54 T.C. 940">*941 Respondent determined deficiencies in the Federal income taxes of petitioner as follows:

After various concessions, the sole issue remaining for decision is whether certain interest expenses incurred during the years in question by petitioner, a dealer in municipal bonds, fall within the meaning of section 265(2), ¹ which disallows the deduction of interest on indebtedness incurred or continued to purchase or carry obligations, the interest on which is wholly exempt from income taxes.

FINDINGS OF FACT

Some of the facts and exhibits have been stipulated and are incorporated herein by this reference.

The petitioner, Kirchner, Moore & Co., is a corporation duly organized under the laws of the State of Colorado with principal1970 U.S. Tax Ct. LEXIS 147">*149 offices at 718 17th Street, Denver, Colo. 80202. The petitioner, on the date of the mailing of the notice of deficiency and on the date of the filing of the petition, maintained its principal offices at the address indicated above.

The petitioner's income tax returns (Forms 1120) for the taxable period commencing December 27, 1961, and ending November 30, 1962, and for the taxable years ending November 30, 1963, through November 30, 1966, were filed with the district director of internal revenue at Denver, Colo. Its income and deductions reported in these returns are based on the accrual method of accounting.

The petitioner's business is principally that of a dealer in the bonds of political subdivisions of the various States, hereinafter referred to as municipal bonds. Also, the petitioner receives remuneration for underwriting services rendered to political subdivisions of the various States relative to the issuance of municipal bonds.

The petitioner's operations as a dealer in municipal bonds are normally conducted in the following manner:

54 T.C. 940">*942 (a) The petitioner, through its officers and employees, will consider and evaluate the profit potential on resale of various municipal1970 U.S. Tax Ct. LEXIS 147">*150 bonds which are expected to be issued by political subdivisions of the various States, sometimes hereinafter referred to as municipalities. Sometimes this analysis and evaluation is conducted in syndicate with other municipal bond dealers.

(b) After determining that a particular proposed issue of municipal bonds has sufficient profit potential on resale, the petitioner, either alone or as a member of a syndicate of municipal bond dealers, submits a competitive bid or negotiates a price for the purchase of these municipal bonds. If the bid is accepted or the negotiation successful, a written contract for the purchase of the bonds is signed with the municipality, providing for completion of the purchase "when, as and if" the municipality receives an appropriate legal opinion upholding the legality of the issue. In general, the time required to obtain this opinion, print the bonds, and then deliver the bonds to the petitioner is about 30 to 45 days from the date the contract is signed.

(c) Immediately after the petitioner's bid is accepted or its negotiation successfully concluded, the petitioner prepares a circular or offering sheet describing in detail the municipality, the terms1970 U.S. Tax Ct. LEXIS 147">*151 and conditions of the bonds, the price at which the petitioner will sell the bonds (expressed by reference to the net yield of the bonds), and other information material to a prospective purchaser of the bonds from the petitioner.

(d) The petitioner immediately mails the circular to its customers, who consist primarily of banks, and to a lesser extent, insurance companies and individuals, mostly located in the Rocky Mountain area. Most of the petitioner's customers have dealt with the petitioner for some time. Petitioner's officers and employees know most of its customers personally, which is very important to petitioner's business. These customers have great confidence in petitioner as a reputable municipal bond dealer. The petitioner has acquired its reputation by its good performance in selling municipal bonds and rendering personal attention to the municipal bond portfolios of its customers.

(e) Concurrently with or shortly after the mailing of the circular, one or more bond salesmen employed by the petitioner telephones the petitioner's customers and solicits commitments to purchase the bonds from the petitioner on the same "when, as and if" basis as the petitioner's commitment1970 U.S. Tax Ct. LEXIS 147">*152 to the municipality. The salesmen seek to obtain purchase commitments on as many of the bonds as possible prior to the delivery of the bonds from the municipality to petitioner. If a commitment is obtained, a written confirmation follows. No definite delivery date is agreed upon, but the bond salesman customarily gives the customer an oral estimate of the anticipated delivery date.

54 T.C. 940">*943 (f) When the municipality is ready to deliver the bonds to the petitioner, it contacts the petitioner (or the manager of the syndicate of dealers to which the petitioner belongs) and negotiates the precise delivery date. On the agreed delivery date, the petitioner receives delivery of the bonds and makes payment for them to the municipality.

(g) As soon as the delivery date from the municipality is definitely determined, the petitioner takes the steps necessary to arrange for the completion of sale to its customers of those bonds which they have previously agreed to buy. These steps consist of (1) sending written notification to the customer that the petitioner will be able to make delivery on a specified date; (2) waiting until the customer can arrange with a bank (hereinafter called the1970 U.S. Tax Ct. LEXIS 147">*153 paying bank) to receive delivery and make payment to the petitioner; and (3) delivering the bonds or causing the bonds to be delivered to the paying bank (by hand if the paying bank is in Denver, or by mail if the paying bank is not in Denver) as soon as possible after the municipality delivers the bonds to the petitioner. When the paying bank receives the bonds, it verifies that they are in order (e.g., that the appropriate legal opinion is attached), releases them to the customer, and remits payment. In those cases where the petitioner has received a commitment to purchase from a customer, the petitioner always endeavors to complete the resale, delivery, and payment procedure described above on the day the petitioner receives the bonds from the municipality; but in many cases, particularly if the paying bank is not located in Denver so that the bonds must be mailed to it, the petitioner is unable to complete the procedure until several days after it receives the bonds from the municipality. The petitioner always endeavors to obtain purchase commitments for the remainder of its bonds and deliver them, as described above, as quickly as it can.

