Brief for Petitioner — Commissioner v. First Security Bank of Utah, NA

Supreme Court brief1972

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“© * OCTOBER. ‘TERM, ant .

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“S COMMISSIONER OF INTERNAL REVENUE; PETITIONER -

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First Security BANK oF UTAu, N.A., ET AL.

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_ ON WRIT OF CERTIORARI "76 THE UNITED. eSee

; COURT OF APPEALS FOR THE TENTH ore T ‘

BRIEF FOR THE PETITIONER :

Aiba si. @ : @

“2

ERWIN N. GRISWOLD, Cae

- Solicitor. General, bata WP ngs:

- Frep'B.Ucasn, =:

Acting Assistant perny General, :

t -

MATTHEW J. Zan, :

Assistant to the Solicitor General,

ee BENNSE NN. HOLLANDER,

. STEPHEN SCHWARZ,

Attorneys, .. |

Department of Jasticd,

= Westiaaton, "D. C. 20530.

“tee !

r pom.

4 °

= INDEX

; \ «Opinions, below — ative tee ag aee! icone

3 ae risdiction cane tee ae nae be

: Y ate presented _ Cae Rae Beat

: = " Statutes and regulations. involved mostinsanesndontenine OS? .-

ee Statement epee aes asters

) Summary of argument . _ Meee ee SAS |

. ay Axgument: ’ os eee |

Tey "Fhe Conimissioner cenauiy iia

the respondent national banks, pursuant .

— to Section 482, the commission element

--the credit: fife insurance premiums paid

by respondents’ borrower's ..:........-2-----:--0---- =

A ntroduetion:. The arm’s length stand-

fk B. The Commissioner's allocation was

| - proper. because respondents rendered |

- services for a commonly controlled cor-'

o. poration, without charge, for which |

/ ... they would have been compensated had .

- ‘the parties been dealing at arm’s

" bngtt |

1. In,an arm’s length waneaction an

° related insuter would have paid ;

COMMISSIONS Te... ns anne eenn ee

2. In an arm’s. length transection re-

as . ' <#pgndents would have been compen-

Be erat sated for their services ......-.........-:-

: Argument-—Continued ; : | Page :

¢. The Commissioner may. dinate com- .

__ Mission income to respondents even if ©

_ they neither received nor “earned”, |

ny DS I I ns. 21

-. D. The failure of reptaients physically

_ to .receive commissions when dealing

. el unrelated insurers'is-no bar to. ss -.

| " * the Commissioner’ 8 allocation ........... eS . 26

E. The épparent prohibitions of federal °

.banking law on respondents’ receipt of ©: - -

income from the sale of insurance do ©

‘- not preclude the Commissioner’s allo-

Ooo ey ee SCS ASME SS a er a ee

SA, Federal banking: 190 2c 28

: - 2. Thé Commissioner ‘may allocate |

commissions to respondents even

though they structired their affairs. |

to comply with their interpretation -

_ of federal banking law™................._ 30

é 3. The allocation does not force ree

33 ‘. .spondents to violate the banking © eg

. E 3 law. pers Ee ane a ee ee aaron Pees scetapeeserstees 31

| s, Appendix: at --veait wrigsesoconnesencdnnapentve . 8F

es oe, CITATIONS 7 ae

— :

Alinco. 'Life aeniac Co. v. United iss

States, 878 F. eee ) ; 17

te - Asiatic Petroleum Co. v. Commissionér, 79

oes 2d 284, certiorari on 296 U.S. ees

64 estasennesenennneten yaw 22,81" °

Cases—Contintied ; eos 2g:

_ Automobile Club o f Michigan. v. Commis-

stoner, O53 U.S, \100 oh ce a ae

Bailey v. Commissioner, 52 T.C. BS ah

firmed per curiam, 420 F.2d 777 .....c.. 380. -

: re Corp. ¥: United peg

‘States, 435 F. 2d°18Qe ec... eeeespe lene 15

Ballentine Motor Co. v. - Commissioner, 321 ite

gk: | Re ae ee |

_ Borge v. Commissioner, 405 F. 2d 673;

certiorari denied, 395 U.S. 933 ., RE 15

- Campbell County State Bank, Ine. v. Com:

missioner, 37 T.C. 430, reversed.on oth- © . _

er grounds, 311 F. 2d 374 picdebenees:. ae.

Central Cuba Sugar Co: v. Commissioner, ee eet

UG Fi RUA aac hncecgictnuechciawe ss _ 14

Commissions? Chelsea Products, 197 F

2 ic, S ssicnnpisp bnc chins oenq titted eae aes chalks 15

Commissioner v. Morris Trust, 367 F. 2d Re ee

794 sumiew a el pe Ee ET. hE PU 29 Bo

: Crowley v. Commissioner, 34 T.C..333....... ~, 25

Davis v. United States, 282 F. 24.623 -..... / 15

Dillard-Waltermire, Ine. v. Campbell; 255" :

Race |. pientonus acne ae eet ig ER ae:

Eli Lilly and Co. v. United States, 872

B26 990 vc BE ind 14, 15, 31

x GU, R. Co, v. Conimiscioner, LIF. 28 ees

“ 187 . piste kaondbnemcmetoaeas «1b

Geiger’s Estate v. “Commissioner, 352 F.

‘2d 221, certiorari denied, 382 US. se

(0 chine aac 30.

Grenada Industries, Inc. v. Commissioner, ‘Sots

i TG. Sa affirmed, 202. F: 2d 873, = =

certiorari denied, Bi 46 U.S, 819... 15

— v. Horst, M. US: 112 . fatima oe:

‘Cases Continued be vet Ss Page:

Jaeger Motor Car Co. v. Commissioner, ie

284 F. 2d 127, certiorari. denied, 865

Soe eee nee «a

= James ¥. United States, 866 U.S. 218... 30 -

| LB. Shunk Latex Products, Inc. v. Com- .

ie missioner, 18 T.C. PO Sinre- i ssbaccineste —- 33.

Liston Zander Credit Co. v. United States, |

te | SEER ereeer eee pi AE

. Local Finance Corp. -v. Commissioner, 48 .

T.C. 778, affirmed, 407 F. 2d 629, cer- .

tiorari denied, 896 U.S. 956 .....8, 17, 19, 20,24 _

Lucas v. Hari, 261 US. 11 ...:.........2.2... 22, 30

Massqglia. v. _ Commissioner, 286 FP. 2ds

|. 2+ aca Da tcisaie ipa Pic csmicnsegen oT

- Mazewell Hardware Co. v. Commissioner, -

| ek Sai Kees . 24,

_ Moke Epstein, Inc. v- Commissioner, 29

Oe a Be

" National Securities ‘Corp. v. Commission-—

OR SBT Be 2a. 600, ‘certiorari “denied, *

mils a = sae

_ Nichols Loan Corp. v. Commissioner, 21.

T.C.M. 805, reversed on. other grounds, a ccous

$21 F-90905 83

Oil Base, Inc. v. ‘Commissioner, 362 F. ae

212, certiorari denied, 385 U:S. 928%... 15>

| Philipp’ Brothers Cheniicals, Inc. AN.Y:) . .° |

_ yw. Commissioner, 485 F. 2d 58 ..............-

Ray Waits Motors v. a 145 | =

— “. 2S a

Rohmer v. Commissioner, 153 ¥F. ‘2d 61, — .

~ ” gertiorari denied, 328 U.S. 862 ................° 23

Rooney v. United States, 305 F. 2d 681... 15

amey. Commissioner, 429 F. 2d 650. aah . 28, 240

- Cases—Continued. : 8 oe he Page

_ Saxon y. Py Ass'n’ ae indopendint ae

Ins. Agents, Inc., 399 F. a 10002 2

- Simon J. Murphy Co. v. _ Commissioner, 3

231..F. 2d 689 ......... Be ERS acts 15

Spicer Theatre, Inc. v. Commissioner, ne ME

FP RG ina iicernenccccsigtabanpeanetbeciet se

Teschner v. Commissioner, 38 T.C. 1008... 25

Travis v. Commissioner, 406 F..2d 987...... 27

' United States VeAtias Ins. Co., 881 US. eit tae

Statutes: oe Dae aie ae N cies

Internal Revenue Code of 1954" =. 2

U.S.G) > fs

| Sec. 61. sddunnesajeipgiccse cious ine loaaiag aa 23, 25, 37

" - Se: 482 ....7,9, 11, 13) 14, 15, 16, 18, 19, 20,

si 22, 28, 25, 26, 27, 29, at 32-88, 34, 37

. "Secs, 801-820. aie = soe

TR eae Life Insurance Company Tax Act of 1955, ge a

i= c, 98, 70 Stat. 36 .W....:..3. 7, 20 —

- Life Insurance: Company Theta Tax ce Ore

of 1959, P.L. 86-69, 73 Stat. 112 ........ 7

Revenue Act of 1928, c. 852, 4 Stat. 791,

Sec. 45 ‘iuohaccenclsapel qrececceceeecceeenn nese sortconseceee 14

* Revised Statutes: a

sec. 5202 (12 U.S.C. 92). sea 6, 28, 39, 39-40

‘See. 5239 (12 U.S.C. 93) -s-.<.----6, 28; 41

War “Finance Corporation . Act, ¢. ‘SS, 40 Aa

Stat. 506, Sec. 20..... accent 28

: 12 U.S.C. 24 (Seventh) . =e . ep

Miscellaneous: ot aoe! DERG ES

: eae

WES

- Comptroller of the Currency Regulations,

i Des be RTE een sree e Cnaeee

Bittker and Eustice, Federal. Income. Tax- -

- ation of Corporations and. Shareholders

-@ded, 1971): Q-

- . Hy Rep. No. 2, 70th Cong., 1st Sess.......:.

