*1235 1. 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" includes undivided profits on hand at the beginning of the taxable year and the current net earnings of that year.
2. Where the amount of a corporation's adjusted net income for the taxable year does not exceed the aggregate of the amounts which can be distributed as dividends without violating the provision of a written contract executed prior to May 1, 1936, it is not entitled to a credit under section 26(c)(1) of the Revenue Act of 1936.
3. An agreement by a corporation to set aside $10,000 each year out of net earnings for the retirement of preferred stock is not a contract requiring the corporation to set aside a portion of its net earnings for the discharge of a debt, and no credit may be allowed under section 26(c)(2) of the Revenue Act of 1936.
4. The distribution by a corporation of $26,620.83 in retirement of a portion of its preferred stock at par is not a distribution properly chargeable to earnings or profits accumulated after February 28, 1913, so as to entitle*1236 corporation to dividends paid credit under section 27(f) of the Revenue Act of 1936.
*1074 The Commissioner determined a deficiency in the income tax of petitioner for the year 1936 in the amount of $1,700. The issues are: (1) Is petitioner entitled to a credit of $20,000 under the provisions of section 26(c) of the Revenue Act of 1936 because of a contract restricting the payment of dividends, and (2), if not, is petitioner entitled to a dividends paid credit under the provisions of of section 27(f) of the Revenue Act of 1936 because of a distribution of $26,620.83 made to its preferred stockholders during 1936, in retirement of a part of its preferred stock at par?
FINDINGS OF FACT.
Petitioner is a Missouri corporation, with principal office at Kansas City, Missouri. It filed its income tax return for the year 1936 with the collector of internal revenue for the sixth district of Missouri.
The Muehlebach Hotel, one of the outstanding hotels in the central west, was built in 1915. S. J. Whitmore leased the hotel for a period of 20 years ending*1237 in 1935 and operated it under the name of the Whitmore Hotel Co. In 1931, the Whitmore Hotel Co., all of the stock of which was then owned by the Mid-Continent Hotels Corporation, owed $75,000 to local banks and about $165,000 to trade creditors. The furnishings and equipment of the hotel had not been repaired or replaced for several years and were in bad condition. The hotel had been sustaining losses and its financial condition was such that discontinuance of its operation was being seriously considered.
The facts set out in the preceding paragraph were communicated to a number of public-spirited citizens of Kansas City, and a plan was evolved to insure the continued operation of the hotel. The substance of the plan was to have the lease on the hotel extended for a *1075 period of 12 years, from 1935 to 1947; to have a new company organized to acquire the assets of, and operate, the hotel, such company to have an authorized capital stock consisting of 10,000 shares of common, par value $5, and 10,000 shares of preferred, par value $25; to have the new company sell for cash 4,000 shares of common and 4,000 shares of preferred stock to new subscribers and 4,800 shares*1238 of common to the operators of the hotel; and to have the creditors of the Whitmore Hotel Co. subscribe for 4,800 shares of preferred. The plan contemplated that the "foregoing financial set-up will enable the new company to begin operation free of all current liabilities and at the same time have a current working capital account of approximately $24,000.00." Other provisions of the plan were that 7 percent cumulative dividends would be paid on the preferred stock; that no dividends would be paid on common stock while any unpaid dividends were due on the preferred; that the preferred should be nonvoting; that, beginning January 1, 1934, a sinking fund should be created from net earnings amounting to $833.33 per month ($10,000 per year) to take care of the retirement of the preferred stock; and that no dividends would be paid on the common stock after 1934 unless the monthly sinking fund had been deposited with a trustee.
The plan was submitted to a meeting of the creditors held in the Muehlebach Hotel in December 1931, and they were asked to indicate their acceptance of it by signing a printed form prepared by the committee handling the reorganization (known as Samuel J. Whitmore*1239 and Associates). By signing the form, the creditors agreed to transfer and assign to the committee, or to its order, their accounts against the Whitmore Hotel Co. upon the payment of one-half of the amount in cash, and the delivery to them of preferred stock of petitioner having a par value equivalent to the remaining one-half of the debts. Early in January 1932 creditors to whom the Whitmore Hotel Co. was indebted in the aggregate amount of $236,066.09 signed the agreement.
