Opinion
Docket No. 5842-67.
1970-05-7
KIRCHNER, MOORE AND COMPANY, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Stephen Gurko, for the petitioner. Charles H. Powers, for the respondent.
Stephen Gurko, for the petitioner. Charles H. Powers, for the respondent.
Petitioner, a dealer in municipal bonds, incurred and continued various amounts of indebtedness for the purpose of purchasing and holding such bonds until the time of their subsequent resale. Held, notwithstanding petitioner's ultimate purpose of reselling the municipal bonds at a profit, the interest on the indebtedness incurred and continued for the purpose of purchasing and carrying such bonds is nonetheless nondeductible under sec. 265(2), I.R.C. 1954
HOYT, Judge:
Respondent determined deficiencies in the Federal income taxes of petitioner as follows:
+-----------------------+ ¦Nov. 30— ¦Amount ¦ +-------------+---------¦ ¦1962 ¦$6,297.47¦ +-------------+---------¦ ¦1963 ¦13,343.46¦ +-------------+---------¦ ¦1964 ¦22,544.02¦ +-------------+---------¦ ¦1965 ¦19,899.00¦ +-------------+---------¦ ¦1966 ¦5,156.00 ¦ +-----------------------+
After various concessions, the sole issue remaining for decision is whether certain interest expenses incurred during the years in question by petitioner, a dealer in municipal bonds, fall within the meaning of section 265(2),
which disallows the deduction of interest on indebtedness incurred or continued to purchase or carry obligations, the interest on which is wholly exempt from income taxes.
The difference between the amounts shown in this column and the totals shown in column II of Table B is attributable to the petitioner's income from underwriting services and other, miscellaneous sources.
All section references are to the Internal Revenue Code of 1954, unless otherwise designated. 2. We reject as contrary to the facts of record the part of the stipulation that the loans were used, inter alia, to complete or accomplish the resale of the bonds, insofar as such stipulation might be regarded as establishing the resale as a purpose of the borrowing. William Ernest Seatree, 25 B.T.A. 396, 401 (1932), affirmed on other issue 72 F.2d 67 (C.A. D.C. 1934); Adolph Weinberg, 44 T.C. 233, 244 (1965), affirmed and reversed in part on other issues sub nom. Sugar Daddy, Inc., et al. v. Commissioner, 386 F.2d 836 (C.A. 9, 1967), certiorari denied 392 U.S. 929 (1968). We have adopted an interpretation of the stipulation which removes the inconsistency and unclear verbiage. Gunderson Bros. Engineering Corp., 42 T.C. 419, 436 (1964); Rule 31(b)(6), Tax Court Rules of Practice. 3. Both parties are in agreement as to the tax-exempt treatment of this interest income.
FINDINGS OF FACT
Some of the facts and exhibits have been stipulated and are incorporated herein by this reference.
The petitioner, Kirchner, Moore & Co., is a corporation duly organized under the laws of the State of Colorado with principal offices at 718 17th Street, Denver, Colo. 80202. The petitioner, on the date of the mailing of the notice of deficiency and on the date of the filing of the petition, maintained its principal offices at the address indicated above.
The petitioner's income tax returns (Forms 1120) for the taxable period commencing December 27, 1961, and ending November 30, 1962, and for the taxable years ending November 30, 1963, through November 30, 1966, were filed with the district director of internal revenue at Denver, Colo. Its income and deductions reported in these returns are based on the accrual method of accounting.
The petitioner's business is principally that of a dealer in the bonds of political subdivisions of the various States, hereinafter referred to as municipal bonds. Also, the petitioner receives remuneration for underwriting services rendered to political subdivisions of the various States relative to the issuance of municipal bonds.
The petitioner's operations as a dealer in municipal bonds are normally conducted in the following manner:
(a) The petitioner, through its officers and employees, will consider and evaluate the profit potential on resale of various municipal bonds which are expected to be issued by political subdivisions of the various States, sometimes hereinafter referred to as municipalities. Sometimes this analysis and evaluation is conducted in syndicate with other municipal bond dealers.
