1968 U.S. Tax Ct. LEXIS 154">*154
The petitioner was, in 1959, a partner of Bache & Co.Bache borrowed large sums of money for the purposes of carrying on its brokerage business. It held a small amount of tax-exempt securities.
50 T.C. 11">*12 The respondent determined a deficiency in the income tax of John E. Leslie and Evelyn G. Leslie of $ 3,848.54 for the taxable year 1959. The only issue for decision is whether, within the meaning of
FINDINGS OF FACT
Some of the facts were stipulated, and those facts are so found.
The petitioners are individuals who were legal residents of New York, N.Y., at the time the petition was filed in this case. They filed a Federal joint income tax return for the taxable year 1959 with the district director of internal revenue, Manhattan, New York. John E. Leslie1968 U.S. Tax Ct. LEXIS 154">*156 will be referred to as the petitioner.
The petitioner was a partner of Bache & Co. (Bache), a partnership that kept its books and filed partnership information returns for Federal income tax purposes using the accrual method of accounting. Its 1959 taxable year, which is involved in this case, ended on January 31, 1959. The petitioner's share of Bache's net profits for the partnership's 1959 taxable year was 2.75344 percent. Hereafter, unless otherwise noted, all findings of fact in regard to the operations of Bache are limited to its 1959 taxable year.
Bache's business consisted of buying and selling, as a broker for customers, securities traded on the New York Stock Exchange, the American Stock Exchange, other exchanges of which it was a member, and the over-the-counter market. Bache also bought and sold, as a broker for customers, commodity contracts traded on various commodity exchanges; bought and sold, as a dealer, over-the-counter securities and tax-exempt bonds; underwrote both taxable and tax-exempt securities; loaned to customers on margin to assist them in financing the purchase of securities; and provided investment and financial counseling. In addition, Bache had1968 U.S. Tax Ct. LEXIS 154">*157 investments for its own account in both taxable and tax-exempt securities.
Bache acquired tax-exempt securities as a dealer for resale to customers, either by purchasing such securities on the open market or through its participation in syndicates that underwrote new issues of tax-exempt securities. In addition, Bache accepted orders from customers for tax-exempt securities. Bache also maintained a market in issues that it underwrote or in which it dealt. It did not encourage investment by the firm in such securities, and the securities were sold 50 T.C. 11">*13 as quickly as possible. A "house rule" of Bache required the securities to be sold within 90 days.
None of the tax-exempt securities owned by Bache was used as collateral for any indebtedness incurred or continued by Bache because such use would, among other things, make it necessary for Bache to substitute such securities frequently since they are issued in small denominations, require the banks to use more physical space for their storage since such securities have more bulk than stock certificates, and require the banks to clip coupons from many of the securities. In addition, Bache's legal counsel advised that the use of1968 U.S. Tax Ct. LEXIS 154">*158 tax-exempt securities as collateral for indebtedness might jeopardize the tax-exempt status of the interest on such securities.
Bache made many loans to customers with "margin accounts," and such loans constituted a significant source of profit to Bache since the interest rate on the margin account loans was at least one-half of 1 percent above the interest rate charged to Bache on its borrowings from the major banks. A margin account is a type of credit account, and its operation may be described as follows: A customer, desiring to borrow money to finance a portion of the cost of purchasing securities, opens a margin account with Bache. The customer then deposits cash in the amount required by the rules of the Board of Governors of the Federal Reserve System and the national securities exchanges of which Bache is a member. Such amount is usually a fixed percentage of the value of the securities to be purchased. The balance of the purchase price is then loaned by Bache to the customer, and the securities are pledged with Bache as collateral. Bache is authorized to repledge the securities purchased by customers on margin as collateral for its own borrowings. The extension of 1968 U.S. Tax Ct. LEXIS 154">*159 credit by Bache to customers having margin accounts tends to tie the customers to channeling their securities transactions through Bache.
Under the rules of the New York Stock Exchange, Bache could not pledge securities in any customer's margin account to a bank as collateral for borrowings by Bache in excess of 140 percent of the amount loaned by Bache to the customer. When a customer sold the securities in his margin account or repaid his indebtedness to Bache, the securities were required to be released from the pledge to Bache and, accordingly, from any repledge that Bache may have made of the same securities as collateral for its own borrowings.
