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Philadelphia Record Co. v. Commissioner of Internal Revenue.

November 1, 1944


On Petition to Review the Decision of the Tax Court of the United States.

Author: Mclaughlin

Before BIGGS, GOODRICH, and McLAUGHLIN, Circuit Judges.

McLAUGHLIN, Circuit Judge.

The petitioner was incorporated under the laws of Pennsylvania in June 1928. The Tax Court found as facts that the corporation in an amendment to its charter, in its by-laws and in its certificates of stock, all prior to May 1, 1936, was prohibited from paying dividends on its common stock until there had been set apart in a sinking fund a sum of money, out of its surplus profits, on or before July 1, 1934, and on or before July 1 of each succeeding year, an amount equal to 2 1/2 % of the maximum par amount of its preferred stock theretofore issued, whether or not then outstanding, until all preferred stock was retired;*fn1 that prior to, and including the taxable year, 16,638 shares of its preferred stock had been issued and that the amount of money required to be set apart each year, including the taxable year, was $41,595; that the amounts to be so set apart were to be used for the purchase and retirement of its preferred stock until all of such stock was retired; that throughout the taxable year there was unretired outstanding preferred and common stock; and that neither during the taxable year nor at any time prior to January 1, 1938, had the full amount required to be set apart in a sinking fund been so set apart in any account entitled "Sinking Fund Cash Account," nor had a sum or sums equal to the periodic credits made on its books in an account entitled "Sinking Fund Reserve Account" been so set apart. The sole question involved is whether the taxpayer is entitled to a credit in the amount of its adjusted net income in the taxable year (1937) under Section 26(c)(1) of the Revenue Act of 1936, 26 U.S.C.A. Int. Rev. Acts, page 836.*fn2

The Tax Court decided that the restrictins contained in the petitioner's amended charter, by-laws and certificates of stock, on the payment of dividends on the common stock of the petitioner, did not entitle the petitioner to such a credit. This holding is directly contrary to the decisions of this court commencing with Lehigh Structural Steel Co. v. Commissioner, 3 Cir., 127 F.2d 67. That case was followed by Eljer Co. v. Commissioner, 134 F.2d 251, where this court said at page 255: "The question whether a certificate of stock which contains an express provision prohibiting the payment of dividends is such a contract as was intended by Congress to be within the purview of Section 26(c)(1) of the Revenue Act of 1936 was answerd by us in the affirmative * * * and is no longer open in this Circuit."

In Budd International Corporation v. Commissioner of Internal Revenue, 143 F.2d 784, 787, the question was again before this court. The amended articles of incorporation and the preferred stock certificates in that case had much the same language as the amended charter and preferred stock certificates here involved. Judge Maris, speaking for this court, said: "The amended articles of incorporation and preferred stock certificates thus do embody a contract prohibiting the taxpayer from paying dividends to the holders of the common stock until the taxpayer has paid into a sinking fund each year an amount equal to 3% of the preferred stock. It follows that to the extent of the sinking fund payment the taxpayer was entitled to a credit in computing its undistributed net income and that the Board erred insofar as it ruled that Section 26(c)(1) of the Revenue Act of 1936 did not entitle the taxpayer to such a credit."

On a rehearing in the Budd case, reported with the main opinion, supra, the court, again speaking through Judge Maris, said: "It follows, therefore, that when a corporate taxpayer was under contractual obligation prior to May 1, 1936 to pay a portion of its profits into a sinking fund which it might not use for the payment of dividends it was entitled to an equivalent reduction in the amount of its undistributed net income subject to surtax." See also Monarch Theatres v. Helvering, 2 Cir., 137 F.2d 588. It is, therefore, settled in this circuit that restrictive provisions in a corporate charter, by-laws and certificates of stock as are present in the instant matter, constitute a written contract within Section 26(c)(1) of the 1936 Revenue Act.

The Tax Court also held that "Petitioner obviously was able financially in the taxable year to pay into a sinking fund the requisite amount for that year," and from this, again reached the conclusion that the petitioner is not entitled to the credit claimed.

The petitioner did not technically set apart any of its funds directly in a sinking fund. It accomplished the same object, however, by purchasing shares of its preferred stock. We agree with the Tax Court, that the sum thus expended complied, to the extent of the cost of the stock, with the requirements of the amended charter, by-laws and certificates of stock as to setting money aside in a sinking fund. The taxpayer does not seriously question the resultant situation. There is a dispute as to the cost to the taxpayer of that preferred stock so purchased. At the end of 1937, the taxable year, there had been debited to the "sinking fund" account a total amount of $159,043.90 as the cost to the taxpayer of the 1918 shares of its preferred stock theretofore purchased by it. That over-all figure was the gross cost of the stock. There was a credit of $3,720.69 of that amount returned to the taxpayer by way of accrued dividends on the shares of stock so purchased so that the net cost of the stock was $155,323.21. It is conceded that the sinking fund reserve credit entry of $166,380 is the true amount. This represents the total sum required by the corporate contract to be set aside by the end of 1937 for the purchase of the preferred stock. Taking the corporation's purchases of preferred stock as partial compliance with the sinking fund provisions, the taxpayer still failed to meet its sinking fund account requirement by the sum of $11,056.79. That deficit was found by the Tax Court to be $7,336.10 as that court did not take into consideration the credit item of $3,720.69 returned to the taxpayer as accrued dividends.

The Tax Court decided that the petitioner was able to pay the balance, as it found, of $7,336.10, into the sinking fund in the year 1937 and so satisfy its corporate obligation. We do not see that the record warrants such conclusion. There is no finding of bad faith, tax evasion motive, or even question of the business management of the taxpayer. The Tax Court did, in its opinion, find that Mr. Stern, the president of the company, was inaccurate in stating that it was the policy and record of the corporation to maintain current assets in twice the amount of its current liabilities, where in fact that had not been done. Accepting this (though such might well have been the company policy, with the practical realization of it impossible because of its financial situation), that statement does not in any way change the detailed figures, upon which the witness based his testimony that the company in 1937 was not financially able to complete its sinking fund payment.

Examination of the petitioner's full balance sheets, which are in evidence, reveals that the status of the corporation was palpably weak during that period. It has never paid any dividends on common stock and there were no dividends on the preferred down to March 30, 1936. The arrearages of preferred dividends were settled at that time, not because of the ability of the company to pay, but because of the then existing crisis in its affairs which would have meant a shift in voting power from the common to the preferred by reason of failure to pay the preferred dividends. The settlement itself was for 25% of the actual arrearages and was paid for principally by common stock of the corporation, instead of cash. The taxpayer's cash declined steadily from $220,344. at the end of 1935 to $119,446. at the end of 1937. At the end of the taxable year its current liabilities were $1,029,675.65. In addition, it owed $36,099.60 on long term machinery notes and $342,500. on debentures due 1938 and 1940. Its current assets were $1,286,771.35. It showed a capital and surplus of $2,443,053 (including the earned surplus figure of $637,829). The petitioner strongly stresses that these capital assets included $1,841,810.55 made up of

Organization expenses $25,795.15

Life insurance premiums 85,778.00

Deferred promotion costs ...

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