NOTE 1-OPERATING-DIFFERENTIAL SUBSIDY AGREEMENT, Grace Line operates under an operating-differential subsidy agreement with the Federal Maritime Board. Certain aspects of the agreement relating to the amount of subsidy, recapture of subsidy, and reserve funds required to be maintained by Grace Line are explained in this Circular under the caption "Operating-Differential Subsidy Agreement".

NOTE 2-OPERATING-DIFFERENTIAL SUBSIDY,

Reference is made to "Amount of Subsidy" and "Service" under "Operating-Differential Subsidy Agreement”. Operating-differential subsidy has been accrued on the basis of final rates established by the Federal Maritime Board for 1955 and prior years, except for subsidy on protection and indemnity insurance for the year 1955 which has been accrued on an estimated basis. Subsidy for 1956 and 1957 has been accrued at estimated rates. The management of Grace Line is of the opinion that the amount of subsidy, when finally determined, will not be less than the amount accrued.

Subsidy receivable of $8,461,783 includes $747,602 applicable to voyages in progress at the year end, and approximately $5,800,000, which is not payable to Grace Line until final audit of Grace Line's accounts by the Maritime Administration (see below), and consequently may not be received during the current year (see Note 6). The audits for the years through 1950 have been substantially completed. Certain minor adjustments arising from these audits and any adjustments which may be proposed in connection with audits of later years will have an effect upon recapture and federal income taxes but the management of Grace Line is of the opinion that any adjustments required will not have a material effect on the consolidated financial position.

NOTE 3 RECAPTURE OF OPERATING-DIFFERENTIAL SUBSIDY, Reference is made to "Recapture" under "OperatingDifferential Subsidy Agreement".

For the recapture period ended December 31, 1947, the recapture liability is estimated to be $179,742 and is payable from the special reserve fund as shown in the accompanying balance sheet. Estimated recapture for the ten-year period ended December 31, 1957 amounting to $19,072,205 has been withheld from subsidy payments by the Maritime Administration. Accordingly, this estimated recapture liability and the related subsidy receivable withheld have not been included in the accompanying balance sheet.

NOTE 4-STATUTORY RESERVE FUNDS,

Reference is made to "Reserve Funds" and "Tax-Free Aspects of Reserve Funds" under "Operating-Differential Subsidy Agreement".

At December 31, 1957 the capital and special reserve funds comprise cash and U. S. Government securities,

having an amortized cost of $17,519,290 which approximated market value. The capital reserve fund balance also includes $68,693 representing accrued interest receivable on the securities in the funds.

Estimated deposits of $5,197,226 to be made in reserve funds at December 31, 1957 consist of $5,361,938 to be deposited in the special reserve fund less $164,712 to be withdrawn from the capital reserve fund to reimburse general funds for expenditures on vessel improvements.

The deposits to be made in the special reserve fund include $4,132,598 representing accrued deposits for prior years including adjustments resulting from redeterminations of deposit requirements for such years, the balance representing that portion of the mandatory deposit of earnings from subsidized operations for the year 1957 which had not been deposited by December 31, 1957. Due to delays in receiving subsidy, Grace Line is permitted to postpone part of its required deposits until subsidy is collected. At December 31, 1957 it was estimated that the full amount of the required deposit ($5,361,938) could be so postponed.

As provided in the Merchant Marine Act, 1936, as amended, and a closing agreement entered into in 1947 with the Commissioner of Internal Revenue, earnings and gains deposited in the reserve funds are not subject to federal income tax in the year earned. Such earnings and gains are inciudible in taxable income upon termination of the subsidy agreement, or, if withdrawn for general purposes, are includible in taxable income in the year of withdrawal. No provision has been made for any possible future tax liability on the approximately $18,000,000 of deposits subject to such liability since it cannot presently be determined if such taxable withdrawals will be made or if made what the amounts of the withdrawals and the resulting taxes would be. Disbursements of earnings deposited in the funds for vessel purchases or payments of vessel mortgages are not considered taxable withdrawals, but the amounts so used are not included in the depreciable cost basis of the vessels for income tax purposes. However, such exclusion for tax purposes has little effect as long as the subsidy agreement is in effect since Grace Line is required to deposit in the capital reserve fund amounts equal to depreciation on a full vessel cost basis and such deposits are deductible in computing taxable income in lieu of tax basis depreciation.

On May 14, 1958, Grace Line received permission from the Maritime Administration to transfer $7,000,000 from the special reserve fund balance of $19,487,242 deposited or to be deposited at December 31, 1957 to an identical fund under the new subsidy agreement and to simultaneously transfer this amount to the capital reserve fund to pay construction costs of the new Santa Rosa and Santa Paula. This permission was granted with the condition that Grace Line deposit a like amount in the new special reserve fund out of the proceeds of any mortgage financing Grace Line may secure in connection with the acquisition of the two new vessels. As provided in the new agreement, the balance of $12,487,242 remaining after transfer of the $7,000,000 mentioned above is to be carried forward into the new special reserve fund.

