575 F.2d 843 | Ct. Cl. | 1978
delivered the opinion of the court:
For the years 1964 and 1965, plaintiff, Investors Diversified Services (IDS), filed consolidated income tax returns on behalf of an affiliated group of which it was the common parent. One of the members of the group was Investors Syndicate of America, Inc. (ISA), a wholly owned subsidiary of IDS. ISA was a face-amount certificate company registered under the Investment Company Act of 1940, 15 U.S.C. § 80a-28 (1970), and was subject to the banking laws of the state in which it was incorporated, Minnesota. Since its incorporation in 1940, ISA has been a financial institution engaged in the business of issuing, selling, and servicing face-amount certificates, investing in qualified assets, and making payments to certificate holders in accordance with the terms of the certificates.
Those certificates were of two types: installment and single-payment. The vast majority of the face-amount certificates issued by ISA during 1964 and 1965 were of the installment type, under which the holder made periodic payments to ISA over the number of years stated in the certificate (the periods ranged from 6 years to 22 years). Where the holder made payments in accordance with the certificate’s terms until the maturity date, ISA agreed to pay the holder, at that time, at least the face amount of the certificate, including an increment over the holder’s total payments. The increment was based upon a stated percentage figure (which could not exceed 3%%), compounded annually. ISA also issued some single-payment-type certificates, under which the holder paid ISA a lump sum which was also to mature at a stated date. Upon the maturity of the certificate, ISA agreed to pay the holder
ISA could not require a certificate holder to redeem a certificate prior to maturity. That option was vested solely in the holder. Thus, so long as the holder of an installment-type certificate complied with the terms of the certificate, ISA had no right, under the provisions of the certificate, to return his payments or otherwise discharge its obligation to him prior to maturity. Yet the holder had the right to demand at any time payment of the amount credited to his account, and ISA did not have any right to refuse payment on a certificate presented prior to maturity. A holder offering a certificate for redemption prior to maturity got the cash surrender value, as stated on the certificate, plus any applicable additional credits that may have been granted by ISA’s Board of Directors. Under the terms of the installment-type certificates having maturity dates of 15 or more years, the "cash surrender value” to the holder was less than the total payments made by the holder until after the end of the eighth certificate year. Nevertheless, at least 50% of the installment-type certificates were surrendered before the end of the eighth year. These purchasers could still have made a profit if sufficient additional credits had been granted by ISA prior to surrender of the certificate.
The certificates were sold by salesmen of the parent IDS in conjunction with the sale of unrelated mutual funds and life insurance. No effort was made by ISA to control the number or type of its certificates sold, and as many certificates were sold as was possible. Investment decisions were also, by contract, handled by IDS.
Under section 28(a) of the Investment Company Act of 1940, 15 U.S.C. § 80a-28(a) (1970), a face-amount certificate company is required to maintain at all times "minimum certificate reserves” on all of its outstanding certificates.
In order to maintain the required level of qualified investments, ISA invested its funds in a diversified portfolio. These investment funds came from sales of new certificates, payments received on installment-type certificates previously sold, and from returns on investments previously made — including dividends, interest, repayments of principal and proceeds from the sale of portfolio securities. In 1964 and 1965, approximately two-thirds of the funds available for investment came from ISA’s investment portfolio, and about one-third came from sales of new certificates and installment payments on old certificates. As the result of a specific policy and program adopted in 1954, a substantial portion of the company’s qualified investments has, since at least 1958, consisted of tax-exempt bonds. In 1964, tax-exempt bonds constituted 29.271% of ISA’s qualified investments; in 1965, these bonds formed 28.567% of its total assets. The overwhelming portion of these bonds had maturity dates of 15 or more years, and they were purchased with the intention and practice of holding them until maturity. These tax-exempt bonds, along with others of its securities, were used by ISA (under collateral security agreements) to fulfill the statutory demand that ISA maintain a reserve of qualified assets
Since IDS filed its consolidated federal income tax returns for 1964 and 1965 on the accrual basis, it deducted as interest expense both the annual increments and additional credits that had been credited on ISA’s face amount certificates during those years; this equalled the ratable part of the difference between the amounts which it received from the certificate holder, and the amount which it ultimately would pay to that holder.
