filed: April 10, 1952.
SHARON HERALD CO.
Before McLAUGHLIN, KALODNER and STALEY, Circuit Judges.
KALODNER, Circuit Judge.
This appeal, involving income and excess profits taxes for the years 1941, 1942 and 1943, is taken from the judgment of the District Court in favor of the Collector of Internal Revenue ("Collector") in an action for refund instituted by the plaintiff, Sharon Herald Company ("taxpayer").
The question presented is whether the taxpayer is entitled to a deduction from gross income for State tax which it paid on behalf of its bondholders*fn1 as (1) interest on indebtedness under Section 23(b) of the Internal Revenue Code; or (2) business expense under Section 23(a) (1) (a).*fn2
The taxpayer contends that it paid the State tax under an express oral agreement with its bondholders and that the tax so paid is deductible either as interest or business expense under the applicable provision of Section 23. The Collector answers that there was no such oral agreement, and moreover, that under Section 23(b) and the pertinent Treasury Regulations*fn3 no deduction is allowable where the bonds on which the state tax is paid do not contain a taxfree covenant; further that the payments in question were not deductible as ordinary or necessary business expenses of the taxpayer under Section 23(a)(1)(a) of the Code since there was nothing in the record to show that the payments were ordinarily incurred or that they contributed to or benefited the taxpayer's business of publishing newspapers.
The District Court premised its judgment in favor of the Collector on the conclusion that the payments of the State tax were not "interest paid" within the meaning of Section 23(b) because of the non-existence of a written tax-free covenant in the bonds and that further, the payments were not "ordinary and necessary expenses" under Section 23(a)(1)(a).
The facts as found by the District Court*fn4 may be summarized as follows:
Taxpayer corporation was incorporated May 13, 1935, under the laws of Pennsylvania, its formation having resulted from the consolidation of two predecessor corporations (the Sharon Herald Publishing Company and the News Telegraph Company) which had been engaged in the publication of daily newspapers in Sharon, Pennsylvania. Four individuals held all of the capital stock of the Sharon Herald Publishing Company and three individuals held all of the capital stock of the News Telegraph Company. Upon incorporation, taxpayer corporation issued $117,500 seven per cent debenture bonds, 975 shares seven per cent preferred stock having $100 a share par value, and 2500 shares no par common stock to former stockholders of the predecessor companies. Three of the latter received all three securities; one received debenture bonds and preferred stock; one received preferred and common stock and two received only common stock.*fn5 The seven per cent debenture bonds did not contain a written covenant to pay the State tax.
In 1937 taxpayer issued $215,000 new five per cent debenture bonds which were exchanged for the old $117,500 seven per cent bonds and $97,500 preferred stock. Since 1937 some of the original holders have died, their holdings being distributed to their heirs and estates, and additional bonds have been issued both to the original holders and to outsiders. During the taxable years taxpayer's outstanding bonds were held by approximately eighty individuals.*fn6
During the taxable years taxpayer paid the corporate loans tax imposed on its resident bondholders by the Pennsylvania Personal Property Tax Act.
The payments were made with the knowledge, consent and approval of the officers, directors, and stockholders of the taxpayer corporation. The five per cent debenture bonds did not contain a written covenant to pay the tax and the taxpayer did not by formal resolution agree to pay the tax imposed upon its resident bondholders by Section 17 of the Pennsylvania Personal Property Tax Act. The amounts paid were not tax payment levied or assessed against the corporate taxpayer by the Pennsylvania statute.
Existence of an agreement was not recognized in a formal manner until a resolution of taxpayer's board of directors, passed November 15, 1943, was formerly adopted by the stockholders on November 27, 1943. This action was taken to meet the objection raised by the Internal Revenue Bureau in disallowing the deductions for the taxable years. Thereafter, for the same purpose, a rider was attached to the outstanding debenture bonds stating that the state tax on the bond was assumed by the taxpayer corporation and would be paid by it.
