# Norton v. Commissioner

> United States Tax Court · September 30, 1970 · 29 T.C.M. 1257

URL: https://www.frixlaw.com/law-library/cases/4593113

## Case

- **Full name:** Samuel P. Norton and Estate of Beatrice Norton, Samuel P. Norton, Administrator v. Commissioner.
- **Court:** United States Tax Court
- **Decided:** September 30, 1970
- **Citations:** 29 T.C.M. 1257; 1970 T.C. Memo. 279; 1970 Tax Ct. Memo LEXIS 82
- **Precedential status:** Unpublished
- **Opinion:** Opinion
- **Cited by:** 0 later opinions in the Frix Law Library

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## Opinion text

Samuel P. Norton and Estate of Beatrice Norton, Deceased, Samuel P. Norton, Administrator v. Commissioner.
Norton v. Commissioner
Docket Nos. 67854, 74913, 74914, 77098, 91362, 94829 1
.
United States Tax Court
T.C. Memo 1970-279 ; 1970 Tax Ct. Memo LEXIS 82 ; 29 T.C.M. (CCH) 1257 ; T.C.M. (RIA) 70279 ;
September 30, 1970 . Filed
*82 Issue 1: Government Bonds Transactions.
(a) Held, upon the facts: That in each one of the four transactions involving $1,000,000 Federal Land Bank bonds, $100,000 U.S. Treasury bonds, $100,000 Treasury bonds, and $500,000 Treasury notes, respectively, the petitioner. Samuel P. Norton, did not enter into a bond fide transaction in each instance, on February 11, 1953, February 26, 1954, March 1, 1954, and December 23, 1955, respectively, for the purchase of the securities which purportedly were involved; that each transaction was without substance and reality and was a sham transaction; that none of the transactions can be recognized for tax purposes; that in reality petitioner did not purchase the securities referred to in each transaction; that petitioner did not borrow and was not indebted for, in the respective transactions, $1,052,000, $105,000, $105,000, $475,000 (note to Gibraltar), and $25,000 (note to CHK); and that the amounts paid by Norton during the 7 taxable years, 1953-1959, pursuant to his several "notes" were not interest paid on indebtedness and, therefore, were not deductible under section 23(b), 1939 Code, and section 163(a), 1954 Code.
(b) Held, That as each *83 purported transaction was a sham, there shall be excluded from taxable income, under Rule 50, for the taxable years the respective amounts which petitioner reported and included in income as "interest" on the Government securities, and the so-called "capital gain" from purported sales of the securities.
(c) Held, upon the facts: That, with respect to Transaction A, which is the only transaction involved under petitioner's alternative claim for a loss deduction since, inter alia, the years 1960 and 1961 are not before the in Transaction A, $9,322.88, as a loss under either sections 165(c)(2), 212(2) or 1234, 1954 Code.
Issue 2: Income in 1953 from BRNM Law Partnership.
Held, upon the facts: That petitioner, Norton, did not realize unreported income from the BRNM law partnership in the amount of $9,876.59, and that his share of the partnership income did not exceed $17,989.44; and therefore respondent's determination was not correct.
Issue 3: Addition to 1954 Income Tax.
Held: That for 1954, in each one of the separate income tax returns of the petitioner, Docket Nos. 74913 and 74914, there was a substantial underestimation of the estimated tax and, therefore, each petitioner *84 is liable for an addition to the 1954 tax under section 294(d)(2), 1939 Code, applicable to the year 1954. DeWitt M. Sherwood, 20 T.C. 733 , 734 (1953) , followed.
*85 Samuel P. Norton, 242 N. Canon Dr., Beverly Hills, Calif., for the petitioners. Eli Blumenfeld and Myron Weiss , for the respondent.
HARRON
Memorandum Findings of Fact and Opinion
HARRON, Judge: Respondent determined deficiencies in income tax for the years of 1953 through 1959, and additions to tax for 1954 under section 294(d)(2), 1939 Code, as follows: Year Docket No. Deficiency Sec. 294(d)(2)
1953 67854 $ 30,582.59
1954 74913 10,991.98 $ 701.31
1954 74914 11,159.99 723.63
1955 77098 30,763.42
1956 77098 $21,546.05
1957 91362 16,407.79
1958 94829 5,098.82
1959 94829 1,893.85
$128,444.49 $1,424.94
*86 The issues are:
(1) Whether payments in each of the 7 taxable years, in the following amounts, totaling $224,449.11, were payments of interest on indebtedness within section 23(b), 1259 1939 Code, and section 163(a), 1954 Code, so as to be deductible; and if not, whether they are deductible as losses. This issue involves purported loans to make alleged purchases of Federal Land Bank bonds, United States Treasury bonds, and United States Treasury notes. Year Docket No. Payments
1953 67854 $ 43,999.89
1954 74913 20,108.78
1954 74914 20,108.78
1955 77098 52,456.31
1956 77098 32,021.82
1957 91362 32,313.61
1958 94829 15,939.92
1959 94829 7,500.00
Total $224,449.11
The deductions taken as "interest" related to payments made by the petitioner, Samuel P. Norton, pursuant to 4 transactions which purportedly involved Government securities of different types. The following schedule provides explanations of the deductions taken on the tax returns for each of the taxable years with respect to each transaction: Year Trans-action Payments Per Tax ReturnsTotal Deduction
1953 A $43,999.89 $43,999.89
1954 A $31,777.71
B 4,222.22
C 4,217.63 $40,217.56
1955 A $21,999.96
B 4,222.24
C 4,217.64
D 16,867.41
D 5,149.11
* $52,456.36 $52,456.31
1956 A $17,782.76
B 4,222.24
C 4,217.64
D 5,799.18 $32,021.82
1957 A $16,373.73
B 4,222.24
C 4,217.64
D 7,500.00 $32,313.61
1958 B $ 4,222.17
C 4,217.60
D 7,500.00
** $15,939.77 $15,939.92
1959 D $ 7,500.00 $ 7,500.00
*87
(2) Whether the petitioner, Samuel P. Norton, realized additional income in 1953 from a law partnership in the amount of $9,876.59.
(3) Whether each one of the petitioners is liable for the addition to the tax for 1954 for a substantial under-estimation of the estimated income tax for 1954 as provided by section 294(d)(2), 1939 Code, and section 6554(h), 1954 Code.
In Docket No. 77098, with respect to the year 1956, the respondent concedes that deductions are allowable, totaling $1,275, for amortization of bond premium on Republic of Cuba bonds due June 30, 1967. Effect will be given under Rule 50 to respondent's agreement.
Findings of Fact
Samuel P. Norton and his wife, Beatrice Norton, were residents of Beverly Hills, California, at the time the petitions in these cases were filed. Their joint and individual tax returns were filed for calendar years, on the cash basis. Individual returns were filed for 1954; joint returns were filed for each of the other taxable years. All of the returns were filed with the district director of internal revenue *88 at Los Angeles, California.
After the trial of these cases, Beatrice Norton died.
Since all of the issues relate to Samuel P. Norton, he is referred to hereinafter as the petitioner, or, for convenience, as Norton. The late Beatrice Norton was involved in these cases, for 1954, only because an election was made to file separate returns for that year. Also, because separate returns were filed, certain items of income and claimed deductions on the 1954 return of Beatrice Norton relate to transactions, here in issue, of Samuel P. Norton.
Issue 1: Federal Land Bank Bonds; U.S. Treasury Bonds and Notes; Deductions for Payments of Alleged Interest on Purported Loans
Norton is a lawyer who is duly licensed to practice law in California. He was engaged in the practice of law at all times material. During the taxable years, he was a partner in the law firm of Brand, Rosenthal, Norton & Miller, which was dissolved on February 23, 1953, and thereafter he was a partner in the law firm of Rosenthal & Norton having its offices at first at 242 North Canon Drive, Beverly Hills, and later at 250 North Canon Drive. At the time of the trial of these cases and before, Norton was not a partner *89 of Rosenthal, and he maintained his own law office. James 1260 B. Rosenthal 2 was Norton's former law partner. Rosenthal and Norton were business advisers to, as well as attorneys for, during 1952-1959, several individuals employed in the motion picture industry, among whom were Martin Melcher and Doris Day Melcher, 3 and Gordon MacRae. 4
In December 1952 Norton and Rosenthal discussed with certain individuals, their clients, the possibility of entering into a certain type of transaction involving the "purchase", or purported purchase, of substantial amounts of securities issued by the Government or its departments, such as United States Treasury bonds or notes and Federal Land Bank bonds, in which type of transaction the client purportedly would utilize "borrowed" funds and pay "interest" *90 thereon. Gordon MacRae was a client of the Rosenthal and Norton law firm. That kind of transaction could be, and was, handled by Cantor, Fitzgerald Co. (C-F), brokers and dealers in securities in Beverly Hills.
Norton was a close friend of B. Gerald Cantor, the president of Cantor, Fitzgerald during the taxable years. During the years 1959-1964, Norton was a vice president of Cantor, Fitzgerald (during which time he may not have engaged in the private practice of law, as he discontinued his private law practice on March 1, 1959).
The Gibraltar Financial Corporation, in New York City, was incorporated under the laws of New York on about December 24, 1952, with invested capital of $2,000, and with initial borrowed working capital of $1,500. During the years involved here, no additional working capital was invested in Gibraltar. Gibraltar was not subject to regulations of the Securities and Exchange Commission. Gibraltar was the correspondent in New York City of Cantor, Fitzgerald, and the latter was Gibraltar's correspondent in California. The principal business of Gibraltar during the taxable years was trading in securities, including municipal bonds, U.S. Treasury obligations, *91 and Government bonds, and it engaged in transactions such as are in issue in these cases.
Jack Bernstein was an employee of Cantor, Fitzgerald from April 1946 until November 1952. He was the sole shareholder of Gibraltar from January or February 1953 until April 10, 1956, and during that period he was a director, a vice president, and an employee of Gibraltar, except for a few months, November 1952 until January 1953. Bernstein is now employed by C-F, having become an employee, again, on May 1, 1963.
The books and records of Gibraltar reflect that during its first week of business, December 24 to 31, 1952, it entered on its books "loans" to customers totaling 17 million dollars; that its first "loan", according to its bookkeeping entries, was $1,220,000 on December 26, 1952; and that entries were made on its books in January, 1953, of more than 17 million dollars of additional "loans".
Cantor, Fitzgerald and Gibraltar were involved in the four transactions of Norton which are in issue here.
There are in issue in these cases, four transactions which are attributed to the petitioner, Norton. In connection with these transactions, Norton reported income, and he took deductions *92 for payments which purportedly represented "interest".
In making the determinations set forth in the statutory deficiency notices, respondent disallowed the claimed deductions for alleged interest. He did not determine, also, that there should be excluded from taxable income in the various years the items of income which Norton reported (in the joint returns, and in the separate returns for 1954), as income received or realized from the transactions in issue. Respondent's disallowance of the claimed deductions for "interest", and his failure to eliminate certain items from taxable income, were seemingly inconsistent, but the seeming inconsistency was a matter of policy, to protect the revenues pending the outcome of these cases; and at the trial of these cases, the respondent took the position that if this Court finds and determines that any or all of the four transactions in issue were sham (unreal) transactions, which were so lacking in substance and reality that they cannot be recognized for tax purposes, then the respondent will agree that no items of taxable income were realized by Norton in the respective years from a transaction held to be an unreal, sham transaction; and *93 such 1261 items of reported "income" will be eliminated from taxable income when recomputations of income tax liabilities and deficiencies are made by the parties under this Court's Rule 50.
Respondent stated in the deficiency notices, in general, that deductions taken for payments of alleged "interest" in each of the taxable years were not interest within the applicable Code provision, either section 23(b), 1939 Code, or section 163(a), 1954 Code, whichever applied to a taxable year involved, and also that the claimed deductions were not allowable for tax purposes under any other section of the Internal Revenue Code.
Each of the four transactions is, for convenience, designated as Transaction A,B,C, and D. The following list describes the bonds or notes, and the principal amount thereof, involved in each transaction:
1. Transaction A: $1,000,000 Federal Land Bank bonds, bearing 1 3/4 percent interest, due October 1, 1957. This transaction began February 11, 1953, and was concluded on September 6, 1957.
2. Transaction B: $100,000 U.S. Treasury bonds due September 15, 1961. This transaction began on February 25, 1954, and was concluded as of September 14, 1961.
3. Transaction *94 C: $100,000 U.S. Treasury bonds due September 15, 1961. This transaction began on Feb. 26, 1954, and was concluded as of September 14, 1961.
4. Transaction D: $500,000 U.S. Treasury notes due April 1, 1960. This transaction began on December 23, 1955, and was concluded as of March 31, 1960.
The facts involved in each of the four transactions were as follows:
Transaction A: $1,000,000 Federal Land Bank Bonds
1. On February 11, 1953, C-F purchased $1,000,000 Federal Land Bank bonds, bearing 1 3/4 percent interest, due October 1, 1957, callable October 1, 1955. The interest on the bonds was payable on April 1 and October 1, $8,750 on each date, $17,500 a year. The purchase price of the bonds was at the market price of 95 1/2, $955,000. The broker's statement, made out as a charge to Norton, set forth a total charge of $961,611.11: Purchase price, 95 1/2 $955,000.00
Broker's commission 0
Bond interest accrued to 2/11/53 6,611.11
$961,611.11
Norton did not make any payment on this charge. The bonds were in New York City. There were 100 bonds of $10,000 each. The trading date was February 11, and the settlement date was February 17.
2. Cantor-F (C-F) *95 handled the purchase of these bonds through C.F. Childs & Co., a securities dealer in New York City, who made the purchase, as described above, on February 11, for the account of Cantor-F, and delivered the bonds "against payment", on February 11, to a New York clearance agent of C-F, Loeb, Rhoades & Co. Loeb, Rhoades then delivered the bonds on February 11 to Irving Trust Co.
Irving Trust Co., in New York City, the clearance agent for Gibraltar, received the bonds from Rhoades "against payment", for the account of Gibraltar, and debited Gibraltar's account $961,611.11 pursuant to Gibraltar's instructions dated February 11.
3. Gibraltar instructed Childs to sell the bonds and Irving to "redeliver" them to Childs on February 11, 1953, against payment, which was done. Gibraltar, on February 11, 1953, sold the $1,000,000 of Land Bank bonds through Childs. Childs sold the bonds at the same market price, 95 1/2 for $955,000, plus accrued bond interest, $6,611.11, for a total of $961,611.11. There is no evidence to the contrary; this is indicated by the debit advice of Irving Trust to Gibraltar (Exhibit 67-BO).