Upon auditing IDS’s income tax returns for 1964 and 1965, the Internal Revenue Service determined that ISA’s interest! expenses were partially proscribed by section 265(2) of the Internal Revenue Code. That section provides for the nondeductability of interest on indebtedness incurred to purchase or carry most obligations on which the interest is exempt from federal income tax.
I
The only issue before us is whether ISA’s face-amount certificates represented indebtedness which was incurred or continued to purchase or carry the tax exempt bonds in ISA’s investment portfolio, thereby precluding, under section 265(2), see note 2, supra, a portion of the tax deductions for the annual increments and additional credits which ISA credited to the certificates during 1964 and 1965.
In applying this statute a set of general principles is commonly accepted. By direction of Congress, the deduction of interest paid on borrowed money is precluded only if the indebtedness was "incurred or continued to purchase or
II.
The Government does not directly dispute these axioms but rather asserts that here the prohibited relationship between the taxpayer’s certificates and the tax-exempt holdings can be inferred from ISA’s general intent to invest and its actual investment in exempt securities.
The question in Atlas was whether section 804 of the Life Insurance Company Income Tax Act of 1959 was unconstitutional because it placed an impermissible tax on interest earned by life insurance companies from state and municipal bonds. Section 804 requires a life insurance company to divide its investment income, including tax-exempt interest, on a pro rata basis between two accounts, one for the
To put it another way, defendant says: although the concern of Atlas was with the constitutionality of section 804 of the Life Insurance Company Income Tax Act, that issue and the reasonableness of the allocation under that Act were tested by the Supreme Court by the standard of section 265(2), as understood by the Court, and under that gauge the disputed additional deduction in Atlas would have been disallowed. Thus, according to the Government, section 804 accomplished what section 265(2) would have accomplished anyway, and the meaning given the latter was a significant factor in upholding the former provision. Defendant concludes that the Atlas language stressed above should be taken literally and broadly as the Supreme Court’s authoritative interpretation of section 265(2).
This expansive reading of the Atlas footnote as applicable to section 265(2) is not persuasive to us; it unnecessarily puts too much into the Atlas Court’s few words. Atlas was interpreting the constitutionality of an unrelated statute— section 804 of the Life Insurance Company Income Tax Act of 1959 which does not contain the "prohibited purpose” test of section 265(2). Section 265(2) is not mentioned in the Atlas footnote, and the statement now relied upon by the Government was not essential to the Court’s decision. Indeed, the only basis for the Government’s current interpretation of that footnote is that the Atlas opinion uses some of the same wording as 265(2). But the Court’s footnote 17 was wholly in reference to the constitutionality of the denial of an interest deduction
Indeed, to accept the very broad construction of the Atlas footnote advanced by defendant would require us to reject
Ill
Rejection of defendant’s reading of Atlas does not end this case, however, for we must still decide whether the prohibited purpose to purchase or carry tax exempts can be found. It is the "bank exception” (already discussed in Part II) plus the similarity of ISA to banks which provide a strong reason for our inability to see the required relationship between ISA’s indebtedness and its tax-exempt holdings. There are many comparisons between banks and face-amount certificate companies like ISA — for example, both are under the banking laws of the state of their incorporation; both are subject to an immediate and short-term demand, see Rev. Proc. 70-20, 1970-2 Cum. Bull. 499, Sec. 3.01; interference with the marketing of government securities caused by application of section 265(2) to banks might very well be equally true if this section were applied to financial institutions like ISA, Rev. Proc. 70-20, 1970-2 Cum. Bull. 499, Sec. 2.03, see note 13, supra; both institutions compete for the same savings of the general public; and both must invest money obtained from depositors/purchasers in order to secure payment of an
There are other telling grounds supporting ISA’s contention that section 265(2) is inapplicable. It is important that (a) the essential nature of ISA’s business was the borrowing of money which had to be invested in order to pay off the certificate-holders; (b) ISA would not and could not reduce this borrowing by disposing of its tax-exempts or abstaining from acquiring new ones, and (c) the sale of certificates (i.e., the borrowing) was wholly separate from and independent of ISA’s investing process and its investments, including the acquisition and maintenance of exempt securities. To take the last element first, the salesmen of ISA were encouraged to sell as many certificates as possible without regard to the type of certificate being sold or to the present or future investment policy of the company. Neither ISA nor its parent made any effort to control the number or the types of certificates being sold. The money from new certificate sales, from installment payments on old sales, and from income on previous investments was commingled for the purpose of making new investments, thus making it difficult to trace a direct connection between the proceeds from certificate operations and the acquisition or maintenance of tax-exempt bonds in the investment portfolio. Moreover, the investment operations of ISA were conducted without regard to the certificate operations. A separate (related) corporation, constituting the investment committee, surveyed the statutory range of possible investments, and purchased those securities that seemed most meritorious; tax-exempt securities were purchased when the committee determined them to be the most worthy
Also compelling is the fact that the issuance, sale and servicing of these certificates was the very essence of the business for which ISA was registered under the Investment Company Act of 1940. This is not the case of an enterprise, operating mainly on capital, which happens to borrow money for a particular purpose. In order to continue its existence, ISA had to borrow continually through the sale of these certificates. Liquidation of exempt securities, though possible, would not have relieved ISA from having to invest these borrowed funds in productive assets to meet its growing reserve requirements (which were accruing interest at the rate of 3%% compounded annually) and to assure its own profitability. Continual investment was therefore a business necessity. Were ISA statutorily prohibited from holding any tax-exempt securities, its indebtedness and investment decisions would be made in the same manner as was done here.
