Petition — Paduano v. Commissioner

Su, eme Court, U. &

{ Fill. ED 5

# MAR 29 1976

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(UMACL KODAK, IR. CLERK

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Supreme Court of the United States

October Term, 1975

GERALD F. PADUANO and CAROLINE PADUANO,

ROCCO M. CAPPUCCILLI and DOROTHY CAP-

PUCCILLI, PETER L. CAPPUCCILLI and GRACE A.

CAPPUCCILLI,

Petitioners,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No. : @5- ] 3 x |

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

VICTOR CHINI, ESQ.

Attorney for Petitioners

Office and Post Office Address

811 State Tower Building

Syracuse, New York 13202

A RT A LL A SN TT A

TABLE OF CONTENTS

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Statute and Regulations Involved ....................

BASEL ET POTTER CETTE TTT CTTT

Reason for Granting the Writ ...................04..

In the Application of Section 482 of the Internal

Revenue Code to Loans Between Related Taxpayers at

Less Than an Arm’s Length Rate of Interest, the

United States Tax Court has Applied Three Different

Rules (tracing concept); Four United States Circuit

Courts of Appeal have Applied a Contrary Rule;

(consistent with each other) but the Rule Applied by

the Four Circuit Courts of Appeal as It Presently

Stands is Contrary to Established Rules of Taxation

(Even as Applied in Their Own Courts), and

Discriminates Against Related Parties. Application of

These Various Rules, Causes Inequities in Tax Ad-

ministration and Confusion of the Tax Law and Should

be Authoritatively Settled by This Court.

Summary of the Problem .......................5.

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Appendix

I. Relevant Treasury Regulations ...............

Il. Opinion of the Tax Court ..................

III. Judgment of the Court of Appeals .............

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TABLE OF CITATIONS

Page

Cases:

American Cigar Co. vs. Commissioner, 66 F2d, 425

EN ., sd oak oko 5k cae os64nsesen Pau 14, 16,18

Atchinson, Topeka & Santa Fe Railway Co. vs. Com-

missioner, 36 Tax Ct. 584(1961) ................. 9

Barker vs. Magruder, 95 F2d 122 (C. Ct. D.D. 1937)

EP ry err Cy rae rar res en ae 14, 16,18

Cayuga Service, Inc., 34 T.C.M. 18 (1975) ........... 13

Club View Corp., 34 T.C.M. 922 (1975) at page 924 ... 13

Combs Lumber Co. vs. Commissioner, 41, B.T.A. 339

DE ci tnauka luke lehasnebdnaehe dakkWenl> even i)

Commissioner vs. First Security Bank of Utah, 405 U.S.

Pe 7. ne rueGee jeuee oneal wieean pleas 17, 20

Corn Exchange Bank vs. United States, 37 F2d 34 (C.A.

5 REP ere ree 14, 15, 16, 17, 18, 20

Fitzgerald Motor Co. vs. Commissioner, 508 F 2d, 1096

(C.A. 5, 1975) affirmed Tax Ct. 60 Tax Ct. 957

SE Ci usd vase nkadereedaekeeed ven teheal 13, 14, 20

B. Forman Co. vs. Commissioner, 453 F2d, 1144 (C.A.

2. 1972) affm’ing in part and reversing in part 54 Tax

Ct. 913 (1970) cert. den. 407 U.S. 934, rehearing den.

409 U.S. 899 (1972) ............5, 7,8, 13, 14, 18, 19, 20

Golsen, Jack E., 54 Tax Ct. 742 (1970) aff'd. 445 F2¢

985 (C.A. 10, 1971) cert. den. 404 U.S. 940 (1971) .. 5,13

Greer-Robbin Co. vs. Commissioner, 119 F2d 92, 93

SRM fos fh Te ee ee eee 15,16, 18

Huber Homes, Inc. vs. Commissioner, 55 Tax Ct. 598

(1971) Pr re ee re ts ee ee er rs ee 9,10, 11

Page

Kahler vs. Commissioner, 486 F2d (C.A. 8, 1973)

rev ing. and remanding Tax Ct. 58 Tax Ct. 496 (1972)

SR 5 64 6 bs inev ndtececseivan 10,11, 12, 13, 14, 20

Kerry Investment Co. vs. Commissioner, 500 F2d 108

(C.A. 9, 1974) aff’ing. and reversing Tax Ct., 58 Tax

Ge SUED od vc cvcccvceses 8, 10, 11, 12, 13, 14, 18, 20

Liberty Loan Corp. vs. U.S., 498 F2d 225 (C.A. 8, 1974)

reversing & remanding 359 F. Supp. 158 (D.C.E.D.

I ed Celie eee ee eae eee ears 13, 14, 20

Pitchford'’s Inc. vs. Commissioner, 34 T.C.M. 384

Sh cr. oa oe hoya eRe O Seance ee tanes 15, 16, 20

P.P.G. Industries, Inc. vs. Commissioner, 55 Tax Ct. 928

SE. cee cvounGres sss baenedes eae eaRee Leet 9, 10,11

L.E. Shunk Latex Products, Inc. vs. Commissioner, 18

poe & 8 rerrrrrrr rrr re rrr rey 17,20

Smith-Bridgman Co., 16 Tax Ct. 287 (1951) Aeq. 1951-

SEs - cetDeas oink dso sseeesebearersiss 9,10, 11

Society Brand Clothes, Inc. vs. Commissioner, 18 Tax Ct.

i ceva. seuugeeheneehiuccaesceeeeKns i)

Statutes:

Internal Revenue Code of 1954, §482 ................

TET Te 2, 4, 6, 7, 8,9, 10, 11, 12, 14, 15, 16,19, 20

Income Tax Regulations:

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i cs een beh eens seeks uae’ 17

er Pe ere 2, 8,13

In The

Supreme Court of the United States

October Term, 1975

GERALD F. PADUANO and CAROLINE PADUANO,

ROCCO M. CAPPUCCILLI and DOROTHY CAP-

PUCCILLI, PETER L. CAPPUCCILL!I . sd GRACE A.

CAPPUCCILLI,

Petitioners,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No. :

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Petitioners ask that a writ of certiorari issue to review the

judgment of the United States Court of Appeals for the Second

Circuit.

Opinions Below

The opinion of the Court of Appeals has not been reported as

of this date. The opinion of the Tax Court (Appendix, pp. A5ff;

R.* 75-84) is reported officially at 34'T.C.M. 368 (1975)

**R” refers to the portion of the printed record in the Court of Appeals en-

titted “APPENDIX”. “Ex.” refers to the Exhibit Volume from the AP-

PENDIX.

Jurisdiction

The decision of the Court of Appeals was rendered on

January 12, 1976, and the judgment was entered on the same

day (Appendix, pp. Al2, Al3). The jurisdiction of this Court is

invoked under 28 U.S.C. §1254(1).

Question Presented for Review

Whether the Commissioner has authority under §482 of the

Internal Revenue Code to impute interest income on related

party loans, whether or not the obligee is on an accrual or a cash

basis, where said loans bear less than an arm's-length rate of

interest, and where the related obligor’s financial situation is

such that payment of the imputed interest could not reasonably

be expected.

