Appeal of I. Unterberg & Co.

OPINION.

Sternhagen:

The taxpayer claims the right to include in its invested capital the full amount of $436,655.71 which it received at the time of its organization from the former partnership. There is no dispute that the net assets received were actually worth this amount, but the Commissioner has disallowed $236,655.71 because he regards it as borrowed capital.

The Revenue Act of 1918 defines invested capital in section 326 to include actual cash and tangible property paid in for stock or shares and paid-in or earned surplus. It expressly excludes borrowed capital, which in section 325 is defined as “money oí other property borrowed, whether represented by bonds, notes, open accounts, or otherwise.” If, therefore, the taxpayer is to succeed, the $236,655.71 must be shown to be within invested capital, i. e., paid in for stock or shares or as paid-in surplus, and not borrowed capital to any extent. The plan of the statute was to assess profits beyond a prescribed return upon the capital risked in the enterprise. La Belle Iron Works v. United States, 256 U. S. 377. Since borrowed capital was'not risked it was excluded from the base of the ratio. Profits derived from the use of other people’s money were, except for the relief provided by the method set forth in sections 327 and 328, fully subject to the profits tax. This general purpose must be kept in mind in applying the statute according to its terms.

At the time of the organization of the corporation by the individuals who had theretofore carried on the business as a partnership, all of the net assets of $436,655.71 were turned in, and the consideration therefori was 2,000 shares of stock of a par value of $200,000 and the issuance to the same persons of the three obligations here in question aggregating $236,655.71. The fact, as it appears, that the latter were not issued until May is not material, because it is clear that the obligations were in fact incurred at the time of the transfer of the assets in February. The determining question is whether these three instruments are such as to constitute the property “ bona fide paid in for stock or shares ” or “ borrowed capital.”

The document has been set forth in the findings of fact. In the corporation’s opening journal entry it is called a “debenture note”; on the face of the instrument it is called a note, and it bears the documentary internal revenue stamps proper for a note. In the stockholders’ agreement it is called a debenture note. But none of these facts conclusively proves it to be a note if it terms give it a different character. Were it not for the last sentence, there could be little room for doubt that each of the three similar instruments was a promissory note of equal standing with the other two. It promises to pay a specified amount, with interest, to a definite person at a definite time. Then follows the restrictive condition that it is subordinate to the claims of general business creditors at maturity or on liquidation. This latter condition, the taxpayer contends, is such that it converts the instrument into preferred stock. The contention is that by subordinating the right of the holder to that of the general creditors the instrument represents property placed at the risk of the business and not property loaned to the corporation. In other words, the dominant feature is said to be the condition and the risk and not the promise to pay.

It can not be doubted that the nature of an instrument may, because of its terms and the circumstances of its issuance and subsistence, be held to be different from what it is denominated. The decisions are numerous in which the courts have held bonds to be stock, In re Fechheimer Fishel Co., 212 Fed. 357; Cass v. Realty Securities Co., 148 App. Div. 96, 132 N. Y. Supp. 1074; have examined the circumstances carefully to determine whether the preferred stockholder was in truth a creditor, Warren v. King, 108 U. S. 389; Hamlin v. Toledo, etc. R. R. Co., 78 Fed. 664; Rider v. Delker & Sons Co., 145 Ky. 634, 140 S. W. 1011; have held that a tax on bonds was not applicable to certificates called preferred stock, Miller v. Ratterman, 47 Oh. St. 141, 24 N. E. 496; and that the rights of bondholders as general creditors could not be defeated by calling them stockholders because the instruments provided for sharing at maturity in the net profits, In re Interborough Realty Co., 223 Fed. 646.

Examining the terms and effect of the instrument, we are unable to hold it to be a certificate of stock. It is evidence of a restricted indebtedness. The fact that the principal amount is subordinated to the claims of general business creditors is not sufficient to warrant this Board’s determination that it is stock for the purpose of invested capital, when for all other purposes so far as we are advised the parties have treated it as a note. The interest is payable semi-annually in any event. Has it been paid, and has it been deducted as interest in computing taxable net income? Has the capital-stock-tax return included the amount of these instruments as the basis of tax? Have the amounts of these notes ever been subjected to any of the tests or vicissitudes of stock? The evidence does not inform us. We are not inclined therefore didactically to say that these are certificates of stock for tax purposes in the absence of convincing evidence that they are regarded as such for other purposes or convincing argument that they must be held to be such for all purposes notwithstanding the apparent intention of the interested parties to the contrary. As counsel for the taxpayer says, they cannot be both stock and notes, and having presumably given them full effect as notes during their life, we will not now say they were stock.

Applying the principle of invested capital, it is questionable whether these amounts were in fact risked in the enterprise. They were payable at maturity, subject to the claims of general creditors. They were an obligation of the corporation, enforcible in all respects except that the general creditors might insist that assets should not be impaired below the amount of their claims. They were of lower degree than such claims, and yet fixed in amount and time so as to distinguish them from stock. Indeed, it may be asked why, if after all they were stock, such care was used to limit the stock to $200,000 and issue notes for the rest? Apparently it may be inferred that the owners were willing to venture $200,000 in the business, but desired to be assured of the return of the $236,000 except in case of failure within three years. One was a business risk and the other a reasonably safe three-year investment.

The question here is in all essential respects similar to that presented in the Appeal of A. H. Stange Co., 1 B. T. A. 58, and, as in that appeal, we hold the instruments in question to represent borrowed capital and hence that the amount thereof may not be included in invested capital.