Docket No. 17760.
M. D. Harris, C.P.A., and Charles E. Ecker, Esq., for the petitioner. A. J. Friedman, Esq., for the respondent.
In 1932 the petitioner was having financial difficulties and reduced from $100 to $50 the par value per share of its outstanding par value common stock, crediting the amount of the reduction, $472.750, to paid-in surplus. Its financial condition improved and in 1942 it paid a dividend of $50 a share, totaling $463,100, in its debentures to the holders of its par value common stock, charging the paid-in surplus account and another account to which a portion of paid-in surplus had been transferred with $448,726.27 of the dividend and charging earned surplus with the balance of $14,373.73. The debentures were due 10 years from date, bore 5 per cent cumulative interest payable out of net income, were subordinate to the claims of all creditors in case of dissolution or liquidation, but superior to the rights of stockholders, and gave no right to participate in the management of the corporation. Held, that the debentures constituted indebtedness of the petitioner and that the interest paid thereon was deductible. M. D. Harris, C.P.A., and Charles E. Ecker, Esq., for the petitioner. A. J. Friedman, Esq., for the respondent.
The respondent determined deficiencies in the petitioner's income and declared value excess profits taxes as follows:
+--+ ¦¦¦¦ +--+
Declared Year Income tax Value excess profits tax 1942 $8,247.13 $1,642.66 1943 9,427.92 2,136.61 1944 9,802.67 2,171.17
At the hearing the respondent conceded error in disallowing a bad debt deduction of $190.12 taken for 1942. The only issue remaining for determination is whether the respondent erred in disallowing deductions of $21,225.42, $23,155, and $23,155 taken by the petitioner for 1942, 1943, and 1944, respectively, as interest on its debentures.
FINDINGS OF FACT.
The facts were stipulated in part and to that extent are found as stipulated.
The petitioner is a Michigan corporation, with its principal place of business at Lansing. It filed its income tax returns for the years in controversy with the collector at Detroit. Its books were kept and its returns were filed on an accrual basis of accounting.
A committee appointed by the Merchants Bureau of Lansing organized the petitioner in October, 1924, to erect a hotel building in that city. The building, which was completed in 1926, was leased for a period of 30 years to the Hotel Olds Operating Co., a corporation organized to operate it, and was opened as the ‘Hotel Olds‘ in July, 1926.
The petitioner was organized with an authorized capital stock as follows:
2,000 shares 6 1/2% cumulative nonvoting preferred stock, par value $100 a share, redeemable on January 2, 1940, at par and callable prior thereto at $101 per share.
6,500 shares common stock, par value $100 a share.
6,500 shares common stock, nonpar value at $1 a share.
The rights of the nonpar value shares to participate in dividends or assets were as follows:
Before any dividend shall be declared on the non-par value common stock, the par value common stock shall first receive a dividend of 7% per annum, cumulative, and after the payment of said 7% per annum cumulative dividend on the par value common stock, then in every year that the available net earnings of the company are more than sufficient to pay the 7% per annum cumulative dividend on the par value common stock, a dividend may be declared on the non-par common stock up to $7.00 per share, and in any further dividends declared for that year the par and non-par common shall share alike, and in any distribution of the corporation's capital assets at any time the par common stock shares shall first receive par and then the non-par shares shall receive up to $100.00 per share and thereafter both par and non-par shall share alike.
In November, 1926, the petitioner's articles of association were amended to provide an increase in the authorized capital stock as follows: ‘From 6,500 shares common stock, par value $100 a share, to 10,000 shares; from 6,500 shares non-par value common stock to 10,000 shares.‘ No change was made with reference to the authorized 2,000 shares of preferred stock.
On May 1, 1928, the petitioner's lessee was in arrears on the rent and arrangements were made whereby the petitioner accepted in settlement the balance of the lessee's authorized capital stock and $110,000 of the lessee's 5 per cent refunding notes, payable in stated amounts, semi-annually, over the period May 1, 1929, to May 1, 1938. The annual rental under the lease was reduced from 8 per cent on the petitioner's investment in the hotel property to 6 per cent. As of December 31, 1931, petitioner made an allowance to the lessee of $39,174.80, the amount it was in arrears on the 1931 rent. For 1932 the petitioner reduced the monthly rental from $8,834.96 to $6,000, and as of December 31, 1932, made an allowance to the lessee of $39,400, representing the amount the lessee was in arrears on the 1932 rent.