Statute and Regulations Involved

Section 482 of the Internal Revenue Code of 1954, 26 U.S.C.

§482 is the applicable statute involved and provides as follows:

§482. Allocations of income and deductions among taxpayers

In any case of two or more organizations, trades, or

businesses (whether or not incorporated, whether or not

organized in the United States, and whether or not

affiliated) owned or controlled directly or indirectly by

the same interests, the Secretary or his delegate may

distribute, apportion, or allocate gross income,

deductions, credits, or allowances between or among

such organizations, trades, or businesses, if he deter-

mines that such distribution, apportionment, or

allocation is necessary in order to prevent evasion of

taxes or clearly to reflect the income of any of such

organizations, trades, or businesses.

The regulations involved are §§1.482-1 and 1.482-2(a) of the

Income Tax Regulations (26 C.F.R. §§1.482-1 and 1.482-

2(a)), pertinent portions of which are reprinted in the Appendix,

pp. Al-A4.

Statement of the Case

Relevant to the questions presented, the material facts in this

case have been stipulated, or are undisputed or are found as

follows:

During the years in issue, taxpayers Gerald Paduano, Rocco

Cappuccilli and Peter Cappuccilli were equal partners in a

partnership known as Cappuccilli, Cappuccilli and Paduano

(hereinafter referred to as CCP). Each of the taxpayers were

also equal shareholders in Stonehedge Development Cor-

poration (Stonehedge), Seneca Sewerage Corporation (Seneca)

and Cappy’s Real Estate, Inc. (Cappy); CCP was principally

engaged in the real estate business (R.62). As a result of land

sales, during the period involved, CCP held purchase money

mortgage notes from Stonehedge amounting to $1,122,850. and

a purchase money mortgage note from Seneca amounting to

$25,006. Stonehedge and Seneca had also assumed existing first

mortgages on land that they purchased from CCP (Joint

Exhibits 33-AG-39AM). Also during 1967 through 1969 CCP

made numerous advances to Cappy and Stonehedge (R. 64-

69). Relative to all of the obligations involved, only the $25,000.

mortgage note from Seneca, and the $81,000. mortgage note

from Stonehedge bore interest (R. 65.78).

The mortgage notes due to CCP from Stonehedge were to be

paid over a 10 to 12 year period from the proceeds from sales of

developed lots (approximately 100 per year) by Stonehedge

(R. 103). Although interest payments were made by Stone-

hedge and Seneca to other creditors during this period, no in-

terest was paid to CCP during this period (R. 65, 79).

Zoning restrictions, a tight money market, a New York State

appropriation action and a general decline in the real estate

business during the years involved, all contributed to a complete

termination of the development plan (R. 104, 105). As a result,

there was no cash flow to Stonehedge and it was unable to pay

its obligations to CCP (R. 122). The financial condition of the

4

debtor corporations was so critical that they could not borrow

funds from banks and CCP had to advance funds so that non-

related first mortgagees and other creditors could be paid.

Funds also were advanced by CCP to the three related cor-

porations so that they could continue operations (R. 122, 123).

In March, 1972 CCP foreclosed on its mortgages against Stone-

hedge and Seneca (R. 107).

Pertinent financial information of these companies, based on

federal income tax returns stipulated in evidence, is as follows:

Current

Taxable Income Cash Balance Liabilities

STONEHEDGE

December 31, 1967 $ 2,835.09 $ 1,948.79 $ 115,879.12

December 31, 1968 *( 57.780.03) 3,099.85 1,409,507.10

December 31, 1969 ( 113,177.10) 1,640.44 1,414,056.67

(Joint Exhibits 25-Y, 26-Z, 27-AA)

SENECA

June 30, 1968 —_ $ 400.41 $ 174,443.73

June 30, 1969 —O— 300.04 149,428.29

(Joint Exhibits 30-AD, 31-AE)

CAPPY

December 31, 1967 —o— $13,271.84 $ 127,078.94

(Joint Exhibit 32-AF)

(The extremely poor cash position in relation to current liabilities is readily

noted.)

Because interest was not paid on the mortgage notes and

loans by the corporate obligors to CCP, the Commissioner,

under Section 482 of the Internal Revenue Code, imputed

interest to CCP for the years 1967, 1968 and 1969, at a rate of

five percent (5%) per annum (R. 81). Correlative adjustments

*Brackets indicate losses.

for interest deductions were allowed by the Commissioner to the

three corporate obligors (R. 81). As a result of the interest

income imputed to CUP each partner’s distributive share of

income increased, and likewise their income tax liability. Total

deficiencies for the three partners amount to $83,429.44 (R. 72-

74). The three partners and their wives (by virtue of their filing

joint income tax returns with their husbands) petitioned the Tax

Court for redetermination (R. 76). The cases were consolidated

for trial and have remained consolidated on appeal.

The Tax Court in a memorandum opinion (Appendix, pp.

AS.ff, R. 75-84) followed the case of B. Forman Company v.

Commissioner of Internal Revenue, 453 F.2d 1144 (C.A. 2,

1972) affirming in part and reversing in part 54 Tax Ct. 913

(1970), certiorari denied 407 U.S. 934, rehearing denied 409

U.S. 899 (1972), which ruled for the Commissioner on this

point. Although the Tax Couri did not (nor does it now) agree

with Forman, supra, it was bound to follow it under the rule laid

down in Jack E. Gelsen, (':'ax Court on cases squarely in point is

bound by Circuit Court decision in which it sits) 54 Tax Ct. 742

(1970) aff'd 445 F.2d 985 (C.A. 10, 1971) certiorari denied

404 U.S. 940 (1971). The United States Circuit Court of

Appeals for the Second Circuit (no opinion has been rendered to

date) affirmed the United States Tax Court (Appendix pp. A1l2,

Al3).

6

REASON FOR GRANTING THE WRIT

In the Application of Section 482 of the Internal

Revenue Code to Loans Between Related* Taxpayers at

Less Than an Arm’s Length Rate of Interest, the United

States Tax Court has Applied Three Different Rules

(tracing concept); Four United States Circuit Courts of

Appeal have Applied a Contrary Rule; (consistent with

each other) but the Rule Applied by the Four Circuit

Courts of Appeal, as It Presently Stands, is Contrary to

Established Rules of Taxation (Even as Applied in Their

Own Courts), and Discriminates Against Related Parties.

Application of These Various Rules, Causes Inequities in

Tax Administration and Confusion of the Tax Law And

Should be Authoritatively Settled by This Court.

Summary of Problem

A review on writ of certiorari is warranted in this case because

there is a difference of opinion between the United States Tax

Court and the United States Circuit Court of Appeals for the

Second, Fifth, Eighth and Ninth Circuits, on the issue of

whether the Commissioner of Internal Revenue has authority

under Section 482 of the Internal Revenue Code and the

regulations thereunder to impute interest income on loans be-

tween related parties, where such loans bear less than an arm's

length rate of interest. The Tax Court has consistently held that

the borrower must have gross income and that all or part of the

gross income was produced by the funds borrowed (a tracing

concept). The Circuit Courts of Appeal have held that there is

no requirement under Section 482, of the Internal Revenue

Code, and the regulations thereunder, that the related borrower

have gross income during the years in issue, and that the

*As used throughout this petition, the term “related” is intended to encompass

the “two or more organizations . . . owned or controlled . . .”’ etc. referred to

in Section 482 of the Internal Revenue Code.

