Earl Warren: Number 489, United States, Petitioner, versus Atlas Life Insurance Company. Mr. Solicitor General.
Archibald Cox: Mr. Chief Justice Warren, and may it please the Court. This is a tax case here on certiorari to the Tenth Circuit which has very great, indeed enormous financial implications for both the government and the life insurance industry. Now, the potential claims for refund according to our estimates run to $400,000,000 and the annual revenue that they have to pay and we would receive we estimate as about $77,000,000. One can get at the issues in the case best I think by beginning a little way of talk. Under state law, life insurance companies are required to maintain a reserve for policyholders. The amount of the reserve is required to be that sum which with annual additions at an assumed rate of interest, the same rate used in calculating premiums plus future accruing premiums will be sufficient to pay the policyholders' claims as they mature according to actuarial competitions. This means that in each year, the company must add to its reserve an addition a sum made up by applying the accrued -- the assumed rate of interest to its -- to the reserve. We've shown this in an example that I shall refer to very frequently on a chart in the very back of our brief. You will note there that we have assumed a company with a total investment yield of a million dollars and it is required to set aside out of that million dollars a total of $800,000 as the annual addition to the policyholders' reserve. That is -- no, the first element of this problem is that Congress has since 1921 taken the view that the addition to the policyholders reserve should be allowed as a deduction in computing a company's net income tax. And that's the first element in the problem, the annual addition to the policyholders' reserve. The second element in the problem is the interest received by a life insurance company from state, county or municipal bonds, I shall call them all-state bonds for convenience. In our example, we assume that the 10% of the total investment yield or $100,000 which is shown on the left of our chart as the cross attached area. I -- as a matter of legislative policy backed perhaps by constitutional necessity, Congress does not tax the income from state bonds. Now the problem --
Potter Stewart: Where is your chart up here?
Archibald Cox: The very back of our brief. It's a (Inaudilbe).
Potter Stewart: All the way at back, I see.
Archibald Cox: Yes, the very back.
Potter Stewart: Thank you.
Archibald Cox: And I shall refer to it to take simplified figures quite frequently. Now the problem revolves around at least two factors. The annual addition of the policyholders' reserve and the income from state bonds and what it is, is simply this. In computing a net income tax, what relationship -- what should be the proper relationship between the dollars that the company receives in state bond interest, $100,000 in our example and the dollars that flow into the annual addition for the policyholders' reserve, the gray area or $800,000 in our example, should it be assumed that all the state bond interest, the whole $100,000 went to make up part of the annual addition to the policyholders' reserve? Should it be assumed that none of the state bond interest went to make up the annual addition to the policyholders' reserve, or should the answer be in between that part of the tax-exempt dollars went to make up to the policyholders' reserve and part of the tax-exempt dollars were left to the company or to the shareholders as their profit. In the Revenue Act of 1921, Congress took what was in effect the first view. It allowed a deduction for the addition to the policyholders' --
William J. Brennan, Jr.: Mr. Solicitor General, would you let me try to simplify it and I hope I don't really complicate it. (Inaudilbe) in your picking?
Archibald Cox: Yes.
William J. Brennan, Jr.: If $8 is needed for the policyholders' reserve --
Archibald Cox: Right.
William J. Brennan, Jr.: -- $3 for the company.
Archibald Cox: Right.
William J. Brennan, Jr.: And actually what they receive is $5 in the state bondage and $5 in General Motors. The problem is something like this, we have to find $8 for the policyholders' reserve. Now, to take $5 of the General Motors interest, they're still shy of $3.
Archibald Cox: Yes.
William J. Brennan, Jr.: Therefore, you have to take three of the tax -- of the state bond interest --
Archibald Cox: You would have to -- surely you have to do that.
William J. Brennan, Jr.: That -- wouldn't you? That would leave, if you did it that way allocating the whole $5 at General Motors plus $3, that would still leave $2 with the company's interest in what would be a state bondage.
Archibald Cox: Right. And that could not be taxed.
William J. Brennan, Jr.: Right.
Byron R. White: (Voice Overlap)
William J. Brennan, Jr.: Now there would be no tax at all.
Archibald Cox: There would be no tax at all.
William J. Brennan, Jr.: Whereas if you'll allocate the $5 of state bond interest to the policyholders and then draw $3 from the General Motors' interest to make up to $8, then there'd be $2 for General Motors' interest that would be taxed.
Archibald Cox: Right.
William J. Brennan, Jr.: Now, what I'm not quite sure off, the government's position is that neither of those solutions applied.
Archibald Cox: That's correct.
William J. Brennan, Jr.: The government's position is that the allocation should be applied.
Archibald Cox: $4 from the General Motors' interest and $4 from the municipal bond reduction.
William J. Brennan, Jr.: So that then the tax is on $1?
Archibald Cox: So the tax would be on $1 --
William J. Brennan, Jr.: One dollar.
Archibald Cox: -- because the company has $1 that's left. Now, you'll note that I may say that in your example, Mr. Darrell's position would be that there's no tax at all.
William J. Brennan, Jr.: That's right.
Archibald Cox: Our position would be that the way you stated it first where the statute requires all the bond interest to be used up first for the policyholders' reserve as in the 1921 Act. But we agree that that is a tax on straight bond interest under the National Life Inc. But we say in effect, to come back if I may to my example, because it's -- it will never happen I think that the municipal bond interest is greater than the amount left with the company. You will all -- nearly always have although it isn't necessarily so, a smaller percentage of your assets in municipal bond. But then you are required to set aside for the partial interest.
William J. Brennan, Jr.: And that's the way the insurance company invest.
Archibald Cox: Yes, yes. In our example, it comes to the same thing. The 1921 statute said that the company -- that the companies could deduct the $800,000 or $8 for the annual addition to the policyholders' reserve but only less the full amount of the state bond interest. And that meant that no matter how much money you put in the municipal bond, how much of your income you derive from it, you still got only the same deductions that was allowed to a company which had no money in municipal bond and that's what the National Life case was. Now, then in 1942, the Congress took what we regard as the proper method of allocation. Instead of saying that all the money, all the addition to the reserve must be treated as coming from taxable income or instead of saying that all of this must be treated as coming from state bond interest to the full amount of the state bond interest, in 1942, Congress said we will assume that the dollars flow ratably. That to use my example, 80% of the state bond interest flowed into the reserve -- the annual addition to the policyholders' reserve and that 80% of the taxable income flowed into the policyholders' reserve. It did this not on a company by company basis but on an industry wide basis but it nevertheless followed that intermediate or third method. Then in 1959, Congress revised the act -- taxing life insurance companies so as again to follow the intermediate method making a ratable apportionment but doing it this time on a company by company basis. That was done with the support of 70% of the life insurance companies measured by the value of their assets and they agreed that that did not impose a tax on state bond interest. Now, let me if I may turn to the actual provisions of the statute and show how this works out.
Potter Stewart: Before you do Mr. Solicitor General, you mentioned a moment ago about tax -- taxability through the company or its stockholders, the -- stock companies or mutual companies are treated --
Archibald Cox: No.
Potter Stewart: -- exactly alike here, I think.
Archibald Cox: If -- for all purposes, they are the same in this.
Potter Stewart: And we're talking only about income as (Voice Overlap) --
Archibald Cox: When I said that --
Potter Stewart: -- on the insurance companies, said company.
Archibald Cox: Right, right. I just meant it was available as a crème at the top, that was -- that's all.
Potter Stewart: Well, that's -- but most of them are -- don't have stockholders anymore, if you know, there's many of them.
Archibald Cox: Right. Well, it's left to the company. I should have avoided the expression. It doesn't affect the case.
Potter Stewart: Right.
