*280 Petitioner, whose stockholder-members were wholesale grocers, was organized to administer a system of merchandising in the food and grocery field which would enable wholesalers and their retail customers to meet chain store competition. Under the plan agreements were entered into between petitioner and the wholesalers, and between the wholesalers and retailers in their territories. Amounts paid by wholesalers for services under petitioner-wholesaler agreements were substantially equivalent to amounts paid by retailers to wholesalers under wholesaler-retailer agreements, but services rendered by petitioner to wholesalers were not identical with services rendered by the latter to retailers. Petitioner was obligated to pay or credit to wholesaler-members a patronage refund out of its profits measured by the amount of business transacted with each wholesaler. Held: Payments which petitioner received from wholesalers were for services it rendered to them, and not to retailers, and the refunds of amounts attributable thereto which it was required to make to wholesalers constituted true patronage dividends.
*1266 The respondent determined a deficiency in the income tax of petitioner for the calendar year 1948 in the amount of $ 12,387.95.
The sole issue is whether petitioner's taxable income for 1948 must be reduced by certain so called patronage dividends distributed by it to its stockholder-members with respect to its 1948 earnings.
FINDINGS OF FACT.
Some of the facts have been stipulated, and the stipulation, together with accompanying exhibits, is incorporated herein*282 by reference.
Petitioner was incorporated on May 19, 1947, under the name of "Clofarm Corporation" pursuant to the General Corporation Act of Ohio, and at all times material to these proceedings kept its books and filed its returns on a calendar year basis, and on the accrual system of accounting.
The Clofarm Corporation, from the date of its incorporation to and including July 31, 1947, was a wholly owned subsidary of Clover Farm Stores Corporation, a Delaware corporation (hereinafter referred to as the "Delaware Company"), and during this period the Clofarm Corporation was wholly inactive and transacted no business.
On August 1, 1947, the Delaware Company was "merged" with petitioner and the Delaware Company ceased to exist. The "merger" was accomplished pursuant to the laws of Ohio and Delaware and pursuant to a certain "Agreement of Merger" executed by the two corporations. The name of petitioner was changed from "Clofarm Corporation" to "Clover Farm Stores Corporation," effective August 1, 1947.
The "Agreement of Merger" constituted petitioner's Articles of Incorporation. Under the agreement petitioner's authorized capital stock consisted of 250 shares of common stock without*283 par value and 2,500 shares of preferred stock of the par value of $ 100 per share.
Article V of the agreement provided in part as follows:
*1267 The Board of Directors of the Surviving Corporation is hereby authorized to fix and determine and to vary the amount of working capital of the Corporation, to determine whether and, if any, what part of its surplus, however created or arising, shall be used or disposed of or (except as otherwise prescribed in these Articles) declared in dividends, or paid to shareholders, and to use and apply such surplus or any part thereof, at any time or from time to time, in the purchase or acquisition of shares, voting trust certificates for shares, bonds, debentures, notes, scrip, warrants, obligations, evidences of indebtedness or other securities of the Corporation to such extent or amount and in such manner and upon such terms as the Board of Directors shall deem expedient, provided that no preferred shares may be purchased at a price in excess of the redemption price, which at the option either of the Corporation or of the shareholder, or both, is then applicable to the shares purchased.
* * * *
At all times herein material, the petitioner's*284 common stockholders consisted entirely of wholesale grocers and, as of January 1, 1948, there were 28 shareholders, each holding one share of petitioner's common stock. One of the shareholders was an individual proprietorship, two were partnerships, and all other shareholders were corporations.
During the taxable year ended December 31, 1948, petitioner's business consisted primarily of the administration of a plan or system of selling and merchandising and operating in the food and grocery field. That plan or system is, and at all times material herein was known as the "Clover Farm Stores System." Embraced within and operating under that system, in addition to petitioner, were, as of January 1, 1948, the aforesaid 28 wholesale grocer stockholders of petitioner and approximately 2,400 retail grocers.
The backbone of the Clover Farm Stores System consists of certain trade-marks which petitioner owns and which are used by petitioner's wholesale grocer stockholders and of a planned merchandising program used by and for the benefit of such wholesalers in selling their merchandise to retail grocers. The System grew out of the need of independent retail grocers for a planned sales and*285 merchandising approach to the customer to meet the growing competition of the chain stores.
