# Petition for Writ of Certiorari — Paduano v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385609_0070%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition for Writ of Certiorari - **Published:** January 1, 1976 - **Citation:** 425 U.S. 992 ## Text siete heed | 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. CAPPUCCILLI and GRACE A. CAPPUCCILLI, Petitioners, vs. COMMISSIONER OF INTERNAL REVENUE, Respondent. Docket No.: @5- 1 3 8 1 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 TPG DHE 6 EA ats RRR allie --* SRE ANE RIAA PSI ETA BLEED THROUGH Oe TABLE OF CONTENTS Page ES cas ic uaede crn ieeees See he oenes li I os oc 5a Saw eae dean ee sean eae es ] NS 85 oro wees tag cy aa he Reedy Ae eA A RE RES 2 III os ohne 5e ic oa se Kiwde nasucneeed es 2 Statute and Regulations Involved .................... 2 Ee eee ee eee Tr eee eo eee 3 Reason for Granting the Writ ....................... 6 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. Appiication of These Various Rules, Causes Inequities in Tax Ad- ministration and Confusion of the Tax Law and Should be Authoritatively Settled by This Court. Summmnaty ORG TVG... «on 55 ee ccc nns 6 I so hy sc a ee ee ped es 8 III os Seca og ok os pia kane ance wae ed ae 20 Appendix I. Relevant Treasury Regulations ............... Al II. Opinion of the Tax Court .................... A5 III. Judgment of the Court of Appeals ............. Al2 u TABLE OF CITATIONS Page Cases: American Cigar Co. vs. Commissioner, 66 F2d, 425 SI eh i ee 14, 16,18 Atchinson, Topeka & Santa Fe Railway Co. vs. Com- missioner, 36 Tax Ct. 584 (1961) .........0....... 9 Barker vs. Magruder, 95 F2d 122 (C. Ct. D.D. 1937) ee me eet are aE es Cicer cg hace see % 14, 16,18 Cayuga Service, Inc., 34 T.C.M. 18 (1975) ....0...... 13 Club View Corp., 34 T.C.M. 922 (1975) at page 924 ... 13 Combs Lumber Co. vs. Commissioner, 41, B.T.A. 339 RE a ie alas PN oi aM GRY ier gare eRe Ree 9 Commissioner vs. First Security Bank of Utah, 405 U.S. en ron ee Nc aes 17,20 Corn Exchange Bank vs. United States, 37 F2d 34 (C.A. ne ae, orc cae aan 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 fg RI AED OP Pea pty een A ee ee 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 F2d 985 (C.A. 10, 1971) cert. den. 404 U.S. 940 (1971) 2. 5,13 Greer-Robbin Co. vs. Commissioner, 119 F2d 92, 93 Se I ee greg Cah oot Sls ua ee 15, 16,18 Huber Homes, Inc. vs. Commissioner, 55 Tax Ct. 598 ERE Se pe a EE a RRO iy Oe 9,10, 11 ’ BLEED TiiROUGH \ iii Page Kahler vs. Commissioner, 486 F2d (C.A. 8, 1973) rev ing. and remanding Tax Ct. 58 Tax Ct. 496 (1972) Rc pig aera onkok «sp on #9 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 ee lt re 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. ee TY eon g May athe et a 13, 14, 20 Pitchford’s Inc. vs. Commissioner, 34 T.C.M. 384 SIDA Natale vena: We 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 related parties. The Commissioner used two arguitients 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 and some could not be traced at all. The Tax Court held that the . BLEED THROUGH POEM a ARENT Ak 8 ES EEE NS SOT BOO SERGE S LOIN LDR ALES PORTA A CLUE BAG: ee 1] 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 and consumption of interest free funds. Consistent with Smith—Bridgman & Co., 16 Tax Ct. 287 (1951) Aeq. 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: rye Vea Pett tetris cieinno.. em ra a a A a RR EI a ah Ar aia 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 Eighth 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. BLEED THROUGH wef POISE REE WO SUR IS Bl ALE i SOARES ARTI ESN LS ROLE EPO 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 Corporation 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. Ct. D.D. BLEED THROUGH ~ eC Te al SP, Pile eS Tie NIMS, EET A 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 inselvent, 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 Commissioner 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). .. SAM 2 PNET IN AE AN ME LETS BIER AO BONES FUT I h R ANCAT TS DIAN RD LR LOI EVO RO LIRII RE. OCD LIDS 35 PL OD lo 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; ie. 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 (eash 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, (1908), the Commissioner has apparently accepted this rule more recently in the Pitchford, case, supra, by virtue of his concession. y BLEED THROUGH Oe A PNT IRS SANT ng ANT a ERE EME Pm, ai AD Bee MENS RAAT SEN AMEAT ALAA AO LAPD hE AE NIOSH eae 17 In Commissioner v. First Security Bank of Utah, 405 U.S. 394 (1972) the Commissioner attempted to charge various banks with commissions on insurance policies which the banks were responsible for initiating but, because it was against the banking law 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. (hmphasis added) See also L. Bb. 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 to 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. r BLEED THROUGH 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-l(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- reer el nig eer gi tape = Bea RS hk Bi RELIED TAPED I> ie Bee tins. 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. BLEED THROUGH APPENDIX