Court Opinion

ID: 9472848
Source: CourtListenerOpinion
Date Created: 2023-08-05 04:12:50.747255+00
Date Added: 2024-06-11T17:39:13.986480
License: Public Domain

CORNELIA G. KENNEDY, Circuit Judge,
dissenting.
The interest payments involved here were interest payments made on fully executed written contracts for the sale of ma*1140chinery and equipment to a number of county and municipal corporations in Tennessee. Unfortunately for the taxpayer, in a number of instances the county or city purchasing agents had not secured approval of the county or city authorities (county judge or chairman of the county court or city ordinance) as required by various Tennessee statutes or private acts. Had these contracts been processed appropriately and received the required approval the government concedes that the interest payments would have been exempt. Despite the lack of required approval, however, the obligations created by these contracts were enforceable under Tennessee law. Because the payments at issue here were therefore interest on obligations of government entities under the plain meaning of I.R.C. § 103(a)(1), I dissent.
Under Tennessee law when a contract with a county or city which was not properly approved has been fully performed by the other party, there is an agreement implied in law according to the exact terms of the original agreement as long as the terms were fair and reasonable. See Keenan v. City of Trenton, 130 Tenn. 71 (1914); Land Co. v. Jellico, 103 Tenn. 320 (1899); Trull v. City of Lobelville, 554 S.W.2d 638 (Tenn.Ct.App.1976); Carter County v. Williams, 28 Tenn.App. 352, 190 S.W.2d 311 (1945). Recovery is not limited to the benefit accrued by the city, but is granted according- to the contract terms. Trull v. City of Lobelville, supra. It is therefore apparent that PEC could have enforced its contracts at any time after it had performed if one of the counties or cities had attempted to renege.
In response the government cites McDonald v. Scott County, 169 Tenn. 374, 87 S.W.2d 1019 (1935), and Carter County v. Williams, supra, for the proposition that a government agent is not bound by an agent’s acts beyond the scope of his authority. These cases are inapposite. McDonald dealt with acts that were beyond the county’s authority to do in any form, rather than procedural mistakes as are present here. This distinction was found crucial in Carter County v. Williams, supra, which held that agreements would not be implied in law for acts entirely beyond the city’s authority, but would be implied in law to cure procedural defects such as lack of proper approval. The Carter County court found that the city would not be bound only in the sense that no legal contract would arise; the same court enforced the implied contract and gave recovery against the city.
The majority reasons that the governmental units’ obligations are limited to the benefits conferred on them, and that there consequently is no obligation to pay the interest. However, in Trull v. City of Lobelville, 554 S.W.2d at 642, the court enforced “an implied contract in terms identical with those of the informal contract under which the parties acted.” Here, the contract terms agreed upon provided for interest. In any event, this argument begs the question. I.R.C. § 103(a)(1) applies to “interest on the obligations” of a governmental unit; it does not require that the interest itself be an obligation.
Under Tennessee law the governmental units were obliged to pay for the equipment and to pay the interest. PEC could have enforced those obligations in a Tennessee court. A definition of “obligation” that excludes these debts seems to me to be inconsistent with the plain meaning of the statute as well as the purpose of the exclusion.
Once we accept the proposition that interest on ordinary contracts is excludable it should not matter whether the state enforces that obligation on the basis of an authorized contract or on the basis of a contract implied in law. In each instance the vendor of the equipment has extended credit to the state or its subdivision believing that the interest it receives will be exempt from tax, thus reducing the rate the vendor will demand. It would place an enormous, if not impossible, burden on the vendor to determine in each instance that the state, county, or city purchasing agent had complied with all of the steps required by voluminous laws and ordinances. It would re*1141quire a lawyer’s opinion in every case to determine whether all procedural steps had been taken on the part of the state, county, or city before the vendor could know that credit could be offered at a reduced rate because the interest was exempt from tax. Only the largest vendors could afford the cost of such legal opinions.
As a practical matter it would be impossible to investigate which interest payments had been made under contracts properly approved and which had not. Many thousands of contracts are entered into each day by states, counties, and cities. This may be why this is the first case in which the Internal Revenue Service has taken the position it does here.1 There is no claim here that the taxpayer knew of any irregularities in the manner in which these contracts were let. The government argues that the exemption’s purpose of enabling states to borrow at the lowest possible interest rates would be frustrated by a ruling in PEC’s favor, since then unauthorized officials, who the government claims do not have the expertise to determine the lowest available rates, would be allowed to act for the state. This argument implicates the state policy expressed in its statutes regulating local governments, not the federal policy expressed in I.R.C. § 103. The Magistrate’s policy analysis makes much more sense: “It would not further this purpose [I.R.C. § 103’s purpose of encouraging easy credit for states] to make the very inducement (the tax exclusion for interest payments) vulnerable to some error on the part of the purchasing agent, presumably outside the control of the seller.”
There remains the regulation:
Obligations issued by or on behalf of any State or local governmental unit by constituted authorities empowered to issue such obligations are the obligations of such a unit.
Treas.Reg. § 1.103-1.
I would hold this regulation inapplicable to ordinary contracts. Until 1937 the Commissioner took the position that “obligations” of a governmental entity included only securities and bonds and not ordinary contracts. In Kings County Development Co. v. Commissioner, 93 F.2d 33, 35 (9th Cir.1937), cert. denied, 304 U.S. 559, 58 S.Ct. 941, 82 L.Ed. 1527 (1938), the Ninth Circuit reversed a holding of the Board of Tax Appeals to that effect. The Ninth Circuit held that “[t]o place an interpretation upon the word ‘obligation’ so as to exclude such ordinary written contracts is too narrow to be either practical, just, or within the ordinary meaning of the words of the statute . . . .” The government acquiesced in this proposition when it acquiesced in Newlin Machinery Corp. v. Commissioner, 82 T.C. 837 (1957), which held interest on contracts for the purchase of equipment exempt.2
The regulation was written3 before the Ninth Circuit held that obligations included ordinary contracts, and at a time when the IRS took the position that the interest was exempt only if the governmental entity had borrowed money through issuance of securities or bonds. The regulation’s language is confined to such instances since it speaks of obligations “issued by” governmental units. Contracts, whether authorized or not, are not “issued.”
It should be noted that the language of the regulation itself does not directly require that the transaction be authorized under state law, but rather requires that the obligation be issued “by constituted authorities empowered to issue such obligations.” (Emphasis added.) It might be argued that a purchasing agent, who normally enters into contracts on behalf of a *1142governmental unit, is an authority empowered to issue such obligations even if a particular obligation is not authorized because statutory procedures for approval by a county or city legislative body were not followed. The regulation might therefore be construed to allow an exemption for the interest at issue here.- Rather than adopt such a convoluted construction, I would merely hold that the regulation is simply inapplicable to the expanded and acquiesced-in definition of obligations as including ordinary contracts.
The obligations in this case were obligations of governmental entities. The interest paid was entered on those obligations and therefore exempt.
Accordingly, I dissent.

. The original challenge to the interest payments here was that the transactions were leases and the payments were not interest. The government has abandoned that claim.

. Newlin does not answer the problem we face here since in Newlin the Tax Court presumed that the governmental unit’s actions were legal and had the necessary approval in the absence of proof to the contrary.

. The pertinent language of the regulation has remained substantially the same since 1918.