By the end of 1932, the petitioner was in a straitened financial condition. In that year it incurred an operating loss of $29,894.37. There was a deficit in its capital structure of $14,373.73, resulting from operations, and at the close of the year, there was, among other liabilities, an unpaid balance of $687,500 owing on its mortgage covering the hotel property.
At a meeting of the petitioner's stockholders held on December 28, 1932, a resolution was adopted to reduce the par value of the petitioner's par value common stock from $100 par value a share to $50. As indicated by the minutes of the meeting, the purpose of the action was to enable the petitioner to save approximately $1,100 in Michigan tax. At the same meeting, the stockholders authorized the petitioner's officers and directors to revalue the assets of the petitioner, to transfer to ‘surplus and/or reserve‘ any excess of capital assets caused by the reduction in capital stock, and to make any other adjustments of the accounts of the petitioner which might be lawful and, in their judgment, wise.
On December 30, 1932, pursuant to the authorized reduction in value of the petitioner's par value common stock, the president and secretary of the petitioner filed with the proper Michigan authorities the appropriate certificate of decrease in capital stock.
Prior to the reduction the par value of the petitioner's par value common stock outstanding was $945,500. On December 31, 1932, the amount of the reduction, $472,750, was credited to the paid-in surplus account and later, on the same day, $427,849.19 was transferred from that account to an account designated ‘Reserve for Contingencies.‘ In all published statements to petitioner's stockholders and references thereto by the officers, the ‘Reserve for Contingencies‘ account was called ‘valuation Reserve.‘
During the period from 1932 to 1942, the petitioner's financial condition improved considerable. In 1935 and 1936 it paid a total of more than $145,800 to extend its hotel facilities. In 1940 and 1941, it retires all of its outstanding preferred stock of $27,500 par value. By the end of 1941 its liability on the principal amount of its mortgage on the hotel property had been reduced to $550,000, and it had an earned surplus of $7,317.55.
At the close of 1941, the petitioner had outstanding 9,262 shares of $50 par value common stock, amounting to $463,100, and 9,480 shares of nonpar common stock, amounting to $9,480. All of the petitioner's outstanding par value common stock and nonpar value common stock had been paid for in cash, except in the case of the subscription of Michigan Mortgage Investment Corporation for $188,136. In settlement of the contract covering the purchase of the premises upon which the hotel was erected, the amount of that subscription was deducted by petitioner.
At the November, 1941, meeting of the petitioner's board of directors, a committee was ‘appointed to study the possibility of revamping ‘ the petitioner's capital structure. At the annual meeting of petitioner's stockholders, held on January 19, 1942, that committee made the following recommendation to petitioner's stockholders:
That a 100% dividend be declared on the present par value common stock in the sum of $463,100.00 payable in a suitable form of Debenture bearing interest at the rate of 5% per annum, said interest to be accumulative (sic) and paid before any dividends are declared on the par common stock out of net earnings or earned surplus.
This will result in the following savings to the Corporation and naturally inure to the benefit of the stockholders. The 5% interest on these Debentures which will amount to $23,155.00 annually on the new issue of Debentures is a deductible expense item on income of the Corporation before computing of Federal taxes. This saving in Federal taxes on the basis of the 1941 - 20% will amount to a saving of $6,946.50. For many years to come we can expect at least not only the 1941 - 30% (sic) tax, but we believe a decided increase in tax rate for the ensuing years.
To approve this plan may call for a tax on about 2% of the Debentures to be issued.
Your committee, therefore, recommends that the stockholders authorize and approve this change in capital structure of the Corporation as per resolution that will be presented following this report.
Thereupon the following resolution was adopted by the unanimous vote of all stockholders present or represented, numbering 119 and voting 7,226 1/2 shares of par and 8,166 1/2 shares of nonpar stock:
BE IT RESOLVED by the Common Par and the No Par Common Stockholders of the Lansing Community Hotel Corporation that the Board of Directors be and they are hereby authorized to declare and pay a dividend of $50.00 per share to the holders of par common stock of this corporation as of record February 1, 1942, payable in Debentures of the denomination of $25.00, $50.00 and larger amounts as in the judgment of the Board of Directors may seem best, said debentures to be dated February First, 1942, payable on the first day of February, 1952, callable at any time at par and bearing cumulative interest at the rate of 5% per annum payable only out of net earnings, and payable annually on the first day of February, 1943, and the first day of February of each year thereafter, and that 3.1% of said dividend be charged against the earned surplus of the corporation and the balance be charged against valuation reserve and capital surplus.