Archibald Cox: The statute is set forth beginning at page 87 of our brief. You'll note that Section 802 over on page 88 imposes a tax on the life insurance company taxable income. And then 802 (b) defines life insurance company taxable income in such a way as to make the major components taxable investment income or gain from operations. Gain from operations is always a component of life insurance company taxable income. In some cases, taxable investment income is and in other cases, it isn't. Now, the same problem here essentially arises both in the case of gain from operations and the computation of taxable investment income. And in order to simplify the explanation, I'm going to confine myself to gain from operations. Section 809 on page 93 deals with the subject of gain from operations, it provides that the share of each and every item of investment yield including the tax-exempt interest, which is set aside for policyholders, shall not be included in the gain from operations. And you'll note that in the second sentence, it provides a formula stating how the share for policyholders shall be computed. And what it is in effect is a declaration that it will be the same percentage as the required annual addition to the policyholders' reserve, $800,000 in our example, bears to the total investment yield, a million in our example or 80%, so the policyholders' share is 80% of every item and the company share is 80% of every item. Then, in defining gain or loss from operations, the statute provides that it shall consist of the company's share of every item, the shares added together plus various items which are chiefly the underwriting income that we're not concerned with, less the deductions allowed in subdivision (d) over on page 94. The sub -- the deductions allowed under subdivision (d) on page 94 include the company's share of any tax-exempt income, specifically state bond interest and the intracorporate dividends to a percentage and so forth. So that in effect what happens is that the 20% of the state bond interest shown in the upper right hand corner of my chart, it is set aside as the company's share and is on any ratable allocation of the company's share is excluded from gain from operations so that it isn't taxed and the rest of it of course isn't taxed because it is treated as set off to the policyholders and that it -- full deduction is allowed for that amount. Now, there's one further point that I should emphasize. When the formula that I have just tried to describe and another formula that was the mathematical and legal equivalent were before the Congress, it was argued that the formulas imposed a tax on state bond interest. But that was disputed by the Treasury. It was disputed by both congressional committees and by most of the proponents of this bill but there was an argument on the point. The -- there was also an argument on the second point which was what the Treasury was -- which was whether the Treasury was really trying not to say that this wasn't a tax on state bond interest but to overturn the whole doctrine that state bond interest is immune from tax as some of the earlier decisions on intergovernmental immunities had been overturned in the 1930s by this Court. The proponents of the bill agreed that it would be undesirable to overturn the basic doctrine apparently. They denied that this was in a violation of the basic doctrine which the critics asserted the opposite. But the upshot was that there was written in to the statute an exception clause which appears on page 94 of our gain from operations is a concern, which provides in substance that if it is established, it's conditional. If it is established that in any case the formula that I explained results in a tax, the imposition of a tax on the state bond interest, then an adjustment shall be made. Now the -- if it isn't satisfied, then of course the clause doesn't operate. Now, in the present case, the respondent originally computed its tax according to the formula I've described and the parallel formula applicable to taxable investment income that has a similar exception clause paid the tax. And then it sued for a refund claiming that the application of the statutory formula resulted in a tax on its state bond interest equivalent to the $100,000 state bond interest in the example that I've been referring to. Now, the District Court rejected that contention and dismissed the suit. The Court of Appeals with the Tenth Circuit reversed holding that in its view since respondent would not have paid as high a tax but for the inclusion of the sate bond interest in the computation. The incidence of the tax was on the state bond interest bringing the case within the exception clause and requiring an adjustment, and we then brought the case here. I think it will be helpful before I turn to the exact legal issue to emphasize the practical difference in the results of the opposing computations. In our view, a life insurance company's taxable income after deduction for the addition to the reserve is reduced proportionally as it shifts its investments from taxable interest -- to take -- yes, taxable interest to tax-exempt interest. For example, in the exe -- in the illustration in the back of the book, if the total investment yield were a million dollars entirely in taxable securities, the company would be taxed on $200,000. If it shifted 10% of its income into tax-free interest or if -- it should -- let me the first 5% of its income into tax-free interest, then the income taxed would be $190,000 or 5% less. If it put 10% in the tax-exempt interest, then as the example shows, the taxed income will be reduced 10%.
Potter Stewart: Are you talking about the -- changing into those percentages of tax-free income, income after the reserved addition --
Archibald Cox: Yes.
Potter Stewart: -- or after?
Archibald Cox: Yes.
Potter Stewart: (Voice Overlap)
Archibald Cox: Oh, no! I put -- talking -- talking --
Potter Stewart: Total?
Archibald Cox: -- about putting total.
Potter Stewart: Total?
Archibald Cox: Total, excuse me. I was talking about the consequence on what was taxed after --
Potter Stewart: After.
Archibald Cox: -- the deduction.
Potter Stewart: But you're talking about total per se.
Archibald Cox: I'm talking about total just as shown -- as we show the 10% here by the cross (Inaudilbe). And my point is that as each fraction but -- of its income is drawn from tax-exempt instead of tax --
Potter Stewart: Taxable?
Archibald Cox: Taxable, it's -- the tax base is reduced proportionately. And we say -- and that continues, Mr. Justice Stewart, no matter how much has shifted. If you work it out, the tax base will never exceed. In fact, it will never equal the amount of income drawn from taxable sources. That will always be true and we think that's one of the things that shows there is no tax imposed on the tax-free interest here.
Byron R. White: Isn't this sort of the analysis from Mr. Justice Stone in Gehner?
Archibald Cox: I think this is very similar to the analysis of Mr. Justice Stone in Gehner.
Byron R. White: It didn't quite prevail.
Archibald Cox: Which didn't prevail, but that was not a case dealing with net -- a net income tax. That was a case dealing with a property tax. And it was a case of course which proceeded, as I would explain a little later the decision in Denman and Slayton and the decision in Helvering against Independent Life Insurance so that we think Gehner is distinguishable on its fact and in the light of the later authority certainly doesn't control this case.
Potter Stewart: If the whole income -- this is probably a very stupid question, but if the whole income came from non-taxable sources, state, county and municipal bonds, there would be no question, no problem at all.
Archibald Cox: There'd be no problem.
Potter Stewart: No taxation, no tax.
Archibald Cox: No. There's be no -- there'd be no problem. Indeed, turning now from our view to the respondent's view and concentrating on gain from operations, the respondent says there should be no tax if 20% of the income came from tax-free sources because it would then say that not $100,000 of the $200,000 white area had to be subtracted but of course, it would be twice as much because it would be 20% rather than 10%, they would subtract $200,000 and they would say that that is true so far as gains from operations is concerned. Even though in fact 80% of what was left originated from taxable sources. That is the practical difference between the two potentials. Now, the legal --
Byron R. White: What's your answer though, Mr. Solicitor General, to the National Life I suppose that if you have $40,000 income from taxable sources, and then you get -- then you get the $20,000 worth of tax-free income, you increase your tax.
Archibald Cox: The tax is --
Byron R. White: (Voice Overlap) By reason if they received a tax-exempt income, your tax bill is increased.
Archibald Cox: Well, that in the first place, there are a number of cases where that happens and it does not violate the immunity or the National Life case Your Honor wishes may discuss it now, seems to me to be a quite different problem in this respect. There, as I explained a little earlier, the deduction which was taken against taxable income was limited to the actual cost to the addition of the policyholders' reserve less the full amount of the state bond interest. That -- to their -- and where is that is not the case here. As I said to Mr. Justice Stewart here, every time you shift money into taxable -- into non-taxable income, you have a somewhat lower tax base and a somewhat lower tax.
Byron R. White: (Voice Overlap)
Archibald Cox: Now, I would say --
Byron R. White: Its -- really a difference in kind, not the --
Archibald Cox: Well, --
Byron R. White: -- not in this degree?
Archibald Cox: Let me point out that the -- two differences. One is there's a complete difference in taxable -- in practical result. The other is I think there's an entire difference in theory that goes to the heart of a net income tax, as I'll explain after (Inaudilbe). I -- in the National Life case, what happened was that the man who had income from state bonds was denied the right to deduct from his taxable income the full cost of earning that income. Under this statute, a man is allowed to deduct from his taxable income the full cost of earning that income. And I think this is very clearly a difference in theory. Now, the language that he's quoted from the National Life case in the briefs against us speaks about a man being denied a deduction allowed others because of his holding state bonds. The Court, just before using that language, emphasized that this statute disallowed the normal deduction for the addition to the policyholders' reserve in the full amount, to the full extent of the state bond interest. And I think what it was saying was that one who doesn't have municipal bonds is allowed to deduct from his taxable income the cost of earning the taxable income. One who does have municipal bond isn't allowed to make that deduction of the cost of earning the taxable income. Under this statute, he is allowed to deduct the full cost of earning the taxable income and we think that is a difference not only in practice, on practical result, but also a most material difference in principles for reasons I'll try to state after the recess.
Speaker: (Inaudible)
Archibald Cox: May it please the Court. The precise legal issue here is whether the formula that I spelled out before the recess as applied to the computation of gain from operations and the parallel formula used in computing taxable investment income result in the imposition of a tax on the state bond interest or tax-exempt income. We submit that from whatever angle one approaches the case the formula imposes no tax on the tax-exempt income. There are in fact two quite different ways of looking at this situation. One way of doing the case is to look upon the policyholders' reserve and the annual additions as if this were a trust fund set aside and this was the annual payment of the beneficiary's share treating the policyholders as beneficiary. That's the way the Senate Finance Committee looked at the situation is the way that the formula and the bill looks at the situation and talks about the share of each and attributes to each its ratable share of the different kinds of income. Now, if as we believe and if as we argue in our brief, that is a proper way of analyzing the situation. But then it plainly follows that the formula imposes no tax on tax-exempt interest for the rule set forth in Section 652 (b) of the Internal Revenue Code and followed uniformly and for a long time is that where a trust has income from various sources, including tax-exempt sources, then each beneficiary is supposed to get his ratable share of the income from each of the sources. And in computing his tax, you simply deduct his share of the tax-exempt income of the trust, and the same thing is what is done here. So I say if this is a proper way of looking at it as the Senate Committee looked at it and as we argue that it is that's the end of the case. Now, the other way to look at the problem is to view the annual addition to the reserve as a cost of doing business. More specifically, as I shall show a little later, as a cost of producing the investment income or the million dollars in our example --
Potter Stewart: Like a conventional deduction?
Archibald Cox: That's right.