The purchase was nullified by the sale by Gibraltar on the same day on *96 which the bonds were purchased for the account of Cantor-F. As Childs handled both the purchase and the sale of the bonds, on the same day, at the same price, the bonds probably never left Childs.
The mechanics of utilizing the services of Irving Trust, with which Gibraltar had an account, involved a credit to Gibraltar's account on Irving's books of $961,611.11, which offset the debit to the account in the same amount. Except for the temporary use on February 11 of Gibraltar's credit with Irving, no money was borrowed to purchase the bonds, and the sale of them on the same day covered the "purchase". It was a paper transaction. The mechanics employed by Gibraltar and Cantor-F involved a round-trip in one day of the bonds from Childs and back to Childs, if they physically left Childs at all, and the sale of 1262 the bonds provided the funds to pay for the charge made on the books for the bonds. The services of Gibraltar and the clearance agents in New York, Rhoades for Cantor, and Irving for Gibraltar, on February 11 were effective in bringing about, within about one day, a purchase and sale of the identical bonds by Cantor, with respect to its bookkeeping entries. As part of *97 the mechanics, Norton signed two letters dated February 11, one to Cantor and one to Gibraltar, instructing Cantor to deliver the bonds to Gibraltar, "against payment of $961,611.11"; and instructing Gibraltar to receive the bonds from Cantor "against payment" of the above amount.
4. Norton sent Gibraltar, with his letter dated February 11, a note, executed by Norton, dated February 17, 1953, in the amount of $1,052,000, payable to Gibraltar on October 1, 1955. The provisions of the note are set forth later, some of which stated that Norton had pledged with Gibraltar $1,000,000 Federal Land Bank bonds due in 1957, (as described above) and that Gibraltar had "withheld and reserved" $90,388.90 as security for the payment of interest on the note.
The principal amount of the note, $1,052,000, represented the total of two figures, $961,611.11 (explained above) plus the so-called "reserve" stated in the note, $90,388.90, less one cent, so that the charge was $961,611.10 for the bonds.
No part of the figure, $961,611.10 was paid to Norton on or about February 11, 1953, by Gibraltar or Cantor, and Gibraltar did not pay that amount to any payee, out of its own funds, for Norton. As set *98 forth above, the money to pay for the charge of C.F. Childs for the bonds was derived from funds of C.F. Childs derived from Childs' sale on the market of the same bonds. Childs did not make a loan to Gibraltar of that amount of money, and Gibraltar, in turn, did not make a loan of that amount of money to or for the account of Norton. Facts about the reserve of $90,388.90 are set forth later.
5. Under date of February 17, 1953, Gibraltar opened on its books, in the name of Norton, a "Secured Account" in which a debit entry was made of $1,052,000, described as a "Secured Loan", with the explanation that Gibraltar had "Bought or Received" the $1,000,000 Land Bank bonds due October 1, 1957, which bonds were held "Long".
This charge to Norton's account reflected Gibraltar's receipt of Norton's note in the amount of $1,052,000, payable to Gibraltar.
6. Norton executed a printed note of Gibraltar dated February 17, 1953, in the amount of $1,052,000, payable to Gibraltar on October 1, 1955, bearing 3 1/2 percent interest, payable in monthly installments on the dates and in the amounts typed on the note. This note was security for the purported "loan" by Gibraltar to Norton of the above *99 amount, and it was stated on the note that the note was secured by the pledge to Gibraltar of the $1,000,000 Land Bank bonds.
The provisions of the note included the following: That Gibraltar had the right to borrow, re-hypothecate, use, or transfer the pledged bonds for any purpose whatsoever, and to use the pledged bonds "to cover delivery of any securities of similar kind which may have been sold to others by the Gibraltar Financial Corporation, as principal and for its own account." The note provides further that at the option of Gibraltar, the pledged bonds or collateral "of like kind" can be turned over to the signer of the note upon the payment of the principal of the note, together with interest due.
The note provides that the bond interest due on the pledged bonds shall be applied to the principal amount of the note; and that the signer of the note shall not be entitled to a refund of any interest paid arising from the reduction of the principal.
The note was renewable for the unpaid balance of principal on October 1, 1955, and could be extended to October 1, 1957. The renewal note was to bear interest for the additional period of time of 1 3/4 percent, payable on the *100 first day of April and October.
It was stated on the original note of February 17, 1953, that the 3 1/2 percent interest was to be paid in installment of specified amounts on the dates and in the amounts typed on the note, namely, $19,555.51 on February 17, 1953, and $9,777.75 on August 17 and October 19, 1953, a total sum of $39,111.01 in 1953; $9,777.75 on January 15, 1954, and $2,444.44 per month beginning on February 15, 1954, through December 15, 1954, a total of $36,666.59 for 1954; and $2,444.44 monthly on January 15, 1955, through August 15, 1955, and on September 15, 1955, $2,444.39, or a total of $21,999.91 for 1955. The sum of all of the periodic payments of "interest" 1263 on the original note, as typed on the note, was $97,777.51. However, the note also provided that Gibraltar would pay $90,388.90, to be paid in equal installments to Norton on the dates when Norton was to pay the stated "interest" to Gibraltar, upon the condition that the interest payments were made by Norton, leaving $7,388.61 as his net payment. The way in which this provision of the note was carried out is set forth hereinafter.
The total charge by C-F for the bonds was $961,611.10, but the *101 note of Norton to Gibraltar was for $1,052,000, which was $90,388.90 more than the charge for the bonds. The printed note executed by Norton states that as "security" for the payment of interest on the note Gibraltar had withheld $90,388.90 of the principal amount of the note as a "reserve", and that Gibraltar would release and pay to Norton the "reserve" in equal installments on the interest due dates set forth in the note upon the condition that the interest payments would be paid by Norton.
The terms of Norton's note to Gibraltar specifying Norton's periodic payments of interest on the note, and those relating to Gibraltar's periodic payments to Norton out of the so-called "reserve", were carried out by Norton and Gibraltar, respectively. Gibraltar mailed notices to Norton stating that the payment of an installment of "interest" would be due, as provided in the note. Norton wrote checks payable to Gibraltar for each installment of "interest". Gibraltar, in turn, mailed its checks to Norton in amounts representing Gibraltar's "release" of parts of the "reserve". During the period February 17, 1953, to September 14, 1955, Norton's checks to Gibraltar for note "interest" totaled *102 $97,777.56, five cents more than prescribed; and Gibraltar's checks to Norton totaled the amount of the reserve, $90,388.90. In effect, Gibraltar repaid to Norton the above sum, and Norton paid Gibraltar from his own funds the net sum of $7,338.66, the difference. The following schedules set forth for 1953-1955, the respective amounts of Norton's payments to Gibraltar, and Gibraltar's payments to Norton:
PAYMENTS OF NORTON (N) TO GIBRALTAR (G); PAYMENTS OF GIBRALTAR TO NORTON; AND NET SUM PAID BY NORTON *10 1953
Check Dates Net Paid byNorton
2/17/53 N to C-F $19,555.51
2/17/53 G to N 18,077.78
Net paid by N $ 1,477.73
8/12/53 N to C-F $9,777.75
8/12/53 G to N 9,038.89
Net paid by N $ 738.86
10/ 9/53 N to C-F 9,777.75
10/ 9/53 G to N 9,038.89
Net paid by N 738.86
12/24/53 N to G 4,888.88
12/24/53 G to N 4,519.45
Net paid by N 369.43
*10 Summary - 1953
Total paid Norton to Gibraltar $43,999.89
Total paid Gibraltar to Norton 40,675.01
Net paid Norton to Gibraltar $ 3,324.88
*10 1954
1/14/54 N to G $4,888.87
1/14/54 G to N 4,519.44
Net paid by N $369.43
2/12/54 N to G 2,444.44
2/12/54 G to N 2,259.72
Net paid by N 184.72
3/12/54 N to G 2,444.44
3/12/54 G to N 2,259.72
Net paid by N 184.72
4/14/54 N to G 2,444.44
4/14/54 G to N 2,259.72
Net paid by N 184.72
5/15/54 N to G 2,444.44
5/15/54 G to N 2,259.72
Net paid by N 184.72
6/15/54 N to G 2,444.44
6/15/54 G to N 2,259.72
Net paid by N 184.72
7/14/54 N to G 2,444.44
7/14/54 G to N 2,259.72
Net paid by N 184.72
8/12/54 N to G 2,444.44
8/12/54 G to N 2,259.72
Net paid by N 184.72
9/15/54 N to G 2,444.44
9/15/54 G to N 2,259.72
Net paid by N 184.72
10/13/54 N to G 2,444.44
10/13/54 G to N 2,259.72
Net paid to N 184.72
11/10/54 N to G 2,444.44
G to N 2,259.72
Net paid by N 184.72
12/15/54 N to G 2,444.44
G to N 2,259.72
Net paid by N 184.72
*103 1264 *10 Summary - 1954
Check Dates Net Paid by Norton
Total paid Norton to Gibraltar $31,777.71
Total paid Gibraltar to Norton 29,376.36
Net paid Norton to Gibraltar $ 2,401.35
*10 1955
1/12/55 N to G $2,444.44
1/11/55 G to N 2,259.72
Net paid by N $184.72
2/15/55 N to G 2,444.44
2/15/55 G to N 2,259.72
Net paid by N 184.72
3/16/55 N tod G 2,444.44
3/16/55 G to N 2,259.72
Net paid by N 184.72
4/12/55 N to G 2,444.44
4/14/55 G to N 2,259.72
Net paid by N 184.72
5/11/55 N to G 2,444.44
5/16/55 G to N 2,259.72
Net paid by N 184.72
6/15/55 N to G 2,444.44
6/16/55 G to N 2,259.72
Net paid by N 184.72
7/13/55 N to G 2,444.44
7/15/55 G to N 2,259.72
Net paid by N 184.72
8/10/55 N to G 2,444.44
G to N 2,259.72
Net paid by N 184.72
9/14/55 N to G 2,444.44
9/15/55 G to N 2,259.72
Net paid by N 184.72
Total, G's payments to Norton, $20,337.48, plus credit to N..05, total $20,337.53 *10 Summary - 1955
Total paid Norton to Gibraltar $21,999.96
Total paid Gibraltar to Norton 20,337.53
Net paid Norton to Gibraltar $ 1,662.43
Summary - 1953-1955
Total paid Norton $97,777.56
Total paid Gibraltar to Norton 90,388.90
Net paid by Norton, own funds $ 7,388.66
*104 7. Norton took deductions for "interest" on his income tax returns for the years 1953-1955 in the sum of his payments to Gibraltar under Transaction A, as set forth above, namely: 1953, $43,999.89; 1954, $31,777.71; 1955, $21,999.96; total deductions $97,777.56.
8. Although the Land Bank bonds had been sold by Gibraltar on February 11, 1953, Gibraltar treated that step as a "borrowing" of the bonds, and Gibraltar credited the accrued bond interest to Norton's account, as the bond interest became due, during the period February 11, 1953, to September 5, 1957. During 1956 and 1957, Gibraltar paid accrued bond interest to Norton at the same time as Norton paid "interest" on his second note to Gibraltar, as is set forth later.
Norton reported the accrued interest on the bonds as income on his income tax returns for the years 1953-1957, as is set forth later.
As of February 11, 1953, the accrued interest on the bonds was $6,611.11. Since this amount was part of the total charge for the bonds, Norton did not report this amount of bond interest in his 1953 income. The accrued interest on the bonds in 1953 was $17,500, which amount, less $6,611.11, was $10,888.89.
9. Gibraltar credited *105 the principal amount of Norton's note with the annual bond interest, $17,500, for 1953, 1954, and 1955. The sum of the credits was $52,500. They reduced the principal amount of the note from $1,052,000 to $999,500, as of October 1, 1955, when the note became due.
The credits to the principal amount of the note were made pursuant to a provision in the note. The note also provided that the note, referred to hereinafter as the first note, could be renewed for a period ending October 1, 1957.
10. Norton executed a second note, dated October 1, 1955, in the principal amount of $999,500, payable to Gibraltar on October 1, 1957, bearing 1 3/4 percent interest (instead of 3 1/2 percent, as on the first note). This note is referred to hereinafter as the second note.
The note stated that it was secured by the $1,000,000 Federal Land Bank bonds due October 1, 1957. Some of the provisions of the second note were the same as those of the first note, but there was no provision that part of the principal amount was to be retained by Gibraltar as a "reserve" to secure the payment of interest, and there was no provision for applying any amount, collected by Gibraltar with respect to the pledged *106 collateral, to reduce 1265 the principal amount of the note. The note provided that Gibraltar could borrow, rehypothecate, and use the pledged securities. The second note was a different printed note of Gibraltar than the first note in several respects.
The second note limited the "right" of Norton to obtain the return of the "pledged" bonds because of two factors: Norton had a right to the return of the "pledged" bonds but not before the time of the Maturity of the note on October 1, 1957, upon the payment of the principal of the note and interest. Also, if Norton elected to have the "market value" of the "pledged" bonds applied to the payment of the note, he could only make that election 30 days before the maturity of the note, and not sooner, or 10 days before the maturity date, and not later.
In Norton's account on Gibraltar's books the amount of the purported "loan" of $1,052,000, a debit, was reduced when the credits for the accrued bond interest were entered, so that as of the date of the second note the purported "loan" had been reduced by the credits to $999,500.
The amounts and due dates of the "interest" on the second note, as stated thereon, were April 1 and October 1, 1956, $8,891.38 *107 on each date; April 1, 1957, $8,842.80; and October 1, 1957, $8,891.38; total, $35,516.94. The last installment of interest was subsequently reduced, as of September 5, 1957, to $7,530.93, which reduced the total charge for "interest" to $34,156.49.
11. Norton made payments by check to Gibraltar for the interest on the second note, as prescribed for 1956 and for April 1, 1957. He received a credit for note interest accrued to September 5, 1957, as stated later. He took deductions for "interest" on the second note on his income tax returns, $17,782.76 for 1956, and $16,373.73 for 1957. The total sum of the "interest" charged on the second note was $34,156.49, which was deducted.
Gibraltar paid the accrued bond interest to Norton for 1956, $8,750 due April 1 and October 1; and $8,750 due on April 1, 1957; total $26,250. Norton reported the bond interest in his tax returns for 1956 and 1957.
For 1956 and April 1, 1957, Norton paid a total sum to Gibraltar, as note "interest", of $26,625.56; and Gibraltar paid Norton $26,250, as bond interest, so that the net amount paid by Norton from his own funds was $375.56.
