Central Cuba Sugar Co. v. Comm.

Decision will be entered under Rule 50.

Robert A. Littleton, Esq., for the petitioner. Walt Mandry, Esq., for the respondent.

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Respondent determined deficiencies in petitioner's income and declared value excess-profits taxes as follows:

 Fiscal year ended

(a) Is the petitioner entitled to additional deductions for interest in the fiscal years ended June 30, 1940, 1941, and 1942, in the respective amounts of 173,462.33, 160,000, and 250,339.27?

(b) Is petitioner entitled to deduct in the fiscal year ended June 30, 1942, an amount of 180,832.68 carried on its books as a "Reserve to cover storage and shipping expenses of sugar"?

(c) Did the respondent properly allocate 300,000 of petitioner's deductions for business expenses for its fiscal year ended June 30, 1943, to Central Cuba Sugar Company of Cuba under the provisions of section 45 of the Internal Revenue Code? FINDINGS OF FACT. Part of the facts are stipulated and they are so found.

The petitioner is a corporation incorporated under the laws of the State of New York on May 19, 1911. It commenced business in the Republic of Cuba on or about July 1, 1911. It adopted a fiscal accounting

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period ending June 30. It continued to transact all its business in Cuba under a registration of its charter with the Mercantile Registry, as required by the laws of Cuba, until November 14, 1942. Petitioner transferred its properties to the Central Cuba Sugar Company of Cuba on November 14, 1942, under a plan of reorganization within section 112 (g) of the Internal Revenue Code.

The property owned by petitioner during the taxable years in question consisted of land, buildings, personal property, and sugar mills in Cuba. The land owned was used for the cultivation of sugar cane and the cane grown was manufactured into raw sugar in its sugar mill properties. Petitioner transacted no business of a commercial character except in Cuba. The stockholders of petitioner were at all times citizens and residents of Cuba with the exception of a minor stock interest. All of the gross income of petitioner has at all times been derived from sources outside the United States. Because of the fact that the charter of petitioner was issued by the State of New York and the fact that it maintained a statutory office at 149 Broadway, New York City, petitioner has regularly filed corporate income tax returns in the second collection district of New York.

Issue 1. During the fiscal years of petitioner ending June 30, 1940, to and including the date November 14, 1942 (in the fiscal year ended June 30, 1943), the petitioner owed debts which arose from money it borrowed for use in its business. These debts were of two classes: (1) the balance of 3,815,334.24 evidenced by first mortgage refundable bonds of the original amount of 5,000,000, bearing interest at 5 per cent per annum, and (2) the amount of 4,886,295.19 being money loaned by J. M. Tarafa during his lifetime prior to July 1932, bearing interest at 3 per cent per annum. Tarafa, during his lifetime, was the principal stockholder of petitioner and up to the time of his death in July 1932 he owned as community property under the laws of Cuba the bonds evidencing the mortgage indebtedness of petitioner in the amount above set forth. At the time of the settlement of Tarafa's estate on July 30, 1937, the indebtedness owed to him by petitioner was transferred and assigned by the executor of his will and his surviving wife to Securities and Real Estate Company, a Cuban corporation. Prior to July 30, 1937, the stock of that corporation was owned as community property by Tarafa and his wife. During the years involved and since the death of Tarafa's wife in 1941 the stock of Securities and Real Estate Company has been owned by their children and heirs at law. Since the deaths of Tarafa and his wife the stock of petitioner and Central Cuba Sugar Company of Cuba, with the exception of a minor interest, has been owned by their children and heirs at law, who are all citizens and residents of Cuba.

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In August 1934 Cuba, acting in the exercise of its sovereign powers, declared and decreed a moratorium on debts and monetary obligations incurred and owing by its citizens and residents. By that moratorium the maturity date of all debts was fixed at June 30, 1970, and the rate of interest that could be demanded by creditors was fixed at 1 per cent of the principal of debts in excess of 800,000. The moratorium, however, was limited to debts prior to August 1934 and it was permissible under the moratorium decree laws that interest on debts could be paid by debtors at the contract rate. The provisions of the law restricting creditors could be waived if the following requirements were met: SECTION SECOND

Provisions as to waiver of the moratoriums and as to voluntary payments without waiver Article 65. * * * 1st. That it be express and subsequent to its promulgation.

2d. That it be made in writing, in a form which is prima facie evidence in court.

3d. That it be of a general character. This requirement shall be deemed to be complied with in either of these cases: a) If the waiver comprises all the obligations subject to moratorium which may be enforced against the debtor. b) When it extends to all the benefits of this law in connection with specified properties of the person making the waiver. 4th. That it does not prejudice the rights of a third party.