It is equally significant that ISA was unable to reduce or affect its indebtedness through disposition of its tax-exempt holdings. Such a sale (though it could be accomplished) would not affect ISA’s indebtedness since its certificate holders alone had the power to terminate or reduce its indebtedness. This inability to affect the amount of its indebtedness supports our view that the relationship between the certificates (representing the indebtedness) and the tax-exempts is too remote for section 265(2) to apply. Cf. Illinois Terminal R.R. v. United States, 179 Ct. Cl. at 683, 375 F.2d at 1021, (power of taxpayer to liquidate bondholdings and use proceeds to reduce debt without adversely affecting working capital held to be significant factor warranting applicability of section 265(2)); Israelson v. United States, 367 F. Supp. at 1107 (ability to avoid borrowing by sale of exempt securities main reason for applying section 265(2)); Rev. Proc. 72-18, 1972-1 Cum. Bull. 740, Sec. 4.04 (individual taxpayer may rebut presumption that section 265(2) applies when holding exempt securities which are not directly connected with personal expenditures or with the active conduct of a trade or business by establishing he could not have liquidated his
True, the fact still remains that ISA, while enjoying a substantial amount of tax-exempt income, deducted all of its accruals of payments to the certificate holders — and the Supreme Court has said that "the tax laws may require tax-exempt income to pay its way,” United States v. Atlas Ins. Co., 381 U.S. at 247. But, as we have already indicated and the "bank exception” proves directly, Congress did not, in section 265(2), go all the way to implement that principle — as it did in the insurance statute involved in Atlas, or it could have done here by providing for automatic allocation.
IV
Defendant emphasizes a number of factors (in addition to those already touched on), but we think that none of them, individually or together, outweighs the considerations we have discussed in Part III, supra. One such element pressed by the Government is a sentence in ISA’s prospectus mentioning state and municipal government bonds (along with other solid securities). Beginning in 1947 and continuing through 1963, the prospectuses filed with the S.E.C. stated that, "The Company has invested, and presently expects to continue its investments, in a portfolio consisting of [a listing including inter alia] * * * state and municipal government bonds.” (In the prospectuses for years after 1963, the words "and presently expects to continue its investments” were deleted). We consider this statement as no more than a normal indication to prospective certificate purchasers that ISA would invest their money in sound and "blue chip” securities — and not as any sort of undertaking to use tax-exempts (in preference to other solid investments).
Another facet of the case stressed by the Government is that in 1954 ISA adopted a specific policy and program for the expansion of its investments and holdings in tax exempts, as compared with its other investments. From 1960 through 1973, year-end holdings of tax exempts ranged from 23%% (1970) to 33%% (1960) of total assets. (In 1964 and 1965 — the tax years involved here — the percentages were 29.11 and 28.20).
In particular, we do not find it crucial that, from 1954 on, ISA knew that it would acquire a substantial amount of tax-exempts each year. Such a course of conduct might be important in some cases to show the required nexus,
Finally, defendant considers it weighty that ISA placed its tax-exempts (along with its other qualified investments) as collateral securing the face-amount certificate indebtedness. This was required by the Investment Company Act of 1940 to protect the certificate holders.
