Court Opinion

ID: 9651462
Source: CourtListenerOpinion
Date Created: 2023-08-23 16:19:47.887364+00
Date Added: 2024-06-11T18:12:34.096386
License: Public Domain

MAGRUDER, Circuit Judge
(dissenting).
I do not regard as decisive the fact that the so-called “interest” to be paid on the “registered notes” is a variable rate contingent upon the amount of the corporation’s net earnings. This feature, the government insists, is “the paramount pro*813prietary characteristic” differentiating the equity interest of a shareholder from the debtor-creditor relationship. It has long been settled in the law of partnership that one may lend money to the proprietor of a business upon an agreement for the payment of interest not at a predetermined fixed rate but in a variable amount ascertained by reference to a percentage of the net profits, without thereby becoming a partner in the business and liable as a coproprietor for the business debts. See Meehan v. Valentine, 1892, 145 U.S. 611, 624, 12 S.Ct. 972, 36 L.Ed. 835. In the case of such a loan, the return paid to the lender under the agreement, though variable in amount from year to year, would surely constitute “interest” within the meaning of section 23(b) of the Internal Revenue Code, since it would be the agreed “compensation for the use or forbearance of money.” Deputy v. Du Pont, 1940, 308 U.S. 488, 498, 60 S.Ct. 363, 368, 84 L.Ed. 416.
Of course, the lending of money is not the only way an indebtedness may arise upon which interest is to be paid.
Thus, upon the sale of goods, the buyer may agree to pay interest on the unpaid installments of the purchase price, and it may be provided that this interest shall be variable in amount contingent upon earnings. This would be deductible under section 23(b) quite as much as if the purchase money had been paid over to the seller and then lent back to the buyer.
And so, it is possible for a corporation to create an “indebtedness,” within the meaning of section 23(b), by an agreement under which the corporation redeems some of its stock at par, and instead of paying cash therefor gives to the surrendering shareholders interest-bearing notes for the redemption price. The exchange of stock for notes would give rise to an “indebtedness,” even though no new capital were thereby brought into the corporation.
The result would be no different if we assume that the main motive for the recapitalization was to achieve a tax advantage. Commissioner of Internal Revenue v. H. P. Hood & Sons, Inc., 1 Cir., 1944, 141 F.2d 467, 471. To test this, suppose that, at the organization of the corporation, the fifteen individuals who were to put up the money had considered the alternatives of having the corporation issue to them 5,000 shares of stock at $100 a share, or 1,000 shares of stock and ordinary interest-bearing notes in an amount of $400,000 ; and had decided on the latter course in order to give the corporation the advantage of the interest deduction under section 23 (b). This advantage would have been achieved had they chosen the second alternative at the outset. Yet the proportionate voting control of the original shareholders would have been the same either way, and their returns in the aggregate might have been the same either way — under the first alternative received solely as dividends, under the second partly in the form of dividends and partly as interest. If interest deductibility could be achieved by an original capitalization as above supposed, it could equally well be achieved by a subsequent recapitalization along the same lines.
Therefore I think we should lay aside as irrelevant two points stressed in the opinion of the Tax Court:' (1) “The factor of tax avoidance loomed large in the minds of the parties by their own admission, and indeed it appears to have been the only substantial purpose motivating the transaction”; and (2) “Each shareholder retained the precise voice in the management which he had prior to the transaction. He retained the same right to participate in the profits of the business; what he did not receive by way of interest he would take by way of dividends on his remaining stock.”
Whether the registered notes are to be classified as evidences of indebtedness depends upon an analysis of their substantive provisions, not upon who holds them. It is not suggested that the notes are a sham, that is, that they do not embody the real understanding of the parties to the transaction. If the notes would have been evidences of indebtedness in the hands of outsiders, they are equally so in the hands of the group who also hold the outstanding stock. And if the notes would have been evidences of indebtedness had some of the original shareholders surrendered all their shares of stock in exchange for the notes, they cannot be anything- different merely because each of the original shareholders surrendered four-fifths of his shares in exchange for a proportionate part of the notes, thereby leaving unaffected the relative voting control.