H. Rep. No. 1098, 84th Cong., 1st’ Sess...

S. Rep. No. 960, 70th Cong., 1st Sess.....

_- & Rep. No. 1571, 84th Cong., 2d. Sess as

‘Teeny Regulations 86, Art. 45-1 ‘s nae

oar cn Pegwiations on Inéuhie “Tax

Boe 0964 Code, Sec. art (26° C.F.R,)..

21.

. 21

15°

8, 14,

16,87

. Sppendix. se" ar

er dott at ns 4

| _ Octoses TERM, 1971 ,

, o.

| No. 70-805 oe

COMMISSIONER. OF "INTERNAL REVENUE, PETITIONER 8

Aisles hoee,

Jia seoiiee ioe N.A., ET AL.

ON WRIT OF CERTIORARI ‘TO THE UNITED STATES. .

. COURT OF APPEALS FOR THE TENTH CIRCUIT

eas

me ». 3

BRIEF FOR THE Aaa a |

OPINIONS BELOW ©

” JURISDICTION

. . 5 4

: “The judgments ‘of the court of appegls were en--

tered on, January 21, 1971 (R.. 193). By eee eae

"R” references are to the seperately bound record

> The memorandum findings of fact and opinion 1 a

"the Tax Court (R. 163-176)* are not reported. ‘The.

opinion “bf the court of - appeals (R.: — is re-~ *

| ported at 486 F. 2d 1192. ee

2 :

April 12, 1971, “Mr, Justice White sithndeid the time —

for filing a. petition fora writ of certiorari to and ~

including June 20, 1971. The petition was filed on —

June 18, 1971, and certiorari. was granted on Oc- —

tober 12, 1971 (R..194). The jurisdiction of this

Court rests on 28 U.S.C. 1254(1). palaaae

- QUESTION PRESENTED |

Whether, pursuant to the authority anand: in

~ Section 482 of the Interrial Revenue Code, . the Com-

missioner properly -allocated to the ‘respondent na-

_ tional banks the commission “element of the credit

life insurance premiums paid by their borrowers in

- connection ‘with loans, where respondents offered the -

life ineaianee. to their borrowers ultimately on be-

half of & life insurance company under ae own- _ |

7 ia and control with respondents, ° -

STATUTES AND REGULATIONS INVOLVED

The pertinent provisions of Sections 61 and 482 of

are Internal Revenue Code of 1954, of Section 1:482-1

the, Treasury ‘Regulations on Income Tax (1954

| oak and of Sections 5202. and 5239 of the Revised

‘Statutes are set forth i in 0 e Appendix, ss bi PP. 87- “a4

; ‘STATEMENT

as ” Remplndnta’ Pst Soetiity Bank ot Uteh; NA,

and First Security Bank of Idaho, N.A., are national ©

= ‘banks which, during the taxable years in controversy

(1966. sarpugh 1959), ‘were wholly-owned copes

See 5: ee

* ee a. wdiete oend bank holding company.

_ Since .1948, in connection with their installment. and ~

real estate loan business, respondents have offered to

their borrowers credit life, health and accident in-

surance. This i insurance, generally referred to herein

as credit life insurance, .is single-premium decreasing. -

. term insurance on the life of the borrower sufficient _

in amount at least to discharge his debt if lie dies or ©

' becomes incapacitated daring the. term of his loan. !

(R. 27-29, 163-166.)

_-. From 1948 to‘April, 1954, the credit Hide insurance

‘ purchased by respondents’ customers was. written, by

. two independent insurance companies at the prevail-

‘A - which provided

464-167, 170.)

~- ing industry rate of $1 per $100 of coverage: per

- yedr on a decreasing term basis, In keeping with

‘the common’ industry ‘practice, the premium in-

cluded a built-in allowance sufficient to provide for .

the payment of a commission to the lending. institu-

ion’ which offered the insurance. to its borrowers,

‘and, the: independent insurers in fact paid’ commis-

sivas, ranging from 40 to 55 percent of the net prem-

jums collected.to Ed D. Smith & Sons (“Smith”), a.

wholly-owned subsidiary of. Holding -Company.-~

Though engaged in the. business of selling life and =

casualty insurance, Smith was in no way involved in’

the sales of credit life insurance and did not report

the commissions as taxable income. . Rather, they were

| reported by First Securi Company (“Management

Company”), , another ;Holding Company subsidiary -

cmaindieniatl and accounting services _

_ to the related group. (R. 19, nts ADEN See

eee *

7 * Late in 1958, American National: Insurance Com- :

pany of Galveston, Texas (“American N: ational’),

anticipating ‘that tax preferences and potential ‘prof-

- its from -gredit life insurance sales would cause, lénd-.

~ ing institutions to establish theit own credit life in-

surance subsidiaries, approached Holding Company

with a new plan designed .to salvage some .of. the’

.. profits for the independent carriers. The plan called

for Holding Company to-create a life insurance sub- -

sidiary which would reinsure thé risks-of the credit -

.. life insurance written by American National for re-

iP spondents’ borrowers. Profits from the business would

‘be retained in the subsidiary for investment. It was -

: anticipated that in its initial years the subsidiary

- would utilize Américan National’s actuarial, ac-

’ counting and ‘other operational services on a fee basis.

and, if: successful, ultimately grow into a ‘full-line,

+ «direct writing i insurance company. (R. 30, 167-168.)

Holding” Company ‘adopted American National’s ?

_ plan and in J une, 1954, formed a wholly-owned life

insurance subsidiary, First Security Life Insurance

Company. of Texas (“Security Life”). The credit in- _.

_ > surance was written. ‘by American National at the -

| prevailing industry rate of $1 per $100 coverage per

year and was reinsured with Security Life under con- ~ :

; tracts called reinsurance treaties, under which Amer-

- ican National received mayen fs 15 percent of

ie _ the premium: dollar as compensation for its manage-

rial services. Security Life retained the: balance for

the assumption of all of the ripk under Se policies. .

— (R. 165, 168-170.)° 0 Ss

Security ‘Life’s sole source of bosinent: income was

——— a -_ its reinsurance Gusinens

rs pes

BH,

eo”

. Z ‘Se .

eee

: ; “ ©.

he was very profitable, cgi’ ini 198 with capital: :

Lad

; -and paid-in’ surplus’ totalling $37,500, Security Life,

by the end of that year, was reinsuring. $6.5: million

of credit life insurance,’ By the end of 1959, Security. ts

Life was reinsuring $41.3 million of such insurance.

million. (R’ 168, 170-171.) - -

Unlike the unrelated compahies ‘which wrote erédit - :

life ‘insuranc® for respondgnts’ borrowers _prior to a

‘April, 1954, Security Life never paid a cominission. ,

. As a result, after all expenses (including American

_ National’s: fes) it was able to retain 52.5: percent of

, the’ total premiums. In addition to American Na- _

tional’s fee, Security Life’s expenses consisted ‘pri-

marily of bank charges, taxes and claim: ‘settlement’

“expenses. Forty percent .of the net premiums would

. have been @’reasonable sales commission on ‘the busi-’

ness covered by the reinsurance treaties and, had See 2"

' ‘Its profit for the period 1955-1959 was more than. $1

curity Life paid such a commission, itigstill would :

. have realized an underwriting profit of approximately

170-171! see

Goer - Respondent? had © numérous , baking offices and.

ae ‘Maintained a routine procedure for offering eredit

12.5 cents on each. premium dollar. . (R. 108, 126-127, oe

life ‘insurance. to their borrowers: Initially, a loan —

"officer, when interviewing a loan applicant, explained’ -

the availability and function af credit life ‘insurance: _

‘and, if the ‘customer desired .the inSurance, the lean

officer proviged the n application forms, The -

"borrower then compli ‘the application forms. and, _

upon receipt of thie executed application respondents’ aes,

eee issued a certificate of i ce ans either

collected the premium from the customer or added it

. a"

* to his loan. Respondents’ employees . then ‘forwarded

- the completed forms and. premiums to ‘Management

ee which made records of the insuiance pur-

chased and forwardéd the forms and premiums to.

American National. ‘Management Company also per-.

_ formed the necessary paper work when claims were

filed under ‘the policies, Tis’ Cost -to respondents of.

processing the ‘eredit life. insurance purchased by —

' their borrowers for the five years in issue was $8,929

and $9,826, respectively. The. cost to Management

_ -sCompany of processing tlie insurance during the same

period was $10,150. (R. 166, 169-170.)