Upon becoming a shareholder in petitioner, or its predecessor, each of the 28 wholesalers entered into a written agreement with petitioner, or its predecessor, known as a "Wholesale Franchise Agreement," and agreed to pay a membership fee to petitioner or its predecessor in the amount of $ 2,500. That membership fee, when received, was taken into the general funds of petitioner, or its predecessor. Of that membership fee, $ 5 was taken as being in payment for one share of common stock of petitioner, or its predecessor, and the balance was credited to paid-in surplus.
During the taxable year ended December 31, 1948, the form of the Wholesale Franchise Agreement in effect between petitioner and each *1268 of the 28 wholesalers was identical. In substance, that Wholesale Franchise Agreement provides, among other things, that, in consideration of the payment of the $ 2,500 membership fee, the wholesaler is granted the exclusive right within a prescribed territory to organize independent retail grocers into the Clover Farm Stores System and to sell, but only to such retailers, "products *286 bearing the CLOVER FARM STORES SYSTEM labels, brands or trade-marks."
Under the Wholesale Franchise Agreement the wholesaler agrees to become active in its territory in obtaining retail grocers to become members of the Clover Farm Stores System.
In order to become a member of the System, a retail grocer makes application to the wholesaler on a form prescribed in the Wholesale Franchise Agreement. Such application, when approved by the wholesaler, constitutes a contract or franchise agreement (hereinafter referred to as the "Retail Franchise Agreement") between the retailer and the wholesaler. The initial cost or membership fee to such retailer, upon the acceptance of its membership application, is $ 37.50, which is to be forwarded by the wholesaler to petitioner.
During the taxable year, 1948, there were approximately 2,400 retail grocers who had contracts of the type hereinabove mentioned with the wholesalers.
Section 3 of the Wholesale Franchise Agreement between each wholesaler and petitioner provides that, during the life of the Agreement (25 years unless sooner terminated by either party upon giving of 6 months' notice) the wholesaler "agrees to purchase * * * [petitioner's] *287 regular services, and to pay therefor, weekly in advance, a sum equal to One Dollar ($ 1.00) times the number of Retailers currently under franchise agreement with the Wholesaler."
During the taxable year, 1948, petitioner accrued on its books as amounts due it from its wholesalers, the total amount of $ 122,468 pursuant to the provision in section 3 of the Wholesale Franchise Agreement wherein the wholesaler agreed to pay petitioner for its "regular services" a sum equal to one dollar times the number of retailers currently under franchise agreement with the wholesaler.
Section 3 of the Wholesale Franchise Agreement states that the regular services include:
Weekly Operating Bulletin; General advisory services; Services in connection with development of new labels, cartons, etc., under Clover Farm Stores System trade-marks and copyrights (including Clover Farm, Foodland, Glendale, Mrs. Lane's and others); Supplying (f. o. b. shipping point) to the Wholesaler, in accordance with his specifications, a sufficient number of Green Sheets and regular point-of-sale advertising and promotional material such as window posters, price cards, etc.; and Supplying (f. o. b. shipping point) a sufficient*288 number of Clovergrams and Clover Farm Bees.
*1269 The "Weekly Operating Bulletin" is a publication prepared by petitioner each week in its offices in Cleveland, Ohio. It is a sales or merchandising bulletin to guide the wholesalers' thinking in conjunction with their sales during a particular week. By means of that bulletin, petitioner, drawing on information which it has gathered over a period of years, informs the wholesalers of those items which it believes would be good items to feature with their retailers during a particular week. These bulletins serve the further purpose of advising the wholesalers of the nature of the consumer advertising material that the petitioner is prepared to furnish to the wholesalers in connection with their sales to the retailers during such week. The bulletins are sent out by petitioner to the wholesalers about a month in advance of the particular week to which they refer. The bulletins go only to the wholesalers and at no time go to the retailers.
