Brief for the United States in Opposition — Northeastern Consolidated Co. v. United States

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‘CONTENTS

* Opinions: below. --_.---.------, ------- ra tarda

thesia seg. acgrag OE E ta PT ON ae

Cqnepiios yrementid, os eee eee

Statute involved_________- ~----- senha ae ovsale a

a fa I ERDAS ies

aE ee Ee rere EY

IR 8 6, oc cee

7 CITATIONS

_ American Processing & Sales Co. vy. United

States, 371 F. 2d 842_..__..t 90 5,-6, 8

Berkowitz v. United States, 69-1 CCH Tax

Ca 196062... ne we We ge ae

Booth N ewspapers, Inc. v. United States, 303

ai re Wiener Lpad, TeRRp ee age Rien ot) Dem 10

Burr Oaks Corp. v. Commissioner, 365 F. 2d 24_ 5

Byerlite Corp, v. Williams, 286 F\ 2d 285... 5, 6, 7,8

Commissioner v. Bagley & Sewall Co., 221 F. =

2d te eS Pee” Sine a hnstgee sata siiaies 102

. \Corn Products Refining Co. v. Commissioner, ~

. 350 U.S. 46_____ Eee cna ae ten g

Covey Investment Co. v. United States, 377 F, *

we Set Pee Wrens com en

Daily Journal Co. v. Commissioner, 135 F. 2d ~

cee OE RN OFRE ES ery SURO sa bce 11

Fin Hay Realty Co. v. United States, 398 F. -

oe eee eee PRer ttre sib. Pie 1 at:

Five Star Manufacturing Go. v. Com nisstoner,

wee Foe oe pice atheaiscentk 10

853-460—¢9 ” B

Fé Sa \ a

SR a ea

Le SEN SEN

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‘ ” Diner Anas OOS a Ge ie ates BOGE

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II

Cases-<-Continued

_ Page

Foresun, Inc. v. Comsnissioner, 348 F. 2d 1006- 7

Gilbert v. Commissioner, 248 F. 9d 399... ...3° 5

Higgins v.' Smith, 308 U.S. ine » #

“ Knetch v. United States, 964 US. 3612 -....-- 8

: Lutz v. Commissioner, 282 F. 2d 614_-------- ae

Moughon v. Commissioner, 329 F. 2d 399_---- 5, 7

Taft v. United States, 314 F. 2d 620__-----,- 5.

: Tomlinson v. 1661 Corp., 377° F. 2d 291-_----- 5, 8

United Gas Improvement Co. v. Commissioner,

ee ea cw ei cto as ae

United States v. Estate of . Saw ‘No. you,

. O.T., 1968, decided June 2, 1968__------- as.

Wood Preserving Corp. of Baltimore v. United |

States, 233 F. Supp. 600, affirmed, 347

F. a, 117 Hd de eciawtinekes ey , Ft

Statute: :

3 Internal Revenue Code of 1954: eae

a Sec. 165 (26 U.S.C. 1964 ed., Sec. 165): - 2

Sec. 165(g) (26 U. & C: 1964" ed., Sec.

TCG aus eink ow daenn ee awe ss 6, 7

' —. See. 166 (26 USC. 1964 ed., Sec. 166) __ 2

Sec. 341 (26 U.S.C. 1964 ed., Sec. 341) _-

’ See. 582 (26 U.S.C. 1964 ed., See. 582) _-~

Secs. 1242-1244 (26 USS. C. 1964 ed.,

Secs. 1242-1244)... Sr apstabettine rhs

Miscellaneous: . , “

Bittker & Eustice, Federal Income Tdcation of

© Corporations and Shareholders. (2d ed.), Sec:

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on January’ 6, 1969: The petition for rehearing was) |

Ou the Supreme Gourt oth the Wnited —.

OcTOBER Term, 1968

No. 1382 °

N ORTHEASTERN . CONSOLIDATED CoMPANy, PETITIONER

yee v.

Unirep States or AMERICA

“oe

- ON -PETITION FOR.A WRIT OF CERTIORARI TO THE UNITED.

