustee of approximately $ 15,500.00 on or before April 1, 1938, such amount being payable in cash and/or in bonds at cost to the Corporation. It is contemplated that a portion of the bonds in the treasury, acquired at an aggregate cost of $ 19,910.00, will be used in connection with this requirement.
The "Plan of Reorganization and Deposit Agreement" contemplated the authorization and issuance of 11,675 shares of $ 3.50 cumulative preferred stock without par value. The plan provided:
The preferred stock is to be entitled, from the net earnings of the new Company, to semi-annual dividends payable on the first days of January and July in each year at the rate of $ 3.50 per share per annum * * *. * * * Thereafter [July 1, 1936] they are to be cumulative. They are to be paid in priority to dividends on the common stock. * * * But for no year, or*51 part thereof, shall dividends on either preferred or common stock be declared, paid or set apart for payment in an amount greater than that by which the net earnings *5 of the new Company for the next preceding fiscal year plus its then existing earned surplus, if any, exceed the amount necessary to enable the new Company to pay interest on its outstanding bonds for the then current year and to make the sinking fund payment required for that year by the provisions of the mortgage securing said bonds, * * *
The plan was prepared by a committee whose object was "to accomplish a reorganization of Eaton Paper Company," petitioner's predecessor. This committee derived a general authority to act with broad discretion from the terms of the "deposit agreement," to which holders of bonds and shares of the Eaton Paper Co. assented by deposit of their certificates. No dividends have ever been paid on the preferred shares. In petitioner's reports to stockholders it was stated that dividend accumulations on preferred stock to December 31, 1936, amounted to $ 20,431.25, or $ 1.75 a share, and to December 31, 1937, to $ 61,293.75, or $ 5.25 a share (including the dividend that would*52 have been payable on January 1, 1938); that net profits were $ 22,350.03, $ 11,342.24, and $ 15,133.92 for 1935, 1936, and 1937, respectively; that there was a deficit of $ 157,756.35 at the end of 1935; of $ 31,654.09 at the end of 1936; and a surplus of $ 11,219.80 at the end of 1937.
In the determinations for 1936 and 1937, credits, unspecified in amount, claimed on the returns because of contracts restricting dividend payments, were disallowed "in the absence of evidence of a written contract executed by the corporation prior to May 1, 1936."
OPINION.
1. The petitioner contests the Commissioner's determination that the amounts of $ 2,560.02 and $ 12,649.97 were discounts in the price of goods purchased from the Brightwater company and as such should operate to reduce the cost of goods in determining taxable net income. Petitioner argues that, by "burrowing under the terms of the contracts" and regarding the extraneous evidence, the Court may determine what the "real agreement of the parties" was, and that what on its face appears to be discount is in reality part of the sale price of the shares of the Adams company. This, we think, is an inadmissible view of the transactions, *53 not because we give greater importance to the form than to the substance of the events, but because, both in form and substance, the petitioner made two separate contracts with two different parties covering two different subjects. The contracts were deliberately cast in the form they took because Guild, who negotiated them, made no offer to buy the shares at petitioner's price of $ 133,000. Instead, after petitioner's refusal of his offer of $ 100,000, he offered petitioner the two propositions, and these were then separately executed -- the sale contract by petitioner and Young, and this has been performed, and the discount contract by petitioner and Brightwater, and this was executory and in the course *6 of performance. In both contracts, carefully drawn under these circumstances, there is a complete omission of any reference one to the other, and the terms are independently clear and complete. Before the law they must be separately regarded, whether for the effect upon taxes or for any other purpose.
So far as the evidence shows, the contemporaneous treatment of the contract by the seller and buyer was that of a discount, so that even if the terms of the contract were*54 ambiguous, it would be necessary to construe it as such. The only support to be found in conduct for petitioner's position, besides the historical circumstances, is its own statements on its balance sheet in the annual report to the shareholders, in which the amounts were called proceeds or payments for the shares. This must be balanced against the seller's treatment of the discounts as such in its income tax return, and is thus deprived of force as a contemporaneous construction to resolve an ambiguity or to construe the contract for tax purposes at variance with its express terms.
We are of opinion that the Commissioner correctly regarded the $ 2,560.02 and $ 12,649.97 as discount in the respective years in determining cost of goods and not as if they were received as part of the sale price of the 200 shares of the Adams company.