“Section 5202 of the Revised Statutes, (Appendix, .

infra, p pp: 39-40) authorizes national banks located in

- “. places having. 5,000 or fewer inhabitants to act as

-, ‘insurance agents and receive commissions from s0-

—~—

_liciting and selling insurance, . Section 5239 of ‘the

_ Revised Statutes (Appendix, infra, p. 41) provides

. eriminal sanctions for any violation of the federal =“,

~ banking laws. From-the time ‘respondents began of-

fering credit life insurance to their customers in

1948, their officers.and those’ of Holding Company .

~ have, believed it would be contrary tb federal

banking law, and thus invite the threat of criminal —

~~ sanctions, for respondents to receive income resulting.

_ from their customers’ purchase | ‘of such insurance.

They did not believe, however, that it would be un-.

— lawful to solicit, sell and process the insurance. Ac-

/ cordingly, respondents have never getually: received

commissions or reinsurance premiums resulting from . ~

adh enthaames eaten, tie eanetesione:. 2018. Pein

— iF :

: surance premiums. dive aves beet pal to corpora. *

tions under’ ‘common ownership with venhiindielice”

‘specifically, to Smith from 1948 to April, 1954, and

~ to SecuPity Life thereafter. (R. 166-167;.172.).. .

' . Seturity Life included the entire amount of rein- .

surance premiums received in its income for 1955-

-1959, Becguse the income of life insurance companies

is subject to a lower effective tax raté than that of.

ordinary corporations,’ this resulted in a smaller total -

tax liability for Holding Company and its subsidiaries \

than if a portion of the reinsurance premiums had~

- been included’ in the income of respondents or Man- —

__, agement Company. (R. 168, #70-172;:Ex, BR-41.) ~

Section 482: of thé,Internal Revenue Code of 1954 .

- (Appendix, infra, p. 87) empowers the Commissioner .

to allocate gross income among “two or more organi--

-. gations, trades, or businesses * -* * ‘owned or. con-. _

trolled directly or indirectly by the same interests -

. 22 if he determines that such * “+ allocation is.

necessary in order to prevent evasion ‘of ‘taxes or~

dearly to reflect’ the income of any such organiza-

* teas * te Acting under this provision, the Commis- -

sioner determined that 40 percent of the premium

income received and included in gross income by Se-

| curity Life during the years 1955 through 1959 was

| allocable to respondents, and cetemmined deficiencies

‘ Both thé Life Ineutance Company. ‘Tax Ack of 100k ¢ 0k.

70 Stat. 36, applicable to the years 1955-1957, and the Life

Insurance Company Income Tax Act of 1959, P.L.: 86-69, 73

Stat. 112, applicable to later years (see Sections. 801-820 of

the Internal Revenue Code of 1954, as amended), accord —

preferential tax treatment to life insurance —, ee

United States Vv. . Atlas Ins. Co., $81 US. ns ;

oi. of . a

enattlait , “This allocation was + Siaciiisite re-

-spondents for selling and processiny the credit life

___. insurance and thereby to-reflect their i income clearly.

The Commissioner alternatively asserted deficiencies

against Management Company by means of a similar

' allocation of. premium income; Both respondents and

". Managemetit Company sought redeterminations of

’ the deficiencies in the Tax Court,. (RY. » 172-175.) _

. That court held that the case was controlled by its

ive “reviewed decision favorable to the goverriment (two

judges’ dissenting) in Local Finance ‘Corp.:v. Com-—

-. ‘missioner, 48 T.C. 778, affirmed, 407 F. 2d 629 (C.A.

Re ),“certiorari denied, 896 U.S. 956, and sustained the .

Commissigner’ s determination that 40- percent of. the

_ premium income was allocable to respondents. It ac-

cordingly did not reach the question of the Commis-

-sioner’s alternative allocation. (R. 174-176.) Re-

_. Spondents appealed, and the Commissioner took a

protective cross appeal for review of the decision

‘favorable to Management Company. The Tenth ‘Cig-

‘quit reversed the decisions of ‘the Tax Court again

respondents, holding (R. 191) that the Commission-_—

* er’s allocation was “arbitrary and capricious and in-

consonant: with the basic concepts of. federal income

- takation;” and also reversed the decision of the Tax

Court for“Management Company._ It remanded the

‘ease for ‘further consideration of the Commissioner’s

alternative allocation. (R. 192.) |

2Of course, ifthe Commissioner’s determination is sus-_ :

tained, Security Life’s income would be reduced by the amount So

‘of income allocated to respondents. See Treasury Regulatioris

2 on inoue ase (1954 omy. Section oe .

? oat a a

lad

that where two or more

owned or controlled: by the same interest¢, the Com-

_ missioner of Internal Revenue may allocate gross in- .

come between them if he determines that dn allocation

| is necessary in order to prevent evasion of taxes or

clearly to reflect the income of the commonly con-...

_ trolled entities. The purpose of this broad delegation

"-, of authority by Congress to. e Commissioner, as re--

vealed in the, legislative: histo and reiterated in the

pertinent Treasury Regulations and court decisions, ;

is to prevent the shifting of profits and resultant dis-

tortion of income between commonly -controlled. busi-

nesses . by placing them on a tax arise we uncon-—

trolled concerns. — 2

» - The inquiry to be made in every case arising under :

Section 482 is whether transactions between common- ce

Section .482. of the Intern eC Code seer Sg

business organizations are

- -

ly controlled parties have. taken place on terms com-—

parable to those which would have occurred in arm’s.

‘length dealings. between unrelated parties. If this ~~

standard is not satisfied; the Commissioner may, by -

allocating income or deductions, restore the related. .

- parties to what ‘he believes their position would have

been if they had dealt at arm’s length. It is well-

_ ‘settled that the Commissioner’s determination under

, the arm’s length standard must be sustained unless

: shown to be unreasonable, es or Options. at

10°

a oe

The holding below denies the «Commissioner the :

_ power to allocate gross income under Section 482 in

. & situation where it is patent: that commo con-

| teeta taxpayers ‘have nét dealt with each other- at

- arm’s length. Any realistic application of the aym’s

; length standard would permit the Commissioner to

° , 4

‘make an allocation where one member of a commonly

controlled group renders services to another member .

‘ for less than an arm’s length charge. That is pre- —

cisely °what ‘occurred here. Respondents offered and

sold credit life insurance to their borrowers on behalf

of a comméfily controlled life. insurance company, but’

did not ‘charge a fee for. ‘their services, Yet, under ©

well known industry practice, it is common for a cred-

it life insurance company to pay generous commis-—

~ sions to a lender’which solicits business and performs

' other selling and processing services. In years prior

to the formation of their life insurance’ affiliate, re-

" gpondents. performed identical selling services for in- .

- dependent insurers, and-those companies did pay com-

missions. It follows that in any arm’s length arrange-

ment, respondents ‘would have. been. compensated for

their services, and, accordingly, that the Commission-

er was fully justified in allocating commission income

| to respondents in order to reflect their income clearly. .

Despite the foregoing, the court of appeals con-

cluded » that, respondents could not be taxed on the

_commissions because they did not receive ‘them or

‘earn them, but only generated the business or income.

| Emphasizing that respondents never directiy received

insurance-relatéd income from independent ingdrers>

“ Q ., “.

'- the court held that even in cnconbaeiiad headings: re

_spondents would not have realized taxable income —

from their sales of credit life insurance. ” And, the

court also held that since respondents were prohibited ~

_. by federal banking law from receiving commissions,

and at. all times attempted to. comply with federal

banking law, it was unreasonable for the. Commiis-

sioner to. allocate commissions ‘to them, and the reby-

place them in violation of ‘law. All these asa mis- ©

construe Section 482. ,

Neither the fact that respondents never physically

“received the commissions, nor the conclusion that they -

' did not “earn” commission income can mask the de-

monstrable. reality that respondents did not deal. with

2 their commonly controlled insurance company in an _

_ arm’s length manner.’ Obviously, the application’ of

Section 482 is not. dependent on the receipt of income, _

for an allocation of gross income thereunder presup-.

poses that the income was not received, but rather —

_ diverted by the taxpayer to a commonly controlled af- _

~~ filiate. The question whether a taxpayer has “earned”

or only generated income may be crucial in cases in- ~

volving general principles of tax Jaw, but it is not

- necessarily critical. for- purposes of. Section 482.

‘Rather, we submit that the’ Commissioner has the ’

power to allocate compensation whenever one con- ~

. trolled’ taxpayer has.rendered services to another.con- —_

.. . trolled taxpayer far less than an arm ’s length charge.

. _ Vo’ | ' :

‘

oA tt nme mca ©

Tt does not follow from respondents’ failure seat:

‘ @y to receive commissiohs from independent: insur-

; ers | in earlier years s that they” realized no ta: taxable i oe

* come ‘from: their uncontrolled dealings. On the cc con-

~ trary, Since the pre-April, 1954 commissions ‘were

paid to another Holding Company. subsidiary, Smith, -

even though it had. nothing to do with the sales of

credit-life. insurance, it is apparent that: respondents so

. did not deal with Smith at. arm’s length. Clearly, if

‘Smith had been an unrelated’ party, respondents .