'. » STATES COURT OF APPEALS FOR THE SEVENTH CIRCUIT

°

. ——— . ‘

» ———

BRIEF FOR THE UNITED STATES IN OPPOSITION

." : \

OPINIONS. BELOW

* The opinion of the district court (Pet. 10a-19a) is

‘ ‘alerted at 279 F. Supp. 592. The opinion of the

court of acute Niecs Ja-Oa) © is ; reported at 406 F.

2d 76. F |

>

Jv RISDICTION

The judgment of the court of appeals was entered

denied on February 17, 1969. The. petition for a writ

of certiorari was filed on May 10, 1969. ‘The jurisdic-_

tion of the Court is invoked under 28 U.S.C. 12! 54(1).-

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QUESTION PRESENTED

Whether the court8 below properly: characterized

advances petitioner. made to a corporation sovnseav Rp

by its sole shareholder as contributions to egpital so that

the resulting loss was a capital 1 loss rather than a bad

debt. , e }

STATUTE INVOLVED

Sections 165 and 166 of the Internal Revenue Code

of 1954 are set forth in the auaas ae 20a-22a).

STATEMENT . oR

: Pelitionar . a Delaware corporation which was or-

ganized in 1949 under the name Consolidated Gas and

Service Company. Its operations involved the con-

struction of gas distribution facilities. John c. Don- ©

nelly owned all the capital stock: (Pet:10a:)°

In 1954, a separate company, Northeastern Electric

Construction Corporation (Necco), was organized to

engage in electrical construction work for one of the

petitioner’s most important customers. Donnelly ‘and —

Arthur Schmidt, an officer of petitioner, were the

stockholder# A separate corporate entity was used to

conform to rules of the International Brotherhood of

Electrical Workers,’ which would contract only with

companies’ doing exclusively electrical work. . (Pet.

10a-11a.) é

Necco’s initial capital was sheet $12, 000. Pron the

end of 1954 to March 1956, Delaware Consolidated

advanced over $300,000 to or on behalf of Necco,

primarily for operating expenses such as. payrolls,

materials and overhead. Although petitioner carried

the advances as accounts receivable, no written-evi-

dences of indebtedness. were given, no interest or

- .

. 7.

~ -yances up’ to the time of the merger.As part of the

oe

. maturity date was agreed upon, and no security was

-.provided.’(Pet. Ila.) ; Pi

Neceo incurred serious losses from its inception.

In March 1956, it was decided to.merge the two com- ©

panies intu one, the present petitioner,-with a trans-

' fer of Necco’s assets to “petitioner. There is no evi-.

" dence of any payments or credits against the ad-

merger the value of Necco’s properties were- applied xe

against the advances. The amount left unreimbursed—_

$199,791.09—was cancelled on sspieporsscal s books of cb

account. (Pet. 11a.) ns EP

- ‘Petitioner claimed a bad debt ies Pox the

$199,791.09, for its taxable year « ending ‘March 31,

1956. The Commissioner of Internal Revenue first

allowed the deduction, intluding the carry-back of

petitioner’s resultant 1956 net operating loss to 1954

and 1955, but subsequently disallowed it and assessed.

deficiencies.” Petitioner paid the deficiencies and filed |

claims for refund. The claims were denied by the

Commissioner and petitioner filed this suit in the dis-

trict court. (Pet. 1la.): That court rendered judg-

ment for-the -governnient (Pet. 192).°@he court of —

appeals, one judge dissenting, affirmed (Pet. la-9a).

1As part of the merger effected in 1956, Necco’s own net

operating loss,. whieh tofalled about $187, 000 at the time of

merger, was made available to petitioner as an “offset against

its taxable income. Petitioner claimed and was allow is

over deductions for 1959, 1960 and 1961 ‘aggregating eon

. ~— (Pet. 1la—12a.)

4

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_ ‘The decisiin below i 1s correct and there i is no conflict |

of decision that calls for further review.: .

1. To justify a ‘business’ bad. debt. deduction under .

Section 166 of the Internal Reventie Code of 1954, a

taxpayer must first demonstrate that a true indebted-

ness existed. Petitioner’s advaiices to Ne¢co must be—

| characterized as debt or capital investment according |

to the substance, rather than the form, of .what oc-

curred. Higgins v, Smith, 308.U.8. 473, GP The un-

derlying determinant is that an investor’s prospects of

return are contingent upon the successful operation

of the LOREEN venture; while the lender’ $s are not.