There were no restrictions on the use of proceeds obtained by Bache from the repledge of customers' securities to banks; such proceeds could be used by Bache for any purpose of its business.
Bache was required by the rules of the New York Stock Exchange to maintain capital resources in the ratio of 1 to 20 of its total indebtedness. 50 T.C. 11">*14 In practice, a ratio in excess of 1 to 15 was not favored by the exchange, and Bache tried to maintain its ratio between 1 to 12 and 1 to 14 1/2. In addition to funds obtained from its general and1968 U.S. Tax Ct. LEXIS 154">*160 limited partners, its capital resources included funds obtained by subordinated indebtedness. Bache obtained capital funds from customers who agreed, for a consideration, to subordinate their loans to the claims of general creditors and from other lenders who agreed, in exchange for a higher interest rate, to the subordination of their loans.
Generally, all cash receipts and disbursements of Bache were deposited and withdrawn daily from various general-purpose checking accounts maintained by Bache. Bache's deposits in such accounts included proceeds from bank borrowings and the securing of subordinated indebtedness, receipts from sales of securities owned by both Bache and its customers, cash advances by customers, cash from other brokers given as security for securities that Bache loaned to such brokers, and cash from advances and capital contributions from partners. Disbursements from such accounts included payment for purchases of securities by both Bache and its customers, cash withdrawals by customers, payment of principal and interest on loans to banks and subordinated lenders, payment of amounts due to other brokers, withdrawals by partners, and the replenishment of funds1968 U.S. Tax Ct. LEXIS 154">*161 and special checking accounts maintained to pay operating expenses of Bache.
In Bache's general purpose checking accounts, funds were completely commingled so that the source of such funds could not be traced through the accounts to any particular application of the funds. For example, the proceeds from bank loans secured by customers' securities were commingled in the general accounts with all other proceeds of Bache; then, from such accounts, Bache, among other things, both loaned funds to customers for the purchase of securities on margin and made payments for the purchase of tax-exempt securities.
The amount of funds that Bache borrowed from banks was determined on a daily basis. This determination was made by a clerk who at a specific time each day would contact each section of the cashier's department to determine the amounts of receipts and disbursements to that point of the day and the amounts of receipts and disbursements that could be expected for the remainder of the day. If total disbursements for the day were expected to exceed total receipts, Bache would borrow from banks the amount needed to maintain a reasonable cash position. If total receipts for the day were1968 U.S. Tax Ct. LEXIS 154">*162 expected to exceed total disbursements, Bache would repay to banks the amount not needed to maintain a reasonable cash position. No specific check of the amounts of receipts and disbursements from sales and purchases of tax-exempt 50 T.C. 11">*15 securities was made, nor was a specific check made of the amounts of debit balances in customers' margin accounts.
The average monthly value of Bache's assets was $ 168,193,418.94, and the average monthly value of all tax-exempt securities owned by Bache, excluding only tax-exempt securities acquired with customers' credit balances in commodity accounts, was $ 1,935,522.67. The average monthly balance of Bache's bank borrowings was $ 77,661,538.46, and the average monthly balance of its subordinated indebtedness was $ 3,208,391.35. The average monthly amounts due to Bache from its customers, largely because of margin accounts, was $ 133,965,259.92.
The total interest expense accrued by Bache on indebtedness was $ 2,853,271.65, and the total amount of interest income on tax-exempt securities was $ 58,933.24. Such income constituted less than one-fourth of 1 percent of Bache's gross income of $ 25,414,365.46 as shown on its partnership tax return.
1968 U.S. Tax Ct. LEXIS 154">*163 On its partnership information return, Bache treated $ 972.48 of the total interest accrued by it as interest that was not deductible under
The respondent's determination that $ 25,913 of the interest accrued by Bache was not deductible under
The respondent determined in the notice of deficiency that Bache paid or accrued interest in the amount of $ 25,913 that was not deductible under 265(2) and thus that Bache had overstated interest allowable as a deduction on its partnership information return in the amount of $ 24,940.52. The petitioner's distributive share of the asserted overstatement was $ 686.71.