Provision for tacit waiver of rights under the law was provided by Article 67 of Decree Law 412 as follows:

Article 67. The tacit waiver of the benefits of this law which is presumed from the making of voluntary payments shall be understood as limited exclusively to the amounts paid in excess of those demandable, which, if the debtor shall so require at any time during the life of this law, shall be considered as advance instalments on account of the unavoidable payments which in future must be made in accordance with its provisions.

On June 4, 1940, the Constitutional Convention of Cuba adopted transitory provisions and rules for the "liquidation" of the moratorium laws of Cuba and/or debts for which demand was suspended. The rules adopted were designed to eliminate the lethargy that existed under the moratorium laws of August 1934 for the liquidation of debts. After the rules adopted by the Convention were sustained as valid by the Supreme Court of Cuba, the Ministry of Justice promulgated regulations to carry into effect such transitory rules for the final renegotiation of agreements relating to debt obligations providing for the payment of interest.

The applicable provision of Decree Law 594 of October 16, 1934, supplementing and regulating Decree Law 412, is as follows:

Article 81. In obedience to section 2 of Article 65 of the Law, the waiver of the benefits derived from the Law can be made only by means of an instrument executed before a Notary Public; and for the purposes of section 4, it shall be

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efficacious only after it has been published by means of a notice inserted in the Official Gazette of the Republic, although without prejudice, in any case, to the judgments rendered judicially by reason of the controversies authorized by section f) of Article 90 of said Law, for impugning their efficacy or scope.

The applicable provisions of the Transitory Provisions of the Constitution, liquidating the moratorium, are as follows:

Second: All interest in arrears that is due when this Transitory Provision becomes effective, as well as any amounts due for commissions, costs, fines, or other penalties, and similar items, even though said interest or amounts have been capitalized, shall be uncollectible; but from its effective date the obligations in question shall bear interest according to the amount of principal, payable as determined by Decree-Laws 412 and 594 of 1934, and in accordance with the rate resulting for each one from application of the following scale: * * * and, finally, when it exceeds 800,000, the obligation in question shall bear interest at 1% per annum. The provisions of the present Rule shall be applied to the obligations referred to in the initial paragraph of this Transitory Provision, whether or not they bear interest, whether the interest is agreed or legal, and regardless of what the agreed rate is, if there is one. * * * *

Fifth: As a supplement to what is established in the foregoing four Rules, the provisions of Decree-Laws 412 and 594 of 1934, as modified by the Sugar Coordination Law of September 3, 1937, shall be applied, but without altering what is established in said Rules and without prejudice to the provisions of the Law of July 10, 1939.

During each of its fiscal years ended June 30, 1940 and 1941, petitioner accrued and reported a deduction for interest payable in the amount of 87,016.29. Thereafter from December 4, 1941, to May 11, 1942, petitioner made payments on the principal of its indebtedness in the amount of 160,000. On May 28, 1942, petitioner made another payment of 430,000 of which amount 86,086.98 was credited to interest for the year ended June 30, 1942, and the balance of 343,913.02 was credited to principal of its indebtedness. Hence, as of May 28, 1942, petitioner had made payments of interest in its taxable years 1940, 1941, and 1942 in the total amount of 260,119.59, and payments on principal in the total amount of 503,913.02.

Subsequently, on June 29, 1942, petitioner entered into a contract with its creditor, Securities and Real Estate Company, whereby the previous payments of principal were then stated to be payments of interest and were reallocated as interest to its taxable years ended June 30, 1940, 1941, and 1942 in the following manner: 92,644.44 was reapplied as an additional payment of interest for the year ended June 30, 1940; 160,000 was reapplied as additional interest for the year ended June 30, 1941; and 251,268.98 was reallocated as additional interest for the petitioner's taxable year ended June 30, 1942. The purport of that contract, therefore, was to increase the petitioner's original deduction for interest by 503,913.02 and decrease its previous payments on principal by the same amount.

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To summarize, the amounts paid as interest, the amounts reallocated from principal to interest, the total amounts now claimed by petitioner, the amounts allowed and disallowed by respondent for the fiscal years involved, are as follows:

                                      1940           1941          1942

Issue 2. During the fiscal year ended June 30, 1942, petitioner claimed deductions in the total amount of 180,832.68 for the following items:

 Storage of raw sugar                                             $ 126,828.42

The amount of 180,832.68 which petitioner claimed as a deduction was designated on its books of account as a "Reserve to cover storage and shipping expenses of sugar." Of the claimed deduction the respondent disallowed the sum of 173,211.20. At the end of fiscal 1942 there was a fixed obligation of petitioner to pay only the amount of 7,621.48.