Under the subsidy agreement, Grace Line is required to carry forward the capital reserve fund balance at December 31, 1957 into an identical fund.

NOTE 5-PROPERTY AND EQUIPMENT,

Major betterments and improvements are capitalized, and maintenance and repairs of the property and equip ment are charged against income. When property is retired or otherwise disposed of, the cost and accumulated depreciation are eliminated from the accounts and any gain or loss realized is recorded in income.

Depreciation of vessels is provided for by the straightline method based on a twenty-year life expectancy from the date of delivery by the builder, less estimated salvage. Depreciation of other properties is provided for by the straight-line method for properties acquired prior to 1954, and by the sum of the years-digits method for properties acquired during and subsequent to 1954. Estimated useful lives of such properties are as follows:

Other floating equipment
Stevedoring and other equipment ..

10-20 years 3-10 years

Construction costs on new vessels include $17,725,769 expended on the construction of the new Santa Paula and Santa Rosa (see "The Santa Rosa" and "Ship Replacement Program"), and $204,588 relating to designs for vessels to be constructed in connection with the further Acet replacement program (see "Ship Replacement Program").

NOTE 6 PAYABLE TO THE MARITIME ADMINISTRATION:

Under the Merchant Marine Act, 1936, as amended, the Maritime Administration is required to withhold payment of a part of each year's subsidy until it has made final audits of Grace Line accounts (see Note 2). In 1958 it was determined that Grace Line had received, as of December 31, 1957, $3,083,931 in subsidy payments for the years 1948 through 1957 which should have been withheld under this requirement. This amount was repaid to the Maritime Administration in 1958 and is included in the $3,106,447 payable to the Maritime Administration shown as a current liability in the accompanying balance sheet. The same amount, $3,083,931, has been restored to the estimated operating-differential subsidy receivable account and is included in the $8,461,783 shown for that account in the accompanying balance sheet.

Grace Line and the Maritime Administration have settled this matter on the basis of the status of the subsidy collections to March 31, 1958. Accordingly, Grace Line repaid to the Maritime Administration $3,857,432 of which $1,773,702 representing that part of the subsidy collections deposited in the special reserve fund was repaid from that fund with the permission of the Maritime Administration. The remainder was repaid by deducting the required amount from subsidy earned and payable in 1958.

NOTE 7-FEDERAL INCOME TAXES.

For 1956 and prior years Grace Line's taxable income was included in the consolidated income tax return filed

by W. R. Grace & Co. and provisions for federal taxes on income for those years and for 1957 represent an allocated portion of the total estimated consolidated tax.

Examinations of the consolidated tax returns by the Internal Revenue Service have not been completed for 1947 and subsequent years. Revenue agents' reports have been received for 1947 and 1948 and W. R. Grace & Ca has agreed to the adjustments proposed for those years and for the year 1949 which has also been examined but for which a revenue agent's report has not been received. The effect of these adjustments is included in Grace Line's accounts. In each of these years final adjustment of taxes cannot be made until completion of audits by the Maritime Administration which will determine the adjustments to be made to the amount of subsidy and the deductions for recapture and deposit requirements originally included in the tax returns (see Note 2). Examinations of tax returns for the years 1950 and 1951 are now in process

Overpayments of federal income taxes for the years 1947 through 1955 have resuited primarily from redetermination of recapture deductions and deposit requirements in accordance with Maritime Administration regulations and directives. The estimated refunds and interest thereon aggregating $2,740,576, are shown in the balance sheet under other assets.

Reference is made to the comments included in Note 4 with regard to the tax status of earnings deposited or accrued for deposit in the reserve funds.

NOTE 8 MORTGAGE NOTES:

The mortgage notes outstanding at December 31, 1957 are payable to the Maritime Administration from the capital reserve fund as follows: $340,852 in each of the five years from 1958 to 1962, $157,543 in 1963, $153,406 in 1964 and $33,524 in 1965.

NOTE 9-RESTRICTION ON EARNINGS RETAINED IN THE
BUSINESS:

The Merchant Marine Act, 1936, as amended, limits the payment of dividends from profits of subsidized operations to 10% per annum of capital necessarily employed in the subsidized operations. For the year 1957, such employed capital is estimated to be approximately $48,700,000 The operating-differential subsidy agreement effective on January 1, 1958 imposes additional restrictions limiting cash dividends. Reference is made to "Operating-Differential Subsidy Agreement-Dividend Policy and Capital Stock".

It is estimated that $41,290,174 of the total earnings retained in the business at December 31, 1957 were not available for payment of dividends principally by reason of having been deposited or accrued for deposit into the reserve funds. See Note 4 regarding the company's right to withdraw certain amounts from the special reserve fund. Any amount so withdrawn would be subject to federal income taxes as explained in Note 4.

Reference is made to "Various Agreements by Grace Line" under "The United States Government Insured Santa Rosa Bonds" for information concerning restrictions on dividends which would be imposed in the event that Grace Line ceased to be a subsidized operator.