50 T.C. 11">*26 OPINION
This case presents us with a new test of the scope of
In his return for 1959, the petitioner treated a small portion of the Bache indebtedness as subject to the rule of
No deduction shall be allowed for -- (1) Expenses. -- Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest * * * wholly exempt1968 U.S. Tax Ct. LEXIS 154">*166 from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 * * * which is allocable to interest * * * wholly exempt from the taxes imposed by this subtitle. (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. * * *
A mere reading of the statute leaves us with questions as to what is meant by the phrase "incurred or continued to purchase or carry" and what significance should be drawn from the differences in the language of
Also in connection1968 U.S. Tax Ct. LEXIS 154">*167 with the Revenue Act of 1918, the House Ways and Means Committee, stating that the statute was "difficult of administration, for in many cases it is impossible to tell for what purpose indebtedness is incurred," proposed that interest should be deductible only to the extent that it exceeded the amount of tax-exempt interest received by the taxpayer. H. Rept. No. 767, 65th Cong., 3d Sess., p. 10 (1918). The Senate rejected the House proposal, and the House receded in conference. S. Rept. No. 617, 65th Cong., 3d Sess., pp. 6-7 (1918); H. Rept. No. 1037, 65th Cong., 3d Sess. (1919), 1939-1 C.B. (Part 2) 135. Then, in connection with the Revenue Act of 1924 and the Revenue Act of 1926, the House proposed similar amendments that would allow a deduction for interest not incurred in carrying on a trade or business only to the extent that such interest (and, in the Revenue Act of 1924, nonbusiness losses) exceeded income from tax-exempt obligations. H. Rept. No. 179, 68th Cong., 1st Sess., p. 21 (1924); H. Rept. No. 1, 69th Cong., 1st Sess., p. 7 (1925). The Senate again rejected the House amendments, and the House receded in the conferences, S. Rept. No. 398, 1968 U.S. Tax Ct. LEXIS 154">*168 68th Cong., 1st Sess., p. 24 (1924); H. Rept. No. 844, 68th Cong., 1st Sess., p. 19 (1924). S. Rept. No. 52, 69th Cong., 1st Sess., p. 21 (1926); H. Rept. No. 356, 69th Cong., 1st Sess., p. 21 (1926).
Finally, as a part of the Revenue Act of 1934, the House again proposed to amend the predecessor of
At the1968 U.S. Tax Ct. LEXIS 154">*169 same time, the Ways and Means Committee also proposed the substance of the rule which now appears as
The Senate disagreed with the changes in the rules of
While your committee is in general accord with the House provision, it is not believed that this disallowance should be made to apply to expenditures incurred in earning tax-exempt interest. To do so might seriously interfere with 50 T.C. 11">*18 the sale of Federal and State securities, which would be unfortunate during the present emergency. Accordingly, your committee recommends that the disallowance be applied to all classes of tax-exempt income except interest. Thus, a bank or other financial institution will not be denied a deduction for expenses incurred in earning tax-exempt interest. [S. Rept. No. 558, 73d Cong., 2d Sess., p. 27 (1934).]
This legislative history is illuminating and furnishes some clarification of the legislative purposes, 1968 U.S. Tax Ct. LEXIS 154">*170 although not enough to eliminate the necessity of judicial interpretations. It is clear that different tests are to be applied under paragraphs (1) and (2) of
In
In
In
In
There is an obvious relationship between the debt and the tax-exempt bonds and it is apparent that continuation of the indebtedness was not necessary other than for the purpose of continuing to hold the bonds. There were undoubtedly good business reasons for holding the bonds apart from the favorable tax aspects, 1968 U.S. Tax Ct. LEXIS 154">*175 but the latter dominated. This conclusion need not jeopardize the taxpayer whose dominant reasons for continuing indebtedness are unrelated to carrying tax-exempt bonds. [
In
The court applied the test of determining whether there was a "sufficiently direct relationship" between the taxpayer's debt and the carrying of the tax-exempt securities. The court found that this relationship existed with respect to the taxpayer's seasonal bank borrowings because the tax-exempt securities were used as collateral for such borrowings, and because --
the deduction should not be allowed if a taxpayer could reasonably have foreseen at the time of purchasing the tax-exempts that a loan would probably be required to meet future economic needs of an ordinary, recurrent variety. * * * (68-1 U.S.T.C. par. 9145)
However, as to the taxpayer's borrowing to build a new plant, the court did not find a sufficiently direct relationship, stating that business reasons dominated the mortgaging of the property -- it was not necessary for the taxpayer to sacrifice liquidity.
