*1411 A contract provision that out of the net proceeds of operation of specified property and other moneys available for the purpose a taxpayer would pay certain notes does not support a credit under section 26(c)(2), Revenue Act of 1936, since the noteholders are the shareholders and directors, and with their consent in the practical administration of the contract no payments on the notes or interest have ever been made, the notes have been frequently renewed, there is no showing of net proceeds from the particular property, and the other money available for the purpose was in practice subject to the discretion of the president.
*1127 The Commissioner determined an income tax deficiency of $22,752.16 for 1936 and of $12,326.10 for 1937, by disallowing any credit under section 26(c), Revenue Act of 1936. Petitioner assails the determination, contending that it was bound by contract to apply earnings and profits to the payment of notes.
FINDINGS OF FACT.
Petitioner, a Maine corporation with principal office at Sonora, California, was organized by creditors*1412 of the Pacific Tungsten Co., pursuant to an agreement executed by them on December 24, 1924, amended by a supplemental agreement of February 16, 1925. One of the creditors, Charles H.Segerstrom, has been its president which the agreement The creditors held interest-bearing notes of Tungsten since organization. ment recited were overdue and uncertain of payment, and as action by one or more might result in bankruptcy proceedings by Tungsten, the parties agreed to form a corporation with a capital stock of $100,000, divided into 100,000 shares, to which each would transfer the notes *1128 and collateral held by him and receive in exchange shares of the new corporation and a promissory note for the unpaid amount of the note s0 assigned.
The said new corporation shall further agree that out of the net proceeds of the operation of the said mining property of the said Pacific Tungsten Company, in the event that the said new corporation shall acquire the same at execution sale in actions to be brought, if necessary, against the Pacific Tungsten Company, and out of any other moneys which the said new corporation may have available for that purpose, it will first pay to The First*1413 National Bank of Boston and The National Shawmut Bank of Boston together the sum of Five Thousand Dollars ($5,000) and after such payment, it will pay one-half of such moneys to the First National Bank of Sonora, until said promissory notes so to be delivered to the said First National Bank of Sonora, with interest thereon, shall have been paid in full, and the remaining one-half of such moneys shall be applied pro rata on account of payment of the respective notes held, as aforesaid, by each of the other parties hereto; and when the said notes held by said First National Bank of Sonora shall have been fully paid, theereafter such moneys shall be applied pro rata to the payment in full of the promissory notes of said new corporation, together with interest thereon, held by the other parties hereto.
Should the said new corporation require funds for the operation of the said properties of the said Pacific Tungsten Company which it may acquire on the said execution sale or saled, then each of the parties hereto willcontribute from time to time when and as called for by the directors of the said new corporation, a sum or sums amounting in the aggregate to ten per cent (10%) of the principal*1414 amount of the promissory note of said new corporation by it or him held, and the moneys so advanced to the new corporation shall be evidenced by the demand promissory notes of the new corporation, bearing interest at six per cent (6%) per annum, and such notes shall be paid pro rata by said new corporation before any other payments are made, as herein provided, by said new corporation. In the event that the said new corporation should require funds for the purposes aforesaid in excess of the amount to be contributed by the parties hereto as hereinbefore provided, the matter of furnishing such funds shall be the subject for further discussion among the parties hereto.
On February 18, 1925, this agreement was "accepted" by petitioner as its own. The Tungsten noteholders on February 20, 1925, transferred their notes and collateral to petitioner and received the following interest-bearing notes of petitioner, equal in face amount to the unpaid principal and interest, respectively, of the Tungsten notes and the following shares of petitioner's stock:
| Principal | Interest | Shares | |
| First National Bank of Boston | $153,233.33 | $37,686.54 | 37,396 |
| National Shawmut Bank | 51,666.67 | 9,798.44 | 12,599 |
| First National Bank of Sonora | 25,000.00 | 19,808.97 | |
| Charles H. Segerstrom | 36,064.38 | 1,868.75 | 42,500 |
| George W. Johnson | 10,501.49 | 677.92 | 7,500 |
*1415 Petitioner, at a sheriff's sale, in June 1925 acquired the Tungsten assets, consisting of mining properties, mining claims, milling plants, shares in the Pacific Milling Co., and shares in the Mill City Tungsten *1129 Mining Co. These shares were security for the Tungsten notes and were acquired by petitioner, together with the notes.