In those situations where petitioner1970 U.S. Tax Ct. LEXIS 147">*154 is unable to complete the resale of the bonds to its committed customers on the date it takes delivery of the bonds from the municipality, or has not yet obtained a purchaser for the bonds, petitioner ordinarily is required to borrow funds to meet the balance due on the purchase price. Under these circumstances, petitioner borrows from the Central Bank & Trust Co. of Denver or the First National Bank of Denver (hereinafter called the lending banks) up to 98 percent of the lower of cost or sales value of the particular bonds for which it has obtained commitments to purchase, but not in excess of par value, and up to 95 percent or 96 percent of the lower of cost or par value of the bonds for which the petitioner has not yet received purchase commitments. Those bonds for which petitioner has commitments of sale and those for which the petitioner has no commitment of sale are held by the lending bank as security for the petitioner's loan which is represented by the petitioner's interest-bearing note.

54 T.C. 940">*944 The parties have stipulated "that the loans referred to" in the above paragraph "are used by the petitioner to pay all or a part of the purchase price of the bonds and to retain1970 U.S. Tax Ct. LEXIS 147">*155 the bonds and to complete or accomplish the resale of the bonds at a later date." We cannot understand or interpret this portion of the stipulation, which is in part meaningless and in part in conflict with other evidence of record, as petitioner urges us to do. The loan proceeds referred to were acquired and used by petitioner to pay all or a part of the purchase price of the bonds referred to, and the loans were continued to carry them pending their sale at the earliest opportunity. The indebtedness was incurred and continued for the purpose of purchasing and carrying tax-exempt securities until their ultimate resale. ² The purchase, retention, and resale of the aforementioned bonds constitute a typical business cycle of petitioner.

1970 U.S. Tax Ct. LEXIS 147">*156 When the petitioner is ready to complete a sale of bonds pledged as collateral for the loans described above, these bonds are transmitted by hand or mailed to the paying bank designated by the purchaser. If the bonds are to be transmitted by hand, the certificates are released to the petitioner upon receipt of the petitioner's check in an amount equal to the prorata share of the loan securing the bonds sold. The petitioner, upon delivery of the bonds to the purchaser's paying bank, receives a check or draft on the customer's account and the said check or draft is deposited in the petitioner's account with the lending bank. This appears to be the substance of the parties' stipulation as to this procedure as far as we are able to interpret it.

The parties have also stipulated as to the procedures followed where petitioners' sales of municipal bonds are handled by mail. Portions of this part of the stipulation are also confusing, garbled, and conflicting. We set it forth as filed although we do not believe that the lending bank was repaid its loans twice, once by check and once by draft proceeds from the purchaser's paying bank as indicated by (b) of the following paragraph 12 of1970 U.S. Tax Ct. LEXIS 147">*157 the stipulation:

12. In the cases where the resale of the bonds is to be completed through the mails, the transaction is handled in the following manner by the respective lending banks; namely, Central Bank and Trust Co. of Denver and the First National Bank of Denver:

(a) Where the lending bank is the Central Bank and Trust Co. of Denver, such bank at the direction of the petitioner will mail to the paying bank the bonds, 54 T.C. 940">*945 and a draft drawn by the petitioner against the customer for the full sales price of the bonds. The draft drawn by the petitioner against the customer is made payable to the lending bank. * * * Upon receipt of the bonds the paying bank will, if it accepts the bonds, honor the draft drawn by the petitioner against the customer and remit payment to the lending bank. Upon receipt of payment, the lending bank deducts costs of handling the shipment of the bonds, such as insurance, mailing costs, and a nominal draft charge, from the sale proceeds. The remaining sale proceeds are deposited into petitioner's general checking account with the lending bank. At the same time of the deposit of the remaining sale proceeds in the petitioner's checking account, 1970 U.S. Tax Ct. LEXIS 147">*158 or immediately thereafter, the lending bank will charge against the petitioner's checking account an amount equal to the loan which was secured by the bonds which were sold.

(b) Where the lending bank is the First National Bank of Denver, such bank on direction of the petitioner will mail to the paying bank the bonds and a draft drawn by the petitioner against the customer for the sales price of the bonds. At the time of the mailing, the lending bank credits the petitioner's checking account for the amount of the draft. At the same time, the petitioner will give the lending bank a check for the portion of the petitioner's note which is allocable to the mailed bonds. The draft drawn by the petitioner on the customer is made payable to the lending bank. Upon receipt of the bonds, the paying bank will, if it accepts the bonds, honor the draft drawn by the petitioner against the customer and remit payment to the lending bank. The lending bank retains this payment and bills the petitioner separately for draft charges, handling, and shipping costs.