Commissioner is authorized to impute interest income to the

related lender, notwithstanding the lack of gross income of the

borrower.

Petitioners are of the opinion that the Tax Court’s tracing

concept is wrong, and further that the rule applied by the Circuit

Courts of Appeal is also erroneous as the rule now stands

Related parties should be treated as non-related parties not only

in applying Section 482, but also in limiting the application of

that section to instances where the related obligor’s financial

condition is such that interest could reasonably be expected to be

paid by the related obligor to the obligee. For example, if “A”

and “B” are non-related parties and on January 1, “A” loans

“B” $1,000,000. at five percent (5%) to be paid in two years,

and “A” is under accrual method of accounting, under the law,

at the end of the first year “‘A™ would be required to accrue

interest income; but, if ‘“‘B’’ became bankrupt during the first

year “A” would not be required to accrue interest income.

However, if ‘““A”’ and “*B” were related, as the law now stands in

the four Circuit Courts of Appeal, “A” would be charged with

an interest income allocation.

Certiorari was denied by this Court in the case of B. Forman

Company, Inc. v. Commissioner of Internal Revenue, supra,

which involved the questions of control and the “creation of

income” concept under Section 482 and the regulations there-

under. Petitioners agree with the “‘control” interpretation as

defined by the Second Circuit Court of Appeals in Forman,

supra, but disagree with the broad Forman rule that the

Commissioner may allocate interest income to the related lender

where less than an arm’s length rate of interest was charged. The

question of the related debtor's financial ability to pay interest

was not an issue in Forman, supra (nor in the decisions of the

other three Circuit Courts of Appeal, which will be discussed

later). Since the Forman case, supra, there have been seven Tax

Court cases, one District Court case and five Circuit Court of

Appeals cases involving the Commissioner's right to impute

interest income on loans between related parties. The law on this

issue is presently in a state of confusion and more litigation

would follow, unless this Court rules and finally settles the

matter.

Argument

Under Section 482, of the Internal Revenue Code the

Commissioner has authority to allocate income, expenses, and

credits between controlled parties, when such allocation is

deemed necessary in order to clearly reflect the income of the

parties and to prevent the avoidance of taxes. Under the

Treasury regulations, where loans are made between controlled

parties at less than an arm’s length rate of interest, the Com-

missioner has authority to make an allocation to the lender of a

proper rate of interest. Regulations §1-482-2(a)(1)(2).

In B. Forman Company, Inc. v. Commissioner of Internai

Revenue, supra, one of the issues involved a Section 482 a'loca-

tion of interest relative to non-interest bearing loans made by

two corporations which each owned 50% of a corporation, they

formed to build a shopping center. The questions before the

United States Tax Court were: was there control (under §482)

by the two corporations over the debtor, and secondly if the

necessary control existed could the Commissioner of Internal

Revenue allocate or impute interest income to the related

obligee. The Tax Court found that the necessary control did not

exist; therefore, the question of allocation of interest income was

not decided. On appeal to the Second Circuit Court of Appeals,

that Court found that the necessary control existed and that the

Commissioner had authority under Section 482 and the

regulations thereunder to allocate interest income to the related

lender, without a showing that there was gross income realized

by the debtor attributable to the borrowed funds.

Prior to the Kerry case (Kerry Investment Co. v. Com-

missioner of Internal Revenue, 500 F.2d 108 (C.A. 9, 1974)

affirming and reversing the Tax Court, 58 Tax Ct. 479 (1972))

9

the United States Tax Court consistently held that as to trans-

actions between related parties the Commissioner was not

authorized under Section 482 (and the regulations thereunder)

to “create’’ income (where none existed), then allocate said

“created” income among the related parties. Likewise, if loans

were made between related parties on an interest free basis (or at

less than an arm's length), the Commissioner could not impute

interest income to the lender to reflect an arm's length rate of

interest.

See Smith—Bridgman & Co., 16 Tax Ct. 287 (1951) Acq.

1951-1.C.B 3; where the borrowing corporation used loan

proceeds from its parent to pay outstanding bonds, but no in-

terest was charged to the borrower. The Tax Court held that the

Commissioner could not impute interest income; true also in

PPG, Industries Inc. v. Commissioner, 55 Tax Ct. 928 (1970);

Combs Lumber Co. v. Commissioner, 41, B.T.A. 339 (1940).

Even where an interesi bearing note was given to the related

obligee, the Tax Court held the Commissioner could not charge

interest if the parties agreed that no interest would be charged

until some future time. Society Brand Clothes, Inc. v. Com-

missioner, 18 Tax Ct. 304 (1952); Atchinson Topeka & Santa

Fe Railway Co. v. Commissioner, 36 Tax Ct. 584 (1961).

in Huber Homes, Inc. v. Commissioner, 55 Tax Ct. 598

(1971) the Tax Court opened the door for the Commissioner to

use a different tactic, i.e. assert that part of the gross income of

the related obligor should be allocated to the obligee on the

theory that the funds which were borrowed at less than an arm's

length interest rate generated income for the related obligor;

therefore, part or all of said income should be allocated to the

obligee in order to properly reflect income of the related parties.

In Huber Homes, supra, the parent sold homes at cost to its

subsidiary. The subsidiary rented the homes, and the Com-

missioner attempted to charge the parent company with income

on the difference between the fair market value of the homes and

10

the cost to the subsidiary. The Tax Court held against Com-

missioner stating at page 607:

the Commissioner does not here contend that any .. .

of (the subsidiary’s) gross rental income was not earned

by it or that any portion of its income should be

allocated to (the parent).

And on page 610 the Tax Court used language which was the

basis of its subsequent decision in Kerry (discussed infra):

But if as a consequence of . . . the use or consumption

by the transferee (of goods or services transferred to it at

less than arm’s length prices) income is realized within

the controlled group, an entirely different question

would be presented.

Citing Smith—Bridgman & Co., supra, PPG Industries,

supra and Huber Homes, Inc., supra, the Tax Court stated in

Kahler v. Commissioner, 486 F.2d 1 (C.A. 8, 1973) reversing

and remanding Tax Court, 58 Tax Ct. 496 (1972) at page 506:

The Tax Court has consistently held that a

prerequisite to the Commissioner's allocation authority

under Section 482 is the existence of an item of income

deduction, credit or allowance which had its genesis in

the particular transaction between the related parties.”’

And at page 507:

Where the controlled group, for example, has realized

no income from the particular transaction within the

group, we have undeviatingly held Section 482 to be

inapposite.

The Kerry case, supra, (which was reviewed by the entire Tax

Court) involved interest free loans between reiated parties. The

Commissioner used two arguments under Section 482 in the

Tax Court: interest income should be imputed to the related

obligee, and gross income should be allocated from the obligor to

the obligee. Of the various loans involved, some were traced to

income producing assets some to non-income producing assets

und some could not be traced at all. The Tax Court held that the

ll

petitioner had the burden of proving that the interest free loans

did not produce income, accordingly the Tax Court held for

Commissioner's allocation on all loans except for the loans

which were traced to non-income producing assets.