In response to the "Weekly Operating Bulletin," each wholesaler prepares and submits to petitioner each week a paper which is called in the language of the Clover Farm Stores System an "Original*289 Green Sheet." That "Original Green Sheet" constitutes, among other things, an order by the wholesaler on petitioner (in easily understandable coded form) for specified consumer advertising material to be used in the retail store of each retailer under franchise with the wholesaler. Such material represents the "regular point-of-sale advertising and promotional material," set forth in section 3 of the Wholesale Franchise Agreement. That material includes banners, posters, and cards, each carrying the name and, usually, the price of a certain grocery item. The material is assembled into packages by petitioner, the number of such packages being equal to the number of retailers under franchise with the wholesaler whose order is being filled. Included in each package is a green sheet (being a verbatim copy of the Original Green Sheet received by the petitioner from the particular wholesaler) and a mimeographed publication published by the petitioner known as the "Clovergram." Each package is placed in an unsealed envelope, the envelopes are then placed in cartons and the cartons are sent to the wholesaler. Upon receipt of the envelopes from petitioner, a wholesaler can and frequently*290 does take some material out of the envelopes or places additional material therein before delivering them to the retailers. The petitioner has nothing to do with the decision of the wholesaler to make such subtractions or additions.
The consumer advertising material which a particular wholesaler orders from petitioner each week by means of the "Original Green Sheet" is rarely the same as the advertising material so ordered from petitioner by a different wholesaler. The reason for that difference is that the advertising material ordered by a particular wholesaler depends upon what grocery items such wholesaler "wants to sell" and, *1270 in turn, that depends upon the stock position of the wholesaler with respect to particular grocery items. Two wholesalers are rarely in the same stock position.
It happens frequently that a wholesaler, upon receipt from petitioner of certain of the advertising material it has ordered, is not in a position to supply the retailer with the grocery items covered by such advertising, or is not in a position to supply such items for sale by the retailers at the price named in such advertising. In those instances, the wholesaler takes such advertising*291 out of the envelopes before delivering them to the retailers, and, in general, removes from them all material that is not applicable to the wholesaler's sales program.
The "general advisory services" furnished by petitioner to each wholesaler, under section 3 of the Wholesale Franchise Agreement, include advice to the wholesaler regarding efficiency in warehouse operations, obtaining orders or business, delivery schedules, handling books and records, accounts receivable, and matters generally pertaining to merchandising and selling. The wholesalers are all independent merchants, and each of them buys merchandise from producers. To assist them in buying, the petitioner prepares and distributes to them "Merchandising Service" bulletins containing information regarding special offers of merchandise being made by various manufacturers and producers. During 1948, some 500 such bulletins, each one different, were sent by petitioner to each of the wholesalers. Petitioner also prepares for the use by the wholesalers' "servicemen" (certain employees hereinafter described) a bulletin called "The Bumble Bee" which contains information intended to assist them with their daily work and problems. *292 During 1948, petitioner sent out approximately 35 or 40 "Bumble Bees," each one different, to each wholesaler. Practically every day the petitioner sends letters to wholesalers making suggestions and discussing problems. Also, as part of its "general advisory services," petitioner is in frequent communication with the wholesalers by telephone, telegraph, and through its traveling representatives.
The services which petitioner was required to furnish "in connection with development of new labels, cartons, etc.," by section 3 of the Wholesale Franchise Agreement consist of petitioner's expert assistance to wholesalers in the preparation of such things as new labels for new products and for different size packages of established products. These services extend to and include both the "Clover Farm Stores System" group of labels, which are used on products sold by the wholesalers exclusively to Clover Farm retailers, and the "Foodland System" group of labels, which the wholesalers use for their general trade in their territory.
*1271 The Clover Farm Bee referred to in section 3 is a magazine published monthly by petitioner and distributed among its wholesalers. It has from 28*293 to 32 pages and is a so called "house organ" containing gossip about people, information regarding marriages, deaths, new retailers, and new wholesalers, etc.
Petitioner has in its employ approximately 22 to 25 persons.
During the taxable year ended December 31, 1948, petitioner's president and general manager was Grant A. Mason. Mason had been an employee of petitioner, and its predecessor, since March 1938. Prior to becoming employed by petitioner's predecessor, Mason, a college graduate, was employed in various capacities by the Great Atlantic & Pacific Tea Company. He worked for that company for 5 years in Pittsburgh as a clerk, store manager, member of the staff of their sales department, and as produce and meat manager. He later went to Youngstown where there were 225 Atlantic & Pacific stores and while there he was a supervisor of stores and sales manager. From there he went to Springfield, Massachusetts, where he was sales manager of the combined Springfield and New Haven units which had approximately 500 stores. During his employment by the A. & P., he acquired a background of warehousing, merchandising, sales, and purchasing experience in the grocery field.
