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Commissioner of Internal Revenue v. Tennessee Co.

March 28, 1940

COMMISSIONER OF INTERNAL REVENUE
v.
TENNESSEE CO.



Petition for Review from the United States Board of Tax Appeals.

Author: Clark

Before BIGGS, MARIS, and CLARK, Circuit Judges.

CLARK, Circuit Judge.

The case at bar is one of first impression, 402 C.C.H. para. 1684B, and cf. Hughes & Co. v. Commissioner, 8 Cir., 109 F.2d 720, involving the surtax imposed on personal holding companies by the revenue Act of 1934, § 351, 26 U.S.C.A. Int. Rev. Acts, page 757. That measure, as we had recent occasion to observe in Sanford Corp. v. Commissioner, 3 Cir., 106 F.2d 882, certiorari denied, February 5, 1940, 60 S. Ct. 513, 84 L. Ed. , is directed to the more efficient elimination of certain methods of tax avoidance. The employment of one of these methods is clearly discernible in the record before us. It was well-known to students of the earlier, but ineffectual avoidance provisions of the Revenue Acts, and consists in using the "incorporated pocketbook", to gain a tax advantage in the purchase of capital assets on credit. See Sherman, Taxation of Corporations Used to Avoid Taxes Upon Stockholders, 15 Tax Magazine 19, 78, 79; United Business Corporation v. Commissioner, 19 B.T.A. 809.

The device is simple. Suppose Mr. X wishes to purchase a $1,000,000 apartment house subject to a $900,000 mortgage. if he does so, he must pay surtaxes on the apartment house rents calculated without deduction of amounts paid in satisfaction of the mortgage debt. Those surtaxes may, however, be escaped by the easy expedient of substituting the indirect and lesser burden of the flat rate corporation tax. To quote by way of illustration:

"Mr. X forms the A Corporation.He transfers to it $100,000 with which it purchases apartment houses of the value of $1,000,000 with mortgage encumbrances to the extent of $900,000, due in twenty years. The property givea A Corp. a net income of $10,000 a year, but no dividends are declared in the next twenty years, as it is necessary to provide for the forthcoming maturity of the mortgages. At the expiration of the twenty years A Corp. pays off some $300,000 of the mortgages, renews the balance for another twenty-year period and continues to accumulate for the next maturity date. Sound business practice? Beyond doubt; every conservative business man would feel inclined to adopt a similar policy if he could afford it. Mr. X need not buy real estate to achieve this result; he can get the same result by purchasing a factory or a railroad heavy in debt to bondholders. It is even conceivable that he will have A Corp. buy securities in the stock market on the strength of a long term loan, backed by his personal signature if necessary." Graubard, Accumulation of Surplus to Avoid Surtaxes, 10 Tax Magazine 415, 418. And, we may add, when stocks are so substituted for apartment houses (as in our circumstance) the A Corporation is exempt from tax on the dividends received, and the avoidance becomes complete.

The combat such arrangements of the taxpayer's affairs, the statute limits the only applicable deduction from the taxable "undistributed adjusted net income" of the holding company to: "Amounts used or set aside to retire indebtedness incurred prior to January 1, 1934, if such amounts are reasonable with reference to the size and terms of such indebtedness." Section 351(b)(2)(B), 26 U.S.C.A. Int. Rev. Acts, page 757. In other words, the stratagem of cancelling an incorporator's income with his corporation's debt for the source of that income, is killed instantly if born later than 1934; but, if born earlier, it lives on to die a natural death upon the eventual satisfaction of the debt. The peculiar variant of that stratagem instanced by the case at bar forces us into a perplexing choice between these alternative fates.

The respondent corporation was organized in May 1933. It had a capital of $150,000 in cash represented by 3,000 shares of no par value stock, all held by the W. W. Hawkins Company. The following December respondent received an "advance" of $153,600 from the Hawkins Company, acquired all the stock of the Memphis Commercial Appeal Inc., a newspaper, for $303,600 (including interest), received an "advance" from the Roy W. Howard Company of $149,000, and returned $149,000 to the Hawkins Company, its sole stockholder, pursuant to a duly authorized reduction in capital stock. Thereupon one Hammond, an assignee of the Hawkins Company, emerged as controlling stockholder. Thus respondent entered the year 1934, as a personal holding company, and, true to form, applied substantially all the dividends received from the Memphis Commercial Appeal Inc. Stock, during that year ($97,000) to the reduction of the "advances" made by the Hawkins and Howard companies. We say true to form because, as can easily be seen, Hammond had in substance through the medium of the respondent corporation merely bought a newspaper on credit and was paying for it out of its own earnings. Even more true to form was the nature of the obligation to repay the "advances". In short, respondent promised, on December 22, 1933, to pay them back out of its net earnings (Memphis Commerical Appeal dividends), when, as, and if those earnings came into existence, and not otherwise except at its own option. The technical question, therefore, is whether such a contingent liability assumed in 1933 and which becomes a due debt in 1934 is an "indebtedness incurred prior to January 1, 1934" within the meaning of the statute.

If anything is well settled it is that the term "indebtedness", when used in a statute, lacks the fixed import of a word of art. Its meaning may be either broad or narrow. As stated in a standard source:

"B. Strict Meaning. In strict legal significance, the word 'indebtedness' applies only to an obligation arising from contracts, express or implied, and in this sense it is defined to be a sum of money due by certain and express agreement; that for which an action of debt will lie; the owing of a sum of money upon a contract or agreement, and, in common understanding, it is not less an indebtedness that such sum is uncertain. * * *

"C. Broad Meaning. The term 'indebtedness' has at times a signification far broader than the law dictionaries assign to it, a more general and common meaning, being often used in the large and general sense, and not in its technical one, not even involving of necessity the idea of money obligation.In its more general sense it is defined to be that which is due from one person to another; that which one person is bound to pay or perform to another. In this sense, it may include every obligation by which one person is bound to pay money, goods, or services to another * * * "

31 C.J. 412, 413.

"Indebtedness", accordingly, may comprehend a contingent liability. If used in the liberal sense, it does; if used in the strict sense, it does not.As is to be expected, the only possible criterion of choice between these two conflicting interpretations of the word is the aim of the enactment which employs it. See 3 Paul & Mertens, Law of Federal Income Taxation § 24.05 (income tax deduction for interest on indebtedness); 6 McQuillan, Municipal Corporations §§ 2377, 2388, 2428 (constitutional debt limit for municipalities); 6 Williston on Contracts § 1998 et seq. (bankruptcy statutes).

The raison d'etre of the instant statute is explained in general terms by its framers: "Considerable hardship has been avoided by permitting the deduction from the adjusted net income of a reasonable amount used or set aside to retire indebtedness incurred prior to January 1, 1934. This will substantially and properly relieve personally owned corporations which have outstanding bonds or other indebtedness that must be ...


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