CTA Case No. 612

DECISION

CoToMe CASE WO. 612 «a 2 = tributed surplus. An itemized statement of the undis. tributed surplus is shown below:

Ralanee of surplus accaunt as of Dec.

31, 1950 annncwnmannene— PF 34),992,92 195] onnn nn ew enn nee nee 135,166. 72 1982 Oe a MD er oe ae ee me Se te Ae Om OD Dan aD wo a a BO 147,491.62 1953 AOR SS SESS USS Ee Eom 10% Pl te 18 Total wp oe om a a It ie contended on behalf of petitioner that its surplus earnings end profits during thy sforesaid years were not improperly accumulated and that, assum- ing the taxability of seid surplus, the same snould be reduced by the amount of the stock dividends des- clared. .

Section 25 of the Netional Interne! Revenue Code provides 4 corpors panies, or personal Seidiae companies whether domestic or feneiens is formed or aveiled of for the purpose of prevent- ing the imposition of the tax upon its shareholders or members or the sherehold- ers ooh veneers of gr ee re ay ge thro medium of pe ting its one and profits te accumulate tnstead of being divided or distributec, there is levied and assessed inst such oy 3 gs for each texa yeer, 2 gol equal to jr ese bea wee portion prof or surnlus which shell in addition to the tax imposed by section 24, and shall computed, collected and p in the geme manner and s to the seme provi- sions of law, penalties, as that tax.

(b) = The fact that any co a mere ho company shall be evidence of @ purpose to av ax upon its share- helders or ceudieaes Similer presumption — ty ~~ —— ll rl

DECISION «

C.T.A. CASE NO. 612 «= 3= will lie in the cage of an investment company where at af any tine. during the . taxable yeer nore t fity’ par Y in value of its outstanding stee owned, directly or indirectly, by one person.

nose, *),2 act or ite of a comporsticn pa permitted to accumulate beyond thu reasonable needs of the business shall be determi- native of the e to avoid the tax upon its shareholders or members unless bo corporation, by clear preporderance of evidence, shall prove the contrary.

/ "Section 2 of the Revenue Code imposes fer each year, in eddition to the tax imposed by Section 24, a tex of 25% on the undistributed portion of the pro- fits or surplus of a corporation which is formed or availed of for the purpose of preventing the imposi- tion of the tax unon its shereholders or membera or the shareholders or members of any other corporation through the medium of permitting gains or profits to accumulate instead of dividing or distributing then.

“At is a prerequisite to the imposition of the tax that the corporation be formed or availed of for the pur- pose ef avoiding the income tax on its stockholders by permitting the earnings and profits of the cerporation to accumulate inatead of dividing them among or distrib. uting them te the stockholders. If the failure te pay dividends is due to some other cause, such as the use of the undistributed earnings and profits for the rea- sonable needs of the business, such purpose dees not fall within the interdiction of the statute. Inasmuch as purpose involves e stete of mind ex intent, it is

Go

DECISION «

C.T.A. CASE NO. 612 ~ 4 always necessary to inquire inte the facts in each individual case to determine whether the purpese of the failure to make distribution was to permit the shareholders to avoid the income tax or for some other purpose, such a6 the use of the earnings and profits for the reasonable needs of the business. (7 Mertens, Law on Federal Income Texetion, Set. 39.263 see also Sec. 21, Rev. Regs. No. 2.)

Some of the circumstances which indicete that the accumulations are beyond the reasonable needs cf the business are (a) accumulations for the benefit of stock~ holders; (b) loans to shareholders or the expenditure of funds by the corporation for the personal benefit of the stockholders: and (c) investments unrelated to the corporetion's business. (7 ‘ertens, Law on Federal Income Taxation, Secs. 39. 33-39. 363. iece 19, Reve Regs. No. 2.) On the other hand, accumulations are deeued for reasonable business needs if they are retained for

(a) expansion of plant, facilities, and activities;

(b) additions to working capitals and (¢) acquisitions of releted business. ( 7 Mertens, Law on Federal In- come Taxation, Secs. 39. 38<39.49; Sec. 21, lev. Regs. No. 2.)