Other employees*294 of petitioner have had extensive experience in advertising, merchandising, marketing, and efficiency operations. Petitioner also employs a home economist who operates an experimental kitchen and develops recipes.
The wholesalers do an average business per year of from one and three-quarters to two million dollars and are what would be termed in the trade "small to medium size wholesalers." They are not financially able, individually, to obtain the services of a group of experts such as are employed by petitioner.
During 1948, petitioner sold to the wholesalers labels, cartons, bags, etc., bearing Clover Farm Stores System brands and Foodland System brands, wholesale and retail store supplies, implements and insignia, and certain cartons or bags for packaging of products by the wholesalers. Such sales were made at petitioner's current list prices, and petitioner's aggregate receipts during 1948, from such sales amounted to $ 58,550.23.
The "Retail Franchise Agreement," which was the contract or franchise agreement in effect during 1948, between the respective retailers and wholesalers provided, in part, as follows:
THE WHOLESALER AGREES:
FIRST: To admit the Retailer as a co-operating*295 retail member of the aforesaid Division of CLOVER FARM STORES SYSTEM, the Retailer not being liable for any debts or liability of any other CLOVER FARM STORES SYSTEM Member.
*1272 SECOND: To furnish a Divisional Manager to advise with and assist the Retailers in said Division in the utilization of the CLOVER FARM STORES SYSTEM and to furnish to the Retailer, from time to time, the regular CLOVER FARM STORES SYSTEM service.
THIRD: To procure and to lease to the Retailer, at the Wholesaler's cost, one official CLOVER FARM STORES sign, and upon termination of this Agreement for any cause, within two (2) years from date hereof, to refund to the Retailer upon return of the sign such cost less rental at the rate of one-third (1/3) of such cost per year or fraction thereof from date of this Application.
FOURTH: To sell to the Retailer all goods which the Wholesaler handles at prices made possible by the co-operative efforts of all Members of CLOVER FARM STORES SYSTEM through modern operations and efficient distribution, and to sell only to CLOVER FARM STORES SYSTEM Retail Members, CLOVER FARM STORES SYSTEM brands of merchandise and commodities.
THE RETAILER AGREES:
FIRST: To pay during*296 the term of the Agreement One Dollar ($ 1.00) per week to the Wholesaler for the services herein agreed to be furnished by the Wholesaler and to pay a pro-rata sum weekly to the advertising and operating fund of the aforesaid Division, as fixed by its Retail Members Advisory Board from time to time.
SECOND: Promptly to paint and arrange and decorate, to maintain the interior and exterior of Retailer's store, to erect and maintain the CLOVER FARM STORES sign, and Retailer's name plate on the Retailer's store, all in conformity with the general CLOVER FARM STORES SYSTEM Plan.
* * * *
FOURTH: That he will sell only at retail all products bearing CLOVER FARM STORES SYSTEM brands. Retailer further agrees to pay for, in accordance with terms fixed by the Wholesaler, all the Retailer's requirements, purchased from the Wholesaler, and that he will co-operate with the Advisory Board of the said Division in order to further the mutual interests of the Division.
* * * *
The "advertising and operating fund," which is mentioned in paragraph "FIRST" of the above quoted portion of the Retail Franchise Agreement under the heading "THE RETAILER AGREES," refers to a fund into which all retailers in*297 a local group pay to do collective advertising by means of newspapers, radio, handbills, television, etc. The wholesaler of the particular territory involved is generally the custodian of that fund.
One of the wholesale grocer stockholders of petitioner is the Bayer-Gillam Company, which is a corporation with its principal place of business at Tyrone, Pennsylvania. It has approximately 165 retailers under contract with it. The maximum number of retailers under contract with any particular wholesaler in the Clover Farm Stores System is 220 and the minimum number is about 30.
The Bayer-Gillam Company employs a person whom it calls its District or Chief Serviceman. He is the one referred to in paragraph "SECOND" of the Retail Franchise Agreement as the "Divisional Manager." His time and efforts are spent among retail members assisting *1273 them in any manner he can "to better enable them to conduct a business in a more progressive" and "profitable manner."