(b) After determining that a particular proposed issue of municipal bonds has sufficient profit potential on resale, the petitioner, either alone or as a member of a syndicate of municipal bond dealers, submits a competitive bid or negotiates a price for the purchase of these municipal bonds. If the bid is accepted or the negotiation successful, a written contract for the purchase of the bonds is signed with the municipality, providing for completion of the purchase ‘when, as and if’ the municipality receives an appropriate legal opinion upholding the legality of the issue. In general, the time required to obtain this opinion, print the bonds, and then deliver the bonds to the petitioner is about 30 to 45 days from the date the contract is signed.
(c) Immediately after the petitioner's bid is accepted or its negotiation successfully concluded, the petitioner prepares a circular or offering sheet describing in detail the municipality, the terms and conditions of the bonds, the price at which the petitioner will sell the bonds (expressed by reference to the net yield of the bonds), and other information material to a prospective purchaser of the bonds from the petitioner.
(d) The petitioner immediately mails the circular to its customers, who consist primarily of banks, and to a lesser extent, insurance companies and individuals, mostly located in the Rocky Mountain area. Most of the petitioner's customers have dealt with the petitioner for some time. Petitioner's officers and employees know most of its customers personally, which is very important to petitioner's business. These customers have great confidence in petitioner as a reputable municipal bond dealer. The petitioner has acquired its reputation by its good performance in selling municipal bonds and rendering personal attention to the municipal bond portfolios of its customers.
(e) Concurrently with or shortly after the mailing of the circular, one or more bond salesmen employed by the petitioner telephones the petitioner's customers and solicits commitments to purchase the bonds from the petitioner on the same ‘when, as and if’ basis as the petitioner's commitment to the municipality. The salesmen seek to obtain purchase commitments on as many of the bonds as possible prior to the delivery of the bonds from the municipality to petitioner. If a commitment is obtained, a written confirmation follows. No definite delivery date is agreed upon, but the bond salesman customarily gives the customer an oral estimate of the anticipated delivery date.
(f) When the municipality is ready to deliver the bonds to the petitioner, it contacts the petitioner (or the manager of the syndicate of dealers to which the petitioner belongs) and negotiates the precise delivery date. On the agreed delivery date, the petitioner receives delivery of the bonds and makes payment for them to the municipality.
(g) As soon as the delivery date from the municipality is definitely determined, the petitioner takes the steps necessary to arrange for the completion of sale to its customers of those bonds which they have previously agreed to buy. These steps consist of (1) sending written notification to the customer that the petitioner will be able to make delivery on a specified date; (2) waiting until the customer can arrange with a bank (hereinafter called the paying bank) to receive delivery and make payment to the petitioner; and (3) delivering the bonds or causing the bonds to be delivered to the paying bank (by hand if the paying bank is in Denver, or by mail if the paying bank is not in Denver) as soon as possible after the municipality delivers the bonds to the petitioner. When the paying bank receives the bonds, it verifies that they are in order (e.g., that the appropriate legal opinion is attached), releases them to the customer, and remits payment. In those cases where the petitioner has received a commitment to purchase from a customer, the petitioner always endeavors to complete the resale, delivery, and payment procedure described above on the day the petitioner receives the bonds from the municipality; but in many cases, particularly if the paying bank is not located in Denver so that the bonds must be mailed to it, the petitioner is unable to complete the procedure until several days after it receives the bonds from the municipality. The petitioner always endeavors to obtain purchase commitments for the remainder of its bonds and deliver them, as described above, as quickly as it can.
In those situations where petitioner is unable to complete the resale of the bonds to its committed customers on the date it takes delivery of the bonds from the municipality, or has not yet obtained a purchaser for the bonds, petitioner ordinarily is required to borrow funds to meet the balance due on the purchase price. Under these circumstances, petitioner borrows from the Central Bank & Trust Co. of Denver or the First National Bank of Denver (hereinafter called the lending banks) up to 98 percent of the lower of cost or sales value of the particular bonds for which it has obtained commitments to purchase, but not in excess of par value, and up to 95 percent or 96 percent of the lower of cost or par value of the bonds for which the petitioner has not yet received purchase commitments. Those bonds for which petitioner has commitments of sale and those for which the petitioner has no commitment of sale are held by the lending bank as security for the petitioner's loan which is represented by the petitioner's interest-bearing note.