V
For these reasons we hold that ISA has met its burden of showing that section 265(2) does not apply to it, for the years 1964 and 1965. Under the record in this case, ISA’s purpose in incurring and continuing its certificate indebtedness was not, in those years, to purchase or carry the tax-exempt securities in its investment portfolio; for those years plaintiff can therefore deduct the interest and additional credits accruing on the face-amount certificates. Plaintiff is entitled to recover and judgment is entered in its favor. Pursuant to Rule 131(c), the case will be remanded to the Trial Division to determine the amount of plaintiffs recovery.
FINDINGS OF FACT
The court, having considered the evidence, the report of Senior Trial Judge Mastin G. White, and the briefs and arguments of counsel, makes findings of fact as follow:
1. (a) The plaintiff, Investors Diversified Services, Inc. ("IDS”), is a corporation which was organized and existed under the laws of the State of Minnesota until December 31, 1974. On that date, IDS became a Delaware corporation.
(b) IDS has its principal office at 800 Investors Building, Minneapolis, Minnesota.
2. (a) During the years 1964 and 1965, IDS filed consolidated income tax returns for an affiliated group of which it was the common parent. During those years, Investors Syndicate of America, Inc. ("ISA”), was a wholly owned subsidiary of IDS and a member of the affiliated group. ISA
(b) The issue in this case arises with respect to ISA for the years 1964 and 1965.
3. ISA is a face-amount certificate company registered under the Investment Company Act of 1940 (15 U.S.C. § 80a-l et seq. (1970)), and is subject to the banking laws of the State of Minnesota, the State in which it was incorporated.
4. (a) Since 1940, ISA has been engaged in the business of issuing, selling, and servicing face-amount certificates, investing in qualified assets, and making payments to certificate holders in accordance with the terms of the certificates.
(b) ISA has been a financial institution since its incorporation in 1940.
5. (a) ISA has no paid employees. The sale and distribution of ISA’s face-amount certificates, and the investment decisions and investment of its funds, are, by contract, handled by its parent company, IDS.
(b) In addition to selling ISA’s face-amount certificates, the IDS salesmen also sell mutual funds and life insurance.
6. During 1964 and 1965, ISA’s face-amount certificates were offered for sale in the District of Columbia and in all the States except Wisconsin and California. Sales of ISA’s certificates during those years were handled by IDS’s sales force of approximately 3,500 salesmen and 700 divisional and regional managers. The salesmen of ISA’s face-amount certificates sell as many certificates as possible. Neither IDS nor ISA makes any effort to control the number of certificates or: the types of certificates being sold by the salesmen.
7. Since 1940, ISA has issued face-amount certificates which provide a systematic plan for the accumulation of funds by certificate holders. Two types of certificates have been issued: (1) the installment-type certificate, under which the holder makes periodic payments to ISA over the number of years stated in the certificate (the periods range from 6 to 22 years); and (2) the single-payment-type certificate, under which the holder pays ISA a lump sum and which matures at a stated date.
(b) The installment-type certificate also provides that the holder may receive additional credits. Additional credits are granted to certificate holders at the option of ISA’s Board of Directors, depending upon the investment performance of ISA during a particular year.
(c) Under the provisions of the certificate, so long as the certificate holder complies with the terms of the certificate, ISA has no right to return his payments or otherwise discharge its obligation to him prior to maturity.
9. (a) Of the ISA installment-type certificates sold in 1964 and 1965, approximately 95 percent had maturity dates of 15 or more years, and approximately 70 percent had maturity dates of 20 or more years.
(b) Of the ISA installment-type certificates sold from 1945 through 1963, approximately 94 percent had maturity dates of 15 or more years, and approximately 62 percent had maturity dates of 20 or more years.
10. (a) Under the terms of the installment-type certificates having maturity dates of 15 or more years, the "cash surrender value” to the holder was less than the total payments made by the holder until after the end of the eighth certificate year. During the first eight certificate years, the "cash surrender value” was equal to a percentage of the payments made by the holder, ranging from 50 percent (if surrendered at the end of year 1) to just over 99.5 percent (if surrendered at the end of year 8).
(b) At least 50 percent of the installment-type certificates were surrendered before the end of the eighth certificate year.
