Eastern Bldg. Corp. v. Commissioner

EASTERN BUILDING CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Eastern Bldg. Corp. v. Commissioner

Docket No. 101222.

United States Board of Tax Appeals

45 B.T.A. 188; 1941 BTA LEXIS 1163;

September 25, 1941, Promulgated

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1. By contract petitioner was obligated to pay certain sums periodically to sinking fund trustees in order to meet interest and retirement requirements under a bond issue. The contract did not, directly or indirectly, require the payments to be made from annual gross income. Held, contract did not expressly deal with earnings and profits of the taxable year and petitioner is not entitled to credit for payments made thereunder pursuant to section 26(c)(2), Act of 1936.

2. Petitioner in the taxable year purchased certain of its bonds at a discount. In the following year it disposed of these bonds by transferring them to the sinking fund as part of its required sinking fund payments, receiving a credit of the face amount thereof. Held, petitioner thereby received income in the taxable year.

Joseph B. Miller, Esq., for the petitioner.

John R. Wheeler, Esq., for the respondent.

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KERN

This proceeding involves income and excess profits tax liability for the calendar year 1936. The Commissioner has determined a dein income tax for the calendar year 1936. The Board adopts the tax in the amount of $140.08. Petitioner claims a refund in the amount of $6,767.64 based on its failure to take a deduction to which it claims it is entitled. The total amount in controversy is thus $7,582.

Petitioner filed its Federal income and excess profits tax returns for 1936 with the collector of internal revenue for the second district of New York.

There are two questions involved in the present controversy:

(1) Whether for the purpose of computing the surtax on undistributed profits petitioner is entitled to a credit for $89,500 paid into a sinking fund as an amount which is required by contract to be paid or irrevocably set aside under the terms of a written contract within the year in discharge of a debt within the meaning of section 26(c)(2) of the Revenue Act of 1936.

(2) Whether the discount at which petitioner in 1936 purchased its own bonds, which were disposed of for face value in 1937, is taxable income of the petitioner in 1936, the year petitioner bought them in.

FINDINGS OF FACT.

The Eastern Building Corporation, petitioner herein, is a corporation organized in February 1921 under the laws of the State of New York. It was a realty corporation, whose principal asset consisted of a United States Post Office building on Varick Street in New York City. Petitioner's income was derived substantially from rentals under a lease of that building.

On August 1, 1924, petitioner executed an "Indenture of Trust Mortgage" with the Irving Bank-Columbia Trust Co., as trustee, under which an original issue of bonds in the principal amount of $2,000,000 was made. Inter alia, the indenture provided for the establishment of a sinking fund and the annual deposit therein of certain sums of money for the retirement of the bonds and interest thereon.

The language of the indenture is as follows:

SECTION 4. The Corporation further covenants that in order to provide for the retirement of bonds of the said initial issue from time to time outstanding hereunder prior to their expressed maturity, and for the payment of interest on such bonds, it will establish an interest and sinking fund, and will deposit therein the several amounts to be computed in the manner and used for the purposes in this section provided.

The Corporation further covenants that it will deposit with the Trustee during each twelve (12) months period, from but not including August 1, 1924, to and including August 1, 1926, one hundred fifty thousand dollars ($150,000), during each twelve (12) months period from but not including August 1, 1926, to and including August 1, 1938, one hundred sixty-five thousand dollars ($165,000), during each twelve (12) months period from but not including August 1, 1938, to and including August 1, 1940, one hundred seventy thousand dollars ($170,000), and during the six (6) months period from but not including August 1, 1940, to and including February 1, 1941, eighty-five thousand dollars ($85,000). One fourth part of the amount so to be deposited during each such twelve (12) months period, and one half part of the amount so to be deposited in the said six (6) months period, less in each case an amount equal to three (3) months' interest on all bonds of the said issue at the time outstanding, shall be deposited with the Trustee on each first day of November and of May occurring in each such period, and one fourth part of the amount so to be deposited during each such twelve (12) months period, and one half part of the amount so to be deposited in the said six (6) months period, plus in each case the amount deducted in determining the amount of the last preceding deposit, shall be deposited with the Trustee on each twenty-fifth day of January and of July occurring in each such period.

The amount deposited in such fund on each first day of November and of May shall be in cash and/or bonds of the said initial issue at par value. Of the amount deposited upon each twenty-fifth day of January and of July, an amount equal to the amount of interest next maturing on bonds of the said initial issue at the time outstanding shall be in cash, and the balance may be in cash and/or bonds of the said initial issue at par value.

Any cash at any time on deposit in the said sinking fund, except only such portion of the deposits herein provided to be made on the twenty-fifth day of January and of July of each year as shall equal the interest next maturing on bonds of the said initial issue at the time outstanding (which amount shall be by the Trustee retained and applied to the payment of such interest as herein provided) shall be available upon the order of the Corporation for the purchase of bonds of the said initial issue at the time outstanding, at prices not in excess of the price or value whereat such bonds may at the next ensuing interest payment date be redeemed through the operation of the said sinking fund, and pursuant to the terms of the said bonds; provided, however, that if there be on any day sixty-five (65) days preceding any date whereon interest is payable on bonds of said initial issue on deposit in the said sinking fund cash funds equal to or in excess of fifteen thousand dollars ($15,000) available, under the provisions of this paragraph, for the purchase of bonds, all such funds so on deposit and available shall be by the Trustee exhausted, as nearly as may be, in the redemption of bonds of the said issue on the then next ensuing interest payment date as provided in the said bonds in respect of redemption through the operation of the said sinking fund; and for the purpose of effecting such redemption the Trustee is hereby authorized and directed by lot to select bonds of the said issue in principal amount aggregating, as nearly as may be, the amount of cash so on deposit and available, and to publish notice of redemption of bonds so selected, in the manner provided in article five of this indenture, and upon selection of bonds for redemption the availability of funds appropriated to such redemption, for purchase of bonds shall cease.