The parties have stipulated ‘that the loans referred to’ in the above paragraph ‘are used by the petitioner to pay all or a part of the purchase price of the bonds and to retain the bonds and to complete or accomplish the resale of the bonds at a later date.’ We cannot understand or interpret this portion of the stipulation, which is in part meaningless and in part in conflict with other evidence of record, as petitioner urges us to do. The loan proceeds referred to were acquired and used by petitioner to pay all or a part of the purchase price of the bonds referred to, and the loans were continued to carry them pending their sale at the earliest opportunity. The indebtedness was incurred and continued for the purpose of purchasing and carrying tax-exempt securities until their ultimate resale.
The purchase, retention, and resale of the aforementioned bonds constitute a typical business cycle of petitioner.
This is a stipulated table but as agreed to contains no column numbers. We have added same in the usual numerical order so that the percentages shown in III and IV may be related to II. All of the other tables set forth above contained column numbers so that references therein to such numbers might be clear.
When the petitioner is ready to complete a sale of bonds pledged as collateral for the loans described above, these bonds are transmitted by hand or mailed to the paying bank designated by the purchaser. If the bonds are to be transmitted by hand, the certificates are released to the petitioner upon receipt of the petitioner's check in an amount equal to the prorata share of the loan securing the bonds sold. The petitioner, upon delivery of the bonds to the purchaser's paying bank, receives a check or draft on the customer's account and the said check or draft is deposited in the petitioner's account with the lending bank. This appears to be the substance of the parties' stipulation as to this procedure as far as we are able to interpret it.
The parties have also stipulated as to the procedures followed where petitioners' sales of municipal bonds are handled by mail. Portions of this part of the stipulation are also confusing, garbled, and conflicting. We set it forth as filed although we do not believe that the lending bank was repaid its loans twice, once by check and once by draft proceeds from the purchaser's paying bank as indicated by (b) of the following paragraph 12 of the stipulation:
12. In the cases where the resale of the bonds is to be completed through the mails, the transaction is handled in the following manner by the respective lending banks; namely, Central Bank and Trust Co. of Denver and the First National Bank of Denver:
(a) Where the lending bank is the Central Bank and Trust Co. of Denver, such bank at the direction of the petitioner will mail to the paying bank, the bonds, and a draft drawn by the petitioner against the customer for the full sales price of the bonds. The draft drawn by the petitioner against the customer is made payable to the lending bank. * * * Upon receipt of the bonds the paying bank will, if it accepts the bonds, honor the draft drawn by the petitioner against the customer and remit payment to the lending bank. Upon receipt of payment, the lending bank deducts costs of handling the shipment of the bonds, such as insurance, mailing costs, and a nominal draft charge, from the sale proceeds. The remaining sale proceeds are deposited into petitioner's general checking account with the lending bank. At the same time of the deposit of the remaining sale proceeds in the petitioner's checking account, or immediately thereafter, the lending bank will charge against the petitioner's checking account an amount equal to the loan which was secured by the bonds which were sold.
(b) Where the lending bank is the First National Bank of Denver, such bank on direction of the petitioner will mail to the paying bank the bonds and a draft drawn by the petitioner against the customer for the sales price of the bonds. At the time of the mailing, the lending bank credits the petitioner's checking account for the amount of the draft. At the same time, the petitioner will give the lending bank a check for the portion of the petitioner's note which is allocable to the mailed bonds. The draft drawn by the petitioner on the customer is made payable to the lending bank. Upon receipt of the bonds, the paying bank will, if it accepts the bonds, honor the draft drawn by the petitioner against the customer and remit payment to the lending bank. The lending bank retains this payment and bills the petitioner separately for draft charges, handling, and shipping costs.
All bonds purchased by the petitioner during the taxable years at issue were purchased for resale to its customers in the ordinary course of its business. Petitioner does not have any plan to invest in and hold municipal bonds as a desirable investment.
On the date it receives delivery of the bonds from the municipality, petitioner acquires legal title to the same and receives all interest income from these bonds until the designated delivery date to the paying bank. The above-mentioned interest income has not been included in the gross income reported on petitioner's income tax returns, such income having been treated as being tax exempt under the provisions of section 103.
In each of the years in issue, the rate of interest on loans collateralized by municipal bonds nearly always exceeded the rate of interest paid on municipal bonds.
