Taxpayers, Rufus C. Salley and Beulah S. Salley, in search of the ever-elusive grail of the "tax loophole," appeal from a determination by the Tax Court that so-called interest payments on loans from their controlled insurance company are not deductible under 26 U.S.C.A. Secs. 163(a), 162(a), or 212(1).1 55 T.C. 896 (1971). We agree with the Tax Court that the alleged loans are without economic substance and do not create a genuine indebtedness between taxpayers and their insurance company that would justify any deductions for so-called interest.

Taxpayers, husband and wife, were officers and directors of Sam Houston Life Insurance Company (Sam Houston) and Houston National Life Insurance Company (Houston National), both operating out of Houston, Texas. Rufus Salley was the president, treasurer, director, and principal shareholder of Houston National, and the president, treasurer, director, and one of the principal shareholders of Sam Houston. Beulah Salley was an officer and director of Houston National, and a director of Sam Houston. In December of 1957, both taxpayers took out separate insurance policies with their controlled company, Houston National. Both policies provided for $20,000 coverage with annual premiums of a little over $26,000.2 Taxpayers allege that they purchased the policies solely in order to permit Houston National to comply with a new Texas statute which required an insurance company licensed by Texas either (a) to maintain not less than 100 policy holders nor less than $200,000 of insurance,3 or (b) to maintain a gross premium income of greater than $50,000 during its last preceding accounting year.4 Although the statute became effective in 1955, it did not become applicable to Houston National until 1956. During 1956 Houston National maintained a sufficient number of policy-holders and total insurance to meet the requirements of the statute. But during 1957, Houston National experienced a substantial and unexplained decline in both policies and total insurance value, which coincided with a corresponding increase in both policies and total insurance held by Sam Houston. As a result of the 1957 decline, Houston National came within the requirements of the Texas Insurance Code only after taxpayers purchased their two policies in 1957, thereby increasing Houston National's gross premium income to more than $50,000 for that year.

Almost exactly six years later taxpayers requested that Houston National convert their original 1957 policies to another policy form that had just been authorized by the Texas Insurance Commissioner. Houston National complied, and the new policies were issued in December of 1963. The converted policies carried on their faces the original execution date of December, 1957, and provided for the same amount of insurance and the same premiums as the 1957 policies. Both the 1963 and the 1957 policies provided for a "guaranteed annual return" of $25,000. None of the guaranteed annual income provisions is keyed to a mortality table, unlike most provisions in life insurance contracts. Nor do the guaranteed annual return provisions involve any of the normal life insurance risks. When taxpayers paid their annual premiums they could elect to allow the guaranteed annual return to accumulate, to receive the return in cash immediately, or to apply the return to the payment of premiums. However, the 1963 conversions differed in some significant respects from their 1957 antecedents. First, the 1963 converted policies provided for profit-sharing, which the 1957 policies did not. Second, the converted policies allowed an interest rate on cash loans of not more than 5%, whereas the earlier policies allowed only 4% interest. Third, the newer policies employed 1958 mortality tables that provided for a 3 1/2% interest factor as the basis for reserves and policy values, while the 1957 policies utilized 1941 mortality tables with an interest factor of 4%. Finally, the new policies did not require Houston National to pay any interest whatsoever on any accrued accumulations of taxpayers' guaranteed annual returns, while accumulations under the 1957 policies earned a 3% return.