12. As of September 5, 1957, Gibraltar sold $1,000,000 new Land Bank *108 bonds, for Norton's account, of the same issue of the 1 3/4 percent bonds due October 1, 1957, as set forth hereinafter. The amount of the accrued bond interest to September 5 was $7,534.72. The amount of the "interest" on the second note to September 5, 1957, was $7,530.93. The credit of the accrued "interest" on the bonds was $3.79 more than the debit for the accrued interest on Norton's note.
Norton had overpaid Gibraltar's charges for "interest" on his original note by five cents. He paid $21,999.96 whereas the note called for payments totaling $21,999.91. There were, therefore, credits to Norton's account of $3.84 more than Gibraltar's charges for "interest" on Norton's notes. Those credits reduced the principal amount owing on the second note to Gibraltar from $999,500 to $999,496.16. As is shown later, when the account on Gibraltar's books was closed by a purported "sale" of Land Bank bonds for the net amount of $997,937.50 as of September 5, 1957, the credit for the "sale proceeds" left a balance owing by Norton of $1,558.66 which Norton paid to Gibraltar.
13. The following schedule summarizes Norton's cash payments to Gibraltar as "interest" on his second note, and Gibraltar's *109 cash payments and credits to Norton for "interest" on Land Bank bonds: Dates Cash Pd. by Nortonas Note "Interest" Cash Pd. byGibraltar as Bond"Interest" Net Cash Pd. byNorton
3/31/56 $ 8,891.38 $ 8,750 $141.38
10/1/56 8,891.38 8,750 141.38
4/1/57 8,842.80 8,750 92.80
$26,625.56 $26,250 $375.56
9/ 6/57 7,534.72 Credit to Norton of bond "interest"
$34,160.28 Total credits tonote "interest"
34,156.49 Total charged byGibraltar as note"interest"
$ 3.79 Excess credited tonote principal
1266
Gibraltar's charges for "interest" on Norton's two notes were $97,777.56 plus $34,156.49, a total of $131,934.05, which Norton deducted on his returns for 1953-1957 with respect to Transaction A. Norton paid the net sum of only $7,388.66 plus $375.56, or a total of $7,764.22 as "interest" on the two notes, after receiving from Gibraltar cash payments of $116,638.90 plus the credit for bond "interest" of $7,530.93, or a total of $124,169.83.
14. The transaction was concluded by a purported "sale" of $1,000,000 Land Bank bonds as of September 5, 1957. The mechanics employed involved another almost simultaneous purchase and sale on *110 the same day, another "In" and "Out" procedure. Cantor, Fitzgerald made a sale of $1,000,000 bonds to J. S. Strauss & Co., a securities dealer in San Francisco. The Norton transaction was closed about 25 days before the date when the particular issue of Land Bank bonds would become due and would be redeemed at 100, on October 1. The mechanics followed to close the transaction were the same as those followed on February 11, 1953, when bonds were "purchased" for Norton's account. The following steps were taken beginning on September 5 with the closing date of September 6:
(a) Cantor-Fitzgerald sold on September 5 a new lot of $1,000,000 of the same issue of Land Bank bonds to J. S. Strauss & Co., a San Francisco dealer.
(b) Gibraltar bought on September 5 in New York $1,000,000 of Land Bank bonds from or through a New York dealer, Devine & Co., to cover the sale of Cantor to Strauss.
(c) The respective clearance agents of Cantor-Fitzgerald, of Strauss & Co., and of Gibraltar were located in New York City, and the bonds were transferred in New York City, in a series of steps, to the account of Wells Fargo Bank with its clearance agent in New York, Chemical Bank, for the account *111 of Strauss.
The clearance agents were Irving Trust for Gibraltar; Chemical Bank for Cantor-Fitzgerald; and Chemical Bank for Wells Fargo Bank.
(d) No money was borrowed. The sale of the bonds to Strauss, on the same date as the purchase of bonds to cover the sale, provided the funds to pay Devine & Co. for its charges for the bonds, except for a small difference between "cost" and "sale proceeds", and charges for fees and commissions, which produced a net charge, or debit, to Gibraltar's account with its clearance agent, Irving Trust, of $822.50, which included a commission of $500 charged by Cantor. The net charge to Gibraltar of represented the following: $822.50
Commission of Cantor-F $500.00
Clearance fee of Irving Trust 10.00
Charged by Devine $1,006,284.72
Paid by Strauss 1,005,972.22
Net charge by Devine 312.50
$822.50
(e) The clearance agents took these steps: (1) Irving received the bonds from Devine against payment and debited Gibraltar's account; (2) Irving delivered the bonds to Chemical against payment and credited Gibraltar's account; (3) Chemical first charged the account of Cantor-Fitzgerald, and then charged the account *112 of Wells Fargo Bank for Strauss & Co., and credited the account of Cantor-Fitzgerald. All of the parties concerned issued instructions to their respective clearance agents. Norton signed letters of instruction to Gibraltar to deliver bonds to Chemical against payment of $1,005,472.22, and to Cantor-Fitzgerald to receive bonds at Chemical from Gibraltar against payment of the same amount.
Gibraltar bought bonds from or through Devine & Co. for the total charge of $1,006,284.72. Cantor-Fitzgerald sold the same bonds to Strauss & Co. for $1,005,972.22, or $312.50 less than Devine's charge.
Cantor-Fitzgerald issued its statement confirming a sale of the bonds for Norton's account for $1,005,472.22, which was $500 less than the proceeds of the sale to Strauss; the $500 represented the commission of Cantor. Norton's account on Gibraltar's books was credited $1,005,472.22, which represented the following: Sold $1,000,000 bonds at 99-27/32 $ 998,437.50
Less commission of C-F 500.00
Net selling price $ 997,937.50
Plus bond interest to Sept. 5 7,534.72
Total net proceeds $1,005,472.22
15. In Norton's account on the books of Gibraltar, an adjustment was made of *113 five cents, reducing the amount of Norton's second note from $999,500 to $999,499.95. As of September 6, a debit to his account was made for "interest" accrued on the note to September 6 in the amount of 1267 $7,530.93, so that as of September 6, there was purportedly owing to Gibraltar $1,007,030.88. His account was credited with $1,005,472.22, the sale proceeds, which left a balance due of $1,558.66. Gibraltar sent Norton a letter stating the balance due, which Norton paid by check on October 2, 1957, which closed the account in Norton's name.
16. On his 1957 tax return, Norton reported a long-term capital gain from the sale of the Federal Land Bank bonds of $42,937.50, of which 50 percent was taken in account in reporting income from capital gains: 9/ 6/57 Proceeds from sale $997,937.50
2/17/53 Cost 955,000.00
Capital gain $ 42,937.50
17. In fact, the arrangements and the transaction for Norton by Cantor-F and Gibraltar did not yield a real and true gain of $42,937.50. Rather, the whole transaction, apart from the anticipated tax benefits, resulted in a deficit in the account on Gibraltar's books of $1,558.66. The deficit resulted from the fact *114 that the purported "loan" of Gibraltar to Norton included a purported "loan" of $90,388.90, to cover part of the note interest, so that the total purported "loan" of $1,052,000, plus all of the charges for note interest, less all of the credits to principal and note interest, for bond interest, was not fully satisfied by sale of the bonds in 1957, and the account showed an amount still "owing" by Norton of $1,558.66 on the principal amount of the "loan".
18. The schedule set forth later is a summary of the account on Gibraltar's books in the name of Norton which was the bookkeeping record of the purported loan in 1953 of $1,052,000. This schedule reflects Gibraltar's charges on its books, in the total amounts, respectively, for interest on each one of the two notes, and the total sum of the credits to the account for bond interest, and note interest. As of September 6, 1957, the debits exceeded credits by $1,558.66, so that the entire transaction, after the sale on September 5, 1957, of $1,000,000 Land Bank bonds (to close the transaction) showed a loss instead of a gain to Norton of $1,558.66, apart from anticipated tax benefits, which was the balance due to Gibraltar, which was *115 paid by Norton.
In his 1957 income tax return, Norton reported a capital gain of $42,937.50 from the sale of the bonds. However, the initial note to Gibraltar was for $1,052,000, and that figure incorporated the "reserve" for note interest of $90,388.89, and bond interest accrued to February 11, 1953, $6,611.11 or $97,000. Thus, the initial debit to Norton's account included $97,000 more than the "cost" of the bonds in 1953, ($955,000), used in computing "gain" upon the sale of a like amount of bonds in 1957.
The credits, direct or part of some larger credit figure, in the account which offset the debits of $97,000 were credits to capital (rather than to the charges for interest). They totaled $95,441.34, which was $1,558.66 less than the above-described debits. These credits were the five cents ($0.05) adjustment in reduction of the principal amount of the second note; the credit to the principal of the first note of $52,500 for accrued bond interest for three years, 1953-1955, inclusive; the reported capital gain of $42,937.50; and the credit of $3.79, the excess of accrued bond interest over accrued note interest for the period April 1, 1957, to September 5, 1957. The summary *116 of the debits and credits and to the account is as follows: *10 Debits to Norton's Account
2/11/53 Charge for $1,000,000 bonds $ 955,000.00
2/11/53 Charge for accrued bond interest 6,611.11
$ 961,611.11
2/17/53 Gibraltar's charge for "reserve" 90,388.90
Reduction in charge, 1 cent (.01)
2/17/53 Total amount of Norton's note $1,052,000.00
"Interest" charged by G, note 97,777.51
"Interest" charged by G, renewal note 34,156.49
Total charges to account $1,183,934.00
1268 *10 Credits to Norton's Account
1953-1955 Bond "interest" credited to principal $ 52,500.00
1953-1955 Paid by Gibraltar to Norton 90,388.90
1953-1955 Net "interest" paid by Norton 7,388.66
1955-1957 Bond "interest" paid by Gibraltar to Norton 26,250.00
1955-1957 Net note "interest" paid by Norton 375.56
9/6/67 Bond "interest" credited by Gibraltar 7,534.72
1953-1957 Cash paid and credits $ 184,437.84
9/6/57 Credit, "sale" of bonds 997,937.50
Total credits to account $1,182,375.34
Balance owing by Norton, paid 10/2/57 1,558.66
$1,183,934.00
19. Norton reported as income in his returns for the *117 years 1953-1957, interest received on Federal Land Bank bonds in the total amount of $79,673.61. The following shows the amount of the bond interest reported for each year: *10 Bond Interest Reported as Income
1953 Credited by G to note $10,888.89
1954 Credited by G to note 17,500.00
1955 Credited by G to note 17,500.00
1956 Paid by G to Norton 17,500.00
1957 Paid by G to Norton $8,750.00
Sales proceeds credit 7,534.72 16,284.72
$79,673.61
As stated above, Norton reported in his 1957 return capital gain of $42,937.50, of which one-half, $21,468.75, was included in income.
The respondent conceded at the trial of these cases that if his determinations are sustained by this Court, disallowing the deductions taken as "interest" on the purported "loan" of Gibraltar to Norton, then there shall be excluded from Norton's income for each of the taxable years the amount included in income as bond interest, for each year, and the capital gain reported for 1957 as gain from the sale of Land Bank bonds.
20. The amounts deducted for each year as "interest" on the purported loan of Gibraltar in Transaction A totaled $131,934.05, *118 as shown below: *10 Deductions for Purported "Interest" on Notes to Gibraltar
Year Method of Payment Amount
1953 Cash $ 43,999.89
1954 Cash 31,777.71
1955 Cash 21,999.96
1956 Cash 17,782.76
1957 Cash $8,842.80
Credit, sale of bonds 7,530.93 16,373.73
Total deductions $131,934.05
21. The transaction in the Land Bank bonds cost Norton $9,322.88, which was his out-of-pocket expense: Net payment of "interest" on 2 notes $7,764.22
Balance due on "loan" 1,558.66
$9,322.88
22. The following schedule summarizes and accounts for the purported "interest" charges of Gibraltar on the purported "loan" to Norton; the payments and credits of Gibraltar on account of its charges for "interest"; and Norton's net cash payments from his own funds: Charges and Credits, "Interest" Account
Debit Credit
"Interest" on Note 1 $97,777.56
"Interest" on Note 2 34,156.49
Cash paid by Gibraltar, Note 1 $ 90,388.90
Cash paid by Gibraltar, bond in- terest 26,250.00
Credit from sale of bonds 7,530.93
Total cash and credit from Gibraltar $124,169.83
Net cash paid by Norton 7,764.22
$131,934.05 $131,934.05
*119 23. The schedule set forth below shows that apart from expected tax benefits, the transaction arranged by Cantor-F and Gibraltar resulted in an economic loss to Norton of $9,322.94. This amount is by coincidence, except for a difference of six cents, the same as Norton's net out-of-pocket expense. *10 Net Economic Loss
(a) Interest charged on notes $131,934.05
(b) Capital gain $42,937.50
(c) Bond interest re- ported in income 79,673.61 122,611.11
Norton's economic loss $ 9,322.94
The economic loss from the transaction can be stated also in the following way:
The charge for the bonds in 1953 was $961,611.11, including accrued bond "interest" of $6,611.11. An additional charge was 1269 made for a so-called "reserve", to be paid by Gibraltar to Norton, of $90,388.90. Those charges totaled $1,052,000.01. After a reduction by Gibraltar of one cent, Norton's note to Gibraltar was in the amount of $1,052,000. Added to those charges, Gibraltar charged Norton $131,934.05 as "interest" on his two notes to Gibraltar, so that the sum of Gibraltar's charges was $1,183,934.05.