The profit earned by the petitioner from its resale of municipal bonds is attributable to a number of factors, including its direct selling activities and services, its reputation and personal contacts with its customers as established over a considerable period of time, and its ability to accurately evaluate and appraise the profit potential on resale of the various tax-exempt securities offered by the municipalities. Of the 17 people in petitioner's employ, 13 are primarily engaged in one or more of the selling activities of the business; the other 4 employees are primarily involved in the buying activities of the business.
The petitioner does not realize gain from any appreciation in the value of its municipal bonds during the time such bonds are retained. The principal reason for this is that the petitioner in virtually all cases, if it is acting outside a syndicate, maintains its initial offering price as stated in its circular; if it is acting within a syndicate, the petitioner will deviate from its price only with permission of the syndicate manager, and then only to lower the price so as to make the bonds more attractive on the market.
The petitioner regularly owns assets other than municipal bonds, which it uses in its trade or business. One of its current assets is ‘good faith’ deposits, which represent deposits made with the municipalities in order to secure petitioner's obligations to purchase the particular municipal bonds there involved.
The following table shows the petitioner's average total assets and its average total municipal bonds on the monthends during each of the 5 taxable years at issue, as shown on the petitioner's books:
+------------+ ¦I¦II ¦III¦IV¦ +-+---+---+--¦ ¦ ¦ ¦ ¦ ¦¦ ¦ +------------+
Average total Average total Average municipal bonds other assets Taxable year ending Nov. 30— total (parenthesis (parenthesis assets shows percent shows percent of II) of II) 1962 $556,078 $363,097 (65.30) $192,981 (34.70) 1963 598,083 382,398 (63.94) 215,685 (36.06) 1964 975,140 827,006 (84.81) 148,134 (15.19) 1965 1,395,638 1,128,945 (80.89) 266,693 (19.11) 1966 1,317,833 986,622 (74.87) 331,211 (25.13)
The following table table (designated ‘Table B’) shows the relative amounts and percentages of the petitioner's tax-exempt municipal bond interest income and its gross income from all other sources:
+-------+ ¦TABLE B¦ +-------¦ ¦ ¦ ¦ ¦ ¦ +-------+
I II III IV Total of municipal Taxable bond interest Municipal bond Other gross year and gross interest (parenthesis income (parenthesis ending income earned shows percent shows percent Nov. 30— from all other of total) of total) sources 1962 $281,748 $9,660 (3.43) $272,088 (96.57) 1963 364,720 12,411 (3.40) 352,309 (96.60) 1964 491,252 28,892 (5.89) 462,360 (94.11) 1965 527,179 33,103 (6.28) 494,076 (93.72) 1966 473,870 43,240 (9.12) 430,630 (90.88)
The following table (designated ‘Table C’) shows the relative amounts and percentage of the petitioner's tax-exempt municipal bond interest income and its gross income from sales of municipal bonds:
+------------+ ¦TABLE C ¦ +------------¦ ¦I¦II ¦III¦IV¦ +-+---+---+--¦ ¦ ¦ ¦ ¦ ¦¦ ¦ +------------+
Total of Municipal Bond resale Taxable municipal bond bond interest gross income year interest and (parenthesis (parenthesis ending bond resale shows percent shows percent Nov. 30— gross income 1 of II) of II) 2 1962 $248,581 $9,660 (3.89) $238,921 (96.11) 1963 339,913 12,411 (3.65) 327,502 (96.35) 1964 472,091 28,892 (6.12) 443,199 (93.88) 1965 473,835 33,103 (6.99) 440,732 (93.01) 1966 375,745 43,240 (11.51) 332,505 (88.49)
Petitioner on its Federal income tax returns for each of its 5 taxable years at issue claimed deductions under sections 162 and 163 of the Internal Revenue Code for an amount of interest expense determined by multiplying its total interest expense for each year times the percentage shown in column IV of Table B for such year.
Respondent, in his statutory notice of deficiency, determined, inter alia, that the petitioner was not entitled to deductions for interest expense ‘on money borrowed and used to purchase or carry obligations, the interest on which is exempt from Federal income tax’ in the following amounts for the taxable years
The periods of limitations on assessment for the taxable period commencing Dec. 27, 1961, and ending Nov. 30, 1962, and the taxable year ending Nov. 30, 1963, were, as the parties stipulate, duly and properly extended to Dec. 31, 1967, by consents executed by the petitioner and by the respondent.
