3 T.C. 95">*95 The Commissioner determined deficiencies of $ 7,588.69 in corporation income tax and $ 2,196.12 in declared value excess profits tax for the fiscal year ending September 30, 1940. Certain minor concessions have altered the amounts in controversy to $ 6,940.15 and $ 2,415.73, respectively. These deficiencies resulted from 1944 U.S. Tax Ct. LEXIS 216">*217 a disallowance by the Commissioner of a claimed deduction of $ 40,000 for interest paid by the petitioner on certain securities issued in exchange for part of its stock. The sole question is whether this amount was properly deductible as interest within the meaning of section 23 (b) of the Internal Revenue Code.

FINDINGS OF FACT.

The essential facts, most of which are stipulated and are hereby found accordingly, are as follows:

The petitioner, a Massachusetts corporation with principal offices in North Billerica, filed its return for the fiscal year in question with the collector for the district of Massachusetts. Prior to the transactions out of which arose the present controversy the petitioner had outstanding as its total capital stock 5,000 shares of common stock, par value $ 100. This stock was held on September 30, 1939, by 15 stockholders who, with the exception of one holder of 10 qualifying 3 T.C. 95">*96 shares, were all members of the Talbot family by descent or marriage, or were trusts created by such members.

For several years the company had been gradually losing money and in 1937 there was some discussion among the stockholders as to liquidation. However, upon the basis1944 U.S. Tax Ct. LEXIS 216">*218 of a proposed renovation of plant and personnel, plus a possible recapitalization, they decided to continue the business. On May 8, 1939, by corporate resolution, the treasurer was authorized "to retain counsel to examine the capital structure of the company with the view to seeing if any modification can be made in same to the advantage of the company." On September 14, 1939, a plan of reorganization was submitted to the directors and adopted by them. The stockholders gave their unanimous approval on September 29, 1939. The tax advantage was one of the motivating facts in the adoption of this plan.

In pursuance of the plan each holder surrendered four-fifths of his stock, which was duly retired by the corporation and the capital stock accordingly reduced. In return for the stock so surrendered the petitioner issued "registered notes" in aggregate face values equal to the aggregate par value of the stock retired. The total amount of the notes issued was thus $ 400,000.

The notes are voluminous and complex. Maturity is set for December 1, 1964, slightly more than 25 years from the date of issue. They provide for annual interest payable on December 1 of each year, but payment1944 U.S. Tax Ct. LEXIS 216">*219 of interest may be deferred by vote of the board of directors for such time as they "may in good faith determine to be necessary by reason of the condition of the corporation * * * provided that such suspension of payment shall in no wise relieve the corporation of the obligation to pay the amount suspended at some future time and shall in no event operate to defer payment beyond December 1, 1964."

The rate of interest was provided as follows: "Interest hereon shall be payable annually * * * at a rate which shall not exceed 10 per cent nor be less than 2 per cent and, subject to these limitations, shall be a rate computed as follows: There shall be taken a sum equal to two-thirds (2/3ds) of the net earnings of the corporation for the fiscal year ended last previous to such December 1, computed in accordance with the regular bookkeeping methods and practices of the corporation as established from time to time in good faith by its directors and officers but without deduction for federal income taxes paid or accrued and without deduction for interest upon these notes, and the rate of interest shall be the rate, figured to the nearest one-quarter (1/4%) which such sum would represent 1944 U.S. Tax Ct. LEXIS 216">*220 as interest upon an assumed principal sum of Four Hundred Thousand ($ 400,000) Dollars. Provided, nevertheless, that from and after the close of the fiscal year ended next previous to December 1, 1964, and for such further time as this note shall remain unpaid, interest shall be at the rate of six 3 T.C. 95">*97 per cent (6%) per annum, and such interest to December 1, 1964 shall be included in the installment payable at that date."

The notes further provided that no dividends were to be paid on any shares of stock until all then due interest on the notes was satisfied. In the event of bankruptcy, receivership, dissolution, or liquidation, the principal and interest were to become immediately due, with interest at the rate of 6 percent from the close of the preceding fiscal year.