The District or Chief Serviceman visits Clover Farm retail stores under contract with the Bayer-Gillam Company and inspects to see that the merchandise of such stores is properly placed, properly displayed and is kept in *298 an orderly and clean condition. He examines the meat cases and meat boxes to see that they are clean and well kept. He examines to see that the Bayer-Gillam Company's sales programs are carried out and that the window posters which are furnished to the retailers are well displayed, and renders many other services. If a retailer desired to change locations, the Chief Serviceman would be the first one that such retailer would consult. The consultation would include matters with respect to the rental to be paid in the new location, whether a lease could be obtained, and, after those matters had been worked out, the Chief Serviceman would consult with the retailer regarding the "set-up" of the store, or the proper "lay-out" for the store to enable it to meet chain store and other competition. Although the Bayer-Gillam Company does not handle baked goods, fresh meat or fresh milk, it has arrangements with bakers, dairy supply companies and meat houses in its district for supplying such products to its retailers. Such arrangements are made by the Chief Serviceman and are known as "hook-ups." It has no financial interest in such arrangements. The Bayer-Gillam Company pays its Chief*299 Serviceman $ 300 a month plus traveling expenses, and also furnishes him with an automobile.
The foregoing services, which the Bayer-Gillam Company furnishes to each of its Clover Farm retailers through its Chief Serviceman, are a part of those services which it is required so to furnish by virtue of its contracts with such retailers as services for which each retailer under the terms of his respective contract pays the Bayer-Gillam Company $ 1 per week.
The Bayer-Gillam Company does business with customers other than its Clover Farm retailers. It sells to other retail grocers and to institutions. None of the services performed by the Chief Serviceman of the Bayer-Gillam Company for its Clover Farm retailers is performed by it or the Chief Serviceman for its other customers. Each wholesaler in the Clover Farm Stores System employs a Chief Serviceman who does work of the type performed by the Chief Serviceman of the Bayer-Gillam Company. Some of those wholesalers employ as many as five assistants to the Chief Serviceman. The petitioner has nothing to do with the supplying of the services by the Chief Serviceman of the wholesaler.
There have been times when a particular wholesaler*300 did not collect from his retailers the $ 1 per week specified in his Retail Franchise *1274 Agreement. In all those instances petitioner collected from that wholesaler the service fee of $ 1 per week per retailer in accordance with section 3 of the Wholesale Franchise Agreement. One of those instances covered a period of 7 weeks during the months of May and June in the taxable year ended December 31, 1948, when a warehouse of one of the wholesalers was closed by strike.
At various times, both unofficially and at meetings of petitioner's board of directors, consideration was given to changing the rate of $ 1 per week per retailer regular service fee which each wholesaler paid petitioner under the Wholesale Franchise Agreements. During none of those discussions was any consideration given or reference made to any equivalent change in the fee of $ 1 per week which each retailer paid his wholesaler pursuant to the Retail Franchise Agreements.
The plan under which petitioner operated during the taxable year ended December 31, 1948, originated with a wholesale grocery concern in Cleveland at a time when independent retail grocers were finding it difficult to survive in the face *301 of competition from large corporation grocery chains which were spreading over the country very rapidly. The plan spread to other wholesalers who, in the year 1931, formed petitioner's predecessor corporation. Since organization, petitioner or its predecessor has been entirely owned by wholesalers and they have at all times dominated its board of directors.
The Clover Farm Stores System wholesalers all do business with customers other than Clover Farm Stores System retailers. The business done by the wholesalers with Clover Farm retailers is more profitable than the business done with others, even though frequently the wholesalers charge Clover Farm retailers lower prices for products than they charge other customers.
Article III of petitioner's articles of incorporation provides, inter alia, that certain of the purposes for which petitioner is organized are as follows:
(b) To acquire by purchase and/or to manufacture, process, pack and otherwise deal in and with commodities handled by food and grocery concerns or useful in connection with such businesses, at wholesale and at retail, and to create, devise and develop services, for sale to wholesale grocers and others, and to*302 contract with such wholesale grocers to return to them out of the income and profits of the Corporation such amounts by way of patronage refunds as shall represent that part of the charges of the Corporation against such wholesale grocers, for the services and commodities sold to them, in excess of the amounts reasonably required to pay all expenses of operation of the business of the Corporation, to conserve the accumulated net worth of the Corporation and moderately to increase the net worth of the Corporation for purposes of future expansion of its facilities and/or payment of reasonable dividends upon its capital stock.