Petitioner was organized as a Missouri corporation on January 23, 1932. Its articles of incorporation provide that the holders of its preferred stock shall be entitled to receive from the net profits of the corporation, or out of its surplus, a yearly cumulative dividend of 7 percent before any dividend is paid on its common stock; that, after January 1, 1935, the company "shall set aside out of its net earnings, if any, the sum of Ten Thousand ($10,000.00) Dollars per year each year for the purpose of retiring issued and outstanding Preferred Stock until all of the issued and outstanding Preferred Stock shall have been retired; and after January 1, 1935, no dividends shall be declared or paid during any*1240 year on the Common Stock until the sum of Ten Thousand ($10,000.00) Dollars for such particular year *1076 shall have been first set aside for the purpose of retiring the Preferred Stock as above stated." The articles also provide that the preferred stock shall have no voting power; that upon 30 days' prior notice, the company may retire any part or all of the preferred stock at par, plus accrued and unpaid dividends; and that the preferred stock to be redeemed shall be selected by lot in such manner as the board of directors might determine. These provisions were incorporated in the preferred stock certificates.
On January 29, 1932, the Mid-Continent Hotels Corporation (owner of all of the capital stock of the Whitmore Hotel Co.) entered into an agreement with petitioner wherein it agreed to sell and convey to it all of the furniture, furnishings, and equipment of the Muehlebach Hotel. In consideration therefor petitioner agreed that it would "acquire by assignment the notes and accounts payable [owing by the Whitmore Hotel Co.] * * * and that as the owner of all of said notes and accounts payable it will release and discharge the Seller and the Whitmore Hotel Company*1241 from liability on all of said notes and accounts payable * * *, and surrender to the makers the notes mentioned therein." The agreement further provided:
It is expressly understood and agreed by and between the parties hereto that the Buyer by accepting delivery of said property does not assume or agree to pay any of the unpaid obligations of the Seller, or of the Whitmore Hotel Company, of any kind or character whatsoever, except that the Buyer agrees to acquire by assignment and to cancel, or cause to be cancelled, all of the notes and accounts payable owing by the Whitmore Hotel Company * * *.
On the same day the Whitmore Hotel Co. executed a bill of sale to the petitioner covering the lease and all of the assets of the Muehlebach Hotel.
On January 31, 1932, petitioner mailed to each of the creditors a check for one-half of the amount owed by the Whitmore Hotel Co., and also delivered to each of them shares of its 7 percent preferred stock having a par value equivalent to the other one-half of the indebtedness. In consideration therefor the creditors, in February 1932, assigned to petitioner their accounts against the Whitmore Hotel Co.
Petitioner commenced operation*1242 of the hotel on or about February 1, 1932, after acquiring the assets of the Whitmore Hotel Co. Its cash working capital at that time was between $30,000 and $40,000. This fund was exhausted by the end of 1932 or early in 1933. During the year 1932 petitioner expended for equipment and leasehold improvements a total of $32,143.55; during 1933, $22,432.04; during 1934, $94,962.37; during 1935, $28,391.85; and during 1936, $64,891.34. These expenditures included only such items as were *1077 capitalized, but did not include ordinary repair and expense items. The ordinary and necessary expenses of operating the hotel averaged approximately $90,000 a month. At the beginning of the taxable year 1936 petitioner had on hand in cash, or on deposit in banks, $103,780.21, current liabilities of $81,153.80, between $50,000 and $60,000 of which were due within 30 days, and surplus and undivided profits accumulated in prior years of $105,699.66. The balance sheets included in petitioner's income and excess profits tax return for 1936 show preferred stock liability of $229,504.17 at the beginning of the year and $202,883.34 at the end of the year.