The records show that the accumulate’ earnings and profits of oetitioner for the years under review were used mainly as additions to working capitel, expan- sion of its business activities, and acquisition of interests in related businesses.

During the reguler annual meeting of the stock-

DECISION «

C.T.Ae CASE NO. 612

Se

holders of petitioner held on Merch 7, 1951, the stock.

helders agreed to ant approved a propesel te increase Ate capital from ?409,009,.00 te 81,000,0°0.00. It was explained thet the proresel would be “te the edvan- tage ef the Company and (would! give the Company grester leeway of expending ite business for the cure rent year and prepsre itself fer whetever criticel ci rcumst ances this year mey bring.” The proposs!] was epproved unanimously. The following appears in the minutes of seid stockholders’ meeting:

TThe Chair then explained thet, 8s appears in the Balence Sheet, the Come pany had ag of December 31, 1950, « sure plus of. 34] 352.50, which surplus may be used by the Compeny to increase its capital from the present 9400 ,000,9% to h1,000,000.00. He explained that this Comp ah ne - gr Pacer ~ a any © give the greeter leeway of expending its business for the current x end prepare itself for whet- ever criticel circumstences this yeer mey bring.

After a thorough discussion of the matter and upon motion of Mr. Federis, duly seconded, the foll reso lution was unanimously approved adopteds “RESOLVED, Thet the author- ized capital steck of the Ricel Trading, Ince, be as it hereby is, increased from 940,000.00 to F1,000,000,03 *RESOLVED, Further that the President and Secretary be, as they hereby ore instructed to take immediate steps to secure the necessary permission or authority from the Securities and exchenge Commission to carry out and give legal effect to said increase. * The Chair then explained that in or- der to utilize the surplus of the for the purpose of increasing its capi

DECISION «

C.TsA. CASE NO. 612 o 6 « 4zation, it is within the means of the Compeny to declare e stock dividend of around 50% Upon motion of Mr. Federis, duly seconded, the following resolution wes wnanimously spproved snd adopted) "RESOLVED, That the any declare, as it hereby declares, @ stock dividend equivalent to ‘SO% of its authorized capital, or 9200,000 out of the present existing surplus of the Corpore- tion, te all shareholders of record as of March 7, 1951, and that fractional shares there-~ of be issued in the form of (7) except in amounts equivelent to one or more full sheres and thet said fractional shares in the form of scrip shall be re- deemable in accordance with the preceding (%) within 2 period of 90 days moximum from date of iesue.”

(See pedes 63-64, B.I.R. records. )

In 1953, petitioner declared a cash dividend of 10%, retaining @ surplus cf *360,708.93. The Poard ef Directors wes informed in its meeting on February 2, 1953 that “a considerabie portion of this surplus (was) still invested in the business and (was) un- available for cash dividends,” and for this reason it was suggested that the matter of declaring stock divi- dends be referred to the stockholders for approval. | In the meeting of the stockholders on ‘iarch 3, 1953, a resolution wes unanimously approved autherizing the declaration of 25% stock dividend. The following ap- peers in the minutes of said meetings The Chair then declared the table open for new business. The accumulated euxrplus profits of the gy ose in the amount of P360,708.93 wos brought to the attention of the body. After refer- ence was made to the unissued portion of vo~ 6

DECISION «

C.TeAs CASE NO. 612 at « the authsrized capital stock of the corporetion, on motion, duly second- ed, the following resolution was wne animously approved and arlopted:

"WHEREAS, for the pee 1952, the Corporation shorn prefite which have been continously reinvested in the business; and *WIERGAS, seid uncdietrib- uted profits, as shown by the "resident*s Annuol Report to Stockholders, now amounts to ©360,78.93, and still are invested in business and could not be sveilable for cash dividends now or in the immediate future due to the business commitments of the Company: Now Therefore, “Pe IT RESOLVED, that in justice to the Sto ld- ers of the Corporstion - subscribed end Unissued Stock being available) e 75% divi- dend in the form of — Stock of this Compeny declared payable to stocks ef record es of Merch 3, 1953, ° (See pages $8.59, B.1.R. records. )

