Before BIGGS, Chief Judge, and KALODNER and GANEY, Circuit Judges.
The petitions for review raise the question of deductibility, pursuant to Section 163(a) of the Internal Revenue Code of 1954*fn1, of "interest on indebtedness" paid by P. M. Finance Corporation to two debenture holders, one of whom, Philip Frank, owns the outstanding capital stock of the corporation. The other debenture holder is Philip's wife, Hilda. The Tax Court decided that the payments made by P. M. were not deductible as interest on indebtedness. It sustained the Commissioner's determination of income tax deficiencies against P. M. for the taxable years ending May 31, 1955, May 31, 1956, and May 31, 1957*fn2
The facts, some of which were stipulated below, are not in dispute. P. M. was incorporated under the laws of Pennsylvania on June 23, 1953. P. M.'s business was lending money to finance purchases of tap rooms and cocktail lounges. Its authorized capital stock consists of 1,000 shares each having a par value of $25. On the day of incorporation 400 shares were issued to Philip Frank. The purchase price, $10,000, was paid by him on July 8, 1953. No dividends have been paid on these shares and there are no other shares outstanding*fn3 Approximately one week after incorporation, viz., on July 1, 1953, the board of directors of P. M. Finance authorized a $300,000 issue of non-voting, five-year, $1,000 debenture bonds, bearing interest of 7% per year. The bonds were unsecured and there is no evidence that provision was made for a sinking fund. Over the period from July 8, 1953 to September 3, 1953, Philip Frank, the president and sole stockholder of the corporation, advanced to it $90,000 and received 90 debentures in return. No additional debentures were issued until March 23, 1954, when Hilda Frank, who was the secretary of P. M., advanced to the company $50,000 and acquired 50 debentures. The only other sale of debentures occurred early in 1957, at which time bonds with a face value of $14,000 were issued to 13 persons. No payment has been made on the principal on the bonds held by Philip and Hilda Frank but some of the debentures issued in 1957 to other persons have been retired. Interest on the debentures has been paid when due. Each debenture shows on its face an unconditional obligation to pay a sum certain in five years with interest at 7% a year*fn4
The capital raised by P. M. through issuance of stock and debentures did not meet its business needs. It had to borrow substantial amounts from banks*fn5 The loaning banks, which need not be named here, advanced money to P. M. to the extent of 75% of the notes received by P. M. from P. M.'s borrowers. As security for these loans, P. M. pledged to the banks the collateral pledged by the borrowers. The financing was carried on on an instalment basis: the borrowers repaying stated amounts to the taxpayer each week, and P. M. in turn making weekly payments to the banks.
The record does not show precisely when the bank loans commenced but it is probable that the date was October 9, 1953. At this time Philip Frank, P. M. and the first lender bank entered into a subordination agreement. This agreement, required by the bank before it would advance money to P. M., provided that the present and future indebtedness of P. M. to the bank was to have priority in payment over present*fn6 and future corporate obligations to Philip Frank. Philip agreed to accept payment of the principal on the debentures owned by him only after P. M. had repaid the bank present and future indebtedness, principal and interest, in full. Another clause provided that, should payments be made to Philip by reason of P. M.'s bankruptcy or insolvency, or by operation of law or otherwise, such amounts were to be turned over to the lender bank.The agreement between the bank and Philip was supplemented by an agreement by P. M. that it would make no payments of principal indebtedness, present or future, to Philip until payment had been made in full to the bank of all present and future indebtedness. Identical subordination conditions were arranged on March 23, 1954 by the bank, the corporation and Hilda Frank in respect to Hilda's $50,000 debenture holdings. Hilda and Philip similarly subordinated the debentures acquired by them to two other banks, creditors of the taxpayer, on March 25, 1954 and May 2, 1957, respectively*fn7 In 1958, the Franks entered into an agreement with P. M. whereby the due date for the repayment of the debentures was extended for three years. On the basis of these facts, particularly the small equity capitalization, the extensions and the subordination agreements, the Tax Court held that the bonds owned by Philip and Hilda Frank did not constitute true indebtedness and entered decisions for the Commissioner. We conclude that the result reached by the Tax Court should be affirmed.
