*651 1. Petitioner, in 1934, in order to obtain a loan from the Reconstruction Finance Corporation, executed a written contract containing a provision that so long as the note remained unpaid it would pay no dividends "without the prior written consent of the R.F.C." Petitioner during the taxable year did not ask for or obtain such consent and paid no dividends. Held, petitioner is entitled to credit under section 26(c)(1), Revenue Act of 1936.
2. In the same written contract petitioner agreed that it would not increase the compensation of its officers without the prior written consent of R.F.C. During the taxable year petitioner authorized an increase of salary to two of its officers, subject to the approval of R.F.C. and with a proviso that any part of such increase not so approved should be cumulative subordinated to the payment of Reconstruction Finance Corporation loan. In a year subsequent to the taxable year the R.F.C. approved a part of such increases and and they were paid in the amounts approved. Held, petitioner is not entitled to deduct any part of such increase in the taxable year.
*749 In this proceeding respondent has determined a deficiency in petitioner's income tax liability for the fiscal year ended June 30, 1937, in the amount of $1,861.06. Petitioner alleges that respondent erred in such determination in that (1) he refused petitioner a credit under section 26(c)(1) of the Revenue Act of 1936 in calculating its surtax on undistributed profits, and (2) he disallowed a deduction claimed by petitioner on account of officers' salaries.
The parties filed herein a written stipulation of facts and a supplemental stipulation of facts. At the hearing herein the parties orally stipulated certain facts. In addition, the testimony of one witness was adduced from which we find one additional fact.
FINDINGS OF FACT.
We find the facts to be as stipulated in the stipulation filed herein and reading as follows:
On July 21, 1934, Cotton States Fertilizer Company, a corporation organized and existing under the laws of Georgia and having its principal office and place of business in the City of Macon, Georgia, applied to the Reconstruction Finance Corporation for a loan of $125,000.00.
To induce the*653 Reconstruction Finance Corporation to make such loan, the Cotton States Fertilizer Company represented, warranted, and agreed as follows, the said representations, warranties, and agreements following being set out as Paragraphs 14 and 16 of its application to the Reconstruction Finance Corporation for a loan:
(14) So long as applicant shall be indebted to R.F.C., applicant will not, without the prior written consent of R.F.C.: (a) if applicant is a corporation, joint stock company, or Massachusetts trust, declare or pay any dividend or make any distribution upon its capital stock, or purchase or retire any of its capital stock, or authorize or issue any additional shares of stock, or reclassify any outstanding shares, or consolidate or merge with any other company, or make any advance, directly or indirectly, by way of loan, gift, bonus, commission, or otherwise, to any of its officers, directors or employes, or to any company directly or indirectly controlling or affiliated with or controlled by the applicant; (b) if applicant is a partnership or individual, make any distribution of assets of the business other than reasonable compensation for services rendered in accordance with*654 the provisions of Exhibit I, or make any advance, directly or indirectly, by way of loan, gift, bonus, commission or otherwise, to any partner or any *750 of its employees, or to any company directly or indirectly controlling or affiliated with or controlled by the applicant * * *.
* * *
(16) This applicant as hereafter amended or supplemented, together with all conditions imposed by and [sic] all agreements required by or entered into with or for the benefit of R.F.C. in connection with the making of the loan hereby applied for and the note or notes of applicant evidencing such loan (all of which are incorporated herein and made a part hereof), shall constitute a contract between applicant and R.F.C. Said contract shall inure to the benefit of the successors and assigns of R.F.C. but shall not inure to the benefit of the successors or assigns of applicant without the written consent of R.F.C. Such contract shall become binding upon the parties thereto only when all or any part of the loan applied for is paid to applicant by check or draft or is unconditionally credited to or for the account of applicant, and only with respect to the amount so paid or credited. The*655 validity, interpretation, legal effect, and performance of such contract shall be governed by the law of the place of payment of the note.