‘would not have allowed it to receive the commissions. —

An allocation of such commissions to respondents

thereforé would have been permissible under the same

principles which we urge are re applicable to the years

here i in eamanticnds :

P E

_ The apparent prohibitions of federal banking law

_do not immunize respondents from an allocation un-

der Section 482. According to their own interpreta-

tion of that law, they may lawfully solicit and sell

credit. life i ce, but may not actually receive

is ‘commissions arising from their activities or report

such commissions as taxable income. Even if their —

-. interpretation is correct, and even if they structured

their activities to comply with:the banking law, the

_ fact remains that they rendered the services for which

_ commissions were paid, and that those services would -

have been compensated if rendered to .an unrelated

insurer. - This is enough, as a matter of federal tax

law, to sustain an allocation of commission income -

o . - ~ a

Fee ; ; 18 s 2 e -

to sdacleadiite and it is. federal. tax eae ‘not federal” 41 :

banking law, which controls tax liability, .

~és ;

ar en on

The Commissioner’s allocation. does not pai te jee

spondents to violate the federal banking law. ‘It was’

_they, not: ‘the Commissioner; who. chage to: solicit .and

‘sell credit life insurance at a rate set at 4 sufficiently _

high level to permit the payment of commissions, If

their activities did not violate.the banking law, the

Commissioner’s allocation will not, of itself, constitute .

a violation on their part. And, surely, the payment of

: tach ywontlel 10h tae ain Saga aa :

| ‘payers to proliferate the number of entities uséd to...

ARGUMENT. pie

THE COMMISSIONER PROPERLY ALLOCATED 3

TO THE RESPONDENT NATIONAL BANKS, PUR-

SUANT TO SECTION 482, THE COMMISSION ELE-

MENT OF THE CREDIT LIFE INSURANCE PREM-

IUMS PAID BY RESPONDENTS’ BORROWERS

i Introduction: The’ arm’s fength stuieed

The facility with which trades or businesses may °

be organized, as well as the many business and tax

advantages to be achieved in using more than one

business organization, have frequently encouraged tax-

conduct what is basically a single economic enter-

prise. The use of such commonly controlled business

‘organizations makes it .possible for owners of inul-

tiple trades or businesses to manipulate intercompany

transactions so as to reduce tax liability. Even in the

absence of tax avoidance motives, ‘common control.

ean foster a considerable amount: of arbitrary shift-

ing of income or. deductions between related eT ;

. can

era, See generally, Bittker and Eusticé, Federal In-

come Taxation of Corporations and Shareholders, Sec.

‘15.01, et seg. (8d ed., 1971). bea

-To avoid some of these: consequences, | Gonaives:

: "since the very earliest days of our income tax history,

has provided a variety of legal weapons for limiting

the use and abuse of commonly controlled. trades. or

businesses, The statutory provision at issue here,

\Section 482 of the Internal Revenue Code of 1974, is

& continuation of prior law enacted to. permit the

Commissioner “to deny [to taxpayers] the power to -

. shift income :* * * arbitrarily among controlled cor-"

porations, and to place such corporations rather on a

parity with uncontrolled concerns.” Central Cuba Sug-

ar Co. v. Commissioner, 198 F. 2d 214, 216 (C.A. 2);

see also Eli Lilly and Co, v. United States, 372 F. 2d

990, \1000- (Ct. CL). First enacted as Section 45 of

the ue Act of 1928, c. 852, 45 Stat. 791, 806,

the statute ‘was designed “to prevent evasion [of

taxes by related taxpayers] (by the shifting of prof- .°

its, the making of fictitious sales, and other methods

-- frequently adopted for the purpose of ‘milking’), and

in order clearly to reflect their true tax liability.”

_ H. Rep. No. 2, 70th Cong., 1st Sess., pp. 16-17; see |

also S. Rep. No. 960, 70th Cong., 1st Sess., pp. 24-25.

In applying Section 482, it is settled that. the touch- -

. stone is “that of an uncontrolled taxpayer dealing -

at arm’s length with another uncontrolled taxpayer.”

‘Treasury Regulations on Income Tax (1954 Code),

Section 1.482-1(b) (1) (Appendix, infra, pp. 38-39) ;

Oil Base, Inc. v. Commissioner, 362 F. 2d 212, 214

. fact situati

Z 15 e ati ‘ E 3

(C.A.: 9), eebtlodik: diated 885 U.S. 928; Baldwin

en, 186 (A Corp. y. United. States, 435 F.2d

182, 1 (C. As To In other words, the arrange-

ments contrived by the -controllirig taxpayer among |

its several business. entities must be tested by what

those arrangements would have been if the businesses

were not commonly controlled. If the related parties

have not acted as.they would ‘have in identical, but

uncontrolled, arm’s length dealings, the Commissioner

is empMered to make an allocation pursuant to Sec- :

tion 482.4. Moreover, because the Commissioner has

been — discretion ‘to appraise a particular

in making a Section 482 allocation, the ~

courts have uniformly held that his determination is

not to be set \aside unless clearly shown to ” unres,

sonable,-arbitrary-and capricious. _ 7

_ There is no dispute among the parties sanding

the existence or applicability of these fundamental 2

"<The arate length standard ines Jong ben eusiindio’ Se the - :

Treasury Regulatiops interpreting Section 482 and its pre-

- _decessors (see Treasury Regulations.86, Article 45-1; Treasury

_ Regulations 111, Section ‘29.45-1; Treasury Regulations 118,

Section 39.45-1) ‘and has been adopted by the courts. (see;.¢.g.,

Borge. v. Commissioner, 405 F. 2d 673 (C.A. 2), certiorari 3

| denied, 395 U.S. 988; Commissioner v. Chelsea Products, 197 -

_F, 2d 620, 623 (C.A. 8); Simon J. Murphy Co. v. Commis>

_ sioner, 231 F. 2d 639, 644 (QA. 6); Davis v. United States, \.

282 F. 2d 628 (C.A: 10); Eli Lilly and Cb. V. United States, aN

:872 F. 2d 990, 1000. (Ct. Cl.))..

: G, U. R. Co. V. Commissioner, 117 F. 24 187, 189 (C.A.

7); Ballentine Motor Co. v. Commissionér, $21 F.2d 796, 800

-(C.A. 4); Spicer Theatre, Inc. v. Commissioner, 346 F. 2d ..

104 (C.A. 6); Rooney v. United States, 305 F. 2d 681 (CA. -

- 9);. Grenada Industries, Ihe. v. Commissioner, 17 T.C. 231,

*. 255, affirmed, 202 F. Se OL ee ee

‘US. 819.

(16

ee for j icing the violas: of a Section 482 3;

~ location." Sapeotioite recognize (Br, in Opp. 10), as

they must, that the standard of “an uncontrolled tax-

_Payer dealing at arm’s: length ‘with another uncon-

“trolled taxpayer”. (Treasury Regulations on Income

Tax (1954 Code), Section 1.482-1(b) (1)) has been’ -

_ “universally, adopted.” And the court of appeals, al-

‘though. rejecting the mmissioner’s allocation, pur-. .

_. ported “to adhere to arm’s length standard (R.

, 186-187, 191). ret ited :

's allocation was proper because _

Ez The

ee. pr Seger ation « services for a commonly con- _

" - trolled ation, without charge, for which they

“ would have compensated had the parties been

i aaa dealing'at arm’s length

__//. «The facts leave no room for doubt 1 that during the

aL, ‘taxable years in ‘question. ‘respondents rendered serv-

E _ices ‘for their commonly controlled affiliate, Security. .

; Life, without charge, for which they would have been

-compensated had the parties been dealing at arm’s

. length. Indeed, one need not search far to ascertain.

the precise. amount of the commission ‘income prop-

erly allocable to respondents. Common. practice in.the

credit life insurance industry and the fact that inde-,

pendent insurers paid ‘commissions: prior to the for- .

. mation of Security Life graphically demonstrate’ the

correctness of the Commissioner’s determination’ that

40 percent of the “reinsurance premiums”. received :

. — 1A

: Teas ic winks cs Mass tek Sicpeienbs

Taser Company and all of of its affilisees were commonly controlled .

feapeehy Sra-erngra. Ly mgcor nated and gener tae

; +

17°

by Security Lite (4. é. igs the connisio ee vs ;

“allocable to respondents. ee

“| 44 In an arm's length transition an unrelated

‘insurer would have ‘pald commissions

"Its is undisputed that during the years in issue, ire-

-"spondente’ borrowers paid: for credit. life insurance at

- the prevailing industry rate of $1 per $100 coverage

- each year (R, 170). The evidence also shows (R, 108,

126-127), andthe courts’ have recognized, that the

industry-wide premium rate is sufficient to allow. in-

‘ surers-to pay sizeable commissions to the lender which

. salts the business and sells the insurance, See Locdl |

-Finance. Corp. v. Commissioner, 48 T.C. 778, 786,

affirmed, 407 F. 2d 629, 681-632 (C.A, 7), certiorari |

. denied, 396. U.S. 956; Alinco Life Insurance Co. v.