As of December 31, 1935, petitioner*1243 had issued and outstanding 9,180 shares of preferred stock, approximately 4,300 of which had not been issued to creditors of the Whitmore Hotel Co. in connection with the assignment of their accounts to petitioner. Prior to the year 1936 no amount had been set aside out of petitioner's net earnings for the purpose of retiring any of its outstanding preferred stock. At the regular monthly meeting of the board of directors of petitioner held on July 28, 1936, the following resolutions were adopted:
* * * BE IT RESOLVED: That pursuant to the authority of the charter of this Corporation there be, and there hereby is appropriated and set aside out of the surplus funds of this Corporation (and allocable to net earnings accrued during the calendar year 1935) the sum of $10,000.00, and that there is hereby further appropriated and set aside out of the net earnings of the Company for the calendar year 1936, the sum of $10,000.00, the said total sum of $20,000.00 to be used for the purpose of retiring issued and outstanding Preferred Stock certificates of this Corporation to the extent of the par amount of $20,000.00, and
BE IT FURTHER RESOLVED: That shares of said seven per cent Preferred*1244 Stock of this Corporation up to the said par amount of $20,000.00 be, and the same are hereby retired as of September 30, 1936, payable with dividends accrued up to said date, and that the Executive Officers of this Corporation be, and they hereby are authorized, directed and empowered to take all steps necessary to consummate the retirement of said stock, including the giving of all and any notice or notices required by law, or by the covenants of this Corporation to effect said retirement, said notice or notices to be sent by United States Mail to each stockholder of record at his last known post office address, whose stock (or the certificate or any part thereof) is called for redemption, and to fix the date of said redemption of said stock to be as of September 30, 1936, * * *
Eight hundred shares of preferred stock were selected, by lot, to be retired and on July 31, 1936, notices were sent to all holders of such stock advising that the 800 shares would be redeemed on September 30, 1936, upon the surrender of the stock certificates. Of the shares thus selected for retirement, the certificate numbers of which were listed on the notice, 294 were held by former creditors of the*1245 Whitmore Hotel Co., and the remaining 506 were held by officer and directors of petitioner and others. Petitioner distributed $21,608.33 in September 1936, $4,987.50 in October, and $25 in December *1078 in connection with the redemption of its preferred stock. The distribution in excess of $20,000 resulted from favorable action taken by the board of directors at a meeting held on September 30, 1936, on the requests made by certain stockholders that their stock be redeemed in its entirety.
During the taxable year petitioner paid dividends on its preferred stock in the amount of $65,502.84, and dividends on its common stock of $46,653.33. These dividends and the $26,620.83 distributed in connection with the redemption of preferred stock were paid out of the current earnings of petitioner for the year 1936.
In its income and excess profits tax return for the year 1936, petitioner computed the amount of its undistributed net income subject to surtax as follows:
| Net income for surtax computation | $195,057.42 | |
| Less: Normal tax | 27,776.02 | |
| Adjusted net income | $167,281.40 | |
| Less: Dividends paid credit | $112,166.17 | |
| Credit for contracts restricting dividend payments | 20,000.00 | |
| $132,156.17 | ||
| Undistributed net income | $35,125.23 |
*1246 In respondent's notice of deficiency he disallowed the $20,000 credit claimed by petitioner, and in the statement attached thereto he stated his reasons for doing so, as follows:
The language used in the preferred stock certificates wherein it is stated that
"The corporation shall have the right at any time, upon 60 days' prior notice, to redeem all or any part of the preferred stock at par, plus accrued and unpaid dividends up to the date of redemption fixed in such notice. * * *" is considered of such import that if the corporation were financially able to redeem the stock there would be no reason for restricting the payment of dividends, since the restriction would not be the result of the contract but rather your corporation's failure to retire the stock.
Your corporation had sufficient earnings available to comply with the contract provisions without restricting dividend payments under section 26(c)(1) of the Revenue Act of 1936, as may be seen by the following:
| Net income, taxable year | $195,459.85 |
| Less: Normal tax | 27,836.40 |
| $167,623.45 | |
| Plus: Earnings and profits at the beginning of the taxable year | 105,699.66 |
| $273,323.11 | |
| Less: Amount required for retirement of preferred stock | 10,000.00 |
| $263,323.11 |
*1247 *1079 OPINION.
MELLOTT: The pertinent provisions of the Revenue Act of 1936 are shown in the margin. 1
*1248 Petitioner's first contention is that it was restricted in the payment of dividends in the taxable year by the provisions of a written contract executed by it prior to May 1, 1936, which required it to set aside $20,000 out of net earnings in 1936 for the purpose of discharging its covenant to satisfy the Muehlebach creditors' claims. It claims that it is therefore entitled to the credit provided by section 26(c)(1), supra.