The said application was signed by the Cotton States Fertilizer Company, through its President, C. B. Clay, attested by its Secretary D. D. Kinnett, and the corporate seal thereof was duly attached.
The said application for a loan also contained a form known as R.F.C. Form L-109(c), the said form being attached to the application as Exhibit "I" and reading as follows: [For the sake of brevity only the pertinent parts of this exhibit are set out in the Findings]
* * *
The undersigned submits herewith a true and complete schedule, prepared in accordance with the foregoing instructions, showing the annual rate of compensation paid to the officers and directors (if Applicant is a corporation), or partners (if Applicant is a partnership), and employees of said applicant (or its predecessor) in effect at January 1, 1930, and at the date hereof, and in consideration of the making by Reconstruction Finance Corporation of a loan or loans to the undersigned whether directly, or in cooperation with banks or other lending institutions, or by the*656 purchase of participations, hereby agrees with Reconstruction Finance Corporation (herein called "R.F.C.") as follows:
* * *
3. So long as the undersigned is indebted to R.F.C., contingently or otherwise, the undersigned will not:
(a) without the prior written consent of R.F.C., increase the compensation (either directly or through appointment to any additional office, or position) of any of its officers or directors (if Applicant is a corporation), or partners (if Applicant is a partnership), or employees above the respective amounts shown on such schedule for named individuals;
* * *
| SCHEDULE. | |||
| Name | Position | Compensation at 1/1/30 | Present Compensation |
| C. B. Clay | Pres. ,& Director | $7,200.00 | $3,600.00 |
| D. D. Kinnett | Secretary | 3,000.00 | 2,100.00 |
| George F. Thompson | V. Pres. Director | 3,000.00 | 924.88 |
| W. J. O'Shaughnessey | Treas. Director | 3,000.00 | 2,600.00 |
| Warner F. Thompson | Director | none | none |
* * *
On *751 the 14 day of August, 1934, a resolution was duly adopted by the Executive Committee of the Reconstruction Finance Corporation, in which it was recited that the Cotton States Fertilizer Company had filed*657 its application, dated July 21, 1934, for a loan under Section 5(d) of the Reconstruction Finance Corporation Act, as amended, and in which it was resolved that the Reconstruction Finance Corporation make a loan to the Cotton States Ferilizer Company upon its aforesaid application in an amount not exceeding $125,000.00, upon the terms of the application, subject to the conditions set out in the resolution.
The loan, in the amount of $125,000.00, was disbursed by Reconstruction Finance Corporation to Cotton States Fertilizer Company as follows:
| September 4, 1934 | $11,812.62 |
| September 4, 1934 | 5,467.32 |
| September 28, 1934 | 25,000.00 |
| October 4, 1934 | 7,720.06 |
| November 9, 1934 | 28,467.83 |
| December 20, 1934 | 25,496.39 |
| January 16, 1935 | 21,035.78 |
| $125,000.00 |
This loan remained unpaid on July 1, 1937.
We find the facts to be as stipulated in the supplement to stipulation filed herein, which reads as follows:
A special meeting of the Board of Directors of the Cotton States Fertilizer Company of Macon, Georgia, was held at the offices of George F. Thompson, 52 Vanderbilt Avenue, New York, New York, on the 4 day of August, 1936, at 4 o'clock, P.M.
The following*658 is an excerpt from the minutes of that meeting, which minutes appear on page 129 of the Minute Book of the Company:
On motion, duly made by George F. Thompson, seconded by Warner F. Thompson, and carried, it was resolved that the salary of C. B. Clay, as President, for the fiscal year from July 1, 1936, to June 30, 1937, shall be the sum of $6,000.00, payable monthly.
The minutes show that there were present at said meeting C. B. Clay, George F. Thompson, Warner F. Thompson and W. J. O'Shaughnessey, being all the Directors of the Company.
