Appeal from the District Court of the United States for the Western District of Pennsylvania; Robert M. Gibson, Judge.
Before BIGGS, CLARK, and JONES, Circuit Judges.
Upon December 8, 1873, the appellee, Washington County Fire Insurance Company, was incorporated pursuant to the provisions of Act No. 236,*fn1 p. 211, Laws of Pennsylvania, Session of 1856, in conjunction with the provisions of Act No. 27, p. 44, Laws of Pennsylvania, Session of 1867. The charter of the company (Section 2), issued by the Court of Common Pleas of Washington County, provided, "The business of the said Company shall be transacted upon the mutual principle, exclusively, and the said Company is allowed to insure on the cash or annual premium system, the sum so received to be paid into the common treasury of the Company, and in consideration thereof the said Company to be responsible for all losses occurring to property thus insured according to the terms of their policies. Insurance thus effected shall not entitle the insured to membership in said Company, nor subject them to the payment of assessments' Paragraph IX of the by-laws of the appellee provides: "Every person wishing to become a member of this Company, shall previous to being insured, deposit his application and premium note with the Secretary of said Company, and if approved, the policy shall bear date on that day, and take effect at noon, unless directed by the applicant to be dated on a future date. A sum equal to at least 5% of the premium note shall be paid at the time of making the application."
It appears from the agreed statement of facts that beginning in 1873, when the appellee was incorporated, all insurance policies were issued by it in consideration of a cash premium and a contingent liability represented by a deposit note. This course was continued until July, 1911, when the by-laws were amended to provide that an insured should execute a deposit note only when the property insured was not rated. Beginning in January, 1914 and until the present time (with the exception set forth in the next paragraph) insurance has been issued upon rated property and unrated property alike for an annual cash premium payable in advance without the execution of deposit notes.
THe exception referred to is as follows. During the period involved in this litigation (1928 to 1936, inclusive) the sixteen persons who were or are in charge of the management of the company did execute deposit notes in accordance with the practice which prevailed prior to 1911. During this period the average number of policyholders was 3,000. The agreed statement of facts (Paragraph 12) states, "Only those persons executing deposit notes are members. The use of the deposit notes has been continued since 1914 for the purpose of providing for the membership entitled to elect the managing officers of the corporation. The personnel of the deposit note makers since 1914 has been determined by the directors of the plaintiff company. Every deposit note maker is a policyholder." No refunds or returns whether by way of the payment of redundancy or otherwise have ever been made to anyone. The corporation has prospered and no assessments have ever been made.
If the charter provisions alone constitute the contract between the appellee and its members, putting to one side for the time being the provisions of the Act under which the appellee was incorporated, only deposit note makers are members. It is clear that throughout the taxable period only the sixteen deposit note makers voted to elect directors, thereby fulfilling one of the functions of membership in a mutual association. All the other policyholders perofrmed none of the duties of members. If the provisions of Section 2 of the charter are to be deemed valid they are not subject to assessment for losses, and polcicies of insurance were issued to them precisely similar to those issued by stock companies to those whom they insured. These policyholders, as distinguished from the deposit note makers, merely paid a fixed premium for which they obtained a contract of insurance.
The question presented for our determination is whether the appellee was exempt from the payment of income taxes during the years 1928 to 1936 inclusive. The Federal Acts*fn2 provide:
"The following organizations shall be exempt from taxation under this title [chapter] -
"(11) Farmers' or other mutual hail, cyclone, casualty, or fire insurance companies or associations * * * the income of which is used or held for the purpose of paying losses or expense."
Was the appellee a mutual company? The court below held that it was, believing that its membership could not be limited to the deposit-note makers despite the provision of the charter to such effect. The argument in favor of this conclusion may be stated as follows. Section 11 of the Pennsylvania Act of 1856*fn3 provides that membership in the company may be obtained by payment of a premium or contracting to pay it and that the extent of the liability of the insured for assessment should be limited to the amount of such premium. Therefore by the payment of a premium, the insured becomes a member of a mutual company, but is not liable for assessment beyond the amount of the premium paid. The Supreme Court of Pennsylvania has construed the Act of 1856 to such effect in the case of Schimpf & Son v. Lehigh Valley Mutual Insurance Co., 86 Pa. 373, 376. The terms of a statute under which a corporation is created may be read into and become a part of the contract between the corporation and its members. Therefore, runs the argument, all policyholders are members of the corporation. All policyholders whether they have given deposit-notes or not, possess the right to vote for directors for such a right is given to policyholders by Section 11*fn4 of the Act of 1856.The policyholders are the only persons interested in the appellee and they are all treated upon an identical basis. Therefore, says the appellee, it is a mutual company.
The exempting statutes, however, require that the appellee meet a two-fold test if it is to gain exemption. Not only must it be a mutual company but its income must be used or held solely for the payment of losses or expenses. MacLaughlin v. Philadelphia Contributionship, 3 Cir., 73 F.2d 582; Baltimore Equitable Society v. United States, Ct. Cl., 3 F.Supp. 427, certiorari denied 290 U.S. 662, 54 S. Ct. 77, 78 L. Ed. 573. The appellee contends that it meets the second requirement as well as the first, that not only is it a mutual company but all of its income is held for the purpose of paying losses and expenses. The District Court so held. Assuming arguendo, that the appellee must be deemed to be a mutual company within the purview of the statutes conferring exemption, let us test first the last contention of the appellee.
It is clear that the income upon which the appellee was taxed in the taxable years in question was net income computed after deducting payments for lesses and expenses. The income taxed was not used for the payment of losses or expenses. Was it held for such purposes? It will be observed that the company's surplus increased from $280,000 in 1929 to $446,000 in 1936. Throughout the taxable years in question the appellee has had insurance in force averaging more than $10,000,000. The amount of surplus is far in excess of unearned premium reserve required by the law of Pennsylvania.*fn5 These facts require a further consideration of the terms of the Act of 1856.
The Act of 1856 was a general incorporation act for insurance companies. It provided for the incorporation of joint stock insurance companies, for mutual companies, and for hybrid companies authorized to issue insurance both as joint stock companies and upon the mutual principle at the same time. It prescribed the terms upon which such companies might to business. Section 12 of the Act provides for the payment of dividends by joint stock companies, and in respect to companies " * * * organized upon the mutual principle exclusively, [the Section states that] each member shall be entitled to such a proportion of the said surplus, as the cash premium paid by such members respectively may bear to the aggregate surplus so declared; and for the proportionate share of each member so ascertained, a certificate shall be issued, declaring him or them to be entitled to such a portion of the accumulated capital of the company; said certificate to be construed and governed as hereinafter ...