Union Planters
National Bank of Memphis v. United States (1970)
Union Planters National Bank of
Memphis, Plaintiff-Appellee
v. United States of America,
Defendant-Appellant
No. 19409
UNITED STATES COURT OF APPEALS FOR
THE SIXTH CIRCUIT
426 F.2d 115; 70-1 U.S. Tax Cas. (CCH)
P9372; 25 A.F.T.R.2d (RIA) 1104
May 4, 1970
SUBSEQUENT HISTORY:
Certiorari Denied, October 12, 1970, Reported at: 400
U.S. 827.
CORE TERMS: dealer, bond, repurchase, coupon interest,
municipal bonds, characterization, decisive, federal income tax, coupon,
customer, borrower, taxation, exempt, paying, tax liability, property law,
collected, disclose, binding, labels, interest income, interest paid, tax
exempt,
sales-repurchases, insolvent, increment, wealth,
lender, margin
JUDGES: Celebrezze, McCree, and Combs, Circuit Judges.
OPINIONBY: McCREE
OPINION: McCREE, Circuit Judge.
This appeal presents the question whether coupon
interest collected by a bank as owner of municipal bonds subject to
repurchase agreements is exempt from taxation under @ 103(a) of the
Internal Revenue Code. We hold that under the circumstances of this case
it is not, and accordingly we reverse the decision of the District Court,
295 F. Supp. 1151 (W.D. Tenn. 1968). Since 1938 or 1939, appellant Bank
has purchased municipal bonds n1 from local bond dealers, subject to
agreements permitting the Bank to require repurchase by the dealer at any
time at the price paid by the Bank. The evidence does not disclose an
instance when the Bank invoked this provision. Rather, as the District
Judge found, "it was the intent and practice that the bonds be
re-acquired by the dealer upon the dealer's request ...." 295 F.
Supp. at 1152. The dealer usually repurchased the bonds when he had found
a customer for them. The Bank invariably resold to the dealer at the same
price it had paid him (this price was either the dealer's cost or a lower
figure), and the dealer's repurchase at this price protected the Bank from
experiencing any loss on the transaction.
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n1 The term "municipal bonds" is used in
this opinion to include those bonds and obligations issued by states,
municipalities, and other local governmental units, which qualify for the
exemption granted by @ 103(a).
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During the period in which the Bank held the bonds, it
would clip bond coupons as they matured and collect and retain the
interest. On repurchase by a dealer, the Bank would be credited with the
pro rata interest accruing from the last coupon redemption date until the
date of repurchase. The tax treatment of coupon interest realized by the
Bank in this manner in the years 1961-64 is the subject of this appeal.
The Bank claims that since it was the owner of the
bonds and the coupons, the interest income from them should be exempt from
taxation under @ 103(a). The Government, on the other hand, insists that
each transaction between the Bank and the dealers was in reality a loan
secured by what was in effect a pledge of the bonds. Thus, the coupon
interest belonged to the dealers and, when they permitted the Bank to keep
it, they were paying the Bank what was in effect ordinary interest on the
loan, which is income not exempt from taxation under @ 103(a). Viewed in
this context, the Government argues, the transactions constitute an
attempt to avoid the effect of @ 265(2) of the Internal Revenue Code. This
provision disallows deductions of interest paid on loans the proceeds of
which are used to buy municipal bonds. Its obvious purpose is to deny the
recipient of tax exempt income the further tax benefit of deducting the
cost of money employed to purchase the securities which produce it.
Accordingly, if the dealer had borrowed the money to purchase the bonds,
the coupon interest would be tax-free to him, but he would not be able to
deduct the interest paid to the Bank for the loan; and the Bank, of
course, would be taxed fully on the income represented by that interest.
But if the transactions are characterized as sales-repurchases, the
Government contends, the Bank will avoid paying tax on the coupon
interest, which in economic effect is equivalent to interest paid for the
use of its money, and the dealer will have obtained the funds to purchase
the bonds without paying interest. Thus, if the parties' characterization
of these transactions is accepted as decisive for federal income tax
purposes, they would be able to enjoy the benefit of the double tax
advantage which Congress intended to prevent.
The form of these transactions tends to support the
Bank's arguments. And the Government does not dispute the fact that the
Bank held title to the bonds in a property law sense. Moreover, the Bank
did not list these transactions on its books as "loans" except
when required to do so by the Comptroller of the Currency from 1957 to
1964. n2
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n2 Although not listed as loans during 1938-57 and
1964-70, nevertheless they were not carried on the Bank's books in the
same category as bonds purchased for investment, which were of course not
subject to the kind of repurchase agreements we are concerned with here.
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However, other facts found by the District Court
support the Government's position. The bond dealers would list these bonds
for sale in trade publications in the same manner as bonds to which they
held legal title. When a dealer found a customer for the bonds, he would
repurchase them from the Bank which never refused to resell although,
under the written repurchase agreements, it was not bound to do so. The
District Judge found that it was understood between the parties that the
Bank would always consent to such repurchases. Most important, the Bank
was protected under the repurchase agreements from suffering any loss, and
its gain was limited to the amount of coupon interest accruing during the
time it held the bonds. n3 In some cases, when the market price of the
bonds was falling, the Bank required the dealer to pay, in advance of
repurchase, money sufficient to protect it in the declining market.