No mortgage of the real estate of the corporation or of its machinery or equipment to secure an obligation maturing after December 1, 1964, other than a purchase money mortgage, could be made while the notes were outstanding without the consent of the holders of three-fifths in interest of the notes. Power to subordinate to any obligation maturing not later than December 1, 1964, was vested in the directors, 1944 U.S. Tax Ct. LEXIS 216">*221 such subordination to impose upon the holders no personal liability other than a liability to deliver to the unsatisfied creditors any sums or securities paid to the holder in connection with any reorganization, or in any substitution of the notes. The corporation might at any time pay and retire the notes at par plus accrued interest, except as otherwise provided in any subordination agreement. There then followed this provision:

* * * With the written consent of the corporation and of the holders of three-fifths (3/5ths) in amount of the total amount of these notes at the time outstanding, filed with the corporation, any of the terms and provisions of this series of notes may be altered or amended so as to bind the corporation and every holder, whether consenting or not, provided that no such change shall: (a) extend the date for the maturity of the principal of the notes; (b) alter the rate of interest or the method of computing the rate of interest, except in so far as required for an adjustment to a changed fiscal year as above; (c) diminish the principal amount payable at maturity or the amount to be paid upon any earlier payment as above provided; or (d) vacate or diminish1944 U.S. Tax Ct. LEXIS 216">*222 the effect of any subordination previously voted and in force.

The notes were transferable by endorsement on an attached form, which was required to be authenticated by the clerk of the corporation. In the following years some few notes totaling $ 6,800 were transferred, but always within the close family circle.

Shortly after the adoption of this plan, the notes were subordinated, by vote of the board of directors, to three loans. Two banks to which the taxpayer was indebted in the amount of $ 100,000 required, as a condition of their forbearing to demand payment, the execution of a formal agreement of subordination as to both principal and interest. On October 10, 1939, the subordination was voted, and on the same date the required agreement was executed. This agreement covered all existing and future indebtedness, and provided that:

So long as any part of the Bank Indebtedness shall remain unsatisfied, the Noteholders will not, without the prior written consent of each of the Banks, 3 T.C. 95">*98 demand, accept or receive from the Mills any payment of principal of or interest on or any collateral or other security for the Notes held by them respectively, or any other notes or obligations1944 U.S. Tax Ct. LEXIS 216">*223 in renewal of or in substitution therefor, except, pursuant to the exchange provisions contained in the Notes, another Note of the same tenor, and the Mills will not, without such written consent, pay any amount on account of the principal of or interest on, or give any collateral or other security for, any of the Notes, or give any other Notes or obligations in renewal thereof or in substitution therefor, except as aforesaid, to any Noteholders.

In the event of any petition in bankruptcy being brought by or against the Mills, and in the event of any other proceedings for the liquidation of the Mills, either by its voluntary action or otherwise, the Noteholders will assign and pay over to the Banks, ratably in proportion to the amount of the Bank Indebtedness owed to them respectively, to the extent necessary to satisfy the Bank Indebtedness in full, any and all distributions and payments in respect of the Notes to which the Noteholders would be entitled in any such proceedings.

This agreement further provided that, in the event of any reorganization or composition, any payment to the noteholders should be paid over to the banks, to be applied to the indebtedness, and any securities1944 U.S. Tax Ct. LEXIS 216">*224 or property so delivered to the banks should be held by them subject to the subordination. No personal liability other than the above was imposed on the noteholders.

On the same date the notes were also subordinated, as to principal and interest, to a $ 100,000 machinery loan and to a further $ 30,000 indebtedness to one of the banks. All of these subordinations have since been terminated by payment of the obligations.

On November 27, 1940, the petitioner's treasurer reported that:

* * * he had ascertained and fixed at 10 per cent the rate of interest applicable to the registered notes of this Corporation for and on account of the fiscal year ended September 28, 1940, such rate of 10 per cent being a rate less than that computable with reference to the net earnings of said fiscal year under the terms of said notes and being the maximum rate provided by the terms of said notes.

The report was forthwith accepted and approved. The directors then voted to defer the payment of three-fourths of the interest which would otherwise be payable on December 1, 1940. On March 25, 1941, this deferment was partially terminated, and on September 15, 1941, was wholly terminated, so that in three1944 U.S. Tax Ct. LEXIS 216">*225 installments over the course of the fiscal year the total of $ 40,000 was disbursed. It is the deduction of this amount which the respondent contests.

OPINION.

The facts presented raise the narrow question as to whether or not the acts of the taxpayer have been sufficient to give rise to an indebtedness within the ambit of section 23 (b) of the Internal Revenue Code. If so, then the payments made as interest are deductible as such; if not, then they must be considered in fact dividends, hence not deductible.

3 T.C. 95">*99 Precedent provides no ready test. The question is factual, and no one factor may be said to be controlling. Commissioner v. Schmoll Fils Associated, Inc., 110 Fed. (2d) 611. "The determining factors are usually listed as the name given to the certificates, the presence or absence of maturity date, the source of the payments, the right to enforce the payment of principal and interest, participation in management, status equal to or inferior to that of regular corporate creditors, and intent of the parties." John Kelley Co., 1 T.C. 457.