*1275 Article VIII of petitioner's by-laws (described as its "Code of Regulations") provides that at the close of each calendar year there shall be paid or credited to each of its wholesale grocer members a "Patronage Refund" calculated in accordance with a detailed formula which is there set forth. In substance, the by-law provision requires that the excess of petitioner's gross revenues for the year over its expenses, losses, reserves, and certain other charges shall be divided among and paid or credited to the wholesale grocer members, the amounts to be*303 paid or credited to each wholesale grocer to depend on the amount of business transacted by each such wholesale grocer with petitioner during the year. These by-laws were in effect without change throughout 1948.
The following is an excerpt from the minutes of a meeting of petitioner's board of directors held on December 13, 1948:
Thereupon, on motion made by Mr. Beasley, seconded by Mr. Schlapp and unanimously carried, the Management was directed to set up as Accounts Payable on the books of the Corporation, any and all other earnings of the Corporation, as a Patronage Refund due members as of December 31st, 1948, in accordance with Article VIII, based on the members' participation in the year's business; and that approximately sixty per cent (60%) be paid in Preferred Stock. Mr. Mason estimated that the amount of the refund would be in the neighborhood of Forty-eight Thousand Dollars ($ 48,000.00).
During the taxable year ended December 31, 1948, petitioner's receipts were as follows:
| $ 58,550.23 | from sales to wholesalers of labels, cartons, bags, etc. |
| $ 122,468.00 | for the "regular services" performed for the wholesalers pursuant |
| to section 3 of the Wholesale Franchise Agreements, paid for by | |
| the wholesalers at the rate of $ 1.00 a week times the number of | |
| retailers under franchise from the wholesalers. | |
| $ 77,531.14 | for promotional and advertising services (after deducting printing |
| costs) performed for outside manufacturers and producers. | |
| $ 5,062.50 | from retailers as franchise fees (after deducting prize |
| awards made to wholesalers' employees for obtaining such | |
| franchises). | |
| $ 2,462.78 | in interest payments, of which $ 266.67 was tax free. |
| $ 266,074.65 | Total receipts. |
*304 In its corporate income tax return for the year 1948, the petitioner included in its gross income all of the foregoing receipts with the exception of the $ 266.67 in tax free interest.
The general expenses of petitioner, deductible under section 23 of the Internal Revenue Code in respect of the taxable year ended December 31, 1948, not chargeable to any particular class of income of petitioner, exclusive of any claimed deduction on account of the "Patronage Refunds" made by petitioner to its shareholders, amounted to $ 209,656.55.
*1276 At the close of the taxable year ended December 31, 1948, the amount of the "Patronage Refund" payable by the petitioner to its wholesale grocer members in accordance with said article VIII of its by-laws was in the amount of $ 48,805.66. That amount was paid, to the extent of $ 28,400, by the issuance as of December 31, 1948, to the wholesalers of a total of 284 shares of the $ 100 par value preferred stock of petitioner, and the balance, amounting to $ 20,405.66, was paid in cash to the wholesalers on January 31, 1949. On line 26 of its income tax return for the taxable year ended December 31, 1948, the petitioner claimed $ 39,699.22 of said*305 amount of $ 48,805.66 as a deduction under the heading "Refund of assessments," and it showed the balance of said amount ($ 9,106.44) in Schedule M of such return as an unallowable deduction under the heading "Patronage refund in excess of amt. allowable."
In determining the deficiency, the Commissioner apparently conceded that patronage dividends, based on petitioner's transactions with its stockholder-members, could reduce its taxable income, and he in fact permitted such reduction to the extent that such patronage dividends were attributable to the $ 58,550.23 received by petitioner from its stockholder-members for sales of labels, cartons, bags, etc. But he refused to allow any reduction to the extent that such patronage dividends were attributable to the $ 122,468, paid to petitioner for "regular services" performed under section 3 of the Wholesale Franchise Agreements. As a result, he restored $ 28,216.89 1 to income, and determined the deficiency in controversy.
*306 The amount received by petitioner in the taxable year ended December 31, 1948, from business transacted by it with its stockholder-members was $ 181,018.23 ($ 58,550.23 plus $ 122,468).
OPINION.
Petitioner is a corporation organized for profit, and does not claim to be exempt from taxation under section 101 or any other provision of the Internal Revenue Code. It does contend, however, that its gross income must be reduced by patronage dividends which it paid to its stockholder-members, and the Commissioner does not disagree that such reduction is proper, provided that the amounts involved are true patronage dividends.