Because of the pertinent language, substantial extracts are

quoted from the concurring opinion of Tax Court Judge Irwin,

and the dissenting opinion of Judge Featherston. Note the

concurring opinion of Judge Irwin at pp. 493, 494:

In both Kerry and Kahler, we affirmed this Court’s

previous position in this area: namely, that the Com-

missioner cannot utilize Section 482 to “create” income

solely by imposing arm's length dealing on related

parties where his only allegation is that there were in-

terest-free advances between the parties. In Kerry, how-

ever, we are going one step further because respondent

not only attempted to allocate non-existent interest

income per se as in Kahler, he in addition sought to

allocate income generated by the Kerry subsidiary from

the use an? consumption of interest free funds.

Consistent with Smith—Bridgman & Co., 16 Tax Ct.

287 (1951) Acq. 1951 — 1 C.B. 3; PPG Industries,

Inc., 55 Tax Ct. 928 (1970); and Huber Homes, Inc.,

55 Tax Ct. 598 (1971) the former type of allocation is

again rejected in both Kerry and Kahler. The latter type

of allocation, however, that of income generated from

the use and consumption of the interest free loans is

approved in Kerry because it is an allocation of income

from one related party to another and is not an

allocation of non-existent interest. Kerry is the first case

before this Court in which we have been faced with the

application of §482 to an improper deflection of income

caused by the use or consumption of interest-free ad-

vances.

Judge Featherston who dissented, disagreed with the tracing

concept as being inconsistent with the language of Section 482

and its implementing regulations. At page 495 he states:

12

As I read Section 482 and these regulations, the

applicability of that section does not depend upon the

realization of pretax profits from a particular non-arm's

length transaction or, in the case of borrowed funds, the

use to which they are placed. The section refers to “gross

income” and “deductions” and does not specify the

source from which they may be derived ...

I fail to see how the tracing concept, which involves

an analysis of the borrowing corporation's use of the

advanced funds and the financial results of such use

during the tax years, can be squared with these

regulations. Moreover, I think the concept gives birth to

a mischievous rule. Apart from the endless disputes it

will engender as to whether particular uses of the

borrowed funds (e.g. to pay overhead, capital expense,

long term investments, etc) produced income during the

tax years, it places a premium on accounting sophistica-

tion and lays a trap for the unwary. By the simple ex-

pedient of investing the particular borrowed dollars in

non-productive assets, section 482 can be circumvented

even though such investment releases other funds for

income-producing uses. On the other hand, if the

borrower is not aware of this limitation which the

majority is writing into the regulations and mingles the

borrowed dollars with other capital, Section 482 may be

applied.

On appeal, the Circuit Court of Appeals for the Ninth Circuit

reversed the Tax Court in Kerry on the tracing concept, holding

that the Commissioner could allocate interest income to the

related obligee regardless whether the funds borrowed, at less

than an arm's length rate of interest, produced or generated

income for the related obligor.

In Kahler, supra, the Tax Court maintained its tracing

concept developed in Kerry, supra, but was reversed by the

Kighth Circuit Court of Appeals, again on the theory that it was

not necessary to show that the borrower earned income on the

interest free loans.

13

The Fifth Circuit Court of Appeals in Fitzgerald Motor Co. v.

Commissioner of Internal Revenue, 508 F.2d 1096 (C.A. 5,

1975) affirmed Tax Court 60 Tax Ct. 957 (1973) but on a

different principle. The Tax Court held for Commissioner on the

tracing doctrine. The Appeals Court held that tracing was not

necessary, stating that the Tax Court's theory required two

elements; did borrower have gross income during the year in

question, and was this income derived from using the borrowed

funds. The Appeals Court said that this test is needlessly

complicated and the requirement that the debtor have gross

income is not required under section 482 of the regulations;

citing Reg 1.482-2 (a)(1).

In a slightly different fact situation involving related party

loans, the Eighth Circuit Court of Appeals upheld the govern-

ment in a situation where a parent company borrowed money at

a rate of 5.55 per cent and loaned the funds to a group of

subsidiaries under an agreement whereby the parent would

receive the same rate of interest — but from the group as a

whole. Some individual subsidiaries paid more than 5.55 and

some (who were losing money) paid no interest at all. The

federal district court held that the Commissioner could not

allocate interest income to the parent from the subsidiaries

which paid no interest. On appeal, the district court was

reversed. Liberty Loan Corporatior. v. United States, 498 F.2d

225 (C.A. 8, 1974) reversing and remanding 359 F. Supp. 158

(D.C.E.D. Miss. 1973).

In one recent Tax Court case the Court followed Forman,

supra, because the Golsen, supra, rule was applied; Cayuaga

Service, Inc., 34 T.C.M. 18 (1975) and in another recent case

the Court held for the Commissioner under the Kerry, supra,

tracing theory, Club View Corporation, 34'T.C.M. 922 (1975).

In the latter case at page 924 the Tax Court in referring to the

divergence of views which had been developed on this issue

(Citing Forman, Fitzgerald, Kerry and Kahler, supra) stated :

14

For petitioners to prevail under this Court's existing

case law they would have to prove ‘that the proceeds of

each particular loan were not used by the borrower to

produce gross income’ during the taxable years in issue.

Fitzgerald Motor Co., supra, at 963. As petitioners have

not presented any evidence on this point, they cannot

prevail and respondent’s determination must be

sustained. Because we have sustained respondent under

this Court’s existing case law, we need not reconsider his

argument that he is empowered to impute interest in-

come irrespective of whether the borrowed funds

produce gross income.

Although petitioners are of the opinion that the Tax Court is

wrong on its tracing theory, (for the reasons given in dissenting

opinion of Judge Featherston in the Kerry case, supra} never-

theless, the rule laid down by the Circuit Courts of Appeal is too

broad, i.e. The Commissioner is authorized under Section 482

and the regulations to impute interest income regardless whether

the funds borrowed produced income. It should be noted that

with respect to all of the Circuit Court cases, Forman, Kerry,

Kahler, Fitzgerald, Liberty Loan, supra, and Paduano (no

citation), no restriction is placed upon the Commissioner's right

to allocate interest income to the related party, in the event

collection of said interest is unlikely because of the related

debtor's financial condition. Also, throughout these cases, the

courts, in upholding the Commissioner, have emphasized the

fact that related parties should deal with each other at arm's

length, and that economic realities should be observed. But

should not this same rule also be applied to related parties when

relief from taxation is sought?

The Courts have recognized that in non-related taxpayer

situations, if collection of interest is not reasonably expected, an

accrual basis obligee is not required to report interest income.

Corn Exchange Bank v. United States, 37 F.2d 34 (C.A. 2,

1930); American Cigar Co. v. Commissioner, 66 F.2d 425

(C.A, 2, 1933); Barker v. Magruder, 95 F.2d 122 (C. Ci. D.D.

15

1937); Greer-Robbin Co. v. Commissioner, 119 F.2d 92, 93

(C.A. 9, 1941).

