*1070 Contract requiring application of a portion of petitioner's earnings and profits for the taxable year against indebtedness incurred prior to 1936. held, to require irrevocable setting aside of such portion and to entitle petitioner to a credit for purposes of the undistributed profits tax to the extent that such payment was actually made in the taxable year. Revenue Act of 1936, sec. 26(c)(2).
*1273 This proceeding was brought for a redetermination of a deficiency in petitioner's income and excess profits taxes in the amounts of $14,776.89 and $548.37, respectively, for the year 1936.
*1274 The issues presented by the pleadings are: (1) Whether petitioner is entitled to a credit under the provisions of section 26(c)(2) of the Revenue Act of 1936 in computing the surtax on its undistributed profits; and (2) whether petitioner was entitled to certain deductions for expenditures for repairs and replacements.
FINDINGS OF*1071 FACT.
Petitioner, an Ohio corporation organized in 1932, has its principal offices at Sebring, Ohio, and is engaged in the manufacture of enamelware.
On or about April 15, 1932, petitioner purchased its plant and equipment from The Central United National Bank, Cleveland, Ohio, trustee for the bondholders of The Sebring Manufacturing Corporation. The purchase price was $50,000, for which petitioner on April 15, 1932, executed a note secured by a mortgage to The Central United National Bank (hereinafter referred to as the bank).
The note was as follows:
For value received The Strong Manufacturing Company, a corporation of the State of Ohio, promises to pay to Central United National Bank, of Cleveland, Trustee, or order, Fifty Thousand Dollars ($50,000) in the following installments (all payments to be made at the principal office of said Central United National Bank in the City of Cleveland, Ohio):
$2,000 on April 15, 1934
3,000 on April 15, 1935
5,000 on April 15, 1936
6,000 on April 15, 1937
7,000 on April 15, 1938
8,000 on April 15, 1939
9,000 on April 15, 1940
10,000 on April 15, 1941
Any unpaid portion of the said principal sum shall bear interest*1072 from April 15, 1932 at the rate of six per centum (6%) per annum until paid; such interest shall be paid semi-annually at said office of Central United National Bank of the 15th day of October and April in each year.
This note is issued pursuant to, and payment of the principal thereof and of the interest thereon is secured by a certain first mortgage deed dated as of April 15, 1932, duly made, executed and delivered by The Strong Manufacturing Company to Central United National Bank of Cleveland, Trustee, to which mortgage deed reference is hereby made to the same effect as if herein set forth for a statement of the properties and rights mortgaged and pledged and the nature and extent of the rights of the holder hereof.
As provided in said mortgage deed installments of the principal sum hereof may be anticipated in whole or in part by The Strong Manufacturing Company. In addition The Strong Manufacturing Company shall apply forty per cent. (40%) of its net earnings in and for any calendar year beginning January 1, 1934 upon the unpaid balance of said purchase price, provided that the amount so applied shall never be less than he installment of the purchase price specified*1073 for payment in such year, all as more fully set forth in said mortgage deed. *1275 All payments in excess of the installment required under the terms hereof in any year, whether voluntary or obligatory, shall be applied by the holder hereof against the latest maturing installments of the principal sum hereof.
On the same date petitioner executed the mortgage securing the note. Its pertinent provisions are as follows:
ARTICLE I.
Anticipation of Payments upon Note.
(1) The Company covenants and agrees that until the principal and interest of the note hereby secured shall have been fully paid and beginning on January 1st, One Thousand nine hundred thirty four, the Company will apply forty per centum (40%) per annum of its net earnings for any calendar year in payment of the interest accruing and becoming payable upon such note in such year, and the balance of the principal amount of such note unpaid prior to April 15th in such year; provided, however, trhat the covenant herein made shall not be construed to relieve the Company from the payment on April 15th in such year of the installment specified for payment by the terms of said note nor of the regular interest*1074 payments in such yerr, likewise as specified in said note. The term "net earnings" as herein used means the gross earnings from the business of the Company for such calendar year, less all current expenses of the business, all taxes payable in such year by the Company and fixed charges other than those created by the note hereby secured.
