Opinion — Bowers v. Kerbaugh-Empire Co.

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SUPREME COURT OF THE UNITED STATES.

No. 173.—Ocroper Term, 1925.

Frank K. Bowers, Collector of In-

ternal Revenue, Second District of

New York, Plaintiff in Error,

vs.

Kerbaugh-Empire Company.

In Error to the District

Court of the United

States for the Southern

District of New York.

[May 3, 1926.]

Mr. Justice Bur er delivered the opinion of the Court.

Defendant in error, a New York corporation, sued to recover

$5,198.77 paid under protest on account of income taxes for 1921.

Revenue Act of 1921, ¢. 136, 42 Stat. 227, 252, et seq.

It owned all the capital stock of H. S. Kerbaugh, Incorporated,

engaged in the performance of large construction contracts, and

applied to the Deutsche Bank of Germany, through its New York

representative, for loans to finance the work being done by its

subsidiary. The bank agreed that it would make the loans by

eabling to the eredit of its New York representative German marks

equivalent in dollars to the requirements of defendant in error,

upon condition that the loans would be evidenced by notes pay-

able as to principal and interest in marks or their equivalent in

United States gold coin at prime bankers’ rate in New York for

eable transfers to Berlin. June 8, 1911, defendant in error advised

the New York representative of the amount in dollars then needed ;

he notified his principal and it put to his eredit in a New York

bank marks equivalent to the amount of money of the United

States applied for. Then he drew his check payable in dollars

against the eredit and gave it to defendant in error, and in exchange

received the promissory note of the latter payable in marks or their

equivalent in gold coin of the United States. Prior to July 2, 1913,

twenty-four loans were made in this manner amounting in all to

$1,983,000. The equivalent in marks was 8,341,337.50. September

1, 1913, there remained unpaid 6,740,800 marks. The notes of de-

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2 Bowers vs. Kerbaugh-Empire Co.

fendant in error then outstanding were surrendered and its new

note for that amount was given. And when that note became due it

was renewed. Partial payments were made and, by March 31, 1915,

the principal was reduced to 3,216,445 marks.

The several amounts from time to time borrowed by defendant

in error were contemporaneously advanced to its subsidiary and

were expended and lost in and about the performance of the

construction contracts. These losses were sustained in 1913, 1914,

1916, 1917 and 1918, and were allowed as deductions in the sub-

sidiary’s income tax returns for those years. The excess of its

losses over income was more than the amount here claimed by

plaintiff in error to be income of defendant in error in 1921.

After the United States entered the War the Deutsche Bank

was an alien enemy. In 1921, on the demand of the Alien

Property Custodian, defendant in error paid him $113,688.23 in

full settlement of principal and interest owing on the note be-

longing to the bank. Of that amount $80,411.12 represented

principal. The settlement was on the basis of two and one-half

cents per mark. Measured by United States gold coin the

difference between the value of the marks borrowed at the time

the loans were made and the amount paid to the Custodian was

$684,456.18. The Commissioner of Internal Revenue, notwith-

standing the claim of defendant in error that the amount bor-

rowed had been lost in construction operations carried on by it

and its subsidiary and that no income resulted from the transac-

tion, held the amount to be income and chargeable to defendant

in error for 1921. Excluding that item the tax return for 1921

shows a deficit of $581,254.77.

The defendant in error by its complaint set forth the facts

above stated and asserted—as it still insists—that the diminution

in value of the marks was not income within the meaning of the

Sixteenth Amendment; that the item in controversy is not within

the Revenue Act, and that, if construed to inelude it, the Act

would be unconstitutional. Plaintiff in error moved to dismiss

on the ground that the complaint failed to state facts sufficient

to constitute a cause of action. The court denied the motion and

gave judgment for defendant in error. This writ of error was

taken under § 238, Judicial Code, before the amendment of Feb-

ruary 13, 1925, e. 229, 43 Stat. 936, 938.