12. In addition to the installment-type certificates, ISA, beginning in 1961, hafe issued single-payment-type certificates, under which the holder pays ISA a lump sum and which mature at a stated date. For each of the years 1961 through 1965, ISA’s sales of single-payment-type certificates constituted approximately 1 percent of the total certificate sales for each year.
13. (a) A certificate holder has the right to demand payment of the amount credited to his account prior to the maturity of his certificate. He can present his certificate for redemption at any time and receive cash.
Ob) ISA does not have any right to refuse payment on a certificate that is presented prior to maturity. The holder presenting a certificate for redemption prior to maturity gets the cash surrender value, as stated on the certificate, plus any additional credits that may have been granted to it.
(c) ISA cannot require a certificate holder to redeem a certificate prior to maturity. That option is vested solely in the certificate holder.
14. (a) As of December 31, 1964, ISA had 365,419 face-amount certificate-holder accounts, and the total maturity value of the certificates was $2,106,747,470.00.
(b) As of December 31, 1965, ISA had 362,507 face-amount certificate-holder accounts, and the total maturity value of the certificates was $2,107,237,582.00.
15. (a) Under the provisions of the face-amount certificates, ISA was required to maintain at least the minimum certificate reserves as provided by section 28(a) of the Investment Company Act of 1940 (15 U.S.C. § 80a-28(a) (1970)). The required reserve for each certificate is an amount which, with future payments, if any, when compounded annually at a stated rate of not to exceed 3%
(b) ISA was required to deposit and maintain cash or "qualified investments” equal to 100 percent of such reserves, as provided by section 28(b) and (c) of the Investment Company Act of 1940 (15 U.S.C. § 80a-28(b) and (c) (1970)).
(c) Section 28(b) of the Investment Company Act of 1940 (15 U.S.C. § 80a-28(b) (1970)) permits a face-amount certificate company to make those investments permitted a life insurance company under the laws of the District of Columbia and such other investments as the Securities and Exchange Commission shall by regulation approve. Generally, qualified investments consist of real estate mortgages, U. S. Government and municipal bonds, and securities of blue-chip industrial, finance, public utility, and transportation companies.
16. The following schedule summarizes ISA’s total assets, investment in tax-exempt bonds ("tax exempts”), and the percentage of tax exempts to total assets as of the end of each of the years 1940 through 1973:
Year Total Assets Tax Exempt Bonds % of Tax Exempts to Total Assets
1940 $ 1,012,500 $ 30,825 3.04%
1941 5,471,145 86,322 1.58%
1942 11,732,283 28,016 .24%
1943 18,146,407 -0--0-
1944 25,683,567 1945 36,970,374 -0--0--0--0-
1946 54,238,018 153,911 .28%
1947 76,815,237 378,541 .49%
1948 102,915,846 376,412 .37%
1949 129,797,314 374,238 .29%
1950 158,569,894 -0--0-
1951 189,333,190 -0--0-
1952 226,266,143 -0--0-
1953 273,506,613 -0--0-
*218 Year Total Assets Tax Exempt Bonds % of Tax Exempts to Total Assets
1954 319,495,296 4,739,884 1.48%
1955 375,357,697 28,678,540 7.64%
1956 420,792,701 48,331,397 11.49%
1957 456,045,074 79,440,465 17.42%
1958 500,308,842 144,067,108 28.80%
1959 545,926,023 187,452,338 34.34%
1960 588,046,018 197,506,108 33.59%
1961 626,222,715 197,134,611 31.48%
1962 675,957,659 198,673,130 29.39%
1963 719,868,431 211,032,137 29.32%
1964 757,233,188 220,409,183 29.11%
1965 805,278,428 227,052,456 28.20%
1966 843,591,261 225,865,864 26.77%
1967 881,977,930 234,637,895 26.60%
1968 909,204,425 241,434,344 26.55%
1969 946,170,596 242,999,072 25.68%
1970 971,953,271 229,071,649 23.57%
1971 1,006,325,477 253,000,339 25.14%
1972 1,006,400,919 265,298,134 26.36%
1973 1,009,845,216 260,543,964 25.80%
17. ISA’s holdings of tax exempts were of long maturity (i.e., 10 to 30 years, and up to 50 years), and they were purchased with the intention and practice of holding them until maturity.
18. (a) Substantially all of ISA’s assets and funds are derived from the payments it receives under its face-amount certificates and from the previous investment of such payments.