Potter Stewart: In ordinary --
Archibald Cox: And we argue that view in this light by any conventional tax principle or any accounting rule or indeed by common sense there is no imposition of the tax on the state bond interest. The principles that govern this are very simple and very familiar. First, we're dealing with a tax on net income. This is not a gross receipt of property tax. Second, the deductible costs that are allowed by the government in computing a net income tax may be and usually are limited to those incurred in producing the taxable income. But personal expenses for example are normally not deductible although to some exceptions. Third, this rule in general is plainly applicable to the cost of obtaining tax-exempt income including interest from state bonds. That rule is set forth in Section 265 (1) of the Internal Revenue Code. I can illustrate it very simply by a case that's covered by a court of -- by tax court opinion and the rulings of the Internal Revenue Service. Suppose that I had an office in which I manage and had a clerical staff to manage, my investment securities from which I receive, let's assume, $10,000 income a year, half from state bond interest and half from other taxable securities. And assume that my -- the cost of my office, the cost of the advice of investment advisers, the cost of safe deposit boxes and so forth ran to $4000. Quite plainly under accepted decisions, I could subtract having half of my income from taxable securities only half my cost because the other half would be eligible to the tax-free income and the Congress would be under no obligation to allow that deduction. Now, that part was squarely decided by the case of Denman against Slayton, a decision rendered after Missouri against Gehner, a fortiori after National Life case. There, the taxpayer borrowed money for the purpose of purchasing state bonds and he sought to deduct the interest paid from his taxable income. The commissioner disallowed the deduction and this Court unanimously held that the denial was correct because it does not impose a tax on state bond interest to limit the deductions from taxable income to the cost of producing the taxable income. We say that the statutory formula now before the Court does no more than limit a life insurance company's deductions from the taxable income to the cost of producing it, and that what it does is to deny a deduction for the cost of producing the tax-exempt income. Now, the statutory formula is the legal and mathematical equivalent as I think everyone agrees, of doing this and I refer again to my example in the very back of the brief on the foldout chart. You start with the million dollars of total investment yield. Then exclude all the state bond interest. That's $100,000 leaving $900,000. The annual addition to the policyholders' reserve, $800,000 is a cost of producing both the taxable and the tax-exempt income. The reserve is in effect money which the insurance company has collected from the policyholders. It borrowed it from them. And the annual addition to the reserve at the assumed rate of interest is what it pays them for the use of their money. Since the money was invested in both taxable and tax-exempt securities to produce both taxable and tax-exempt income, the interest paid the policyholders in effect for a loan that the interest -- a portion of the loan put into the tax-exempt securities for the cost of producing the tax-exempt income is under Denman and Slayton, something that the government need not allow in allowing the deduction from the cost of producing taxable income. So to go back to the chart, it needn't allow $80,000 of the total cost of producing both kinds of income and may limit the deduction to $720,000 which comes out the arithmetic of it in every case exactly the way the formula in the Senate Bill. Indeed, this was the formula in the House Bill but the Senate thought the other way. The first way I described of looking at it was clearer. Now, I can see only two conceivable distinctions between Denman and Slayton and the present case. One is that in Denman and Slayton, it was possible to trace the proceeds of the loan into the municipal bonds and to make the allocation via system of tracing. But we're thoroughly familiar with other ways of making allocations in accounting and I take that it's not even the respondent would care to stand on that difference. The difference urged by the respondent is that the interest paid in Denman and Slayton was a direct cost of producing the taxable income, whereas here he says it's not. He argues that the taxpayer in Denman and Slayton would not have incurred the cost of the interest charges without receiving the tax-exempt income. Whereas he says that if the insurance company would have been obliged to make this addition to the policyholders' reserve even though it didn't receive any income, any of the $100,000 from the money invested in the state bonds. We deny both the fact of the difference and that the difference has any legal significance even if it exists. Slayton would have had to pay the interest on the money that he borrowed it, if he'd borrowed it and say the municipality had defaulted on the payment of interest, or if he borrowed it and had let the money stand as idle cash. Equally, the respondent, the only way it could have this much borrowed from the policyholders if he did borrow it is either by having the municipalities default or by letting the money stand as idle cash as a practical matter for both of them. Slayton when he obtained the loan and the insurance company when it's obtaining money on this scale from its policyholder has only one choice. It must either invest this in taxable or tax-exempt securities. It couldn't survive and let it stay idle and it's quite absurd we think to talk about this case as if an insurance company went out and obtained this money for policyholders and then just held it in idle cash and to make a comparison to that fantastic supposition, Congress certainly wasn't required to do that. Second, we say that even if this is a factual difference, it's not of any legal significance because this is a properly allocable cost even if you say it isn't as direct a cost as I argue it is. And that we think was plainly decided in Helvering against Independent Life Insurance Company, which followed Denman and Slayton and was decided on the authority of Denman and Slayton. There the statute, a tax in the insurance company not only on its investment income generally speaking but also on its income from rent, the particular company owned a building part of which it rented, part of which it occupied. The statue provided in effect -- it was more complicated but in effect as the Court saw it, the statute provided that the deduction they've got for the cost of the building should be allocated partly to its own occupancy and partly to the portion that was rented and would yield a taxable income. And that the only deduction that was allowed was the allocable part -- there was the part of those costs allocable to the rent and none was allowed for its own -- the party occupied itself. It argued that this was a direct tax in violation of the Constitution. The Court said no under Denman and Slayton. It's constitutional to limit a deduction to the fairly -- to the part of the cost fairly allocable to the income taxed. Now, the cost there certainly would have been incurred, many of them, the taxes and the depreciation of whether the company was in the building or not. And I might say also, I don't want to pause to develop it at any length, that this same principle of allocation is followed over and over again in another parallel problem. A state may not tax -- state A may not tax the income of a company received from out of state sales. Well, that's constitutionally immune from tax. But clearly in determining what is the income from in state sales, you may force it to allocate part of its expenses of its home office incurred within the state to the out of state sales and limit the deduction to the fairly allocable part of the cost. That is all we think that has been done here that it's in accordance with familiar accounting and taxation principles. Now you may say at this stage well the -- that's all very well but if that is right, what did Congress put the exception clause in the statute for? You've got to give some meaning to this clause that if the computation results and attack the imposition of tax on state bond interest then there shall be an adjustment. Our answer to that is simply this, that there was the argument I referred to in Congress over whether this did result in the imposition of a tax. There was also -- there were also arguments that the Treasury was seeking to attack the whole doctrine of intergovernmental immunities as applied to income from state bonds. We think that the Exemption Clause had the affect of doing two things. First, it made it plain at the Treasury if it had this purpose could not attack the general doctrine that you may not impose a tax on the income from state bonds. And second, that it re -- but remitted to the courts the other argument as to whether this formula did impose a tax and I have shown I think affirmatively that under familiar principles, it does not. Now let me turn if I may --
Speaker: (Inaudible)
Archibald Cox: If -- I think that's the cost -- that's the question whether this (Inaudible) -- violates --
Speaker: (Inaudible)
Archibald Cox: -- the question I've been attempting to direct myself to.
Speaker: (Inaudible)
Archibald Cox: No. I think there were two -- I think there were two questions in all fairness. One was what I called the question of the basic constitutional doctrine that the federal government has no power to tax income from state bond. I think the Congress did not want that question relitigated.
Byron R. White: Do you think that the (Inaudible)
Archibald Cox: I think they accepted the basic doctrine that you may not impose. I think they accepted the whole body of law that there was no I think National Life and Gehner as I try to explain to Your Honor before lunch, was not inconsistent with what they've done and that they might for the purposes of this statute have accepted it.
Byron R. White: (Inaudible)
Archibald Cox: Well, I think first they don't.I think second that the Congress intended the Court to appraise National Life and Gehner as part of the context of all the cases dealing with this problem, including Denman and Slayton and Helvering against Independent Life Insurance Company. I don't think the Congress said, well you take one particular case and extrapolate a rule from the language of that case without reading it in its context where we read cases in our laws to read them in the over all context of the parented decision.