The evidence presented by petitioner indicates that it did enter into a written contract prior to May 1, 1936, under the terms of which, after January 1, 1935, it was required to "set aside out of its net earnings, if any, the sum of Ten Thousand ($10,000.00) Dollars per year each year for the purpose of retiring issued and outstanding Preferred Stock until all of the issued and outstanding Preferred Stock shall have been retired; and after January 1, 1935, no dividends shall be declared or paid during any year on the Common Stock until the sum of Ten Thousand ($10,000.00) Dollars for such particular year shall have been first set aside for the purpose of retiring the Preferred Stock as above stated." The quoted provision was contained in the preferred*1249 stock certificates issued by petitioner in 1932.
*1080 It is axiomatic that provisions in preferred stock certificates constitute a binding contract between the issuing company and the purchaser of the stock. Respondent contends, however, that, despite the provision set out above, petitioner is not entitled to any credit under section 26(c)(1), supra. He points out that this section allows credit in 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 a corporation prior to May 1, 1936," and takes the position that such "aggregate" consisted of petitioner's surplus and undivided profits of $105,699.66, on hand at the beginning of the taxable year, plus its adjusted net income for that year of $167,623.45, and minus the $10,000 which it was required to set aside out of its net earnings. This amount is $263,323.11, which is in excess of petitioner's adjusted net income of $167,623.45. Respondent therefore contends that petitioner is not entitled to any credit under section 26(c)(1), supra.
Petitioner*1250 urges that its earnings and profits of $105,699.66 accumulated prior to January 1, 1936, could not be distributed within the taxable year since they were needed to pay the current expenses of the hotel and to pay for necessary repairs and replacements, and, therefore, should not be included in the computation of "the aggregate of the amounts which can be distributed within the taxable year as dividends * * *." One witness for petitioner testified that the current and necessary expenses of the hotel amounted to approximately $90,000 a month; that petitioner was required to keep this amount of cash on hand to meet these expenses; that at the beginning of the taxable year 1936 petitioner had current liabilities in excess of $81,000, of which between $50,000 and $60,000 was due within 30 days; that large amounts had to be expended for equipment and leasehold improvements; and that petitioner expended for such improvements $32,000 in 1932, $22,000 in 1933, $94,000 in 1934, $28,000 in 1935, and $64,000 in 1936. The testimony of this witness does not convince us that the surplus on hand at the beginning of 1936 was needed for the payment of current expenses or necessary capital improvements, *1251 and that it was not available for distribution as dividends. In its income tax return for 1936 petitioner reported gross receipts of $1,364,945.92 and cost of operations $325,868.69. Thus it had a gross income of $1,041,232.23. It claimed deductions of $846,174.81 for compensation of officers, rent, interest, and insurance, depreciation, salaries, and other expenses, leaving a net income of $195,057.42. Its balance sheet showed $97,910.21 cash on hand at the beginning of the year and $117,723.91 at the end of the year, and capital assets of $381,410.93 at the beginning of the year and $438,297.40 *1081 at the end of the year. Despite the distribution of dividends in the amount of $112,156.17 and the retirement of $26,620.83 of its preferred stock, the surplus of petitioner was increased from $105,699.66 at the beginning of the year to $156,763.83 at the end of the year. From this evidence it is apparent that petitioner's income for 1936 was more than sufficient to take care of its current expenses and capital improvements, and that it was not necessary to call upon the accumulated earnings of prior years for such purposes.
Petitioner's contention that the surplus on*1252 hand at the beginning of 1936 was not available for distribution as dividends during that year is further disproved by the action taken at the regular monthly meeting of its board of directors held on July 28, 1936. At that meeting, after referring to the prior declaration of a 7 percent dividend on preferred stock made on December 31, 1935, for the period February 1, 1932, to February 1, 1933, a declaration of a 7 percent dividend made April 28, 1936, for the period February 1, 1933, to February 1, 1934, and a declaration of a 7 percent dividend made May 27, 1936, for the period February 1, 1934, to February 1, 1935, the following resolutions were adopted:
BE IT FURTHER RESOLVED: That there be at once appropriated, out of the surplus of this Corporation, the sum of $16,065.29 to pay as of the date hereof, the seven percent annual dividend on the outstanding Preferred Stock of this Corporation provided by this Company's charter, and allocable to the period from February 1, 1935, to February 1, 1936, and
BE IT FURTHER RESOLVED: That the said dividends be, and they hereby are, ordered and directed to be paid forthwith out of said surplus and earnings of this Corporation,*1253 to the preferred stockholders of this corporation of record as of this date. [Italics supplied.]