The following is an excerpt from the minutes of the same meeting, appearing on the same page of the Minute Book:
On motion, duly made, seconded and carried, it was resolved that the salary of W. J. O'Shaughnessey, as Treasurer of the Company, for the fiscal year from July 1, 1936, to June 30, 1937, shall be the sum of $4,800.00, payable monthly.
At the same meeting, the following occurred:
It was further resolved that the payment of the aforesaid salaries of the President, Treasurer, and Secretary shall be made subject to approval by the Reconstruction Finance Corporation during the time their loan to the Company is in effect, and any*659 part thereof not approved by said Reconstruction Finance Corporation shall be cumulative and subordinated to the payment of the Reconstruction Finance Corporation loan.
*752 This appears at page 131 of the Minute Book of the company.
Payment of $2,400.00 of the amount voted to C. B. Clay was authorized by the Reconstruction Finance Corporation on September 3, 1937.
$1,200.00 of this amount was actually paid by the Cotton States Fertilizer Company to C. B. Clay on September 7, 1937, and $1,200.00 on September 13, 1937.
$600.00 of the additional amount authorized as herein stated for Mr. O'Shaughnessey was approved by the Reconstruction Finance Corporation on October 11, 1937, and paid June 9, 1938.
No additional amounts of the salaries authorized by the petitioner were approved by the Reconstruction Finance Corporation.
Attached hereto is a copy of the balance sheet of the petitioner as of June 30, 1937, being a copy of the balance sheet which was attached to its income tax return for the fiscal year ended on that date.
* * *
| Trial Balance | ||
| June 30, 1937 | ||
| ASSETS | ||
| 1. Cash | Amount | Total |
| (a) Demand deposits, including checks | $45,377.52 | |
| (c) All other cash | 25.00 | |
| $45,402.52 | ||
| 2. Notes receivable | 46,740.78 | |
| 3. Accounts receivable | 13,624.74 | |
| (a) Less reserve for discounts, etc | 4,367.04 | 9,257.70 |
| 4. Inventories: | ||
| (a) Raw materials | 4,737.56 | |
| (b) Work in process | 22,171.12 | |
| (c) Finished goods | 20,498.72 | |
| (d) Supplies | 4,492.74 | |
| 51,900.14 | ||
| 7. Deferred charges: | ||
| (a) Prepaid insurance | 232.08 | |
| (c) All other | 232.08 | |
| 8. Capital assets: | ||
| (a) Buildings | 69,283.55 | |
| (b) Machinery and equipment | 245,681.75 | |
| (c) Furniture and fixtures | 4,261.74 | |
| (d) Autos | 1,411.75 | |
| (e) Appreciation by appraisal | 168,506.57 | |
| (f) Total of Lines (a) to (e) | 489,145.36 | |
| (g) Less reserves for depreciation | 280,055.10 | |
| 209,090.26 | ||
| (j) Land | 20,300.00 | |
| 11. Other assets (describe fully): Mis. Accts | 815.00 | |
| Stocks - Corporate | 491.00 | |
| Accounts Payable - Dr. Bal | 410.63 | 1,716.63 |
| 12. Total Assets | 384,640.11 | |
| LIABILITIES | ||
| 13. Notes payable (less 1 year) | 124,300.00 | |
| 14. Accounts payable | 82.79 | |
| 17. Accrued expenses: | ||
| (a) Interest | 9,591.73 | |
| (b) Taxes | 2,453.41 | |
| (c) All other - Officers Salaries | 11,600.00 | |
| 23,645.14 | ||
| 18. Other liabilities (describe fully): | ||
| Reserve for bad debts | 650.00 | |
| Deferred Notes & Accounts Payable | 29,043.30 | |
| 29,693.30 | ||
| 19. Capital stock: | ||
| (a) Preferred stock (less stock in treas.) | 55,290.00 | |
| (b) Common stock (less stock in treas.) | 120,133.33 | |
| 175,423.33 | ||
| 20. Surplus | 31,495.55 | |
| 21. Undivided profits | 31,495.55 | |
| 22. Total liabilities | 384,640.11 |
*660 *753 We find the facts to be as stipulated orally by the parties as follows:
The Reconstruction Finance Corporation did not give its consent in writing to the Cotton States to the item of dividends for the fiscal year ending June 30, 1937. Cotton States made no request to the R.F.C. for the payment of such dividends.
