Opinion
No. 45566.
January 6, 1944. As Amended on Denial of Motion for New Trial May 1, 1944.
A.E. James, of Washington, D.C., for plaintiff.
D.F. Hickey, of Washington, D.C., and Samuel O. Clark, Jr., Asst. Atty. Gen. (Robert N. Anderson and Fred K. Dyar, both of Washington, D.C., on the brief), for defendant.
Before WHALEY, Chief Justice, and LITTLETON, WHITAKER, JONES, and MADDEN, Judges.
Action by Rex-Hanover Mills Company against the United States to recover corporation income taxes paid, with interest, by the plaintiff.
Judgment for plaintiff.
This case having been heard by the Court of Claims, the court, upon a stipulation of the parties, makes the following special findings of fact:
1. The plaintiff, Rex-Hanover Mills Company, a North Carolina corporation, is the successor of the Rex Spinning Company and Hanover Mills Company, reorganization involving those companies having been effected as of November 1, 1939.
2. Rex Spinning Company was incorporated under the laws of the State of North Carolina on July 12, 1915, with an authorized capital of $500,000, divided into 2,500 shares of common stock and 2,500 shares of preferred stock, the shares of both classes of stock having a par value of $100 per share. The company's business was the manufacturing of cotton yarns.
3. The original issue out of the authorized capital stock of Rex Spinning Company consisted of 2,008 shares of common stock of a par value of $100 per share, all of which were issued for value.
4. On February 20, 1920, the charter of Rex Spinning Company was amended pursuant to the provisions of the corporation law of the State of North Carolina and the authorized capital of said corporation was increased from $500,000 to $1,000,000. Following the amendment the company increased its issued and outstanding common stock of a par value of $100 per share from 2,000 shares to 6,000 shares by declaration of a stock dividend, and increased its issued and outstanding preferred stock of a par value of $100 per share from 1,000 shares to 4,000 shares by a sale of 3,000 shares of preferred stock for cash. Theretofore and in the year 1920 Rex Spinning Company issued 1,000 shares of its original authorized preferred stock for cash.
5. The outstanding capital stock of Rex Spinning Company at January 1st of each of the years from 1916 to 1933, inclusive, was as follows:
Capital Stock Com. stock Pfd. stock par $100/sh par $100/sh
January 1, 1916 ........... $200,800 January 1, 1917 ........... 200,800 January 1, 1918 ........... 200,800 January 1, 1919 ........... 200,800 January 1, 1920 ........... 200,000 January 1, 1921 ........... 600,000 $400,000 January 1, 1922 ........... 600,000 400,000 January 1, 1923 ........... 600,000 400,000 January 1, 1924 ........... 510,750 400,000 January 1, 1925 ........... 510,750 400,000 January 1, 1926 ........... 510,750 400,000 January 1, 1927 ........... 510,750 360,000 January 1, 1928 ........... 511,000 360,000 January 1, 1929 ........... 600,000 360,000 January 1, 1930 ........... 600,000 360,000 January 1, 1931 ........... 600,000 358,000 January 1, 1932 ........... 550,000 340,100 January 1, 1933 ........... 550,000 320,500
6. On October 17, 1933, the charter of the Rex Spinning Company was again amended and the authorized share structure was changed to 10,000 shares divided into 6,000 shares of common stock without par value and 4,000 shares of preferred stock having a par value of $100 per share. This action was taken pursuant to a resolution of the directors adopted at a meeting held October 11, 1933, submitting the proposal to the stockholders, and reading as follows:
"Resolved, that in the judgment of the Board of Directors of this Company it is advisable to amend section four of the Certificate of Incorporation so as to cause the same to read as follows:
"4. The total number of shares of stock authorized is 10,000 shares, divided into 6,000 shares of common stock having no par value, and 4,000 shares of preferred stock, having a par value of $100.00 per share, such preferred stock to have such preferences, dividend rate, conditions, restrictions and limitations as shall be agreed upon by the stockholders and they do hereby call a special meeting of the common stockholders, to be held at the company's office in the City of Gastonia, on Wednesday the 16th day of October 1933, at 2 P.M., to take action upon the above resolution."
This resolution was duly ratified by the stockholders of Rex Spinning Company at a meeting held on October 16, 1933, at which meeting the following resolution was duly adopted:
"Resolved, That in the judgment of the stockholders, it is deemed advisable to amend section four of the Certificate of Incorporation so as to cause the same to read as follows:
"4. The total number of shares of stock authorized is 10,000 shares, divided into 6,000 shares of common stock having no par value, and 4,000 shares of preferred stock, having a par value of $100.00 per share, such preferred stock to have such preferences, dividend rate, conditions, restrictions and limitations as shall be agreed upon by the stockholders."
"Resolved, Further, That the President and Treasurer execute under their hands and the seal of the corporation, duly proved as in the case of deeds to real estate, a certificate setting forth the foregoing resolution and the action of this body thereon, which said certificate, together with the written assent of more than two-thirds in interest of the outstanding common capital stock of this company, they shall cause to be filed in the office of the Secretary of State of North Carolina, and in the office of the Clerk of the Superior Court of Gaston County, N.C.
"Thereupon, all of the stockholders being present and voting for said resolutions, signed the written certificate of their assent to the change of the charter provided for therein, to be filed in the office of the Secretary of State.
"Upon motion of Mr. Rudisill, seconded by Mr. Robinson, the following certificate of preferred stock was adopted, and on motion of Mr. Robinson, seconded by Mr. Rudisill, the officers of the corporation were authorized, empowered and directed to issue and sell not to exceed $250,000 of such preferred stock, the proceeds of such sale to be used in the retirement of a like amount of the present issue of preferred stock now outstanding. Both said resolutions were unanimously adopted.
"This is to certify that is __________ the owner of __________ fully paid shares of the Preferred Capital Stock of Rex Spinning Company, transferable only in person or by attorney, on the books of the company upon surrender of this certificate duly endorsed. This stock is part of an issue amounting in all to $250,000.00 par value, due and maturing on or after December 1, 1938, as authorized by the amended Charter or Certificate of Incorporation of this company, filed in the office of the Secretary of State of North Carolina and recorded in the office of the Clerk of the Superior Court of Gaston County.