While we have answered petitioner's contention that its accumulated earnings as of January 1, 1936, should not be included in computing the aggregate amount available for distribution as dividends in that year because they were needed for current expenses, etc., we desire to point out that there is, in our opinion, considerable substance to the respondent's contention on brief that, even if petitioner had proved that the accumulated earnings were needed for the specified purposes, the act did not provide for any exception in such cases and they would have to be included in the aggregate which could be distributed as dividends during the taxable year.
Petitioner also strenuously urges that even if its surplus as of January 1, 1936, be considered a "free surplus", it may not be used to lessen the amount of credit to which petitioner is entitled under section 26(c)(1); that the statute is leveled at undistributed current earnings, and not at undistributed surplus of earlier years on hand at the beginning of the current year; that the purpose of the act is to impose a surtax on the*1254 current net income of a corporation in *1082 an amount measured by the undistributed net income; that to the extent the current net income is undistributed it is taxable, except in the amount that it can not be distributed by virtue of contractual prohibitions resulting from contracts entered into prior to the date the statute became effective; and that Congress intended to allow a credit to the extent that the current net income exceeds that part of the current net income which can be distributed without offending a contract restricting dividends.
Section 14 of the Revenue Act of 1936 provides for the imposition of a surtax upon the undistributed net income of every corporation, and subdivision (a)(2) of this section defines "undistributed net income" to be "the adjusted net income minus the sum of the dividends paid credit provided in section 27 and the credit provided in section 26(c), relating to contracts restricting dividends." An examination of the sections discloses that the credits are not limited to current net income. Section 27 allows a credit for dividends paid, either out of earnings of prior years or out of the earnings of the current year. It also allows, *1255 under certain circumstances, as a part of the dividends paid credit, dividends paid in a preceding year in excess of the adjusted net income for that year. The purpose of section 26(c)(1), as we interpret it, was to allow a taxpayer an additional credit where a corporation was prevented from distributing an amount equivalent to its adjusted net income of the current year by reason of a written contract executed prior to May 1, 1936, expressly dealing with the payment of dividends. Congress apparently realized that there would be instances, such as we have here, where, even though a corporation was required by the provisions of a written contract to set aside a portion of its earnings for a particular purpose, it might still be in a position, after it had discharged this contractual obligation, to distribute an amount equivalent to its adjusted net income. It, therefore, provided for a credit equal to the excess of the adjusted net income over the aggregate of the amounts which could be distributed within the taxable year as dividends without violating a written contract, etc. The aggregate amount which petitioner could distribute during the taxable year included its surplus as*1256 of January 1, 1936, and its adjusted net income of the current year, less the amount it was obligated by contract to set aside out of 1936 earnings, and which it did so set aside, for the retirement of its preferred stock. Since the aggregate of these amounts is in excess of its adjusted net income for 1936, we hold that it is not entitled to the claimed credit under section 26(c)(1), supra.
Petitioner contends in the alternative that it is entitled to a credit under the provisions of section 26(c)(2), supra. Before petitioner can be allowed such a credit, it must appear that a portion of its *1083 earnings and profits of the taxable year is required by the provisions of a written contract executed prior to May 1, 1936, expressly dealing with the disposition of earnings and profits, to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within such year for the discharge of a debt.
It has been pointed out in connection with the first issue that petitioner was obligated by a provision in its preferred stock certificates to set aside, after January, 1935, out of its net earnings, if any, the sum of $10,000 per year each year, for*1257 the purpose of retiring issued and outstanding preferred stock. This provision expressly dealt with the disposition of a portion of petitioner's earnings and profits of the taxable year, and was contained in a contract executed by petitioner prior to May 1, 1936. If, therefore, petitioner was required to set aside $10,000 per year each year "for the discharge of a debt", it is entitled to a credit under section 26(c)(2).