The concept that "patronage dividends" paid by a corporation may operate to reduce its gross income (or constitute a "deduction" therefrom) is not founded upon any specific statutory provision. However, *1277 the concept has been recognized for a number of years, 2 and it apparently rests upon the theory that such dividends are in reality rebates or refunds upon business transacted by the corporation with its stockholders or members, where it was committed to make such refunds, and that the amounts thus repaid never should have been included in income in the *307 first instance.
The Commissioner has allowed petitioner to reduce *308 its gross income to the extent that the amount paid by it to its stockholder-members was allocable to the $ 58,550.23 which it had received from them for sales of labels and other materials. But his proposed deficiency is based upon refusing similar treatment with respect to that portion of the alleged patronage dividend allocable to the $ 122,468 received from its stockholder-members in connection with its fee of $ 1 a week per retailer for "regular services" under section 3 of the Wholesale Franchise Agreements. Thus, the sole question presented to this Court for decision is whether the patronage dividend, to the extent in controversy, was a "true" patronage dividend.
The Commissioner contends that it was not a true patronage dividend because: (1) the $ 122,468 had really been received by petitioner from the retailers in payment for services rendered to them by petitioner, and therefore to the extent that the patronage dividend was based upon that amount it did not constitute a rebate to its stockholder-members on any sales prices or service charges which they had previously paid to petitioner, but did constitute rather a distribution of net profits; and (2) the amount so distributed*309 was not distributed pursuant to a definite pre-existing obligation between petitioner and its stockholder-members.
True patronage dividends include only those amounts which the taxpayer is required to return to its members as rebates or refunds on business transacted with such members. Any profits made on business transacted with nonmembers which may be distributed to members are fully taxable. See A. R. R. 6967, III-1 C. B. 287, 289; Valparaiso Grain & Lumber Co., 44 B. T. A. 125, 126, 127. Petitioner's members were its wholesalers, and the amount rebated or distributed to them at the close of the taxable year ended December 31, 1948, included profits made by it on business transacted with nonmembers and profits made by it on business transacted with the wholesalers. The *1278 respondent determined that only $ 58,550.23 of the total income received by petitioner during the taxable year was derived from business transacted with its members. The petitioner contends that, in addition to this $ 58,550.23, the sum of $ 122,468 (or the total amount of $ 181,018.23) was derived by it from business transacted with such members.
The parties are in apparent*310 agreement that the disputed sum of $ 122,468 was physically received by the petitioner from the wholesalers during the taxable year. The position of the respondent is in substance, however, that the wholesalers merely acted as conduits for receiving $ 1 per week from each retailer in their respective territories, in exchange for services rendered each retailer by petitioner, and passing it on to the petitioner. The fact that under the terms of the Retail Franchise Agreements each retailer agreed to pay his wholesaler $ 1 per week and that the amounts paid by the retailers to the wholesalers, assuming that the terms of the agreements were fully performed, would have totaled $ 122,468 (the amount which petitioner claims it received during 1948 from business transacted with the wholesalers) would seem to indicate that there is a superficial basis for respondent's position. An analysis of all the facts leads us to a different conclusion.
The respondent's theory is bottomed upon the premise that the services rendered by the petitioner were of the type and kind intended exclusively for the use of the retailers and not the wholesalers, and that what petitioner really did was sell its *311 services to the retailers and receive payment from them. That some of the services, indeed a significant portion of them, rendered by petitioner were intended to and did help the retailers is undoubtedly true. This follows from the fact that one of the objects of the plan under which the petitioner operated was devised by a wholesaler and adopted by other wholesalers to enable retailers who were customers of the wholesalers to meet chain store competition. But the wholesalers formed the petitioner to perform services for them. They and not the retailers were its customers, and they and not the retailers were bound by contract to pay for the services rendered. Their apparent purpose in organizing the petitioner was to get certain expert advice, assistance, and services by collective action which they could not afford to purchase individually. Although there was some overlapping, the services which petitioner was required to render and did render to them pursuant to section 3 of the Wholesale Franchise Agreements were not the same as those which they were required to render and did render under the terms of the Retail Franchise Agreements. As shown by our findings, petitioner *312 rendered a variety of services that were exclusively for the benefit of its wholesalers, and the wholesalers, in turn, rendered a variety of services to its retailers that were not included *1279 in the services originating with the petitioner. Our conclusion is that the payment of $ 122,468 which petitioner received during the taxable year from its wholesaler-members was for services which it rendered to them. In these circumstances, the fact that they contracted for and received from their retailers an equivalent amount for services rendered by them to such retailers provides no basis for the application of respondent's conduit theory.
