Court Opinion

ID: 4601102
Source: CourtListenerOpinion
Date Created: 2020-11-20 19:26:55.132763+00
Date Added: 2024-06-11T07:52:25.550763
License: Public Domain

THE SUTCLIFFE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Sutcliffe Co. v. CommissionerDocket No. 94235.United States Board of Tax Appeals41 B.T.A. 1009; 1940 BTA LEXIS 1110; May 1, 1940, Promulgated 1940 BTA LEXIS 1110">*1110  In 1934 petitioner negotiated a long term bank loan for $50,000 in order to secure additional working capital.  The loan was evidenced by short term notes which were renewed from time to time, two renewals occurring during the taxable year.  A condition of the loan was that the petitioner would pay no dividends while indebted to the bank.  During 1936 the bank waived this restriction as to petitioner's preferred stock which permitted petitioner to refund an accumulated dividend obligation for a small fraction of the amount thereof, and to reduce its preferred dividend rate from $7 to $5.50 per share.  No dividends were paid by petitioner on its common stock.  Held, that petitioner is entitled to the credit provided by section 26(c)(1) of the Revenue Act of 1936 because the 1936 transactions did not remove the restrictions on payment of dividends contained in the 1934 contract.  Ben F. Washer, Esq., and W. Waller Grogan, C.P.A., for the petitioner.  Stanley B. Pierson, Esq., and Philip M. Clark, Esq., for the respondent.  ARNOLD 41 B.T.A. 1009">*1009  This proceeding involves a redetermination of income tax for the calendar year 1936 in the amount of1940 BTA LEXIS 1110">*1111  $5,554.80, of which $5,505.20 is in controversy and represents surtax on undistributed profits.  41 B.T.A. 1009">*1010  FINDINGS OF FACT.  The petitioner, a corporation organized in 1904, is engaged in the wholesale and retail sporting goods and electrical appliances business in Louisville, Kentucky.  For a period of about five years prior to 1934 petitioner had suffered business reverses, and when business began to pick up it sought to procure working capital through a long term loan.  Negotiations to that end were conducted with the Citizens Union National Bank of Louisville, Kentucky (hereinafter referred to as the bank), which resulted in a loan by the bank to petitioner in the aggregate amount of $50,000.  Arrangements were made by the bank with the Federal Reserve Bank for participation in the loan under section 13B of the Federal Reserve Act.  To obtain the loan petitioner was required to sign an application on a form prescribed by the Federal Reserve Board, governing the terms and conditions under which the loan was made.  The loan, secured in September and October 1934, was to continue until it was finally liquidated, which occurred in 1938.  The promissory notes evidencing the1940 BTA LEXIS 1110">*1112  loan were of short maturity, due to the adverse feeling of commercial banks for long term obligations and to enable the bank to enforce penalty provisions in case of breach of conditions.  Renewals were made for periods not exceeding six months.  On February 25, 1936, the loan having been reduced to $40,000, a loan application identical in form to the original application in 1934 was executed and delivered by petitioner to the bank for the balance due.  The application recited that the proceeds of the loan should be used for working capital purposes and petitioner's assets and other collateral were pledged as security for the indebtedness evidenced by the note.  The application contains among other provisions the following: 8.  The applicant agrees to be and remain bound for the payment of all obligations to the Bank pursuant hereto and that the lien hereof and any pledge or pledges hereunder shall remain undisturbed notwithstanding any delay, extension of time, substitution of securities, renewal, or other indulgence granted by the Bank, hereby waiving all notice of such delay, extension, substitution, renewal or other indulgence.  * * * * * * 11.  During such time as the1940 BTA LEXIS 1110">*1113  applicant, whether a corporation, joint stock company, partnership or sole proprietorship, may be indebted to the Bank, it will not pay any dividends or withdrawals, or make any distribution of assets or any distribution upon its capital stock, or purchase or retire any of its capital stock, or authorize or issue any additional shares of stock, or reclassify any outstanding shares, or consolidate or merge with any other company or concern, or make any advance directly or indirectly by way of loan, gift, bonus, commission or otherwise to any of its officers, directors, partners or employees, or to any company or firm directly or indirectly controlling or affiliated with 41 B.T.A. 1009">*1011  or controlled by the applicant, other than for compensation or salaries for services reasonably necessary in the normal operation of the applicant's business.  