*1071 By the terms of a mortgage indenture petitioner was required to pay to the corporate trustee $2.50 per thousand feet of logs and lumber currently sold and used and the trustee was required to place amounts so received in a sinking fund for the purchase or retirement of bonds. Held, petitioner is entitled to the credit provided by section 26(c)(2) of the Revenue Act of 1936 to the extent of the amount paid by it pursuant to such contractual provision. Michigan Silica Co.,41 B.T.A. 511">41 B.T.A. 511, followed.
*780 The Commissioner determined deficiencies of $14,971.56 and $25,564.82 in the petitioner's income taxes for the years 1936 and 1937, respectively, and also a deficiency of $385.85 in its excess profits tax for the year 1937.
The only question now in controversy is whether or not the petitioner is entitled to a credit under section 26(c)(2) of the Revenue *781 Act of 1936, for the purpose of computing the surtax on undistributed profits.
It was stipulated that the net income for each of the calendar years 1936 and 1937, *1072 as shown in the deficiency notice, dated March 15, 1940, shall be reduced and adjusted by the allowance of additional depreciation amounting to $22,366.79 for each of said years, and that the remaining value as of January 1, 1936, of the power plant was $225,630.50. The respondent conceded that the petitioner was not liable for excess profits tax for the year 1937.
FINDINGS OF FACT.
Certain facts were stipulated substantially as follows:
The petitioner is a Delaware corporation engaged in business in Williams, Arizona, and has its offices in Chicago, Illinois.
On January 1, 1932, the petitioner defaulted in the payment of interest and principal on first mortgage bonds amounting to $350,000, being the outstanding balance of an original issue of $400,000 of such bonds secured by an indenture executed by the petitioner under date of June 2, 1930. By that indenture the petitioner-mortgagor granted and conveyed certain specified property, including timber and timber lands, water rights, mill site, reservoir site, equipment, etc., to secure a bond issue of $400,000. The mortgage indenture was amended by supplemental agreement dated January 8, 1936. As amended, article III*1073 provided, inter alia, as follows:
ARTICLE III.
Possession and Use of Mortgard Property, Payments Therefor and Partial Releases Thereof.
SECTION 1. - Sinking Fund Established: All moneys received by the Trustees for the release of timber or other properties from the lien hereof, and generally all funds coming to the Trustees from any source whatsoever (except from the proceeds of insurance or from the foreclosure sale of mortgaged property, and except as may be herein otherwise expressly provided) shall be deposited in a Sinking Fund of which the Trustees are made the Depositary. Disbursements shall be made from the Sinking Fund for the purposes and in the manner herein provided.
SECTION 2. - Mortgagor's Right to Use of Mortgaged Property: Until a declaration of default under this Instrument, the Mortgagor shall be permitted to remain in full possession and control of the mortgaged property; and, provided (a) that all timber covered by the lien of this mortgage (except such timber as has been first released therefrom under the next succeeding paragraph of this Article) and all timber included in the contract between the Secretary of Agriculture of the United States and*1074 the Mortgagor referred to in Fourth paragraph of the conveying clause hereof and all other timber cut by or for the Mortgagor shall be manufactured into lumber at the plants of Mortgagor covered hereby, (b) that each and every of the reports and payments provided for in the next *782 succeeding paragraph are promptly made and (c) that Mortgagor has complied with all other provisions of this Instrument, it shall have the right in the orderly conduct of its business to cut, remove and manufacture into forest products the timber covered hereby, and to receive the issues and profits thereof.