(b) ISA invests its funds in a diversified portfolio. These funds come from three principal sources: (1) current sales of certificates, (2) payments on installment-type certificates previously sold, and (3) return on investments previously made, in the form of dividends, interest, and repayments of principal, including the proceeds from sales of portfolio securities.
(c) Approximately one-third of the funds that were available to ISA for investment in 1964 and 1965 came directly from ISA’s certificate operations (i.e., installment payments on old certificates and sales of new certificates),
19. (a) Beginning in 1947, and continuing through 1963, ISA’s prospectuses filed with the Securities and Exchange Commission stated that "The Company has invested, and presently expects to continue its investments, in a portfolio consisting of [inter alia] * * * state and municipal government bonds.” As interpreted by ISA, the purpose of this statement was to note the fact that ISA had in the past invested in "[inter alia] * * * state and municipal government bonds” and to note its intention to make and continue investments therein in the future.
(b) In its prospectuses for all years after 1963, the words "and presently expects to continue its investments” were deleted.
20. In 1954, ISA (through its contractual arrangements with IDS) adopted a specific policy and program for the expansion of its investments and holdings in tax exempts, as compared with its other investments. Thereafter, ISA’s year-end holdings of tax exempts increased from approximately 1% percent of total assets in 1954 to a high of over 34 percent of total assets in 1959. For each of the years from 1960 through 1973, ISA’s year-end holdings of tax exempts ranged from 23% percent to 33% percent of its total assets.
21. (a) The plaintiff filed its federal income tax returns for the calendar years 1964 and 1965 on the accrual basis, and timely paid the income tax liability shown thereon in the amounts of $2,876,100.78 for 1964 and $3,146,514.25 for 1965.
(b) Interest increments and additional credits credited on ISA’s face-amount certificates during 1964 and 1965 were deducted as interest expenses on the returns for the respective years.
22. (a) During 1964, ISA owned certain bonds the interest on which was wholly exempt from federal income tax. ISA also owned during 1964 other securities and investments the income from which was subject to federal income tax. The Commissioner of Internal Revenue determined that the average investment of ISA in tax exempts for 1964 was $215,474,431.60, while its average investment
23. During 1965 ISA owned certain bonds, the interest on which was wholly exempt from federal income tax. ISA also owned during 1965 other securities and investments the income from which was subject to federal income tax. The Commissioner determined that the average investment of ISA in the tax exempts for 1965 was $222,368,889.52, while its average investment in other assets was $556,027,415.57, thus making a total of $778,396,305.09. The proportion of the tax exempts to the total assets thus determined was 28.567 percent for 1965. In his statutory notice of deficiency for 1965, the Commissioner determined that certain deductions claimed by ISA as interest and expenses were not deductible under section 265(2) of the Internal Revenue Code of 1954 (26 U.S.C. § 265(2) (1970)). The Commissioner computed a disallowance of deductions in the amount of $2,429,334.17 by taking 13.567 percent (the difference between the 28.567 percent previously mentioned and the 15 percent statutory exclusion) of the $17,906,200.14 claimed by ISA as deductions for interest and expenses on the consolidated income tax return filed by the plaintiff.
24. The Commissioner of Internal Revenue assessed the following deficiencies on November 19, 1971, which were timely paid by plaintiff:
*221 Year Tax Interest Total
$1,036,026.41 $411,987.45 $1,448,013.86 Tr CD 05 rH
1,147,756.77 385,146.64 1,532,903.41 ID CD 05 rH
25. The plaintiff timely filed formal claims for refund for 1964 and 1965, in which it claimed refunds of the following amounts, or such greater amounts as are legally refundable, plus statutory interest:
Year Tax Interest Total
$1,001,616.06 $398,303.79 $1,399,919.85 ^ CD 05 i-H
1,166,080.40 385,146.64 1,551,227.04 ic CD 05 i — I
CONCLUSION OF LAW
Upon the foregoing opinion and findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that the plaintiff is entitled to recover, together with interest as provided by statute, and judgment is entered to that effect. The amount of recovery will be determined in proceedings under Rule 131(c).
For this purpose, all of ISA’s holdings of tax exempts were maintained on deposit at banks and other depositories under collateral security agreements securing the face-amount certificate indebtedness.
