The opinion of the court was delivered by: KNIGHT
This is an action for the refund of federal taxes paid under Section 102 of the Revenue Act of 1936, 26 U.S.C.A.Int.Rev.Acts,page 851, by the plaintiff, a New York State corporation, to the defendant Collector of Internal Revenue for the 28th District of New York.
Plaintiff alleges three causes of action. In the first it demands judgment for $ 740,918.28, paid to defendant on October 7, 1943, being the sum of $ 532,468 additional income tax for the calendar year 1936 and $ 108,450.28 interest. In the second it demands judgment for $ 980.46, being the sum of $ 704.62 excessive payment made to defendant on October 7, 1943, because of failure to allow a deduction of $ 11,743.65, as alleged in the first cause of action, and $ 275.84 interest. In the third it demands judgment for $ 801,710.29, paid to defendant on October 7, 1943, being the sum of $ 602,119.91 additional income tax for the calendar year 1937 and $ 199,590.38 interest.
The total amount of refund, exclusive of interest, demanded by plaintiff in its three causes of action is $ 1,543,609.03.
Since the Attorney General, after service of the answer, directed an administrative refund of $ 11,341.02, plus interest, involving depreciation in patents, the only question now presented, according to defendant's brief, is: 'Whether taxpayer in 1936 and 1937 was availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of Trico Securities Corporation through the medium of permitting its earnings or profits to accumulate instead of being divided or distributed, as provided in Section 102, Revenue Act of 1936.'
Section 102, Revenue Act of 1936, provided in part as follows:
'(a) Imposition of tax. There shall be levied, collected, and paid for each taxable year (in addition to other taxes imposed by this title) upon the net income of every corporation (other than a personal holding company as defined in section 351) if such corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation, through the medium of permitting earnings or profits to accumulate instead of being divided or distributed --
'(1) In the case of corporations not subject to the surtax on undistributed profits imposed by section 14, a surtax equal to the sum of the following:
'25 per centum of the amount of the retained net income not in excess of $ 100,000, plus
'35 per centum of the amount of the retained net income in excess of $ 100,000.
'(2) In the case of corporations subject to the surtax on undistributed profits imposed by section 14, a surtax equal to the sum of the following:
'15 per centum of the amount of the retained net income not in excess of $ 100,000, plus
'25 per centum of the amount of the retained net income in excess of $ 100,000.
'(b) Prima facie evidence. The fact that any corporation is a mere holding or investment company, or that the earnings or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to avoid surtax upon shareholders.'
Defendant's answer admits the allegation that 'At no time was the plaintiff a more holding or investment company.'
Two questions must be decided in this case: (1) Did plaintiff during the calendar years 1936 and 1937 permit its earnings or profits to accumulate beyond the reasonable needs of its business? (2) If so, was this done to avoid surtax upon shareholders? If the first question is answered no, judgment must be rendered for the plaintiff.
The history of the plaintiff corporation prior to 1936 is reported in Trico Products Corp. v. Commissioner, 46 B.T.A. 346; Id., 2 Cir., 137 F.2d 424. From the facts there stated and the evidence in the instant case, the following may be deemed established:
Plaintiff's history begins with the organization of Tri-Continental Corporation in 1917. An automobile accident brought forcibly to the attention of John R. Oishei, now Trico's president, the need for some device to keep automobile windshields clear. He discovered that one John W. Jepson of Buffalo, New York, had invented a windshield wiper, which he was delivering in market baskets. Mr. Oishei then organized said corporation to distribute this wiper. He was joined by Dr. Peter C. Cornell and, with $ 10,000 borrowed capital, they began business. About eight or nine months after incorporation, the Tri-Continental bought Jepson's business and manufactured and distributed his wiper under the name 'Rain Rubber.' World War I proved disastrous to its business, which it tried to revive after the war ended. Car manufacturers had changed the construction of windshields and this had made the 'Rain Rubber' unworkable. Mr. Oishei then invented, a new type of wiper called the 'Crescent Cleaner,' which proved successful. To exploit this new invention, plaintiff was incorporated in New York State on April 26, 1920.
Plaintiff took over all the assets of the Tri-Continental. Its capitalization consisted of 7,500 shares of common and 2,500 shares of preferred stock. The certificate of incorporation provided:
'The Board of Directors shall have absolute discretion to determine, from time to time, what sum shall be retained by the Corporation out of its surplus profits * * * before the declaration of any dividend upon the common stock, as working capital for the Corporation, and the stockholders shall have no right to insist upon the distribution of any profits so reserved by the Board of Directors.'