Again, in 1955 it wes shown that petitioner had @ surplus of 95286,401.70 as ef the close ef the calen~ daz year 1954. The matter of disposing of the surplus was submitted te the stockholders who unanimously ap- proved, in its meeting on March 1, 1955, a resolution authorizing a stock dividend of 33-1/3% \“e quote from the minutes of the stockholders’ meeting of March 1, 1955s pow aintges’ Tos Sngtuiie ite Del”

Decenber 31

had, as of » 1954 a surplus ef 9586,401.70. With the declaretion of m7

DECISION ~

C.T.A. CASE NO. 612 2 c td a 1OF cesh dividenc, this surplus wes cut down to about P514,000,0 as of the date of the meeting. After a therough Giscussicon and there being aveilable an unsubseribed ond unissued portion of capital stck, it wass “RESCLVED, that e 23-¥ar dividend in the form of capi- tal stock of this Corporation be declered, payable to stecks of record es of July 1, 1955* The above resolution wes unanimously approved.

(See pege 57, 5.1.8. records. }) It will be observed that the authorized capital stock of petitioner corporation was only ®400,000.00, With the expansion of its business activities, it was deemed necessary to increase its cepital stock to P1,000,°00.00. This was sought te be accomplished by vtilizing its surplus earnings and profits as part of ite working capitaj, and to thid end, stock divie dends were declared, although in two instances cash dividends were aleo declared. That there wes need for increased capitalization is borne out by the ovis dence. In 195], the gross seles of petitioner amount. ed to °1,676,636.00; in 19352, P1,624,144,92; in 1953, 92,0239,697.133 in 1954, €2,296,792,95. (Page 10, Memorandum for Respondent; Exhs. E, F and G) Un- doubtedly, the volume of sales justified increased inventories.

Under the circumstances, were the surplus pro- fits and earnings of petitioner and the conversion thereof as part of its working capital by the declare- tion of stock dividends unreasonable as to justify —— — a

DECISION «=

C.T.Ae CASE NO. 612 = 9 « the imposition of the penalty tex impesed by Section 23 of the Revenue Code?

| The intention of the law is not te penalize ac- cumulations of surplus which are within the reasonable requirements of the business. | (Semagraph Company, 9 TCM G12, affd. in 152 F. Td 62 (CA-4)3 Trico Prede uets Corporetion v. McGowan, 67 F. Supp. 311 (DC N.Y. ), affd. in 169 F. 2d 343 (GA-2), cert. den., 339 U.S. 899; Metel Office Furniture Compeny, 11 TOM 1066. ) What is a reasoneble accumulation is largely a ques- tion of fact, which must be decided upon principles ef sound business menegement. (Almours securities, 902 U.S. 765; Becton, Dickinson & Company v. Comais- sioner, 134 F. 2d 354 (CA-27)3 Eastern Reilwey & Lumber Company, 12 TC 869. )

Since the management of a corporetion is entruste ed to its board of directors, its decision as to the reasonsbleness of reteaifBiing the corporetiocn's surplus earnings and profits must be civen great weight. In Re C. Tway Cowl Sales Company v. \. 3., 3 Fe Supp. 668 stated:

"Necessarily, the directors and of- ficerse of a corporetion must be given, even in Pederal tax matters, some dis.

cretion and some latitude as to what constitutes the reasonable needs of the pte By business. Tt may well be if the Federal government, for the purpose of increasing its taxes, can absolutely destroy or arbitrarily limit this discretion resting in the directors of a corperation orgenized under state lav.*