Speaker: (Inaudible)
Archibald Cox: By adding the clause, they --
Speaker: (Inaudible)
Archibald Cox: Oh I think it is clear that the bulk of the Congress thought that this was not a tax on. After all, if the bulk of the Congress had thought that this was a tax on income from state bonds. Why under this -- under -- they enact a formula particularly in the gain from operations formula because if the Congress subjectively thought that under the gain from operations formula, the formula resulted in a tax on state bonds. There was no earthly sense in writing it into the statute. Under the gain from operations formula, every time, if there's a tax on state bonds in any instance under the gain from operation formula, there's a tax on state bonds in every instance and everybody knew that. There was no doubt in anyone's mind about what the arithmetical result of this formula. The only question that anybody could have felt uncertain about was what was meant by imposition of a tax on state bonds. And the majority as they explained in the committee report felt that this wasn't a tax on state bonds but they were willing to say if we're wrong, then we're willing to have the courts decide it. And if we are wrong then we shall make an adjustment. Indeed, the first fallacy as we see it -- well let me state a little more clearly what we understand to be the respondent's argument. The respondent says that if the formula including the state bond interest results in the imposition of a higher tax than if you excluded the receipt of the state bond interest and left everything else the same then it says there is a tax on state bonds. Now I say that if that is a correct interpretation of the exception clause as applied to -- in gain from operations, then the formula that Congress enacted in the gain from operations section, never can have any operation because that will be the arithmetical result in every single case. When we say to the respondent, why did Congress enact this formula, there answer is, “Oh well, its part of the gain from operation clause.” There answer is, “Oh well, Congress didn't understand its formula.” It didn't mean what it did. Well, in the first place, I submit that one cannot interpret it -- interpret something as specific as this formula in the statute on the assumption that Congress didn't understand it and to give effect to some general language such as the exception clause. And in the second place, the legislative history as quoted in our brief and describe there, makes it perfectly clear that Congress did understand the arithmetical computation. It was explained over and over again. It was explained by the very committee that put the exception clause into the statute of the only evidence that is quoted to the contrary are general statements saying that we do not intend to impose a tax on state bonds. Well those statements don't advance the argument because the -- those in favor of the statute said that there wasn't a tax on state bonds. We think the only coherent explanation that can be put on the exception clause is the one I suggested. The second fallacy in the argument that submitted by respondents we think is the suggestion that their interpretation must be adopted in order to avoid having a repressive effect on the municipal bond part. The -- we think that this argument has no merit because it was carefully explained to the Congress that the 1959 statute, if anything, would probably make municipal bonds more attractive to life insurance companies as a whole then they were under the 1942 statute, in other words, than they had been for 17 years. Not only was that explained as being something that would happen treating the industry as a whole but so far as one can judge from the figure that is the very thing that has happened. In each of the five years since the enactment of the 1959 statute, insurance companies have had a larger proportion of their assets in municipal bonds than they had in any of the five years proceeding reenactment of the statute. Not only that but the -- taking that each five years as an average of the post statute ratio was 26% higher than the pre-statute ratio. Now there may have been other reasons. I don't suggest for a minute that this is the only factor, but we do explain in our reply brief that this one could expect to be the natural tendency of the 59 statute as compared with the 42 statute which was what Congress would replace. Our third reason which goes both to the constitutional argument and to any question of statutory interpretation for thinking that respondent's formula is insufficient is that you simply cannot determine what a tax is on when you're talking about net income by the simplicity “but for” rule. Now suppose that a taxpayer has $5000 of income from each of five sources, A, B, C and D and he has $20,000 of deduction that leaves $5000 to be taxed. Respondent says, “Well, we determine whether the tax is on the $5000 that came from source A by excluding that $5000 leaving everything else the same and seeing if there will be a tax but there won't be because you then have only $20,000 of income, $20,000 of deduction and so the respondent's argument runs, the tax must be on source A.” Well let's apply the same formula to source B. Eliminate the $5000 from source B while leaving the $5000 from A and you again have nothing left so the tax must be on source B. You can do the same with C and you find that the tax must be on C with D and with E. Well this of course is an absurdity. The tax can't be on the $5000 from each of the five sources because there's only $5000 that's taxed. And it doesn't change the case to suppose that source B is municipal bond, the logic and the fallacy in the logic are exactly the same. That leads to our next objection. We know no where that the “but for” rule is applied in tax law or accounting or in any other field of law having to do with this problem of allocation. The fourth or fifth reason for our quarreling with the respondent's approach is that it requires the Court to make or assumes that Congress have to make the fantastic assumption that if the respondent had not had the income for municipal bond then everything else would have remained the same. That could have happened, it could have happened if respondent had been so foolish as to leave something like the million dollars that produced its $36,000 of municipal bond interest as idle cash but he wouldn't have survive very long if he'd than that. It could have happened if all the municipalities and bonds it bought had defaulted but that's most -- in most of them likely. The real choice is open to the respondent if it wasn't going to have the municipal bond interest were two. One was to put the money into something else and its tax under the government's formula would be higher if he put the money into something else. The other choice that it had would have been to curtail its operation so that he didn't have so much money paid in his premiums by the policyholder. It would borrow less and therefore it would have to make a smaller addition to the reserve and in that event its tax would be exactly the same as if it hadn't borrowed the money allocable to the obtaining of the interest from the state bonds and that would be exactly the way the tax comes out here. But there assumption I submit has no reality in terms of the business world and certainly was not from the Congress would require to make. Finally, I turn to the cases. I discussed before lunch the first case and the one that the respondent pitches its -- states its whole case on, the National Life Insurance Company against the United States. And I sought to show then that that case was distinguishable both in practical result and in legal theory. In practical result, the statute involved in the National Life case denied a tax state insurance company on the same dollars of income regardless of how much of its income was derived from tax free bond. Our statute as I showed before plainly does not do that. Every dollar you shift in to tax free bond results in a proportionate reduction in the income tax. Second, in terms of legal theory, it cannot be said in our case as it was said and was properly said in National Life that the company that has municipal bonds, tax free securities was not denied the same -- was not allowed the same treatment given to other taxpayers because other taxpayers were allowed to deduct the full cost of earning the taxable interest. Whereas under the 1921 statute, a company that had municipal bonds was not allowed to deduct the full cost of earning the taxable interest. Under our statute it is. Oh, I think that makes the case clearly distinguishable. Now Gehner did not allow apportionment in taxing the net worth of an insurance company. It said that you can't apportion part of the liabilities to the tax-exempt assets. We think that the dissenting opinion by Justice Stone in which Justices Holmes and Brandeis concurred is the far more persuasive. We've emphasized the number of distinctions taken the case as suppressed in our brief. The prime one I think is that that was a property tax and this problem of apportionment is -- and limitation of deductible cost is well established in imposing a net income tax. It has not been treated the same way, I think is not as familiar in dealing with a tax on property. Furthermore, the tax on property of course was ought to make far more direct tax on the municipal bonds anyway than a net income tax. But finally, whatever doubt Gehner it might have left, I submit that the decisions in Denman and Slayton and in Helvering against Independent Life Insurance Company make it apparent that Missouri and Gehner does not apply here. And that the principle of apportionment and of limiting deductible cost to the cost of earning the taxable income is a sound one in accordance with constitutional law and indeed in accordance with the general principles of income taxation.
Earl Warren: Mr. Darrell.
Norris Darrell: May it please the Court. Perhaps it maybe helpful at the outset to indicate what we consider the basic differences between the parties. Petitioner gives no real substantive meaning to the exception clauses, respondent does. Petitioner argues as though the views of the majority of the Court in National Life represented the rule -- governing rule of constitution law, Congress had in mind when it enacted the exception clauses and when the leaders explained them to Congress in seeking the vote. The petitioner says that where a life insurance company receives tax-exempt income, it is constitutionally permissible and was intended to reduce its major business expense deduction because it has received some tax-exempt interest and in proportion to the amount received because it is fair and reasonable to do so. It says this not withstanding that the expense would have been incurred had the company not received any tax-exempt interest. The respondent on the other hand says that it was not intended and would be unconstitutional under the decisions of this Court so to reduce a business expense deduction that would have been allowed the taxpayer had he not received the tax-exempt interest that when it finally faced up to it, Congress added the exception clauses because it did not want to burden states and municipal buying power and because it did not wish to contravene the decisions of the this Court which -- in the light of which as the court below found the exception clauses were added. The record shows that without application of the exception clauses, the respondent in this case has a marginal -- effective marginal rate of tax on its tax-exempt interest of 29.1% and that with that marginal rate, taxable securities with higher interest rates would be much more attractive under normal market conditions. Now, I should say parenthetically that this result would not be true in every case. Study show that an increase tax would not result in every case from the statutory formula and on page 55 of our brief we give one such illustration. In our brief, we review the legislative history of the 1959 Act and its predecessors and show how the Treasury has persistently sought to persuade Congress to test anew the constitutional immunity doctrine. The story starts with the 21 Acts which has then explained to you allowed a 4% deduction but reduced the deduction by the amount of tax-exempt interest received. If the computation of the reserves with -- as in this case was not affected by tax-exempt interest and the full 4% would have been deductible if the company had not had tax-exempt interest. Now this Court in National Life held that by so diminishing the 4% deduction, National Life was required to pay an additional tax because of the receipt of the tax-exempt interest and that this amounted to imposing a tax on such interest contrary to general --
Byron R. White: Mr. Darrell, I gather that you think is the “but for” --
Norris Darrell: That's what he means for the “but for”.
Byron R. White: Yes. Which he --
Norris Darrell: I cannot read that case and the other cases as coming out the way of the learned Solicitor General suggested.
Potter Stewart: This was a “but for” test that the Court applied in --
Norris Darrell: Yes.
Byron R. White: -- National Life.
Norris Darrell: Yes.
Byron R. White: And in Gehner?
Norris Darrell: In Gehner. The story continues with the 9th --
Arthur J. Goldberg: (Inaudible)
Norris Darrell: That is correct but in the National Life, the Court decided the Packard Motor Power Company, a Michigan Supreme Court case which involved just such an apportionment and inside of that case was approval. It also cited National Life when it decided Gehner and it seems to me that you can't ready these cases without thinking that the situation is the same whether it was a full deduction or an apportionment.
Arthur J. Goldberg: (Inaudible)
Norris Darrell: I think I do.
Arthur J. Goldberg: (Inaudible)
Norris Darrell: I think so.
Arthur J. Goldberg: (Inaudible)
Norris Darrell: That's the way you -- the fact said.