Plaintiff still had insufficient capital and was hard pressed. Mr. Oishei then invented a power-operated wiper, known as the 'Trico' and the sales of the hand-operated 'Crescent Cleaner' increased . In 1924, plaintiff bought the assets of the defunct Polk-Hueber Company of Seattle to acquire its patent on an automatic windshield wiper known as the 'Visionall.'
From 1922 through 1925, plaintiff was subject to severe competition, particularly from Folberth Auto Specialty Company of Cleveland, which sued it for alleged patent infringement. It bought out the Folberth Company in 1925 for $ 1,000,000, and increased the number of its preferred shares to 15,000. In 1926 it secured a reissue of the Hueber patent after it had been determined by the Patent Office as between Folberth and Hueber that Hueber was the first inventor. In 1927 its basic patents on the vacuum-operated windshield wiper were judicially determined to be valid. Trico Products Corp. v. Perfection Products Co., D.C., 19 F.2d 173, affirmed 6 Cir., 31 F.2d 522. These patents expired on January 25, 1942.
By 1927 plaintiff had conquered the windshield wiper field. Pres. Oishei testified that in 1927, about 70% of all cars being produced, except Fords, were equipped with the Trico vacuum-operated wiper and the remaining cars with the Trico hand-operated wiper.
Since the organization of the Trico corporation, John R. Oishei has been its president and acting head. In 1927 plaintiff's outstanding common stock of 7,999,91 shares was held by 21 stockholders. Mr. Oishei and Dr. Cornell held 4,519.955 shares.
In 1927 a banking syndicate made a contract with plaintiff's 21 stockholders, a majority of whom had been interested in the business from the start. The terms of this contract are stated in Trico Products Corp. v. Commissioner, 2 Cir., 137 F.2d 424, 425, where it is said:
'Under the terms of this contract a recapitalization of (plaintiff) took place and resulted in the issuance of 225,000 shares of common stock without par value and entitled to share ratably in all dividends declared and of 450,000 shares of restricted stock without par value and entitled to share ratably in that part only of dividends which should be declared in excess of $ 2.50 in any one year on each of the free shares. There was no other kind of stock. The bankers agreed to, and did, purchase 175,000 of the unrestricted shares for $ 4,225,000 in cash; the twenty-one old stockholders took the rest of the unrestricted shares and all of the restricted shares were also taken by them. In accordance with the syndicate agreement all of the latter were put into a voting trust which provided for their release as free shares as follows:
"It is agreed that commencing January 1, 1928, up to 112,500 deferred shares may be exchanged for free shares accordingly as net earnings of the Company for the calendar year 1927 or for any year thereafter shall be equal to $ 5 per share upon the sum of the free shares then outstanding plus the number of free shares required for such exchange and in like manner commencing January 1, 1929, additional deferred shares up to 112,500 may be exchanged accordingly as the net earnings of the Company for the calendar year 1928 or for any year thereafter are equal to $ 6 per share on the sum of the free shares plus the free shares required upon such exchange and in like manner the remaining 225,000 deferred shares may be exchanged accordingly as the net earnings of the Company for the calendar year 1929 or for any year thereafter are equal to $ 9 per share on the sum of the then outstanding free shares plus free shares required upon such exchange; provided that as condition precedent to such exchange in 1928, dividends at the rate of $ 2.50 per share shall have been paid on the free shares from date of issuance and provided that at the date of each successive exchange herein provided for, dividends aggregating $ 2.50 shall have been declared and paid during the then next preceding twelve months upon the free shares then outstanding."
The voting trust could be ended at any time by the concurrence of those holding a 60% interest in it. The trust was terminated in 1929 when the 21 old stockholders, who had continued to hold all the restricted stock, replaced it with the Trico Securities Corporation.
It was further agreed that plaintiff should have no debts except current ones; that its fixed assets should be not less than $ 1,100,000 with current assets of an equal amount; that the condition of the corporation as shown on its balance sheet of April 30, 1927, was not to be changed, except as changes might arise in the ordinary course of business. John R. Oishei agreed to and did assign to plaintiff all the patents which he owned in consideration of an annual salary of $ 150,000 and 10% of the net profits before payment of taxes for acting as manager. This continued until 1942, when it was changed.