As indicated by the above resolution, all but 3.1 per cent of the dividend was to be charged against the ‘valuation reserve and capital surplus‘ accounts of the petitioner. As of December 31, 1941, the amount carried on the petitioner's books in its valuation reserve was $412,849.19. The amount of $35,877.08 was carried on the petitioner's books as paid-in surplus. The total of these amounts, $448,726.27, was, with the exception of $2,923.02, a direct result of the decrease in the par value of the petitioner's common stock which, prior to the year 1938, had been carried on the petitioner's books as money paid on petitioner's subscribed for, but unissued, common stock which was transferred to the paid-in surplus account in 1938. The $448,726.27 in those two accounts represented approximately 96.9 per cent of the amount of the dividend.
The minutes of the meeting of the petitioner's board of directors held immediately following the stockholders' meeting of January 19, 1942, contain the following:
Mr. Ecker then called the attention of the Chairman to the Resolution of the stockholders authorizing the Board of Directors to declare and pay a dividend of $50.00 per share to the holders of par common stock of this corporation, as of record February 1, 1942, payable by debentures in denominations of $25.00, $50.00 and larger amounts as in the judgment of the Board of Directors may seem best, said debentures to be dated February 1st, 1942, payable on the first day of February 1952, callable at any time at par, and bearing cumulative interest at the rate of 5% per annum, payable only out of net earnings and payable annually on the first day of February 1943, and the first day of February of each year thereafter. 3.1% if said dividend to be charged against the earned surplus of the said corporation and the balance to be charged against valuation reserve and capital surplus.
It was then moved by Mr. Harper and seconded by Mr. Potter that a dividend of $50.00 per share to the holders of par common stock of the corporation as of record February 1st, be declared payable as provided in said resolution of the stockholders above referred to.
Debentures in the principal amount of $463,100 were issued pursuant to the above resolutions of the petitioner's stockholders and directors, and on December 18, 1942, were accepted by the Michigan Corporation and Securities Commission for filing for trading.
The following is a copy of one of the debentures issued by the petitioner pursuant to the foregoing action of its stockholders and board of directors:
UNITED STATES OF AMERICA
STATE OF MICHIGAN
LANSING COMMUNITY HOTEL CORPORATION
This debenture is one of a series of 682 debentures of like date, aggregating Four hundred Sixty-three thousand one hundred dollars of like maturity but in amounts as follows:
+---------------------------------------------------+ ¦2 of $25.00 ¦37 of $50.00 ¦372 of $100.00 ¦ +-------------+---------------------+---------------¦ ¦48 of $500.00¦180 of $1,000.00, and¦44 of $5,000.00¦ +---------------------------------------------------+
The Lansing Community Hotel Corporation, organized and existing under the laws of the State of Michigan and having its principal office and place for the transaction of business in the City of Lansing, State of Michigan, hereinafter called ‘the company,‘ for value received hereby promises to pay to the registered owner thereof on or before February 1st, 1952, at the principal office of the company, 1102 Olds Tower Building, Lansing, Michigan.
ONE HUNDRED DOLLARS
in lawful money of the United States and to pay interest thereon out of available net operating income from February 1, 1942 until the payment of the principal sum at the rate of 5% per annum, payable annually, on the first day of February, 1943 and on the first day of February of each year thereafter subject to the following terms and conditions.
If for any reason an interest payment is not made as above provided, such interest shall be cumulative. The amount of any interest so accumulated shall be paid before any dividend may be declared and paid on the common par stock of the company. In case of dissolution of the company by any process, or upon liquidation, the principal sum hereof shall be subordinated to the rights of the creditors of the company, but shall be paid in full, together with any accumulate interest, before any distribution to common stockholders shall be made.
The company shall have the right at any interest payment date to call, pay and retire this security upon mailing a thirty days' previous notice in writing addressed to the registered owner hereof advising him or her of the intention so o do.
The company shall have the right to renew or extend its present mortgage or to refinance the same without obtaining the consent of the holders of these debentures.
IN WITNESS WHEREOF, the company has caused its name to be affixed over the signature of its president or one of its vice presidents and attested by the signature of its secretary or assistant secretary, as of the 1st day of February, A.D. 1942.
(Signed) CLYDE B. SMITH, Secretary
LANSING COMMUNITY HOTEL CORPORATION (Signed) ALTON J. HAGES, President
(On back thereof)
Date . . . In Whose Name Registered . . . Registrar . . .
At the time of the stockholders' meeting on December 28, 1932, there were 350 holders of petitioner's par value common stock. At the time of the meeting on January 19, 1942, the number of holders of that class of stock was 298. During the period 1932 through 1941, no dividends were paid by the petitioner on its nonpar value common stock and none were paid on its preferred stock or its par value common stock until 1936. The total dividends paid on the preferred and the par value common stocks during 1936 through 1941 averaged approximately $22,000 annually.