Settlement for all amounts becoming payable under this provision in excess of the principal and interest payments absolutely required in the calendar year as of which such net earnings are determined shall be made by the Company to the Bank not later than April 15th of the succeeding year.
(2) The Company covenants and agrees that so long as the principal and interest hereby secured remain unpaid, it will furnish to the Bank quarterly statements of the financial condition and operations of the Company, and in addition, shall on or before April 15th in each year furnish to the Bank a detailed balance sheet as of the close of the preceding calendar year, audited by public accountants acceptable to the Bank. The Company shall also furnish to the Bank, at any time that it may so demand in writing, such information as may, in the Bank's judgment, *1075 be necessary and proper to give it sufficient ground for the taking or not taking of any action required or permitted hereunder, and shall permit the Bank or its agents, upon like demand at any time, to examine its premises, property, records nd books of account, and the Company shall and will do everything in its power to facilitate such examination.
(3) The Company may, at its option, at any time so long as it is not in default under any of the provisions hereof, anticipate any part of the principal amount secured hereby. Any sums paid by the Company in excess of the principal and interest payments fixed by the terms of the note hereby secured, whether made voluntarily under the provisions of this paragraph or under the provisions of paragraph (1) of this Article I, shall be applied by the Bank in payment of the latest maturing installments specified in said note.
* * *
ARTICE IV.
Remedies on Default.
(1) If the Company shall make default in the payment of any interest or principal specified in the note hereby secured, and any such default shall have *1276 continued for thirty (30) days; or shall default in the performance of its covenants contained in Article*1076 I, Paragraph 1 hereof, and such default shall have continued for thirty (30) days; * * * the Bank may declare the entire principal then unpaid immediately due and payable, and the same and the interest accrued thereon shall thereupon become and be immediately due and payable, anything in said bonds or herein contained to the contrary notwithstanding. * * *
(2) No waiver by the Bank of any such default by the Company, whether such waiver be full or partial, shall extend to or be taken to affect any subsequent default or to impair the rights resulting therefrom.
* * *
The provision of article I, paragraph 1, above quoted, with reference to petitioner's obligation to apply 40 percent of the earnings of each year on the note and mortgage, was required by the bank in order that in prosperous years petitioner would devote a portion of its profits to the payment of the mortgage, and the bank would be protected to this extent should the company later become involved in difficulties.
On May 28, 1934, petitioner and the bank executed an agreement wherein it was recited that the company was not able to pay the principal installment of $2,000 due April 15, 1934, and was in default in*1077 payment of the interest in the approximate amount of $3,500. By the agreement the bank granted an extension to April 158 1941, for the payment of the principal installment and an extension to April 15, 1935, for $3,000 of the delinquent interest. The extension on the principal payment was "with the understanding, however, that such extension shall not be construed as a waiver of any subsequent defaults."
There was no modification of the provision requiring petitioner to apply 40 percent of its net earnings in payment of the principal and interest.
Petitioner's income and excess profits tax return for the year 1936 reported a net income of $126,786.04.
On January 1, 1936, petitioner owed $47,000 on its indebtedness on the note and mortgage. During the year 1936 it made payments on the principal sum on the dates and in he amounts as follows:
| 2/15/36 | $2,500 |
| 4/15/36 | 2,500 |
| 5/15/36 | 500 |
| 5/29/36 | 1,000 |
| 6/15/36 | 500 |
| 6/29/36 | $1,000 |
| 7/14/36 | 500 |
| 7/31/36 | 1,000 |
| 8/14/36 | 500 |
| 8/31/36 | 2,0000 |
| 9/15/36 | $500 |
| 10/15/36 | 34,000 |
| Total | 46,500 |
The bank accepted the $46,500 payment in 1936 in full satisfaction of the $47,000 due, and also forgave $117.50 interest.
*1078 By September 30, 1936, petitioner's approximate profits were $86,000, and it had orders on its books in that month of approximately $100,000. Since it appeared that petitioner's profits would be *1277 such that 40 percent thereof would be in excess of the amount required to discharge the mortgage in full, it was decided to make the payment at that time. It would not have been possible to determine on January 1, 1937, the profits of petitioner for 1936 with complete accuracy.