"The holders of the preferred stock shall be entitled to receive when and as declared by the Board of Directors from the surplus or net profits of this company, cumulative dividends at the rate of (but never exceeding) 7% per annum, payable semiannually on the first days of June and December of each year. If any dividends period shall be passed without payment of the dividend, such dividend shall be cumulative and shall bear interest at the rate of 6 per cent per annum until paid. No dividends shall be paid on any other class of stock until payment shall be made of all past due and accrued dividends on the preferred stock and provision shall have been made for the current accruing dividend thereon.
"The holders of the preferred stock shall in case of liquidation or dissolution of the company be entitled to receive in full the par value of their shares and accrued dividends thereon, whether declared or undeclared, with interest, out of the assets of this company before any payment shall be made to the holders of any other class of stock.
"The company shall not, without the consent of the holders of seventy-five (75) per cent of the aggregate par value of the outstanding preferred stock, create any mortgage, lien or other encumbrance upon its plant or plants, or any of the machinery constituting a part thereof or any real estate of said company, or issue bonds, notes, or other evidences of indebtedness having a longer maturity than one year, and the company shall not, without like consent, authorize or issue any stock having superior preference or priorities over said preferred stock or equal preferences or priorities. Nor shall the company guarantee the bonds, notes, or other obligations, or the dividends on the stock of any other company, firm or individual. Provided, however, that nothing herein contained shall prevent the corporation from purchasing property which may at the time of such purchase be subject to mortgage or other lien.
"The preferred stock, or any part thereof, may be retired at the will of the Board of Directors on giving thirty (30) days written notice to the stockholders of record, by paying One Hundred and Five ($105.00) Dollars per share with all unpaid and accrued dividends and interest, if any.
"The company shall, on December 1, 1934, and on the first day of December on each year thereafter, provide for a sinking fund by setting aside out of the assets, represented by its earnings or surplus, and before the payment of any dividends on any class of stock other than Preferred Stock, the sum of Thirty Thousand ($30,000.00) Dollars. And if there should be a failure in any year to set aside said fund it must be provided for in the next succeeding years, before the payment of any dividend on any common stock. This fund shall be kept separate and apart from all other assets of the company, and shall be used by the Board of Directors during the calendar year in which such sum is set aside in purchasing the Preferred Stock at the best price obtainable, but not exceeding One Hundred and Five ($105.00) Dollars per share and accrued dividends. If sufficient Preferred Stock cannot be purchased at or below the price aforesaid to exhaust the sums in the sinking fund available therefor, the balance in the sinking fund shall be kept separate from the other assets of the company until such time as it may prove possible to purchase Preferred Stock at or below the price aforesaid.
"All Preferred Stock purchased or retired by the company shall be cancelled and shall not be reissued for any purpose whatever.
"This issue of Preferred Stock shall not be increased except upon the consent of three-fourths majority of the entire outstanding issue of such Preferred Stock.
"The holders of the Preferred Stock shall not be entitled to vote at any stockholders meeting unless there should be default in the payment of at least three (3) consecutive semi-annual dividends, and in case of such default the holders of the Preferred Stock shall have the right to vote at all stockholders meetings, and this right shall continue until all dividends so accrued on the Preferred Stock, with interest thereon, have been paid, and on such payment, the right to vote such Preferred Stock shall immediately cease.
"Witness the seal of the company and the signature of the President, and of the Secretary, this ___ day of __________, 19__.
"__________ President.
"__________ Secretary."
On October 17, 1933, the Rex Spinning Company filed with the Secretary of the State of North Carolina the amendment to its charter hereinabove referred to, duly amending section four of its charter in words and figures as hereinabove set forth.
7. When the stockholders and directors of plaintiff company used the words "surplus or net profits" and the words "earnings or surplus" in the reorganization agreement recited in finding 6, they did not intend to include within the meaning of those words any surplus or earnings previously accumulated and capitalized by the stock dividends previously distributed.
8. In the year 1933 and following the charter amendment of October 17, 1933, the accountant for Rex Spinning Company charged the common capital stock account appearing on its books with the sum of $550,000 representing the entire amount carried as common capital stock thereon and credited the surplus account appearing on its books with the sum of $550,000. At the time this entry was made the surplus account consisted of a deficit on the books in the amount of $166,285.34 so that the entry as so made had the effect of changing the deficit as so carried on the books to a surplus of $383,714.66 and had the effect also of eliminating from the books the common capital stock account theretofore carried thereon. No resolutions of the Board of Directors or of the stockholders of the company were adopted authorizing or directing the making of the said entry or relating to the stated value of the said common stock other than as contained in the minutes hereinabove recited of the meeting of the Board of Directors on October 11, 1933, and the meeting of the stockholders on October 16, 1933.
9. At the date of the amendment to the charter in 1933 as hereinabove set forth, Rex Spinning Company had outstanding 3, 160 shares of preferred stock issued pursuant to its original charter or pursuant to the amendment of 1920, of a total par value of $316,000, and that stock continued outstanding until after January 1, 1934.
During the month of January, 1934, the company retired 1,332 shares of its preferred stock as then outstanding and, in exchange for their old certificates, issued to the holders of the remaining 1,828 shares, new certificates under the authorization of the stockholders as hereinabove set forth and as adopted at the meeting of October 16, 1933.
During the month of February the company issued 672 shares of its new preferred stock. The total number of shares of preferred stock then outstanding was, therefore, 2,500 shares of a par value of $100 each.
The new certificates of preferred stock contained printed provisions substantially identical, so far as material, with those set forth and adopted in respect of preferred stock at the meeting of October 16, 1933. A sample copy of the new preferred stock certificates is Exhibit 1 and is made a part hereof by reference.
A surplus account to which was posted all earnings and profits, was carried upon the books of Rex Spinning Company from its beginning to and including December 31, 1936, and all entries in respect thereof (or consolidations of such entries) are contained in the following tabular statement under the heading "Per Books."
