*1013 Petitioner was organized as a public service corporation to construct a waterworks system for use of the town of Geneva, Indiana, and its citizens. Its common stock was all subscribed for by the town and its preferred stock by individuals. Upon completion of the waterworks system it was leased to the town under an agreement whereby the net rentals were to be used in payment of dividends on and retirement of the preferred stock. Held, that for such years the petitioner had no income tax liability.
*582 This proceeding involves deficiencies in petitioner's income tax and penalties for the calendar years 1932, 1933, and 1934 as follows:
| Year | Deficiency | Penalty |
| 1932 | $235.13 | $58.78 |
| 1933 | 238.15 | 59.54 |
| 1934 | 226.60 | 56.65 |
*583 The petitioner's contentions are that it is exempt from Federal income tax and that if not exempt it is entitled to certain deductions or exclusions from its income which the respondent has not allowed.
In an amended answer filed subsequent to the hearing in*1014 this proceeding the respondent contends that the taxes herein proposed against the petitioner for the years 1932, 1933, and 1934 constitute additional income for those years and asks that the deficiency be increased accordingly. This contention is based on the fact that under a certain lease agreement the taxes in question were to be paid by the petitioner's lessee.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the State of Indiana on February 25, 1925, for the purpose of constructing a waterworks plant and system for the town of Geneva, Adams County, Indiana.
Prior to that time the citizens of the town had maintained their own water system. The town had installed a sewerage system, but it has no water supply for flushing it and no fire protection. The construction of an adequate waterworks system had been under consideration for several years, when, on petition of a group of leading citizens, the town board adopted the plan to organize the petitioner corporation for that purpose. The town was not able to finance the undertaking itself because of the legal limitation on its bond issue. Under the plan adopted the additional necessary funds*1015 for the construction of the plant were to be raised from the sale of petitioner's preferred stock. All of the common stock was to be issued to the town.
The petitioner was organized as a public utility corporation, with an authorized capital stock of $40,000, consisting of 140 shares of common and 260 shares of preferred, all of a par value of $100 per share. Both classes of stock carried voting rights. All of the common stock was issued to the town of Geneva or its nominees and was paid for out of funds raised from the sale of bonds. All of the preferred stock, except a few unissued shares, was subscribed and paid for by individuals who, for the most part, were citizens of Geneva. The preferred shares bore a 6 percent dividend rate, the dividends being cumulative and the shares redeemable at par plus accrued dividends.
The waterworks plant was constructed by the petitioner some time prior to the taxable year 1932 at a total cost of approximately $35,000.
On March 27, 1925, a franchise contract was entered into between the town of Geneva and the petitioner whereby the petitioner was granted the right to construct and maintain the waterworks and water supply system in*1016 accordance with specifications therein set forth. The *584 agreement provided that the petitioner would install and maintain 28 fire hydrants and such other additional hydrants as might be needed, for which the town would pay an annual rental of $80 per hydrant. The petitioner was authorized to charge a fixed meter rate for water furnished to the inhabitants of the town. This contract was to run for a period of 25 years.
On the same date, March 27, 1925, the petitioner and the town of Geneva executed a lease agreement under the terms of which the petitioner leased the waterworks plant and system them under construction to the town for a period up to and including July 15, 1943, at an annual rental of $2,400. The rental payments were to apply against and be credited to the fire hydrant rentals which the town was obligated to pay under the franchise agreement referred to above. The town further agreed to pay all taxes and assessments that might be levied against the lessor or any of its properties by any public or governmental authority, to keep the properties insured, and to make necessary repairs and additions at its own cost. Paragraph 14 of the agreement provides*1017 that:
The lessor agrees that it will not sell or convey said waterworks plant and system or encumber the same by lien or mortgage without first obtaining the written consent of the lessee so to do; and further agrees that it will promptly apply its net proceeds derived from the lease rentals herein provided for to the redemption and retirement of its outstanding preferred stock and to the payment of accruing interest thereon, all in accordance with the provisions of the articles of associations, by laws, and preferred stock certificates of said lessor.
Pursuant to the lease agreement the town of Geneva took over the waterworks system as soon as it was completed and has continued to operate it up to the present time. During the taxable years involved the town collected water rentals amounting to $1,597.48 in 1932, $1,540.62 in 1933, and $1,320.55 in 1934. In those years dividends were paid on petitioner's preferred stock and shares of preferred stock were redeemed in the following amounts:
| Year | Dividonds paid | Par value of shares retired |
| 1932 | $1,125 | $1,300 |
| 1933 | 1,047 | 1,400 |
| 1934 | 963 | 1,500 |
The excess of the amounts which the town paid to the petitioner*1018 as rentals over the amounts which it received in each year from the operation of the waterworks system was paid out of the general taxes.