United States, 373 F.2d 836, 837-838. (Ct. CL); Lis-

ton Zaniler ‘Credit Co. Vv: United States, 276 F. 2d

417, 428-424, n. 15 (C.A. 5). Finally, as the Seventh

_ Cireuit’ observed in Local Finance Corp. v. Commis-

_. stoner, supra, 407 F. 2d'at 632, “[{i]t is well known - 2

- that insurers pay solicitors a portion of the premium _

as_ a’ commission for generating and. processing the -

insurance.” See also R. 105-106. ‘These facts, in and. |

ogurance company ‘during the years in issue, instead

of with their cammonly controlled affiliate, Security .

. Life, the unrelated insurer would have paid commis- . *

sions.

‘Any argumént tothe eontrary is foreclosed by re-,

spondents’ own experience prior to the formation uf

a af

bo oN ee

_ Sua in (1964. ' From. 1948 to April 1954,

_ Yespondents offered credit life insixrance to their bor-

. Towers, just as they did during the years issue, and

_, the independent insurers paid commissiobs ranging

from 40 to 55 percent of the premiums collected. Un-.

like the independent companies, Security Life paid no

commissions. In ednsequence, it was able to retain,

. after payment of death claims, more than 59 percent.

- of the net premiums ‘received during the period. in

\ question, a percentage far greater than an independ-

it company would have realized on the sale pf credit

‘lif&insurance.’ Given these facts, there is no basis

for conclusion except that—tested by the’ arm’s

‘length: dard—Security Life’s income was inflated |

_ was a result of the inclusion therein of the commission

element of the insurance premiums (as well as the

underwriting eh ent), and that an allocation was --

appropriate to reflect its income =. |

* For example, American Nati the iia largest iit

. life insurance company in the Uni Stages at the time of the .

- five percent (R. 25, 33). As for respondent:

- that Security Life could not afford to pay ; oe a

‘entise it would become actuarially unsound, it is s t to

disability resulted from Security Life’s unusually low initial .

' its cash is undercut by its 1959 dividend distribution of al-.

‘ most $400,000 to its parent company (R. 50, 171). At all

! "events, Security Life’s need for capital cannot displace the

Le ae implicit requirements of Section 482-that, for tax purposes,

- it must pay a. related corporation . arm’ s length compensation

*. for services rendered.

Se A

: x rs . . ~

= . :

he ‘ ° -

. ‘ ° .. .

SQ ne

‘ :

trial of this case, operated on a pro argin of less than .

note: the Tax Court’s ‘observation (R..174-175) that this -

capitalization. Moreover, Security Life’s alleged need to retain’

3 sheik sallion chants cadrebdha that, endac the ve. -

‘ ‘ : . o

. , Ro, S ‘

2 Ie oe ages inet ; napintas! Ciiaaie

rbipecromeccr ro poral

To what entities related to Security Life is the com- =

mission element of the insurance premiums allocable | :

under Section 482? That is the only question remain- |

ing once it is seen that commissions would have been

paid in an arm’s length transaction. In our view, °°

this question is not difficult to answer—the commis-

sions should be included in the i income of respondents, 2

since they “performed those minimal [but . crucial] |

~ services which were the sine qua non of the insurance

business.” Local Finance Corp. v. Commissioner,

supra, 407 F. 2d at 6383. On the record in this case,

there can be no doubt on this score, Respondents ad-

vised‘ debtors of the opportunity to’ obtain. ‘insurance;

they. provided the: necessary forms; they issued cer-

_ tificates of insurance; and they collected the premi-

ums for the insurer (R. 169). In short, they did. what =|

was -necessary to sell the insurance, <

Respondents’ experience prior to the forniation of

Security . Life again precludes a contrary argument,

> fer the hee gone facts are that as were compen-

retained a Sicaiee ‘Life (85. percent. of the total premi- |

ums) included a commission. Replying to Holding Company’s |

ee question (R. 129-130) whether a clause. should be inserted in

the reinsurance treaties providing for the payment of com-

missions’if Security Life ceased to reinsure the risks, Ameri-

can: Natignal wrote (R. 131) that, in such circumstances, “an —

agency contract will be executed with an agency of your Pe

., Selection whereby American National pays a commission on

any accident and health premiums being held by’ American

National.” ‘American National further advised (R, 131) that —

:-. “flor very good reasons, this. matter cannot be mentioned

ve relawereme Geeyy ** *" eae 3

sated i the independent insurers, for the services

- they rendered: Since they were not compensated when - -

they rendered identical services to Security Life, their

income—tested by the aim’s length standard—was

. "understated asa result of the exclusion therefrom of

the commission element of the insurance premiums,

and an allocation was “appropriate to reflect their in- .

come clearly. |

That was the result reached in Local Finance Corp.

- v. Commissioner, .supra, the only other precedent

‘directly in point. There, a majority of the full

Tax Court and the Seventh Circuit: ‘sustained the

Commissioner’ Ss power to allocate the commission ele-

_ ment. of insurance premiums from an ‘insurance

‘company to a related lending institution which had

solicited the insurance business, -but diverted the com- ©

missions to the insurer. Moreover, the allocation of

gross income in cases where a lender diverts profits

to a so-called “captive Jifé insurance company” was

__ specifically approved by Congress in connection with ©

‘the enactment of ‘the Life Insurance Company Tax :

Act of: 1955, c. 88, 70 Stat. 36. At that time, both con-

gressional tax-writing committees, recognizing the .

obvious potential for abuse through the arbitrary

shifting of income from a lending institution which

solicits insurance business to a related insurance com-

pany which enjoys preferential tax treatment, stated

their understanding that Section 482 provided the

Commissioner with ample regulative authority to deal

with problems analogous to the problem presented

-. 7

‘ ar

here. H. Rep. No, 1098,.84th Cong., 1st Seas, p. 7;

8. Rep. No, 1571, 84th Cong., 2d Sess, .p. 8. .- -

- The fact that respondents did not deal with Securi-

ty Life as they would have dealt with an independent

insurer is, we sitbmit, dispositive of this case. . The

court below thought otherwise. It concluded that the

_ ‘Commissioner was without power to allocate any part

of the commissions: or reinsurance premiums to re-

_ Spondents because they did not receive them (R. 188,

190-191) or earn them (R. 190-191), but only gener- :

ated the business or income (R. 189-191). The court

also held that since respondents did not physically

receive“comfhissioris (other than as.a conduit) when

they dealt with “unrelated insurers, they would ‘not °

have realized taxable income even in uncontrolled

dealings, and, thereforé, the Commissioner could not.

allocate commissions to them when. they dealt with Se-

curity Life (R. 188, 191). Finally; the court accept-

~ ed respondents’ principal argument (Br. -in Opp:

11) that the Commiissioner’s allocation was unreason- 7

able because federal banking law prohibited them

from receiving commission income from credit life

_ insurance sales, dnd because they structured their ac-

tivities in such a manner as to comply with that law’

(R. 187-188; 190-191). We turn now to these as-

pects of the case. , 7 +

_ G. The Commissioner may allocate commission income —

to respondents even if they neither received nor.

__ “earned” such income ae ee ars aie

. In holding that respondents’ failure to receive com-

missions during the years in issue somehow disabled |

the Commissioner from allocating income to them,

the court apt misinterpreted’ ‘Section’ 482, Appli-

cation of that section is not dependent on the receipt:

of income. See Asiatic Petroleum Co. v. Commission-

er, 79 :F. 2d 284, 286 (C.A.,2), certiorari denied, 296

: “US. 645. On the contrary, an allocation of gross in- t

‘come thereunder presupposes that the income was

not received by the taxpayer which has so arranged

~~ its affairs as to divert the income to another.

_ Nor is the question whether respondents “earned”

- the income determinative under Section 482. .The. —

court of appeals’ conclusion to the contrary (R. 190-

' 191). mistakently substitutes fer the arm’s. length

standard applicable under Section 482 one test’ for

~ determining to. whom income is taxable under Section

61 of the Code (Appendix, ‘infra, p. 37). That section

provides, to the extent pertinent here, that “gross in- -

come means all income from whatever source de-

. rived, including * * * [c]ompensation for services, .

_* * * fees, commissions,-and similar items * * *.”

Subsumed thereunder are an’ amalgam of principles

forged -by this Court which hold that income is

taxed to the true earner thereof (Lucas. v. Earl,

: 281 U. S. 111), and that the exercise of power to dis-

. _ pose of income and procure the payment of it to an-

-. other is the equivalent, for federal tax purposes, of

the realization’ of income (Helvering v. Horst, 311

‘U.S. 112). It is true, as both the Tax Court and

Severith -Circuit recognized in Local Finance Corp.

v. Commisioner, supra, that application of the arm’s

length standard under Sectidn 482 may on occasion —

involve the same considerations arising in Section 61 .

abet

°” Bes “ie Rubin v. Commissioner, 429. F od

ay (6. A. 2); Bittker and Eustice, supra, Sec. 15.06.