Section 265(2), as amended by Revenue Act of 1964, Pub. L. No. 88-272, § 216(a), 78 Stat. 19, 56, provides:
"No deduction shall be allowed for—
"(2) Interest. — Interest on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest on which is wholly exempt from the taxes imposed by this subtitle. In applying the preceding sentence to a financial institution (other than a bank) which is a face-amount certificate company registered under the Investment Company Act of 1940 (15 U.S.C. 80a-l and following) and which is subject to the banking laws of the State in which such institution is incorporated, interest on face-amount certificates (as defined in section 2(a)(15) of such Act) issued by such institution, and interest on amounts received for the purchase of such certificates to be issued by such institution, shall not be considered as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle, to the extent that the average amount of such obligations held by such institution during the taxable year (as determined under regulations prescribed by the Secretary of his delegate) does not exceed 15 percent of the average of the total assets held by such institution during the taxable year (as so determined).”
This figure was arrived at by subtracting the 15% specifically excluded by section 265(2), supra, from the 29.271% of plaintiffs total assets which constituted tax-exempt securities.
See note 3, supra.
Defendant has not argued that the annual increment and the additional credit should be treated differently for tax purposes, and we shall so assume. See I.R.C. § 301; Investors Syndicate of America, Inc. v. Simon, 407 F. Supp. 83 (D.D.C. 1975).
Defendant does not contend that the 1964 amendment to section 265(2), Revenue Act of 1964, Pub. L. No. 88-272, § 216(a), 78 Stat. 19, (which excludes tax-exempt holdings of face-amount certificate companies if such holdings form no more than 15% of the company’s total assets) provides the upper limit of exclusion for such companies and that all exempt holdings above that percentage necessarily fall within the prohibitions of section 265(2). In this position defendant is correct, for the 1964 amendment merely provided a safe harbor up to the 15% level. Beyond that, the courts are to apply the tests otherwise applicable in order to determine if the prohibited purpose exists, and if so found, to deny deductions on a proportionate amount of interest. This is made clear in the legislative history. H. Conf. Rep. No. 1149, 88th Cong., 2nd Sess. 32, reprinted in 1964-1 Cum. Bull. (Part 2), 805. The taxpayer has the burden of persuasion.
The portion of the Atlas opinion which the defendant invokes is contained in footnote 17, 381 U.S. at 248-49. After quoting the statement of a representative of the life insurance companies that "required interest cannot be construed to be true income or profit, just as the cost of goods sold by a merchant must be eliminated from his gross income,” the footnote goes on to say:
"Under this view of the reserve increment, we think this case is strikingly similar to Denman v. Slayton. On this theory the reserve increment is an accrued expense in the nature of interest on the funds obtained from policyholders for investment, and the denial of that part of the deduction which exempt income bears to total investment receipts represents disallowance of an expense attributable to the production of exempt income, which is precisely what Denman permits. It is argued, however, that the rule of Denman disallowing deduction of exempt interest is limited to 'but for’ situations: Interest incurred on loans used to purchase exempt bonds may be disallowed only where there would have been no interest charge except for the purchase of exempt securities. It is by no means clear that this is not the case here, for there is a relationship between the amount of the reserve increment, representing interest on funds obtained from policyholders, and the amount of a company’s investments, exempt or otherwise, unless it be assumed that a company does not sell policies and obtain funds for the purpose of investment. However this may be, we do not read Denman so narrowly. We think interest can be said to be incurred or continued as a cost of producing exempt income whenever a taxpayer borrows for the purpose of making investments and in fact invests funds in exempt securities.
"There was no problem of allocating interest in Denman, but surely no one doubts that the case would not have been any different if the dealer there borrowed and purchased taxable securities with half the loan and used the other half to purchase exempt securities.”
Defendant would also have us give greater significance to the Court’s characterization of this argument as also being responsive to the taxpayer’s other argument in its brief that such reserve additions were an expense which would have existed in the presence or absence of tax-exempt interest contributing to its net investment income.
In indicating that to view the reserve increment as an accrued expense might make it vulnerable to disallowance as an expense attributable to the production of exempt income, the Court said such disallowance "is precisely what Denman permits.” Denman, was a constitutional case, and the reference is to what Denman permits constitutionally. (In Denman, the "prohibited purpose” test was plainly satisfied no matter how interpreted.)