* * *
It is further stipulated by the parties in connection with the salary issue, that the $2400.00 increase in salary to W. J. O'Shaughnessey for the fiscal year ended June 30, 1937, authorized by resolution of Petitioner August 4, 1936, only $600.00 thereof was approved by the Reconstruction Finance Corporation and paid by the Petitioner.
In addition to the facts stipulated we find that any consent which might have been given by the Reconstruction Finance Corporation to the payment of dividends by petitioner would have had to have been given by the Directors of the Reconstruction Finance Corporation.
OPINION.
KERN: The first question presented in this proceeding is whether petitioner is entitled to the credit provided by section 26(c)(1) of the Revenue Act of 1936. 1 In order to be so entitled, petitioner must show *754 (1) a written*661 contract; (2) executed by it before May 1, 1936, (3) expressly dealing with the payment of dividends, (4) which would be violated by its distribution during the taxable year of amounts as dividends. The written contract executed by petitioner in 1934 provided that "applicant will not, without the prior written consent of R.F.C. * * * declare or pay any dividend or make any distribution upon its capital stock." Petitioner did not ask for the consent of R.F.C. to the payment of dividends; none was granted; and petitioner paid no such dividends during the taxable year. The precise issue, therefore, is whether, under the facts shown, the distribution of dividends by petitioner during the taxable year would have been in violation of the quoted provision of the contract.
*662 It seems to us obvious that it would have been. A distribution of dividends by petitioner would not have been a violation of such contract only if consented to in writing by the other party to the contract. Such a consent would have been in the nature of a waiver or modification of an obligation by the obligee of a contract, which is always possible even though not expressly provided for, but until the obligation is waived or modified, it is in full force and can not be violated with immunity. That such consent might have been granted by R.F.C. if requested by petitioner seems to us immaterial. It was not granted and no request was made. Moreover, we can not assume that R.F.C. would have given its consent. .
In , we held that a similar contractual provision effectively prohibited the payment of dividends. It is true that in that case it was stipulated that a request for permission from the obligee to pay dividends would have been refused, that the payment of dividends by the taxpayer would not have been sanctioned by sound business practice, and that the taxpayer knew*663 that any request to pay dividends would have been refused. These facts, however, were not essential to our holding. The essential fact is pointed out in one sentence: "It [taxpayer] did not request * * * permission from either of the banks to pay a dividend nor was such permission granted."
The situation here presented is the legal converse of that considered by us in . There the taxpayer corporation could declare a dividend without violating a contract, but if it did, then the creditor could take certain steps. Here the petitioner could not make a dividend distribution without violating a contract, but if the creditor consented, then and only on that condition could such a distribution be made.
On this issue we decide in favor of petitioner.
*755 The second issue has to do with the right of petitioner in the taxable year to deduct officers' salaries in amounts in excess of those authorized by its contract with the Reconstruction Finance Corporation. The salary items in question consisted of certain increases in the salaries of the president and treasurer of petitioner which were made by petitioner's board of directors*664 in the taxable year, "subject to the approval of the Reconstruction Finance Corporation during the time their loan to the company is in effect, and any part thereof not approved by said Reconstruction Finance Corporation shall be cumulative and subordinated to the Reconstruction Finance Corporation loan." The Reconstruction Finance Corporation in the following taxable year approved only a part of such increases and petitioner in the latter year paid to the officers in question only that part of the increases so approved. The stipulations of fact do not disclose whether petitioner is on the accrual basis of accounting and do not disclose how petitioner treated the amounts, paid and unpaid, of such salary increases on its books during the taxable year. Petitioner's tax returns for the taxable year were not introduced in evidence.