+----------------------------+ ¦TYE Nov. 30— ¦Amount ¦ +-----------------+----------¦ ¦1962 ¦$11,311.27¦ +-----------------+----------¦ ¦1963 ¦16,466.96 ¦ +-----------------+----------¦ ¦1964 ¦30,316.54 ¦ +-----------------+----------¦ ¦1965 ¦42,521.00 ¦ +-----------------+----------¦ ¦1966 ¦51,101.00 ¦ +----------------------------+
As a result of various concessions made by respondent, the following amounts of interest incurred by petitioner during the years in question remain at issue:
+------------------------+ ¦TYE Nov. 31 — ¦Amount ¦ +---------------+--------¦ ¦1962 ¦$10,281 ¦ +---------------+--------¦ ¦1963 ¦15,026 ¦ +---------------+--------¦ ¦1964 ¦28,842 ¦ +---------------+--------¦ ¦1965 ¦40,956 ¦ +---------------+--------¦ ¦1966 ¦53,308 ¦ +------------------------+
The above amounts represent the interest on notes and drafts to the lending banks attributable to those periods of time of the various loans up to the designated delivery dates of the bonds to the paying banks. Respondent has conceded, inter alia, that the interest incurred after the delivery of the bonds to the paying bank, whereupon petitioner no longer holds beneficial title to the bonds, is a deductible interest expense directly attributable to the carrying of the accounts receivable which come into existence for an average 2 1/2-day interlude between the delivery of such bonds and the receipt of payment thereon by petitioner.
In its amended petition to this Court for redetermination of the deficiencies set forth by respondent in his notice of deficiency, petitioner has prayed that we find that there is no deficiency in income taxes due for any of the years in question, and further, ‘that there are overpayments of such taxes for such years in such amounts as the Court may determine in accordance with its findings in the case.’
ULTIMATE FINDING OF FACT
Petitioner, a dealer in municipal bonds, incurred and continued the indebtedness in question for the purpose of purchasing and carrying such bonds until the time of their subsequent resale.
OPINION
In its business of dealing in municipal bonds, during the years in question, petitioner found it necessary in many cases to borrow money from various banks in order to finance the purchase and holding of such bonds until the time of their subsequent resale. Petitioner incurred interest on these borrowings, a substantial part thereof (the amounts here in issue) being attributable to the periods of time of the various loans up to the designated delivery dates of the bonds to the paying banks representing petitioner's customers. The issue presented for our decision, upon these facts, is whether all or any part of the above-described interest expense falls within the disallowance provisions of section 265(2).
Section 265(2) provides, in pertinent part, as follows:
SEC. 265. EXPENSES AND INTEREST RELATING TO TAX-EXEMPT INCOME.
No deduction shall be allowed for
(2) INTEREST.— 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.
Petitioner interprets the above-quoted subsection as having no application to the interest expenses incurred in the context of its business as a municipal bond dealer, where the primary purpose of such business is to derive income from the resale of municipal bonds at a profit. As has been the case with several other courts, we likewise cannot adopt this interpretation of section 265(2).
Paul P. Prudden et al., 2 B.T.A. 14 (1925), also involved a municipal bond dealer who found it necessary in his business to incur and continue indebtedness in order to purchase and carry tax-exempt obligations. Admitting that they fell within the literal wording of the predecessor of section 265(2),
the petitioners in Prudden nonetheless contended that the amounts of interest in question, having been incurred in this business of dealing in municipal bonds, were not within the intendment of this subsection, but instead were deductible as business expenses. The board of Tax Appeals rejected petitioners' contention, and held that the subsection did apply, stating that (p. 16):
Sec. 214(a)(2) of the Revenue Acts of 1918 and 1921.
There is no occasion * * * for the application of the rules of statutory construction. The language of the statute is clear and makes no exception. If Congress had intended to except dealers in this class of securities it would have so provided.