The purchase price of the 175,000 shares ($ 4,225,000), after payment of certain expenses, was to be ratably distributed among the stockholders. Dividends upon the 225,000 shares of free stock up to but not exceeding $ 2.50 per share in each calendar year were to be paid before any payment of them upon the 450,000 restricted shares but all dividends in excess of $ 2.50 were to be declared and paid ratably upon the entire 675,000 shares.
Trico Securities Corporation was organized in 1929 'to take the place of the voting trust and acquired all the then restricted stock, amounting to 337,500 shares, from the original stockholders, who became stockholders of (it) in proportion to their holdings of the restricted shares.' In 1936 and 1937, six of the original stockholders held 85% of these 337,500 shares. Trico Securities Corporation officers during these years were: John R. Oishei, president; Peter C. Cornell, vice-president; S. H. Evans, secretary. They and Ieuan Harris and Charles H. Oshei were directors. The Corporation owned 55% of plaintiff's stock in 1935, 1936 and 1937. Of plaintiff's 675,000 total shares, the original stockholders owned 416,633 shares in 1936, 425,160 shares in 1937 and 457,636 shares in 1938.
Plaintiff has paid a regular dividend of at least $ 2.50 each year since 1927 on all of the free shares outstanding. The total dividends from 1928 to 1941, inclusive, were $ 15,437,322.99. The dividends paid in 1936 were $ 2,210,894.88 and in 1937, $ 1,960,768.77. In those years, because of the undistributed profits tax law, plaintiff declared an additional dividend of $ 1,375 on all shares. A fifth dividend of $ .625 was paid in 1936 in order to receive a credit for distribution of dividends declared in the preceding year.
Plaintiff's original capital was $ 1,750,000. Its net income for 1927 to 1941, inclusive, was $ 38,731,218.57. In 1936 it was $ 4,184,560.81 and it spent $ 813,283.42 for plant and equipment and $ 384,655.20 to purchase shares of its own free stock. In that year it paid dividends of $ 4.50 on its free stock and of $ 1.375 on its restricted stock, making the above total of $ 2,210,894.88 or 52. 83% of its net income. As of December 31, 1936, it had a book surplus of $ 4,913,737.07 and a capital account of $ 6,000,000, including $ 1,000,000 transferred from surplus. In 1937 its net income was $ 3,792,244.62 and it spent $ 1,623,332.42 for plant and equipment and $ 856,603.28 to purchase shares of its own free stock. In that year it paid dividends of $ 3.875 on its free stock and of $ 1.375 on its restricted stock, making the above total of $ 1,960,768.77 or 51.70% of its net income. As of December 31, 1937, it had a book surplus of $ 5,745,212.92 and a capital account of $ 7,000,000 for diversification of its products, including $ 1,000,000 transferred from surplus.
The above figures were stipulated as correct. It was also stipulated that the balance of undistributed net income in 1936 was $ 2,201,028.88 and in 1937 was $ 1,831,475.85.
John F. McCabe, accountant and auditor with the Internal Revenue Bureau, testified as follows:
'Q. Now * * * what were the accumulated earnings and profits of (plaintiff) at the close of 1936, and * * * how did you arrive at that figure? A. The total is $ 10,913,737.07 * * * . That was made up of surplus as shown by the books of $ 4,913,737.07, and the transfer back of $ 6,000,000 which had been transferred from surplus to capital account -- $ 5,000,000 in 1935, and $ 1,000,000 in 1936.
'Q. Now * * * what were the accumulated earnings and profits of (plaintiff) at the end of 1937? A. $ 12,745,212.92.
'Q. And how did you arrive at that figure? A. By taking the figure that is shown by the books, Exhibit P-2 -- $ 5,745,212.92, and adding back $ 7,000,000 which had been transferred from surplus to capital in 1935, 1936, and 1937.'
Plaintiff's investment in United States, state and municipal bonds and stocks and other investments in 1936 aggregated $ 9,036,743.27; in 1937, $ 10,192,815.47; in 1941, $ 18,949,883.88.
Were plaintiff's undistributed earnings or profits of $ 2,201,028.88 in 1936 and of $ 1,831,475.85 in 1937 permitted to accumulate beyond the reasonable needs of plaintiff's ...