SECTION 3. - Payment for Timber Cut at Mortgagor's Plants: Payments shall be made in reduction of the principal indebtedness secured hereby in the amounts and at the times and in the method provided for in this Section. On the last day of each month during the life hereof, the Mortgagor will cause to be made an actual inventory of the lumber then in its possession, whether such lumber was manufactured from timber covered hereby or from any other timber hereinafter acquired by the Mortgagor. The Mortgagor shall issue invoices for each sale of lumber and logs made by it; and for all lumber*1075 used by it for any purpose (except to improve or repair the mortgaged property). These invoices shall issue at the time of each sale or use, in consecutive numerical order, and shall each show the number of thousand feet in each transaction. On or before the 15th day of each month during the life hereof, the Mortgagor will deliver to the Trustees and Bankers a written statement which shall show: (a) the aggregate number of feet of logs (according to the log scale customarily used in Arizona for logs of the kind covered thereby) which the Mortgagor sold during the immediately preceding month; (b) the aggregate number of feet of lumber which the Mortgagor sold or used as aforesaid during the immediately preceding month; and (c) such additional information as the Trustees or Bankers may from time to time require. These statements shall be accompanied by copies of the aforementioned invoices, and by an original duplicate of the inventory taken on the last day of the preceding month, above provided for. Concurrently with the delivery of each statement, the Mortgagor will pay to the Corporate Trustee the sum of Two and 50/100 ($2.50) Dollars for each thousand feet of logs and lumber*1076 shown in such statement. The term "lumber" as used in this Instrument includes ties, lathes, box shooks and all other merchantable productions of logs. The aforementioned inventories, invoices and statements shall be in form satisfactory to the Trustees and Bankers; and the statements shall be signed and sworn to by some one acquainted with the facts and shall bear the certificate of the Mortgagor's President, Vice-President, Secretary, Treasurer, Manager or Chief Clerk, that the believes them to be correct.
To further secure the due and punctual making of payments provided for in this Section, the lumber yard of Vortgagor, at Williams, Arizona, has been leased - and the inventory of logs and lumber thereon from time to time has been assigned to George R. Birkelund upon trust that none of such inventory shall be withdrawn while Mortgagor is in default inrespect of any such payments.
SECTION 4. - Partial Releases of Mortgaged Property: So long as there is no Declaration of Default under this Instrument, the Mortgagor shall be entitled, from time to time, upon its written request, signed by its President, Vice-President or Manager, to have released therefrom:
(a) The timber*1077 on each Lot or 40-acre subdivision described herein, upon paying into the Sinking Fund the releasing price for such timber (before entering such parcel otherwise than as provided in the next preceding paragraph hereof) fixed in the Releasing List, which concurrently herewith is executed in triplicate by the Mortgagor, Corporate Trustee and Bankers, an original thereof being held by each of them.
(b) Any land covered hereby, the releasing price of all timber thereon having first been paid, - upon paying into the sinking fund a price approved in writing by the Bankers: PROVIDED, HOWEVER, That the Trustees may reserve such rights of way as the Bankers deem necessary for the advantageous operation of the *783 property then covered hereby, and that no land shall be thus released which in the Banker's opinion is necessary to make the enterprise an efficient operating entity;
(c) With the Bankers' prior written consent,
(c-1) Such land or timber or both, covered hereby, as the Mortgagor may desire to have leased herefrom, provided other land or timber or both (whether owned by the Mortgagor or others) which is not then covered hereby and which the Bankers consider of at least*1078 equal value (or if not equal in value the difference in value as fixed by the Bankers may be paid by the Mortgagor in cash or in any other way satisfactory to the Bankers) shall, in a manner approved by the Bankers, at or before the delivery of such release, be subjected to the first lien hereof, and a Supplemental Releasing List, satisfactory to the Bankers, shall be prepared and executed;
(c-2) The surface or sub-surface of any land covered hereby, reserving the timber thereon; or rights of way thereover; or any other property covered hereby which in the Bankers' opinion is not necessary to make the enterprise an efficient operating entity, - upon paying into the Sinking Fund a price approved in writing by the Mortgagor and Bankers.
* * *
SECTION 7. - Manner of Paying Consideration for Releases: Neither the proceeds of fire insurance, nor of condemnation or expropriation proceedings (except as to property covered by such proceedings), nor any bonds paid, purchased or redeemed with such proceeds or with other Sinking Fund money, shall be used to effect the release of property from the lien hereof. Otherwise any consideration required to be paid hereunder for releases (and*1079 for service charges, if any) may be paid, either in cash, or in the principal of cancelled or uncancelled bonds secured hereby and not theretofore used to discharge any payment due hereunder, or partly in cash and partly in the principal of such bonds, or partly in cash and/or such bonds and partly in obligations secured by a first mortgage on the property released or secured in any other way the Bankers approve in writing. The Trustees will keep a list of all bonds used under this Section and cancel all uncancelled bonds thus used.
SECTION 8. - Application of Sinking Fund Before Default: So long as there is no declaration of default under the Mortgage, all money now in the Sinking Fund, and all monies thereafter paid and payable into said fund, shall be used solely for the retirement of the principal of the unpaid Bonds either through purchase on tender or in the open market, or to the payment of Bonds called for redemption. The coupons shall be paid with other than Sinking Fund money to be provided by the Mortgagor for the purpose. All bonds paid, purchased or redeemed shall be cancelled by the Corporate Trustee, delivered to the Mortgagor and never reissued.