Obviously this practice served the same purpose as the requirement of the
posting of additional margin by a borrower whose security is decreasing in
value. It is clearly more consistent with the characterization of these
transactions as loans than as sales.
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n3 On three occasions when the dealer refused to
repurchase on demand by the Bank, the Bank sold the bonds to a third party
and kept the resulting profit. The record does not disclose the details of
these transactions, except that in one case the dealer was "probably
insolvent". We would assume that all three dealers in question were
insolvent or defunct; otherwise why would they refuse to repurchase when a
profit was apparently guaranteed? In any event, these isolated incidents
do not alter our opinion about the substance of the many dozens of these
transactions.
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The District Court, in ruling for the Bank, held that
"the determination of this case requires an inquiry into the intent
of the parties." 295 F. Supp. at 1152. We do not agree that
subjective intent is decisive here. The intent of the parties may be
important in determining just what their contractual relations inter sese
were, but there is little dispute here about what obligations and rights
the parties expected their agreement to confer. This case hinges, rather,
on the legal characterization, for federal income tax purposes, of the
transactions between the parties. That characterization is not a question
of fact, but rather one of law. Cf. Cordovan Associates, Inc. v. Dayton
Rubber Co., 290 F.2d 858 (6th Cir. 1961). Accordingly, we are not bound by
the District Court's conclusion that the Bank should be treated as the
owner of the bonds for federal income tax purposes. n4
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n4 The intent which the District Court found binding
was apparently the bank's intent to adopt the form of sale and repurchase,
rather than that of a secured loan. It should come as no surprise that
taxpayer wished to characterize the transactions in this way, because it
results in minimum tax liability, and does not give any of the parties any
economic rights which they would not have had if the transactions had been
characterized as loans. If this kind of intent is to be decisive, then, as
the Government argues, any taxpayer could "determine its own tax
liability by choosing the names which its arrangement should be called
when those labels will affect nothing but its tax liability." Cf.
Burnet v. Harmel, 287 U.S. 103, 110, 77 L. Ed. 199, 53 S. Ct. 74 (1932).
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We are not here concerned with an area of the law
where intent determines whether or not an increment of wealth is to be
deemed income, as was the case in Commissioner of Internal Revenue v.
Duberstein, 363 U.S. 278, 4 L. Ed. 2d 1218, 80 S. Ct. 1190 (1960), where
the presence or absence of a subjective state of mind, donative intent,
was declared to be decisive. Here the question is not whether or not an
increment of wealth is income (for it clearly is), but whether it is
income from interest paid by a borrower, or tax exempt interest income
from municipal bonds.
In cases where the legal characterization of economic
facts is decisive, the principle is well established that the tax
consequences should be determined by the economic substance of the
transaction, not the labels put on it for property law (or tax avoidance)
purposes. E.g., Commissioner of Internal Revenue v. P.G. Lake, Inc., 356
U.S. 260, 266-67, 2 L. Ed. 2d 743, 78 S. Ct. 691 (1958); Gregory v.
Helvering, 293 U.S. 465, 79 L. Ed. 596, 55 S. Ct. 266 (1935). "In the
field of taxation, administrators of the laws, and the courts, are
concerned with substance and realities, and formal written documents are
not rigidly binding." Helvering v. F. & R. Lazarus & Co., 308
U.S. 252, 255, 84 L. Ed. 226, 60 S. Ct. 209 (1939).
Here it is clear that the coupon interest functioned
as the interest collected on a loan, however the parties may have
characterized the transactions on their books. Like any secured lender,
the Bank took great pains to insure itself against any loss of principal,
even to the extent of requiring margin payments (which took the paper form
of advances on the repurchasing price). And like any borrower on security,
the dealer was obliged to pay only the amount of the principal in order to
extinguish his obligation, besides having to forego the gains he would
otherwise have made through the maturing of interest coupons. In contrast,
in a transaction that would be characterized as a sale for tax purposes,
we would expect the Bank, rather than the dealer, to assume the risk of
fluctuations in the market value of the bonds.
The Fifth Circuit has recently ruled for the
Government in a substantially identical case. American National Bank of
Austin v. United States, 421 F.2d 442 (1970). We think that the
Government's case here is, on balance, stronger than in the Bank of Austin
case. Here, there were written repurchase agreements under which the Bank
could oblige the dealer to repurchase at any time at a price which would
guarantee the Bank against any loss; in Austin, the dealers had only an
unwritten option to repurchase, and there was no written contract as there
was here. Other differences between the operations of the Austin and
Memphis banks n5 we deem immaterial.
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n5 Apparently the Austin bank usually conveyed bonds
directly to customers of the dealers. The Memphis bank, with a few
exceptions, consistently observed the formalities of sale and repurchase.
Of course such adherence is not dispositive in tax cases when the real
question is the economic substance of the
transaction.
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We hold, for the reasons found persuasive by the Fifth
Circuit in Judge Ainsworth's opinion, that these transactions, although
characterized as sales-repurchases by the parties, will be regarded as
secured loans for federal income tax purposes, and that accordingly, the
Bank, as economic lender, cannot exclude the bond interest from its
taxable income. The judgment of the District Court is reversed, and the
case is remanded for entry of judgment and other proceedings not
inconsistent with this opinion.
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