The amounts paid by taxpayer were paid from its own funds. The resident treasurer of taxpayer did not at any time assess the State tax against the resident holders of either the seven per cent or five per cent debenture bonds, nor did he notify them that it had assessed and deducted the State tax on the bonds nor did it at any time deduct the amount of taxes from the interest due to the bondholders.
The minutes of the taxpayer did not contain any reference to any undertaking by it to pay the State tax prior to adoption of the resolution in November, 1943.
The District Court found as a fact "* * * the taxpayer orally obligated itself to pay the State taxes on the 1935 and 1937 bonds * * * and that the existence of such a corporate agreement has been established."
Further, in Paragraph 19 of its Findings of Fact the District Court specifically found:
"19. The 5% debenture bonds issued by the plaintiff did contain an oral taxfree covenant to pay the tax imposed upon the resident bondholders by Section 17 of the Pennsylvania Personal Property Tax Act."
With respect to the fact-finding stated, the District Court, however, concluded as a matter of law that under the pertinent Treasury Regulations the tax-free covenant had to be written on the bonds or attached thereto as a rider.
The taxpayer's insistence here that the State tax is deductible as interest is premised (1) on the District Court's fact-findings that it had orally obligated itself to pay the tax and that the five per cent debenture bonds issued in 1937 contained "an oral taxfree covenant to pay the tax"; and (2) the contention that the Court erred as a matter of law in ruling that an oral covenant was not sufficient, and that a written covenant was imperative under the Treasury Regulations.
On the latter score, we are of the opinion that the District Court's interpretation of the phrase "containing an appropriate tax-free covenant" as meaning a written agreement is reasonable and correct. It is well-settled that a fundamental requisite of a "covenant" is that it be signed and sealed. Schram v. Coyne, 6 Cir., 1942, 127 F.2d 205, certiorari denied, 317 U.S. 652, 63 S. Ct. 48, 87 L. Ed. 525. The Commissioner of Internal Revenue has for many years construed the word "covenant" as used in the Regulations to mean a written covenant appearing on the bond or attached thereto. The courts have repeatedly held that the administrative view of a regulation should be followed. Helvering v. Griffiths, 1943, 318 U.S. 371, 398, 63 S. Ct. 636, 87 L. Ed. 843; further, Treasury Regulations subsequently re-enacted in the same terms are considered to have received legislative approval and to have the force and effect of law. Helvering v. Griffiths, supra; Commissioner of Internal Revenue v. Wheeler, 1945, 324 U.S. 542, 547, 65 S. Ct. 799, 89 L. Ed. 1166, rehearing denied, 325 U.S. 892, 65 S. Ct. 1182, 89 L. Ed. 2004.
As pointed out by the Collector, language identical to that used in the pertinent Treasury Regulations first appeared in Article 761 of Treasury Regulations 74 promulgated under the Revenue Act of 1928, and has been repeated without change in successive Regulations issued under subsequent Acts.*fn7
Notwithstanding our view as to the correctness of the District Court's conclusion of law, we are compelled to a further consideration as to whether there was any basis in the record for its fact-findings, because the Collector challenges them as erroneous and the taxpayer insists with equal vigor that they are well-founded.
Consideration of the testimony makes it crystal clear that there was no basis for the District Court's fact-findings that (1) the taxpayer had orally obligated itself to pay the State tax on the five per cent debenture bonds in 1937; and (2) the latter bonds contained "an oral tax-free covenant" to pay the tax. As to the latter finding, it is a contradiction in terms to speak of a written instrument "containing" an oral undertaking.
Only two witnesses, called by the taxpayer, testified on the subject of the State tax payments. One was Lartz, taxpayer's general manager, and the other McDowell, its president. Their testimony justified a finding that there was an agreement to pay the State tax on the original seven per cent debenture bonds issued in 1935, but just as clearly established that there was no basis for such a fact-finding with respect to the five per cent bonds issued in 1937 involved in this litigation. McDowell was never even questioned nor did he testify as to what transpired in connection with the 1937 issue.
The sum total of Lartz's testimony on that aspect follows:
"Q. (page 34 N.T.) Now, in your conferences prior to this action, was there anything agreed to as to the state tax on the 5 per cent bonds? A. I can't say that it was definitely mentioned, but it certainly was assumed that if we paid it before on seven, we would naturally pay it on five."