During the period February 17, 1953, to September 6, 1957, Gibraltar made *120 cash payments to Norton consisting of the "reserve" and purported "interest" on the bonds, $90,388.90, and $26,250, or $116,638.90, and gave him credits for purported bond interest of $52,500 and $7,534.72, or $60,034.72. Gibraltar's payments and credits totaled $176,673.62. Gibraltar credited the account on September 6, 1957, for the "sale" of bonds $997,937.50, and allowed a credit of five cents, also, as an adjustment. The sum of all of Gibraltar's cash payments and book credits was $1,174,611.17. The economic loss to Norton was $9,322.88, which also was his out-of-pocket expense for the net sum which he paid Gibraltar as "interest" on the two notes, $7,764.22, and the balance due to close the account, $1,558.66, $9,322.88. The following schedule shows the details: Charged to Norton
2/11/53 $1,000,000 bonds $ 961,611.10
2/17/53 "Reserve" to be paid 90,388.90
2/17/53 Note to Gibraltar $1,052,000.00
1953-1957 Charges for "interest" 131,934.05
Total charges $1,183,934.05
Cash & Credits by Gibraltar
Cash pd. to Norton, "Reserve" $ 90,388.90
Cash pd. to Norton, bond "inter- est" 26,250.00
Credits to note, bond "interest" 52,500.00
Credit, bond "interest" 7,534.72
$ 176,673.62
Credit, adjustment .05
Credit, "sale" of bonds 997,937.50
Total $1,174,611.17
Economic Loss to Norton 9,322.88
$1,183,934.05
*121 The transaction in the Land Bank bonds was one from which a real gain from the purported "purchase" and "sale" could not reasonably have been expected or realized, apart from anticipated tax deductions and benefits, because the total "charge" to Norton included a charge of $90,388.90 (the "reserve") in addition to the "charge" for the bonds, $961,611.11, and the total "charge" for "interest" on Norton's notes to Gibraltar was $131,934.05. Norton's original note to Gibraltar was in the amount of $1,052,000. Gibraltar reduced that principal amount by credits for bond "interest", $52,500, to $999,500. It would have been necessary to "sell" the bonds for $999,500, rather than the net amount of $997,937.50, in order for the proceeds of the "sale" of the bonds to have been equal to the balance due on Norton's second note to Gibraltar. If the bonds could have been "sold" at par, $1,000,000, and the broker's commission had been $500, the net "sale" proceeds, $999,500, would have been the same as the balance "due" on Norton's note.
The credits of $52,500 for bond "interest," in reduction of the principal amount of Norton's note, if applied to the "reserve" included in principal of $90,388.90, *122 would still leave $37,888.90 owing by Norton for that charge. The charge for the bonds on February 11, 1953, was $961,611.11. The sum of the two above figures is $999,500.01. The "sale" of the bonds as of September 5, 1957, for $997,937.50 did not yield enough to equal the "charge" of $999,500.01.
Moreover, the total "interest" charged by Gibraltar was $131,934.05, and when that is added to the charge for the "reserve," $90,388.90, there were charges totaling $222,322.95 which would have had to be covered and exceeded by proceeds from the "sale" of the bonds and by "interest" received from the bonds, but the rate of bond interest was only 1 3/4 percent, whereas the rate of "interest" charged by Gibraltar was 3 1/2 percent up to October 1, 1955, and 1 3/4 percent thereafter. The Land Bank bonds were to mature and become payable at par on October 1, 1957. In the transaction the second note of Norton to Gibraltar was due on the same date. The bonds purportedly were "held" until September 5, 1957, when they were "sold" at a price below par, 99-27/32. Under all of the circumstances and the arrangements in which the form of the transaction was cast, the transaction was not entered into *123 for profit and no profit could have been reasonably expected apart from anticipated tax deductions and benefits.
24. On the basis of a stipulation of the parties agreeing to the incorporation into the record of these cases of the testimony of Professor John P. Shelton in the cases of Jerome B. Rosenthal, Docket Nos. 67848, 77923, et al., the following list of bid prices for the Land Bank bonds due October 1, 1957, during the period February 2, 1270 1953, to September 3, 1957, is included herein, since it appears to have been so intended by the parties in their stipulation. The fractions in the list of bid prices have the same denominator, 32; thus, 95-12 means 95-12/32. Since the bonds matured October 1, 1957, the market prices tended to approach 100 as the time before the maturity date became shorter:
UNITED STATES FEDERAL LAND BANK BONDS
1 3/4% - October 1, 1957/55
LOW BID PRICES Year Date Low Bid Price
1953 Feb. 2 95-12
Mar. 2 95-12
Apr. 30 95-8
May 29 94-26
June 8 94-16
July 1 94-26
Aug. 28 94-30
Sept. 9 94-26
Oct. 1 95-18
Nov. 25 96-6
Dec. 1 96-8
1954 Jan. 4 97-4
Feb. 1 98-26
Mar. 1 99-6
Apr. 1 99-12
May 27 99-4
June 1 99-4
July 1 99-16
Aug. 2 99-26
Sept. 24 99-20
Oct. 26 99-16
Nov. 15 99-12
Dec. 29 99-0
1955 Jan. 18 98-18
Feb. 25 98-8
Mar. 1 98-4
Apr. 28 98-0
May 2 98-0
June 27 98-2
July 29 97-28
Aug. 30 96-14
Sept. 6 97-10
Oct. 4 97-16
Nov. 30 97-20
Dec. 23 97-16
1956 Jan. 3 97-16
Feb. 27 98-2
Mar. 29 97-20
Apr. 17 97-16
May 1 97-18
June 1 97-24
July 27 98-10
Aug. 28 98-1
Sept. 6 97-30
Oct. 1 98-4
Nov. 29 98-10
Dec. 17 98-8
1957 Jan. 2 98-10
Feb. 1 98-23
Mar. 1 99-0
Apr. 1 99-1
May 1 99-6
June 3 99-10
July 1 99-14
Aug. 1 99-21
Sept. 3 99-26
*124 Transactions B and C: $200,000 U.S. Treasury Bonds Due September 15, 1961
Two transactions in the same amount, $100,000 of the same Government security, U.S. Treasury 2 3/4 percent bonds due September 15, 1961, were arranged by Gibraltar for the account of Samuel P. Norton. These transactions are referred to herein as Transactions B and C. The facts are substantially the same but are set forth separately. Transaction B was initiated on February 25, 1954. It was concluded on Gibraltar's books on September 14, 1961, closing date September 15, 1961, the maturity date, by a purported purchase of the bonds "from" Norton by Gibraltar at par for $100,000. Transaction C purportedly involved another $100,000 of the same issue of Treasury bonds, which was initiated on February 26, 1954, and was concluded on Gibraltar's books on September 14, 1961, by a purported "purchase from Norton" by Gibraltar at par for $100,000. In both transactions the form of the "purchase" of the Treasury bonds was that the "coupons" were "detached" for the bond "interest" otherwise payable during the years 1956-1961, the dates for the payment of bond interest being March 15 and September 15 of each year. Except *125 for bond "interest" due in 1954 and 1955, the bonds purportedly involved in both transactions were noninterest-bearing bonds during the 6 years 1956-1961.
The mechanics were followed in both instances of Gibraltar's placing an order with Faroll & Co. to purchase the bonds, and placing another order almost simultaneously with another broker to sell the bonds on or about the same day, so that it was an almost simultaneous "In" and "Out" transaction in which no funds were borrowed as the sale proceeds covered the purchase charges. The mechanics followed purportedly involved a "borrowing" of the securities to make a "short sale," in form, but in substance there were no real short sales even though the device used was supposed to give the appearance of a short sale. In fact and substance, no U.S. Treasury bonds were bought and held for the account of Norton except of a momentary, one-day purchase which was nullified by the almost immediate and simultaneous sale of the bonds. Each transaction was a paper transaction on the books of Gibraltar in an account in the name of Norton called a "Secured Account." 1271
In each transaction Norton executed a promissory note payable to Gibraltar *126 on September 15, 1961, which also was the maturity date of the Treasury bonds. In each transaction the principal amount of the promissory note was $105,000, "interest" on the note was stated to be 2 5/8 percent; and it was provided that Norton would make payments of installments of the "interest" on the dates and in the amounts typed on the notes, beginning in February or March 1954, and continuing until October 15, 1958, after which date no payments of "interest" on the note were to be made up to the maturity date of the promissory note. Each note was cancelled by Gibraltar on the maturity date and the account of Norton was credited $100,000.
The transaction was cast in the form of an involvement of Treasury bonds bearing 2 3/4 percent interest for 2 years, 1954 and 1955, and with the promissory notes payable to Gibraltar bearing 2 5/8 percent interest during the 5 years, 1954-1958, during which "interest" on the note was to be paid to Gibraltar. In each instance the principal amount of the promissory note included a so-called "reserve" of $17,359.46, Transaction B, and $17,211.67, Transaction C, which meant that Gibraltar would pay, and did pay, those sums to Norton, with the result *127 that Norton's net, cash payments of the purported note "interest" was $3,751.65 (rather than $21,111.11) in Transaction B; and $3,876.48 (rather than $21,088.15) in Transaction C. However, in his tax returns for 1954-1958, Norton's deductions for "interest on the notes totaled $21,111.11 and $21,088.15, respectively.
Both transactions per books were concluded in 1961. The taxable years in these cases include only the six years 1954-1959, inclusive, and the two years 1960 and 1961 are not before the Court. The details about the entirety of each transaction are set forth, however, so as to show each complete transaction, as follows:
Transaction B: $100,000 U.S. Treasury Bonds
1. On February 26, 1954, Irving Trust Co. in New York sent a debit advice to Gibraltar's clearance agent, stating that it had charged Gibraltar's account for $100,000 U.S. Treasury bonds due September 15, 1961, with coupons for September 15, 1954, through September 15, 1955, attached, received from Joseph Faroll & Co. (in New York), account of Samuel P. Norton. The debit advice stated that Irving would "redeliver" the bonds "against payment"; that Irving's charge of $2.50 covered "receipt and delivery of *128 bonds"; and that it had received instructions February 25, 1954.
On March 1, 1954, Irving sent Gibraltar a credit advice, according to instructions dated February 26, 1954, stating that Irving had delivered $200,000 U.S. Treasury bonds due September 15, 1961, with coupons September 15, 1954, attached, to C. F. Childs & Co. (New York). This credit advice referred to two orders of Gibraltar, one of which was No. 43593, the same as the number of the debit advice of February 26, 1954, described above, referring to Norton. The other order referred to in the credit advice related to an account of Jerome B. Rosenthal.
On February 25, 1954, Jack Bernstein, for Gibraltar, instructed the securities clearance department of Irving Trust to receive from Faroll & Co. $100,000 of the bonds for the account of Norton, and $100,000 of the same bonds for the account of Rosenthal. The order described the bonds as having the interest coupons for March 15, 1956, and the subsequent coupons detached.
The mechanics included a sales slip of Faroll to Norton dated February 25, 1954, of a sale to him of $100,000 of the bonds, charging him for the cost; a letter of Norton to Faroll of the same date instructing *129 Faroll to deliver the bonds to Gibraltar against payment; a slip of Gibraltar to Norton dated February 26, 1954, advising him of the receipt of the bonds from Faroll against payment; and a credit slip of Faroll to Norton dated February 26 advising Norton that Faroll had delivered $100,000 Treasury bonds with certain coupons detached to Irving Trust for the account of Gibraltar.
The several brokers' statements reflected the following steps: On February 25, 1954, $100,000 Treasury bonds due September 15, 1961, with certain coupons detached, were purchased from Faroll & Co., but they were delivered to Irving Trust for the account of Gibraltar, for the account of Norton, on February 26. Gibraltar instructed Irving, on February 25, 1954, to receive the bonds from Faroll and to redeliver the bonds. On February 26, Gibraltar instructed Irving to deliver them to Childs. Irving delivered the bonds to Childs & Co. Childs bought, or sold, the bonds, and Irving credited Gibraltar's account on March 1, 1954, with the proceeds 1271-3 of the sale, which offset the charge to Gibraltar's account on February 26 for the payment to Faroll. Accordingly, the bonds came "In" by a purchase from Faroll *130 on February 25, 1954, and they went "Out" through a sale to or by Childs on February 26 or March 1, 1954. In 1954, the date, February 25, was Thursday, and March 1 was Monday. February 27 and 28 were Saturday and Sunday. Excluding the weekend dates, the circuit from Faroll to Irving and from Irving to Childs was cleared in either two days, February 25 and 26, or three days, including March 1. The transaction was handled, "In" and "Out", by Irving's securities clearance department for Gibraltar.
In the course of the transaction, as it applied to $100,000 of Treasury bonds "for the account of" Norton on Gibraltar's books, the account of Gibraltar on Irving Trust's books was debited and credited as follows: 2/26/54 Debit at 86-26/32 $ 87,640.54
Debit Irving's charge 2.50
Total debit $ 87,643.04
3/ 1/54 Credit at 103-9/32 104,132.08
Credit balance to G $ 16,489.04
2. No funds were borrowed in the transaction handled by Irving for Gibraltar. Rather, Gibraltar's credit, represented by its account with Irving, was used for two or three days. There was a charge of $2.50. The sale to or by Childs paid for the purchase from Faroll. The bonds paid for *131 themselves. The sale to Childs nullified the "purchase" as a "purchase" of securities, as an investment, for Norton's account. * Faroll's charge for the bonds took into account the interest coupons which were detached, so that its charge was only $87,640.54. Irving's credit to Gibraltar, upon delivery of the bonds to Childs, in the amount of $104,132.08, may have included a credit for the interest coupons if they had been reattached to the bonds. The evidence does not show this detail. The credit balance in Gibraltar's account with Irving of $16,489.04 may not have represented a "profit" to Gibraltar if it had made an expenditure to repurchase detached coupons. As the purchase slip of Childs is not in evidence, the credit balance of $16,489.04 in Gibraltar's account with Irving on March 1, 1954, has not been explained.
In this transaction, no funds were loaned by Gibraltar to Norton, and Norton did not make any payment for or toward the purchase of the bonds. Norton did not receive delivery or possession of the bonds; neither did Gibraltar; *132 and the bonds were not physically held by Gibraltar for Norton. Norton did not pledge the bonds to Gibraltar, except on paper. Gibraltar did not receive the payment of any coupon interest on the bonds.
3. The Treasury bonds were 2 3/4 percent bonds due September 15, 1961. Coupon interest, if paid, was $2,750 a year, payable $1,375 on March 15 and September 15. In the transaction with Faroll, the coupons for 1954 and 1955 were attached to the bonds and that interest would amount to $5,500 for the two years if the bonds were held. In the transaction with Faroll, the bonds were sold with the coupons for 1956 and the subsequent years detached.
Faroll's sale slip showed that the $100,000 of bonds had accrued interest of $828.04 to February 25, 1954, and that the cost of the bonds at 86-26/32, exclusive of the accrued interest was $86,812.50, as follows: 2/25/54 $100,000 Treasury bonds, 9/15/61, at 86-26/32 $86,812.50
2/25/54 Accrued interest 828.04
Total charge $87,640.54
In the transaction with Gibraltar, Norton's cost of the bonds was $86,812.50.