But it does not follow that the two sections are iden- ©

. tical- in. seope or outlook,, for “concepts employed in

construing one section of a statute are not necessarily .

pertinent when /construing another with a disting-

'. ulshable background.” * Rohmer v. Commissioner,

158 F. 2d 61, 65 © A.-2), certiorari denied, 828 U. S.

862. |

If, as the c court below tinplied. Section 482 is mere-

ly a specific vehicle for applying Section 61 principles

to commonly controlled taxpayers, the provision is

superfluous, at least insofar as allocations of gross

- Income are concerned: Our. submission i is that Section

482 should not be so construed, and that, although it:

incorporates principles developed under Section 61,

it is broader in scope, and permits the Commissioner -

to reallocate income whenever related parties have not

° For this reason, be Commissioner alii predicates tax

deficiencies .on both Sections 61 and 482 and has done so in

' this case (R.. 163). While under the facts here we believe

that respondents “earned” the commissions, at this juncture

our reliance is solely on Section 482.

1° As the Third Circuit has explained (National Securities —

‘Corp. V. Commissioner, 137 Fed 600, 602, certiorari denied,

_ US: 794) > \

In every case in which the, section {[i.e., Sectinl 482] is.

applied its application will. “necessarily result in an ap-

parent conflict with the literal requirements of .some

other provision of the act. If this were not so Section —

- .* * * [482] would be wholly superfluous. We accordingly .

| | conclude that the application of Section * * * [482] may -

. not be denied because it appears to run afoul of the literal

'. provisions of * * * [other sections of the Code}; .

dealt with orie » sncthar as they. would have if £ they had

* been unrelated. Compare ‘Rubin. y. Commissioner;

a supra, with Mazwell Hardware Co. v. Commissioner, —

_ 843 F. 2d 718 (C.A. 9);’ see also Tannenwald, J.

- concurring in Locaf Finante Corp. _y. Commissioner,

” supra, 48 T.C. at-799.. For example, if employees of

' - Security Life had been stationed i in ndents’ vari-.

_ ous branches in order to sell life i insurance, an

allocation may well have been warranted, since, in an

. arm’s length arrangement, . an independent insurer

would have been required to pay a fee for the use. -

‘of respondents’ premises and the opportunity to con-

_duct its insurance business on ‘those premises.. There-

_ fore, the conclusion’ reached below (R. 190) that re-

spondents did not “earn” : commission income, and

| hence could not be taxed, because their services re-

quired minimal effort and negligible cost, cannot con-

-ceal the facts that it was they and no one else who ©

“rendered the ‘essential services, and that such serv-

ices would have commanded compensation. if ren-

dered to an unrelated party.” pee

Finally, the error in the court of appeals’ reason-

; ing is compounded by its assumption (RB. 189) that ~

[t]he position of the Commissioner in effect is that —

whoever generates income must include the amount —-

" thereof-in his gross income”, and its concomitant re- ©

jection of the allocation on the ground that (R. 191)

“[g]eneration of business is not enough to impose

federal income tax liability.” It is unclear precisely

what the court meant when it said that respondents

11 Similarly, “since the ‘Colaabiinabairs allocation" to 3

compensate respondents for selling and processing insurance, -

the fact that they had no underwriting risk, relied upon by the ,

A ould alae oeiagaues epatoge se

- % 7 :

only “generated” the income. - This is not simply a

case involving a diversiorr of a corporate opportunity

or the: mere channelling of profitable ‘business from .

| one corporation. to ansther. Respondents performed. —

all of the usual selling and’ processing services which

_ under credit life insurance industry practice entitle

. a lender to generous compensation. This, to the ex-

“tent that the decision below is premised on the as-. —.

sumption. that respondents only generated the income,” —

it. erroneously disposes of the Commissioner’s alloca-

. tion on the basis of a non-existent piste set of

facts.

The more fandaniesitel 1 enptiedd fallacy i in ‘the rea-

soning beloW lies in the court’s apparént view that

the Commissioner was imposing a. “[g]eneration of

income” standard (as opposed, presumably, to a who

“earnedthe income” standard) in determining wheth-

er té allocate: income under Section 482. In fact, he -. :

was imposing neither of these standards. The subtle

distinction | between earning and generating income

has been deemed critical only in the determination

of taxability under Section 61. A Section. 482 alloca-

- tion, on.the other hand, turns on. the’ entirely different

question whether. the income of related entities has

been distorted because they dealt with each other ona

‘non-arm’s ee basis.” . ene e-

32.-For this reason, the cent of aul caine (R. 189),

that generation of income differs from assignment of income ©

(see, @.g., Crowley v. Commissioner, 34 T.C. 338, 345), is

beside the point. Likewise beside the point. are cases like _

_ ‘Teschner v. Commissioner, 38 T. C. 1008, which hold, under

Section 61, that’generation of income does not give rise- to =

| taxable income to the generator. Similarly, the court’s qualms -_ .

(R. 190) ‘that acceptance of the Ceuneration of Pustness

D. The failure of respondents physically to ‘receive

commissions when dealing with unrelated insurers.

is no bar to the Commissioner’s allocation. 3

"- Respondents conterid (Br. in Opp. 10-12) and the

. court below held (R, 188, 191) that since they did not

physically receive commissions in arm’s length trans-

actions with unrelated insurers prior to April, ‘1954

.—other than‘as a conduit—they did not realize taxa-

* ble income from the prior transactions. On the basis

of this premise, respondents argue. that because they

had rio commission income in dealings with unrelated.

insurers, the Commissioner is powerless to allocate

commission income to them resulting from their deal- —

= ings with Security Life.

This.argument is incorrect because’ the premise on

which it rests is incorrect. It is true that pre-April,

1954 commissions were paid to Smith, another Hold-

ing Company subsidiary. But the fact that they were r ©

paid to Smith, rather than to respondents—even

though respondents solicited the: insurance business —

and Smith had nothing to do with it—demonstrates .

that although respondents dealt with. the unrelated

- insurers on. an arm’s length basis they did not deal

: similarly with Smith. For this reason, an allocation

of. commissions from Smith to respondents would

_ have been perinissible under Section 482 or its pred-

~ ecessor, if Smith had included the commissions in its

income. Smith did not do so, however~the commis-

heey” will have. “alarming consequences on ‘pommel com-

- mercial practices such as all types of referral business and

* gecurity commission giveups” are unfounded. Section 482

does not apply to normal commercial transactions between.

unrelated entities, but only to abnormal transactions between |

—— controlled _— |

: sons were reported income by Manageinent Com

pany.”

years,then, far from advancing their case, highlights

Holding Company’s power to designate which of its -

_ subsidiaries would receive commissions and which

would report them for tax purposes. It also emphas-

izes the need for a Section 482 allocation to prevent ~

the arbitrary shifting: of incomé among controlled |

| corporate entities. It manifestly does not establish

” the arm’s length standard by which respondents’ deal-

ings with Security Life are to be judged. ~ igs

Moreover, if the arm’s length standard ‘is to be de-

- termined by reference to receipt and non-receipt in

’ the earlier years, as respondents apparently claim,

the bizarre and untenable conclusion is that the Com-

. * missioner may allocate the income in question only to ©

Smith, despite. the fact that it had © no substentive

. connection with either the earlie or later transac-

tions. Even this argument is not open to respondents,

however, for. the reporting practices of the Holding’

Company affiliated group show that it at no time has

‘ considered the fact of receipt as the touchstone of

taxability. we

| ‘ rhe

18 The Commissioner’s failure in the earlier years to allocate

commissions from Management Company to respondents is,

, of course, no bar to 4 correct determination for the years here

The fact of respondent’ nn dacoke in the earlier oe

~ in isste (see Travis v. Commissioner, 406 F. 2d 987,990 (C.A.\. . :

- 6); Massaglia'v. Commissioner, 286 F. 2d 258, 262 (C.A. 10); .

cf. Automobile Club of Michigan v. Commissioner, 353 U.S.

180), particularly since the total tax liability of the Holding .

Company affiliated group would, ‘in those years, have been the. -

same whether or not an allocation was made. ‘ees

| ‘38.

£1 a “ . The apparent prohibitions of federal basking law

1 Vey guage "on respondents’ receipt of income from the sale of

f insurance do not Bt tan the —

gps 1. Federal banking Laue i

f Sections 5202 and 5239 of the Revised Statutes pro-

vide that a national bank may act as ‘an insurance -

agent in any place “the population of which does not -

exceed five thousand inhabitants * * *” and appar-

_ ently prohibit national banks, ‘under threat of crim-

. inal sanctions, from acting as insurance “agents in. -

places having a population of more than 5,000, Re-

spondents do not interpret these \statutes as prohib-

\ . iting them from offering life insu

nk try-wide premium rate (which

. \ commission factor), or from. perfo

\, Spondents’ read. the statutes as

from receiving the commission’ income ‘and reporting

iton their income tax seers Because of these, pro- °

16 There be been some , qeestion whether Section 5202 of 2

‘the Revised Statutes remains in force. Because the provision

.. was omitted from the 1918 ameridment and reenactment of

ae Section 5202-of the Revised Statutes by Section-20 of the ~

i War Finance Corporation Act, c. 45, 40 Stat. 506, 512, thé

revisers of the United States Code have omitted. it from

' editioris of the Code, subsequent to the 1946 edition, on the

theory that it was, repealed in 1918. The implicit statutory. -

proscription is, however, incorporated in.the Comptroller of .