In the column headed "Adjusted by Commissioner" is an adjusted statement of the surplus of the company for the same period after eliminating from the said surplus as contained on the books (a) an appraisal writeup of assets resulting in a credit of $100,000 in the year 1917, (b) the charge to surplus in 1920 resulting from the stock dividend of $400,000 issued in that year, (c) the charge to surplus of $93,500 in 1928 resulting from a stock dividend in that year and (d) the credit to surplus made in 1933 as set forth in finding 8 hereof on account of the change of the value of the common capital stock of the company from a par value of $100 per share to no par value.
In addition to the foregoing, adjustments as computed by the Commissioner include the elimination (e) of a charge of $600 to surplus for premium paid on capital stock of the company purchased in 1919, (f) a charge to surplus of $22,330.33 representing a premium paid on stock of the company purchased in 1927; (g) a credit to surplus in 1928 of $1,500 resulting from a purchase of stock of the company at a discount and (h) $16,585 credited to surplus in 1932, likewise on account of stock purchased at a discount.
The Commissioner's adjustments also include three items relating to purchases of the plaintiff's common stock in 1923, 1928, and 1931, all these adjustments arising from and being consistent with his elimination of surplus debits representing the stock dividends issued by the company in 1920 in the amount of $400,000 and in 1928 in the amount of $93,500. Common stock was purchased by the company in 1923, 1928, and 1931 in the respective amounts in par value of $89,250, $5,500, and $50,000. The entire amount of the par value of the purchase was charged on the company's books to the capital stock account. Because of his elimination of the 1920 and 1928 stock dividends so as to restate the common stock in accordance with its original cost, the Commissioner made compensating adjustments in the surplus account by reason of the fact that of each three shares of stock purchased in 1923 and 1928 one share was considered by him to represent original issue stock and two shares were considered by him to represent stock dividend stock. Two-thirds, therefore, of each purchase of common stock in the years 1923 and 1928 is entered by the Commissioner in the column hereinabove designated as "Adjusted by Commissioner" as reductions of surplus, and one-third was regarded by him as representing a reduction of the original investment of common stock in the company. In 1931 a similar adjustment was made in slightly different proportions by reason of the stock dividend of 1928. These adjustments, as tabulated below, are respectively (i) $59,500, (j) $3,666.67, and (k) $35,930.
The purpose of the following stipulated figures is to show the surplus of the company as carried on its books and to show in figures how that surplus would be affected by the various adjustments enumerated above, all with reference to the question whether or not the company in 1936 had in fact and in law a surplus out of which the retirement of the preferred stock could have been provided for and the stock retired without reference to the profits and earnings of the said year, it being agreed that the adjustments contained in the column headed "Adjusted by Commissioner" are mathematically correct if in fact and in law resort to such adjustments or any of them is proper in determining whether or not the company had in 1936 an earned surplus available for the reserve required to be set up for retirement of its preferred stock.
Surplus per books and computation of earned surplus irrespective of appreciation of assets and stock dividends declared and issued
Surplus Year Common stock Per books Adjusted by commissioner 1916 Capital stock ........... $200,800 ........... .......... 1916 Profits ................. ........... $55,368.52 $55,368.52 Dividends ............... ........... (12,048.00) (12,048.00) ----------- ----------- ----------- 12-31-16 Balance ..... 200,800.00 43,320.52 43,320.52 =========== =========== =========== 1917 Profits ................. ........... 68,358.64 68,358.64 " Appraisal ............... .......... (a)100,000.00 ........... " Dividends ............... ........... (20,080.00) (20,080.00) ----------- ----------- ----------- 12-31-17 Balance ..... 200,800.00 191,599.16 91,599.16 =========== =========== =========== 1918 Profits ................. ........... 73,323.53 73,323.53 " Dividends ............... ........... (20,080.00) (20,080.00) " Income tax .............. ........... (12,000.18) (12,000.18) ----------- ----------- ----------- 12-31-81 Balance ..... 200,800.00 232,842.51 132,842.51 =========== =========== =========== 1919 Profits ................. ........... 158,627.26 158,627.26 " Dividends ............... ........... (26,096.15) (26,096.15) " Income tax .............. ........... (36,643.95) (36,643.95) " Income tax .............. ........... (50,325.95) (50,325.95) " Premium on stock ........ ........... (e)(600.00) ........... " Stock retired ........... 800.00 ........... ........... ----------- ----------- ----------- 12-31-19 Balance ..... 200,000.00 277,803.72 178,403.72 =========== =========== =========== 1920 Profits ................. ........... 156,349.45 156,349.45 " Dividends ............... ........... (73,375.00) (73,375.00) " Income tax .............. ........... (5,166.74) (5,166.74) " Stock dividend .......... .......... (b)(400,000.00) ........... ----------- ----------- ----------- 12-31-20 Balance ..... 200,000.00 (44,388.57) 256,211.43 =========== =========== =========== 1921 Profits ................. ........... 66,915.64 66,915.64 " Dividends ............... ........... (28,263.75) (28,263.75) " Income tax .............. (33,101.76) (33,201.76) ........... ----------- ----------- ----------- 12-31-21 Balance ..... 200,000.00 (38,868.44) 261,761.56 =========== =========== =========== 1922 Loss .................... ........... (69,415.13) (69,415.13) " Income tax .............. ........... (9,475.03) (9,475.03) " Dividends ............... ........... (4,047.75) (4,047.75) ----------- ----------- ----------- 12-31-22 Balance ..... 