Petitioner attempts to distinguish Prudden from the present case because of the absence herein of any admission on its part that it fell within the literal wording of section 265(2). The facts we have found on the record herein, however, are equivalent to the admission made in Prudden. Additionally, we have concluded, as an ultimate finding of fact, that petitioner, in its business as a dealer in municipal bonds, did incur and continue the indebtedness in question for the purpose of purchasing and carrying such bonds until the time of their subsequent resale, thus fitting it squarely within the wording of this subsection. Prudden establishes quite clearly that the fact that the taxpayer is in the business of dealing in municipal bonds does not in any manner deprive this subsection of application where its terms are fulfilled.
In Nauts v. Slayton, 36 F.2d 145 (C.A. 6, 1929), reversed and remanded sub nom. Denman v. Slayton, 282 U.S. 514 (1931), the Circuit Court of Appeals was confronted not only with the issue of the application of the predecessor of section 265(2) to municipal bond dealers, but also of its constitutionality in such application. The court found the statute clearly applicable to municipal bond dealers, but went on to hold that it was unconstitutional in its application to them. The Supreme Court reversed the Circuit Court of Appeals on the constitutional issue and remanded the case to the District Court with instructions to enter judgment for the collector. Although it is not explicit in the decision, the Supreme Court's remand with instructions to enter judgment for the collector obviously had to be based on the determination that the statute applied to the taxpayer, notwithstanding his status as a municipal bond dealer. After describing the double income tax benefit that the statute was enacted to prevent, i.e., both a deduction for interest on indebtedness incurred for the purpose of purchasing or carrying tax-exempt securities, as well as an exclusion from income of tax-exempt interest, the Supreme Court made the final statement (p.520) that ‘The fact that respondent (the municipal bond dealer) engaged in the business of buying and selling is not important.’
Wynn v. United States, 288 F.Supp. 797 (E.D. Pa. 1968), affirmed per curiam 411 F.2d 614 (C.A. 3, 1969), certiorari denied 396 U.S. 1008 (1970), involved facts substantially similar to the present case, except that it dealt with a separate account maintained by a security brokerage firm for the sole purpose of buying and selling municipal bonds. The taxpayer in Wynn contended that the interest on the obligations in question, notwithstanding their direct traceability to the purchase of tax-exempt bonds, was incurred as a deductible expense in conducting his brokerage business and not ‘to purchase or carry’ tax-exempt securities within the meaning of section 265(2). The court rejected the taxpayer's contention as requiring an untenable interpretation of section 265(2), if its application is limited to purchases of tax-exempt bonds for the purpose of earning the interest thereon, and it is not applied to cases in which the bonds were purchased for the purpose of subsequent resale at a profit. If the money is borrowed for the purpose of purchasing tax-exempt securities section 265(2) denies any interest deduction to the bond dealer.
Notwithstanding the cases summarized above,
petitioner seemingly feels that if it somehow gives a new twist to the same arguments presented by the taxpayers in these cases a different holding will magically be forthcoming from this Court. Instead of offering the already rejected argument that a municipal bond dealer does not come within the intendment of section 265(2), petitioner applies a ‘purpose’ test, as established in a line of indirectly related cases, to come to the same result precluded by the aforementioned cases.
For other cases essentially to the same effect, see R. O. Holton & Co., 44 B.T.A. 202 (1941); and Clyde C. Pierce Corp. v. Commissioner, 120 F.2d 206 (C.A. 5, 1941), affirming a Memorandum Opinion of the Board of Tax Appeals.
In each of the cases relied upon by petitioner, the courts were faced with a situation where the relationship between the purchasing or carrying of the municipal bonds and the incurring or continuation of the indebtedness could not be directly traced. In view of the absence of a direct relationship, the courts found it necessary to examine the particular facts and circumstances involved in order to determine the purpose of the loan.
Thus, in John E. Leslie, 50 T.C. 11 (1968), revd. (subsequent to the filing of briefs herein) 413 F.2d 636 (C.A. 2, 1969), certiorari denied 396 U.S. 1007 (1970), the case upon which petitioner seems to place its heaviest reliance, we were confronted with a situation where a large stock brokerage firm was incurring an average monthly indebtedness of $80 million and carrying an average monthly amount of tax-exempt securities of $2 million. It was not the tidy situation where $2 million of the $80 million was directly traceable each month to the purchase of tax-exempt securities; the loans were made on a day-to-day basis for all general business needs, at which time the firm was either already carrying the tax-exempt securities or making the initial purchase thereof.