2. In the deficiency notice, the disallowance of credits said to have been claimed on the return for contracts restricting dividend payments is based upon the absence of evidence of a written contract executed before May 1, 1936. The return is not in evidence, and the evidence does not show what credits were so claimed on the return, and the allegations*55 on the subject in the petition were denied in the answer. The nearest the evidence comes to showing the specific facts to support a credit is, as shown in the findings, that the amounts of $ 12,398.40 and $ 15,537.93 were estimated by the trustee as the amounts of sinking fund payments to become due April 1. Respondent, in his brief, mentions the inadequacy of the evidence, but argues as a matter of law that the petitioner is not entitled to any credit because it has no such contract as would support the credit under the statute. While the evidence is deficient, cf. Greenwood Packing Plant, 46 B. T. A. 430, 435 (on review C. C. A., 4th Cir.), we are of opinion that in any event the restrictions upon the petitioner are not those prescribed by the statute. These undistributed profits tax credits are extremely technical and may be taken only when all of the factors which the statute prescribes are shown. Helvering v. Northwest Steel Rolling Mills, Inc., 311 U.S. 46">311 U.S. 46; Antietam Hotel Corporation v. Commissioner, 123 Fed. (2d) 274; Helvering v. Moloney Electric Co., 120 Fed. (2d) 617;*56 certiorari denied, 314 U.S. 682">314 U.S. 682; Helms Bakeries, 46 B. T. A. 308.
The conditions of section 26 (c) (2) have not been met. No part of petitioner's "earnings and profits of the taxable year" is required by a contract "which expressly deals with the disposition of earnings and *7 profits of the taxable year," to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; and no part of such amount of earnings and profits of the taxable year has been so paid or set aside. The sinking fund provisions of the bond indenture do not require that any part of the annual payments be made from the current earnings and profits. The source of such payments is not limited. They might be taken from any source, and the amount thereof was measured by the excess of the amount of the preceding year's earnings (if less than $ 75,000) over the preceding year's interest. This is further from the statutory terms than that of the sinking fund provision in Helvering v. Moloney Electric Co., supra, or Antietam Hotel Corporation v. Commissioner, supra.*57 Cf. Commissioner v. Strong Manufacturing Co., 124 Fed. (2d) 360; certiorari granted Apr. 6, 1942. See A. E. Staley Manufacturing Co., 46 B. T. A. 199 (on review C. C. A., 7th Cir.). Payments may be made in bonds, and apparently, according to the note on the 1937 report to the shareholders, such a payment was made with bonds which may have been acquired out of earnings or other funds of an earlier year. This shows that the sinking fund was not limited to payments out of earnings and profits of the taxable year, A. E. Staley Manufacturing Co., supra.
The petitioner also claims that it is entitled to credit under section 26 (c) (1) because it is prohibited by the terms of the deposit agreement of March 8, 1933, from paying dividends. The petitioner itself was not a party that executed this agreement, and the evidence contains no written agreement executed by the petitioner. Petitioner relies upon the fact that the agreement was signed by its reorganization predecessor and that the president testified that petitioner's preferred shares are governed by the deposit agreement. The terms*58 of the preferred shares are not in evidence. In view of the requirement of strict proof called for by these credit provisions, this is not sufficient proof of a contract executed by petitioner as the statute requires. Although the petitioner itself did execute the mortgage indenture of May 1, 1933, which provided for the payment of interest and payments to the sinking fund, it contained no provision dealing with the payment of dividends. Apparently, petitioner did not at the same time also execute a dividend restriction agreement, and the evidence does not show either a contract restricting dividends or an amendment of the charter or other share restriction. See Lehigh Structural Steel Co. v. Commissioner, 127 Fed. (2d) 67; and compare Warren Telephone Co. v. Commissioner, 128 Fed. (2d) 503, and Metal Specialty Co. v. Commissioner, 128 Fed. (2d) 259. We may not pass these deficiencies in the evidence and build one supposition on another to support petitioner's claim. The disallowance of credit under section 26 (c) (1), *8 as well as under (c) (2), must be sustained. *59 It may be added that if the terms of the 1933 reorganization plan set forth in the findings were in a contract of petitioner, and therefore to be tested against the provisions of section 26 (c) (1), it is by no means clear that the statutory conditions could be found in the contract. See Commissioner v. Columbia River Paper Mills, 127 Fed. (2d) 558.
Decision will be entered for the respondent.