200,000.00 (121,776.35) 178,823.65 =========== =========== =========== 1923 Loss .................... ........... (31,956.17) (31,956.17) " Income tax .............. ........... (8,207.20) (8,207.20) " Dividends ............... ........... (21,031.90) (21,031.90) " Stock purchased ......... (29,750.00) ........... (i)(59,500.00) ----------- ----------- ----------- 12-31-23 Balance 170,250.00 (182,971.62) 58,128.38 =========== =========== =========== 1924 Loss .................... ........... (140,518.89) (140,518.89) " Income tax .............. ........... (248.11) (248.11) ----------- ----------- ----------- 12-31-24 Balance ..... 170,250.00 (323,738.62) (82,638.62) ========== =========== =========== 1925 Loss .................... ........... (30,978.41) (30,978.41) ----------- ----------- ----------- 12-31-25 Balance ..... 170,250.00 (354,717.03) (113,617.03) =========== =========== =========== 1926 Loss .................... ........... (37,790.22) (37,790.22) " Income tax .............. ........... (5,974.06) (5,974.06) ----------- ----------- ----------- 12-31-26 Balance ..... 170,250.00 (398,481.31) (157,381.31) =========== =========== =========== 1927 Profit .................. ........... 60,386.78 60,386.78 " Dividends ............... ........... (2,100.00) (2,100.00) " Premium on stock ........ .......... (f)(22,330.33) ........... " Depreciation adjustment ........... 29,358.63 29,358.63 " Stock sold .............. 250.00 ............ ........... ----------- ------------ ----------- " Balance .............. 170,500.00 (333,166.23) (69,735.90) =========== ============ =========== 1928 Profits for period ...... ........... 107,714.59 107,714.59 " Discount on stock ....... ........... (g) 1,500.00 ............ " Stock purchased ......... (1,833.33) ............ (j)(3,666.67) " Stock sold .............. 1,000.00 ............ ............ " Dividends paid .......... ........... (25,200.00) (25,200.00) " Stock dividend .......... ........... (c)(93,500.00) ............ ----------- ------------ ------------ 12-31-28 Balance 169,666.67 (342,651.64) 9,112.02 1929 Profits ................. ........... 127,456.20 127,456.20 " Dividends ............... ........... (25,725.00) (25,725.00) " Income tax .............. ........... (14,611.12) (14,611.12) ----------- ------------ ------------ 12-31-29 Balance ...... 169,666.67 (255,531.56) 96,232.10 =========== ============ ============ 1930 Profits ................. ........... 63,618.13 63,618.13 " Dividends ............... ........... (25,195.33) (25,195.33) " Income tax .............. ........... (14,196.25) (14,196.25) " Insurance premiums ...... ........... (2,864.00) (2,864.00) ----------- ------------ ------------ 12-31-30 Balance ..... 169,666.67 (234,169.01) 117,594.65 =========== ============ ============ 1931 Profits ................. ........... 62,340.38 62,340.38 " Insurance rec'd ......... ........... 50,020.26 50,020.26 " Dividends ............... ........... (24,283.33) (24,283.33) " Income tax .............. ........... (12,486.08) (12,486.08) " Insurance premiums ...... ........... (3,820.30) (3,820.30) " Stock purchased ......... ........... (14,070.00) (k)(35,930.00) ----------- ------------ ------------ 12-31-31 Balance ..... 155,596.67 (162,398.08) 153,435.58 =========== ============ ============ 1932 Profits ................. ........... 14,509.67 14,509.67 " Discount on stock ....... ........... (h) 16,585.00 ............ " Dividends ............... ........... (23,029.39) (23,029.39) " Income tax .............. ........... (8,132.24) (8,132.24) " Insurance ............... ........... (3,820.30) (3,820.30) ----------- ------------ ------------ 12-31-32 Balance 155,596.67 (166,285.34) 132,963.32 =========== ============ ============ 1933 Profits ................. ........... 66,704.90 66,704.90 " Insurance rec'd ......... ........... 700.00 700.00 " Capital stock ........... ........... (d) 550,000.00 ............ " Dividends ............... ........... (20,518.86) (20,518.86) " Income tax .............. ........... (1,647.66) (1,647.66) " Insurance ............... ........... (3,620.30) (3,620.30) ----------- ------------ ------------ 12-31-33 Balance ..... 155,596.67 425,332.74 174,581.40 =========== ============ ============ 1934 Profits ................. ........... 34,169.33 31,169.33 " Insurance ............... ........... 3,300.00 3,300.00 " Dividends ............... ........... (16,527.63) (16,527.63) " Income tax .............. ........... (15,118.40) (15,118.40) " Insurance ............... ........... (3,206.30) (3,206.30) ----------- ------------ ------------ 12-31-34 Balance ..... 155,596.67 427,949.74 177,198.40 =========== ============ ============ 1935 Profits ................. ........... 50,650.79 50,650.79 " Insurance ............... ........... 1,550.00 1,550.00 " Dividends ............... ........... (17,500.00) (17,500.00) " Income tax .............. ........... (5,600.59) (5,600.59) " Insurance ............... ........... (3,416.30) (3,416.30) " Adjustment in depreciation ........... (4,991.69) (4,991.69) ----------- ------------ ------------ 12-31-35 Balance ..... 155,596.67 448,641.95 197,890.61 =========== ============ ============ 1936 Profits ................. ........... 113,399.77 95,270.29 " Processing taxes not paid ........... 54,582.87 54,582.87 " Repairs disallowed ...... ........... 4,991.69 4,991.69 " Insurance ............... ........... 1,700.00 1,700.00 " Unclaimed wages ......... ........... 726.86 ............ " Claim refund income tax ........... 205.67 205.67 " Dividends, cash ......... ........... (32,464.96) (32,464.96) " Income taxes ............ ........... (19,478.78) (19,478.78) " Insurance ............... ........... (3,958.80) (3,958.80) " Inventory adjustment .... ........... (5,971.93) (5,971.93) " Processing tax refunds ........... (16,340.08) (16,340.08) ----------- ------------ ------------ 12-31-36 Balance 155,596.67 546,034.26 286,421.5610. Copies of the balance sheets attached to the returns filed by the Rex Spinning Company for the years 1934, 1935, and 1936 are Exhibits 2, 3, and 4, and are incorporated herein by reference.