Issue 3. For the period July 1 to November 14, 1942, petitioner was engaged in the regular and ordinary business that it had engaged in since July 1, 1911. During the time from July 1 to November 14,

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1942, petitioner received gross income from the final liquidation and sales of sugar made during the fiscal year ended June 30, 1942, in the amount of 52,531.37. In the ordinary and necessary course of its business it incurred and accrued expenses in the period July 1-November 14, 1942, in the amount of 311,182.

On November 14, 1942, petitioner transferred all of its property, business and assets to a company of the same name organized under the laws of Cuba. In connection with that reorganization petitioner requested of respondent a ruling under the provisions of section 112 (i), Internal Revenue Code, to the effect that the proposed transaction described hereinafter is not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes. The respondent replied in part as follows:

As to the reasons for the proposed transaction, you refer to the provisions of Section Second, Title VI, Article 90 of the Constitution of Cuba, in force since October 10, 1940 That Section provides as follows:

"The acquisition and possession of land by foreign persons and companies shall be restrictively limited by law, which shall provide measures tending to restore the land to Cubans."

It is apparently your opinion that under the above-quoted provisions of the Constitution, any lands owned by corporations, as well as individuals, will be expropriated. * * * *

Based on the facts and circumstances set forth in the application for a ruling, together with the supporting exhibits, it is the opinion of this office that the proposed transaction described above is not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes within the meaning of section 112 (i) of the Internal Revenue Code.

The transfer on November 14, 1942, was pursuant to a plan of reorganization as provided by section 112 (g), Internal Revenue Code. The consideration which petitioner received for the transfer of its business, property and assets to the Cuban company was the assumption of debts unpaid at November 14, 1942, together with preferred and common stock of the Cuban company. The stock so received by petitioner was then exchanged for the shares of stock of petitioner, so that, when the transfers and exchanges provided for in the plan of reorganization were completed on November 14, 1942, the persons who were former stockholders of petitioner became the stockholders of the Cuban company.

In the return filed by petitioner for its fiscal period June 30, 1943, it reported the gross income received and expenses incurred, accrued and/or paid for the period from July 1 to November 14, 1942, which figures are above set forth. This resulted in the computation of a net loss of 258,650.63 and petitioner claimed this amount as a carry-back credit allowable as a deduction for the fiscal year ended June 30, 1942, under the provisions of sections 122 (b) (1) and 23 (s) of the Code.

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The respondent allocated 300,000 of petitioner's deduction for business expenses for its fiscal year ended June 30, 1943, to Central Cuba Sugar Company of Cuba under the provisions of section 45 of the Code. OPINION

We believe that respondent's determination must be sustained in so far as he disallowed the increased deductions claimed by petitioner for interest paid. Petitioner based such increase upon a contract of June 29, 1942, by which it agreed with its creditor, whose stockholders were the same as petitioner's, that payments previously made on principal should all be allocated to interest and prorated back over the years 1940, 1941, and 1942, in the amounts shown in our findings.

With respect to petitioner's fiscal years ending June 30, 1940, and 1941, it paid interest at the rate of 1 per cent in the amounts of 87,016.29 in each year. Throughout 1940 and 1941 there was in effect the Cuban moratorium law limiting petitioner's liability for interest payments to a maximum of 1 per cent. At the end of those years petitioner had made no attempt to waive the provisions of the law. It was not until June 29, 1942, that petitioner purported to waive its rights and pay interest at the contract rate. It does not contend and indeed we do not believe it could properly do so under the facts here, that its original method of deducting accrued interest for fiscal 1940 and 1941 was incorrect or improper under the taxing statute.

The facts of Security Flour Mills Co. v. Commissioner, 321 U.S. 281, are parallel here. The Supreme Court in that case pointed out the rationale of the annual basis of returns of income and then added:

This legal principle has often been stated and applied. The uniform result has been denial both to government and to taxpayer of the privilege of allocating income or outgo to a year other than the year of actual receipt or payment, or, applying the accrual basis, the year in which the right to receive, or the obligation to pay, has become final and definite in amount.

So here, assuming the validity of the contract of June 29, 1942, of providing for the adjustment of interest payments, it is clear that the obligation to pay any increased interest over and above the 1 per cent limit provided by the laws of Cuba did not become fixed until June 29, 1942. Hence petitioner's right to an increased deduction for interest, if it ever existed, did not become final for accrual purposes prior to June 29, 1942. In view of what the Supreme Court said in Security Flour Mills Co. v. Commissioner, supra, we do not believe that petitioner should be permitted to reopen its taxable years 1940 and 1941 for the purpose of adjusting interest deductions. We so hold. See Baltimore Transfer Co. of Baltimore City, 8 T. C. 1, 9.