Taxpayers paid all premiums as due from 1957 through 1966 and elected throughout to allow the guaranteed annual returns to accumulate at 3% interest until 1963, and at no interest thereafter. Taxpayers then proceeded to "borrow" certain sums every year from Houston National.5 The Tax Court found that these so-called loans were drawn annually upon the $25,000 guaranteed annual return in each policy. In some cases taxpayers also borrowed sums based upon the cash values per $1,000 face amount of insurance on the policies. Taxpayers signed new notes annually to cover the increasing amounts of the purported loans. Each note provided for an interest rate of 4%, which taxpayers prepaid for each succeeding year. The notes specifically stated that taxpayers were not personally liable for payment of either principal or interest. As a result of these loans and payments, taxpayers made so-called interest payments of $54,000 from 1964 through 1966, the tax years in question here, while receiving from Houston National some $47,580.93 in the form of non-taxable insurance dividends. The Commissioner disallowed the purported interest deductions taken on the so-called loans in taxpayers' joint returns for 1964 through 1966. The Tax Court sustained the Commissioner's determination with regard to the alleged interest payments for loans drawn on the guaranteed annual returns, but overruled his determination with regard to loans drawn on the cash values of the policies. The Government does not appeal that part of the decision adverse to it. Taxpayers, however, do appeal, alleging basically that the Tax Court erred in concluding that the transactions involved here were without economic substance or business purpose, and, therefore, not deductible as interest under Section 163(a), as business expense under Section 162(a), or as expenses paid for the production of income under Section 212(1), supra note 1. Finding the judgment of the Tax Court correct, we affirm.

The net result of taxpayers' well-choreographed ballet is that both taxpayers paid about $7,000 out-of-pocket for three years, while at the same time acquiring interest deductions of more than $50,000, which in taxpayers' bracket amounted to a tax windfall of some $20,000.6 Knetsch v. United States, 1960, 364 U.S. 361, 81 S. Ct. 132, 5 L. Ed. 2d 128, made an effort to ring down the tax curtain on so-called interest deductions that derived from transactions without "commercial economic substance." In Knetsch the taxpayer purchased 30-year deferred annuity savings bonds from an insurance company at 2 1/2% interest compounded annually. During the two tax years in question, taxpayer paid $294,570 to the insurance company and then "borrowed" back $203,000 at 3 1/2% interest, secured only by the annuity bonds. For the $91,570 difference, taxpayer received an annuity contract that would produce monthly annuity payments of over $90,000 when taxpayer reached the age of 90 or substantial life insurance proceeds in the event of taxpayer's death before maturity of the bonds. The Supreme Court concluded that taxpayer's annuity bond contract

". . . was a fiction, because each year Knetsch's annual borrowings kept the net cash value, on which any annuity or insurance payments would depend, at the relative pittance of $1,000. . . . [I]t is patent that there was nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction. What he was ostensibly 'lent' back was in reality only the rebate of a substantial part of the so-called 'interest' payments. The $91,570 difference retained by the company was its fee for providing the facade of 'loans' whereby the petitioners sought to reduce their 1953 and 1954 taxes. . . ."

Knetsch v. United States, 364 U.S. at 366, 81 S.Ct. at 135, 5 L. Ed. 2d at 132.

The real inquiry in this appeal is whether or not the loan transaction in question demonstrates sufficient economic substance, "business purpose," or "purposive activity" to come within the scope of the interest deduction allowed under Section 163(a)-cum-Knetsch. See Campbell v. Cen-Tex, Inc., 5 Cir. 1967, 377 F.2d 688; Knetsch v. United States, supra; see also Goldstein v. Commissioner of Internal Revenue, 2 Cir. 1966, 364 F.2d 734, cert. denied, 385 U.S. 1005, 87 S. Ct. 708, 17 L. Ed. 2d 543; Golsen v. Commissioner of Internal Revenue, 10 Cir. 1971, 445 F.2d 985; Goldman v. United States, 10 Cir. 1968, 403 F.2d 776. As the Tax Court correctly points out, if any so-called interest payments are not deductible as "interest" under Section 163(a) because the loan transaction here is without economic substance, then that lack of economic substance would also prohibit deductibility of the so-called interest as a business expense, Section 162(a), or as an expense paid for the production of income, Section 212(1). See Walton O. Hewett, 47 T.C. 483 (1967); Rufus C. Salley, 55 T.C. 896 (1971).7