Petitioner engaged in mining operations and milling, and sometimes to fulfill contracts purchased foreign ores. To provide working capital, its noteholders were assessed for advances equal to 15 percent of the amount of their notes. By December 27, 1926, their advances had aggregated $63,104,47, of which $43,104.47 remained unpaid. For these advances the noteholders received additional notes.
On April 1, 1929, petitioner issued new notes in exchange for the old notes, on which nothing had been paid. Prior thereto Segerstrom had acquired Johnson's notes (excepting a small one). Later in 1929 he purchased those of the First National Bank of Sonora. Separate notes were issued for the principal and the accumulated interest (inclusive of the interest accrued before February 18, 1925), as follows:
| Principal | Interest | |
| First National Bank of Boston | $153,233.33 | $84,780.10 |
| National Shawmut Bank | 51,616.67 | 25,162.42 |
| First National Bank of Sonora | 25,000.00 | 31,018.69 |
| Charles H. Segerstrom | 49,112.55 | 12,286.33 |
| First National Bank of Boston, agent | 43,104.47 | 11,318.94 |
*1416 The two last named notes, issued to the First National Bank of Boston, agent, represented principal and interest of the aforesaid advances for working capital. During 1931 and 1932 Segerstrom voluntarily made advances of $43,050.99 to enable petitioner to continue in operation and make necessary repairs, and received petitioner's interest-bearing demand notes.
On July 12, 1934, petitioner's board of directors voted to issue new notes for the outstanding notes, excepting current acceptances and a note for $18,000 held by the Bank of America. Three demand notes, dated June 30, 1934, were issued to the First National Bank of Boston - one for $177,008.74, representing principal then owed by petitioner to the bank; one for $124,303.17 representing interest accrued on petitioner's notes from April 1, 1929, to June 30, 1934; and one for $352,675.75, representing principal and interest accrued to April 1, 1929, on all petitioner's notes except principal due the First National Bank of Boston. On July 12, 1934, the directors also voted to pay $2,000 monthly until satisfaction of the $18,000 note and, in respect of all the others, including the notes for advances:
On the first day of*1417 September, 1934, and on the first day of each succeeding month thereafter until otherwise decided by the President and the Secretary to make payment in the amount of ten thousand dollars ($10,000) on account of note indebtedness of this Company, said payments to be distributed pro rata to the holders of such note indebtedness. * * * *1130 This resolution was rescinded on December 3, 1934, petitioner being unable to pay so much.
Petitioner maintained a special and a general bank account with the First National Bank of Boston. Moneys received were deposited in the special account and transfers were made from that to the general account in such amounts and at such times as were judged by Segerstrom, the president, to be necessary for operating expenses. On petitioner's instructions, given by Segerstrom, the bank made withdrawal charges against the special account and applied the withdrawals in proportionate amounts on petitioner's indebtedness to creditors "evidenced by notes dated June 30, 1934," The notes were satisfied by the following proportionate payments:
| Dec. 3, 1934 | $30,000.00 |
| June. 20, 1935 | 150,000.00 |
| Dec. 23, 1935 | 100,000.00 |
| Jan. 29, 1936 | 67,455.43 |
| Apr. 1, 1936 | 25,000.00 |
| June 22, 1936 | $100,000.00 |
| Mar. 18, 1937 | 75,000.00 |
| Aug. 6, 1937 | 56,000.00 |
| Oct. 25, 1937 | 50,734.36 |
*1418 The note for $177,008.74 was fully paid on January 29, 1936; that for $352,675.75 on March 18, 1937; that for $124,303.17 on October 25, 1937.
Each time that petitioner's notes were remewed its creditors at directors' meetings discussed the effect of the contract of December 24, 1924, and more particularly the status of notes for operating advances, and it was agreed among the creditors that all would be covered "under the terms of the same contract and take their effect pro rata with the other notes that were outstanding." The board of directors consisted of Segerstrom, the bank's attorney, and five of the bank's employees. Segerstrom determined the amounts to be paid on the notes and, in so doing, endeavored to pay as much as possible, leaving to petitioner the minimum balance which he deemed necessary for operation.