Arthur J. Goldberg: (Inaudible)
Norris Darrell: That is correct. Now the story continues with the 1932 Act which dropped the appending provision and -- but the raised the reserve deduction by a quarter percent in order to restore the tax basis the same status as before. No one at that time suggested that they could get around National Life by a proportionate deduction and for the reason we've just discussed those cases were all decided by that time. And even Slayton had been decided which reaffirmed National Life and nobody thought then that you could do it. Now this was the situation in 32 but the Treasury didn't give up. Ten years later in 1942 though these decisions had in no way been modified, the Treasury initially proposed that the reserve deduction be reduced by a proportion -- the proportion that tax-exempt interest or the total income. This as objected to is violating National Life. The Treasury at the same time proposed that Congress take a whole look at the general statutory provision exempting those bonds from tax, the whole immunity doctrine. The whole matter then was reviewed by both tax committees very carefully. Both turned down a proposal. In the 1942 Act is finally enacted and then all successive Acts until 1959, the reserve deduction were expressed as a percentage of net investment income to be computed by the Treasury on -- for the entire life insurance industry. While tax-exempt interest was taking into account for the Treasury in computing its formula its industry wide percentage, an individual company's tax liability was not affected by the fact that it received more or less tax-exempt income. Two companies having the same taxable income but with differing tax-exempt income would pay exactly the same tax. Thus from 1942 to 194 -- 57, no question could arise as to whether a tax is imposed on tax-exempt interest from an individual company standpoint. The story is brought up to date with the 1959 Act which reverted to the individual company basis by determining the reserve deduction and which for the first time taxed insurance -- life insurance companies not solely on their investment income but on their total income including gain from operations resulting from favorable experience with mortality and expense assumption. The House bill adopted the basic two phase approach reflected in the Act as finally enacted and both phases contained the so-called “add-back” clauses pursuant to which the reserve deductions was reduced by a proportion of the tax-exempt interest received. The state and local governments were not alerted until the bill reached the Senate. In the Senate Finance Committee, their representatives and several Senators complained vigorously that the cost of borrowing would be increased. Their bonds would be less attractive. The “add-back” provisions were unconstitutional under National Life and Gehner. Mr. Lindsey, assistant to the Secretary was questioned. He admitted that the bill might well result in litigation and in the subsequent memorandum suggested that subsequent decisions cast out on National Life. But senatorial opposition mounted and in the hearings no committee member expressed the slightest doubt as to the desirability of full exemption or the continuing validity of National Life. On the contrary, both were made a basic objection to the House bill. The Senate Committee then redrafted the bill to change the reserve deduction into an exclusion of a so-called policyholders' share. I personally doubt that at first the effect of this plausible sounding change was fully understood by all members of the Finance Committee and state and municipal representatives but be that as it may, in time fair words expressed that the revised formula did not adequately take care of the tax-exemption problem. In the end and without the approval of the Treasury when it came to a showdown, the committee added the exemption -- exception clauses. These clauses survived the conference committee although I suspect the Treasury may have tried and may even have expected to have them (Inaudible) -- eliminated in Congress. And it was only with the leaders firm on qualified insurances that it was not intended to tax tax-exempt interest and that the exemption clauses had been added to make certain that this would -- that no tax would be posed on tax-exempt interest that Congress enacted the bill.
Byron R. White: Mr. Darrell, is that -- could you see any difference between this proviso that was put on in its present form and a proviso which would have said if this results in unconstitutionally taxing interest an adjustment shall be made.
Norris Darrell: I think it's an entirely different thing. I do not think Congress intended to raise the constitutional question in this Court. I think that --
Byron R. White: I know but the way you put it --
Norris Darrell: -- (Voice Overlap) --
Byron R. White: The way you put it, you said the proviso means that if this results in taxing -- tax-exempt interest.
Norris Darrell: Yes, the proviso does say that no -- that it could result in imposing a tax on tax-exempt interest, the interest that the --
Byron R. White: What does tax-exempt interest mean?
Norris Darrell: I mean state and municipal bond interest.
Byron R. White: I know but tax-exempt by what?
Norris Darrell: Well --
Byron R. White: Constitutionally?
Norris Darrell: Well, I would say that -- I would say that the Congress meant that they did not want a tax tax-exempt interest. I would say further that this is reinforced for the fact that they knew of the decision of this Court. I think also that you must look at this in connection with Section 103 which is the general exemption provision that covers the same problem and that's what it was tied in with. Now, the petitioner seeks to counter this compelling legislative history of the exception clauses by insisting that the tax effect of the statutory formula was self-evident and clear and plain and understood to everyone and was not intended to be modified by the exception clauses except under judicial compulsion. Now we think the congressional history tells a contrary story. Whatever it may have been the understanding and desire of the Treasury and some members of the committees, the fact is that there was no straightforward disclosure of the crucial point on the floor of either House when the many members of Congress who did not participate in the committee hearings are called upon to vote. At no point even in response to a specific question was it ever stated on the floor of the House or the Senate that the effect of the revised bill without the exception clauses would be to increase a life insurance company's tax liability because of its receipt of tax-exempt interest. Surely the distinguished congressional leaders who presented the matter on the floor of Congress and who are fully aware of National Life would have been impelled to point this out if they have not thought the exception clauses made it unnecessary to do so. It seems to us that any other conclusion would be inappropriate, highly inappropriate. The language of the exception clauses Your Honor is clear. They're not limited in their application to state and municipal bond interest. They cover a certain federal interest and inner company dividends as well. Insofar as it covers state and municipal bond interest, they refer to a tax on any interest which under the general exemption provision would be excluded from gross income. And the only reasonable meaning that can be given to these words, it seems to us is that insurance companies were intended to have the same exemption as taxpayers generally. This we submit can only be accomplished by making the adjustments excluding such income from gross income calculations as ordered by the court below thus making the receipt of tax-exempt and come a neutral factor in arriving at the tax. Now passing for the moment the exception clauses, the essence of petitioner's case is that no tax is imposed on tax-exempt interest if the statutory scheme provides a fair apportionment of deductions between classes of income. The question it is said is not whether the tax is more but whether the apportionment is reasonable that the attempt to justify the allocation on the ground of fairness it seems to us must concede the nature of the exemption. It is not enough that an allocation be fair in the sense that it does not discriminate against tax-exempt income. If these were the test of immunity, such interest could always be taxed by investing in tax-exempts, taxpayers forego the higher yield they'd get from taxable securities and the real beneficiaries are of course state and municipal governments. Slayton and Independent Life upon which the petitioner heavily relies do not support it in our opinion neither was cited or referred to by the Treasury or any Congressman during the committee hearings or the congressional debates neither sustains a rule petitioners suggest and vote expressly reaffirm National Life. The expenses disallowed in Slayton were directly incurred in purchasing tax-exempts. It would not have been incurred. They had not bonds bearing tax-exempt interest being bought with borrowed money. It was entirely consistent with National Life to exclude from the Slayton tax computation, the expense incurred in buying the bonds along with the interest on the bonds. Otherwise, the taxpayer would gain an undue advantage by reducing the tax on his taxable income. Now assume two companies with identical total assets arrive from identical sources with identical taxable income from taxable investments and identical investments in tax-exempts but with differing income from tax-exempts because one taxpayer invested in lower quality tax-exempts producing higher income. Under the 1959 Act, the income tax liability of the two companies will not be the same. Income from tax-exempt security it itself -- in itself accounts for the difference. Slayton had nothing whatsoever to do with the said situation. Here, the petitioner proposes a much broader rule than Slayton. Deductions would be denied for any expense to which the income from tax-exempts is allocated or apportioned even though the expense would have been incurred in any event and would have been deductible if no tax-exempt interest had been received. The annual increase in the life insurance companies reserve liabilities is no more a cost of earning tax-exempt income than as any business expense of any taxpayer having tax-exempt income. It occurs regardless of the nature of the company's income or its amount. To disallow a deduction for such an expense because of the result of the receipt of tax-exempt income would be a radical departure from -- to the policy the exemption long followed by Congress and committed by the courts. The real meaning as the exemption would be lost for the economic effect of the denial of deductions are the same as including exempt income and gross income. Insurance companies do not sell -- go out and sell policies in order to get money to buy tax-exempts as petitioner suggest. On the contrary, they face investment decisions as do others only after they have the funds to suggest. Now this Court's discussion in 19th -- 1959 case of S.C.C. against Variable Annuity Life Insurance Company which is not cited in our brief seems to us to rebut the thought that reserve increases our marginal cost of a company's investment. The concept of insurance said the Court involves investment risk taking with his present and policyholders are guaranteed payments in fixed amounts. It is this investment risk taking not the company's decision as to investment policy that is represented by the reserve increases. Petitioner's argument would be applicable to every taxpayer whose income is derived from business activity and its logic could easily be applied to reduce deduction -- deductions otherwise allowable for money spent, stolen or given to charter -- charity by every taxpayer receiving tax-exempt income. It disregards the view plainly inherent in the governing decisions to which we have referred that tax-exempt income should be ignored for the purpose of the exemption. In the present case, the company's reserve deduction is actually -- that is the policyholders' shares actually reduced by the -- is actually reduced by this opinion. As for Independent Life far from limiting National Life, this Court there recognized that the problem is different. Independent Life was taxable only on its investment income and only investment expenses determined under a statute were deductible. Its attempt to reduce its tax on net investment income by enlarging its deductions to include items directly attributable to the portion of the billing occupied by itself and therefore not producing taxable income can actually fail. The question of intergovernmental tax immunity was not involved. The same maybe said of the petitioner's example of the allocation of automobile expenses between personal and business use. This again is only a matter of identifying expenses directly attributable to different uses. Petitioner's failure to recognize a difference between this and the denial of deductions for business expenses that are relatively fixed and are denied only because of the receipt of tax-exempt interest which is not really allocation at all is a fundamental defect in its argument. It's a tended analogy