5 T.C. 543 (1945)

For an indebtedness to qualify as ‘borrowed capital’ for excess profits tax credit purposes under Section 719(a)(1) of the Internal Revenue Code, the underlying debt must be evidenced by a valid and delivered debt instrument, demonstrating the taxpayer’s relinquishment of control over the instrument.

Summary

Economy Savings & Loan Co. sought to include certain credit balances owed to shippers as ‘borrowed capital’ to increase its excess profits tax credit. These balances were represented by promissory notes. The Tax Court ruled against the company, holding that the notes did not ‘evidence’ the debt because they were never validly delivered to the shippers, and Economy Savings & Loan Co. retained too much control over them. The court emphasized that a valid delivery requires the maker to relinquish control and dominion over the notes, which did not occur here.

Facts

Economy Savings & Loan Co. (petitioner) handled grain and seed sales for various shippers, retaining the proceeds until payment was demanded. Under grain exchange rules, the petitioner paid interest on the retained funds. The amounts owed fluctuated due to withdrawals and new sales. To secure a tax advantage, the petitioner issued promissory notes to the shippers reflecting these credit balances. However, the petitioner struck out ‘the order of’ from the notes to render them non-negotiable and informed shippers that manual delivery of the notes could cause difficulties. The original notes were canceled and substitutes issued solely on the petitioner’s initiative, without notice to the payees.

Procedural History

Economy Savings & Loan Co. claimed an excess profits tax credit, including the shipper credit balances as borrowed capital. The Commissioner of Internal Revenue disallowed this portion of the credit. The Tax Court reviewed the Commissioner’s determination.

Issue(s)

Whether the promissory notes issued by Economy Savings & Loan Co. to its shippers validly ‘evidenced’ the underlying debt, such that the debt qualified as ‘borrowed capital’ under Section 719(a)(1) of the Internal Revenue Code.

Holding

No, because Economy Savings & Loan Co. never validly delivered the notes to the shippers and retained significant control over them; therefore the notes did not actually evidence the debt.

Court’s Reasoning

The court stated that to qualify an indebtedness as borrowed capital, the taxpayer must show (1) an outstanding indebtedness and (2) that the indebtedness is evidenced by one of the enumerated documents in Section 719(a)(1). While the credit balances represented a bona fide debt, the notes did not ‘evidence’ this debt. The court emphasized the importance of delivery for a note to be a valid obligation. Citing Miller v. Hospelhorn, the court stated, “The final test is, did the endorser of the notes, at the time of their issuance, do such acts in reference to them as evidenced an unmistakable intention to pass title to them and thereby relinquish all power and control over them?” The court found Economy Savings & Loan Co. retained too much control. The parties largely ignored the notes, relying instead on the book balances. The fluctuating balances, the lack of notation of payments on the notes, and the unilateral cancellation and reissuance of notes by the petitioner, indicated the notes were not true outstanding obligations. The court concluded the notes served no real business purpose and were solely for securing a tax advantage. Because Economy Savings & Loan Co. retained sufficient control to forestall confusion resulting from actual delivery, a valid constructive delivery did not occur, and the notes did not truly evidence the debt.

Practical Implications

This case clarifies the requirements for an indebtedness to qualify as ‘borrowed capital’ for tax purposes. It highlights that merely issuing a debt instrument is insufficient; a valid delivery, demonstrating the maker’s relinquishment of control over the instrument, is crucial. Practitioners must ensure that debt instruments intended to qualify for such treatment are handled in a way that demonstrates a true transfer of rights and obligations. The case also serves as a reminder that tax benefits will be scrutinized where the underlying transaction lacks a genuine business purpose beyond tax avoidance. Subsequent cases applying this ruling would likely focus on whether the taxpayer genuinely relinquished control over the debt instrument, considering factors such as possession, negotiability, and recording of payments.