Numerous cases are cited by petitioner which bear upon, but do not1944 U.S. Tax Ct. LEXIS 216">*226 decide the question. Especially relied upon is Commissioner v. O. P. P. Holding Corporation, 76 Fed. (2d) 11. In that case a corporation, in part payment for the entire capital stock of another corporation, issued debenture bonds maturing in 25 years, unless extended by a two-thirds vote of the holders, bearing interest at 8 percent, with provisions for the subordination of principal and deferment of interest. The deferment was not, however, to relieve the corporation of the ultimate obligation to pay. The securities were held to evidence an indebtedness, and payments made as interest thereon were properly deductible. But these securities lacked the variable rate of interest computed with reference to profits that is a prominent feature of the present notes; and, further, they were not, as here, issued in exchange for stock of the issuing corporation.

In John Kelley Co., supra, there was present the exchange feature. There the petitioner, a closely held corporation, issued maturing, 8 percent "income debenture bonds" in exchange for outstanding preferred stock, the excess after exchanges to be sold at face value1944 U.S. Tax Ct. LEXIS 216">*227 to the shareholders. The interest was to be paid "out of income," and there was provision for suit for enforcing payment of principal and interest in case of default. This Court held that the transactions gave rise to a valid indebtedness, and the deduction of interest payments was allowed. Here again there are distinctions. In John Kelley Co., supra, there was a flat rate of interest, though payable out of income, as contrasted with the variable, profit-determined rate of the Talbot notes; the interest payments were due whenever the net income was sufficient, with provision for suit in case of default in punctual payment, whereas in the instant case the payment of interest might be deferred, though the net income was sufficient, for such time as the directors might see fit; and debentures remaining after the exchange were issued on subscription to the stockholders, whereas this transaction was exclusively an exchange.

In Kena, Inc., 44 B. T. A. 217, a substantially similar interest provision was considered, and this Court, holding for the taxpayer, said: "It is not essential that interest be computed at a stated rate, 1944 U.S. Tax Ct. LEXIS 216">*228 but only that a sum definitely ascertainable shall be paid for the use of borrowed 3 T.C. 95">*100 money, pursuant to the agreement of the lender and the borrower." Nor is the deferability of interest payments at the option of the corporation fatal, standing alone. Commissioner v. O. P. P. Holding Co., supra.

It is the cumulation of these various restrictive features that tends to cast doubt on the real nature of the instant transaction. In this state of affairs reference must be had to the circumstances surrounding the issuance, to determine the intent of the parties. See Commissioner v. Proctor Shop, Inc., 82 Fed. (2d) 792, where it is stated, in the words of the United States Board of Tax Appeals, "In each case it must be determined whether the real transaction was that of an investment in the corporation or a loan to it. * * * The real intention of the parties is to be sought and in order to establish it evidence aliunde the contract is admissible."

The factor of tax avoidance loomed large in the minds of the parties, by their own admission, and indeed it appears to have been the only substantial purpose motivating1944 U.S. Tax Ct. LEXIS 216">*229 the transaction. It was stated in testimony that there were also the advantages of a reduction in equity control, enabling a concentration of control to effect a stable management and the providing of a form of investment which would be negotiable and more readily salable. As to the first, it is difficult to see how a pro rata reduction of capital stock would facilitate concentrated control, nor did it in fact change the control. Each shareholder retained the precise voice in the management which he had prior to the transaction. He retained the same right to participate in the profits of the business; what he did not receive by way of interest he would take by way of dividends on his remaining stock. As to negotiability, only a very slight fraction of the notes has actually been severed from stockholdings, and this all within the close family circle. It is questionable how much more salable than the original stock the restricted, subordinated, deferable notes would have been.

In the light of these facts, it appears that what the parties really intended to create was a security retaining the profit-sharing advantage of stock, leaving intact their voice in the management, but 1944 U.S. Tax Ct. LEXIS 216">*230 extending a tax advantage to the corporation not possible in stock. This would seem to create no proper indebtedness. This being so, the 2 percent minimum provision of the note will stand upon no better footing than the whole.

In view of the foregoing, it is our conclusion that the "registered notes" were more in the nature of a capital investment than a loan to the corporation, and payments made as "interest" are not deductible under section 23 (b) of the Internal Revenue Code.

Decision will be entered under Rule 50.