11. The reduction during the years 1934, 1935, and 1936, of the amount of preferred stock outstanding, from 3,160 shares to 1,600 shares, is shown by the following analysis of the preferred stock account:
No. Par Date Explanation shares value
December 31, 1933 Balance (old) ... 3160 316,000 ======= 1934 ............ Stock retired (old) ......... 1,332 Less: Reissued (new) ......... 672 ------ ------- Net retired ... 660 66,000 ====== ------- December 31, 1934 Balance (new) 2,500 250,000 1935 ............ Stock retired None None ------ ------- December 31, 1935 Balance ........ 2,500 250,000 1936 ............ Stock retired ... 900 90,000 December 31, 1936 Balance ........ 1,600 160,000
12. The company failed to set aside the sum of $30,000 on December 1st of each of the years 1934 and 1935 for a sinking fund as provided in the sixth paragraph of the preferred stock' certificate.
In its Federal income tax return filed for the calendar year 1936, Rex Spinning Company reported a net income of $109,859.59.
On January 28, and November 27, 1936, Rex Spinning Company authorized the setting aside out of its earnings for that year the sums of $30,000 and $60,000, respectively, a total of $90,000, representing the sinking fund requirement under the terms of its preferred stock for the years 1934 to 1936, inclusive, paid dividends on its preferred stock in the amount of $15,964.96 and made distributions to holders of its common stock in the amount of $16,500. During the years 1934 and 1935 the company had paid dividends on preferred stock only, in the amounts of $16,527.63 and $17,500, respectively.
13. In the determination of the undistributed net income of Rex Spinning Company for the calendar year 1936 for the purpose of the surtax imposed by Section 14 of the Revenue Act of 1936, the company took credit for the sum of $32,464.96, representing the dividends and distributions during the calendar year 1936 to holders of its preferred and common stock, and for the sum of $30,000 out of the total sum of $90,000 set aside in the calendar year 1936 as a sinking fund in accordance with the terms of its preferred stock. As a consequence its return showed an undistributed net income of $32,075.69 and a surtax due thereon under section 14 of the Revenue Act of 1936 of $4,034.75.
14. On review of the income tax return of Rex Spinning Company for the year 1936 by the Internal Revenue Agent in Charge at Greensboro, N.C., the net income of the company for that year was determined to be reduced to $95,270.29.
In the determination of the undistributed net income of Rex Spinning Company for the calendar year 1936 for purposes of the surtax imposed by Section 14 of the Revenue Act of 1936, the Internal Revenue Agent in Charge allowed as a credit the sum of $32,464.96, representing the dividends and distributions made to holders of preferred and common stock in the year 1936, but disallowed as a credit any part of the sum of $90,000 set aside in the year 1936 as a sinking fund in accordance with the terms of the company's preferred stock. As a consequence the Revenue Agent in Charge determined that the undistributed net income of the corporation for the year 1936, subject to surtax under Section 14 of the Revenue Act of 1936, was $49,682.78, and the surtax due thereon was $8,074.75 These findings of the Revenue Agent in Charge were approved by the Commissioner and a deficiency in income tax in the amount of $6,180,59 was determined and assessed by him in accordance with the findings.
15. The total tax on income and undistributed income originally assessed against Rex Spinning Company for the calendar year 1936 was $19,353.69, of which $4,327.58 was abated on March 22, 1938. A deficiency of $6,180.59 was assessed pursuant to the determination of the Commissioner as set forth above and was paid on June 24, 1940, together with $1,197.67 interest thereon, the balance of the original tax having been paid in the year 1937.
16. On or about September 5, 1940, Rex-Hanover Mills Company, successor by merger to Rex Spinning Company, duly filed a claim for refund for the sum of $6,180.59, representing that part of the taxes paid by Rex Spinning Company for the calendar year 1936 within two years prior to the filing of the claim for refund. A true copy of the claim for refund is Exhibit 5, and is made a part hereof by reference.
By letter dated January 24, 1941, the Commissioner of Internal Revenue duly notified Rex Spinning Company, care of Rex-Hanover Mills Company, Successor, that the claim for refund filed by it had been rejected.
17. The basis for the claim for refund filed on or about September 5, 1940, and the basis for this suit, is that in the computation of undistributed net income of Rex Spinning Company, it was entitled under Section 26(c)(1) of the Revenue Act of 1936 to a credit of $90,000, representing the sum required to be set aside in accordance with the terms of its preferred stock before any distributions could be made to holders of common stock, and that upon the allowance of that credit the company had no undistributed net income for the year 1936 as shown by the following calculations:
Net income as determined by Commissioner of Internal Revenue ................. $95,279.69 Less: Normal tax ...................... 13,131.95 ---------- Adjusted net income ................. $82,147.74 Less: Dividends paid credit ... $32,464.96 Credit for contract restricted payment of dividends (Sec. 26(c)(1) .......... 90,000.00 ---------- 122,464.96 --------- Undistributed net income .................. None
The plaintiff sues to recover corporation income taxes in the amount of $6,180.59 assessed against the income of its predecessor in title, Rex Spinning Company, as a surtax on that company's undistributed net income for the year 1936, and paid, with interest, by the plaintiff. The word "plaintiff", in this opinion, is used to designate either the plaintiff or its predecessor. The plaintiff claims that if it had been given the credit authorized by Section 26(c)(1) of the Revenue Act of 1936, 26 U.S.C.A. Int.Rev. Acts, page 836, it would have had no taxable undistributed net income. The tax was assessed under Section 14 of the Revenue Act of 1936, 26 U.S.C.A. Int.Rev. Acts, page 823, the parts of which, here pertinent, are printed in the footnote.
"§ 14. Surtax on Undistributed Profits.
"(a) Definitions. As used in this title —
"(1) The term `adjusted net income' means the net income minus the sum of —
"(A) The normal tax imposed by section 13.
Section 26(c)(1), under which the plaintiff claims that it should have received the credit which would have relieved it of the tax here in question, is as follows:
"§ 26. Credit of Corporations
"In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax —
* * * * *
"(c) Contracts Restricting Payment of Dividends.
"(1) Prohibition on payment of dividends. An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. 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."
No regulation of the Department is of assistance in the solution of our problem.