4. With respect to the transaction between Gibraltar and Norton, the following steps were taken: Norton *133 executed a promissory note dated February 26, 1954, payable to Gibraltar on September 15, 1961, which was the maturity date of the bonds, in the principal amount of $105,000, bearing 2 5/8 percent interest, secured by the "pledge" of the $100,000 Treasury bonds. The note was a printed form of Gibraltar. The principal amount of the promissory note, $105,000, was the total sum of a cash "reserve" of $17,359.46, to be paid to Norton by Gibraltar, and $87,640.54, the charge for the bonds according to Faroll's statement. None of the $87,640.54 was paid by Gibraltar to Norton, and Norton did not in fact borrow any amount from Gibraltar. Gibraltar did not pay $87,640.54 from its own funds to anyone. The note stated that Gibraltar withheld $17,359.46, as a "reserve", as "security" for Norton's payment of "interest" on the promissory note. Other provisions of the promissory note are set forth later. 1272
On February 26, 1954, Gibraltar opened on its books a "secured account" in the name of Norton, with a debit entry of $105,000 described as a "secured loan", secured by the $100,000 Treasury bonds which were held "Long". The debit entry reflected Gibraltar's receipt of Norton's note.
*134 The note provided inter alia that Norton had pledged the $100,000 Treasury bonds with Gibraltar as security for the "loan" of $105,000, and that Gibraltar had the right to borrow, re-hypothecate, use or transfer the bonds for any purpose, to use the bonds 1273 "to cover delivery of any securities of similar kind which may have been sold to others" by Gibraltar, and to use them "for its own account". Norton had a right to pay the note before the maturity date, upon 30 days notice, and upon the payment of a premium of 1 1/2 percent per year on the principal amount of the note from the prepayment date to the original maturity date. The "prepayment privilege" could not be exercised after March 15, 1961. Or Norton could pay the entire amount of the note on its due date, September 15, 1961, and obtain return of the "pledged" bonds. However, this provision in the printed form of the note was not of significance because the "pledged" bonds matured on September 15, 1961, and were to be redeemed at par, for $100,000, whereas the principal amount of the note was $105,000. The note also gave Norton the right to have the market value of the "pledged" bonds applied toward the payment of the *135 note, but that right could be exercised no sooner than 30 days prior to the due date of the note in 1961 and no later than 10 days before the due date. This provision, too, had little significance under all of the circumstances.
The note provided that interest received on the pledged collateral shall be applied to the principal of the note but that no refund would be made of any interest on the promissory note resulting from the reduction of the principal.
The installment payments of "interest" on the note to Gibraltar to be paid by Norton were $4,222.22 on February 26, 1954, and 15 payments of $1,055.56 from January 15, 1955, through July 15, 1958, quarterly, and $1,055.49 on October 15, 1958. The sum of the payments was $21,111.11. The note provided that Gibraltar would pay Norton $17,359.46, "reserve" which Gibraltar purportedly "withheld" from the principal amount of the note, which was to be paid in equal installments on the dates when Norton's payments of "interest" became due, provided Norton paid the installments of "interest".
Norton and Gibraltar made the reciprocal payments to each other pursuant to the provisions in the note. They exchanged checks with each other *136 on or about the same date. Gibraltar mailed notices to Norton stating that the payment of an installment of "interest" would be due, as provided in the note. Norton wrote checks payable to Gibraltar for each installment of "interest." Gibraltar, in turn, mailed its checks to Norton in amounts representing Gibraltar's "release" of parts of the "reserve". During the period February 26, 1954, to October 15, 1958, Norton's checks to Gibraltar totaled $21,111.11; and Gibraltar's checks to Norton totaled the amount of the reserve, $17,359.46. In effect, Gibraltar repaid to Norton the above sum, and Norton paid Gibraltar from his own funds the net sum of $3,751.65, the difference. The following schedule set forth for 1954-1958 the respective amounts of Norton's payments to Gibraltar, and Gibraltar's payments to Norton:
PAYMENTS OF NORTON (N) TO GIBRALTAR (G); PAYMENTS OF GIBRALTAR TO NORTON; AND NET SUM PAID BY NORTON 1954
Check Dates Net Paid by Norton
2/26/54 N to G…$4,222.22
2/26/54 G to N… 3,471.89
Net paid by N $ 750.33
1955
1/12/55 N to G…1,055.56
1/11/55 G to N… 867.97
Net paid by N 187.59
4/12/55 N to G…1,055.56
4/14/55 G to N… 867.97
Net paid by N 187.59
7/13/55 N to G…1,055.56
7/15/55 G to N… 867.97
Net paid by N 187.59
10/12/55 N to G…1,055.56
10/13/55 G to N… 867.97
Net paid by N 187.59
Summary - 1955
Total paid Norton to Gibraltar $ 4,222.24
Total paid Gibraltar to Norton 3,471.88
Net paid Norton to Gibraltar $ 750.36
1956
1/ 9/56 N to G…$1,055.56
1/ 9/56 G to N… 867.97
Net paid by N $ 187.59
3/31/56 N to G…1,055.56
4/20/56 G to N… 867.97
Net paid by N 187.59
7/10/56 N to G…1,055.56
7/12/56 G to N… 867.97
Net paid by N 187.59
10/16/56 N to G…1,055.56
10/18/56 G to N… 867.97
Net paid by N 187.59
Summary - 1956
Total paid Norton to Gibraltar $ 4,222.24
Total paid Gibraltar to Norton 3,471.88
Net paid Norton to Gibraltar $ 750.36
1957
1/15/57 N to G…$1,055.56
1/16/57 G to N… 867.97
Net paid by N $ 187.59
4/ 9/57 N to G…1,055.56
4/10/57 G to N… 867.97
Net paid by N 187.59
7/ 9/57 N to G…1,055.56
7/ 9/57 G to N… 867.97
Net paid by N 187.59
10/15/57 N to G…1,055.56
10/18/57 G to N… 867.97
Net paid by N 187.59
Summary - 1957
Total paid Norton to Gibraltar $ 4,222.24
Total paid Gibraltar to Norton 3,471.88
Net paid Norton to Gibraltar $ 750.36
1958
1/14/58 N to G…$1,055.56
1/16/58 G to N… 867.97
Net paid by N $ 187.59
4/ 8/58 N to G…1,055.56
4/ 9/58 G to N… 867.97
Net paid by N 187.59
7/ 8/58 N to G…1,055.56
7/10/58 G to N… 867.97
Net paid by N 187.59
10/14/58 N to G…1,055.49
10/15/58 G to N… 867.97
Net paid by N 187.52
Adjustment G to N….05 (.05)
Summary - 1958
Total paid Norton to Gibraltar $ 4,222.17
Total paid Gibraltar to Norton 3,471.93
Net paid Norton to Gibraltar $ 750.24
Summary - 1954-1958
Total paid Norton to Gibraltar $21,111.11
Total paid Gibraltar to Norton 17,359.46
Net paid by Norton, own funds $ 3,751.65
*137 1274
5. Norton took deductions for "interest" on his income tax returns for the years 1954-1958 in the sum of his payments to Gibraltar under transaction B, as set forth above, namely: 1954, $4,222.22; 1955, $4,222.24; 1956, $4,222.24; 1957, $4,222.24; 1958, $4,222.17; total deductions, $21,111.11.
6. Although the Treasury bonds had been sold to Childs & Co. on February 26, 1954, Gibraltar credited the principal amount of Norton's note with amounts for interest on the bonds for 1954 and 1955 since the bonds had been "purchased" with the interest coupons for those years attached. For some unexplained or unclear reason, the credit for the coupon interest for 1954 was $2,332.18 instead of $2,750. (This is not explained by the fact that the bond interest accrued to February 25, 1954, date of "purchase" from Faroll, was $828.04.) The credit for 1955 was $2,750. The total credits of $5,082.18 reduced the principal amount of Norton's note from $105,000 to $99,917.82.
7. For March 15, and September 15, 1954, Gibraltar's credit to Norton's account for "interest" on the Treasury bonds was $2,332.18 (not $2,750). Since accrued bond interest of $828.04 was part of the charge for the *138 bonds, Norton reported on his tax return for 1954, in income, the net amount of bond "interest" of $1,504.14 ($2,332.18 less $828.04). On his return for 1955, he reported in income bond interest for that year in the full amount of $2,750. The bonds did not have coupons attached for the years following 1955. The total amount of income from "interest" on the bonds which was reported on Norton's tax returns was, therefore, $4,254.14.
8. On September 15, 1961, the maturity date of the Treasury bonds, Gibraltar credited $100,000 to Norton's account and canceled his note. Since the debit balance was $99,917.82, there was a credit balance "owing" to Norton of the difference, $82.18, which Gibraltar paid to Norton. Gibraltar sent Norton its slip confirming its "purchase" of the bonds "from" him for $100,000. Gibraltar did not pay $100,000 in cash to Norton; the "purchase" by Gibraltar was represented by the credit to the account on Gibraltar's books.
Norton reported on his 1961 tax return a capital gain from the transaction of $13,187.50: 1275 9/15/61 Sale $100,000.00
2/25/61 Purchase 86,812.50
Capital gain $ 13,187.50
9. The following schedule shows *139 and explains the debits and credits in Norton's account for the transaction: Debits
2/26/54 "Cost" of $100,000 bonds $ 86,812.50
2/26/54 Accrued bond interest 828.04
$ 87,640.54
2/26/54 Gibraltar's "Reserve" per note of N 17,359.46
2/26/54 Amount of Norton's note to G $105,000.00
1954-1958 "Interest" charged on Norton's note 21,111.11
Total charges $126,111.11
9/15/61 Pd. by Gibraltar to Norton 82.18
$126,193.29
Credits
1954 Bond interest credited to note $ 2,332.18
1955 Bond interest credited to note 2,750.00
1954-1958 Net note "interest" pd. by Norton 3,751.65
1954-1958 Paid by Gibraltar to Norton 17,359.46
9/15/61 Gibraltar's "purchase" of bonds 100,000.00
$126,193.29
10. Apart from anticipated tax savings and benefits, the Treasury bonds transaction could not and did not result in a true economic gain and benefit to Norton and, instead, it resulted in an economic loss to him of $3,669.47, as follows: *10 Net Economic Loss
Debit: "Interest" charged by Gibraltar on note $21,111.11
Credits: Purported "capital gain" $13,187.50
Credits for bond "interest" 4,254.14 17,441.64
Norton's net economic loss $ 3,669.47
*140 The purported "capital gain" was unreal, was a sham, and was a component part of the sham transaction.
11. * The transaction was of benefit to Gibraltar to the extent of $3,669.47, the difference between Norton's payments of "interest" to Gibraltar of $21,111.11, and Gibraltar's payments to Norton of $17,441.64 as the so-called "reserve" of $17,359.46 plus the payment of $82.18 to close the account on its books as of September 15, 1961.
12. The transaction in the Treasury bonds lacked substance and commercial reality; it was nothing more than a paper and book-keeping transaction; and it was a sham transaction devised to obtain tax deductions and benefits. Apart from expected tax benefits, no economic benefit and no actual profit and gain could be realized from the transaction. Rather, apart from expected tax benefits, the transaction resulted in an economic loss to Norton of $3,669.47. Also, he incurred and paid a net expense, his out-of-pocket expense, of $3,669.47, as follows: Net amount of payments to Gibraltar per note $3,751.65
Less payment 9/15/61 rec'd from Gibraltar 82.18
Net out-of-pocket expense $3,669.47
*141 1276
Since the transaction was a sham, Norton did not realize any income or capital gain therefrom. Respondent agreed at the trial of these cases that if his determinations are sustained, there shall be eliminated from Norton's taxable income for 1954 and 1955, under the Rule 50 computations, the purported "interest" on the bonds which he included in income on his returns. As the year 1961 is not before the Court, we do not have jurisdiction in these cases over any adjustment for the purported "capital gain" in that year.
13. The transaction was in the form of one from which Norton could not realize a gain because the principal amount of his note to Gibraltar included the figure of $17,359.46, the so-called "reserve", which made the principal amount of Gibraltar's charge $105,000. The due date of the note was the same as the maturity date of the bonds which then would yield only their face amount of $100,000. In addition, Norton was required to make the purported "interest" payments on the note. However, the Treasury bonds allegedly involved were non-interest bonds during the years 1956-1961 (coupons detached). The following illustrates the built-in barrier to Norton's realization *142 of profit from the transaction as it was set up:
Upon the maturity of the note to Gibraltar on September 15, 1961, Norton was to be "obligated" to pay Gibraltar for the "cost" of the bonds, $87,640.54, plus the additional charge for the so-called reserve of $17,359.46, or $105,000. But he was to "receive" "interest" on the bonds of only $4,254.14, which was $13,105.32 less than the charge of $17,359.46 for the "reserve" which he had to repay to Gibraltar. In addition, he was to make payments to Gibraltar as "interest" on his note in the net sum of $3,751.65 which, when added to $13,105.32, increased the net amount of the charges to him upon the maturity of his note to $16,856.97. The "charge" to Norton for the Treasury bonds in 1954 was $86,812.50, and at the time of the due date of his note to Gibraltar he could expect to receive from a "sale" of the bonds no more than their face amount of $100,000. Although the redemption value of the bonds was $13,187.50 more than the "cost" of $86,812.50, such "gain" would be $3,669.47 less than the extra charges to him of $16,856.97, explained above. There was, therefore, a built-in loss in the transaction of $3,669.47, unless the bonds could *143 have been "sold" for as much as $103,669.47, the break-even figure. There is no evidence that the parties intended that the transaction could or might be closed prior to September 15, 1961. In fact, there was a premium charge of 1 1/2 percent if the note were to be "prepaid" before March 15, 1961.
The transaction was not entered into for profit, and a profit could not have been reasonably expected, apart from anticipated tax deductions and benefits.