DECISION =

C.T.A. CASE NO. 612

- We

But while the judgment of corporate directors is not to be lightly disregarded, there is no rule that it is conclusive. (L. Schepp Company, 25 BYA 419.) As to what constitutes a reasonable accumulation must be detemined, in the final analysis, by the court. (Trico Products Corporation, 46 BTA 346, affd. in 137 F. 2d 424 (CA~w2), cert. den., 3%) U. 5. 799.) In Jerome & Casey, 267 FP. 2d 26 (CA-2), reversing the decision of the U.S. Tex Court in 16 TCM 1024, it was helds "We think that the 1954 and 1955 enactments indicate that Congress did not want the taxing authorit to be second-quessing the responsible managers of corporations as to whether and te what extent profits should be distributed or retained, unless the taxing authorities were in a position to prove that their position was cor- rect. :

Judge Hand's concurring opinion is even more emphatice He expressed the view thats *. « « the statute meant to set up as a test of ‘reasonable needs,‘ only the corporation's honest belief that the existing accumulation was no greater than was ut ewan Section $32(a) wes a penal statute, designed to defeat any plan to evade the shareholders’ taxes, and there can be no doubt that it pre- supposes some deliberate purpose to do so and is not satisfied proving that the corporation was mistaken in its es- timate of its future ‘needs’.

"In the case at bar the embarrass- ment is in deciding what were those ‘needs', and for that one must look to the estimate of those in contre] of the corporation, because, being an artifi- cial person, it could obviously have no independent estimate.”

DECISION «

C.T.Ae CASE RO. 612

«~ Ii «

However, in order to justify « holding that an accumulation is ressonable, it is necessary thet the records of the corporetion show why the earnings are being retained.

“Prerequisite te 2 helding thet an ecoumulation is reescneble, is = well documented corporete record as to why V the eaxings are being retzined. There must be substantial proof of a specific plen, objective or centingency which, in the exercise of good bueiness judo- ment, demented the accumuletion of the earnings and préfits in a reasonable and Teascnably definite amount. In order to justify an eccumuletion the need must be treated as an economic rerléty: the penalty tox cannot be evoided by simple tion of a need. Definiteness of an coupled with action taken toward te consummation are essentiale."

is *Accunuletion Beyond Reasonable Needs* of tho Business?, Edwerd N,. Dela ney, Taxes, May, 1961, pp. 402, 409;

see also cases cited therein. )

In the case at bar, the minutes of the meetings of the Board of Directors and stockholders show clear- ly the necessity of retaining the surplus earings and prefits of the corporation. And what is sigqnifi- cant is the fact thet the need for retention of the surplus earings and profits for use ss edditional working capital was considered, passed upon and ap-~ proved not only by the Board of Directers of peti- tioner but also by ail its stockholders. ‘The records Glearly shew that the bulk of its surplus earnings and prefits were invested in inventories. And in the case of the investments in stocks and securities of other corporations, such corporations were affiliated companies with which petitioner hes business dealings.

DECISION «

C.T.A. CASE NOD. 612 =» 12 « In the case, for instence, cf the Motor Service Con- pany end the B. F. Goodrich Philippines, Inc., peti- tioner secures eutomobile spare parts and tires from seid companies. It has been held that - "To the extent that surplus hes been tronsleted into plent expansion, increased receivables, _ or 0 t business, “the corporation may eaccumu- aurplus with relative impunity. “ iy Taxes, 492, 410, citing Smoot Send & Gravel Corporation 274 F. 2d 498 (Chm 32 affirming 17 TOM 1086, cert. den., 3 u. S. 976; emphasis supplied. )

Under the circumetances described above, we are not prepered to substitute our judgment for that of the hoard of Directors of petitioner and ite stockhold. ers.

Respondent argues thet petitioner's original working cepitsa] of 2399,200.(vwas sufficient for ite business operstione so thet there was mo need to capi- talize its earningse Said counsel for respondents “as heretofore stoted, in 1981, the working capital of the petitioner was only °399.200.00 for which it realized a ~ of 1,676. 826. with a net gain therecn of P226,798.00. In 1954, the working cepitel of the Lod gute gg ype: wes sirendy °749,600,.0) et it anly ree- lized a net profit of of 9242 625 oO. This goes to show thet the cand ialanstied ae the corporation of its net ~ surplus was not necessary, _ 4 ra yigps for the periods teen and 954 having been more or less the same. We therefore submit thet the accumuls~ tion by the petitioner for the periods under Be was beyond the reasonable needs of the businese.” (Page 10, Memo- randum for Respondent. )