Petitioner takes the position that its agreement to set aside $10,000 per year out of its net earnings for the purpose of retiring issued and outstanding preferred stock should be construed to be a contract requiring it to set aside a portion of its net earnings for the discharge of a debt. It urges that its preferred stock certificates were in reality certificates of indebtedness and that the general rule that the holders of preferred stock of a corporation are not creditors should not therefore be applied. It is true, as petitioner points out, that the corporate designation of the character of the instrument is not conclusive. *1258 ; . Each case must be decided upon its own facts. ; affd., . The evidence in the instant proceeding does not convince us that the certificates of preferred stock issued by this petitioner were other than what they purport to be. Petitioner relies strongly upon the testimony of former creditors of the Whitmore Hotel Co. to the effect that they understood petitioner's preferred stock was being given to them as evidence of the unliquidated balance of the debts owed to them; that they did not consider the preferred stock as an investment; and that they did not desire to become investors in a hotel property. It argues that this testimony shows that the intention of the creditors was not to embark upon the corporate venture and take the risks of loss attendant thereon in order to enjoy the chances of profit, and that it was the intent of petitioner to acquire the assets of an embarrassed hotel by paying off its creditors, half in cash and half in*1259 deferred payments. As proof that a debt was recognized as such by petitioner, it introduced in evidence a page from a combination journal and ledger book, kmown as a "voucher register," showing that in September 1936 $22,616.76 was credited to preferred stockholders as an *1084 account payable. It also points out that the holders of its preferred stock had no voting power and were not entitled to notice of stockholders' meetings.
The evidence convinces us that it was the intention of petitioner from the very beginning to acquire the accounts of creditros of the Whitmore Hotel Co. in exchange for cash and preferred stock. The purpose of acquiring these accounts in this manner was to permit petitioner to begin its operation of the hotel "free of all current liabilities." The contract under which it acquired the assets of the hotel specifically provided that petitioner did not assume or agree to pay any of the obligations of the Whitmore Hotel Co., except that it agreed to acquire by assignment all the accounts payable of that company. When the accounts were assigned to petitioner, it issued shares of its preferred stock in part payment therefor. The preferred stock certificates*1260 gave the holders the right to receive, out of surplus or net earnings of the corporation, a yearly cumulative dividend of 7 percent per annum; the right to have $10,000 per year set aside out of the net earnings of the corporation after January 1, 1935, for the purpose of retiring preferred stock; and the right to receive upon dissolution or liquidation, the full par value of the stock and all unpaid dividends accrued thereon before any payment to the common stockholders. These provisions, including the provision that the holders of the preferred stock should have no voting power, differ in no material respect from those usually contained in preferred stock issues.
While the corporate designation of the character of an instrument such as the preferred stock certificates issued by petitioner is not conclusive, the name given will not be ignored and courts will not lightly assume that the corporation has given the instrument an incorrect name. . The provisions of the certificates are an important factor in determining whether the holders thereof should be treated for tax purposes as preferred stockholders or creditors. A corporate*1261 creditor has been defined by this Board to be "one who has loaned to the corporation money or its equivalent, usually for compensation or interest, at a fixed rate, to be repaid at a designated time or in a designated manner." ; affd., . In ; affd., , in determining that fixed periodic payments made to holders of "guaranteed stock" were in reality interest although denominated "dividends", we said: "It seems to us * * * that in this case the basic test to be applied is whether the stockholder invested his money with the view of receiving a return from its use dependent on the successful operation of the company, on the one hand, or, on the other hand, whether he invested with no regard *1085 to the profit or loss which the company might enjoy or sustain, but with a dependency on the regular payment of compensation for the use of the money and the assurance of its ultimate payment." If the intention of the petitioner were to treat the holders of its preferred stock as creditors, we are at*1262 a loss to account for the absence of any provision fixing a definite time when the debt would mature and requiring payment to be made whether earnings existed or not. Cf. . Dividends were not payable to the holders of such stock in any event, but only when and if declared by petitioner's board of directors. Moreover, the rights of the preferred stockholders to dividends and to have their stock redeemed depended upon earnings derived from the successful operation of the hotel. They were given preference only over common stockholders in the event of dissolution or liquidation.