In Leslie we carefully reviewed the legislative history of section 265(2) and concluded that this subsection is to be applied only when the indebtedness was incurred or continued for the purpose, not merely because the proceeds are so used, of purchasing or carrying tax-exempt securities.
In the absence of any direct relationship or traceability between the borrowing involved and the relatively minor purchases of tax-exempt securities, we could not infer the prohibited purpose of section 265(2) and, consequently, sustained petitioner's position that all of the interest in question was deductible. While agreeing with the ‘purpose’ test set out by the Tax Court, the Court of Appeals found, however, that there was a sufficient nexus between an allocable portion of the average monthly loans and the purchasing and carrying of tax-exempt securities to warrant an application of section 265(2).
A good illustration of the distinction between the use of loans proceeds and the purpose of the incurrence of the loan is found in Rev. Rul. 55-389 1955-1 C.B. 276. This revenue ruling dealt with a taxpayer who borrowed money with the purpose in mind of financing plant and equipment expansion, but temporarily used a substantial portion of the loan proceeds to purchase and carry tax-exempt bonds while awaiting the time when payment on the plant and equipment expansion would have to be made. Recognizing the true purpose of the borrowings, as distinguished from their temporary use, the Internal Revenue ruled that sec. 265(2) was inapplicable to the situation. We are not confronted with such a situation in that both the use and purpose of the loans involved are quite obviously the same, i.e., to purchase and carry tax-exempt securities.
The other cases cited by petitioner as authority for the validity of the ‘purpose’ test, which it seeks to apply herein, e.g., Illinois Terminal Railroad Co. v. United States, 375 F.2d 1016 (Ct. Cl. 1967), Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (C.A. 7, 1968), also involve situations where the purchase and carrying of the tax-exempt securities were not directly traceable to the incurrence and continuation of the indebtedness. The only inquiry of these cases was as to whether there was a ‘sufficiently direct relationship’ between the incurrence and continuation of certain indebtedness and the purchase and carrying of the tax-exempt securities there involved. The taxpayer's ultimate intention of either holding the tax-exempt securities for investment, or later reselling them at a profit, was irrelevant to the application of the purpose or ‘sufficiently direct relationship’ test.
Petitioner has lifted the purpose test out of the context of the indirectly related cases described above and stretched it to the point of distortion in applying it to the facts of the instant case. Petitioner correctly points out that its business cycle consists of three steps, namely the purchasing, carrying, and reselling at a profit of municipal bonds. In that the ultimate or primary purpose of its business resides in the third step of the cycle, i.e., reselling at a profit, the other steps shall all be viewed as being incidental to this primary purpose. Having concluded that the purchasing and carrying steps are merely incidental to the third step, petitioner rounds out his misapplication of this test by concluding that the purpose of the indebtedness incurred and continued herein was to resell municipal bonds at profit, a purpose which is not within the disallowance provisions of section 265(2).
We reject the suggested legerdemain of this slippery interpretation of the purpose test. The net result would be contrary to Prudden, Denman, Wynn, and other like cases, and deny this subsection's application to municipal bond dealers, in whose business the primary purpose would always be reselling at a profit. We conclude that a proper application of the purpose test, in alignment with the results of already decided cases, requires a determination as to what the loan proceeds were intended to be expended for, not the ultimate purpose of the purchaser by whom the expenditure was made. Put another way, the application of section 265(2) is determined by the purpose of incurring or continuing an indebtedness, and not by the ultimate plan or purpose for the subsequent disposition of such bonds.
We have concluded as an ultimate finding of fact that petitioner incurred and continued the indebtedness here involved for the purpose of purchasing and carrying tax-exempt securities; accordingly, petitioner's contention that all or an allocable part of the amounts of interest in issue do not come within the disallowance provisions of section 265(2) cannot be sustained.
In its alternative contention, petitioner asserts that the excess of the interest expenses in question over the amounts of tax exempt income earned during the years involved should be deductible. Unfortunately, the statute does not give any indication of approval of this method, and the legislative history thereto clearly rejects this ‘offset’ approach. See discussion and review of legislative history in the Leslie case and Wynn v. United States, supra. We must also reject it here.
To reflect the above conclusions and various concessions made by both parties,
Decision will be entered under Rule 50.