From the foregoing I think it is clear that, had the notes in the present case been simple promissory notes in the conventional form, unencumbered by the special provisions which have been set forth. in the opinion of the court, the amounts annually paid thereon would have been deductible as “interest * * * on indebtedness.”
The special provisions in the notes do *814not require a different conclusion. The provision for subordination is no novelty in debtor-creditor agreements. It happens to be the fact that, at the date of the hearing before the Tax Court, all the subor-dinations had been terminated by the payment of the obligations. In the event of bankruptcy, the holders of the notes would have provable claims pari passu with the other general creditors. As already indicated, the provision for a variable rate of interest, from a minimum of 2% to a maximum of 10%, depending on earnings, is wholly consistent with the existence of an indebtedness, and indeed provisions of that general type are not uncommon in debt-creating instruments. See Meehan v. Valentine, 1892, 145 U.S. 611, 12 S.Ct. 972, 36 L.Ed. 835; Edwards v. Bay State Gas Co., C.C.D.Del.1898, 91 F. 946. The minimum of 2% is not contingent upon earnings, and payment of this 2% by the corporation would certainly not be in violation of provisions in the various corporation laws against payment of dividends out of anything but earnings or surplus. True, the corporation under certain conditions may defer the payment of the stipulated interest, not, however, beyond the maturity date of the principal. This, again, is a proper matter of agreement between debtor and creditor.
ín other words, the notes are characteristic evidences of indebtedness, in that (1) they contain an unqualified obligation to make a fixed principal payment on a day certain (which may be accelerated under certain conditions, but not postponed);1 (2) they carry no voting power or voice in management of the obligor’s business;2 and (3), at least outside the field of taxation, the notes would be given effect according to their terms, and the holders of the notes would have the recognized status of creditors.
Of course, Congress might restrict the deduction for interest to cases where interest is payable at a fixed rate irrespective of earnings. This is exclusively a matter of legislative policy. So far, no such restriction has been put into the Act. The courts _are bound by the unqualified statutory command in § 23(b) that deduction shall be allowed for- “all interest paid or accrued within the taxable year on indebtedness” [italics added] — with one exception not now' relevant.
In the case at bar, there is no disputed question of fact relevant to the issue to be decided. The terms of the notes speak for themselves, and their legal effect, that is, whether they constitute evidences of “indebtedness” within the meaning of section 23(b), is a question of law. This is not even the kind of legal question with which the Tax Court may be assumed to have specialized familiarity, for the legal effect of the instruments as constituting an indebtedness may arise in many ways outside the tax field, and there is no indication that Congress meant the word “indebtedness” to have any peculiar meaning in section 23(b). Congress has given the Circuit' Courts of Appeals authority to modify or reverse decisions of the Tax Court if “not in accordance with law” (44 Stat. 110). The reports of the Senate and House committees state pretty clearly what Congress meant by that; one of the “questions of law” which the reports say courts may consider on review is “the proper interpretation and application of the statute or any regulation having the force of law.” H.R. Rep. No. 1, 69th Cong., 1st Sess. (1925), p. 19; Sen. Rep. No. 52, 69th Cong., 1st Sess. (1926), pp. 36-37. Prior to Dobson v. Commissioner, 1943, 320 U.S. 489, 64 S.Ct. 239, the Circuit Courts of Appeals would certainly have been considered free to make an independent review of issues such as that in'the present case. Helvering v. American Dental Co., 1943, 318 U.S. 322, 63 S.Ct. 577, 87 L.Ed. 785; Powers v. Commissioner of Internal Revenue, 1941, 312 U.S. 259, 61 S.Ct. 509, 85 L.Ed. 817. I think the reviewing courts should continue to assume that this is so, until the Supreme Court explicitly tells us otherwise. The Dobson opinion, to my reading, contains no such explicit direction. Cf. Security Flour Mills Co. v. Commissioner of Internal Revenue, 321 U.S. 281, 64 S.Ct. 596; Norton v. Warner Co., 1944, 321 U.S. 565, 569, 64 S.Ct. 747.
Such being my view, with all deference I dissent from the opinion and judgment of the court.

 To further assure the fulfillment of this obligation, the notes provide that no corporate mortgage shall be made to secure an obligation maturing later than the due date of the notes, and that no subordination agreement shall extend beyond such due date.

 If the original shareholders should transfer their remaining shares of stock, they would cease to have any voting power in the corporation, though they still held on to the notes.