The provisions of the stock certificates are not the only evidence that a debtor-creditor relationship did not exist between petitioner and its preferred stockholders. Petitioner's articles of incorporation provided that its capital stock should consist of 10,000 shares of common stock having a par value of $5 per share and 10,000 shares of preferred stock having a par value of $25 per share, and contained the statement that more than 17 percent of the authorized capital stock (3,746 shares of common and 1,342 shares of preferred) had been actually*1263 paid up in cash. In the minutes of the meetings of its stockholders and directors the preferred stock was always referred to as such and not as a certificate of indebtedness. In its capital stock tax return for 1936, it reported that its outstanding capital stock consisted of 9,180 1/6 shares of preferred stock and 9,330 2/3 shares of common stock. Approximately 4,300 shares of its outstanding preferred stock were not issued in connection with the acquisition of the accounts of Whitmore Hotel Co. creditors. In the balance sheet forming part of its income and excess profits tax return for 1936, it listed as a capital stock liability "Preferred Stock (less stock in treasury)" amounting to $229,504.17 at the beginning and $202,883.34 at the end of the year. In the same return it claimed $112,156.17 as a "Dividends paid credit", $65,502.84 of which represented distributions to the holders of its preferred stock, and in computing its net taxable income no deduction was claimed for "Interest paid" during the year.
The provisions of petitioner's preferred stock certificates, petitioner's consistent treatment of these certificates as preferred stock, its repeated reference to "dividends" *1264 to be paid or paid to the holders thereof in the minutes of its corporate meetings and tax returns, its action in setting aside $20,000 out of its surplus funds and earnings for the purpose of retiring issued and outstanding preferred stock, and other evidence heretofore mentioned, all serve to convince us that petitioner *1086 did not set aside $20,000 during the taxable year for the discharge of a debt. In reaching this conclusion we do not doubt the sincerity of those former creditors of the Whitmore Hotel Co. who testified that they did not intend to become investors and accepted petitioner's preferred stock as evidence of the unliquidated balance of the debts owed to them. Whatever their intention may have been, they became investors when they assigned their Whitmore Hotel Co. accounts to petitioner in exchange for cash and preferred stock. Respondent did not err in disallowing the credit claimed by petitioner under the provisions of section 26(c)(2), supra. Cf. .
The remaining contention of petitioner is that if it is not entitled to a credit under section 26(c), then it is entitled to an additional dividends*1265 paid credit under section 27(f) of the Revenue Act of 1936 for the $26,620.33 (should be $26,620.83) which it paid during the taxable year in retirement of its preferred stock.
Section 27(f) of the 1936 Act provides that in the case of amounts distributed in liquidation the part of such distribution which is properly chargeable to the earnings or profits accumulated after February 28, 1913, shall, for the purposes of computing the dividends paid credit under this section, be treated as a taxable dividend paid. Section 115(c) of the same act provides that in case of a distribution in partial liquidation the part of such distribution "which is properly chargeable to capital account shall not be considered a distribution of earnings or profits." In , this Board discussed at length the provisions of section 27(f), supra, and among other things said: "It seems * * * plain that Congress did not intend to confer dividends paid credit for a return of capital. * * * Indeed, Regulations 94, article 27(f)-1(b) states: 'To determine the amount properly chargeable to the earnings or profits accumulated since February 28, 1913, there*1266 must be deducted from the amount of the distribution that part allocable to capital account.'"
The amount of $26,620.83 which petitioner paid during 1936 in retirement of a part of its preferred stock was not properly chargeable to its earnings or profits accumulated after February 28, 1913. The entire amount distributed, representing the par value of 1,064 5/6 shares retired, was chargeable to its capital account, and as a result of this distribution petitioner's preferred stock liability on the balance sheets forming part of its 1936 return was reduced from $229,504.17 at the beginning of the year to $202,883.34 at the end of the year. Under these circumstances, petitioner is not entitled to an additional dividends paid credit because of the provisions of section 27(f).
Decision will be entered for the respondent.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
* * *
(c) CONTRACTS PESTRICTING 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. If a corporation would be entitled to a credit under this paragraph because of a contract provision and also to one or more credits because of other contract provisions, only the largest of such credits shall be allowed, and for such purpose if two or more credits are equal in amount only one shall be taken into account.
(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.
(3) DOUBLE CREDIT NOT ALLOWED. - If both paragraph (1) and paragraph (2) apply, the one of such paragraphs which allows the greater credit shall be applied; and, if the credit allowable under each paragraph is the same, only one of such paragraphs shall be applied.
SEC. 27. CORPORATION CREDIT FOR DIVIDENDS PAID.
* * *
(f) DISTRIBUTION IN LIQUIDATION. - In the case of amounts distributed in liquidation the part of such distribution which is properly chargeable to the earnings or profits accumulated after February 28, 1913, shall, for the purposes of computing the dividends paid credit under this section, be treated as a taxable dividend paid. ↩