_ the Currency’s current Regulations as 12 C.F.R. 2.1-2.5. It |

~ * is also not entirely settled whether respondents’ interpretation

of the prohibition is correct. In 1963, the Comptroller of the —

_ Currency held (R. 187; Ex. AV) that a national bank in a

_ with a pepulation pete eer 5,000 —_ receive income

Stain

| | VO ry |

hibitions on physical receipt, respondents contend °

(Br. in Opp. 11, n. 6) that they remained aloof from

any “entitlement” to insurance-related income,. and Be

(Br. in Opp. 12) that the Commissioner, by his gllo-

cation, is forcing them to “violate a law” which they

“have in good faith been attempting to respect, —

We accept ‘respondents’ representation that their

' understanding of federal banking law prompted them -

to structure their affairs so as to remain aloof from

the receipt of insurance-related income, Acceptance of

their argument that they may not be taxed, however,

would accord tax reality to formalistic arrangements |

which taxpayers devise only to comply with federal —

or state law requirements based on policy considera-

_ tions wholly unrelated to: Section 482. We submit a

‘that even if the arrangements adopted by respond-

ents were réquired to, and did, satisfy the: federal

banking law, the question under Section 482. remains

whether—applying the standard of arm’s length bar-.

_ gaining—respondents’ income was clearly reflected.

during the years when they rendered selling and proc"

essing services for Security Life. The ‘answer to. this

question turns on federal tax law, not on federal bank-

” ‘ing law, and’under the former, illegal gains, like legal

gains, are os received or not, Compare

° - oArpy P

from selling credit. life insurance if such income was closely

lated to the bank’s normal lending activities. See 12, U.S.C.

(Seventh). The Fourth and Fifth Circuits,. construing the

’ law in other contexts, subsequently indicated otherwise (see

Commissioner v. Morris Trust, 367 F. 2d 794 (C.A. 4); Saxon

Vv. Georgia Ass’n of Independent Ins. Agents, Inc., 399 F2d ~~

1010 (C.A. 5)), and the court below apparently followed their

decisions (R. 187). " ipa eee oS vine

~ ple

e...

7 Ve substance from ‘the argument, rejected long ago by ae 7

. eet

Bee sav

: ‘ =x | oe

es” ‘v. United States, 366 ‘US. 213, with Bailey v.°

, 352 F, 2d 221 (C.A. 8), wa ea denied,

2 “8898.1 012. ac

=z “The Commissioner may allocate’ es to ue

/- federal banking law | ,

Respondents concede (Br. in 2 Opp: 11) ‘that deere) :

“or state. prohibitions on: the receipt of income, do not...

rbtads the: taxation of illegal i income if it is received.

_. They argue. that since. the existence of the federal

banking law caused them consistently and in. good —

‘faith to “remain removed from’‘any entitlement to

"commission income, they would not have ‘received such —

income even in. dealings with unrélated insurers, and,

. iy fact, did’ not recéive commissions prior ‘to April,

“1954. We have already shown (pp. 21-22, 26-27, su-

pra) that the fact of non-receipt i in the earlier, as well

a ‘as. the. later, years is no bar to the Commissioner’s: al-

~ location, Respondents’ attempt to use their alleged :

- -eompliance wie. the law ‘as a shield against applica- .

"tion of the arm’s length standard is no. different in

this Court; that! a taxpayer may: not be taxed on in- |

come which he cannot legally claim as his own. See _

_ Lucas v. Earl, eipra; see also J James v. United States,

_ supra.

issions,. they unquestionably rendered the serv-

fees for weet commissions were e paid, and their deal-

20 F . 24 777 (CA. 5), and Geiger’s Estate v. Se

A a : ies “even though they structured. their See §

ee ee ae affairs . to comply with ‘their ee of

. Even though respondente-n never Suieieatiy sibel are

yeas ae :

ings with ehaaetg. Life were significantly different

_ from ‘their’ prior dealings: with independent insurers. _

Clearly, respondents would not (and did not, prior to . e

April, 1954). allow an independent insurer to retain

that portion of the premiums representing a built-in

ee allowance for commissions. The only reason that.the -

-arrangement with Security: Life was countenanced | by

respondents was. ‘because the companies were under. nee

common control..To hold the Commisioner’ powerless .

. to apply Section 482 under these circumstances mere-

. becailsea commonly controlled group has been able —

to. divert income in supposed compliance with federal —

or state law would velaoonicees the: —— of the — :

ute. 16

? 3. ‘The allocation * not force. respondents to. ,

* piolate the banking law n |

Respondents also maintain (Br. in Opp. 12) that °

- the Commissioner’s allocation is unreasonable because

it forces them to violate ‘a law which they have been.

attempting to respect. ‘Tf. respondents have violated s

the banking law, however, it is their own ‘actions,

not the Commissioner’ s allocation, which. would trig-

ger the indictment. The Commissioner has never r forced :

18 3 Respondents likewise anata escape a eliecatinn because ~

_. their dealings with Security Life did not involve tax-avoidance

‘motives. The grant of power to the Comniissioner to allocate

under Section 482 is in the disjunctive and either:a tax-avoid-

ance motive or a failure. to reflect clearly the inconge of the —

controlled organizations will support an application) of the

statute. Asiatic Petroleum Co. v. Commissioner, supra; Eli -

Lilly and Co. Vv. United States, supra; Philipp Brothers Chem-

icals, Inc. (N.Y.) V. Commissioner, 435 F. 2d 58°/(C.A. 2);

Ditlard-Waltermére Inc. Vv. = 255° F. 2d 483; 436. (Ge

5).

82 ee

~ respondents to.engage in selling and processing activi-

ties akin to those of an insurance agent, but only to

reflect their i income clearly. In any event, respondents

- could have avoided’ both | their federal banking law

problems and their federal tax dilemma simply by

offering cre@jt life insurance to their borrowers at a

. lower rate, which did not include the built-in commis- .

sion factor common in the industry. Security Life .

still could have realized the standard underwriting

- profit, and respondents, would have fostered their ex-

_ pressed goal: (R. 166) of obtaining the benefits: of.ad-

. ditional collateral which credit insurance provided. _

Indeed, by charging a lower rate, respondents might —

well have attracted more loan customers and thereby |

increased their profits. — +

Respondents rely heavily (Br. in Cen: 12-18) on

line of authorities. presumably standing for the prop-

osition that good faith efforts by the taxpayer to.com- |

_ ply with the law must be recognized. and sustained.

"None of these authorities enunciates the broad propo- .

sition that good faith efforts to comply with the law ~

preclude the applicatiofi of Section 482. Many of _

them are inapposite because they involve the particu- —

- larized fact question whether a controlling share-

-. holder-officer was ‘selling insurance on behalf of .

his corporation or in his capacity as a separate

3 insurance agent.” Others do not involve Section

16 E.g., Moke Buatein, Tnce..V. Cikeniosienie, 29 T.C: 1005;

Ray Waits Motors v. United States, 145 F. Supp. 269. (E.D. *

S.C.); and Jaeger Motor Car Co. v. Commissioner, 284-F. 2d

127 (C.A. 7),. certiorari denied, 365-U.S. 860, each involved

— that the efforts of an individual officer —— the a

. ‘

ae rae RAK ; OS as : doe

e, : ;

482. “id Although Campbell Gis State Bank, Ine. v.

“Commissioner, 34 T.C. 480, reversed on other. pees 3

811 F. 2d 874 (C.A, 8); refers to, a state law prohib-

| iting: banks from engaging in the insurance business,

_the law was regarded as relevant only to show some

business purpose (other than the saving of taxes) .

for the formation of a separate taxable entity to sell .

insurance. The law.was not construed to preclude ap-

plication of Section 482. . :

L. E. Shunk Latex Products, Inc. v. Commissioner, -

18 T.C.:940, does not stand for the proposition that

the legal right to receive income is a necessary pre-

. requisite to the application of Section 482. In Shunk, .

the Tax Court held that an allocation was unreason-

able because the price charged by the taxpayer to its

controlled distributor was fixed by Office of Price Ad-

ministration limits. The pivotal fact there was that

the taxpayer could not have raised its price even to

an uncontrolled distributor; the 0.P.A: price levels

established a. de jure arm’s length price such that even

_ jn uncontrolled dealing, the taxpayer would have been

forced to forego the economic. benefit attributed by

the Commissioner. Here, on the other hand, respond-. :

ents’ own interpretation. of federal _ banking | law

(which-we accept — made it possible to per-

finding that he, nate’ than his controlled @eporativn, ‘had

earned commission income. Here, it cannot seriously be con-.

tended that respondents did not expend the necessary effort

to become entitled to the portion of credit life indarence

premiums representing commissions.