In recapitulating these cases, we see that the courts have applied a purpose test in determining whether indebtedness is incurred or continued to purchase or carry tax-exempt securities. The finding of the taxpayer's purpose does not depend solely upon1968 U.S. Tax Ct. LEXIS 154">*177 looking into his mind and learning what he was thinking; although his intentions are relevant, purpose may be inferred from his conduct and from the circumstances 50 T.C. 11">*21 that confronted him. In
In the case before us, the facts are materially different from those cases in which the courts inferred that the purpose for the borrowing was to purchase or carry tax-exempt securities. The average amount of Bache's indebtedness at the end of each month during its 1959 taxable year was approximately $ 80 million, and the average amount of its tax-exempt securities held at the end of each such month was a little less than $ 2 million. Thus, there was some relationship between its indebtedness and its holding in tax-exempts -- if it had held no tax-exempts, it would have had to borrow less. Nevertheless, we think that the circumstances of this case do not support an inference that indebtedness was 1968 U.S. Tax Ct. LEXIS 154">*179 incurred to purchase the tax-exempt holdings. When the daily decision was made as to whether Bache would borrow more or repay some of its loans, the evidence indicates that no one consciously considered that by selling off all the tax-exempts they could reduce the amount which had to be borrowed. Furthermore, unlike
1968 U.S. Tax Ct. LEXIS 154">*181 To state the respondent's argument reveals its weakness. He argues that Bache borrowed money for the purpose of conducting its business, including the holding of some tax-exempt securities; that since the use of the borrowed funds cannot be traced, it is reasonable to allocate them to all the business purposes of Bache; that since Bache cannot show that the borrowed funds were used for purposes other than the holding of tax-exempt securities, some of the borrowed money should be allocated to that purpose; and that his method of allocating some of the indebtedness to the purchase of the tax-exempt securities is reasonable. However, this proposition is manifestly inconsistent with the legislative purposes of
Our interpretation of the scope of
1968 U.S. Tax Ct. LEXIS 154">*184 Accordingly, we find that in its 1959 taxable year, Bache did not incur or continue any indebtedness to purchase or carry tax-exempt securities within the meaning of
In order to reflect the computations required by this opinion and the failure of the petitioner to contest other adjustments in the notice of deficiency,
Tannenwald,
Bache, as an ongoing integral part of its business operations, regularly purchased tax-exempt securities in the course of its participation in underwriting securities and also regularly bought tax-exempt securities to help maintain a market in the issues of this type in which it was interested. It cannot be gainsaid that such purchases were for its own account and not for the account of customers. The fact that it had a house rule pursuant to which it sought to sell tax-exempt securities thus purchased within 90 days does not militate against this conclusion. It is clear that Bache calculated its borrowing needs in terms of its daily cash requirements, 1968 U.S. Tax Ct. LEXIS 154">*186 of which cash used to purchase tax exempts was one. Under these circumstances, there is a sufficiently direct identification between the purchases and the borrowings to warrant the application of
Nor does the legislative history eliminating interest from the allocation provision of
1. All statutory references are to the Internal Revenue Code of 1954 unless otherwise indicated.↩
2. All values in such fraction are average monthly values.↩
3. Although the stipulation provides that Bache invested in tax-exempts, other evidence indicates that the tax-exempts which the partnership owned were acquired as an incident of the brokerage business -- through participation in syndications, through maintaining a market in tax-exempts, and through purchases for customers. The evidence also indicates that the firm policy was to dispose of tax-exempts as promptly as possible. Taking all of this evidence into consideration, it appears that Bache had no plan to purchase tax-exempts and hold them as a desirable investment.↩
4. A contrary inference might conceivably be drawn from the 1964 enactment of a provision allowing a face-amount certificate company a partial exemption from the application of