To our mind, ve facts and figures mentioned above ¥ weaken ratherjstrengthen the stend of respondent. If, with a working capital Of F399,200.00 in 1951, peti- f- 12

DECISION «

C.T.Ae CASE NO. 612 ~ 13 .

tioner was able to derive a net profit of 9226,798.00 it does not necessarily follow that the employment of the same amount of capitel would produce the ‘same amount ef profit in 1954. This is sho@n by the fect that despite ea working capitel of #749,600.00 in 1984, it derived only e net profit of °232,822.00. ‘The reason is obvious.

Conditions in 1954 must have been different from those existing in 1951 te justify en increase in the work- ing capital, so that if petitioner had maintained its werking capital in 1954 to the 1951 level, the net profit would undeubtedly have been reduced by about 50% It would sewm, therefore, thet the retention of surplus earnings and profits for use as pert of peti- tioner's working capitel was a sound business judgment. Our attention has been drawn to the facta that petitioner is controlled by J. M. Tuason & Co., which is practically owmed by the Tuasen family, namely, Nicasio Tuason, Severo Tuason and Jose Tuason; that out of the total shares of 5,999 in paid-up stocks in 1952, 4,009 sgheres were owned by Tuason & Co.3 and thet although qualifying shares were issued, the busi- ness of petitioner was in the hands of J. M. Tuason & Co. From these facts, it is contended that the in- tention end purpose of petitioner in not distributing :

-_ oe ac - ' ® <<.

ll cel a ie el

DECTSION « '

C.oTec As CASE WM 612 ~ 14 ~ its surplus was to maintain et the minimum the tax bracket of the Tuscon family who are the stockholders i of petitioner.” Therefore, respondent submits “thet the organizotionsl errangement of this nature demands the strictest judicial consideration of the case.” (Page 11, Memorandum for Respondent, ) It must be admitted that corperstions mest vul- nereble te the penalty tax have been *corporstions the stock of which wes owned or controlled by e single femily or at the most by » few individuals, In the case of one-man corporstions and se-called ‘ineorpere- ted talents’ compenies, the reasons for eccumuletions have been carefully investigeted.* (7 Mertens, Law on Federal Income Taxetion, Sec. 39.53.) Nowever, the fact thet ¢ corporation {s closely held does not give rise te the conclusive presumption that el] its eccumuletions of earnings and profits are unreasonable. Authorities are agreed thet such fect Justifies carg- If earnings and profits sre accumulated because they are needed to maintain and expand ite business activi- ties, as has been proven in the case at bar, the fact thet a corporation ie closely held will not make the accumulation unreasoneble. As aptly stated by coun.

sel for respondent:

i However, no attempt was meade to produce evidence \ as to the extent of the tex savings on the part of the controlling stockholders, although such evidence was available to respondent.

" ‘ ~BECTSE... - C.TeAe CANE MO. G12 = 15 « "On the other hand, it requires no argument that the eforecited section does not contemplate that « business shell remain statics 4t must be assumed that ‘any business shall have the right to grow. Necessarily incident to the exere | cise of this ri are the meking and | pursuit) ef plens both as to the organize~ — and =. to gage which will permit } pn Pog (ities & Ge - Millie “ite breast, Inc. v. Comm. of Internel Revenue, X) BTA #26, B30 \" (Page 2, Memorandum for Respondent, } We believe the foreqoing quotation sufficiently ane- wers respondent's contention as regards the signifi- cance of the ownership by members of the seme family of the majority stock of petitioner corporation.

In view of ovr opinion that the eccoumulations ef earnings end profits of petitioner for the years under review were reasonably necessary for the main- 7 tenence ant expension of its business operations, we / find it unnecessary to pass upon the questicn whether or not stock dividents ere deductible from the taxable eerninos ond profits unreasdnably accumulated under Section 25 of the Revenue Code, The decision sppeales from is reversed, without pronouncement ss to costs, . i