The respondent urges that even though the payments in controversy were received by petitioner for services rendered to the wholesalers, it still may not prevail in its claim to the exclusion for the reason that it has not shown that its stockholder-members unqualifiedly had the right to and did receive the net profits arising from the sale of such services. His argument in support of this contention is that under the provisions of article V of the Agreement of Merger the board of directors of petitioner had the power to withhold any part of*313 its earned surplus and place all of it at the risk of the business rather than distribute part of it to the patron members as patronage refunds. Thus, according to the respondent, the petitioner never ceased to lose control over funds coming into its possession; the allocation of any amount to the patronage refund account was within the discretion of the directors; and, since petitioner thus had the power to treat all funds as its own, no part thereof ever really belonged to its patron members.
The portion of article V of the Agreement of Merger relied upon by the respondent is set forth in our findings. It grants to petitioner's board of directors authority regarding the use or disposition of petitioner's "surplus" once it has been created. The difficulty with this contention is that article VIII of petitioner's Code of Regulations, which has "all the force and effect of a contract between the corporation and its members" ( State v. Shaw, 103 Ohio St. 660">103 Ohio St. 660, 669, 134 N. E. 643, 646), provides that "At the close of each calendar year, there shall be paid or credited to the Patrons of the Corporation, a Patronage Refund * * *" in an*314 amount equal to the excess of petitioner's gross revenues over its expenses and certain other items specified therein. Thus, to the extent that article VIII was applicable, the corporation was charged with a liability with respect to the amount involved, and it therefore never did become a part of surplus. The provisions of article VIII were mandatory and neither petitioner's board of directors nor its officers had any discretion to determine whether a refund would or would not be made, and petitioner's general manager could not, as respondent urges on brief, have decided, with the approval of the directors, that the entire amount of $ 48,805.66 set up on petitioner's books at the end of 1948 as a "patronage refund" be retained by petitioner with no distribution to its stockholder-members in cash, stock or otherwise. In *1280 passing a resolution on December 13, 1948, directing the management "to set up as Accounts Payable on the books of the Corporation, any and all other earnings of the corporation, as a Patronage Refund due members as of December 31st, 1948, in accordance with Article VIII * * *," the board of directors merely recognized the pre-existing obligation to make*315 the "Patronage Refund." Cf. United Cooperatives, Inc., supra, p. 107; Farmers' Union Co-operative Association, 13 B.T.A. 969">13 B.T.A. 969. This corporate action was not required to be taken before petitioner became definitely liable to make the patronage refund to its stockholder-members.
The respondent erred in his determination that the profits resulting from the payments of $ 122,468 made to petitioner by its wholesaler-members should be included in its taxable income for the year 1948.
Decision will be entered under Rule 50.
Footnotes
1. In its petition, petitioner has assigned error to the inclusion of $ 26,906.55 of the above amount in its income; no error has been assigned as to the remaining $ 1,310.34, and it admits a deficiency in the amount of $ 301.38.↩
2. See, e. g., Anamosa Farmers Creamery Co., 13 B. T. A. 907; Midland Cooperative Wholesale, 44 B. T. A. 824; United Cooperatives, Inc., 4 T.C. 93">4 T. C. 93; Colony Farms Cooperative Dairy, Inc., 17 T. C. 688; Dr. P. Phillips Cooperative, 17 T.C. 1002">17 T. C. 1002; Cooperative Oil Assn., Inc. v. Commissioner (C. A. 9), 115 F. 2d 666, 668; Uniform Printing & S. Co. v. Commissioner (C. A. 7), 88 F. 2d 75, 76; Farmers Cooperative Co. v. Birmingham (N. D. Ia.), 86 F. Supp. 201">86 F. Supp. 201; I. T. 1499, I-2 C. B. 189; S. M. 2595, III-2 C. B. 238; G. C. M. 12393, XII-2 C. B. 398; G. C. M. 17895, 1937-1 C. B. 56; I. T. 3208, 1938-2 C. B. 127↩.