In Corn Exchange Bank, supra, (involving an accrual basis

taxpayer), the Court said at page 34:

When a tax is lawfully imposed on income not ac-

tually received, it is upon the basis of a reasonably

expectancy of its receipt, but a taxpayer should not be

required to pay a tax when it is reasonably certain that

such alleged accrued income will not be received and

when in point of fact it never was received.

The example given by Judge Augustus N. Hand in his

concurring opinion at page 35 is relevant:

If “A” loaned $100,000. to “B” and the latter was a

hopeless insolvent, but “A” did not know it, can it be

thought that “A” would create taxable income by

mistakenly entering interest upon the loan upon his

books? What the government is permitted by the

constitution to tax is real not supposed income.

But suppose in that example “A” and “B” were related,

should the Commissioner have authority to impute interest

income regardless of “B's” insolvent position? The answer

should be no, otherwise the law would discriminate against

related parties who make loans to each other. However, the

Commissioner in the Pitchford's Inc. v. Commissioner, 34

T.C.M. 384 (1975) must have realized the inequity of such an

application of the law. Pitchford, supra, involved transactions

between related taxpayers, and the petitioner used the accrual

method of accounting. The Cormmissioner conceded that he

could not allocate interest income to petitioner under section

482 if the obligor’s financial condition was so shaky that there

was no reasonable expectancy of collection. The Tax Court held

that the obligor was not economically sound during the tax years

involved; therefore, the Commissioner could not allocate in-

terest income to the controlling obligee (taxpayer).

16

However, the Tax Court stated at page 386:

We express no views on the question whether

allocation of interest income under section 482 is indeed

precluded where there would not have been a reasonable

expectancy of collection of such interest. For purposes of

this case only, we accept respondent's concession on this

point.

Notwithstanding the Tax Court's remarks, petitioners are of

the opinion that the concession by the Commissioner makes

good sense. His concession squares with the treatment that in

loan transactions related parties should be treated as non-related

parties, not only for purposes of imputing additional interest

income, but also in determining whether there is a reasonable

expectancy in the collection of such additional interest income.

In essence, the imputation of interest income under §482 should

be tempered with the ruling in the Corn Exchange Bank case;

i.e. interest income should not be imposed when the debtor's

financial condition would make collection remote.

If as between related taxpayers no interest should be imputed

to an accrual basis taxpayer \obligee) because of the obligor’s

shaky financial situation, the same rule should also apply to

related taxpayers if the obligee happens to be on the cash basis.

The accounting method (cash or accrual) employed by the

obligee has no bearing on the obligor’s financial ability to pay.

Thus if an obligor has no funds with which to pay an accrual

basis obligee, the same would be true as to the obligor’s ability to

pay a cash-basis obligee. Any other rule would be discriminatory

against cash basis taxpayers who make loans to related parties.

Although, the cases holding, that an accrual basis taxpayer is

not required to accrue interest income where collection is not

reasonably expected, (Corn Exchange, Greer-Robbin, Barker,

America Cigar, supra) were decided prior to the promulgation of

regulations under section 482, (1968), the Commissioner has

apparently accepted this rule more recently in the Pitchford,

case, supra, by virtue of his concession.

17

In Commissioner v. First Security Bank of Utah, 405 U.S.

394 (1972) the Commissioner attempted to charge various

banks » ih commissions on insurance policies which the banks

were responsible for initiating but, because it was against the

banking !aw for banks to engage in insurance business, or to act

as insurance agents, the banks referred the policies to an in-

dependent company without charging a commission. The in-

dependent company and the banks were part of a related group

of companies. The Commissioner was unsuccessful in at-

tempting to allocate part of the commission income to the banks.

While First Security Bank of Utah concerned the allocation of

prohibitive income, parts of the decision are relevant to our case.

Justice Powell in stating that the question was ‘‘whether there

was a shifting or distorting of the Banks’ true net income .. .”’

(pp. 400-401) said at page 403:

We know of no decision of this Court wherein a

person has been found to have taxable income that he

did not receive and that he was prohibited from

receiving. In cases dealing with the concept of income it

has been assumed that the person to whom the income

was attributed could have received it. The underlying

assumption always has been that in order to be taxed for

income a taxpayer must have complete dominion over it.

(Emphasis added)

See also L. E. Shunk Latex Products, Inc. v. Commissioner, 18

Tax Ct. 940, 961 (1952) cited by the Supreme Court in First

Security Bank of Utah, supra, where the Tax Court held that the

Commissioner “had no authority to attribute to petitioners

income which they could not have received.” In the Corn Ex-

change Bank case, supra, the creditor had a right to the interest

income, but because collection was not reasonably expected, a

tax was not imposed.

Under Treasury Regulations §1.482-1(d)(2) whenever the

Commissioner makes an adjustment to a taxpayer's income, he

18

is required to make an appropriate correlative adjustment to the

other related party. It would appear from the regulation that if

“A” makes an interest free loan to “B”, a related party, and the

Commissioner charges “A*’ with $50,000. of interest income,

then from an accounting viewpoint the entries for “A” and “B”

would be as follows:

On A’s Books:

Debit: Interest Receivable from B $50,000.

Credit: Interest Income $50,000.

On B's Books:

Debit: Interest Expense $50,000.

Credit: Interest Payable te A $50,000.

Thus, “A” would be entitled to $50,000. from “*B” as a result of

the “correlative adjustments’ required under the afore-

mentioned regulations. But if *“B’’, for the year in issue becomes

bankrupt, then, under the present rule of the Circuit Courts of

Appeal, “A” would have to pay an income tax on the interest

income although it could not possibly collect the interest due

from “B". Yet if “A” and “B” were not related, ““A’’ would not

have to pay a tax, Corn Exchange Bank, (Second Circuit)

American Cigar Co., and Barker and Greer-Robbin Co., (Ninth

Circuit), supra. Thus, the Second and Ninth Circuit agree that

nonrelated parties (on an accrual basis) would not have to pay a

tax on interest income if the possibility of collection is remote.

Yet, according to the rule set forth in Forman, (Second Circuit)

and Kerry, (Ninth Circuit) the Commissioner would be

authorized to impute interest income in related party loans

which bear less than an arm's length rate of interest without

limitation as to the related obligee’s possibility of collecting the

imputed interest from the related obligor. In effect, these two

Circuit Courts would be contradicting their own established rule

of taxation regarding interest income, or they would be

discriminating against related party loans, unless their present

rule is limited.

19

According to the Regulations:

The purpose of section 482 is to place a controlled tax-

payer on a tax parity with an uncontrolled taxpayer, by

determining, according to the standard of an un-

controlled taxpayer, the true taxable income from the

property and business of a controlled taxpayer. Treasury

Regulations $1.482-1(b).

Thus, on the question of collectability of interest income there

is no justification for applying one standard to non-related

parties, and a different standard to related parties.

In fact, the Second Circuit Court in Forman established the

principle (followed by the Fifth, Eighth and Ninth Circuits) that

related parties should deal with each other at arm’s length; i.e.

as non-related parties would. Then, why should not the Court

follow its own rule and apply the “nonrelated”’ standard to

related parties when it involves the collection of the imputed

interest income. In effect, the Second Circuit applied the

nonrelated standard to impute interest income to the related

obligee in the instant case, but would not apply the same

standard to determine the collectability of the interest income

which was imputed.