It was further provided that the application, with all the conditions imposed thereby, should constitute a contract between the applicant and the bank.  Pursuant to the terms and conditions of the application, petitioner executed and delivered a note in the amount of $40,000, dated April 9, 1936, payable September 2, 1936.  The application and1940 BTA LEXIS 1110">*1114  note were on the form prescribed by the Federal Reserve Bank.  An additional $10,000 was paid on the principal, and on September 2, 1936, the loan was again renewed in the sum of $30,000 by a promissory note in that amount payable to the bank four months after the date thereof.  This renewal note was on the customary commercial form used by the bank.  On the same date the bank addressed a communication to petitioner confirming the understanding had as to the renewal.  The letter is as follows: In connection with the renewal of your company's note for $30,000, we desire to extend the agreement heretofore made, namely - That during such time as the Sutcliffe Company may be indebted to this bank it will not pay any dividends or withdrawals, or make any distribution of assets, or any distribution upon its capital stock, or purchase or retire any of its capital stock, or otherwise, or issue any additional shares of stock, or reclassify any outstanding shares or consolidate or merge with any other company or concern, or make any advance directly or indirectly by way of loan, gift, bonus, commissions or otherwise, to any of its officers, directors, partners or employes, or to any company1940 BTA LEXIS 1110">*1115  or firm directly or indirectly controlled or affiliated with, or controlled by the Sutcliffe Company, other than for compensation or salaries for services reasonably necessary in the normal operation of the business.  Exception only is made to those dividends required by the new Preferred stock issue which refunded the old Preferred stock and accumulated dividends.  Your acknowledgement in agreement with this will be appreciated.  Written acknowledgment in agreement, as requested in the above letter, was received by the bank from petitioner.  Petitioner had outstanding approximately $70,000 par value 7 percent preferred stock, none of which was owned by the common stockholders, on which dividends approximating $22,000 had accumulated.  Negotiations were undertaken to work out compromise settlement of the accumulated dividends, which in the early part of 1936 resulted in an arrangement between petitioner and all the preferred stockholders whereby the preferred stockholders agreed to accept $5 per share in full discharge and satisfaction of the accumulated dividends, and to reduce the dividend rate on he preferred from 7 percent to 5 1/2 percent.  Of this amount, $2 was to be1940 BTA LEXIS 1110">*1116  paid immediately and the balance at a later date.  The bank deemed this proposed settlement to the best interest of both itself and petitioner and consented to the arrangement.  41 B.T.A. 1009">*1012  During the taxable year the petitioner paid $6,609.87 under its refunding arrangement, or as dividends on its new preferred stock issue.  No dividends were paid on petitioner's common stock.  The respondent disallowed the credit claimed by the taxpayer in its return for the reason, as stated in the deficiency notice, "that the evidence submitted by you fails to disclose that at the close of the taxable year there existed a written contract entered into prior to May 1, 1936, prohibiting or limiting the payment of dividends by your company." He also adjusted the net income of $41,650.29 as disclosed by the return by adding thereto $330.65 excessive depreciation claimed, making the net adjusted income $41,980.94.  Petitioner does not contest this latter adjustment.  OPINION.  ARNOLD: Petitioner contends that the application for a loan executed February 25, 1936, constituted a written agreement or contract, which prohibited the payment of dividends during the year 1936, and therefore it is1940 BTA LEXIS 1110">*1117  entitled to the credit provided under the provisions of section 29(c)(1) of the Revenue Act of 1936.  Respondent contends that petitioner entered into a new agreement or contract with the bank on September 2, 1936, regarding the payment of dividends, which was in substitution for that entered into on February 25, 1936, and that the agreement or contract of September 2, 1936, fails to meet the requirements of the statute.  He further contends that in any event the agreement or contract entered into on February 25, 1936, was subject to modification by mutual consent and it is, therefore, not one which falls within the terms of section 26(c)(1) of said act.  