For the years 1942, 1943, and 1944, the petitioner paid the 5 per cent provided for in the debentures, and in its income tax returns for those years deducted therefor, as interest, the amounts of $21,225.42, $23,155, and $23,155, respectively. The respondent determined that those amounts were in fact dividend distributions and disallowed them as deductions.
The debentures here involved constituted indebtedness of the petitioner.
The underlying question for determination is whether the $463,100 of debentures represented indebtedness owing by the petitioner, or merely evidenced ownership of stock in it. It is undisputed that the debentures were issued against earned surplus to the extend of $14,373.73, and paid-in surplus to the extent of $448,726.27. Of the latter amount, $445,803.25 resulted from a reduction in par value of the petitioner's par value common stock and the remainder, $2,923.02, represented payments on subscribed for, but unissued, capital stock which were transferred to paid-in surplus in 1938 . As to the paid-in surplus of $448,726.27, the respondent concedes that it represents money which originally had been invested in the petitioner. It thus appears that the debentures were issued dollar for dollar against paid-in or earned surplus, both of which the corporation was at liberty to distribute pro rata to its stockholders, and, even though there was no paying in or borrowing of new money, the consideration for their issuance was in an amount equal to face value.
See sec. 5345, vol. 77, Fletcher's Cyclopedia of the Law of Private Corporations.
Internal Revenue Code, section 23:‘In computing net income there shall be allowed as deductions:‘(b) INTEREST.— All interest paid or accrued within the taxable year on indebtedness * * * .‘
There is no comprehensive rule by which the question here presented can be determined. Consideration must be given not only to the instrument involved, but to all the surrounding circumstances. While in similar cases the determining factor or factors have varied from case to case, the factors usually stated as determining are: The name given to the certificates, the presence or absence of a maturity date, the source of payments, the right to enforce the payment of principal and interest, participation in management, status with respect to claims of general corporate creditors, and the intention of the parties. John Kelley Co., 1 T.C. 457; affd., 326 U.S. 521.
In the petitioner's minutes, in its books of account, and in its income tax returns, the debentures have been called by that name and the payments thereon have been designated interest. The debentures had a fixed maturity date for the principal and the interest was payable annually on a specified date. While the interest was to be paid ‘out of available net operating income,‘ the fact that there might, in a given year, be no operating net income, did not relieve the corporation of payment when it did have ‘net operating income,‘ since it was provided that interest was cumulative. The debenture holders, as such, did not have any right to participate in the management of the petitioner.
The respondent takes the position that there was no fixed and absolute obligation on the part of the petitioner to pay the principal of and interest on the debentures, contending that the interest was payable only ‘out of available net operating income‘ and that the wording and punctuation of the debentures presents a question as to whether there was an obligation at maturity to pay such amount in all events, or only in the event there should be ‘available net operating income.‘ While it is true that interest was to be paid ‘out of available net operating income,‘ we do not understand that payment or nonpayment of interest was within corporate discretion when it did have ‘operating net income‘ available for such payment and that in such case the interest did not become payable in any event, and, further, while there was no provision, as in the John Kelley Co. case, for the acceleration of maturity of the obligation on principal in the event of default in the payment of interest, there was no limitation whatever to pay principal when it did become due. In other words, the only reasonable conclusion, we think, is that at maturity the obligation to pay was unqualified and absolute. In our opinion, the principal was payable at the maturity date, irrespective of what the petitioner's ‘available net operation income‘ might be on that date or might have been during the interval.
Cf. Talbot Mlls, 3 T.C. 95.
Webster's New International Dictionary (1924), p. 1125.
As a further bar to a holding that the indentures represented indebtedness, the respondent contends that to the extent of the paid-in surplus of $448,726.27 the debentures represented capital which originally had been invested in, and placed at the risk of, the petitioner's business by its stockholders and that none of the debentures here involved represented ‘borrowed money‘ with respect to which the petitioner had contracted to pay anything for its use. The import of the contention is that it is essential that new or additional money must have been paid in to the corporation in order to constitute the indentures an indebtedness of the petitioner.
Approximately 76 per cent of the debentures issued in the John Kelley Co. case was in exchange for outstanding capital stock and the remainder was issued on subscription. In holding that the issue of debentures there involved constituted an indebtedness and the interest was deductible, we made no distinction between those issued in exchange for stock and those issued on subscription. In affirming our holding, the Supreme Court pointed to none. The entire amount of new money was paid in on account of those issued for stock and the interest thereon was held to be deductible. See also New England Lime Co., 13 T.C. 799.