Of the many cases that have construed Knetsch, the most critical to this appeal is this Court's decision in Campbell v. Cen-Tex, supra. In Cen-Tex a corporate taxpayer purchased life insurance on the lives of its insurable shareholders, who were all members of the same family. The purpose of those purchases was to enable the corporation to meet certain contractual obligations that it had assumed, specifically a deferred compensation plan and an obligation to purchase the stock of deceased shareholders. The corporation paid the first annual premium on each policy, prepaid the next four annual premiums at a 3% discount, and then borrowed each policy's loan value at 4% interest. The loan value had been substantially increased by the prepayment of the premiums. This Court concluded that the transactions in Cen-Tex demonstrated economic substance in that the prepayment of the premiums allowed "additional death benefits and larger loan values" to the policies. Campbell v. Cen-Tex, 377 F.2d at 689.

We conclude, as did the Tax Court, that the facts of the Salleys' transactions make Cen-Tex inapposite. There was simply no economic substance to taxpayers' perennial "borrowing" of their guaranteed annual returns. It is undisputed that the taxpayers could have claimed their guaranteed annual returns of $25,000 in cash immediately upon payment of their annual premiums. By "borrowing" the amount of the returns instead, taxpayers received substantial "interest" deductions, while at the same time allowing their annual returns and their annual loans to accumulate to sizeable sums on Houston National's books. By their annual premium payments of about $26,000 per policy and their annual "loans" of about $25,000 per policy, primarily on the basis of their guaranteed annual returns, taxpayers here, as the taxpayers in Knetsch, ". . . kept the net cash value, on which any . . . insurance payments would depend, at the relative pittance of $1,000." Knetsch v. United States, 364 U.S. at 366, 81 S.Ct. at 135, 5 L. Ed. 2d at 132. Neither Houston National nor taxpayers received any substantial new funds from this premium/loan duet, played to the tune of the guaranteed annual returns. Houston National received only taxpayers' 4% interest on the "loans" of the guaranteed annual returns, while taxpayers received only substantial interest deductions from the "loans." In no sense can it be said that taxpayers paid any "interest" to Houston National as "compensation for the use or forbearance of money," Deputy v. Du Pont, 1939, 308 U.S. 488, 60 S. Ct. 363, 84 L. Ed. 416, which is the standard business test of indebtedness. See also Old Colony Ry. Co. v. Commissioner of Internal Revenue, 1931, 284 U.S. 552, 52 S. Ct. 211, 76 L. Ed. 484. We agree with the Tax Court that the sole purpose of the "borrowing" pirouette between taxpayers and Houston National was ". . . taxpayer's desire to obtain the tax benefit of an interest deduction", Goldstein v. Commissioner of Internal Revenue, 364 F.2d at 741, a purpose which, alone and without economic substance, is proscribed by both Knetsch and Cen-Tex.

In the alternative, the Government alleges that the terms of the 1963 conversions differ so substantially from those of the original 1957 policies that the conversions amounted to a "purchase" of new policies. If the 1963 conversions were "purchases" that took place after August 6, 1963, then any purported interest deductions for the three tax years in question would presumptively fall within the grasp of 26 U.S.C.A. Sec. 264(a) (3), which proscribes deductions on

". . . any amount paid or accrued on indebtedness incurred or continued to purchase or carry a life insurance . . . contract . . . pursuant to a plan of purchase which contemplates the systematic direct or indirect borrowing of part or all of of the increases in the cash value of such contract (either from the insurer or otherwise)."8

Like the Tax Court, we do not find it necessary to reach the Government's alternative argument.9

In sum, taxpayers have produced and directed a choreography of some stylistic contrivance and ingenuity. It appears that taxpayers' dance with Houston National was not an arms-length cha-cha after all, but rather a clinched two-step. Like the Tax Court, we conclude that taxpayers' performance at its outset should have been declared a turkey and trotted off the stage of tax deductibility. The judgment of the Tax Court is affirmed.

Affirmed.