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) evaluated in the light of. this underlying distinction.

The pertinent criteria were most recently summarized

thusly (Berkowitz v. United States; 69-1 CCH Tax

Cases 1 9398, at p. 84, 636 (C.A. 5)):

Theré are at least eleven separate determin- —

ing factors generally used by the courts in de--

termining whether amounts advanced to a cor-

poration constitute equity capital or indebted- —

~ ness. They are (1) ‘the names given to the certi-

, ~ ficates—evidencing—the-indebtedness;— (2) -the-

presence or absence of a maturity date; (3) the

source of the payments; (4) the right to en-

- force the ‘payment of principal and interest;

(5) participation in‘management; (6) a status

equal to or inferior to that of regular corpo--

rate creditors; (7) the intent of the parties; —

(8) “thin” or adequate capitalization; (9).

identity of interest between creditor arid stock-

DS tan lt OTA Hp tasers Da ete a tN Se a ich Ba bok

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holder ; : (10) payment. of interest only out of

“dividend” money; (11) the ability of the cor-.

poration to obtain loans from outside lending

institutions. |

The circuits generally agree. See, e.g., Gilbert v. Com-

missioner, 248 F. 2d 399 (C.A%2); Fin Hay Realty

Co. v. United: States, 398 F. 2d 694 (C.A. 3); Wood

Preserving Corp. of Baltimore v. United States, 347

F, 2d 117 (0.A. 4); Tomlinson v. 1661 Corp., 377*F.

2d 291 (C.A. 5); Moughon v. Commissioner, 329 F.

* 24 399 (C.A. 6); Burr Oaks Corp. v. Commissioner,

365 FF. 2d 24, 27 (C.A.7) ; Taft v. United States, 314 F.

2d 620 (C.A. 9); Covey Investment Co. V.- United

States, 37% F. 2d 408 (C.A. 10). ot

As the majority opinion below recognized (Pet.

App. 3a), analysis of these factors’ in this case mili- |

tates against the conclusion that a bona fide debt

existed. Necco was thinly capitalized, repayment was

contingent on Necco’s success, Neeco and ‘petitioner

~ had ‘some identity of interest, and comparable outside

lending was unavailable. Only the nomenclature the

parties used to describe the transaction supports peti-

tioner’s claim that a debt existed, and ‘that fact ‘alone

~—eannot-overeome the sigficant indication of a cani-

' tal contribution shown i in this record.

2... There: i is not, as petitioner argues (Pet. 12-13),

a present’ conflict between thé decision hete and the

position: of the Sixth Circuit evide need in Byerlite

Corp. v. Williams, 286 F. 2d 285, and the Court of

Claims decision in American Processing & Sales Co. v.

United States, 371 F. 2d 842. There are similarities

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wy a 8 Bee Grans 90 senda ad

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between the instant case and those cases, but the con-

siderable amount of litigation in this area shows.a mul-

titude of variations depending upon the facts of each

-ease, The decision in each instance must rest. on a —

~ balaheing of the: relative. Weight of a mixture of facts

which seldom ptesent-themselvi és again inthe. same.

proportion. | The result is that square precedent: is | *

Income Taxation of Corporations and Shareholders

(2d ed.) See. 4.02, p. 122. Certiorari should be granted.

to resolve a conflict, we suggest, only in those in-

stances where thé lower courts have disagreed as to

the characterization to be given virtually identical

factual patterns or where a court, in disagreement

with the decisions cited at pp. 4-5, supra, holds that one

of the enumerated factors either should be given no

weight or should be considered dispositive.

Neither of these suggested criteria would -justify

review of this cagé. As the Court of Claims noted

in American Processing supra 371 F. 2d at 859, both

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we

case, the credits indicated that, in economic substance,

the advances were treated as loans by the “borrower”’,

_ thus suggesting the parties intended that the advances

would be repaid. No such evidence appears in the in-

stant case: -

2There i is no inconsistency (see Pet. 17) in the government's —

_ arguments: respecting Section 165(g) (3) of the Internal Rev-

enue Code of 1954. Section 165(g) (3) provides in relevant part

that any ‘security of a corporation affiliated with the taxpayer

shall not be treated as a capital asset. This statute fails to apply

==

ed

vances in the form. of delivered materials. In each

- rarely encountered. See Bittker & Eustice, Fedeval

SS PSS Sse see

7

It is true that language in Byerlite suggests that

the parties’ nomenclature and purported intent to

create a debt controlled, without,zegard to the pres- :

ence of other factors indicating,the existence of a

‘capital investment. But this does not provide an

adequate basis for a grant of certiorari, since inter-

-vening developments indicate that Byerhite no longer °

‘expresses the position of the Sixth Circuit. In"