Section 26(c)(1) of the Revenue Act of 1936, so far as applicable, is as follows: SEC. 26.  CREDITS 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 provision1940 BTA LEXIS 1110">*1118  of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends.  * * * The terms and conditions of the instrument of February 25, 1936, were binding on petitioner until its obligation to the bank was satisfied, unless it was abrogated or supplemented by the September 2, 1936, agreement to the extent it was rendered ineffective as an agreement or contract prohibiting or restricting the payment of dividends during the taxable year.  41 B.T.A. 1009">*1013  The letter or contract of September 2, 1936, refers in express terms to the renewal of the company's note for $30,000, balance due on the original obligation, and expresses the desire to extend the agreement made February 25, 1936.  As the terms and conditions of that instrument were binding on petitioner until all the obligations to the bank were discharged, no extension or renewal was necessary.  The obligation to the bank was not dischaerged until 1938.  While the letter or contract of September 2, 1936, modified the agreement of February 25, 1936, by the removal of the prohibition or restriction against the payment of preferred dividends, in all other respects it was1940 BTA LEXIS 1110">*1119  a confirmation of that agreement and did not otherwise abrogate or supplant its terms and conditions.  The giving of the note of September 2, 1936, can not be considered as the discharge of the existing obligation and the creation of a new obligation, in the absence of evidence that it was so intended.  ; ; ; . The evidence is to the contrary.  The change in form of the September 2, 1936, note is immaterial.  That form was used for the reason the bank no longer cared for the participation of the Federal Reserve Bank in the loan.  All arrangements were made and transactions had with the bank.  The application for the loan was directed to the bank, the original note and renewals were payable to the bank, and thue money was furnished by the bank.  Participation in the loan by the Federal Reserve Bank was a matter between the bank and the Federal Reserve Bank, with which petitioner was not concerned.  Petitioner produced two executives of the bank who were personally familiar1940 BTA LEXIS 1110">*1120  with the circumstances under which the loan was made.  Each of them testified in detail about the circumstances under which the bank made the loan, and that the bank preferred short term maturities because of the adversed feeling of commercial banks generally for long term obligations, and because, in case of a breach of any of the conditions under which the loan was made, a short term note afforded the bank an opportunity to demand payment.  Both executives testified that the bank contemplated a loan for the purpose of providing the petitioner with working capital for a period of years, and that the conditions, including restriction on the payment of dividends and other restrictions, would continue throughout the term of the loan.  Each testified that the bank emphasized these restrictions in the various conferences held with officials of the petitioner, and we find their testimony very persuasive.  As to the respondent's contention that, since the agreement of February 25, 1936, was subject to modification by mutual consent, it is not one which falls within the terms of section 26(c)(1) of the act, it may be said that, if this were so, no contract could be 41 B.T.A. 1009">*1014  effective1940 BTA LEXIS 1110">*1121  to prohibit or restrict the payment of dividends, as the right to modify by mutual agreement is inherent in all contracts.  The bank's consent to the removal of the restriction, whereby for a relatively small amount of cash a large amount of accumulated dividends could be discharged, enhanced the bank's prospects of collection.  For this reason the bank consented to the removal of the restriction to the extent provided by the letter of September 2, 1936.  The removal of the restriction went no further than to permit settlement of accumulated dividends on preferred stock and payment of subsequent preferred dividends at a lower rate.  Beyond this petitioner was restricted by the agreement of February 25, 1936.  It can not be assumed that the bank would consent to any further modification and permit earnings to be distributed to common stockholders so long as petitioner was indebted to it.  As petitioner was prohibited or restricted from payment of dividends by written contract executed prior to May 1, 1936, it follows that it is entitled to credit under section 26(c)(1) of the Revenue Act of 1936.  Reviewed by the Board.  Decision will be entered under Rule 50.