Even if we assumed in petitioner's favor that it was on the accrual basis during the taxable year, we are still not of the opinion that the salary increases provided for in the quoted resolution are items properly subject to being accrued, because of the contingency of petitioner's obligation to pay them. *665 ; .
On this issue we decide in favor of respondent.
Reviewed by the Board.
Decision will be entered pursuant to Rule 50.
SMITH, dissenting: In its income tax return for the fiscal year ended June 30, 1937, the petitioner deducted from gross income an increase of $4,600 in salaries voted to its president and treasurer. The increased salaries were to be paid monthly. They were to be paid, however, subject to approval by the Reconstruction Finance Corporation. At the close of its fiscal year, June 30, 1937, the petitioner had not received the authority of the Reconstruction Finance Corporation to pay the additional salaries and the amount of the salaries unpaid was $4,600. The respondent disallowed the deduction of these accrued salaries in the determination of the deficiency.
It is stipulated that the Reconstruction Finance Corporation on September 3, 1937, approved the increase in the salary of the president in the amount of $2,400 and $1,200 of that amount was paid to *756 the president on September 13, 1937. *666 On October 11, 1937, the Reconstruction Finance Corporation approved the payment of an additional salary of $600 to the treasurer, which had theretofore been authorized by the petitioner for the taxable year, but disapproved the payment of the balance authorized.
In the Board's opinion it is stated that:
* * * The stipulations of fact do not disclose whether petitioner is on the accrual basis of accounting and do not disclose how petitioner treated the amounts, paid and unpaid, of such salary increases on its books during the taxable year. * * *
I do not think that this statement is correct in view of the stipulated facts. The trial balance clearly shows that the petitioner was on the accrual basis. It includes among its assets inventories and deferred charges and among its liabilities accrued expenses, including officers' salaries in the amount of $11,600. It is not necessary to stipulate specifically that the return was made on the accrual basis where the stipulated facts show that it was.
In , the Supreme Court held that the accrual system was incorporated into the law:
* * * to enable the taxpayers to keep*667 their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period. * * * [Italics supplied.]
Quite clearly the additional salaries voted the petitioner's president and treasurer were "expenses incurred in and properly attributable to the process of earning income" during the taxable year. They were not expenses of the taxpayer of the years during which the payments were made.
It is furthermore to be noted that petitioner's income tax return for the fiscal year ended June 30, 1937, was not due to be filed until September 15, 1937. Prior to that date the Reconstruction Finance Corporation had approved the payment of an additional salary to the petitioner's president of $2,400. I do not see in any event how the Board can say that that was not an expense of the petitioner of the taxable year.
In , it was held that additional excise taxes upon the profits of the petitioner for the year 1918 accrued in that year even though*668 the Revenue Act of 1918 was not passed until February 24, 1919, and made changes in the rates. The court held that the change made by Congress in the rates of the excise tax was made in ample time to enable the taxpayer to deduct from gross income in its income tax return for *757 1918 the excise taxes which had accrued for the year 1918 at the increased rates authorized by the Revenue Act of 1918. By the same process of reasoning I think that it should be held that petitioner is entitled to deduct the additional salary for its president authorized by the petitioner's board of directors during and for the taxable year to the extent of $2,400.
The Reconstruction Finance Corporation did not authorize any additional payment of salary to the petitioner's treasurer for the taxable year until October 11, 1937. The additional salary of $600 was paid to the treasurer on June 9, 1938. I think, however, that under the principle of the cases above cited it must be held that the additional salaries voted to the petitioner's president and treasurer for and during the taxable year should be allowed as deductions from the gross income of the taxable year to the extent approved by the*669 Reconstruction Finance Corporation. They were not expenses of the year in which the payments were made.
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 -
(1) PROHIBITION ON PAYMENT OF DIVIDENDS. - An amount 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. * * * ↩