14. On the basis of a stipulation of the parties agreeing to the incorporation into the record of these cases of the testimony of Professor John P. Shelton in the cases of Jerome B. Rosenthal, Docket Nos. 67848, 77923, et al., the following list of bid prices for Treasury bonds due September 15, 1961, during the period March 31, 1954, to September 1, 1961, is included herein, since it appears that the parties so intended by their stipulation. The fractions in the list of bid prices have the same denominator, 32; thus, 103-26 means 103-26/32. Since the Treasury bonds matured September 15, 1961, the market prices tended to approach 100 as the time before the maturity date became shorter:
UNITED STATES TREASURY BONDS 2 3/4% DUE 9/15/61 - *144 WITH COUPONS ATTACHED - LOW BID PRICES Year Date Low Bid Price
1954 Mar. 31 103-26
Apr. 1 103-26
May 26 102-30
June 2 103-2
July 27 103-26
Aug. 9 103-18
Sept. 28 103-11
Oct. 25 103-0
Nov. 29 102-19
Dec. 28 102-7
1955 Jan. 17 101-7
Feb. 28 100-25
Mar. 1 100-23
Apr. 26 100-22
May 6 100-19
June 27 99-31
July 29 99-4
Aug. 1 98-29
Sept. 1 99-2
Oct. 5 99-21
Nov. 21 99-10
Dec. 22 99-1
1956 Jan. 3 98-31
Feb. 23 99-28
Mar. 28 98-22
Apr. 16 97-26
May 9 98-7
June 26 98-28
July 31 97-30
Aug. 21 96-24
Sept. 5 96-15
Oct. 29 96-28
Nov. 27 96-4
Dec. 17 95-24
1957 Jan. 2 96-9
Feb. 18 97-8
Mar. 7 97-6
Apr. 30 96-22
May 27 96-2
June 21 95-12
July 22 95-2
Aug. 12 95-4
Sept. 25 95-10
Oct. 31 95-0
Nov. 1 95-6
Dec. 2 98-16
1958 Jan. 6 99-24
Feb. 3 99-30
Mar. 11 100-22
Apr. 2 101-6
May 1 101-22
June 27 101-8
July 29 100-14
Aug. 29 98-0
Sept. 29 97-20
Oct. 1 97-14
Nov. 3 97-30
Dec. 22 97-14
1959 Jan. 19 96-24
Feb. 2 97-2
Mar. 9 97-0
Apr. 21 96-30
May 13 96-26
June 4 96-12
July 28 96-6
Aug. 31 95-28
Sept. 15 95-22
Oct. 2 95-30
Nov. 30 96-10
Dec. 3 95-30
1960 Jan. 6 96-6
Feb. 19 96-24
Mar. 1 97-16
Apr. 12 97-30
May 19 97-28
June 1 98-8
July 8 99-10
Aug. 16 99-24
Sept. 12 99-23
Oct. 10 99-25
Nov. 21 99-25
Dec. 1 99-27
1961 Jan. 9 100-0
Feb. 28 99-30
Mar. 1 99-30
Apr. 3 100-0
May 24 100-1
June 2 100-0
July 31 100-1
Aug. 8 100-0
Sept. 1 100-0
*145 1277 Transaction C: $100,000 U.S. Treasury Bonds
The facts about the second transaction in Treasury bonds are the same as the facts in Transaction "B" except for small differences in figures. Gibraltar made the sale of the bonds, closing date March 1, 1954, to C. J. Devine & Co. instead of to Childs & Co. as in Transaction B, Norton executed a promissory note in the principal amount of $105,000 payable to Gibraltar on September 15, 1961, which was the maturity date of the bonds, and the transaction was closed on September 15, 1961, by a purported "purchase" of the bonds by Gibraltar at par for $100,000 which was credited to Norton's account. In this transaction, Norton sustained a net economic loss of $3,794.30. The detailed facts are as follows:
1. On Friday, February 26, 1954, Joseph Faroll & Co., New York City, issued its sale invoice for $100,000 U.S. Treasury 2 3/4 percent bonds due September 15, 1961, with the interest coupon for March 15, 1956, and subsequent coupons detached. The settlement date was Monday, March 1, 1954. The sale price of the bonds was 86 - 30/32 $86,937.50; the accrued bond interest was $850.83; and the total charge was $87,788.33. The sale slip *146 was addressed to Samuel P. Norton.
The ledger card of Faroll, for an account in the name of Norton, showed a debit on March 1, 1954, of $87,788.33, and a credit on the same date in the same amount with the notation "Irving Trust Co." On the same ledger card there are debit and credit entries on February 26, 1954, for the purchase of the other lot of $100,000 of Treasury bonds (Transaction B) for $87,640.54, with the same notation, "Irving Trust".
Pursuant to instructions of Gibraltar to Irving Trust dated February 26, 1954, Irving received the bonds from and paid to Faroll $87,788.33. Irving charged Gibraltar's account on its books for the payment to Faroll, plus a charge of $2.50, a total of $87,790.83. The bonds were not delivered to Norton or to Gibraltar; they were delivered to Irving and Irving sent its debit advice to Gibraltar. On the debit advice, dated March 1, 1954, there was the instruction, "Redeliver vs Payment. Our charge covers receipt and delivery of Bds."
On February 26, 1954, Gibraltar sold the $100,000 of bonds to C. J. Devine & Co., New York City, at 103 - 10/32, and instructed Irving to deliver them to Devine against payment. Irving followed the instructions. *147 Irving's credit advice to Gibraltar showed a credit to Gibraltar's account on March 2, 1954, for delivery of the bonds to Devine, in the total amount of $104,170.93, which represented a sale price of $103,320.10, plus accrued interest of $850.83.
The debit and credit entries to Gibraltar's account on Irving's books for this transaction of a purchase from Faroll and a sale to Devine provided a credit balance or profit in Gibraltar's favor of $16,380.10; 1278 3/2/54 Credit at 103 - 10/32, recd. from Devine $104,170.93
3/1/54 Debit at 86 - 30/32, Paid to Faroll 87,790.83
Credit balance, profit to Gibraltar $ 16,380.10
The mechanics employed included a letter signed by Norton, dated February 26, 1954, instructing Faroll to deliver the bonds to "Gibraltar" on March 1, 1954, against payment of $87,788.33; and a letter of the same date signed by Norton to Gibraltar instructing it to receive the bonds on March 1 from Faroll and to pay Faroll the above amount. Also, Gibraltar issued a confirmation slip of its own to Norton dated March 1 stating that Gibraltar had "Received" for Norton's account the $100,000 of bonds against payment of $87,788.33.
2. In *148 fact, Gibraltar did not physically receive the bonds, and it did not pay Faroll $87,788.33. Gibraltar did not make a true and real "short sale" of the bonds. In fact, the bonds paid for themselves by the sale to Devine which was almost at the same time as the purchase from Faroll. The sale to Devine nullified the "purchase" from Faroll as a "purchase" of securities, as an investment, for Norton's account. The bonds came "In" and went "Out" through the securities clearance department of Irving Trust, the clearance agent for Gibraltar. In that "In" and "Out" transaction on February 26, Gibraltar did not use its own funds, and it did not borrow funds, but it only used its account with Irving, Gibraltar did not loan $87,788.33 to Norton, and it did not purchase $100,000 of Treasury bonds for Norton's account other than for one or two days pending the sale and redelivery of the bonds to Devine. Gibraltar's purchase from Faroll and sale to Devine of $100,000 of Treasury bonds was a separate, complete, and closed transaction beginning on Friday, February 26, 1954, and ending with the delivery to Devine on Monday, March 1, or Tuesday, March 2, 1954. (In 1954, February had 28 days, and February *149 28 was Sunday.) Gibraltar's order to sell the bonds was made at or about the same time as the order to purchase the bonds. The bonds were sold. Norton did not "pledge" the bonds to Gibraltar, except on paper. Gibraltar did not receive the payment of any coupon interest on the bonds.
3. The Treasury bonds were 2 3/4 percent bonds due September 15, 1961, on which interest was payable, if paid, on March 15 and September 15; $1,375 on each date; and $2,750 a year. In the transaction with Faroll, the bonds had attached the interest coupons for 1954 and 1955, and the coupons were detached for the years 1956-1961.
In Gibraltar's transaction with Norton, Gibraltar treated the transaction as one involving a "purchase" of the bonds for Norton at 86 - 30/32, $86,937.50, with bond interest accrued, $850.83, for a total charge of $87,788.33. Subsequently on its books, Gibraltar gave Norton a credit of $2,332.18 as the "interest" on the bonds for 1954 (which figure is not explained); and a credit of $2,750 as the "interest" on the bonds for 1955, a total of $5,082.18 for "interest" on the bonds.
4. With respect to the transaction between Gibraltar and Norton, the following steps were taken: *150 Norton executed a promissory note (on a printed form of Gibraltar) dated March 1, 1954, payable to Gibraltar on September 15, 1961, which was the maturity date of the bonds, in the principal amount of $105,000, bearing 2 5/8 percent interest, secured by the "pledge" of the $100,000 Treasury bonds. The principal amount of the promissory note was the sum of a socalled cash "reserve", withheld by Gibraltar, of $17,211.67, to be paid by Gibraltar to Norton and $87,788.33, the charge for the bonds according to Faroll's statement. None of the $87,788.33 was paid by Gibraltar to Norton, and Norton did not in fact borrow any amount from Gibraltar. Gibraltar did not pay $87,788.33 of its own funds to anyone. The note stated that Gibraltar withheld $17,211.67 as a "reserve", as "security" for Norton's payment of "interest" on the promissory note. Other provisions of the note are set forth later.
On March 1, 1954, Gibraltar opened on its books a "secured account" in the name of Norton with debit entry of $105,000 described as a "secured loan" secured by the $100,000 Treasury bonds which were said to be held "Long". The debit entry reflected Gibraltar's receipt of Norton's note.
The note provided *151 inter alia that Norton had pledged the $100,000 Treasury bonds with Gibraltar as security for the "loan" of $105,000, and that Gibraltar had the right to borrow, re-hypothecate, use or transfer the bonds for any purpose, to use the bonds "to cover delivery of any securities of similar kind which may have been sold to others" by Gibraltar, and to use them "for its own account". Norton had a right to pay the note before the maturity date, upon 30 days 1279 notice, and upon the payment of a premium of 1 1/2 percent per year on the principal amount of the note from the prepayment date to the original maturity date. The "prepayment privilege" could not be exercised after March 15, 1961. Or Norton could pay the entire amount of the note on its due date, September 15, 1961, and obtain return of the "pledged"bonds. However, this provision in the printed form of the note was not of significance because the "pledged" bonds matured on September 15, 1961, and were to be redeemed at par, for $100,000, whereas the principal amount of the note was $105,000. The note also gave Norton the right to have the market value of the "pledged" bonds applied toward the payment of the note, but that right *152 could be exercised no sooner than 30 days prior to the due date of the note in 1961 and no later than 10 days before the due date. This provision, too, had little significance under all of the circumstances.
The note provided that interest received on the pledged collateral shall be applied to the principal of the note but that no refund would be made of any interest on the promissory note resulting from the reduction of the principal.
The installment payments of "interest" on the note to Gibraltar to be paid by Norton were stated on the note to be $4,217.63 on March 1, 1954, and 15 payments of $1,054.41 from January 15, 1955, to July 15, 1958, quarterly, and $1,054.37 on October 15, 1958. The sum of the "interest" payments was $21,088.15. However, the note provided that Gibraltar would pay $17,211.67 in equal installments to Norton on the dates when Norton was to pay the installments of "interest" to Gibraltar, upon the condition that the payments were made by Norton. Therefore, the net amount to be paid by Norton as "interest" was in fact $3,876.48.
Norton and Gibraltar made the reciprocal payments to each other periodically pursuant to the note, and they exchanged checks on *153 or about the same date. Gibraltar mailed notices to Norton stating that a payment of an installment of "interest" would be due as provided on the note. Norton wrote checks payable to Gibraltar for each installment of "interest". Gibraltar, in turn, mailed its checks to Norton in amounts representing "release" of parts of the "reserve". During the period March 1, 1954, to October 15, 1958, Norton's checks to Gibraltar totaled $21,088.15, and Gibraltar's checks to Norton totaled $17,211.67, the amount of the "reserve". In effect, Gibraltar repaid to Norton $17,211.67 of Norton's payments to Gibraltar, and Norton's payments from his own funds totaled $3,876.48, the difference.
Norton's note to Gibraltar was to become due on September 15, 1961, but the provision for the payment of "interest" on the note did not extend to the due date of the note. Rather no "interest" payments on the note were to be paid after October 15, 1958. The following schedules set forth for 1954-1958 the respective payments of Norton to Gibraltar and of Gibraltar to Norton:
PAYMENTS OF NORTON (N) TO GIBRALTAR (G); PAYMENTS OF GIBRALTAR TO NORTON; AND NET SUM PAID BY NORTON 1954
Check Dates Net Paid byNorton
3/ 1/54 N to G $4,217.63
3/ 1/54 G to N 3,442.33
Net paid by N $ 775.30
1955
1/12/55 N to G $1,054.41
1/11/55 G to N 860.58
Net paid by N $193.83
4/12/55 N to G 1,054.41
4/14/55 G to N 860.58
Net paid by N 193.83
7/13/55 N to G 1,054.41
7/15/55 G to N 860.58
Net paid by N 193.83
10/12/55 N to G 1,054.41
10/13/55 G to N 860.58
Net paid by N 193.83
Summary - 1955
Total paid Norton to Gi- braltar $4,217.64
Total paid Gibraltar to Norton 3,442.32
Net paid Norton to Gi- braltar $ 775.32
1956
1/ 9/56 N to G $1,054.41
1/ 9/56 G to N 860.58
Net paid by N $ 193.83
3/31/56 N to G 1,054.41
4/20/56 G to N 860.58
Net paid by N 193.83
7/10/56 N to G 1,054.41
7/22/56 G to N 860.58
Net paid by N 193.83
10/16/56 N to G 1,054.41
10/18/56 G to N 860.58
Net paid by N 193.83
Summary - 1956
Total paid Norton to Gi- braltar $4,217.64
Total paid Gibraltar to Norton 3,442.32
Net paid Norton to Gibraltar $ 775.32
1957
1/15/57 N to G $1,054.41
1/16/57 G to N 860.58
Net paid by N $ 193.83
4/ 9/57 N to G 1,054.41
4/10/57 G to N 860.58
Net paid by N 193.83
7/ 9/57 N to G 1,054.41
7/ 9/57 G to N 860.58
Net paid by N 193.83
10/ 8/57 N to G 1,054.41
10/11/57 G to N 860.58
Net paid by N 193.83
Summary - 1957
Total paid Norton to Gi- braltar $4,217.64
Total paid Gibraltar to Norton 3,442.32
Net paid Norton to Gi- braltar $ 775.32
1958
1/14/58 N to G $1,054.41
1/16/58 G to N 860.58
Net paid by N $ 193.83
4/ 8/58 N to G 1,054.41
4/ 9/58 G to N 860.58
Net paid by N 193.83
7/ 8/58 N to G 1,054.41
7/10/58 G to N 860.56
Net paid by N 193.85
10/14/58 N to G 1,054.37
10/15/58 G to N 860.56
Net paid by N 193.81
$ 775.32
Summary - 1958
Total paid Norton to Gibraltar $4,217.60
Total paid Gibraltar to Norton 3,442.28
Net paid Norton to Gi- braltar $ 775.32
Summary - 1954-1958
Total paid Norton to Gi- braltar $21,088.15
Total paid Gibraltar to Norton * 17,211.67
Net paid by Norton own funds $ 3,876.48
*154
5. Norton took deductions for "interest" on his income tax returns for the years 1954-1958 in the sum of his payments to Gibraltar under Transaction C, as set forth above, namely: 1954, $4,217.63; 1955, $4,217.64; 1956, $4,217.64; 1957, $4,217.64; 1958, $4,217.60; total deductions, $21,088.15.