The plaintiff claims that it had made such a written contract as is contemplated by Section 26(c)(1). In 1933, upon the retiring of its old preferred stock and the issuance of new preferred stock, the plaintiff's stockholders properly authorized the plaintiff to enter into an agreement with its stockholders, and to print on the stock certificates the following language embodying the agreement:
"The company shall, on December 1, 1934, and on the first day of December on each year thereafter, provide for a sinking fund by setting aside out of the assets, represented by its earnings or surplus, and before the payment of any dividend on any class of stock other than Preferred Stock, the sum of Thirty Thousand ($30,000.00) Dollars. And if there should be a failure in any year to set aside said fund it must be provided for in the next succeeding years, before the payment of any dividend on any common stock. This fund shall be kept separate and apart from all other assets of the company, and shall be used by the Board of Directors during the calendar year in which such sum is set aside in purchasing the Preferred Stock at the best price obtainable, but not exceeding one hundred and five ($105.00) dollars per share and accrued dividends. If sufficient Preferred Stock cannot be purchased at or below the price aforesaid to exhaust the sums in the sinking fund available therefor, the balance in the sinking fund shall be kept separate from the other assets of the company until such time as it may prove possible to purchase Preferred Stock at or below the price aforesaid."
The plaintiff did not, in 1934 or 1935, put money in the sinking fund for the retirement of its preferred stock in accordance with the agreement. On January 28, 1936, the plaintiff authorized the setting aside out of its 1936 earnings, $30,000, and on November 7, 1936, $60,000, to fulfill the sinking fund requirements for 1934, 1935, and 1936. The fund was used, in 1936, to retire preferred stock of a par value of $90,000. In its income tax return for 1936 the plaintiff only claimed a credit of $30,000 under Section 26(c)(1). The Commissioner disallowed the credit. In its claim for refund made after the payment of the assessed deficiency, the plaintiff claimed a credit of $90,000. It now urges that a credit of $30,000 would be sufficient to reduce the tax on its undistributed income sufficiently so that it would be entitled to recover all that it sues for, and that it could in no event recover more, because of the statute of limitations. This is apparently correct, but since the Government makes no contention for a distinction between the plaintiff's right to a credit of $30,000 or a credit of $90,000, and no such distinction occurs to us, we shall not examine the point further.
The Government contends (1) that the agreement recited above was not the kind of agreement contemplated by Section 26(c)(1); and (2) that, in the financial circumstances in which the plaintiff was in 1936, it had other undistributed earnings and profits which it could have distributed even if the Section 26(c)(1) had been applicable to the $90,000, which other undistributed earnings and profits would have justified the tax collected and here sued for.
In disposing of the Government's first contention, we assume a negative answer to the second, i.e., we assume that the tax was not properly due if Section 26(c)(1) was applicable to the agreement recited above.
The text of the statute seems to apply quite exactly to the agreement as made. The statute allows a credit against the "adjusted net income" in the case, inter alia of (c) "Contracts restricting payment of dividends." To (c)(1) we find the heading "prohibition of payment of dividends." The text of (c)(1) speaks of the non-credit amount as the amount which can be distributed 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."
The Government points us to certain decisions of the Supreme Court of the United States and other courts, which, it contends, support its argument. We turn to those decisions. In Helvering v. Northwest Steel Rolling Mills, 311 U.S. 46, 61 S.Ct. 109, 111, 85 L.Ed. 29, the corporation, because of a previously existing deficit, was prohibited by state law from distributing as dividends its profits earned in 1936. The Supreme Court said: "The only `written contract executed by the corporation' upon which respondent relies for its claimed exemption is its corporate charter, granted by the state of Washington. Upon the premises that respondent's Washington charter was a written contract, and that the Washington laws prohibiting dividend payments were by operation of law a part of that contract, the court below concluded that the taxpayer had satisfied the requirements of section 26(c)(1)."
The Court concluded that the kind of contract contemplated by Section 26(c)(1) was not present, and that the corporation was not entitled to the credit. The Court also said in its opinion: "That the language used in section 26(c)(1) does not authorize a credit for statutorily prohibited dividends is further supported by a consideration of section 26(c)(2). By this section, a credit is allowed to corporations contractually obligated to set earnings aside for the payment of debts. That this section referred to routine contracts dealing with ordinary debts and not to statutory obligations is obvious — yet the words used to indicate that the section had reference only to a `written contract executed by the corporation' are identical with those used in section 26(c)(1). There is no reason to believe that Congress intended that a broader meaning be attached to these words as used in section 26(c)(1) than attached to them under the necessary limitations of 26(c)(2)."
49 Stat. 1664, 26 U.S.C.A. Int.Rev. Acts, page 836. The credit allowed is "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."
The phrase "routine contracts dealing with ordinary debts," has given rise to much discussion in later cases. The Government strongly urges its' significance in our consideration of the instant case.
In the case of Metal Specialty Co. v. Commissioner, 43 B.T.A. 891, the Board of Tax Appeals held that a resolution of the corporation's board of directors, approved by a resolution signed by all stockholders, providing for the amendment of the corporation's charter to restrict the payment of dividends until after the accumulation of a sinking fund to retire preferred stock, was not the kind of agreement contemplated by Section 26(c)(1). The Board relied strongly on the Supreme Court's phrase "routine contracts dealing with ordinary debts," and concluded that a contract evidenced only by the corporate minutes, and made effective only by "de-livery of the certificate of amendment and charter to the secretary of state" was not such a "routine contract" as was described in the Supreme Court's phrase. The Circuit Court of Appeals for the Sixth Circuit agreed with the Board. 128 F.2d 259.
In Warren Telephone Company v. Commissioner, 6 Cir., 128 F.2d 503, 506, the same court reached the same conclusion, though there, as in the case before us, the preferred stock certificate had printed on it the provisions restricting the payment of dividends. The court said: "The commitments contained in the stock certificates are but references to and repetitions of the charter provisions, and stand on no higher ground. Moreover, they are not contracts entered into by the corporation with creditors and are but internal agreements within the framework of corporate organization, and impose no external prohibition upon the corporation in respect to dividends."
Other language in the court's opinion shows that the Supreme Court's phrase about "routine contracts dealing with ordinary debts" was the real basis of the decision.