The facts in the instant case clearly show that because of the

problem which arose concerning development the related

obligors could not develop the lots, as planned, consequently

there was no cash flow with which to pay the obligations, (in-

cluding the imputed interest to CCP). In fact, Stonehedge,

Seneca and Cappy could not borrow from banks and CCP had

to advance funds to them so that they could pay third party

creditors in order to avoid foreclosure on first mortgages and to

keep these companies in operation. Finally, because payments

were not forthcoming, CCP had to foreclose on its mortgages

against Stonehedge and Seneca.

Except for the instant case, in the other Circuit Courts of

Appeal cases ruling on section 482 (on the issue of loans be-

20

tween related parties at less than an arm’s length rate of in-

terest); namely, Forman, Kerry, Kahler, Fitzgerald and Liberty

Loan, supra, the question of the related obligor’s financial

ability to pay interest was not raised. Nevertheless, it is

respectfully submitted that based on the cases previously cited

(Pitchford’s, L. E. Shunk Latex Products, Inc., First Security

Bank of Utah, Corn Exchange Bank, supra) an equitable and

simple rule to be applied in section 482 cases involving loans be-

tween related parties would be:

Where less than an arm’s length rate of interest is

charged on related party loans, the Commissioner has

authority to apply section 482 to reflect a proper interest

rate, regardless whether the related obligee is on the cash

or accrual basis of accounting, but only if there is a

reasonable expectation that interest could be collected

by the obligee from the related obligor.

This rule would avoid the unwieldly “tracing” test applied by

the United States Tax Court, and also, would avoid the

discrimination against related parties which is inherent in the

present expansive rule applied by the Circuit Courts of Appeal

for the Second, Fifth, Eighth and Ninth Circuits.

CONCLUSION

For the foregoing reasons, the petition for a writ of certiorari

should be granted.

Respectfully submitted,

VICTOR CHINI, ESQ.

Attorney for Petitioners

Office and Post Office Address

811 State Tower Building

Syracuse, New York 13202

1976.

APPENDIX

Al

| RELEVANT TREASURY REGULATIONS

INCOME TAX REGULATIONS:

Sec. 1.482-1

(a) (3) The term ‘controlled’ includes any kind of control,

direct or indirect, whether legally enforceable, and however

exercisable or exercised. It is the reality of the control which is

decisive, not its form or the mode of its exercise. . . .

| * . *

(6) The term ‘true taxable income’ means, in the case of a

controlled taxpayer, the taxable income (or, as the case may be,

| any item or element affecting taxable income) which would have

resulted to the controlled taxpayer, had it in the conduct of its

affairs (or, as the case may be, in the particular contract, trans-

action, arrangement, or other act) dealt with the other member

or members of the group at arm’s length.

(b} Scope and purpose. (1) the purpose of section 482 is to

place a controlled taxpayer on a tax parity with an uncontrolled

taxpayer, by determining, according to the standard of an

uncontrolled taxpayer, the true taxable income from the

property and business of a controlled taxpayer. The interests

controlling a group of controlled taxpayers are assumed to have

complete power to cause each controlled taxpayer so to conduct

its affairs that its transactions and accounting records truly

reflect the taxable income from the property and business of

each of the controlled taxpayers. If, however, this has not been

done, and the taxable incomes are thereby understated, the

district director shall intervene, and, by making such distribu-

tions, apportionments, or allocations as he may deem necessary

of gross income, deductions, credits, or allowances, or of any

item or element affecting taxable income, between or among the

controlled taxpayers constituting the group, shall determine the

true taxable income of each controlled taxpayer. The standard

2 ey Oe Ce ee

Sees ee A PR. 2s Oe ee ee Lee ee eee

aD, Se Se

A2

Relevant Treasury Regulations

to be applied in every case is that of an uncontrolled taxpayer

dealing at arm's length with another uncontrolled taxpayer.

* ad *

id) Method of allocation. (1) The method of allocating,

apportioning. or distributing income, deductions, credits, and

allowances to be used by the district director in any case, in-

cluding the form of the adjustments and the character and

source of amounts allocated, shall be determined with reference

to the substance of the particular transactions or arrangements

which result in the avoidance of taxes or the failure to clearly

reflect income. The appropriate adjustments may take the form

of an increase or decrease in gross income, increase or decrease

in deductions (including depreciation), increase or decrease in

basis of assets (including inventory), or any other adjustment

which may be appropriate under the circumstances. .. .

(2) Whenever the district director makes adjustments to the

income of one member of a group of controlled taxpayers (such

adjustments being referred to in this paragraph as ‘primary’ ad-

justments) he shall also make appropriate correlative adjust-

ments to the income of any other member of the group involved

in the allocation. The correlative adjustment shall actually be

made if the U.S. income tax liability of the other member would

be affected for any pending taxable year. Thus, if the district

director makes an allocation of income, he shall not only ia-

crease the income of one member of the group, but shall

decrease the income of the other member if such adjustment

would have an effect on the U.S. income tax liability of the other

member for any pending taxable year... . If a correlative ad-

justment is not actually made because it would have no effect on

the U.S. income tax liability of the other member involved in the

allocation for any pending taxable year, such adjustment shall

nevertheless be deemed to have been made for the purpose of

A3

Relevant Treasury Regulations

determining the U.S. income tax liability of such member for a

later taxable year, or for the purposes of determining the U.S.

income tax liability of any person for any taxable year .. . .

* * *

(4) If the members of a group of controlled taxpayers

engage in transactions with one another, the district director

may distribute, apportion, or allocate income, deductions,

credits, or allowances to reflect the true taxable income of the

individual members under the standards set forth in this section

and in §1.482-2 notwithstanding the fact that the ultimate

income anticipated from a series of transactions may not be

realized or is realized during a later period .... if one member

of a group lends money to a second member of the group in a

taxable year, the district director may make an appropriate

allocation to reflect an arm's length charge for interest during

such taxable year even if the second member does not realize

income during such year. The provisions of this subparagraph

apply even if the gross income contemplated from a series of

transactions is never, in fact, realized by the other members.

Sec. 1.482-2

Determination of taxable income in specific situations. — (a)

Loans or advances — (1) In general. Where one member of a

group of controlled entities makes a loan or advance directly or

indirectly to, or otherwise becomes a creditor of, another

member of such group, and charges no interest, or charges

interest at a rate which is not equal to an arm's length rate as

defined in subparagraph (2) of this paragraph, the district

director may make appropriate allocations to reflect an arm’s

length interest rate for the use of such loan or advance.

(2) Arm's length interest rate. For the purposes of this

paragraph, the arm’s length interest rate shall be the rate of

interest which was charged, or would have been charged at the

A4

Relevant Treasury Regulations

time the indebtedness arose, in independent transactions with or

between unrelated parties under similar circumstances. ... If

the creditor was not regularly engaged in the business of making

loans or advances of the same generai type as the loan or ad-

vance in question to unrelated parties, the arm's length rate for

purposes of this paragraph shall be...