As to the claimed deduction for interest in the amount of 337,355.56 for the taxable year ended June 30, 1942, we do not believe that under

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the facts here an obligation for the payment of such amount of interest arose from the purported contract of June 29, 1942.

As indicated in our findings, on May 28, 1942, petitioner made a payment of 430,000 to its creditor. At that time it was agreed that 343,913.02 of that amount was to be a payment on principal and the rest of the payment in the amount of 86,086.98 was to be for interest. Thereafter on June 29, 1942, the purported contract above mentioned was entered into. The contract admittedly was entered into solely to reduce petitioner's income tax liability for the years in question. It is clearly shown by the language of the contract that it was motivated solely by a tax-saving scheme. It applied only to the fiscal years between July 1, 1939, and June 30, 1942. It is apparent that subsequent to that time there was to be a resumption of paying only at the rate of 1 per cent. There was no legitimate business purpose for the contract. The stock of petitioner and the creditor corporation were owned by the same people. The very nature of the contract indicates that it was not one that would have been entered into by parties negotiating at arm's length. Petitioner received no consideration for consummating it. We believe that the contract, therefore, was nothing more than a sham, the type of which has been consistently rejected by the courts in determining Federal income tax liability.

What we said in Granberg Equipment, Inc., 11 T. C. 704, 714, 715, is applicable here:

Not only the steps leading to the execution of the agreement, but the agreement itself, demonstrates that all were incidents of an artificial maneuver to avoid taxes. Few provisions protecting petitioner's interests were included, whereas an inordinately high minimum royalty was established. On its face it appears to be an agreement that parties dealing at arm's length would not have formulated. "Surely, [the royalty] is not an ordinary and necessary business expense of carrying on petitioner's trade or business. Except for the close relationship of the parties, it seems hardly conceivable that such an agreement would ever have been entered into." Eskimo Pie Corporation, 4 T C. 669, 677; affd. (CCA-3), 153 Fed. (2d) 301.

We have carefully examined the cases cited by the petitioner on this point and find that they are not applicable to the situation here.

This brings us to respondent's determination that petitioner's deduction for interest for the fiscal year ended June 30, 1940, should be reduced from 87,016.29 to 6,198.40 for the reason that

* * * the Transitory Provisions, effective June 4, 1940, cancelled interest prior to that date, hence, the only interest accruable or deductible by the petitioner for the year ended June 30, 1940, was the interest at 1% from June 4 to June 30, 1940, namely, 6,198.40. * * *

We do not agree with respondent's interpretation of the decree law. Article 67 of Decree Law 412, set forth in our findings, provides that the tacit waiver of the benefits of that law should be presumed from

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the making of voluntary payments. We think that petitioner's voluntary payment of 87,016.29 for the year 1940 did waive any rights it had under the various laws of Cuba. Therefore petitioner properly deducted the amount of 87,016.29 for interest in its fiscal year ended June 30, 1940.

Issue 2. The respondent has also disallowed for petitioner's fiscal year ended June 30, 1942, 173,211.20 of a claimed deduction of 180,832.68, which was designated on petitioner's books as a "Reserve to cover storage and shipping expenses of sugar." The various items making up the claimed total of 180,832.68 are set forth in our findings.

The respondent supports his determination by arguing that although petitioner had sold its entire sugar production by June 30, 1942, still not all of it had been shipped by that date and the sugar then on hand was shipped at various times during the following fiscal year. The respondent adds that since in connection with the sugar not shipped by June 30, 1942, the petitioner was required to keep the sugar in storage and incur other expenses including mending of bags, sampling, polarizing, and commissions, neither the liability nor the amount of such expenses was definite and fixed until after the close of the fiscal year 1942. We agree with respondent's position.

In Dixie Pine Products Co. v. Commissioner, 320 U.S. 516, the Supreme Court stated in part as follows:

* * * It has long been held that, in order truly to reflect the income of a given year, all the events must occur in that year which fix the amount and the fact of the taxpayer's liability for items of indebtedness deducted though not paid; * * *.

Here, obviously since the storage and other charges could not have been incurred until a subsequent fiscal year, the fact of petitioner's liability did not occur in fiscal 1942. We therefore hold that petitioner is entitled to deduct only the amount of 7,621.48 allowed by respondent in its year ended June 30, 1942. See Capital Warehouse Co., 9 T. C. 966.