In Lehigh Structural Steel Co. v. Commissioner, 44 B.T.A. 422, upon facts closely analogous to those now before us, the Board of Tax Appeals denied the credit, and said: "The legislative intent was primarily to tax corporate earnings to the shareholders; and any attempt to frustrate the tax through the nondistribution of earnings was to be futile. The method adopted was the levy of a surtax upon earnings, with credits for dividends paid and for earnings which the corporation was contractually prevented from distributing. Obviously, to recognize a voluntary restriction not imposed from outside would defeat the purpose."
We think the Board, in its effort to protect the purpose of the act, did not give sufficient weight to the fact that the agreements contemplated by Section 26(c)(1) were agreements made prior to May 1, 1936, which was before the act which imposed the tax became effective. The statute therefore does not need to be given a construction shaped for the purpose of preventing parties, by agreement made with the objective of evading the tax, from succeeding in doing so. It would seem that the principal purpose of Congress in providing the credit, was to avoid penalizing a corporation for failure to distribute its earnings when it could not distribute them without violating its previously made agreement. This general purpose might have caused Congress to extend the credit to the corporation forbidden by law, as well as the one forbidden by agreement, from declaring dividends. But the fact that the section did not go so far would not seem to be a reason for construing it more narrowly than its words seem to justify.
This seems to have been done, retroactively, by Section 501(a)(2), (b), and (c) of the Revenue Act of 1942, 26 U.S.C.A. Int.Rev.Acts.
The Circuit Court of Appeals for the Third Circuit reversed the decision of the Board of Tax Appeals in the Lehigh Structural Steel case, 127 F.2d 67. It concluded that an agreement made by a corporation with the purchasers of its stock, expressly dealing with and restricting the payment of dividends, is no less within the contemplation of Section 26(c)(1) because the agreement is printed on the stock certificates and is, by amendment, inserted in the corporate charter. In the Warren Telephone Company case, supra, the court referred to and disagreed with the reasoning of the court in the Lehigh Structural Steel case.
We think that Section 26(c)(1) is applicable to the agreement which the plaintiff corporation made with its stockholders. The language of the section seems to be completely satisfied. The agreement was a real agreement, a natural one for the corporation to make in the circumstances, and not intended as a means of evading taxes. When persons purchased preferred stock containing this agreement, they were entitled to its benefits, not because it was imposed upon them by law, but because the plaintiff was willing to make it, and the purchaser was willing to buy the stock if it included it. We think the Supreme Court could hardly have intended to read into 26(c)(1) a limitation of the written agreements there mentioned to agreements with creditors, when the Court's language was directed to Section 26(c)(2) which expressly deals only with written agreements requiring that earnings be set aside for the "discharge of a debt."
We now consider the Government's second contention. It is that the plaintiff had, in 1936, a surplus from which it could have paid dividends after setting aside the $90,000 as required by its contract, and that therefore the plaintiff paid no greater undistributed profits tax than it properly owed.
The difference between the parties as to whether the plaintiff had an accumulated surplus of earnings arises out of the following facts. The plaintiff was incorporated in 1915, under the laws of the State of North Carolina, with an authorized capital of $500,000, divided into 2,500 shares of common and 2,500 shares of preferred stock, both of a par value of $100 per share. It issued only 2,008 of the common shares. In 1920, by amendment to its charter, its authorized capital was increased to $1,000,000. It increased its issued shares of common stock of $100 par value, from 2,000 shares, the number then outstanding, to 6,000 shares, by the declaration of a stock dividend. The par value of its outstanding common stock was then $600,000. Between then and 1933 some of this stock was retired. In 1928 another and smaller stock dividend was declared. On January 1, 1933, there were outstanding 5,500 such shares of a par value of $550,000.
On October 17, 1933, the plaintiff's charter was again amended, and the authorized share structure was so changed as to provide for 6,000 shares of common stock without par value, instead of 6,000 shares of $100 par value. The number and par value of preferred shares were set at 4,000 and $100 respectively, as before. The agreement of the stockholders and of the corporation, printed on the new certificates of preferred stock, concerning the setting aside of a fund for the retirement of the preferred stock, has already been described.
Before the 1933 reorganization the plaintiff's books showed a deficit in the surplus account of $166,285.34. After the reorganization, the company's accountant charged the common capital stock account with $550,000, the entire par value of the common stock outstanding before the reorganization, and credited the surplus account with the same amount. This changed the surplus account from the deficit of $166,285.34 to a surplus of $383,714.66. The effect of the change was to eliminate from the books any common capital stock account. The accountant made this change without any direction from the board of directors or of the stockholders. The corporation's books during the years 1934, 1935, and 1936 followed the same practice and thus showed a large surplus for each of those years. When the question of the taxation of the company's undistributed earnings under the 1936 act arose, the Commissioner of Internal Revenue went over the corporation's accounts for all the years following its organization in 1915, making "readjustments" for the reasons given in finding 8. The greatest changes made by the Commissioner in his adjustments consisted in the elimination of any effect upon the corporation's surplus accounts of the stock dividends which had been issued in 1920 and 1928, and which had been deducted from surplus on the company's books, and other changes resulting from those. The net result of his adjustments was to show a surplus of $286,421.56, at the end of 1936, instead of the surplus of $546,034.26, shown, erroneously as the plaintiff says, by the corporation's books, because of the accountant's having credited the $550,000 to surplus in 1933 when the common stock was changed to no par value.
The Government urges that the surplus shown by the Commissioner was available to satisfy the preferred stock redemption commitment made by the plaintiff in 1933, and that therefore the plaintiff's 1936 earnings could have been distributed. Since they were not, the Government says they were properly taxed as undistributed earnings.
The plaintiff, on the other hand, claims that the deficit of $166,285.34 which its books showed as of the end of 1932, persisted through the succeeding years, except as reduced by $64,927.29 during the years 1933, 1934, and 1935, and should have shown as a deficit of $101,358.05 at the end of 1935; that credits to surplus in 1936 of $113.892.31 finally wiped out the deficit, but only by $12,534.26 by the end of 1936; that that amount of surplus available for the redemption of the preferred stock would not have relieved enough of the plaintiff's earnings for 1936 of their commitment to the preferred stock redemption fund to make the plaintiff liable for the tax here sued for. The plaintiff subtracts $550,000, from each of the annual surpluses shown on its books, saying that the accountant's addition of that amount to surplus after the 1933 reorganization, and annually thereafter, should be disregarded.