The parties have stipulated, and we accordingly find, that petitioner should be allowed deduction of $2,215.88 as expenses for repairs and replacements during the taxable year.
OPINION.
OPPER: The present issue calls for the application to the foregoing facts of the provisions of section 26(c)(2) of Revenue Act of 1936 1 entitling a corporation to a "credit" against the "undistributed profits tax" if it complies with certain requirements.
*1079 On this record, compliance with these conditions is questionable only in one respect. There was a written conract executed prior to May 1, 1936, containing a provision expressly dealing with the disposition of earnings and profits for the taxable year. The credit claimed is for an amount equal to the portion of such earnings and profits required to be paid in discharge of a debt, and this amount was paid in the taxable year. The sole remaining condition is that such portion of the earnings and profits be required by the contract to be paid or irrevocably set aside within the taxable year. We are of the opinion that the "application" to the indebtedness of the designated portion of the earnings may, for present purposes, be considered to be called for by the contract "as of" the taxable year, , and therefore to constitute the irrevocable setting aside contemplated by the statute. The credit should have been allowed and respondent's determination to the contrary is overruled.
Repair and replacement expenses may be deducted as stipulated.
Reviewed by the Board.
Decision will be entered under Rule 50.
*1278 BLACK, dissenting: I can readily agree that from the standpoint of reason and logic there would seem just as good reason for Congress to grant a credit in determining surtax on undistributed profits to a corporation situated as was the petitioner in the instant case as there was to other corporations which had contracts of indebtedness which come more precisely within the terms of the statute (sec. 26(c)(2), 1936 Act). But it is the precise statute which we have to construe and I do not see how it can be so broadly construed as to admit a credit to petitioner under the facts as they have been found.
The statute in question, which has been set out in the majority opinion, seems to provide four things as conditioins precedent to securing the credit. These are:
(1) There must exist a written contract executed by the corporation prior to May 1, 1936. Here there was a written contract executed prior to May 1, 1936, and so that condition is fulfilled.
(2) This contract must deal with the earnings and profits of the taxable year. The contract in question does deal with 40 percent of the net earnings of petitioner for the taxable year, so that condition is met.
*1081 (3) The contract must require the payment or the irrevocable setting aside of the earnings in question during the taxable year for the discharge of the debt in question. In the instant case it is plain that the contract does not require that the 40 percent of the net earnings be paid on the indebtedness during the taxable year. On the contrary, petitioner was granted until April 15 of the following year in which to make payment. So it seems clear to me that, in so far as payment is concerned, the contract in question does not meet the terms of the statute. But the statute grants the credit if there is a requirement in the contract that the portion of earnings in question be "irrevocably set aside" during the taxable year for the discharge of the debt. I see nothing in the contract which required the taxpayer to irrevocably set aside any of its earnings of 1936 prior to the granted time of payment which was April 15, 1937. So, in the view I take, one of the conditions precedent is not met. I can not take the view expressed in the majority opinion that when the statute says that the contract must require either payment or irrevocable setting aside of earnings*1082 within the taxable year it means "as of" the taxable year. I see no warrant for such construction.
(4) The credit granted, when all conditions have been fulfilled, is the amount which "has been so paid or set aside." In the instant case there has been a payment all right on the indebtedness to the full extent of the credit claimed, but, as I view it, in the absence of a requirement in the contract that these earnings be paid or irrevocably set aside in 1936, their actual payment in 1936 becomes immaterial.
*1279 Congress in the Revenue Act of 1938 wrote a provision which seems to be broad enough to permit a credit under the facts and circumstances of the instant case. See sec. 27(a)(4), Revenue Act of 1938. This section, however, has no retroactive application and, for reasons which I have already stated, I do not believe that the credit which petitioner claims can be granted under the terms of the 1936 Act. I think the Commissioner should be sustained and I, therefore, respectfully dissent from the majority opinion.
MELLOTT and KERN agree with this dissent.
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) CONSTRACTS 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 has 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 Arpil 30, 1936. ↩