*1337 Petitioner's amended charter provided for sinking fund for retirement of preferred stock, whereby percentage of net earnings of taxable year after payment of preferred dividends was to be set aside before any other dividends could be paid. The charter provision was set out in preferred stock certificates. Held, petitioner is not entitled to credit of such amount under section 26(c)(1), Revenue Act of 1936; charter provision held not a contract within meaning of act.
*422 The Commissioner determined deficiencies in income tax and surtax of $999.23 for 1936 and $3,839.83 for 1937. He disallowed credits under section 26(c) of the Revenue Act of 1936. The facts are all stipulated and the stipulation is made part of this report.
FINDINGS OF FACT.
The petitioner is a Delaware corporation, with its principal office at Allentown, Pennsylvania.
On October 18, 1920, its certificate of incorporation was amended to authorize 5,000 shares of $100 par value preferred stock. 3,677.8 shares were issued, *1338 the certificates providing for the creation of a sinking fund for their retirement.
On August 1, 1933, when 297.3 shares had been redeemed and 3,380.5 remained outstanding, the board of directors, in a letter signed by the secretary, proposed a plan to the preferred shareholders to reduce the fixed capital charges, whereby 20 percent of the outstanding preferred stock would be redeemed and the dividend rate on *423 the balance reduced from 8 percent to 6 percent. This plan was approved by all the preferred shareholders.
On September 29, 1933, the charter was amended, authorizing the new preferred stock. On October 2, 1933, 2,704.4 new 6 percent shares were issued to the then preferred shareholders. The amended charter and the share certificates contained the following provision:
(d) A sinking fund for the retirement by purchase of the preferred stock shall be created out of the net profits that shall remain after deducting therefrom from any accrued dividends on the preferred stock, and for this purpose there shall be credited to an account to be called the preferred stock sinking fund account on January 1, 1934, and at the beginning of each calendar year thereafter*1339 out of the remaining net profits of the previous calendar year after providing for the payment of the full dividend for such year and unpaid dividends for previous years or year on the preferred stock until the whole of the preferred stock issued and outstanding shall have been purchased or retired, the sum equivalent to five per cent of the outstanding preferred stock at the beginning of the preceding calendar year before any dividends shall be paid upon any other stock. The Company shall out of said sinking fund created for the retirement of the preferred stock authorized to be issued in pursuance of the Resolution adopted by the Board of Directors on September 20th, 1920, from time to time retire by purchase at public or private sale (but not to exceed the sum of $110 per share) shares of the preferred stock until all of said preferred stock shall have been retired or otherwise redeemed.
On December 31, 1936, $13,522 was transferred to a preferred stock sinking fund out of the earnings of that year, this being 5 percent of the $270,440 outstanding preferred stock at the beginning of that year, and on December 31, 1937, $13,414 was so transferred, this being 5 percent of the*1340 $268,280 preferred stock outstanding at the beginning of that year.
Petitioner's accumulated surplus on December 31, 1935, exceeded its adjusted net income for 1936, and its accumulated surplus on December 31, 1936, exceeded its adjusted net income for 1937.
OPINION.
STERNHAGEN: The petitioner claims a credit for the amount set aside in the sinking fund for the purchase and retirement of its preferred stock. The Commissioner has disallowed the credit "because the instrument on which your claim for credit is based does not satisfy the conditions as prescribed in section 26(c)(1), Revenue Act of 1936." 1 If the share be called a contract, the statute is literally *424 met, for it is in writing, was executed in 1933, and contains a provision which prohibits the payment of dividends until after the required credit to the sinking fund. The question is whether such an application of the statute is consistent with its manifest purpose and intendment, for no other interpretation is permissible.
*1341 The legislative intent was primarily to tax corporate earnings to the shareholders; and any attempt to frustrate the tax through the nondistribution of earnings was to be futile. The method adopted was the levy of a surtax upon earnings, with credits for dividends paid and for earnings which the corporation was contractually prevented from distributing. Obviously, to recognize a voluntary restriction not imposed from outside would defeat the purpose. A charter importing a state statute expressly prohibiting dividends under certain circumstances is not within the statutory provision, despite the fact that it is a written contract with the state of its creation. It is not "a routine contract dealing with ordinary debts." .
The preferred stock clause in the present case, although for some purposes a contract, has no better ground for recognition under the credit statute than the charter provision in the Northwest Steel case. It derives no greater strength from the fact that it is spread upon the share certificate, for this is but a reprint of the charter provision. For some purposes the charter*1342 is a contract with the shareholders; but the shareholders are in many respects the corporation itself, and in that conception the charter provisions are more constitutional than contractual. The present charter provision prescribes a method for liquidating the preferred shares out of earnings, cf. (on review C.C.A., 4th Cir.); . A distribution of dividend to the common shareholders before setting aside the required sinking fund contribution would be a violation of the charter provision not in the sense of a contract but as one of the constitutional restraints of the corporation with regard to its shareholders. A charter provision that a corporation would use some or all of its income in the acquisition or construction of a plant, even though it were spread on the share certificates or stated in a written agreement with the shareholders, would not be ground for a credit. It would be an inhibition against distribution, but to regard it as a contract would defeat the plain purpose of the statute. There is no more virtue in a corporation's undertaking with its shareholders*1343 to retire their shares out of earnings than there is in its undertaking to use its earnings for acquiring a capital asset. Cf. .
The Commissioner's determination is sustained.
Decision will be entered for the respondent.
Footnotes
1. (c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
(1) PROHIBITION OF PAYMENT OF DIVIDENDS. - An amount equal to the 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. If a corporation would be entitled to a credit under this paragraph because of a contract provision and also to one or more credits because of other contract provisions, only the largest of such credits shall be allowed, and for such purpose if two or more credits are equal in amount only one shall be taken into account. ↩