The petitioner's net income, as disclosed by its books and as found by the respondent in his deficiency notice, except that the respondent *585 has deducted $700 depreciation in each year which is not shown on the books, was $2,410 in 1932, $2,432 in 1933, and $2,348 in 1934.
The petitioner is still in existence and all of its common stock is still owned by the town of Geneva. All of its preferred stock, except $9,900, has been redeemed and canceled and plans have been made by the town to issue bonds for retiring the remainder of the preferred stock as soon as the present tax matter is settled.
The petitioner filed no income tax returns for any of the years before us, and for its failure to do so that respondent has assessed the statutory 25 percent penalty.
OPINION.
SMITH: The questions for our determination are whether the petitioner is a tax-exempt organization either within the meaning of section 103(14) of the Revenue Act of 1932 (appearing as section 101(14) of the Revenue Act of 1934), or on the broad constitutional*1019 grounds that Federal taxes can not be imposed upon a state instrumentality, and, if the petitioner is not entitled to an exempt status, whether a portion of its income is exempt from taxation under the provisions of section 116(d) of the Revenue Acts of 1932 and 1934. The petitioner has made no protest against the imposition of the penalty for failure to file returns. The sections of the statutes referred to read in material part as follows:
SEC. 103. EXEMPTIONS FROM TAX ON CORPORATIONS.
The following organizations shall be exempt from taxation under this title -
* * *
(14) Corporations organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, to an organization which itself is exempt from the tax imposed by this title.
SEC. 116. EXCLUSIONS FROM GROSS INCOME.
In addition to the items specified in section 22(b), the following items shall not be included in gross income and shall be exempt from taxation under this title:
* * *
(d) INCOME OF STATES, MUNICIPALITIES, ETC. - Income derived from any public utility or the exercise of any essential governmental function and*1020 accruing to any State, Territory, or the District of Columbia, or any political subdivision of a State, or Territory, or income accruing to the government of any possession of the United States, or any political subdivision thereof.
In , the court held, reversing , that a corporation which was organized for the same purpose and in substantially the same manner as the petitioner and whose functions were but little different from those of the petitioner, was an instrumentality of the State of Illinois and that the amounts paid to it by the city of Decatur, Illinois, out of the water rents collected by the *586 city were not income to the company and were not subject to Federal income tax. In its opinion the court said:
It is thus seen that the corporate entity (the taxpayer) was but an instrumentality adopted by the City of Decatur for the accomplishment of a specific purpose. As a means of raising necessary funds, citizens subscribed to the company's stock, thus creating a fund for the acquisition of the property required by the city. The city in*1021 effect pledged its water revenue for the repayment of this capital by agreeing that all over operating expenses be set up in a special fund, ninety per cent of which was paid to the company. The company in turn was obligated by its charter provisions and by its contract to apply its percentage of this fund (after payment of expenses and 7% dividends on preferred stock) to the retirement of its preferred stock at par. From the time of its receipt such fund was earmarked for a single purpose - the return of capital to its preferred stockholders. The company could not and did not profit by its receipt, but in effect it acted as an agency for restoring to the investors to corpus of their investment. To the extent that seven per cent dividends were paid, a taxable income is conceded, but it is difficult to see how this restoration of capital can equitably be said to be a taxable income of the company.
* * *
* * * How can it be said in the instant case that the Company has received anything for its use and benefit? The money received was for the use and benefit of those who had furnished the capital - the preferred stockholders. The charter and contract set up a barrier to its*1022 use otherwise. The Company had no freedom of disposal, but its disposition was limited to a very narrow channel; rather do we think it fairer to say that such sums were at the predetermined disposal of the city. Such funds had no exchangeable value because of the restrictions attaching to their receipt. The company was not enriched by their receipt either in fact or on its books. When it reduced its stock liability by the return of such funds to stockholders, it also reduced by that same amount its future right to receive the capital investment made for the city. To state it in another way the city gained by such payments an additional equity of equal amount in the property it had optioned from the company and which the company later transferred to it. With each payment to the company, thus earmarked for its stockholders, the city built up an additional equity in the property in ratio to the sums paid. Carried to its ultimate consummation it meant the return in full of the funds advanced by the preferred stockholders and the acquisition, unrestricted by the city, of the property which those funds purchased - a simple transfer of the property purchased to the municipality, without*1023 profit to the company, and in full compliance with the letter and spirit of the charter and contract.
The respondent attempts to distinguish the instant case from , on the facts, but obviously the distinction, if any, is superficial. The facts as well as the questions of law presented are substantially the same in both cases. The petitioner had no taxable income for the years 1932, 1933, and 1934.
Reviewed by the Board.
Judgment will be entered for the petitioner.
STERNHAGEN, MURDOCK, LEECH, and MELLOTT dissent.