6. Although the Treasury bonds had been sold by Gibraltar on February 26, 1954, Gibraltar treated that step as a "borrowing" of the bonds, and Gibraltar credited the accrued bond interest to Norton's account, as the bond interest became due, during the period February 26, 1954, to September 15, 1955. Because the Treasury bonds were "purchased" with March 15, 1956, and subsequent coupons detached, Norton's account was not credited with accrued bond interest after September 15, 1955. Norton reported the accrued interest on the bonds as income on his income *155 tax returns for the years 1954 and 1955.
As of February 26, 1954, the accrued interest on the bonds was $850.83. Since this amount was part of the total charge for the bonds, Norton did not report this amount of bond interest in his 1954 income. The accrued interest on the bonds in 1954 was $2,332.18, which amount, less $850.83, was $1,481.35.
Gibraltar credited the principal amount of Norton's note with the bond interest, for 1954, $2,332.18, and with the bond interest for 1955, $2,750, total credits $5,082.18. The credits reduced the principal amount of the note from $105,000 to $99,917.82. The bond "interest" reported in income was $1,481.35 for 1954, and $2,750 for 1955, total $4,231.35.
7. On September 15, 1961, the maturity date of the bonds, Gibraltar credited $100,000 to Norton's account, the redemption value, and canceled his note. Gibraltar treated this step as a "purchase" by itself of the bonds from Norton, and sent Norton a slip to confirm the "purchase" dated September 14, closing date September 15, 1961. The principal amount of Norton's note had been reduced from $105,000 to $99,917.82. Therefore, the credit of $100,000 left a credit balance in the account of $82.18 *156 due to Norton. On October 4, 1961, Gibraltar sent its check to Norton in that amount which closed the account. Gibraltar did not pay $100,000 in cash to Norton; the "purchase" of the bonds by Gibraltar was represented 1281 by the credit to the account on Gibraltar's books.
On his return for 1961, Norton reported a capital gain from the "sale" of the bonds of $13,187.50, of which 50 percent was taken into account in reporting income from capital gains: 9/15/61 Sale of bonds $100,000.00
2/25/54 Cost 86,937.50
Capital gain $ 13,062.50
8. The following schedule shows and explains the debits and credits in Norton's account for the transaction: Debits
2/26/54 "Cost" of $100,000 bonds $ 86,937.50
2/26/54 Accrued bond interest 850.83
$ 87,788.33
3/ 1/54 Gibraltar's "reserve" per note 17,211.67
Amount of Norton's note to G $105,000.00
"Interest" charged on Nor- ton's note 21,088.15
Total charges $126,088.15
Credits
1954 Bond "interest" credited to note $ 2,332.18
1955 Bond "interest" credited to note 2,750.00
1954-1958 Paid by Gibraltar to Norton 17,211.67
1954-1958 Net "interest" paid by Norton, note 3,876.48
9/15/61 Gibraltar's "purchase" of bonds 100,000.00
Total credits $126,170.33
9/15/61 Less paid by Gibraltar to Norton 82.18
$126,088.15
*157 9. Apart from anticipated tax deductions and benefits, the transaction could not and did not result in a real economic gain and benefit to Norton and, instead, it resulted in an economic loss to him of $3,794.30, as follows: Net Economic Loss
Debit: "Interest" charged by Gi- braltar on note $21,088.15
Credits Purported capital gain $13,062.50
Bond interest in- come 4,231.35 17,293.85
Norton's net economic loss $ 3,794.30
The purported "capital gain" was unreal, was a sham, and was a component part of the sham transaction.
10. * Gibraltar benefitted from the transaction to the extent of $3,794.30, the difference between Norton's "interest" payments to Gibraltar, $3,876.48 less the payment by Gibraltar to Norton of $82.18.
The seeming profit to Gibraltar of $16,380.10 (the credit balance in its favor on Irving's books; see par. 1 on page 52, supra) may not have been a "profit" to Gibraltar if it had repurchased the detached coupons for delivering the Treasury bonds to Devine on February 26, 1954.
11. The transaction *158 in the Treasury bonds lacked substance and commercial reality; it was nothing more than a paper and bookkeeping transaction; and it was a sham transaction devised to obtain tax deductions and benefits. Apart from expected tax benefits, no economic benefit and no actual profit and gain could be realized from the transaction. Rather, apart from expected tax benefits, the transaction resulted in an economic loss to Norton of $3,794.30. Also, he incurred and paid a net expense, out-of-pocket expense, of $3,794.30, as follows. Net amount of payments to Gibraltar $3,876.48
Less receipt from Gibraltar 10/4/61 82.18
$3,794.30
Since the transaction was a sham, Norton did not realize any income or capital gain. Respondent has agreed that if his determinations are sustained, there shall be eliminated from Norton's taxable income for 1954 and 1955, under Rule 50 computations, the purported "interest" on the bonds which he included in income on his returns. As the year 1961 is not before the Court, we do not have jurisdiction in these cases over an adjustment to eliminate the reported capital gain in that year.
12. The transaction was in the form of one from which Norton *159 could not realize a gain because the principal amount of his note to Gibraltar included the figure of $17,211.67, the so-called "reserve", which made the principal amount of Gibraltar's charge $105,000. The due date of the note was the same as the maturity date of the bonds which then would yield only their face amount of $100,000. In addition, Norton was required to make the purported "interest" payments on the note. However, the Treasury bonds allegedly involved were non-interest bonds during the years 1956-1961 (coupons detached). The following illustrates the built-in barrier to Norton's realization of profit from the transaction as it was set up: 1282
Upon the maturity of the note to Gibraltar on September 15, 1961, Norton was to be "obligated" to pay Gibraltar for the "cost" of the bonds, $86,937.50, plus the additional charge for the so-called reserve of $17,211.67, or $105,000. But he was to "receive" "interest" on the bonds of only $4,231.35, which was $12,980.32 less than the charge of $17,211.67 for the "reserve" which he had to repay to Gibraltar. In addition, he was to make payments to Gibraltar as "interest" on his note in the net sum of $3,876.48 which, when added *160 to $12,980.32, increased the net amount of the charges to him upon the maturity of his note to $16,856.80. The "charge" to Norton for the Treasury bonds in 1954 was $86,937.50, and at the time of the due date of his note to Gibraltar he could expect to receive from a "sale" of the bonds no more than their face amount of $100,000. Although the redemption value of the bonds was $13,062.50 more than the "cost" of $86,937.50, such "gain" would be $3,794.30 less than the extra charges to him of $16,856.80, explained above. There was, therefore, a built-in loss in the transaction of $3,794.30, unless the bonds could have been "sold" for as much as $103,794.30, the break-even figure. There is no evidence that the parties intended that the transaction could or might be closed prior to September 15, 1961. In fact, there was a premium charge of 1 1/2 percent if the note were to be "prepaid" before March 15, 1961.
The transaction was not entered into for profit, and a profit could not have been reasonably expected, apart from anticipated tax deductions and benefits.
13. On the basis of a stipulation of the parties, the list of the bid prices for the Treasury bonds from March 31, 1954, to *161 September 1, 1961, is included herein. (See page 50, Transaction B.)
Transaction D: $500,000 U.S. Treasury Notes
1. On December 23, 1955, a purchase was made from Faroll of $500,000 U.S. Treasury notes, due April 1, 1960, bearing interest at 1 1/2 percent. The Treasury notes will be referred to as bonds for convenience. The interest on the bonds was payable semi-annually on April 1 and October 1, $3,750 on each date, $7,500 annually. The purchase price of the bonds was at 95-12/32, $476,875, plus a commission of $156.25, a total of $477,031.275. Faroll's total charge, including accrued interest of $1,700.82, was $478,732.07, as follows: Purchase price, 95-12/32 $476,875.00
Broker's commission 156.25
Cost $477,031.25
Bond interest accrued to 12/23/55 1,700.82
Total charge $478,732.07
The transaction date and the settlement date were December 23, 1955.
Norton made a payment of $3,732.07 to Faroll by check dated December 23, 1955, which was deposited to Faroll's account with the Farmers and Merchants Bank in Los Angeles, Calif., leaving a balance due of $475,000.
2. Faroll "delivered" the bonds "against payment" to Irving Trust, Gibraltar's clearance *162 agent. Irving debited Gibraltar's account in the amount of $475,000 for the bonds, plus its fee of $12.50, or $475,012.50.
3. Gibraltar "sold" the bonds on the same day, December 23, 1955, to a dealer in New York, Arthur Ehlenberger & Co., for $478,369.57, which was $362.50 less than Faroll's charge on the same day. Gibraltar instructed Irving to immediately "redeliver" the bonds to Ehlenberger's clearance agent, Chemical Bank, "against payment" of $478,369.57. Irving did so, and credited Gibraltar's account on its books with the above amount.
The debits and credits by Irving to Gibraltar's account were, therefore: Credit $478,369.57
Debit 475,012.50
Credit balance in Gibraltar's favor $ 3,357.07
Except for the temporary use, on December 23 of Gibraltar's credit with Irving, no money was borrowed for making the "purchase" and the "sale" of the bonds on the same day. The sale offset the "purchase".
Norton signed two letters dated December 23; one to Faroll and one to Gibraltar, instructing Faroll to deliver the bonds to Gibraltar "against payment" of $475,000, and noting that $3,732.07 was being deposited to Faroll's account at Farmers and Merchants Bank; *163 the other, instructing Gibraltar to receive the bonds from Faroll "against payment" of $475,000. The letters were part of the mechanics.
4. Gibraltar did not "borrow" $475,000, and did not "loan" that amount to Norton, or for his account.
5. Under date of December 23, 1955, Gibraltar opened on its books in the name of Norton, a "Special Loan Account" in which a debit entry was made of $475,000, with the explanation that Gibraltar had "Bought or Received" $500,000 Treasury notes due April 1, 1960, which bonds were held "Long". This charge to Norton's 1283 account reflected Gibraltar's receipt of Norton's note in the amount of $475,000, payable to Gibraltar.
6. Norton executed a printed note of Gibraltar dated December 23, 1955, in the amount of $475,000, payable to Gibraltar on April 1, 1960, bearing 2 3/8 percent interest, payable in installments on the dates and in the amounts typed on the note. This note was security for the purported "loan" by Gibraltar to Norton of the above amount, and it was stated on the note that the note was secured by the pledge to Gibraltar of the $500,000 U.S. Treasury notes.
The provisions of the note included the following: That Gibraltar *164 had the right to borrow, re-hypothecate, use, or transfer the pledged bonds for any purpose whatsoever, and to use the pledged bonds "to cover delivery of any securities of similar kind which may have been sold to others by the Gibraltar Financial Corporation, as principal and for its own account." The note provides further that at the option of Gibraltar, the pledged bonds or collateral "of like kind" can be turned over to the signer of the note upon the payment of the principal of the note, together with interest due.
The note provides that the bond interest due on the pledged bonds shall be applied to the principal amount of the note; and that the signer of the note shall not be entitled to a refund of any interest paid arising from the reduction of the principal. The note did not have a provision for renewal.
It was stated on the note of December 23, 1955, that the 2 3/8 percent interest was to be paid in installments of specified amounts on the dates and in the amounts typed on the note, namely, $16,867.41 on December 23, 1955, a total of that amount in 1955; $2,049.18 on April 1, 1956, and $3,750 on October 1, 1956, a total of $5,799.18 in 1956; $3,750 on April 1 and October 1, 1957, a *165 total of $7,500 in 1957; $3,750 on April 1 and October 1, 1958, a total of $7,500 in 1958; $3,750 on April 1 and October 1, 1959, a total of $7,500 in 1959; and $3,750 on April 1, 1960, the maturity date of the bonds and the note. The sum of all the periodic payments of "interest" on the note, as typed on the note, was $48,916.59. The note did not provide for any "reserve" withheld to secure the "interest" payments.
7. On December 23, 1955, Norton received a payment of $25,000 from Gibraltar, which as will be explained hereinafter was made to appear as a "loan" from CHK to Norton; on December 23, 1955, Norton executed a second promissory note in favor of the CHK Company, a partnership consisting of B. Gerald Cantor, Irving Hoffstein, and Burt Kleiner located in Beverly Hills. The promissory note in favor of CHK was for $25,000 payable on April 1, 1960, with interest at 4 3/4 percent from December 23, 1955, to April 1, 1960, a period of five years. The "interest" for the entire duration of the note amounted to $5,149.11 and was payable in advance on December 23, 1955. The note for $25,000 was secured by Norton's pledge of the collateral given to secure the note between Norton and *166 Gibraltar, for $475,000, CHK receiving a second lien on the collateral which was subordinate to Gibraltar's rights with respect to the $500,000 Treasury bonds pledged under the larger note.
CHK paid Norton $25,000 by check dated December 23, 1955. On that date, Norton paid CHK the prepayment of "interest" of $5,149.11, as provided in the note executed in favor of the latter.
On December 23, 1955, CHK purportedly "borrowed" $25,000 from Gibraltar, executing a note and pledge agreement in favor of Gibraltar, which note was payable on April 1, 1960, with interest at 4 1/4 percent from December 23, 1955, to April 1, 1960, a period of five years. Under the note executed by B. Gerald Cantor for CHK in favor of Gibraltar, the interest for the entire period of the note, amounting to $4,607.14, was payable in advance on December 23. Gibraltar paid CHK $25,000 by check on December 23, and CHK prepaid the "interest" of $4,607.14 to Gibraltar on that date. Under the note given by CHK in favor of Gibraltar, CHK pledged all of its rights under the note and pledge agreement between itself and Norton to Gibraltar to secure the "loan" of $25,000 to CHK on December 23. In reality, the "prepaid interest" *167 of $5,149.11, paid by Norton to CHK, went to Gibraltar in the form of CHK's payment of $4,607.14 as its prepayment of "interest" to Gibraltar. The rate of "interest" on Norton's note to CHK was 4 3/4 percent, but it was 4 1/4 percent on the note of CHK to Gibraltar. CHK kept the difference beween the two amounts, $541.97, presumably as a fee for its services.
In substance, Norton was "charged" $500,000 by virtue of his execution of the two notes, for $475,000 to Gibraltar, and $25,000 to CHK. In substance, the $25,000 1284 served the same function as the "reserve" of cash to be paid by Gibraltar to Norton, which was the mechanics adopted in Transactions A, B, and C, supra, except that in this instance the "reserve" of $25,000 was paid to Norton through CHK and it was paid at the beginning of the transaction on December 23, 1955.