Moughon % Commissioner, 329 F. 2d 399, and Fore-

sun, Inc. v. Commissioner, 348 F.2d -1006, the Sixth

Circuit had occasion to review the debt-equity issue ,

anew. In both cases, the court adopted the-generally

4 accepted objective criteria for resolution of the debt-

equity issue. See pp. 4-5, supra. It avoided any ref- .

erence to Byerlite in either opinion, which led Chief

Judge Thomsen in Wood Preserving Corp. of Balti-.

more v. United States, 233 F. Supp. 600 (D: Md.),\

| affirmed, 347 F, 2d 117 (C.A. 4), to observe (233 F:

Supp. at 605) that the Byerlite decision “has: been

considerably weakened by Moughon’*, Thefe has been

no countervailing indication that at the present time

Byerlite is of controlling significance in the Sixth

Circuit. Rather, it appears that Byerlite is to be lim-

here for two independent reasons: first, Necco does not qualify as

an affiliated corporation, since (see Section 165(g) (3) (A)), peti-

tioner did not own at least 95 percent of each class of Necco’s

stock; and, second, because its investment in Necco did. not,

in the statutory sense, become “worthless,” but was merely im-

‘paired to the extent of the loss occasioned by the subsequent

merger ‘of Necco. with petitioner. Petitioner never questions

either of these facts.

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* e.g, Lomlinson v. 1661 Cor

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ited to its own facts, even in‘its own circuit.’ Any.

‘thought that the Court of Claims, in its reliance on

Byerlite, has ventured an approach different from or in _

, confijet with that taken in the circuits is put to rest.”

by the following passage in eco cl acuie Processing (371

F. 2d at 848): -

There -is no dearth of cases in this province

of tax law. So large is their number and dis-.

parate their facts, that for every parallel ...

found, a qualifiedtion hides in the. thicket. At

most they offer tentatixe clues to what i Is debt

and what is equity for, tax purposes ; ‘but in'the.

. . final analysis eticli:’ case “must rest and be de-

~* eided. upon its own unique faetual flavor, -dis-

similar from all others, for’ the intention to

create a debt is a compound. of many diverse

external elements pointing in the end to what

. ' * these elements “have pear such criteria as

-——the |“real intention’”’ or “true intention’4 of

of :.debt and. corroborated by . surrounding

facts; ratio of debt to equity in the -financial

structure of the debtor (i.e., the “thin incorpo-

ration’? line of decisions which enjoyed a

decade of popularity); reasonable expectation

of repayment regardless of the success of the

venture; substantial. economic reality- of: the

_ transaction; and maintenance of prgportional

what it thought: it was doing; or meant to do, have at most

marginal relevance in posing ei ar it in fact did do. See,

pra, 377 F, 2d at 299; cf. Knetsch

v. United States, 364 U.S. 361, 365; United States v. Estate bed

Grace, No. 574, O.T., 1968, decided June 2 ,1969,_

the parties as dine in the instrument.

2

is essentially a subjective conclusion. Elsewhere ©

“Wy, * Subjective intent or motivation should - -not have the sig- |

_ nificance Byerlite attaches to‘ it. A’ taxpayer's allegations of:

9 ,

holdings by stockholders whose purported loans

remain in suspicious balance with their capital

contributions. ions, = i

“Ss N or is there a conflict with this Court’s decision

in Corn Products Refining - Co. V. Commissioner, 350

US. 46, ‘OF “any” “of the various court of appeals deci-

sions cittd at pp. 14-17 of the petition. Those cases

_ do not remotely suggest, as petitioner would appar- ~

| , ently. have. It, that securities owned By a corporate ‘~

| taxpayer are generally non-capital assets.. Rather the

_ €ases are exceptions ‘to the general rule that. a “secu-

rity’’ investment in a corporat¥ % a capital asset, *

2

v-. and rest# on special factual contexts which in no way-

resemble the instant ease. ©

In Coin Products, the Court was asked. to decide

whether the taxpayer, a. manufacturer of corn by-

products,. was entitled to capital gains~treatment on

-its profit from dealing in corn futures. The deejsion

* ‘that the profits were Ordinary i income’ proceeded from

the fact that the taxpayer’s “long position’’ in corn.