SECTION 9. *1080 - Application of Sinking Fund after Default: After a Declaration of Default under this Instrument, any moneys in the Sinking Fund shall be applied as follows:
(a) To the expense of such proceedings as may be instituted to enforce the lien hereof and the rights of the Trustees and bondholders herein;
(b) To the repayment with interest of all advances made before such Declaration of Default by the Trustees and/or the Bankers for taxes, insurance or other protection of the mortgaged property;
(c) To the payment of the reasonable compensation of the Trustees and Bankers, their attorneys, agents and servants, for services rendered in the administration of this trust before the Declaration of Default;
(d) Any balance not applied as above to be disbursed as if it were a part of the proceeds of the sale of mortgaged property.
*784 On and after August 10, 1932, the petitioner's affairs were managed under the supervision of a bondholders' protective committee (hereinafter called the committee), consisting of Edward E. Barthell, George E. Birkelund, and Edward H. Williams.
The supplemental agreement of January 8, 1936, above referred to, was executed by the petitioner, the*1081 Continental Illinois National Bank & Trust Co., trustees under the original bond indenture, and the committee. By its terms the petitioner conveyed to the trustees all of its interest in a new Forest Service contract and also all its property of every kind. Certain leasehold bonds were released from the mortgage lien, the maturity date of the primary bond was extended, the sinking fund payment was increased, section 3 and section 8 of article III of the indenture of June 2, 1930, were amended as above reflected.
By terms of section 3, supra, the mortgagor was required to pay to the corporate trustee $2.50 per thousand feet of logs and lumber which had been currently sold and used, as determined by monthly invoices covering such sales and disposition of the lumber and as contained in a monthly statement of such transactions to be delivered to the trustees and bankers by the mortgagor on or before the fifteenth day of the succeeding month.
On January 8, 1936, the petitioner and George R. Birkelund, as trustee, entered into a written agreement under which the petitioner leased to the trustee its lumberyard at Williams, Arizona, and assigned to him all logs and lumber, etc. *1082 , as specified in the inventory and valued at about $300,000, until the mortgage should be fully paid. The agreement provided that "no lumber will be shipped or withdrawn from said yard when Mortgagor is in default in the performance of the above quoted covenant of the Mortgage and that no lumber will be withdrawn therefrom without the consent and approval of the Trustee."
The surplus account of the petitioner at December 31, 1935, December 31, 1936, and December 31, 1937, shows deficits as follows:
| 1935 | $657,423.88 |
| 1936 | 597,043.32 |
| 1937 | 498,652.18 |
The record discloses the following additional facts:
On and after August 10, 1932, the committee represented all of the outstanding bonds in default, totaling $349,700, bonds of $300 par value having been paid off by consent of the committee, supervised the management and operation of the petitioner, and conserved the assets for the payment of its bonds and obligations. No payments on the principal of the bonds, excepting $300, were made prior to January 8, 1936. During the year 1936 bonds totaling $87,200 par value were purchased and retired at a cost of $87,671.25 by direction of the committee. During the year*1083 1937 bonds of a par value of $107,700 were purchased and *785 retired at a cost of $110,342.50 by direction of the committee. The money to acquire the bonds was paid to the Continental Illinois National Bank & Trust Co. at the direction of George R. Birkelund.
The amount in board feet of lumber shipped and withdrawn from the yard during the year 1936 was 34,687,016 feet, and the amount of timber cut during that year was 32,483,360 feet. The amount in board feet of lumber shipped and withdrawn from the yard during the year 1937 was 27,228,430, and the amount of timber cut during that year in board feet was 32,423,142.
All of the assets of the corporation were covered by the original mortgage indenture of June 2, 1930, or supplemental mortgage dated January 8, 1936, except lumber in the yard, or lumber cut and thereafter to be placed in the yard. The agreement of January 8, 1936, between the petitioner and Birkelund, as trustee, was executed in order to create a lien in favor of the bondholders and to control the proceeds from the sale of lumber and other forest products manufactured by the petitioner and placed in its yard. Pursuant to that agreement Birkelund controlled*1084 the proceeds from such sales and applied them first to the petitioner's operating expenses and then to the retirement of the bonds.