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Bowers vs. Kerbaugh-Empire Co. 3

The question for decision is whether the difference between the

value of marks measured by dollars at the time of payment to the

Custodian and the value when the loans were made was income.

The Sixteenth Amendment declares that Congress shall have

power to levy and collect taxes on ineome, ‘‘from whatever source

derived’’ without apportionment among the several States, and

without regard to any census or enumeration. It was not the

purpose or effect of that Amendment to bring any new subject

within the taxing power. Congress already had power to tax

all incomes. But taxes on incomes from some sources had been

held to be ‘‘direct taxes’’ within the meaning of the constitutional

requirement as to apportionment. Art. I, § 2, el. 3, § 9, el. 4; Pol-

lock v. Farmers’ Loan and Trust Co., 158 U. S. 601. The Amend-

ment relieved from that requirement and obliterated the distinction

in that respect between taxes on income that are direct taxes and

those that are not, and so put on the same basis all incomes ‘‘from

whatever source derived.”’ Brushaber v. Union Pac. R. R., 240

U.S. 1, 17. ‘‘Income”’ has been taken to mean the same thing

as used in the Corporation Excise Tax Act of 1909, in the Six-

teenth Amendment and in the various revenue acts subsequently

passed. Southern Pacific Co. v. Lowe, 247 U.S. 330, 335: Merchants

L.& T. Co. vy. Smietanka, 255 U.S. 509, 519. After full eonsidera-

tion, this Court declared that income may be defined as gain de-

rived from capital, from labor, or from both combined, including

profit gained through sale or conversion of capital. Stratlon’s In-

dependence v. Howbert, 231 U. S. 399, 415; Doyle v. Mitchell

Brothers Co., 247 U.S. 179, 185; Eisner v. Macomber, 252 U. S.

189, 207. And that definition has been adhered to and applied

repeatedly. See e. g. Merchants L. & T. Co. v. Smietanka, supra,

518; Goodrich v. Edwards, 255 U. 8. 527, 535; United States v.

Phellis, 257 U.S. 156, 169; Miles v. Safe Deposit Co., 259 U.S.

247, 252-253; United States v. Supplee-Biddle Co., 265 U. 8.

189, 194; Irwin v. Gavit, 268 U. S. 161, 167; Edwards v. Cuba

Railroad, 268 U.S. 628, 633. In determining what constitutes in-

come substance rather than form is to be given controlling weight.

Eisner vy. Macomber, supra, 206.

The transaction here in question did not result in gain from

eapital and labor, or from either of them, or in profit gained

through the sale or conversion of capital. The essential facts set

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forth in the complaint are the loans in 1911, 1912, and 1913, the

loss in 1913 to 1918 of the moneys borrowed, the excess of such

losses over income by more than the item here in controversy, and

payment in the equivalent of marks greatly depreciated in value.

The result of the whole transaction was a loss.

Plaintiff in error insists that in substance and effect the trans-

action was a ‘‘short sale’’ of marks resulting in gain te defendant

in error. But there is no similarity between what was done and

such a venture. A short seller borrows what he sells, and the pur-

chase price goes to the lender and is retained as security for re-

payment. The seller receives nothing until he repays the loan.

Such a transaction would not meet the requirements of defendant

in error. It needed the money for use and received the amount

borrowed and expended it.

The contention that the item in question is cash gain disregards

the fact that the borrowed money was lost, and that the excess of

sich loss over income was more than the amount borrowed. When

the loans were made and notes given, the assets and liabilities of

defendant in error were inereased alike. The loss of the money

borrowed wiped out the increase of assets, but the lability re-

mained. The assets were further diminished by payment of the

debt. The loss was less than it would have been if marks had not

declined in value; but the mere diminution of loss is not gain, profit

or income.

Judgment affirmed.

Mr. Justice BRANDEIS coneurs in the result.

A true copy.

Test:

Clerk, Supreme Court, U.S.