As shown by its returns, petitioner's taxable net income was $90,382.32 in 1934; $183,090.02 in 1935. The Commissioner determined an adjusted net income of $110,986.21 for 1936; $60,127.30 for 1937. During 1936 and 1937 petitioner extracted tungsten ore from its lands and milled it at its mill, which it had reconstructed about 1928. It also worked leased*1419 mines at Mina, Nevada, on a royalty basis, but sustained losses from these operations, and about 1937 abandoned its rights to title upon payment of specified royalties. Receipts from the sale of concentrates from the Mina properties, amounting to $53,831.26 in 1936 and $47,312.21 in 1937, were deposited in the special account and commingled with other funds. Petitioner also worked a tract known as the Humboldt property under a lease made in 1927; it acquired title about 1933, after royalties which it had paid aggregated $75,000. Sale proceeds of ores extracted were likewise deposited in the special account. In 1934 petitioner purchased for $15,000 all the shares of the *1131 Mill City Tungsten Mining Co., Mill City Development Co., and Pacific Milling Co., which it had not previously acquired. Prior to 1936 it acquired all their assets. To replace a broken pipe line of the water system of the Mill City Development Co., petitioner expended $15,000 in 1936, drawn from the special account.
OPINION.
STERNHAGEN: The petitioner claims and respondent denies in each year a credit under Revenue Act of 1936, section 26(c)(2). 1
*1420 To get as directly ad possible at the determinative factors, several propositions may be assumed arguendo, without deciding them: That the contract term "net proceeds from operation and other moneys available" is within the statutory term earnings and profits; that the interest accrued for which new notes were given is the sort of debt intended by the statute; that the original indebtedness of Tungsten, to cover which petitioner's notes were issued, was, although the creditors were shareholders, incurred under circumstances which bring it within the intendment of the statute.
The credit provided by section 26(c)(2) is carefully set forth in the statute and is to be administered literally, ; (on review C.C.A., 8th Cir.); ; cf. (on review C.C.A., 6th Cir.). Here there was a written contract accepted (which arguendo we treat as executed) prior to May 1, 1936, expressly dealing with the disposition of earnings and profits. It*1421 dates back to the beginning of the petitioner's existence in 1925. Since that time there have been circumstances from which it may be clearly inferred that it has not been treated by its parties as imposing the strict restraints upon petitioner as to the disposition of its earnings and profits as its language would indicate. The creditors were all shareholders ahd Segerstrom, one of the principal creditors, was petitioner's active president. There is no *1132 showing as to the net proceeds or other available moneys from year to year from 1925 to 1936, nor is it shown what in practice that term "net proceeds" has been interpreted to mean. Taking it, as we have, to mean earnings and profits, it would appear that there had been earnings and profits in the past and that they were used otherwise than to pay the notes as the petitioner urges that the contract requires. For example, in 1928 the mill was reconstructed; in 1933 the Humboldt tract was acquired after $75,000 royalties had been paid; in 1934 $15,000 was paid for the remaining shares of three corporations; in 1936 $15,000 was spent to replace a pipe line. All this time there was no payment of the notes but a periodical*1422 renewal of them and an extension of the time for interest. Such a practical administration of a contract and the acquiescence therein of the obligees precludes a recognition of the contract as a stricture upon the corporation's use of its funds in any one year. Apparently the contract was not recognized by the parties as a binding requirement of payment from earnings and profits in any earlier year, and there is no more reason to regard it as requiring payment in the years in question. In fact, the notes were paid in 1936 and 1937.
Another weakness in petitioner's position is that the 1924 contract provides that the notes shall first be paid not only out of the net proceeds of the operation of the mining property of the Tungsten Co., but also out of any other moneys available. The meaning of this was in practice left entirely to Segerstrom, the president and a noteholder. The petitioner is shown to have other activities and sources of earnings and profits besides the Tungsten mining properties, and upon its own conception of the statute it can not say that the earnings and profits other than the net proceeds of the Tungsten mines were required to be used for the payment of*1423 the notes unless in the opinion of Segerstrom they were "available." If Segerstrom, even though in unquestioned good faith, regarded the other moneys as not available, they were not subject to any contract obligation and hence not within section 26(c) (2). Only the net proceeds from the operation of the Tungsten mines would then be left as subject to the restriction, and there is no telling from the evidence what the amount of such net proceeds was.
It can not be held that petitioner was in 1936 or 1937 under any contractual requirement to pay within those years out of the earnings and profits of those years the amounts of the notes. The determination is therefore sustained.
Decision will be entered for the respondent.
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. -
* * *
(2) DISPOSITION OF PROFITS OF TAXABLE YEAR. - An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and 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; to the extent that such amount had been so paid or set aside. For the purposes of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word "debt" does not include a debt incurred after April 30, 1936. ↩