Despite the Tax Court's insistence that this is a case of "thin capitalization", it is far from clear that P. M.'s capitalization was "thin". The inadequate capitalization test has a number of variations with regard to computation of the debt-capitalization ratio and the significance of a computed ratio as it applies to various types of business*fn8 Where, as here, the taxpayer is a finance company, a business in which sizable amounts of borrowed capital are customary*fn9, the ratio of debt to capitalization would not appear to be significantly high*fn10 The case at bar presents those problems inherent in a situation where the sole or principal stockholder and his wife*fn11 hold evidence of unconditional debt issued by their corporation. Many decisions have found this factor to be persuasive evidence that debt in form is not indebtedness for purpose of income tax*fn12 These decisions possess merit. To the sole shareholder-creditor it may make little difference, taxation aside, whether his investment be labeled "debt" rather than "stock". Complete control of the corporation will enable him to render nugatory the absolute language of any instrument of indebtedness. Nonetheless, while these considerations have caused the courts to examine the shareholder-creditor relationship with great care, the decisions*fn13 in most instances have required some further indication that sole or pro-rata shareholder "debt" is in reality equity rather than indebtedness*fn14 Such indicia are present in the case at bar.
The burden of proving the reality of the indebtedness rests on the petitioner. White v. United States, 305 U.S. 281, 292, 59 S. Ct. 179, 83 L. Ed. 172 (1938); John Wanamaker Philadelphia v. Commissioner, 139 F.2d 644, 646 (3 Cir. 1943). We think that the taxpayer cannot carry the burden imposed in the face of the subordination agreements. These agreements are incompatible with the taxpayer's assertions that the debentures evidenced indebtedness in the taxable years in question. While as a general rule it may be true that "debt is still debt despite subordination", Kraft Foods Co. v. Commissioner, 232 F.2d 118, 125-126 (2 Cir.1956), it is necessary to draw the line at some point. The subordination agreements in the case at bar were "complete" and not "inchoate"*fn15 The complete subordination effected by these agreements not only tends to wipe out a most significant characteristic of the creditor-debtor relationship, the right to share with general creditors in the assets in the event of dissolution or liquidation, John Wanamaker Philadelphia v. Commissioner, 139 F.2d 644, 647 (3 Cir.1943), but it also destroys another basic attribute of creditor status: i. e., the power to demand payment at a fixed maturity date*fn16 The repayment condition imposed by the banks has rendered this right, expressly granted by the debentures, nonexistent. Although contingent obligations generally have been held to be inconsistent with "indebtedness" as employed in Section 163(a)*fn17, the nature of the condition precedent here imposed, repayment of all present and future bank loans, is particularly significant. The record indicates, and all parties agree, that the bank loans were indispensible to P. M.'s ability to function. Moreover, the arrangements for repayment of the loans and the high loan levels at the end of each of the taxable years in issue strengthen the inference that the borrowings from the banks would continue as long as the taxpayer remained in business. Such a course would have been in accordance with the custom of finance companies. One must conclude therefrom that the Franks' debentures would not be subject to payment for an indefinite period of time, a period that very likely would be coextensive with the life of petitioner's business. See Beaver Pipe Tools, Inc. v. Carey, 139 F.Supp. 470 (N.D.Ohio 1955), aff'd, 240 F.2d 843 (6 Cir.), cert. denied, 353 U.S. 958, 77 S. Ct. 864, 1 L. Ed. 2d 909 (1957).
To put it bluntly, it seems to us that the petitioner has not sustained the burden imposed on it. The money advanced by the Franks in substance was placed at the disposal of the business on a permanent basis. It seems to us that this money constituted risk capital, as it did to the Tax Court. The debentures held by Philip and Hilda Frank in our view do not reflect indebtedness within the meaning of Section 163(a) of the Internal Revenue Code. See Commissioner of Internal Revenue v. Schmoll Fils Associated, 110 F.2d 611 (2 Cir.1940); Beaver Pipe Tools, Inc. v. Carey, supra.
The decisions of the Tax Court will ...