Issue 3. The petitioner, as indicated above, transferred its assets and business to a Cuban corporation on November 14, 1942, under a plan of reorganization approved by the Commissioner in 1942 as one not motivated solely as a tax-saving device. See section 112 (i) of the Code. In its return filed for the fiscal year ended June 30, 1943, petitioner reported gross income of 52,531.37 and expenses of 311,182, which resulted in a reported net loss for fiscal 1943 of 258,650.63. Petitioner seeks to carry back such loss to the fiscal year 1942 as a net operating loss deduction. See sections 122 (b) (1) and 23 (s) of the Code. The respondent has determined that petitioner may not do so, stating "In order to clearly reflect petitioner's net income for the fiscal year ended June 30, 1943, 300,000 of its deductions

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for expenses should be allocated to its successor corporation under the provisions of section 45 of the Internal Revenue Code."

We do not agree with the respondent's determination. He points out that an independent taxpayer in the same position as petitioner would not have transferred its business at the very time when it was on the verge of reaping the income to which it was entitled by virtue of its expenditures without receiving some adequate consideration and that the selection of the date of the transfer was solely for tax purposes. So far as the adequate consideration argument is concerned respondent apparently ignores the fact that on November 14, 1942, there was an exchange of the property and business of petitioner for the assumption by the Cuban corporation of its debts plus its common and preferred stock. Respondent's argument also fails to recognize that the transfer of property on the date in question was not motivated primarily by a tax-saving scheme; instead it was a transaction carried out because the officials of the petitioner felt that under a provision of the Constitution of Cuba its property could be expropriated. The petitioner did not know until July 17, 1942, that the transaction had the approval of the respondent for tax purposes. On that date the respondent stated in a letter that in his opinion the plan in question was not one having as its principal purpose the avoidance of Federal income taxes within the meaning of section 112 (i) of the Internal Revenue Code. Certainly, the lapse of time between that ruling of the respondent on July 17, 1942, and the transfer of the property and the business to the Cuban corporation on November 14, 1942, was not unreasonable. We therefore think that what we said in Seminole Flavor Co., 4 T. C. 1215, 1235, is applicable here:

Actually, the principal force behind all of the Commissioner's argument is that the petitioner could as well have done all the things that the partnership did and reaped all of the earnings of the related enterprises. Since petitioner could have had the earnings, the Commissioner would make it so by exercising the authority conferred by section 45. The same type of argument was made in the Koppers case, supra, [2 T. C. 152] which rejected the argument in language equally apt to the present contention, due allowance being made for factual differences, * * *.

We stated as follows in Koppers Co., 2 T. C. 152, 158:

The answer, however, to this argument is that petitioner did not do this. It was free to and did use its funds for its own purposes. It was under no obligation to so arrange its affairs and those of its subsidiary as to result in a maximum tax burden. On the other hand it had a clear right by such a real transaction to reduce that burden. [Citing Helvering v. Gregory, 293 U.S. 465, and other cases.]

We believe that under the circumstances of this case, where a sound reason not primarily related to tax saving was the motivating force

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of the transaction in question, the respondent should not be permitted, under the guise of section 45, to allocate certain of the expenses of the petitioner to the Cuban corporation. Miles Conley Co., 10 T. C. 754, 762, 763. The carry-back is therefore to be allowed.

Petitioner also raised an issue which appears to be germane to all of the questions involved. In its brief in concluding its argument on this contention petitioner states:

2. And, unless the laws of the United States grant to petitioner the benefits claimed in the computation of net income subject to tax -- the taxing powers of the United States may not legitimately be exercised against petitioner in the manner proposed.

In its discussion leading to this conclusion petitioner, among other things, contends that it is not a "citizen" of the United States within the meaning of Article IV, Section 2, Clause 1 of the Constitution of the United States. Therefore, it adds, the United States renders no protection to petitioner with respect to the property it owns and/or the business carried on in the Republic of Cuba for which it can ask a return in the form of taxes.

The argument is vague and unconvincing. Perhaps this is the reason why the respondent failed to answer it on brief. Certainly the petitioner being incorporated under the laws of the State of New York and not falling within the class of exempt corporations provided for in the Code, can not claim that its income is not subject to tax. See sections 52, 54 (f), and 13 of the Code. And in deciding the issues involved here we have given to petitioner the benefits under the taxing statutes in accordance with what we believe to be a proper interpretation of the law. We therefore hold against petitioner on this contention.

Decision will be entered under Rule 50.