The latter part of the answer was stricken by the Court on motion of the Collector's counsel.
"Q. (page 35 N.T.) Do you recall whether you discussed that question of the state tax on the new bonds with any of the other six involved in the two companies? A. I can't recall, Mr. McKay. That was a small detail in my book."
"Q. (pages 35-36 N.T.) What was your own understanding as to whether the original obligation of the corporation to pay the state tax out of corporate funds was to continue on and be effective as to the five per cent bonds?"
The Court sustained an objection to this question and at the same time stated:
"I can only draw one inference from the testimony - let's be frank - that everyone agreed that the corporation would pay the tax as stated. I will make that a finding of fact. What other inference can I draw?"
Up to that point, when the Court made the finding of fact mentioned, the only testimony as to the taxpayer's agreement with respect to five per cent bonds was as set forth above.*fn8
The testimony referred to inevitably leads to the conclusion that the District Court arrived at its disputed fact-findings on what can only be described as speculation or intuition and nothing else, and accordingly must be held to be clearly erroneous. We have in the past held that "A finding of fact must have more substantial foundation than an intuition * * *" and that while the trial court "'* * * has the primary function of finding the facts in tax disputes, weighing the evidence, and choosing from among conflicting factual inferences and conclusions those which it considers most reasonable' it is well settled that speculation cannot be substituted for proof and 'the requirement is for probative facts capable of supporting, with reason, the conclusion expressed in the verdict.'" In re Lueders' Estate, 3 Cir., 1947, 164 F.2d 128, 133.
It is apparent that the District Court made its fact-finding with respect to the 1937 bond issue on an inference that the taxpayer's obligation as to the 1935 issue carried over. The evidence, however, disclosed that there was no agreement entered into by the taxpayer with its stockholders to that effect in 1937. We agree with the Collector that there is no principle of law which would impute to a new bond issue a supplemental oral agreement in connection with the prior bonds, particularly, where, as here, only a part of the new bonds were issued in exchange for the old.
As to the taxpayer's contention that the District Court erred in ruling that it was not entitled to a deduction from gross income for the State tax as "business expenses" under Section 23(a)(1)(a):
In our opinion the contention is without merit. This section of the Code provides that in computing net income there shall be allowed as deductions "All the ordinary and necssary expenses paid or incurred * * * in carrying on any trade or business * * *." In Section 23(a)(1)(a) "Ordinary has the connotation of normal, usual, or customary * * * the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved." Deputy v. duPont, 1940, 308 U.S. 488, 495, 60 S. Ct. 363, 367, 84 L. Ed. 416. It was specifically held in Warner Co. v. Commissioner, 1948, 11 T.C. 419, affirmed by this Court, 1950, 181 F.2d 599 that Pennsylvania corporate loans tax, imposed by law on the individual stockholder, when paid by the obligor is not a business expense. As was held by the District Court, the fact that the taxpayer may have been required under the terms of the State statute to withhold and make the payments to the State on behalf of its bondholders, is not enough to establish them as deductible as business expense.
Allowances as business expense must not only be obligatory but also must be such as are ordinarily incurred in carrying on the taxpayer's trade or business. Interstate Transit Lines v. Commissioner of Internal Revenue, 1943, 319 U.S. 590, 63 S. Ct. 1279, 87 L. Ed. 1607, rehearing denied, 320 U.S. 809, 64 S. Ct. 26, 88 L. Ed. 489; A. Giurlani & Bro. v. Commissioner, 9 Cir., 1941, 119 F.2d 852; Welch v. Helvering, 1933, 290 U.S. 111, 54 S. Ct. 8, 78 L. Ed. 212.
In the instant case there was adequate basis for the District Court's fact-finding that there was no showing that the State tax payments "were ordinary in character or that they were in any way related to the taxpayer's business of publishing newspapers" and that they "in no way benefitted anyone but the stockholders."
For the reasons stated the judgment of the District Court will be affirmed.*fn9