While in the instant case no outstanding capital stock was retired at the time the debentures were issued, the reduction in 1932 of the par value of the petitioner's par value common stock had the same effect, with the money represented by the reduction being retained by the petitioner as paid-in surplus. The issuance of the instant debentures in 1942 against such paid-in surplus was the final step in a transaction which had the same effect as an exchange of debentures for stock.
We accordingly hold that the debentures involved herein were evidences of indebtedness and that the petitioner is entitled to the deductions taken for interest paid thereon.
Reviewed by the Court.
Decision will be entered under Rule 50. OPPER, J., dissenting: This was not ‘interest on indebtedness,‘1 for two reasons. First, it was not interest and, second, there was no indebtedness.
Interest has been defined as payment for the use or forbearance of money. 2 Nothing was contributed to this enterprise either in the first place nor at the time the securities in controversy were issues which can be construed as the contribution of money or even of money's worth. 1432 Broadway Corporation, 4 T.C. 1158; affd. (C.C.A., 2d Cir.), 160 Fed.(2d) 885; Swoby Corporation, 9 T.C. 887, cf. New England Lime Co. 13 T.C. 799. Not even property committed to the venture as in those cases was involved here. There could hence be no payment for the use or forbearing of anything.
There is some suggestion that the resolution of petitioner's directors, declaring the ‘dividend,‘ created an indebtedness, the liquidation of which was accomplished by issuance of the debentures. The form of the resolution, however, prevents us from accepting the contention. The distribution was not to be made in money but in debentures. The stockholders were given no option to have the obligation paid in cash. It seems evident that all they were even entitled to were the debentures themselves. We can not say that any debt ever existed outside the four corners of whatever the debentures themselves provided, or that the corporation received anything of value by the cancellation of such an additional debt.
There was no indebtedness because the nature of the original participation, constituting an equity interest at the risk of the business, was never changed. Even after the so-called debentures were issued, there was no present indebtedness. Neither the interest payable only out of net ‘operating income,‘ and only then if ‘available,‘ nor the principal, was payable in any event; and during these years neither the interest nor the principal partook of the nature of a definitive promise to pay any sum at any time. The most that can be said is that the securities carried a due date some years in the future. Even if nonpayment at that time would create an indebtedness, a point that is be no means clear, there was no real change whatever in the relationship of the parties before and after the ‘debentures‘ were issued; certainly not any during the tax years at bar. The securities came behind creditors and were senior only to the common stock, a position typically held by preferred shares. It is moreover, as Judge, now Mr. Justice Minton, said in Commissioner v. John Kelley Co. (C.C.A., 7th Cir.), 146 Fed.(2d) 466, 468, not ‘unusual today for preferred stock to have a maturity or retirement date.‘
There is no more reason for holding these to be interest-bearing obligations on authority of the Kelley case than for holding the contrary on the authority of Talbot Mills. The Kelley and Talbot Mills cases were straight Dobson decisions. The Dobson principle is no longer law. Sec. 36, P.L. 773, 80th Cong., 2d sess.; 26 USC., 1141(a), amending section 1141(a), I.R.C. If those cases still stand for anything, it is only the proposition that, as triers of the fact, we have an unavoidable primary obligation which I fear in this instance we are failing to discharge.
Even the Kelley case as viewed by the Supreme Court is not authority for the present result. A factor, relating not to the terms of the obligation, but to the surrounding circumstances, was evidently regarded as significant in the John Kelley Co. and Talbot Mills cases. It serves to indicate the nondeductibility of the present claim. That is the lack of any consideration received by petitioner for the issuance of its so-called obligations, with the consequence that the payments of ‘interest‘ can hence not be treated as expended for the use of money or property borrowed or acquired by petitioner by their issuance. Thus, in John Kelley Co., supra, the Supreme Court said (325 U.S. 521, 526):‘ * * * In the Kelley case there were sales of the debentures as well as exchanges of preferred stock for debentures * * * On the other hand, in the Talbot Mills case, the Tax Court found the factors there present of * * * the limitation of the issue of notes to stockholders in exchange only for stock, to be characteristics which distinguished the Talbot Mills notes from the Kelley Company debentures * * * .‘We think these conclusions should be accepted * * * .‘
Dobson v. Commissioner, 320 U.S. 489.
VAN FOSSAN, ARNOLD, HILL, DISNEY, and HARRON, JJ., agree with this dissent.