Re, Nichols Loan Corp. v. Commissioner, 21 'T.C.M. 805,

_. reversed on other. ~— 321 F. 2d 905 (C.A. ™ a ei

form insurance-selling services and divert their com-

_ pensation to Security Life, and as their experience -

_ in prior years demonstrates, they would not have for- — |

‘feited the economic benefit of commission income had

Security Life been an unrelated insurer. _

ae In sum, none of the foregoing cases, erroneously a

. characterized by the court below (R.. 190) as “indis-

__ tinguishable” from “the standpoint of principle”; sup-

ports setting aside the Commissioner’s Section 482° al-

. . Iecation, either on the ground that federal banking

law prohibited respondents from receiving commis-

sion income or on: any other ground. The Commis-

- sioner’s determination here was based on the plain

and simple fact that respondents and Security Life,

by: failing to deal. at arm’ 's length, were able to shift

‘income properly attributable to respondents. -The al-

location was therefore appropriate “to prevent evasion .

of taxes” and “clearly to reflect the income” of both

respondents and Security Life.. Under. these circum- »

law nor the fact that. respondents structured their

affairs to circumvent that law can ‘justify abandon- -

ing the arm’s length standard and repenting the

allocation. |

4 ;

’ 85

CON CLUSION

For the reasons stated, the judgments of the, court |

Respectfully submitted.

'-NovEMBER. 1971.

. of appeals should be reversed.

‘ERwin Ny Griswom, --

Soli General.

. FRED B..UGast,

Acting Assistant: Attorney Genera

MATTHEW J. ZINN,

- Agsistant to the Solicitor General.

BENNET N. ‘HOLLANDER, :

STEPHEN. SCHWARZ, hee ies 2

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- Internal Revenue Code of 1954 (26U.S.C.): 0. =

_ SEC. 61. Gross INCoME DEFINED. Se ae

x* _ provided -in this subtitle, gross income means all . .

income from whatever source derived, includir

. (but not limited te) the following items: E

_ (1) Compensation for services, including fees, _

- commissions, and similar items; Bag

s | eae * ee | .

SEc. 482, ALLOCATION oF INCOME AND DEbuc-

TIONS AMONG TAXPAYERS. | fis :

In any case of two or more organizations, |

trades, or businesses (whether or: not, incorpo-

States, and whether or not affiliated) owned or

controlled directly or indirectly by the same in-

terests, the Secretary or his delegate may dis-

tribute, apportion, or allocate gross income, de-

: ‘ductions, credits, or allowances between or among

~ -- gueh organizations, trades; or businesses, if he

__, determines that such distribution, apportionment,

or allocation is necessary in order to prevent eva-

3 ‘any such organizations, trades, or businesses.

_ Treasury Regulations on Income Tax (26 CFR): |

a ‘Sec. 1.482-1. “Allocation of income and deductions —

"| among taxpayers. Pee nl ee

. (a) Definitions. When. used in this ‘section

Me OM Ber Be iO AY Gas ii ete a. oe ee

AGE Been woe

eee

(a) General Definition. Except as otherwise __

A rated, whether or not organized in the United .

sion of taxes or clearly to reflect the income of

(6). ‘The term true aes income” means, in -

. come (or, as the case may be, any item or, ele-

_-ment 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, transaction; arrange-

ment, or other act) dealt with the other member

-. or members of the group at arm’s length. It does

not mean the income, the deductions, the credits,

the allowances, or the item or element of income,

deductions, credits, or allowances, resulting to

the controlled taxpayer by reason of the particu-

lar’ contract, transaction, or ‘arrangement, the

—-eontrolled taxpayer, or. the interests controlling .

it, chose to make (even though such contract, .

transaction, or arrangement be legally binding

upon the parties thereto). |

(b) Scope and purpose.—

(1) The purpose of section 482 is ay ate a

. _ gontrolled ‘taxpayer on a tax parity with an un-

controlled taxpayer, by determining, according

to the standard of an uncontrolled taxpayer, the |

/ true taxable income from the property and busi-.

ness of a controlled taxpayer. ‘The interests con- . -

i trofing a group of controlled taxpayers are as-

sumed to have complete power to cause each con- —

trolled taxpayer so to conduct its affairs that its

__ transactions and accounting records truly: reflect

ness of each of the controlled taxpayers. If, how-

ever, this has not been done, and the taxable in-

eomes are thereby understated, the district di-' -

- rector shall intervene, and, by making such dis-

a tributions, apportionments, or allocations as he ~

Pes me deem — of gross income, deductions, ee

as - credits, wk seniinidies el ak tot elon

: 7 affecting taxable. income, between or among the —

e ‘» controlled taxpayers a the group, shall

'- @etermine the true taxable income of each con-

‘trolled taxpayer. The standard to be -applied in

every case is that of an uncontrolled taxpayer :

dealing at arm’s length with another uncontrolled

Be ise A He ; io

° * * * = ,

oe contvolled taxpayer and another will be-subjected

, to special scrutiny to ascertain whether the com-

mon control is being used to reduce, avoid, or 2

escape faxes. In determining the true ‘taxable in-"

come of,a controlled taxpayer, the district di- | :

rector is not restricted to the case of improper‘ ° °.

accounting, to the case of a fraudulent, colorable, ~

or sham transaction, or to the case of.a device.

designed to reduce or avoid tax by. shifting or

_. distorting income, deductions, credits, or allow- .

ae ances. . The authority to determine true taxable |

: ee . ineome extends to any case in which either by in- °

a i . advertence or design the taxable i income, in whole

- or in part, of a controlled taxpayer, is other than

_ it weuld have been had.the taxpayer inthe con-_

‘duct.of his affairs been an uncontrolled taxpayer

dealing at arm’s length with other uncontrolled _

taxpayer..

oa *-.9 ae

Revised Statutes:

a ‘Sec. 5202 [as Saiendid by Section 1, Act of Sep- ‘

a _tember 7, 1916, . 461, 39 Stat. 752). * *°*

= * * *

ue That i in. addition to the piers sic asain ee

iow in national raped associations ee

| under the ees of: the - United States any such

association located and* doing business in. any

place the population of which does not exceed five-

thousand inhabitants, as shown by the last. pre-

_. eeding decennial census, may,. under such rules

and regulations as may be prescribed by the’

Comptrolle of the Currency, ac the agent .

fer any , life,*or other insurance company -

authorized by the authorities of the State in

-which. said bank is located to do business in said.

_ State, by soliciting and selling insurance and col-

| lecting premiums on. policies issued by such com-

pany; and imay receive. for services so réndered

such fees or commissions as may. be agreed upon .

between the said association and .the insurance: ..

‘company for which it may act as agent; and may

also act as thé broker or agent for others in

_ making or procuring loans on real estate located

within one hundred miles of the place i in which

said bank may be located, receiving for such

~ gervices a reasonable fee or commission: Pro--

_ wided, however, That no such bank shall in any

case guarantee either the principal or interest of

_ any such loans or assume or guarantee the pay-

_ ment of any: premium—on insurance policies is- |

_ sued through its agency by its principal: And.

provided further, Jhat the: bank shall not. guar-

antee the truth of any statement made by an |

assured in filing his application for insurance. —

| [12 USC. (1946 ed) 92.)

: SEC. 5239,

: ‘Tf the ‘directors of; any. national bichon:

_ sociation shall knowingly. violate, or knowingly

permit any of the officers, agents, or servants of -

= association to violate any of the seam

of this Title all the rights, ceive ant feaind.

chises of the association shall be thereby forfeit- e

. ‘ed, Such violation shall, however, be determined BN

‘» . and adjudged by a. proper district or Terri- - - §

”” torial court of the United States in asuit brought |

for that purpose. by the Comptroller of the Cur-

‘rency, in his own name, before the association -

shall be declared dissolved. “And i in cases of such

._ violation, every director who’ participated in or

assented to the same shall be held liable in his

:. personal and individual capacity for all dam-

ages which the association, its shareholders, or

- .. any other person, shall have sustained in conse- -

a quence of such violation. |

[12 U.S.C, 93.]

ee 8. §. COVERNMENT PRINTING OFFICE; 1971 ee

; i jue

oceania

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iad RARY

Bo ‘supa: osu, w. |

be a

IN THE SUPREME COURT

OF hae UNITED STATES |

OCTOBER ‘TERM, 1971.

] . Qupreme Court, ‘ S.

F I LE

P—

oe $ ‘ es

: : SE

- COMMISSIONER 04 INTERNAL REVENUE, ‘PETITIONER ,

‘FIRSH SECURITY RANK OF UTAH, NA, ‘ET AL

r \

ON WRIT OF CERTIORARI To THE | ‘UNITED STATES

Bacecan. OF ih sauir ge — THE are CIRCUIT

Bere Soe BRIEF ON BEBALY OF a Ble

". .-* BUD KOUTS CHEVROLET COMPANY,

WESLEY H. KOUTS AND MARGARET E. KOUTS, HIS WIFE

| AS AMICUS CURIAE — ,

_IN SUPPORT OF RESPONDENTS

- + 800 mint! National Building

Beg et: pe ae - Detroit, Michigan 48226.

Beg . .. ., Attorney for Amicus Curiae -

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.