Hercules Gasoline Co. v. Commissioner of Internal Revenue

HOLMES, Circuit Judge.

Section 26(c) (1) of the Revenue Act of 1936, 26 U.S.C.A. Int.Rev.Acts, page 836, relieves corporations from taxes upon undistributed profits to the extent that such profits could not be distributed without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly dealt with the payment of dividends. Petitioner’s transferor, prior to May 1, 1936, issued preferred-stock certificates, and incorporated therein by reference an article of its charter providing that no dividend should be paid on the common stock of the corporation until all the preferred stock had been redeemed and retired. The certificates provided for cumulative dividends, at 8% per annum, payable whenever declared out of surplus net profits.

The two principal issues presented are (1) whether the preferred-stock certificates were contracts within the purview of Section 26(c) (1), supra, and (2) whether the corporation could deduct, as interest, the dividends paid on the preferred stock during the tax years.

The second question requires little comment. The mere fact that some of the shares were issued to creditors in payment of corporate debts does not serve to convert dividends into interest. The respective terms have acquired definite meanings. Interest is a fixed percentage premium paid on a time basis for the use or detention of money. It becomes a debt merely upon the passing of time, either by the terms of the primary obligation or by operation of law. A dividend, on the contrary, does not become a debt until profits have been earned and a declaration of dividends is made. It is a distribution of profits to adventurers in a common enterprise.¹ Here the corporate creditors became corporate stockholders by accepting stock, and the distributions to them were dividends declared from profits rather than payments upon corporate debts.² Such distributions were not deductible as interest.

The solution to the other question is not so plain. Section 26(c) (1) has been construed in parallel or closely related cases in several other circuits,³ but with, so balanced a divergence of opinion that those decisions are not particularly helpful. We think the reasoning and pronouncements of the Supreme Court in the leading case of Helvering v. Northwest Steel Mills, 311 U.S. 46, 61 S.Ct. 109, 113, 85 L.Ed. 29, when analyzed and applied to the facts present here, require an affirmance of the Tax Court’s decision disallowing the credit.

While the precise question in the Northwest Steel Mills case was whether the provisions of a state statute could be -read into a corporate charter so as to form a contract containing the restrictive provision required by Section 26(c) (1), much of what was said is applicable here where we are concerned with the provisions of stock certificates containing by reference certain charter provisions. The court in the Steel Mills case, construing the statute strictly, held that the prohibition against dividend payments must be expressly written in the executed contract, and could not be incorporated therein by reference, implication, or otherwise. Here the share certificates, upon which complete reliance is placed, did not include the prohibition other than by reference to the charter. The court’s opinion also has been construed to hold that a corporate charter, though it contains the formal requisites of a contract, is not such a contract as was contemplated by Congress in the enactment of the statute.⁴ It may be that the very question before us was decided adversely to the taxpayer in the Northwest Steel Mills case, as footnote 17 of the opinion recites: “Respondent contended that the stock certificates satisfied the statutory requisites even if the charter did not; but what we have here said with respect to the charter applies equally to the certificates.”

The holding of the opinion that we find most persuasive, however, is that the credit was intended to apply only to corporations contractually obligated to set earnings aside for the payment of debts. The shareholders of a corporation are not its creditors; they are its owners. As the court said in Warren v. King, 108 U.S. 389, 399, 2 S.Ct. 789, 798, 27 L.Ed. 769:

“Whatever position the holders of preferred certificates occupied before they accepted preferred stock, whatever special right of lien they had, they became corporators, proprietors, shareholders, and abandoned the position of creditors, and took up towards existing and future creditors the same position which every stockholder in a corporation occupies towards existing and future creditors. His chance of gain, by the operations of the corporation, throws on him, as respects creditors, the entire risk of the loss of his share of the capital, which must go to satisfy the creditors in case of misfortune. He cannot be both creditor and debtor, by virtue of his ownership of stock.”

We are therefore of the opinion that the stock certificates were not contracts within the provisions of Section 26(c) (1). The minor contentions that the 1937 settlement was res judicata, and that petitioner’s transferor was a deficit corporation, are without foundation in the record, and the decision of the Tax Court is Affirmed.

1 The distinction is clearly drawn in Warren v. King, 108 U.S. 389, 2 S.Ct. 789, 27 L.Ed. 769.

2 The allowance of a deduction under Section 23(b) of the Revenue Act of 1936, 26 U.S.C.A. Int.Rev.Acts, page 827, is only with respect to interest paid or accrued within the taxable year on indebtededness.

3 Lehigh Structural Steel Co. v. Commissioner, 3 Cir., 127 F.2d 67; Metal Specialty Co. v. Commissioner, 6 Cir., 128 F. 2d 259; Warren Tel. Co. v. Commissioner, 6 Cir., 128 F.2d 503; Elliott Addressing Machine Co. v. Commissioner, 1 Cir., 131 F.2d 700; Monarch Theatres v. Helvering, 2 Cir., 137 F.2d 588; Rex-Hanover Mills Co. v. United States, Ct.Cl., 53 F. Supp. 235.

4 Warren Tel. Co. v. Commissioner, 6 Cir., 128 F.2d 503.