futures was established “ ‘as a part of its coin buying

* Although it is unquestioned that the definition of a capital

asset must he narrowly construed, a corporate security is gen-

erally a capital asset because it represents investment in a cor-

_’ porate venture placed at the risk of the enterprise’ over an

indefinitey future, except in certain very special situations. Sec- -

tion 166 of the Code, among others, supports this premise, since

i it is ofly by express exception (Section 165(g)(3)) that a .

worthless ‘security is given ordinary loss treatment. See, also,

Section 341 ( collapsible corporations), Section 582 (securities

‘held by a dealer), and Sections 1242 through’ 1944 (relating to

small business investme companies and stock of. small .busi-

nesses). In contrast, no -section affirmatively defines a sds

type.of security to be a capital asset.

2.

a.

77

10»

» program’ and ‘as the most economical method ef obtain-.

ing an adequate supply of raw corn’ ” (350 U.S. at 48)

‘and that. it therefore constituted an intégral part of

its manufacturing business (350 U.S. at 51). In con-

trast, the operation of Necgo, in the instant case,’ was

_ not an intégral part of petitioner’s business, but was ee

+ a separate and distinct field of endeavor which Don-

nelly decided to enter. 3 7

‘In each of the court of appeals ‘decisions which .

petitioner* cites, the expenditures either were under-—

taken to alleviate temporarily sorie-impediment to the

operation of the business, or were an integral part

of a non-capital item, such as the acquisition of raw

materials. In Booth Newspapers, Inc, v. United States,

303 F. 2d 916, 921 (St. Cl.), the ma bah purchased

stock in a paper manufacturing company, but dnly to

insure a short term source of newsprint, In Lutz v. Com-

missioner, 282 F. 2d 614, 619 (C.A. 5), payments to cred-

itors of the taxpayer’s wholly owned corporation were

negessary to retain an agricultural commodity ‘bro-

. kerage license. In United Gas Improvement: Co. v.

Commissioner, 240. F. 24 312 (C.A. 3), the taxpayer

made short-term advances to a. controlled subsidi-

ary corporation to enable the subsidiary to meet its

~ current dividend obli ations. In Five Star Manufgctur-

ing Co. V. Commissior 7, 805. 2d 724, 727 (C.A.5), the

holding of one shareholder was purchased-in order to

free the oe ae from “unwarranted fetters’’. In

Commissioner v. Bagley & Sewall Co., 221 F. 2d 944, 947

€C.A. 2), the taxpayer had purchased government bonds

11

to guarantee performance of its purchase, contract with

a foreign corporation ; and in substance the bonds served Weg

the function of a performance bond.’ —

. -Petitioner’s’ sole ‘shareholder, Donnelly, ‘desired to."

aaa the electrical contracting business. While this.

* new -venture in part permitted it. to service an exist- :

ing customer- (Pet. lla), the activity was an attempt

- to expand its operations permanently. Petitioner’s ad- ;

te ‘vances representeé ‘capital placed at the risk of Nec-

“i co’s operations over’ an indefinite time in the future,

and there is no precedent for allowing an er .

loss ‘deduction upon the. unprofitable termination of.

-® Wee ecco’s ere

CONCLUSION ce rete : “

é oes $

“The petitio for’a writ of certiorari should be.

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sae

ERWIN- N. GRISWOLD,

Soticitor General.

sistant t attorae General.

ONATHAN S.. CoHEN,

‘Rosert I: Waxman,

Attorneys.

a UNE 2 1969.

5In Daily Jourbat Co. v.

(C.A. 9), the only question

payer’s president was _)

performed.

ommissioner, 135 F. $a 687, 688:

s whether salary paid to the tax- |

nable in. relation to the services.

U.S. GOVERNMENT PRINTING OFFICE: 1969