(i) The rate of interest actually charged if at least 4 but not

in excess of 6 percent per annum simple interest,

(ii) 5 percent per annum simple interest if no interest was

charged or if the rate of interest charged was less than 4, or in

excess of 6 percent per annum simple interest, . . .

(3) Loans or advances to which subparagraph (1) applies.

Subparagraph (1) of this paragraph applies to all forms of bona

fide indebtedness and includes:

(i) Loans or advances of money or other consideration

(whether or not evidenced by a written instrument), and

(ii) Indebtedness arising in the ordinary course of business

out of sales, leases, or the rendition of services by or between

members of the group, or any other similar extension of credit.

AS

OPINION OF THE UNITED STATES

TAX COURT

T.C. Memo. 1975-69

UNITED STATES TAX COURT

GERALD F. PADUANO AND CAROLINE PADUANO, ET

AL.,! Petitioners vx. COMMISSIONER OF INTERNAL

REVENUE, Respondent

Docket Nos. 7103-72, 7168-72, Filed March 20, 1975.

7169-72.

Victor Chini, for the petitioners.

John D. Steele, Jr., for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

FAY, Judge: Respondent has determined the following

deficiencies in the Federal income tax of the petitioners :

Petitioners Year Deficiency

Gerald F. and 1967 $11,061.91

Caroline Paduano 1968 8,881.62

1969 8,824.21

Rocco M. and 1967 $10,553.54

Dorothy Cappuccilli 1968 9,217.04

1969 | 7,921.75

Peter L. and 1967 $10,094.08

Grace A. Cappuccilli 1968 8,753.64

1969 8,121.65

Cases of the following petitioners are consolidated herewith: Rocco M.

Cappuceilii and Dorothy Cappuccilli, Docket No. 7168-72; and Peter L.

Cappuccilli and Grace A. Cappuccilli, Docket No. 7169-72.

A 6

Opinion of the United States Tax Court

We are to decide if respondent properly imputed interest

income to petitioners pursuant to section 482, Internal Revenue

Code of 1954, as amended. 2

FINDINGS OF FACT

Gerald F. and Caroline Paduano, Rocco M. and Dorothy

Cappuccilli, and Peter L. and Grace A. Cappuccilli, husbands

and wives, filed joint Federal income tax returns for the years in

issue with the district director of internal revenue, Buffalo, New

York, and were residents of Syracuse, New York, when the

petitions herein were filed.4

In 1954 petitioners formed a partnership styled ““Cappuccilli,

Cappuccilli and Paduano” (CCP), in which each had a one-

third interest and which engaged principally in the business of

renting and selling realty. Each of petitioners also held a one-

third stock interest in: Stonehedge Development Corporation

(Stonehedge), organized on April 8, 1953; Seneca Sewerage

Corporation (Seneca), organized on April 1, 1961; and Cappy’s

Real Estate, Inc. (Cappy), organized on September 3, 1958.

In the period February 22, 1961 — January 3, 1962, CCP

acquired five contiguous farms, known colleccvely as Seneca

Knolls, at a total cost of $320,083.4 On January 10, 1962,

a . . o

<All section references are to the Internal Kevenue Code of 1954. as

amended.

3Hereinafter “petitioners” shall refer to Gerald Paduano, Rocco Cappuccilli

and Peter Cappuccilli, collectively.

4

Farm Date of Purchase Purchase Price

Walter 2/22/61 $ 64.005

Commane 10/20/61 71,830

Green 10/26/61 34,788

Patterson 11/24/61 22,400

Higgins l/ 3/62 127,000

AT

Opinion of the United States Tax Court

CCP conveyed Seneca Knolls to Stonehedge in consideration of :

a cash payment in the amount of $3,430; the assumption of

mortgage obligations totalling $275,170; and a note in the

amount of $1,075,000, bearing no interest, secured by a pur-

chase money mortgage, and providing for for the payment of

$75,000 on January 10, 1964, and of $100,000 on January 10

of each of the ten succeeding years.

Henderson Farm, lying adjacent to Seneca Knolls, was

purchased by CCP on March 8, 1960, for $125,460. The farm

was sold to Stonehedge on February 20, 1961, in consideration

of: a cash payment of $27,894.86; the assumption of mortgage

obligations totalling $107,605.14; and a note in the amount of

$81,000, bearing interest at an annual rate of six percent,

secured by a purchase money mortgage, and providing for

payment to be made in equal installments on the first and

second anniversaries of the sale.

CCP purchased Preston Farm from Stonehedge on April 15,

1961, for $22,500. Petitioners intended that a sewerage treat-

ment plant be built at Preston Farm to service Seneca Knolls

and Henderson Farm. Pursuant to that design they caused CC?

to sell one-half of the Preston Farm to Seneca on April 16, 1961,

in consideration of: a cash payment of $5,000; the assumption

of mortgage obligations of $10,000; and a note in the amount of

$25,000, bearing interest at the rate of six percent per annum,

secured by a purchase money mortgage, and providing for

paymer’ in full on April 15, 1966.5

Petitioners anticipated that Seneca Knolls and Henderson

Farm would be subdivided into lots, the sales of which would

provide Stonehedge with sufficient funds to discharge the

obligations which it incurred in acquiring the realty; but owing

°The note afforded Seneca a limited right of prepayment but provided for no

abatement in purchase price in the event that right were exercised.

SE

A8

Opinion of the United States Tax Court

to circumstances which need not be recounted here, the

development of those properties could not proceed as planned.

Consequently, Stonehedge was unable to reduce the principal

amount of its indebtedness to CCP in compliance with the terms

of its several obligations. These obligations were not wholly

satisfied until March 14, 1972, pursuant to an action in fore-

closure initiated by CCP. ®

Seneca did not discharge the obligation which it incurred in

purchasing one-half of Preston Farm until 1973.

CCP waived compliance with the interest obligations in-

curred by Stonehedge and Seneca in purchasing Henderson

Farm and one-half of Preston Farm, although both of these

corporations paid interest to others of their creditors while the

mortgage obligations to CCP remained outstanding.

Aside from the mortgage loans, CCP made advances to

Stonehedge and Cappy to enable them to defray expenses

necessary to their continuing in operation. Certain of these

loans, in respect of which interest was neither charged nor paid,

were outstanding during the years in issue.

6Prior to January |, 1967, Stonehedge reduced the principal amount of its

mortgage obligations to CCP by $33,150. It made no further payments of

principal prior to the foreclosure.

A9

Opinion of the United States Tax Court

OPINION

Where one member of a group of commonly controlled en-

tities becomes indebted to another but is charged no interest,

respondent may allocate interest to the creditor under section

482.7 would interest have been charged under like cir-

cumstances in an arm’s length transaction. B. Forman Com-

pany v. Commissioner, 453 F.2d 1144 (C.A. 2, 1972), affirm-

SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS

AMONG TAXPAYERS

In any case of two or more organizations, trades or businesses (whether

or not incorporated, whether or not organized in the United States, and

whether or not affiliated) owned or controlled directly or indirectly by the

same interests, the Secretary or his delegate may distribute, apportion, or

allocate gross income, deductions, credits, or allowances between or

among such organizations, trades, or businesses, if he determines that

such distribution, apportionment, or allocation is necessary in order to

prevent evasion of taxes or clearly to reflect the income of any such

organizations, trades, or businesses.