to the taxation, their trust is no closer. Life insurance companies are not conduits. Their reserves reflect liability under contracts that are claims against its entire assets like corporations generally. They are separate taxpaying units and not trust anything in the advertising man, sales, literature for the contrary not withstanding. In its reply brief and again in argument, petitioner presses its view that on the issue here involved, the 1942 Act was very much like the 1959 Act. Petitioner does not deny that from 1942 to 1958, an individual company's tax liability was not affected by the amount of tax-exempt interest it received. Under the 1942 Act, the reserve deduction against taxable income never changed whereas under the 1959 Act, the deduction was lowered by the receipt of tax-exempt interest. But it says that because the tax on taxable income in those years was much lower than under the 1959 Act, the tax-exempt feature of tax-exempt bonds was not then worth as much as it was under the 1959 Act when the tax on -- taxable income is greater. In other words, it is quite alright to impose a tax on tax-exempt interest if the tax imposed on taxable income is efficiently greater than under prior law so as to make tax-exempts more attractive. The resulting difference in the attractiveness of course has nothing to do with the statutory exemption or constitutional prohibitions but apart from this, study show that the more likely explanation of changes in life insurance company investments and tax-exempts during the period is a substantial increase in yield in tax-exempts from 304% to 352% that occurred during the five years following enactment of the 1959 Act. The factor petitioner had -- did not know -- did not mention. Petitioner faced with the exception clauses is hard pressed to explain them away. Its attempt to avoid the impact by the semantic argument focusing on the words tax on deprives the clauses of any substance and applies in the face not only of the congressional intent to meet the complaints of state and municipal governments but what this Court said in National Life was tax on exempt interest. In an effort to give some meaning to the exception clauses, petitioner, we submit runs into other inconsistencies that disclosed its real objective. They were intended -- it is said to prevent litigation on the question whether tax-exempt income maybe constitutionally taxed, yet they applied as added only if it is first found that the formula violate and assumed constitutional prohibition, a determination that would raise the very constitutional question Congress intended to avoid. Again, stating it differently, petitioner says, the function of the exception clauses is to provide adjustments only if the statutory formulae cannot be applied consistently with the established constitutional immunity. Yet in effect it argues that the doctrine established by this Court in the case to which I have referred should be disestablished and the new one substituted more in line with the dissents in National Life. Thus according to petitioner in legislating with a view toward the established doctrine in this area, Congress meant not the existing doctrine established by these unreversed decisions but a living, growing body of principles that might hopefully be developed in some sets of litigations as this. This attempt to avoid the consequences of the exception clauses when given their plain and normal meaning should we submit be rejected. As a matter of sound judicial policy, this Court does not consider constitutional questions where they may be avoided. This policy is particularly fitting where the constitutional area involved is a sensitive area of intergovernmental tax immunity. It is all more fitting where the statutory interpretation sought would narrow the tradition immunity and raise a constitutional question that has not been fully canvassed by the lower courts and where the economic and other effects of such action are not developed by the record. This Court currently has constitutional burdens enough without becoming unnecessary involved in this delicate one. The exception clauses we believe should be interpreted in the light of the constitutional doctrine prevailing at the time of their enactment. This rule was followed by the Second Circuit in Shamberg's Estate and White's Estate relating to Port of New York Authority and Triborough Bridge Authority bonds and the statute there so interpreted I note has not been modified. Helvering against Griffiths, the stock dividend case is to the same effect and dictates we think that National Life should not be reconsidered here. We think Griffiths is very much closer to this case and petitioner admits and for reasons more fully developed in our brief should be controlling. In conclusion, we believe the purpose and meaning of the exception clauses is clear. But apart from this, we respectfully submit that Congress has not indicated certainly, not clearly and unequivocally, a desire to impair the full tax-exemption that this Court has said in the cases to which I have referred was constitutionally guaranteed. That Congress has not created a situation compelling this Court to reconsider the validity of the doctrine it announced in those cases.And that in keeping with the established principles of -- concerning the judicial approach to constitutional questions strikingly reflected in Griffiths. This Court should refrain from reconsideration of the constitutional question and should unhesitatingly enforce as the court below consistently with National Life, the congressional mandate contained in the exception clauses. In mandate, Congress can easily remove if it wishes. Thank you.
Earl Warren: Mr. Goldberg.
Daniel B. Goldberg: May it please the Court. My appearance is on behalf of the states and the local governments which issue the bonds whose interest petitioner seeks to tax. From the Solicitor General's argument would be almost hard to deduce that this is basically a question of the relationships between the federal government and the states rather than the relationship between the federal government and life insurance companies. Only from the short range view is this is a controversy between United States and life insurance companies. We, of the state and local governments appear on the side of respondents prior to any identification of the life insurance company industry but because the burden of any tax on our bond issues must ultimately fall on state and local governments. We have the greatest stake in this review. The benefits of the exemption involved here can be procured to its true beneficiaries, the issuing governments only by being translated into lower interest rates accepted by the investors. For us to receive the full measure of this benefit, the investors have to know that when they invest in our bonds and pay for the exempt -- the exemption by accepting these lower rates, the interest they receive is not going to cause them tax dollars. Now there's only one significant fact in this litigation and it is undisputed. Without the adjustment authorized by the exception provisions, the basic formula can in some cases like the present one but not in all cases, impose a tax on the investor on our state municipal obligation solely as a result if its receiving interest on them. That is undisputed. And the basic question on this review is whether the exception provisions shall be construed to be inoperative, the Solicitor General's word in his brief, inoperative or to authorize the adjustment of which they speak, to avoid any tax increase which results solely from the receipt of state and local bond interest, a result which has never before existed in our law for an investor of any class including life insurance companies under the 1942 Act. There are many ways to test the true meaning of the exceptions. I will limit myself to just three tests selected by the petitioner because I feel that they require the Tenth Circuit result rather than the result with the petitioner itself to rise from its own tests and there are tests that you think are most appropriate to represent in the state and local governments to apply. First, petitioner says at page 15 of its brief that “The function of the exception clauses was to reassure those who were anxious to maintain the established immunity of state bonds and to prevent the defense of the statute which would cast that immunity invalid”. Fine, since we give the state and local governments were foremost among those holding that anxiety and seeking that reassurance from Congress, it becomes significant to determine exactly what we were seeking and why. From the legislative history, it is inescapable that the Solicitor General states only a part of what we were seeking when he says that we sought to prevent an attack on our basic immunity. Most of what we were seeking was reassurance to avoid the additional tax which receipted just on our bonds could produce under both the House bill and the unadjusted Senate formula. Why we sought that result is clear.It was the only way we could protect the market for our bonds. By petitioner's own test of this function of the exceptions, its construction fails miserably. I can't state it too broadly. The petitioner's construction only fails to reassure us, it increases our anxiety. It threatens us. It was extended to banks and other investors within emasculation and truncation of our traditional immunity and exemption which could devastate the market for our bonds. I hope that is not a constitutional argument although the Solicitor General's brief begins with 33 pages of constitutional argument. This is the argument we make at -- to Congress. Point one, a 33-point brief. Point one of the government's brief as a constitutional argument. Mr. Justice Brennan, I make these statements to you. I should have prefaced it by saying, this is what we told the Senate and that's why it's significant.
Speaker: (Inaudible)
Daniel B. Goldberg: No he is making a constitutional argument as to the validity of the peroration attack or effect. He assumed the -- I think the word assumed in his caption is assuming that there is any immunity whatsoever but he is out and has made a vigorous constitutional argument that the formula without the adjustments is constitutional.
Speaker: (Inaudible)
Daniel B. Goldberg: He uses the phrase that you should decide, the meaning of exceptions by determining what the living, growing body of law is following trends. I think that he does ask you to overrule.
Speaker: (Inaudible)
Daniel B. Goldberg: I think he is asking you to substitute the minority views and National Life and Gehner for the majority views which I think Congress enacted.
Speaker: (Inaudible)
Daniel B. Goldberg: He has distinctions but I think he is happy with the minority views in those cases.
Speaker: (Inaudible)
Daniel B. Goldberg: I didn't get that question Your Honor.
Speaker: (Inaudible)
Daniel B. Goldberg: The entire first point is a constitutional defense of the formula without adjustment.
Byron R. White: Would you think National Life and Gehner are constitutionally (Inaudible)?
Daniel B. Goldberg: Oh yes. They certainly are.
Byron R. White: Do you think they're plan holdings that the -- the securities of local governments are constitutionally (Inaudible).
Daniel B. Goldberg: Well, National Life dealt with local securities. Gehner dealt with federal securities but on the authority of National Life so they do stand for the exemption of -- in the case of National Life, the interest on state and local government bond interest. And by extension in the Gehner case --
Byron R. White: Wouldn't be in a constitutional discussion with National Life?
Daniel B. Goldberg: The National -- I don't have the opinion in front of me but the National Life case did involve the constitutionality of the formula in the 1921 Life Insurance Company Tax Act which definitely had if not been displaced by the Court on constitutional grounds would have reduced -- would have increased the tax as a result of the state and local -- receipt of state and local bond.
Byron R. White: If that's just the -- because of the 1921 statute.
Daniel B. Goldberg: The Court struck down that part of the 1921 statute.
Byron R. White: Yes, but this -- that's just because the Congress has said that it should be there.
Daniel B. Goldberg: No, the Congress --
Byron R. White: Where do you see -- what -- where do you see anything in National Life got (Inaudible)?
Daniel B. Goldberg: A -- National Life decision -- in the National Life decision, this Court disallowed or rejected as unconstitutional, a limitation, a deduction of the reserve increase deduction -- business deduction of doing the business of life insurance. Congress provided that the deduction should be reduced by the amount of --
Byron R. White: Oh, I understand -- I understand what it held but I don't -- I'm wondering when -- what part of the constitution it placed that decision on. Did it just assumed some constitutional exemption or --
Daniel B. Goldberg: I have--
Byron R. White: Or if even discussed it?
Daniel B. Goldberg: It is based upon the constitutional decision of this Court in the Pollock case --
Byron R. White: Yes.
Daniel B. Goldberg: -- which is the case that first established the constitutional immunity of state and local government bond interest.