On its income tax returns for the years 1936 and 1937 the petitioner listed certain items as "other income." Those items consisted of amounts received such as receipts from the company's store, scrap iron sold, box wood sold, gasoline charged to departments of the plant at a price exceeding cost, discounts, etc., but were offset by corresponding deductions in its general operating expense account. During 1936 the petitioner sold electric power to the Santa Fe Railroad and the town of Williams, Arizona aggregating $25,438.44. In 1937 the amount of such sales was $25,213.81. These receipts were offset by operating losses of $29,255.84 and $52,273, respectively.
At the direction of Birkelund the receipts from all sources in excess of operating expenses for both years were deposited in a general fund in the Continental Illinois National Bank & Trust Co. and applied to the retirement of the first mortgage bonds.
All lumber manufactured by the petitioner went through its yard and was subject to the agreement of January 8, 1936, between the petitioner*1085 and Birkelund. All parties to the several agreements construed them as preventing the petitioner from paying dividends if it had attempted to do so. The funds derived from the excess of receipts over operating expenses were used as fast as possible to retire the outstanding bonds.
In his notice of deficiency the Commissioner determined the petitioner's net income for the year 1936 to be $66,294.16 and for the year 1937 to be $110,938.93.
*786 OPINION.
VAN FOSSAN: The petitioner contends that the amended mortgage indenture and other agreements among the several interested parties, as interpreted and carried out by the parties, constituted an "agreement expressly dealing with the disposition of earnings and profits of the taxable year", as provided by section 26(c)(2) of the Revenue Act of 1936, 1 citing G.B.R. Oil Corporation,40 B.T.A. 738">40 B.T.A. 738, and other cases. On this premise it is argued that all of petitioner's receipts were required by contract to be used in payment of debts incurred prior to May 1, 1936. With greater vigor it is argued that at least to the extent of the payments into the sinking fund of $2.50 per thousand feet of lumber and logs*1086 shipped or used by petitioner it comes within the scope of the Board's decision in Michigan Silica Co.,41 B.T.A. 511">41 B.T.A. 511, and thus is entitled to the credit contemplated by the cited section.
*1087 We disagree with the former and agree with the latter proposition. Although section 1 of article III of the mortgage, set out in the findings of fact, set up a sinking fund and required all moneys received by the trustees (with certain exceptions) to be paid thereto, this general requirement did not bind the petitioner to pay all receipts to the trustees. The fact that the parties interpreted the agreement as granting entire control of all receipts to Birkelund, who applied them to the retirement of bonds, does not satisfy the statute. Helvering v. Moloney Electric Co., 120 Fed.(2d) 617.
Petitioner's obligation arose from section 3, which begins: "Payments shall be made in reduction of the principal indebtedness secured hereby in the amounts and at the times and in the method provided for in this section." The section proceeded to obligate the mortgagor to pay $2.50 per thousand feet of logs and lumber used or sold. The funds so arising were to go to the trustee and be used toward liquidating the principal debt. Section 4 provided for release from the mortgage lien of property sold upon payment into the sinking fund of the agreed price. *1088 There is no evidence of any payments under *787 this provision. In our opinion the provision for payments of $2.50 per thousand feet of lumber sold or used brings petitioner within section 26(c)(2). G. B. R. Oil Corporation, supra; Michigan Silica Co., supra.This was a positive and express restriction, requiring payment to the trustees and thus to the sinking fund to be used in discharge of a debt. It was entered into prior to May 1, 1936. Although the payment was not specified as to be made out of earnings and profits, we believe it comes within the reasoning of the Board in Michigan Silica Co., supra.
The respondent bases his argument largely on the assumption that the petitioner engaged in activities other than the lumber business and thus was not subject to the payments prescribed in article III, section 3, as amended. In its returns the petitioner listed as "other income" receipts from the company store and sales of electric power, as well as the sale of scrap iron, box wood, etc. The record shows that such items were offset by appropriate deductions in the general operating expense account and do not reflect true items of*1089 income.
The activities in which the respondent alleges the petitioner engaged were only incidental to its primary lumber business. The running of the company store obviously was a necessary operation and the generation of electric power was only a byproduct of the business. All of the property of petitioner was comprehended in the agreements of January 8, 1936, and necessarily was the source of any so-called "income" which the two departments of its business might produce.
From the foregoing it follows that for the years 1936 and 1937 the petitioner is entitled to a credit as provided in section 26(c)(2), limited in amount to the sums paid in each year pursuant to article III, section 3, as amended.
Reviewed by the Board.
Decision will be entered under Rule 50.
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 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 April 30, 1936. ↩