Income Tax Regs. adopted pursuant to sec. 482 provide in pertinent part:

Sec. 1.482-1(b) Scope and purpose. (1) The purpose of section 482

is to place a controlled taxpayer on a tax parity with an uncontrolled

taxpayer, by determining, according to the standard of an uncontrolled

taxpayer, the true taxable income from the property and business of a

controlled taxpayer. ***

Sec. 1.482-1(a}(6) The term “true taxable income” means, in the case

of a controlled taxpayer, the taxable income *** which would have

resulted to the controlled taxpayer, had it in the conduct of its affairs ***

dealt with the other member or members of the group at arm's length.

**

Sec. 1.482-2(a) Leans or advances—il) In general Where one

member of a group of controlled entities makes a loan or advance directly

or indirectly to, or otherwise becomes a creditor of, another member of

such group, and charges no interest, or charges interest at a rate which is

not equal to an arm's length rate as defined in subparagraph (2) of this

paragraph, the district director may make appropriate allocations to

reflect an arm's length interest rate for the use of such loan or advance.

4

A 10

Opinion of the United States Tax Court

ing in part and reversing in part 54 T.C. 913 (1970), certiorari

denied 407 U.S. 934 (1972).8 Pursuant to his authority under

section 482, respondent has imputed interest income to CCP at

the rate of five percent per annum on the loans to Stonehedge,

Seneca and Cappy outstanding during the years in issue. ?

Petitioners have acknowledged that no interest was charged

on the nonmortgage loans but have failed to demonstrate that a

party dealing with Stonehedge and Cappy at arm's length would

have done the same. Accordingly, we hold that respondent

properly imputed interest income to CCP in respect of the non-

mortgage loans.

Petitioners have also failed to demonstrate that a party

dealing with Stonehedge at arm’s length would not have charged

interest on the obligation of $1,075,000 incurred by Stonehedge

in purchasing Seneca Knolls. And had CCP been dealing with

Stonehedge and Seneca at arm’s length, it would likely have

insisted that they honor their commitments to pay interest

annually on the obligations which they incurred in purchasing

Henderson Farm and one-half of Preston Farm, respectively ;

This Court does not espouse the interpretation of sec. 482 set forth in B.

Forman Company v. Commissioner, 453 F.2d 1144 (C.A. 2, 1972), af-

firming in part and reversing in part 54 T.C. 913 (1970), certiorari denied

407 U.S. 934 (1972). See Kerry Investment Co., 58 T.C. 479 (1972),

affirmed in part and reversed in part 500 F.2d 108 (C.A. 9, 1974); Kahler

Corp. 58 T.C. 496 (1972), reversed 486 F.2d 1 (C.A. 8, 1973); Fitzgerald

Motor Co., 60 T.C. 957 (1973), affd. ——-F.2d —— (C.A. 5, 1975). We

shall, however, apply it in this instence. See Jack E. Golsen, 54 T.C. 742

(1970), affd. 445 F.2d 985 (C.A. 10, 1971), certiorari denied 404 U.S. 940

(1971).

9Petitioners concede that if interest is properly imputable to CCP under the

circumstances obtaining herein, the rate utilized by respondent is ap-

propriate.

Respondent has allowed Stonehedge, Seneca and Cappy additional

interest deductions for the years in issue in amounts equal to the interest

income which he has allocated to CCP under sec. 482.

ial Winnie ott eee beet A © ute “tr 28 ©

All

Opinion of the United States Tax Court

for both corporations were paying interest to others of their

creditors while the aforesaid two obligations were outstanding.

CCP, however, failed to enforce these commitments, apparently

for no other reason than that it was commonly controlled with

Stonehedge and Seneca.

Petitioners maintain that while ostensibly no interest was

paid on the mortgage loans, the price for which the realty was

sold included an element of interest. This contention is properly

to be sustained only upon a demonstration that in each instance

the realty was intentionally sold at a price exceeding its fair

market value by the amount of interest that would have accrued

at a definite rate over the term of the contract of sale. Elliott

Paint & Varnish Co., 44 B.T.A. 241 (1941); Kingsford Co., 41

T.C. 646 (1964).

Petitioners have purported to show that Seneca Knolls,

Henderson Farm and one-half of Preston Farm were each sold

for an amount sufficiently in excess of fair market value to

include interest accruable over a 12-year period at 8.5 percent,

7.5 percent and 12 percent, respectively. In our judgment, this

evidence does not substantiate petitioners’ contention. Of the

three contracts of sale, only one provided for payment over a 12-

year period, the other two providing for payment over periods of

two and five years.!° Seneca was authorized to prepay its

obligation to CCP; had it availed itself of that privilege, .

however, there would have been no abatement of the purchase

price under the terms of the contract of sale. Petitioners, fur-

thermore, have not undertaken to explain in terms of their

contention why CCP might have charged differing rates of

interest with respect to each of the mortgage obligations; or why

two of the contracts of sale were made expressly to provide for

!OClearly it is irrelevant to the matter in issue that neither of the latter two

obligations was in fact timely paid.

A 12

Judgment of the Court of Appeals

the payment of interest over and above the sale price at the

aunual rate of six percent. We are therefore convinced that in

setting the price at which each piece of mortgaged realty was

sold by CCP, petitioners did not intend that the price include

unstated interest.!! Accordingly,

Decision will be entered

for the respondent.

JUDGMENT OF THE COURT OF APPEALS

United States Court of Appeals

Second Circuit

At a Stated Term of the United States Court of Appeals, in

and for the Second Circuit, held at the United States Courthouse

in the City of New York, on the twelfth day of January one

thousand nine hundred and seventy-*‘x.

Present:

HON. IRVING R. KAUFMAN

Chief Judge

HON. WILLIAM H. TIMBERS

HON. ELLSWORTH A. VAN GRAAFEILAND

Circuit Judges

| 1See by way of contrast Estate of Betty Berry, 43 T.C. 723 (1965), affd. per

curiam 372 F.2d 476 (C.A. 6, 1967), certiorari denied 389 U.S. 834

(1967).

< AAO. nce entgn oe eta ly alll

A 13

Judgment of the Court of Appeals

Gerald F. Paduano and Caroline Paduano, Rocco M. Cap-

puccilli and Dorothy Cappuccilli, Peter L. Cappuccilli and

Grace A. Cappuccilli,

Petitioners-Appellants,

vs.

Commissioner of Internal Revenue,

Respondent-Appellee.

75-4138

Appeals from The Tax Court of the United States

This cause came on to be heard on the transcript of record

from The Tax Court of the United States, and was argued by

counsel,

ON CONSIDERATION WHEREOF, it is now hereby

ordered, adjudged, and decreed that the order of said The Tax

Court of the United States be and it hereby is affirmed with costs

to be taxed against the petitioners-appellants.

A. DANIEL FUSARO,

Clerk

By VINCENT A. CARLIN,

Chief Deputy Clerk