Two other problems should be mentioned briefly. First, rejection of the "but for” test as the only permissible reading of Denman (assuming that the Atlas Court was passing upon the scope of Denman and thus of section 265(2)) does not carry the Government very far. Such rejection of the "but for” standard as the exclusive test for all cases does not logically preclude application of a "but for” test under certain factual circumstances. In arguing the significance of its continued indebtedness irrespective of its tax-exempt holdings, IDS does not have to urge adoption of the "but for” criterion as the sole gauge; such continuation of indebtedness need be only one of several factors determining the presence or absence of the required prohibited purpose.
Secondly, a literal interpretation of the Supreme Court’s language in Atlas would be contrary to the Tax Court’s refusal to give that language a very broad reading. In Edmund F. Ball, 54 T.C. 1200 (1970), the Tax Court construed the meaning of the Atlas footnote to be, at the least, inapplicable to a taxpayer who made no new investments in tax exempts during the years of indebtedness. It is noteworthy that our difficulty in placing great weight on the literal language of the Atlas footnote is
I.T. 2028, III-1 Cum. Bull. 297 (1924) provides in part: "It is clear that indebtedness incurred by reason of deposits in a bank is not incurred to purchase or carry tax-exempt securities * * *.”
Revenue Ruling 61-222, 1961-2 Cum. Bull. 58, similarly provides:
"The provisions of section 265(2) of the Internal Revenue Code of 1954 have no application to interest paid on indebtedness represented by deposits in banks engaged in the general banking business since such indebtedness is not considered to be 'indebtedness incurred or continued to purchase or carry obligations * * *’ within the meaning of section 265.”
Rev. Proc. 70-20,1970-2 Cum. Bull. 499, Sec. 2.03, declares: "The Congress has repeatedly recognized that indebtedness incurred by a bank to its depositors is not to be treated as indebtedness incurred or continued to purchase or carry tax-exempt securities within the meaning of section 265(2). To do so would 'seriously interfere with the marketing of government securities, which are bought for the most part by banks * * S. Rept. 558, 73rd Cong., 24 (1934), cf. H. Rept. 704, 73rd Cong. 21-22 (1934) and Hearings Before the Senate Committee on Finance on the Revenue Act of 1934, 73rd Cong., 206-209 (1934). Also, see 110 Cong. Rec. 2211-2215 (1964); Hearings Before the House Committee on Banking and Currency on H.R. 14026, 89th Cong., 152-153 (May 19, 1966).”
Alternatively, the Government argues that even if its current interpretation of Atlas is inconsistent with the revenue rulings, those rulings have never been tested against a Supreme Court decision and may well be wrong. But we must accept the rulings as the IRS’s near-contemporaneous, long-continued, settled interpretation of
In Leslie v. Commissioner, 413 F.2d 636, 639, 640 (2d Cir. 1969), cert. denied, 396 U.S. 1007 (1970), it was clear that the taxpayer, if it had held no tax-exempts, would have had to borrow less.
As pointed out in Leslie v. Commissioner, supra, 413 F.2d at 638, Congress did provide in companion provision section 265(1) for non-deductibility by mechanical allocation (of otherwise deductible expenses) to classes of exempt income other than interest.
Defendant does not argue that ISA was able to use its tax savings on the exempt obligations (obtained by deducting the accrued amounts to be paid to certificate-holders while paying no income taxes on the interest received) to increase the optional special credits which could be declared, or that certificate-holders (or potential certificate-holders) were induced to purchase certificates by the prospect of special credits attributable to such tax savings. Nor is the record such that we can say that either of these propositions is true in this case. See also note 5, supra.
Under the 1964 amendment to section 265(2), we are concerned, of course, only with the amounts above 15%. See notes 2, 6, supra.
See Leslie v. Commissioner, 413 F.2d at 639, in which the taxpayer could reduce or abolish his borrowing by disposing of tax-exempts, note 15, supra; Wisconsin Cheeseman, Inc. v. United States, 388 F.2d at 422-23, in which purchase of the tax-exempts required the taxpayer regularly to borrow further for economic needs of an ordinary recurrent variety.
As we have said, the Act required ISA to deposit and maintain cash or qualified investments equal to 100% of the reserves on the certificates. The required reserve for each certificate is an amount which, with future payments, if any, when compounded annually at a stated rate of not to exceed 3Vz% will equal the face amount of the certificate at maturity.