According to the note to Gibraltar, Norton's first payment of "interest" was due on December 23, 1955, in the amount of $16,867.41. Norton paid that amount to Gibraltar. In substance, there was simply an exchange of checks covering that amount as the receipt of the $25,000 (from CHK) covered Norton's payment of $16,867.41 to Gibraltar on the same date. *168 The receipt of $25,000 also covered Norton's payment of $3,732.07 to Faroll and most of Norton's payment of $5,149.11 to CHK as "prepaid interest", except $748.59.
In substance, therefore, Norton used only $748.59 of his own funds in making payments of the above-described, three items on December 23, 1955, as follows: 12/23/55 Received by Norton, CHK $25,000.00
12/23/55 Paid by Norton:
(a) To Faroll $ 3,732.07
(b) To CHK 5,149.11
(c) To Gibraltar 16,867.41
Net paid by Norton own funds 748.59
$25,748.59 $25,748.59
The mechanics of this part of the transaction also involved a "round robin" from Gibraltar and back to Gibraltar. Gibraltar transferred $25,000 to CHK, but Gibraltar received $16,867.41 "interest" from Norton; $4,607.14 "interest" from CHK. Also Norton's payment of $3,732.07 to Faroll had the effect of reducing Irving's charge to Gibraltar's account by that amount in the step when Irving received the Treasury bonds from Faroll "against payment". Gibraltar's account with Irving, in that step, was charged only $475,000 (plus the fee of $12.50) rather than all of Faroll's charge of $478,732.07. Gibraltar realized the *169 following benefits: 12/23/55 Gibraltar pd. CHK - Norton $25,000.00
12/23/55 Gibraltar received:
(a) Credit from Faroll-Irving $ 3,732.07
(b) Cash "interest" from CHK 4,607.14
(c) Cash "interest" from Norton 16,867.14
Excess from Norton, net 206.62
$25,206.62 $25,206.62
As shown above, with respect to the step in this transaction involving $25,000, Norton's out-of-pocket expense was $748.59 (see schedule above). The recipients of that expense of Norton were CHK which received, evidently as a fee, $541.97, and Gibraltar which received $206.62 (see schedule above). The total of those figures is $748.59.
8. With respect to the provisions of Norton's note to Gibraltar relating to any possible prepayment of the principal amount of $475,000 prior to the maturity date of April 1, 1960, the following are relevant: The note was a printed form of Gibraltar. Norton purportedly had "pledged" with Gibraltar the $500,000 U.S. Treasury notes (bonds) dur April 1, 1960, which had been sold to Ehlenberger & Co. on December 23, 1955. It was stated in the note that the signer of the note, Norton, had the right to receive Treasury notes in like kind *170 from Gibraltar "upon full payment of the principal and interest [on the note] at maturity." There was no specific provision for prepayment of the note prior to its due date in 1960. However, there was a provision that Norton had the right, upon giving written notice, to apply the market value of the securities, "pledged" pursuant to the note, "to the payment of this note", but that right could be exercised, if desired, only in 1960; that is to say, "no less than 10 days nor more than 30 days prior to the maturity date of this note." Accordingly, the provisions of the note did not permit Norton to pay the principal amount of the note before April 1, 1960; or if he had desired to close the transaction by exercising the option to have the market value of the "pledged" securities applied to the payment of the note, he could not have exercised that right any earlier than about March 1, 1960, 30 days prior to April 1, 1960. 1285
In this instance, the purportedly "pledged" securities were of such type that the right to apply the "market value" of the securities "to the payment of the note" was of little or no practical significance because the Treasury notes referred to matured on *171 April 1, 1960, were to be redeemed at their face value, and ordinarily under such circumstances the market price of that kind of security tends to approach par, or 100, as the time preceding the redemption date approaches and comes close to the redemption date. In form and according to Norton's notes to CHK and to Gibraltar, $500,000 was to be paid, and if Norton received 500,000 by way of application of market value, or credit, or in part in cash, that amount would just cover the sum of the principal amount of the two notes and there would be just an even break.
The note also provided that if "upon application of any credit * * * there is a surplus over and above the liability of the undersigned hereunder, then * * * Gibraltar * * * shall pay such surplus to the undersigned." Also, the note was binding upon the legal representatives and assigns of the signer of the note for the benefit of Gibraltar.
In the separate note to CHK for $25,000, which incorporated a "loan" agreement between Norton and CHK, which also referred to Norton's note to Gibraltar, there was no provision allowing Norton to pay that note before its maturity date, April 1, 1960.
9. Under the note of Norton to *172 Gibraltar, Gibraltar could have applied "interest" "received" on the allegedly "pledged" Treasury notes to the reduction of the principal amount of the note, but Gibraltar did not do that. Of course, the $500,000 of Treasury notes had been sold on December 23, 1955, to Ehlenberger & Co., and that sale had nullified the purchase of the securities on the same day from Faroll & Co. Gibraltar did not hold those securities and it did not receive any interest on them. The interest on the Treasury notes would have been payable on April 1 and October 1 of each year, $3,750 on each date, $7,500 annually. On Norton's note to Gibraltar, the purported "interest" on the note was payable by Norton on the first of April and October of each year beginning with the second payment due on April 1, 1956.
The procedure followed by Norton and Gibraltar, respectively, beginning on April 1, 1956, involved an exchange of checks. Norton sent his check to Gibraltar, and Gibraltar sent its check to Norton, so that in effect Norton did not make any payment out of his own funds. Gibraltar's checks were purportedly for the accrued interest on the "pledged" Treasury notes, $3,750 biannually.
The first payment *173 to Gibraltar of the purported "interest" on the note, $16,867.41, has been explained and accounted for above. Norton's receipt of $25,000 from Gibraltar, through CHK, covered Norton's first payment.
The second payment of the purported "interest" on the note was stated to be $2,049.18. Norton sent Gibraltar a check for that amount, due April 1, 1956. However, on April 1, 1956, Gibraltar sent Norton a check for $3,750, as "interest" accrued on the Treasury notes, which was $1,700.82 more than Norton's payment. Therefore, Norton did not have any expense in connection with that payment to Gibraltar.
As explained above, Norton had out-of-pocket expense of $748.59 in connection with his payments on December 23, 1955, and in connection with his receipt of $25,000. When Gibraltar paid Norton $3,750 on April 1, 1956, Norton's "surplus" of $1,700.82 over and above his payment to Gibraltar of $2,049.18, served to offset that out-of-pocket expense, and he still had a "surplus" of $952.23, as follows: 12/23/55 Norton's expense $ 748.59
4/ 1/56 Norton paid Gibraltar 2,049.18
$2,797.77
4/ 1/56 Gibraltar paid Norton 3,750.00
Surplus to Norton $ 952.23
The *174 remaining payments of the so-called "interest" on Norton's note to Gibraltar, beginning on October 1, 1956, were $3,750, on October 1, 1956, and on April 1 and October 1 of 1957, 1958, and 1959, and on April 1, 1960. That is to say, the note called for eight payments of $3,750 by Norton. He gave his checks to Gibraltar in those amounts. At about the same dates, Gibraltar gave its checks to Norton for $3,750, each, as the purported "interest" on the Treasury notes. In those exchanges of checks, Norton received back what he had paid to Gibraltar and he did not have any out-of-pocket expense.
As stated hereinbefore, Norton's payments to Gibraltar of the so-called note "interest" aggregated, per the note, $48,916.59. Taking into account the payment to Norton of $25,000 by CHK on December 23, 1955, and all of Gibraltar's payments and a credit to 1286 him of "interest" on the purportedly "pledged" Treasury notes, Gibraltar paid and credited Norton as "interest" $1,700.82 more than Norton paid Gibraltar as "interest" on his note, and Norton did not have any out-of-pocket expense with respect to what he paid Gibraltar as "interest", as follows: Pd. by Gibraltar to Norton Pd. by Norton to Gibraltar Excess Pd. by Gibraltar to N
12/23/55 $16,867.41 (CHK) $16,867.41
4/ 1/56 3,750.00 2,049.18 $1,700.82
10/ 1/56 3,750.00 3,750.00
4/ 1/57 3,750.00 3,750.00
10/ 1/57 3,750.00 3,750.00
4/ 1/58 3,750.00 3,750.00
10/ 1/58 3,750.00 3,750.00
4/ 1/59 3,750.00 3,750.00
10/ 1/59 3,750.00 3,750.00
4/ 1/60 3,750.00 3,750.00
$50,617.41 $48,916.59 $1,700.82
*175 Upon making all of the payments to Gibraltar of the purported "interest" on his note, and other payments, Norton's out-of-pocket expense of $748.59 was reimbursed by Gibraltar's payments and a credit of "interest" on the Treasury notes, and in addition Norton received from Gibraltar the net amount of $952.23 which was his "gain": 1955-1960 Net payment by Gibraltar to Norton $1,700.82
12/23/55 Norton's out-of-pocket expense 748.59
1955-1960 Norton's net gain $ 952.23
9. On his tax returns for 1955-1960 (1960 is not before us), Norton deducted as "interest" paid on his note to Gibraltar $16,867.41 for 1955; $5,799.18 for 1956; and $7,500 for each of the years 1957, 1958, and 1959, and $3,750 for 1960. The total of the deductions for the years 1955-1960 was $48,916.59. In addition, for 1955 he deducted as a payment of "interest" the $5,149.11 paid to CHK. Therefore, his deductions for purported "interest" in this transaction totaled $54,065.70. Since 1960 is not involved here, the deductions for "interest" which are in issue here were those taken in the returns for 1955-1959 which aggregated $50,315.70 (excluding $3,750 "paid" April 1, 1960).
10. In his *176 returns for 1956-1959, the years involved here, Norton reported in taxable income, the payments received from Gibraltar as "interest" on the Treasury notes. For 1955, no interest on the Treasury notes was reported. For 1956, Norton included in income as Treasury notes "interest" the net amount of $5,799.18, which was the $7,500 received from Gibraltar less $1,700.82, the interest accrued to December 23, 1955, the date of the purported "purchase" of the bonds. The $1,700.82 was part of Farroll's charge for the securities and was part of "cost". Norton included in income as "interest" on the Treasury notes $7,500 for each of the years 1957, 1958, and 1959. The total amount so reported was $28,299.18. He reported $3,750 in income in his return for 1960, bringing the total to $32,049.18. However, 1960 is not involved here.
11. On March 31, 1960, Gibraltar issued a confirmation slip to Norton confirming a "purchase" "from him" of $500,000 Treasury notes, 1 1/2 percent due April 1, 1960, at 100, the redemption value of the Treasury notes, with the closing date April 1, 1960. The confirmation slip noted $3,750 as the accrued interest on the notes to April 1, 1960, and that the total proceeds *177 of Gibraltar's purported "purchase" were $503,750.00.
On its books in the account in Norton's name, Gibraltar entered a credit to his account in the above amount. Gibraltar then marked Norton's note of $475,000 paid and canceled the note.
Gibraltar did not purchase any U.S. Treasury notes due on April 1, 1960, from Norton or anyone else. On December 23, 1955, in an "In" and "Out" transaction Gibraltar had purchased and sold $500,000 of Treasury-April 1, 1960, notes. It did not hold any for Norton. Gibraltar's confirmation slip, addressed to Norton, of March 31, 1960, merely provided the basis for the credit entry in Norton's account on its books.
12. The step involving Norton's note to CHK, and the latter's payment of $25,000 to Norton on December 23, 1955, was an integral part of Gibraltar's transaction with Norton purportedly involving $500,000 of Treasury notes. Since the $25,000 was advanced by Gibraltar, as another type of a 1287 "reserve" in connection with a note, the "charges" to Norton of $475,000 and $25,000 in the form of his two notes represented, in substance, one charge of $500,000. Gibraltar's purported "purchase" "from Norton" of $500,000 Treasury notes, and *178 its credit to him of $500,000 in his account, represented, in substance, a credit which covered both notes, and in closing the transaction as of April 1, 1960, Gibraltar in fact reversed the procedure with respect to CHK and the $25,000 and gave Norton a check for $25,000 which Norton paid to CHK and, in turn, CHK paid to Gibraltar in repayment of Gibraltar's advance of $25,000 to CHK. Again, the procedure was a "round robin" of $25,000 from Gibraltar which came back forthwith to Gibraltar, and Norton and CHK were the conduits for that transfer "around" and back to Gibraltar.
The mechanics adopted consisted of bookkeeping entries as follows: As of March 31, 1960, there was a debit balance due Gibraltar in Norton's account of $475,000, the principal amount of his note. There also was a charge (debit) to Norton of the last installment of "interest" on his note of $3,750, making the total debits $478,750. On April 1, 1960, Gibraltar credited $503,750 to the account. The credit of $3,750, representing the purportedly accrued "interest" due April 1, 1960, on the "Treasury notes" might have offset the debit in the same amount for "interest" on Norton's note to Gibraltar but instead Norton *179 sent Gibraltar a check for $3,750 on March 31.
On May 12, 1960, the account was closed by Gibraltar's payment of $28,750 to Norton. That payment represented a payment to Norton of $25,000, the difference between the credit of $500,000 and $475,000, and $3,750 for the April 1, 1960, "interest" on the Treasury notes. Norton reported that $3,750 as income in his 1960 tax return.
The charges and credits to the account on Gibraltar's books in 1960 were, therefore, as follows: Charges:
Due on note of Norton $475,000
"Interest" due 4/1/60 on note of N 3,750
$478,750
Credits:
Paid by Norton, note "interest" $ 3,750
Treasury notes bought by Gibraltar 500,000
"Interest" 4/1/60 Treasury notes 3,750
$507,500
Less Gibraltar paid Norton 28,750
$478,750
On May 13, 1960, Norton paid $25,000 to CHK. CHK had given its note to Gibraltar for $25,000 on December 23, 1955, which was payable April 1, 1960. CHK paid $25,000 to Gibraltar.
13. On his 1960 tax return, Norton reported the "sale" of the Treasury notes and a capital gain of $22,968.75: 3/31/60 "Sale" of Treasury notes $500,000.00
12/23/55 "Cost" of Treasury notes 477,031.25
Capital gain $ 22,968.75
*180 The "cost" used by Norton was Faroll's charge of $476,875 plus its commission of $156.25.
Norton did not in fact and substance realize a capital gain of $22,968.75.
14. It is our finding that the item of $25,000 was

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4593113. Public record. Not legal advice.