The Trustee shall on each successive day whereon interest matures on bonds of the said initial issue, out of funds on deposit with it in the said interest and sinking fund, make payment of such interest in like manner as the Corporation herein covenants to do, if there be in the said fund monies sufficient thereunto.

During 1936 petitioner paid to the sinking fund trustee $89,677.50, consisting of cash and bonds issued under the indenture and surrendered in lieu of cash at their face value. Of this sum $89,500 was used for the purchase, retirement, and cancellation of outstanding bonds.

Attached to the income tax return of petitioner for 1936 was a rider claiming that, although no credit was taken for the $89,500 paid to the sinking fund in 1936, in computing the surtax on undistributed profits, the petitioner was entitled to a credit therefor under the provisions of section 26(c)(2) of the Revenue Act of 1936.

In the year 1936 petitioner bought in some of its own bonds in the face amount of $34,000, paying therefor $31,039.50. These bonds were shown on the balance sheet of petitioner as of December 31, 1936, as an investment and were carried at $31,039.50, the purchase price. The interest on these bonds was collected and credited to income account in 1936. Petitioner disposed of these bonds in 1937 by transferring them to the sinking fund as part of the required annual payment. Petitioner was credited with the face value of the bonds.

No accounting of any income attributable to this purchase of its own bonds at a discount was made by petitioner in its 1936 return. The gain thereon was reported in its return for 1937, the year in which the bonds were disposed of.

Respondent included in taxable income for 1936 a profit of $2,334.64, arrived at by deducting the purchase price of such bonds in the sum of $31,039.50 from the face amount of $34,000 of such bonds, less unamortized discount of $625.86.

As of December 31, 1935, petitioner's balance sheet showed a surplus of $264,799.40 and undivided profits in the amount of $59,381.68, totaling $324,181.08. As of December 31, 1936, petitioner's balance sheet showed a surplus of $264,799.40 and undivided profits in the amount of $100,271.81, totaling $365,071.21. The undivided profits as of December 31, 1935, are included in the $100,271.81 figure for December 31, 1936.

Cash dividends of $63,150 were paid in 1936.

OPINION.

KERN: The first question presented by this proceeding is whether, for the purpose of computing the surtax on undistributed profits, petitioner is entitled to a credit for certain sums paid to a sinking fund pursuant to a trust indenture for the retirement of bonds. The applicable statute is section 26(c)(2) of the Revenue Act of 1936, set out in the margin. ^{*1172 The facts in the instant case disclose a debt which arose when the bonds were issued. The indenture of trust, which is a written contract executed by the corporation prior to May 1, 1936, required that a certain sum of money be irrevocably set aside within the taxable year in discharge of that debt. And, as we said in , the fact that the petitioner had the option of redeeming the bonds or purchasing them does not affect the result. Our ultimate question, therefore, narrows down to an issue similar to one involved in the Michigan Silica Co. case, i.e., whether the provision of the trust indenture requiring the depositing of sums certain in the sinking fund "expressly deals with the disposition of earnings and profits of the taxable year." In the cited case, under somewhat different facts, we concluded that it did; here we reach the opposite conclusion.}

Regardless of whether petitioner realized any earnings and profits in the taxable year, the regular annual payment was still required by the indenture of trust. Without earnings, petitioner would have had to resort to some other manner of obtaining the necessary funds. This could have been done by applying accumulated surplus, if any, by the sale of assets, by issuing additional stocks or bonds, or by any other method of borrowing. Since the indenture does not require the payments to be from current earnings and profits or to be measured by current earnings and profits, it becomes immaterial whether the payments actually were out of earnings and profits of the taxable year. Provisions granting special exemptions are to be strictly construed. .

The three decisions which petitioner relies upon, ; ; and , are all readily distinguishable. As was pointed out by the Board in the latter case, the terms "earnings and profits of the taxable year" do not have to be written into the contract; but in all three of those cases the Board said that there must be some provision in the contract which, when read in the light of reason, expressly deals with the distribution of earnings and profits of the taxable year. Annual gross receipts were referred to in the contracts in each of those cases, and we held that gross receipts necessarily included earnings and profits. We do not have a similar state of facts in the instant case, for neither annual gross receipts nor any specific receipts are mentioned in the indenture; and therein lies the distinction.

The second and sole remaining issue for our determination is whether the discount at which petitioner in 1936 purchased its own bonds, which were disposed of for face value in 1937, is taxable income of the petitioner in 1936 or, as the petitioner contends, in the later year of disposition.

It appears that the sole purpose of the purchase of the bonds in 1936 was to have them on hand for deposit in the sinking fund at a later date at their face value. By this procedure the petitioner actually realized a profit between what it paid for the bonds and their face value. Petitioner claims that the purchase of the bonds was a transaction entered into for profit and that, consequently, no income was realized until petitioner disposed of the bonds. The actions of petitioner point to the inescapable conclusion that they were purchased for retirement. However, its purpose in purchasing its own bonds is immaterial. As we said in (affd., ):

* * * The purchase of the bonds by the petitioner constituted such a closed transaction as gives rise to recognizable gain or loss under the revenue act. The fact that the petitioner had such bonds available for resale is not controlling. Such a resale would be an entirely new transaction.

See also .

On this issue we hold for respondent.

Decision will be entered for the respondent.

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Footnotes

• 1. 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 -

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  (c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -

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  (2) DISPOSITION OF PROFITS OF TAXABLE YEAR. - An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. For the purpose of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word "debt" does not include a debt incurred after April 30, 1936. ↩