The Commissioner of Internal Revenue's theory of determining surpluses is based upon the language of Section 115(h)(2) of the Revenue Act Of 1936, 26 U.S.C.A. Int.Rev. Acts, page 870, which is as follows:
"§ 115 Distributions by Corporations
* * * * *
"(h) Effect on earnings and profits of distributions of stock. The distribution (whether before January 1, 1936, or on or after such date) to a distributee by or on behalf of a corporation of its stock or securities or stock or securities in another corporation shall not be considered a distribution of earnings or profits of any corporation —
* * * * *
"(2) if the distribution was not subject to tax in the hands of such distributee because it did not constitute income to him within the meaning of the Sixteenth Amendment to the Constitution or because exempt to him under section 115(f) of the Revenue Act of 1934 or a corresponding provision of a prior Revenue Act."
Since, the Government says, the stock dividends declared by the plaintiff in 1920 and 1928 were not, under the doctrine of Eisner v. Macomber, 252 U.S. 189, 40 S.Ct. 189, 64 L.Ed. 521, 9 A.L.R. 1570, taxable to the recipients, they should "not be considered a distribution of earnings or profits," and should not have been followed by any deduction from the corporation's surplus account. Ergo the plaintiff had a surplus, could have used it to satisfy the preferred stock retirement commitment, and had earnings which were distributable without violating the 1933 agreement but were undistributed and taxable.
The plaintiff says that Section 115(h) has nothing to do with the case; that Section 26(c)(1) permits the deduction of earnings which are foreclosed from distribution by an agreement; that while the plaintiff's agreement did permit provision to be made for the preferred stock sinking fund out of "earnings or surplus," the meaning of the word "surplus" as used in that agreement was the meaning which was in the minds of the parties to the agreement, and not some other meaning which might be found in a federal statute or elsewhere.
We agree with the plaintiff on this point. The intent of Section 26(c)(1) is that if the corporation has made a binding agreement not to declare dividends out of certain accumulated earnings, it shall not be taxed for not declaring such dividends. Our only question is whether the plaintiff did in fact agree that it would not declare dividends until it had made provision for the preferred stock retirement fund out of earnings or surplus, not including in the word surplus as there written the values which it had previously earned but had capitalized by declaring stock dividends in 1920 and 1928, even though it had in 1933, as a part of the same transaction with the making of the agreement, changed its common stock from par value to no par value. What the accountant or even the directors did in the way of keeping books after the agreement was made would seem to have little bearing on what the parties meant by the agreement, except as evidence of what may have been in the minds of the parties at the earlier, and decisive, time.
We think the meaning which the plaintiff attributes to the agreement was the real meaning of the parties to it. If the parties had intended that the reorganization would make existing assets available for the preferred stock retirement fund, and then for the payment of dividends on the common stock some evidence of that intent would have arisen during 1934, 1935, or 1936. There would, we suppose, have been demands by stockholders that the fund be set up, and the way thus cleared for the payment of dividends on the common stock. The language of the agreement is mandatory. It says "The company shall, on December 1, 1934, and on the first day of December on each year thereafter, provide for a sinking fund by setting aside out of the assets, represented by its earnings or surplus * * *." No money was set aside for the fund until new earnings of sufficient amount were available.
This conduct of the managers of the company in not setting aside funds for the retirement of preferred stock was also in accord with their duties under the laws of North Carolina, where the corporation was chartered. Sections 1161 and 1179 of Michie's North Carolina Code, as amended, provide:
"§ 1161. Decrease of capital stock. —
"The decrease of capital stock may be effected by —
* * * * *
"6. Reducing the par value of shares.
"When a corporation decreases the amount of its capital stock as above provided, the certificate decreasing the same shall be published at least once a week for three successive weeks * * *. In default of such publication the directors of the corporation are jointly and severally liable for all debts of the corporation contracted before the filing of the certificate, and the stockholders are also liable for such sums as they respectively receive of the amount so reduced. * * * "
"§ 1179. Dividends.
"Dividends from profits only; directors' liability for impairing capital. —
"No corporation may declare and pay dividends, except from the surplus or net profits arising from its business, * * * nor may it reduce, divide, withdraw, or in any way pay to any stockholder any part of its capital stock except according to this chapter: * * * In case of a violation of any provision of this section, the directors under whose administration the same occurs are jointly and severally liable, at any time within six years after paying such dividend, to the corporation and its creditors, in the event of its dissolution or insolvency, to the full amount of the dividend paid, or capital stock reduced, divided, withdrawn, or paid out, * * *."
The fact that no steps were taken by the managers of the corporation to comply with these affirmative provisions of the law is a further strong indication that they had no intention when they made the 1933 agreement, to treat any of their existing assets as surplus, available for the preferred stock retirement fund or for dividends.
We conclude, therefore, that the plaintiff is entitled to recover $6,180.59 with interest as provided by law.
It is so ordered.
JONES, Judge, took no part in the decision of this case.
* * * *
"(2) The term `undistributed net income' means 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."(b) Imposition of Tax. There shall be levied, collected, and paid for each taxable year upon the net income of every corporation a surtax equal to the sum of the following, * * *
"7 per centum of the portion of the undistributed net income which is not in excess of 10 per centum of the adjusted net income.
"12 per centum of the portion of the undistributed net income which is in excess of 10 per centum and not in excess of 20 per centum of the adjusted net income.
"17 per centum of the portion of the undistributed net income which is in excess of 20 per centum and not in excess of 40 per centum of the adjusted net income.
"22 per centum of the portion of the undistributed net income which is in excess of 40 per centum and not in excess of 60 per centum of the adjusted net income.
"27 per centum of the portion of the undistributed net income which is in excess of 60 per centum of the adjusted net income."