Byron R. White: But that is -- that's a case cited in the National Life. Well, go ahead. I was just wondering whether this was a -- even if the Solicitor General were asking us to overrule National Life and Gehner doesn't mean that exactly to make a constitutional decision unless those (Inaudible) --
Speaker: (Inaudible)
William J. Brennan, Jr.: But unfortunately the next sentence at the very same paragraph suggests differently.
Speaker: (Inaudible)
William J. Brennan, Jr.: Yes.
Speaker: (Inaudible)
William J. Brennan, Jr.: I won't take anymore of your time in this Mr. Goldberg to -- but do you know of any explicit holding you suggest in Pollock, that has Pollock?
Daniel B. Goldberg: Oh, Pollock.
William J. Brennan, Jr.: Which says clearly that the federal government has no constitutional power to tax state and local bonded --
Daniel B. Goldberg: Pollock said it squarely and in the very first Revenue Act, it was enacted, “Not to arouse the antagonism of the states.” Congressman Cordell Hall in 1913 in introducing the bill to establish the first Revenue Act and since Congress has kept that exemption ever since, there's never been another occasion except in dicta for this Court to retrieve -- to refer to the issue again. Many dicta all conforming and following the Pollock rule.
Tom C. Clark: Go over to page 19 of the Solicitor General's brief. He says the whole predicate in his brief is that no tax maybe constitutional laid on income from state bonds. So that by saying that, the assumption on which he argues is this to accept the concept that no tax may be constitutional laid on income from state bond --
Daniel B. Goldberg: That we -- and we --
Tom C. Clark: -- is that correct?
Daniel B. Goldberg: We agree on that.
Tom C. Clark: So that constitutional issue is not important.
Daniel B. Goldberg: That is correct. Now our interest rates can be forced up and our duty to finance our local improvements can be as effectively destroyed by the tax which petitioner seeks by no matter what name such a tax is called. The damage is just as severe if it is said that the tax merely results from the receipt of our bond interest as if it is said and I think in one normal colloquial fashion but the tax is on the interest. Semantic differences don't interest the investors. Now Solicitor General stressed reality, he invoked the principle of reality in saying no life insurance company is going to keep idle cash unnecessarily. I wish he would apply the principle of reality on the impact of the tax he is seeking instead of using a semantic quibble between the word on and the word resulting from. We want the principle of reality in this case. And all these as I said, we told the Senate and protest against the House bill. Now the second test that I would like to apply is that if approach the question from the point of view or the background of congressional purpose, we come out with the same result. According to the petitioner, Congress was seeking to avoid a constitutional challenge to a traditional established immunity. And by that, he means Pollock alone, granted. But you can't stop there if you want to know how far Congress went in foreclosing constitutional controversy in this sensitive field in federal state relations. According to the petitioner, Congress went only so far as to prevent the constitutional reexamination of the naked existence of the immunity rule but not far enough to foreclose a reexamination seeking to narrow its scope which is I think the gravamen of the first point of the petition in this brief. According to the Tenth Circuit, Congress sought to avoid any and all constitutional questions existence in (Inaudible). Now to choose between these views, we think it's necessary to ask why Congress insisted on heading off a suspected Treasury attack on the established state exemption immunity of being -- can say to the Congress suspect that such a tax can attack and wanted to avoid it. Now we submit that the answer is found in the history of the running debate in Congress for decades now between the Treasury proponents of taxation in this field and the state and local government defenders of the exemption. Volumes of testimony on both sides were submitted in 1938 to 1940 and 1942, 1951 to the congressional committees and reports were issued and debates were had and votes were taken on the committees and on the floor of Congress. I remember almost vividly having work on this issue this past 27 years. Always the Treasury was defeated. Always the exemption was retained in the Revenue Act in the basic form it took in the first Act when Congressman Cordell Hall as I said before -- mentioned that it was inserted to avoid arousing the antagonism of the states. Always without exception, the individual investor was assured that he could buy state and local government obligations tax free with no tax increase resulting from the interest receipt. Now the history of this debates shows that Congress was only partly motivated by respect to constitutional proprieties and I think that bears on some other questions I had as to the nature of the National Life decision. I don't think it is significant and I don't think we have to stand on the floor on whether National Life was or was not a constitutional decision. In all these cases, Congress is responding not merely to constitutional suggestions from state and local government defenders of their exemption but from their insistence upon the importance to their market of preserving this exemption. The Treasury was always arguing a loss of federal tax revenues and alleging that investors received an unfair advantage. We for our part have always discounted these alleged defects but more important, we have stressed the adverse results on our state in this profound market. We stressed entries -- an increased interest cost. We stressed the total destruction of the ability to borrow in some cases, an impairment of the ability in all cases and we always stress the importance of the exemption to underpin sound local finances which are essential to the preservation of state and local government in their proper sphere in this federal system of ours. In short, Congress was always concerned with these practical results, reality as the Solicitor General said was the guiding principle. Why now should it suddenly have changed its purpose and be satisfied with labels, with semantics instead of results. Doesn't such a reversal or form needs some evidence in the legislative history? Doesn't it require at a minimum at least one unequivocal statement in the record after the exceptions were agreed to that Congress intended by this Act that receipt of state and local government bond that it should increase the taxes paid by the investor? And what do we find, exactly the contrary. What could be more revealing of the congressional purpose in the colloquy on the Senate floor reported on page 45 of our brief. I won't take time to read it Your Honors may care to glance at it. Between Chairman of Board of the Senate Finance Committee in dissenting affirmant who will try to find out the effect of the final bill before he voted on. If there was any purpose to produce the result of increased taxes which is admitted, pressed by the petitioner now, wouldn't Senator Byrd had been duty bound to say so when he was asked point blank whether the bill tax county and municipal bonds? When the finance committee chairman identified the exceptions in that colloquy as assuring continued exemption and accepted thanks for his efforts and holding on to them in conference with the House. How can we impute to any member of Congress a hoax which would have been perpetuated if there was to be a tax but one secretly rationalized as not being on the interest but neither result that its receipt? The only so-called evidence which petitioner elicits is the alleged internal contradiction between the basic formula and the statutory exceptions. Petitioner calls it schizophrenia, the Solicitor General's word, page 59 of his brief. He says, he calls it schizophrenia for Congress to have both enacted a taxing formula and enacted an exemption to undo its result in some but not all cases. To us, this is normal behavior and the form shows a rule and then exceptions was particularly acted to enhance the chance of concurrence by the House which had started with a different view point. This is the way things work when you have two Houses of Congress trying to get together and one starts off one way and the other wants to make a change. But we would apply the label of schizophrenia to a Congress which set out in a single legislative subsection to show its deep concern for state and local governments by preventing a constitutional reexamine of their -- reexamination of their basic immunity doctrine as set out in the Pollock case. At the same time proposed to damage them severely by deliberately (Inaudible) -- provoking a constitutional challenge to erode the traditional scope of the self same rule. We will not impel such self contradiction and irrationality to Congress. Nor can we accept petitioner's claim that it is unthinkable that Congress had its own standard of what it takes to authorize a taxpayer to make the adjustment under the exceptions to avoid the tax result prohibited. Petitioner claims Congress intended, “Some superior external standard with which the courts were more familiar than the Congress”, page 56. In other words, the petitioner concludes that Congress delegated to the courts the completion of the legislative process.
Speaker: (Inaudible)
Daniel B. Goldberg: No comment. Such a view comes suspiciously close to offending the doctrine of separation of powers. It certainly contradicts the court's view of the respective functions of Congress in the judiciary as exemplified in the Sinclair case which is cited on page 52 of our brief. Now the third test that I would like to apply is the test -- and we welcome this test. The Solicitor General's brief says that the ultimate test is that the exceptions were designed to preserve the traditional, his word, and established, his word, exemption and immunity and no more. Search every Revenue Act and every Life Insurance Company Income Tax Act and you will find that never has any investor traditionally been required to pay an increase tax solely by reason of receiving state and local bond interest. The only time it could have happened was under that 1921 Act which this Court struck down. But read without that provision which the Court struck down, never has any taxpayer, life insurance company or otherwise ever been required to pay increased taxes by reason to receive a state and local government bonds and that's the effects sought --
Byron R. White: Mr. Goldberg, you -- do you still -- you would agree I suppose so that you have $200,000 (Inaudible) -- if the insurance company has $200,000 worth of taxable income. It pays X dollars in tax and -- but then if it has $200,000 of an income but $50,000 of it is tax-exempt income. It's going to pay less tax.
Daniel B. Goldberg: It's going to pay less tax.
Byron R. White: Now why isn't that as meaningful as your “but for” test.
Daniel B. Goldberg: My “but for” test is the test that Congress adopted in response to the demonstrations -- these very demonstrations that you -- that you're mentioning Your Honor. This whole mechanical process was added in our protest to the Senate. The formula that the Senate --
Byron R. White: Oh, yes but if that's what they meant, if that's what they -- if that's what a tax on was, it is a very peculiar way of writing the Act because the inevitable result was the elimination of the allocation to the policyholder's share at all.
Daniel B. Goldberg: It doesn't always work that way. There are instances in which there will be an adjustment and instances which there won't be an adjustment. Under our interpretation -- under the Solicitor General's interpretation, there will never be an adjustment. And yet the language also calls for adjustment --
Byron R. White: I don't see however yours (Inaudible) -- ever won't be an adjustment.
Daniel B. Goldberg: Oh, there will -- there were -- there are situations in which there won't be an adjustment. Now, the Solicitor General has concentrated on the game for operation section, phase two of the Act. The phase two portion will produce I think according to the Senate Finance Committee is asking that something like 8% of the total revenue. Most of the money is going to come from phase one. Most of the money has come from phase one.And in the complex formula, it isn't an easy one, there is -- there are -- there's a so-called --
Byron R. White: Well, you don't need to spell it out, meaning, -- but you do --
Daniel B. Goldberg: There are instances.