All bonds purchased by the petitioner during the taxable years at issue were purchased for resale to its customers in the ordinary course1970 U.S. Tax Ct. LEXIS 147">*159 of its business. Petitioner does not have any plan to invest in and hold municipal bonds as a desirable investment.

On the date it receives delivery of the bonds from the municipality, petitioner acquires legal title to the same and receives all interest income from these bonds until the designated delivery date to the paying bank. The above-mentioned interest income has not been included in the gross income reported on petitioner's income tax returns, such income having been treated as being tax exempt under the provisions of section 103. ³

In each of the years in issue, the rate of interest on loans collateralized by municipal bonds nearly always exceeded the rate of interest paid on municipal bonds.

The profit earned by the petitioner from its resale of municipal bonds is attributable to a number of factors, including its direct selling activities and services, its reputation and personal contacts with its customers as established1970 U.S. Tax Ct. LEXIS 147">*160 over a considerable period of time, and its ability to accurately evaluate and appraise the profit potential on resale of the various tax-exempt securities offered by the municipalities. Of the 17 people in petitioner's employ, 13 are primarily engaged in one or more of the selling activities of the business; the other 4 54 T.C. 940">*946 employees are primarily involved in the buying activities of the business.

The petitioner does not realize gain from any appreciation in the value of its municipal bonds during the time such bonds are retained. The principal reason for this is that the petitioner in virtually all cases, if it is acting outside a syndicate, maintains its initial offering price as stated in its circular; if it is acting within a syndicate, the petitioner will deviate from its price only with permission of the syndicate manager, and then only to lower the price so as to make the bonds more attractive on the market.

The petitioner regularly owns assets other than municipal bonds, which it uses in its trade or business. One of its current assets is "good faith" deposits, which represent deposits made with the municipalities in order to secure petitioner's obligations to purchase1970 U.S. Tax Ct. LEXIS 147">*161 the particular municipal bonds there involved.

The following table shows the petitioner's average total assets and its average total municipal bonds on the monthends during each of the 5 taxable years at issue, as shown on the petitioner's books:

The following table (designated "Table B") shows the relative amounts and percentages of the petitioner's tax-exempt municipal bond interest income and its gross income from all other sources:

The following table (designated "Table C") shows the relative amounts and percentage of the petitioner's tax-exempt municipal 54 T.C. 940">*947 bond interest income and its gross income from sales of municipal bonds:

Petitioner on its Federal income tax returns for each of its 5 taxable years at issue claimed deductions under sections 162 and 163 of the Internal Revenue Code for an amount of interest expense determined by multiplying its total interest expense for each year times the percentage shown in column IV of Table B for such year.

Respondent, in his statutory notice of deficiency, determined, inter alia, that the petitioner was not entitled to deductions for interest expense "on money borrowed and used to purchase or carry obligations, the interest on which is exempt from Federal income tax" in the following amounts for the taxable years ⁴ indicated below:

1970 U.S. Tax Ct. LEXIS 147">*164 As a result of various concessions made by respondent, the following amounts of interest incurred by petitioner during the years in question remain at issue:

54 T.C. 940">*948 The above amounts represent the interest on notes and drafts to the lending banks attributable to those periods of time of the various loans up to the designated delivery dates of the bonds to the paying banks. Respondent has conceded, inter alia, that the interest incurred after the delivery of the bonds to the paying bank, whereupon petitioner no longer holds beneficial title to the bonds, is a deductible interest expense directly attributable to the carrying of the accounts receivable which come into existence for an average 2 1/2-day interlude between the delivery of such bonds and the receipt of payment thereon by petitioner.

In its amended petition to this Court for redetermination of the deficiencies set forth by respondent in his notice of deficiency, petitioner has prayed that we find that there is no deficiency in income taxes due for any of the years in question, and further, "that there are overpayments1970 U.S. Tax Ct. LEXIS 147">*165 of such taxes for such years in such amounts as the Court may determine in accordance with its findings in the case."

ULTIMATE FINDING OF FACT

Petitioner, a dealer in municipal bonds, incurred and continued the indebtedness in question for the purpose of purchasing and carrying such bonds until the time of their subsequent resale.

OPINION

In its business of dealing in municipal bonds, during the years in question, petitioner found it necessary in many cases to borrow money from various banks in order to finance the purchase and holding of such bonds until the time of their subsequent resale. Petitioner incurred interest on these borrowings, a substantial part thereof (the amounts here in issue) being attributable to the periods of time of the various loans up to the designated delivery dates of the bonds to the paying banks representing petitioner's customers. The issue presented for our decision, upon these facts, is whether all or any part of the above-described interest expense falls within the disallowance provisions of section 265(2).

Section 265(2) provides, in pertinent part, as follows:

SEC. 265. EXPENSES AND INTEREST RELATING TO TAX-EXEMPT INCOME.

No deduction shall be1970 U.S. Tax Ct. LEXIS 147">*166 allowed for --

* * * *

(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.