Byron R. White: You do assert that at least in some few instances, the burden of this statute will actually have some substance in it. But in most instances, I would think -- you would think -- he would see if -- that there would have to be an adjustment.
Daniel B. Goldberg: It would depend on the way the municipal bond market was going. If the life insurance companies were reducing their holdings during a particular period, rates going down, corporate rates returns going up, it wouldn't work that way. During a period of time when over the five-year period, there was an increase in the receipt of state and municipal bond interest, you would have an adjustment practically in all those cases. It would depend on many things. I hope that the adjustments would be made because I would hope that as a result of a victory in this case, we can look to increased investment state and local government bonds by the life insurance company industry which has never been a great holder to date of our bonds.
William J. Brennan, Jr.: Well Mr. Goldberg, did I understand you at the outset to suggest that a decision in favor of the government in this case would have an impact upon the market for taking this to bonds, not this life insurance company, its customers but other investors?
Daniel B. Goldberg: Oh, Yes.
William J. Brennan, Jr.: And why would -- why did they --
Daniel B. Goldberg: The logic of the Solicitor General's argument of saying that where you don't have a specific authentication as in the (Inaudible) case, there was where you don't have a specific identification of the interest received and of course, of the interest paid. You nevertheless can take the totality of the business and attribute as a cost of receiving the interest a portion of the cost of doing business of the particular person has a potential for application in other circumstances.
William J. Brennan, Jr.: Under the present statute.
Daniel B. Goldberg: Not under the present statute, absolutely not under the present statute.
Potter Stewart: Wouldn't require -- would require (Voice Overlap) --
Daniel B. Goldberg: As to the --
Potter Stewart: (Voice Overlap) other taxpayers --
Daniel B. Goldberg: That's correct.
Potter Stewart: -- for the amendment of the law.
Daniel B. Goldberg: That is correct.
Hugo L. Black: (Inaudible)
Daniel B. Goldberg: That would be my argument if I had to make it Mr. Justice Black. It is agreed that Congress has prevented that inquiry and therefore, it is not open for question at this time. Now, search the opinion --
Hugo L. Black: Now just tell me about the colloquy, because colloquy sees the Fourth -- the Sixteenth Amendment.
Daniel B. Goldberg: I have three minutes left Your Honor.
William J. Brennan, Jr.: I know.
Daniel B. Goldberg: That I can't tackle in three minutes. Search the opinions of this Court and you will find that the peroration technique of eroding any governmental bond exempt -- exemption has never been countenance, never been countenance. All the cases that are mentioned independently have nothing to do with government bonds. Where the cases haven't dealt with intergovernmental immunities has never been a case where there has been the payment of tax by reason of the receipt of state and local government bond interest. I do have to say this to you Mr. Justice Brennan that that question has been considered by this Court in the post Sixteenth Amendment cases in the dicta. They had to be dicta because the first Act of course preserve the exemption ever since it makes it clear that that was not affected, no change was made by the Sixteenth Amendment. We couldn't want a better standard in tradition or a better test than the equal treatment of all classes of taxpayers past and present. None of whom has ever paid a higher tax just for having receive state and local government bond interest. Now, just -- on the question with which Mr. Justice Brennan opened with the $2, $5 pieces of income, I just -- I know your example was hypothetical but I want to make it very clear that the workings of this Act with the adjustment which we think that the Congress required. You'll never going to have -- you can't have this type of a 50:50 arrangement. You can't even get up to the 20% ratio. The Solicitor General talks about. If he got up to five, I think it'd reach the point where you'd practically have a cut off by the economic effect. You have a $141 billion of life insurance company assets to try to fit into a shoe that only has something like $89 billion of state and municipal bonds and most of which are put and held by other people. In conclusion, we of the state and local government submit that the petitioner has broken faith with Congress in seeking to -- the tax and raising the constitutional issue which Congress so carefully sought to avoid.
Byron R. White: Mr. Goldberg just one more. Assume that the Court decided the -- with considering going with the government on this case, I'm not suggesting anyone is about to but assume they were and were -- and we're say -- we're going to say that under the -- under this proviso, this tax was not on. It was not on tax-exempt interest under Section 103, wouldn't that automatically then have to go on and say, but is it on tax-exempt interest for purposes of the constitution?
Daniel B. Goldberg: I have feared that. I have feared that and I think that is why Congress --
Byron R. White: I mean, what do you mean --
Daniel B. Goldberg: -- didn't want you to make the first step.
Byron R. White: Oh, I know but isn't -- wouldn't you be forced to get to the next step. It may not be on within the -- under Section 103 within the terms of a proviso but how about the constitution?
Daniel B. Goldberg: Well, I have been relying --
Byron R. White: Don't you have to -- don't you have to get to the constitutional argument about that?
Daniel B. Goldberg: I have been relying on the Solicitor General's concession perhaps unwisely that Congress did not leave open the question of existence of our basic immunity for us to make the defense that would be necessary to get into that would take --
Byron R. White: I know but Congress I don't suppose could waive the constitutional immunity if there is one.
Daniel B. Goldberg: That Congress could waive?
Byron R. White: No. I said it could not waive the constitutional --
Daniel B. Goldberg: That's correct.
Byron R. White: -- immunity which the states enjoy if there is one.
Daniel B. Goldberg: That's correct.
Byron R. White: And just because they said -- just because they might have said, well, if it isn't on for purposes of Section 103, we hope it isn't on for purposes of the constitution.
Daniel B. Goldberg: Oh, I'm missing the impact of your question. You're quite right. You can't take the government -- the Solicitor General's position and then without confronting the question after you come there whether you have -- you're constitutionally going to do what he asked you to do. You have to. Now I have not cast my defense about that.
Byron R. White: If there is a constitutional immunity about that.
Daniel B. Goldberg: If there is a constitutional immunity.
Earl Warren: Mr. Solicitor General.
Archibald Cox: Mr. Chief Justice, I would like to direct myself simply to two specific points. First, I would like to emphasize once again that there is nothing extraordinary or a departure from normal tax principle in the allocation of cost to particular kinds of income that we urge here. Section 265 of the Internal Revenue Code, since 1934, has imposed a tax on one who will receive state bond interest in the sense in which they use the expression greater than he would have had to pay if he hadn't received the state bond interest because his investment advice, because of running his office, the rent that he pays on his safe deposit box must be allocated under Section 265 and he may deduct only the part allocable to his taxable investment interest. That's done everyday buying a -- so far as I can make out every taxpayer who is in this situation. The second point to which I would like to address myself is the suggestion made by Mr. Darrell in his oral argument and then his brief and I take it from the brief in order to be accurate. No member of the committee questions the soundness of the policy of complete exemption long followed by Congress and by complete exemption, he means first deducting all the state bond interest and then deducting from what is left the total amount of the annual addition to the reserve for policyholders including what we would say was the part fairly allocable to the state bond interest. Now the first time a congressional committee objected to that was back in the Revenue Act of 19 -- enacting the Revenue Act of 1942 where they referred to this as a double deduction and they said that the purpose of the Revenue Act of 1942 was by a system of peroration to eliminate that double deduction. Our brief in one of the early pages refers to that committee report. Second, no member of the committee may have said this during the hearings. The Senate Finance Committee made it perfectly clear in its report quoted on page 69 of our brief. It said, your committee believes the division of income and expense items between the policyholders and the insurance company with only the latter being taken into account for tax purposes is a much better concept to follow. It also makes it clear that the items which are properly exempt or deductible such as tax-exempt state and municipal bond interest, partially tax-exempt federal bond interest, 85% of the corporate dividends received are properly divided between the policyholders and the insurance company. And that so far as the latter the insurance company is concerned, the only portion including in the tax base that each had, full allowance is made for those items by deducting the proportionate part of it. And this was explained by Senator Curtis on the Senate floor. It was explained by Senator Byrd, the chairman of the committee on the Senate floor who read a letter from the Treasury, saying that there was no objection to the inclusion of the exception clause because in the Treasury's view, the formula did not impose a tax on state bond interest. So Congress knows perfectly well what the effect of this formula was arithmetically going to be.
William J. Brennan, Jr.: Mr. Solicitor General, the question that was last asked to Mr. Goldberg. If we agree with you that under this formulation as far as 103 is concerned, there is no tax on income. Do we then have to reach a constitutional question?
Archibald Cox: Well I would say that if there is no tax on income within the meaning of 103, there was really no argument left as to whether this tax went beyond the con -- the assumed constitutional immunity.
William J. Brennan, Jr.: I know, but if there isn't, that's the question. Would the answer yes then, we will have to decide (Voice Overlap) --
Archibald Cox: (Voice Overlap)
William J. Brennan, Jr.: -- for the purpose of the statute whether it is for the purposes of the constitution?
Archibald Cox: I think you would have to decide whether this is a tax on state bond interest for the purposes of the basic constitutional doctrine that a tax may not be imposed on state bond interest. I've seen no way of escaping that much of a constitutional question. What I meant to say Justice Brennan and perhaps I misspoke myself was that if this did not impose a tax on state bond interest contrary to 103 then I thought it was really clear that it was not a tax on state bond interest for the purposes of the constitutional doctrine. I did misspeak myself earlier and I mean what I said on the second case. Thank you.